The Greek government experiencing problems to control its public debt is not a new message. Greece spent more than half the years in default since it was liberated from the Ottoman Empire in 1832 (Nelson, et al., 2011). The high initial debt level Greece shows is rooted in the past. During the eighties they faced a foregoing debt explosion. Alogoskoufis (2012) claims this expolosion was due to 3 reasons. First, there were the high primary deficits which caused financial destabilization. Second, Greek debt boomed in the eighties because of a pullback in economic growth. At last, during that decade the socialist governments caused primary government deficits by conducting an expansionary fiscal policy. This paper is not aimed to comment on whether policies could have foreseen such a crisis. However, subsequently several macroeconomic fundamental shall be reported to prove the Greek situation was neither sustainable nor healthy.
The time span for these fundamentals ranges from 2000 up and to 2009. A sufficient span to capture a vivid picture of how things evolved preceding the crisis. The data comes from Eurostat and is reported for the PIIGS countries, Germany and Belgium.
Government gross debt to GDP ratio
First, table 1 reports the general government gross debt to GDP ratio. The ratio is a valid determinant to evaluate a country’s creditworthiness. It is not difficult to take note of the government debt stacking trend in Greece. Throughout the 10 years preceding the crisis, the ratio raised by 21.8 percentage points. Besides, not only the growth of the debt is disturbing, there’s also the relatively high initial debt level in 2000. Nonetheless, Greece continued to stack up its debt to proportions unseen in the EU.
Though Belgium and Italy started off at a similar debt level, they succeeded to control their debt level until 2007, ignoring the growth explosion in 2008 and 2009. Furthermore Ireland and Spain report strong budget positions, out of the fast growth pace starting in 2008. However, as Klitgaard & Higgins (2011) point out, these strong positions are misleading as both countries had massive real estate bubbles and credit-fueled construction booms going on. They would face dramatic losses in tax revenues as the bubble would pop and booms would turn into busts. On the contrary Germany and Belgium showed a good budget discipline. The global financial crisis effect can be witnessed as from 2007 none of the listed countries succeeded in lowering its ratio. At that time government had to support large institutions and banks to reduce the systemic risk. This required an enormous amount of liquidity support.
Beneficiary insight are achieved when the government debt to GDP ratio is split into its two components. Table 2 and 3 show figures for these components individually. The reason for splitting up this ratio is to avoid captious interpretations. When the general government gross debt to GDP ratio rises, it doesn’t necessarily imply that a country is taking on more debts. All it might say is that the GDP growth is shrinking causing the ratio to explode. Even when a country is diminishing its debts, an even stronger drop in the GDP growth can still cause the ratio to rise.
However, table 2 shows that once again Greece is setting a bad example. Greece stacked up debts throughout the decade preceding the crisis. The minor improvement in 2005 is negligible, as it is the only year in which Greece succeeded lowering its yearly debt level related to the prior one. In the same manner 2008 was the start of a general government gross debt explosion in all countries. It is important to keep in mind that figures are reported in millions of national currencies and as such absolute figures cannot be compared meaningfully to one another. However, they do show evolutions for each country individually.
The real GDP growth is equally important and is reported in table 3. To provide a meaningful comparison between countries the real GDP growth per capita is used. The reason for this is because the real GDP accounts for inflation. The figures show that up and to 2007, the major trend within Europe consisted of a growing GDP per capita. In 2008 a collapse of this growth was realized. The drop was significant and in 2009 none of the countries report a growth in its GDP per capita. This collapse had an amplifying effect on the rise in Greece’s government debt to GDP ratio. The stacking of debts together with an economy implosion had put Greece in dire financial straits.
Balance of the current account
A second meaningful macroeconomic fundamental is the balance of the current account, which is reported in table 3 as a percentage of a countries GDP. The current account balance shows to what extent a country saves or spends money, as the difference shows in which manner domestic saving and domestic spending differ. When a country’s government reports a negative current account balance, its domestic spending is on a higher level than its domestic savings. Countries with a surplus stack wealth accessible to other countries. In contract, countries with a deficit will require borrowing funds abroad to compensate for this deficit (Klitgaard & Higgins, 2011).
