Rain and Tears in Greece

On March 5th, following Prime Minister Papandreou’s consultations with the European Commission, the European Central Bank and the IMF, the Greek parliament approved the austerity plan intended to reassure international financial markets on Greece’s creditworthiness. The plan envisages budget cuts of 4.8 billion Euros, about 2.5 points of GDP, comprising of  both expenditure cuts (one month wage cut and pensions’ freeze for public employees) and revenue increases (+ 2% on VAT , +20% on luxury goods, tobacco, alcohol, gasoline). While protests are already taking the streets, news agencies unveiled the details of the European support strategy:  a guarantee fund of 20-25 billion which would allow German KfW bank and the French Caisse des Dépôts, both publicly-owned, to underwrite the securities that markets would not be willing to roll-over. This fund would be financed by Germany (5 billion) and other Euro members (on the basis of their shares in the BCE). Meanwhile, the latest auction of ten-year Greek Treasury bonds was a success: all securities were subscribed (at a 6.4% interest rate).  Moreover, Moody’s, the rating agency, decided to confirm the current A2 rating: this will allow banks to continue to use Greek debt as collateral for their refinancing operations at the ECB. These are good signs, for sure. So, is the danger (of default and contagion) over?

To answer this question, one must address two issues: 1) whether the Greek plan is adequate for avoiding a debt crisis b) for how long such a plan must be implemented before it can bear its fruits.

Is the plan adequate? Many observers have singled out the Greek public debt and the huge budget deficit as the crisis’ culprits. Yet, the most serious imbalance in terms of size and in terms of its consequences for the European financial stability is probably the Greek external debt, public and private (which incidentally is the best empirical early-warning indicator of sovereign debt crises). Thanks to the adoption of the euro, many PIIGS have been able finance large current account deficits very cheaply. In turn, these large imbalances were due to persistent real appreciations (see Figure 1).



Source: Economist Intelligence Unit

The euro membership even spared the PIIGS from depleting their foreign exchange reserves. Table 1 gives an estimate for the PIIGS’ external (net) debt, and the trade balance, both in percentage of GDP, for 2009. The third column shows the “stabilizing” trade balance

Table 1



 net external  debt/GDP   


stabilizing trade balance/GDP   


actual trade balance/GDP   






113,6 – 174,8   


3,4 – 5,2   




16,7 – 18,5   




79,9 –  232,6   


2,2 – 6,9   




12,4 – 17,1   




132 –  57,1   


1 – 4,6   




6,3 – 9,9   




57 – 125,1   


1,7 – 3,7   




1,1 – 3,1   




83, 3  –  928,3   


27,4 – 83,3   




-16,8 – 8,1   





Source: (Gross) debt figures are  from Joint IMF WB BIS OECD Debt Hub; trade balance from EIU. As net foreign debt figure are not available, a range has been estimated as follows: the upper bound is equal to gross debt, therefore assuming foreign assets = 0; the lower bound is estimated by public external debt, thus assuming private external assets= private external debts. The stabilizing trade balances are author’s calculations. They assume zero real depreciation, an interest rate of 4,5% on external debt, and a growth rate of the economy of 1,5%.

This indicator is the value that the trade balance should take in order to freeze  the external debt/GDP ratio at its current level. For Greece, this indicator takes a very high value, between 3.4 and 5.2 points of GDP. Comparing the stabilizing to the actual trade balance, -13.3 % of GDP in 2009, yields the required adjustment:  a number between 16.7 (= 3.4 + 13, 3) and 18.5 (= 5.2 + 13.3) points of GDP.

Too see what this implies, recall that a country’s trade balance equals the difference between the value of output  produced in a year (GDP) and the value of total spending (consumption, government expenditures and investment). Thus, if the Greeks were willing to stop accumulating external debt, they should reduce overall spending relative to GDP by almost a fifth (!). How?

If Greece really wants to remain in the eurozone, the least costly instrument, a competitive devaluation, is precluded. Thus there is no alternative to massive budget /wage cuts. This suggests that the plan that was recently passed in Parliament (2.5% of GDP) represents about one seventh of what is required to ensure the solvency of the foreign debt. Clearly, no one is suggesting that cuts of this size should be implemented in one year: the economy (and the government) may not survive the cure. This leads to the second question.

For how long should the deflation last? Figure 2 describes the evolution of external debt/GDP (the blue stripe) under the (deliberately) “heroic” assumption that the Papandreou government manages to reduce the share of total spending in GDP (and to improve the trade balance, in red) at the pace of 2.5 points of GDP per year.

Figure 2


Source: author’s calculation, see Table 1 for assumptions

In the early years of the adjustment, the cuts are not sufficient to stop the external debt, so the debt keeps rising for about 8 years (!). Only after reaching a peak of 150 – 250% of GDP, does the recovery start. 

To sum up, the approved austerity plan is a significant step, albeit only the first, of a long process of tough measures, whose political and economic feasibility are yet to be tested. If Greece stays in the euro, it will remain a “limited (fiscal) sovereignty” country under the European “surveillance” for many years to come.  Hence, it is good news that the German finance minister, Wolfgang Schäuble, has put on the table the issue of creating new institutions (a European Monetary Fund) for managing and possibly preventing sovereign debt crises in the eurozone (the original proposal by Daniel Gros and Thomas Mayer is here: http://www.ceps.eu/book/towards-european-monetary-fund). In light of the pathetic failure of the Stability Pact, the question raised by the Greek case is not whether it is up to Europe or IMF to bail out Greece, rather it is about endowing Europe with adequate institutions and instruments so that as it can survive the next crises.

(also appearing on lavoce.info and paolomanasse.blogspot.com)

53 Responses to "Rain and Tears in Greece"

  1. Guest   March 29, 2010 at 11:41 am

    The so-called EU bailout deal for Greece just announced is a joke. Greece must exit the eurozone, devalue the drachma, restructure its debt and borrow from the IMF at 3.5% interest, if needed, instead of at 6% from the markets or from its eurozone partners. Whether there is in fact any point remaining in the EU at all is a valid question. Because it is well established in economic theory that a monetary and trade union increases the divergences in competitiveness, and this is the root of the problem. Because intra-EU imbalances and structural weaknesses are now too evident. And because, without solidarity, the EU is kaput. This is the best course of action for all the GISPI (Greece