A swift glance at table 4 is sufficient to realize Greece outpaced the other countries in a negative manner. Besides Portugal, no countries even came close to the level of deficits reported by Greece. With a yearly average deficit of 9.81 percent Greece did not run a sustainable policy. The difference with Germany is significant. In 2007, Germany provided accessible wealth to foreign countries for no less than 7.4 percentage points of its GDP.
Inefficient spending policies, competitiveness and social impact
Without delay the spending purposes of Greece are discussed. The central question is whether Greece did succeed in using the accessible funds efficiently. As far as lending is considered, it should not be perceived in a negative way. Lending can be very fruitful for an economy given it is used under the right circumstances. Prechter (2012) defines these types of loans as “self-liquidating credit”. These are loans tied to a production purpose and paid back in a relatively short period from production. Engaging in these types of loans adds value to the economy. Because as the loan facilitates production, it makes the repayment possible for the debtor. Which is why engaging in these types of loans is fruitful.
On the other hand there are non-self liquidating loans, loans in which Greece engaged on a large scale. Non-self liquidating loans have no relation with production efforts. They do not add value to the economy, but costs. As such they are counter-productive and should be avoided when trying to conduct a sustainable policy. The repayment for these types of loans comes from money sources other than production and cause deterioration in the spending pattern of the debtor (Prechter, 2012).
Klitgaard & Higgins (2011) confirm that Greece did not allocate acquired funds efficiently. They were used to boost domestic consumption instead of desirable productivity bounded investments. Doing so Greece built up a debt burden on future revenues. Coupled with this argument, Nelson et al. (2011) claim that Greece prevented sustainable economic growth because of deeply rooted features of its society and economy. Among these features are the enormous public clientelism and tax evasion trends. Most compelling evidence is found in their expenditure purposes, as they had rising public sector wages and benefits as a purpose. This is explained by Greek politicians approaching these expenses as a boost for their electoral campaign. When the crisis erupted in 2009, 50% of the GDP consisted of government expenditures (Nelson, et al., 2011). Simultaneously problems were forming shape on the income side. In 2010, Greece was ranked as the most corrupt country in the EU, followed by Bulgaria and Romania (Nelson, et al., 2011).
A theory that gains popularity in these crisis times, is the one of John Maynard Keynes, the world renowned British conomist. The essence of his theory is found within the aggregate demand.
AD=C+I+G+NX
A country’s aggregate demand is defined as the sum of four components: consumption spending (C), investments (I), government spending (G) and the net exports (NX). It is the most dominant economic stimulant. Keynes justifies government policy interventions to achieve price stability and full employment. This is needed as Keynes states that free markets do not self-balance itself to a state of full employment (Jahan, et al., 2014).
During a recession, consumption and investments typically drop as a spending attitude is replaced by a more conservative one. To compensate for this decrease in aggregate demand, government intervention is required. State intervention flattens the economic cycles if applied correctly. Keynes is not judgmental about government deficits, in fact he encourages governments to do so in a countercyclical way. The government should compensate for the drop in private demand during recessions (Jahan, et al., 2014).
Although this theory is still respected, putting it to practice reveal certain flaws. As Greece lacked government discipline during better economical times, they did not succeed to stack up wealth accessible in the future. Instead they boosted aggregate demand and thus strenghtening the booms and busts.
On top of these questionable investment policies, is the matter of competitiveness. As a country is more competitive, its goods become cheaper and easier to export. And exports are an excellent way to reduce foreign borrowing by performing in external markets, doing so a country saves more than it consumes (Klitgaard & Higgins, 2011). However, this was a no go for Greece. As Klitgaard & Higgins (2011) examined unit labor costs to evaluate Greece’s competitiveness. They argue that this measure is valid as it combines three drivers of competitiveness: wages, labor productivity and the exchange rate. The outcome was negative. The only country that came out worse from 2005 up and to 2010 was Spain. Greece reported labor costs 15 percentage points higher than Germany.
Next, the social impact of the crisis on the Greek population is mirrored by the unemployment figures. In 2008 the unemployment rate was only 7.8 percent according to Eurostat. Table 5 shows that this unemployment boomed during the crisis reaching a level of no less than 27.5 percentage in 2013.
The GDP per capita in purchasing power standards (PPS) is shown in table 6. We capture the data during the crisis and added the EU average of 28 countries as an index average. The data is retrieved from Eurostat, and are defined as “the value of all goods and services produced less the value of any goods or services used in their creation”.
The three worst countries are found in the Euro area periphery. Bosnia and Herzegovina, Albania and Serbia reported scores of 29, 30 and 36 in 2015. This goes to show the huge imbalances compared to the Euro zone core countries. Germany reported a score nearly four times as high. During the crisis Greece’s GDP per capita in PPS plumetted to a level of 71 in 2015.
As a consequence negative social side-effects occurred. In the two years following the eruption of the crisis, suicides rose with 25 percentage points. A reduced health service acces was shown by an increase of 52 percentage points concerning HIV infections and the closure of certain health centers, caused by budget cuts. Another worrying fact was the “brain drain” that occurred, highly educated people were encouraged to work abroad, while high-schooled immigrants were less tempted to employ themselves in Greece (Reynolds, 2015).
Eurozone accession and the Greek unemployment
A brief clarification of the Greek accession to the EMU is in place. History shows that countries in the euro are periphery had to face much higher costs of capital compared to the core countries. These differences flattened out when periphery countries prepared themselves to join the monetary union. Interests rate fell and the financial markets judged that allocated funds would not be exposed to the depreciation risk (Klitgaard & Higgins, 2011). As Greece prepared itself during the nineties to implement the Euro as its currency, interest rates on its 10-year bonds plummeted (Nelson, et al., 2011).
Graph 1 shows the Greek 10-year bond yield compared to the German one which serves as a benchmark measure. These yields did not diverge significantly until the end of 2009. A consequence of the so called “convergence trading” hypothesis, which states that markets solely believed in an optimistic convergence scenario by the EMU economies. A belief that European nations would completely converge to the German example (Arghyrou & Kontonikas, 2011).
Financial markets still held on to this belief at the beginning of 2008. Spreads remained relatively small given the very differing fundamentals Greece and Germany reported. This implies that once markets would abandon the positive convergence hypothesis and start giving credence to a negative one, Greek bond yields would spark. Without a common currency area, Greece would never have had the possibility to obtain such low interests on borrowed funds. Investors would have reassessed the creditworthiness of Greece much sooner without the EMU safety net (Klitgaard & Higgins, 2011).
This vulnerability to shifts in investors’ confidence was a precarious situation. Once the confidence in Greece’s payback capacity faded away, foreign lending to Greece would stop abruptly as it would cause unaffordable interests for the Greek government. Greece would find itself in a vicious circle, and wouldn’t be able to rollover its debts. Strict austerity measures would appear to be the only way out, together with financial aid (Nelson, et al., 2011).
The global crisis that hit the world in 2008 cannot be omitted as it set stage for the Greek crisis. At that time loads of liquidity were provided to avoid a credit crunch, economical and financial important institutions were bailed out and protectionism was not a topic (Alogoskoufis, 2012).
EU responsibility
The crisis situation was mainly Greece’s responsibility, as they kept spending foreign wealth not offset with productive investments. The macroeconomical fundamentals that continuously worsened, bad competitiveness performances and spending purposes brought the population to a higher standard of living. This effect was temporarily and the Greek population would experience first-handed the repercussions as we have showed.
However, the European Union shared the blame to a certain extent. Ut infra we will address certain inadequacies of the policies conducted by the European Union. A first inadequacy consists of article 125 of the Lisbon treaty. An article that states ‘the union shall not be liable for or assume the commitments of central governments’. In short it means that the Union would not intervene or bail out a country when faced with severe financial problems. However, the markets never believed article 125. Later on the Union would violate this very article by approving financial support to Greece along with the IMF and the ECB.
A second inadequacy is found in the convergence criteria and the SGP imposed by the European Union. The convergence criteria were a set of policy criteria a country had to meet in order to join the Eurozone. These convergence criteria along with the GSP were aimed at reducing the fiscal differences between Eurozone states (Nelson, et al., 2011).
However, the Union did not succeed at enforcing the rules of the SGP, nor the ones of the convergence criteria. They did not prevent countries to accumulate public debt levels to contestable heights. The SGP and convergence criteria were theoretically a solid thought, but lacked efficiency in practice. Greece, along with other European member states, violated fiscal SGP rules. From 2003 onwards, the EU had more than thirty cases running against countries violating the fiscal rules. Even though they disposed of the authority to impose fines on member states violating these rules, they never sanctioned a member state for these violations (Nelson, et al., 2011).
Moreover, the convergence criteria were not applied equally with respect to the member countries. Greece was able to join the Euro zone while violating the GDP ceiling of the government deficit. Whether this is a failure of the European leaders or a structural failure of the criteria, depends on interpretation (Woods, 2014).
The impotency of the Union was shown once again in 2002 and 2003. During those years France and Germany ran large deficits. Given the rules of the SGP, those deficits would have been punished with Union sanctions. In addition commission countered these violations by taking the case to the European Court of Justice. However, the verdict was in favor of the national governments, and undermined the credibility of the rules imposed by the Union (Woods, 2014).
These matters show the lack of credibility of the European Union. Member states might be less tempted to meet criteria assuming they would not be punished if they failed to do so. Of course, Greece is the main culprit for its financial situation. But these Union shortcomings certainly contributed to the crisis situation at the end of 2009. Greece was able to use the Eurozones credibility to continue foreign borrowing while violating entry restrictions. Future research on the impact of government priorities and their self-interest within a bigger European Union might thus be instructive, but are not the focus of this review. The Greek irresponsible spending policies along with the European shortcomings, caused a forced intervention to avoid a Greek default.
Financial support
In May 2010 the Troika intervened for the first time in the Greek crisis tale. The Troika responded to Greece’s request for financial assistance grating loans for a total of 110 billion Euros (European Commission, 2010). As Greece found itself in a financial lockout, it had to replace its lost access to foreign borrowing with these aid packages. Greece had to respect the conditions implemented in the financial bailout agreement. In addition the government had to follow a programme with a sustainable fiscal policy and had to implement several structural reforms which would be monitored by the lending institutions (European Commission, 2010).
The Greek government respected the programme with a deep cut to public spending. In addition Greece tried to raise its tax revenues by tackling tax evasion problems and establish tax raises on certain commodities like fuel, tobacco and alcohol (Nelson, et al., 2011). The resistance of the Greek people came in the shape of several demonstrations. On May 5 2010, three people got killed during the protest against the imposed austerity measures (The New York Times, 2010).
In June 2011, the Greek state needed financial aid once again as the economy was contracting more than expected. Greece risked a default on its debt for the second time. The negotiation process was accelerated by a speculative attack on Italian bonds, the troika feared a major sell-off and seized the opportunity to subside the financial markets with a second bailout package. As a result additional structural reforms and austerity measures were implemented by Greece to meet the terms for a new disbursement of funds. New consolidation measures were aimed to reduce the abundance of public staff and improve the performances of public enterprises. In July, the second financial aid package of another 109 billion Euros was announced (Nelson, et al., 2011).
The third and up to now last economic adjustment programme for Greece came in August 2015. The programme is part of the bigger ESM framework. Once again this support addresses the economic imbalances, and tries to reignite growth in Greece in a sustainable manner (European Commission, 2016).
These interventions by the European Union had to endure a lot of protest. As other European countries that had exercised budget discipline, were obliged to come to the rescue for Greece (Nelson, et al., 2011). This created a moral hazard, as Greece was not punished fully by the markets. Of course, the Greek population had suffered under the austerity measures and the unemployment levels. But the financial aid packages that they had gotten access to, were a helping hand to resolve problems the Greek government caused by themselves. As Nelson et al (2011 emphasize, bailing out Greece implied setting a bailout precedent, which could enforce the moral hazard even more for other countries.
The mainly attributable for the troika to intervene in the Greek crisis is the spill-over concern. Fear of contagion asked for a swift and solid crisis response. If the Greek crisis caused a “wake-up” call among investors, it might have urged them to start a sell-off action of bonds of countries that share some of the characteristics with Greece. The PIIGs countries fit this image, as they report a high debt ratio relative to the EU average (Nelson, et al., 2011). In addition, the institutions holding Greek debts in the form of bonds were not always known, as a result the consequences of a default would have been incalculable (Mink & de Haan, 2013). To date, the policy responses have managed to avoid a Greek default.
The contagion phenomenon within Europe is the most vital aspect of our study; as such a brief literature discussion on this matter is given in the next chapter.
3. Literature review
An accurate definition of contagion is given by Kaminsky et al (2003). They define it as “an episode in which there are significant immediate effects in a number of countries following an event – that is, when consequences are fast and furious and evolve over a matter of hours or days” (p.3). The fast and furious character is applicable as an event triggers a chain reaction in other countries. Doing an observational study of 24 events, the goal of their study is to determine why financial contagion does or does not occur in several cases. Eventually Kaminsky et al (2003) determined three elements that together cause fast and furious contagion: an abrupt reversal in capital inflows, announcements that surprise the markets and a leveraged common creditor. In such a particular case they speak of “the unholy trinity of financial contagion”. Another addressed explanation is the “wake-up call hypothesis”, once investors are warned by the characteristics of a crisis country, they shall avoid countries that share these characteristics. As a consequence these countries might end up in a similar crisis because of the reduced financial markets access (Kaminsky, et al., 2003).
When the arguments above are applied to the Greek case, contagion was bound to occur. First of all, Greece used large capital inflows to finance their government budget. Second, the deterioration of the government budget in 2009 surprised the financial markets and sparked the 10-year bond yields. Lastly, there was a leveraged common creditor involved as Greek bonds held by foreign banks could impose contagion when faced with a value cut.
Kaminsky et al (2003) advise a policy where governments do not overspend and overborrow because these capital inflows most likely will end up in a “sudden stop”. For Greece, this sudden stop appeared when the bond yields sparked and the government was faced with a limited access to foreign borrowing.
However, Kaminsky et al (2013) did not consider the interventions of other institutions. The troika provided Greece with a replacement of foreign borrowing by sending them financial aid packages, as a result reducing the contagion probabilities.
At last they dissuade procyclical fiscal policies, a countercyclical spending pattern could ease or even prevent crisis situations instead of reinforcing them. For this reason the study is in agreement with the theory of John Maynard Keynes reported earlier on in this review.
Samitas&Tsakalos (2013) applied an Asymmetric Dynamic Conditional Correlation (A-DCC) model with copula functions to check whether the Greek crisis infected other Euro member states. Their sample consisted of 7 countries: France, UK, Germany and the other PIIGS countries. Daily data of these sample countries were used to measure the dependence with the Athens Stock Exchange. Results show that in contrast to the subprime crisis, the Greek crisis had a lower impact on the correlation between these 7 indices and the Athens Stock Exchange. Despite the lower impact on the correlation, the results provide evidence for the contagion effects of the Greek crisis. In fact they do confirm our argument that these effects were the reason why the Union wanted to resolve the Greek crisis as soon as possible to protect other member states from being infected by Greece. However, contagion effects already occurred on the other PIIGS countries as these countries problems to reduce their debt persevered (Samitas & Tsakalos, 2013).
At last Samitas&Tsakalos (2013) claim that there’s a lot of analogy between the role the Lehman Brothers played during the subprime crisis and the Greek role within the Eurozone. European countries draw attention to Greece to buy time for other countries to handle similar problems more efficiently.
Although this may be true, an event study methodology by Mink & de Haan (2013) shows contradictory results. To obtain their results DataStream data of 48 European banks were used. The twenty days with abnormal returns on Greek sovereign bonds were coupled to news events at that time. The year of focus is 2010. Measuring the impact of news about Greece as well as news about a Greek bailout on these bank stock prices, they found that news about Greece did not lead to contagion except on Greek banks, whereas news about a Greek bailout did. Mink & de Haan (2013) assert this as news about a possible bailout reflects the willingness of European governments to combat the financial crisis. Even bank stock prices of banks not exposed to Greece or other GIIPS countries, experienced effects of these news reports. In addition, for all other GIIPS countries, except Italy, the bank stock prices responded to both news about the Greek situation and the attitude of European countries concerning a Greek bailout. Mink & de Haan (2013) explain these results by the ‘wake-up call’ hypothesis, as bondholders of countries that show similar characteristics with Greece might reassess their vulnerability.
Rather than testing for contagion in se, Brutti & Sauré (2015) assess the channel through which contagion is passed on to other countries. Their methodology consists of a VAR model based on the narrative approach by Romer and Romer (1989). Daily sovereign CDS premia serve as a measure for sovereign risk and are used for eleven European countries. This choice is a solid one as these premia shall increase as the default risk increases. Cross-country bank exposures to the Greek debt are used as they want to find out how transboundary effects transmit. They state that Greek crisis effects transmit through different channels, however cross-border bank exposures are seen as the main driver of the contagion. In short it becomes clear that “as the Greek banking system becomes stressed in a Greek sovereign debt crisis, foreign counterparties of Greek banks are adversely affected, which again strains the financial health of the respective foreign countries”(p231).
Findings showed that financial linkages are a significant channel to transmit sovereign risks. Although a part of the transmission rate remains unexplained, these financial linkages had a large explanation power. Exposures to these sovereign debts entail a high danger of contagion risks. However they did not find robust transmission evidence for bank-to-bank lending (Brutti&Sauré, 2015).
Another relevant study is the one conducted by Bhanot et al (2014). The focus of this study is to examine the reaction of financial sector stock returns on changes in Greek sovereign yield spreads. To do this they consider announcements of credit rating agencies containing possible up- or downgrades, as well as other news events concerning the Greek crisis. Daily data on 5-year government bond yields are used together with the MSCI stock prices for each of the included countries their financial firms. In like manner as Mink&De Haan (2013), they confirm that news about a possible bailout tends to generate positive abnormal returns for financial firms. To obtain these results a multivariate GARCH model containing a conditional mean model of the returns was used. Defining a spillover as “an event where increases in Greek yield spreads lead to negative abnormal returns on an index of financial firms in another country” (p.61), they find evidence for such an effect. Bad news of CRAs concerning Greece caused spillovers to the Netherlands, whereas Belgium and Austria experienced such effects when bailout related news came on the radar. Their study shows that news events do lead to spillover effects, on top of the part of the transmission explained by other determinants.
Coupled with the study of Bhanot et al (2014), Kosmidou et al (2014) use news events to serve another purpose in their study. They assess the impact of troika bailout programs concerning banking, financial and real economic sectors of the Greek economy. The event horizon runs from October 2009 up and to December 2012. As the two bailout programs we discussed ut supra are captured within this period, it shows that significant events were taking place at that time. In accordance with Mink&De Haan (2013), they based their event selection on the effect on the 10-year government bonds spreads of Greece and on the general price index of the ASE. Five different categories were created based on the matter these events reported on. The data used to check their hypotheses consist of daily stock returns. First, for the banking sector nine banking stocks were used. Second, the financial sector proxy consisted of 30 financial and insurance services firms. At last the real economic sectors were captured with 182 stocks from the primary and secondary domain of the Greek economy. To obtain the results three regression equations were estimated. Regression analysis shows that the policies conducted by both the troika and the Greek government, failed to stop the financial crisis causing a real crisis. Kosmidou et al (2014) suggest that to end the crisis a fierce liquidity support is needed for both the real economy and the banking sector. In addition, in order to retrieve access to European funds, Greece should revalue its credibility and has to create a positive perception among investors.
Not only effects of the Greek sovereign debt crisis form the existing literature, there’s also evidence of transmission effects of the 2007-2010 financial crisis. Grammatikos&Vermeulen (2012) tested for these effects including fifteen countries of the European monetary union. These 15 countries were split up into three categories, and financials and non financials were tested for sensitivity to US developments. First the low default risk countries that consisted of Austria, Belgium, Finland, France, Germany and the Netherlands. Second the high default risk countries more known as the GIIPS countries. Third and last, the small countries namely Cyprus, Luxembourg, Malta and Slovenia. The reason why Grammatikos&Vermeulen (2012) split of this last group was that as these countries have illiquid stock markets, the process of transmission might work differently than if they not. The exchange rate is taken into account and measured in US dollars per Euro. As such a depreciation of the euro is signalled by a drop in the exchange rate. The event window runs for 27th February 2007 up and to the 31st August 2010. They use daily Datastream stock market index prices for the US and the listed countries and have separate indices for both the financial and non financial sector. The computed returns are on a daily basis and calculated a log price changes for the low default risk countries. For the PIIGS and little countries, daily weights are used based on stock market capitalization values. The results obtained from the GARCH model show proof of transmission from US to European non-financials. Nonetheless European financials their dependence upon their US associates is rather limited. Connections between the European debt crisis and the global financial crisis of 2007 were found as since the Lehman Brothers scandal, financials bondage increased on changes in Greek CDS spread compared to the situation prior to the scandal. These results do not hold for the smaller countries as they seem to be isolated from international events.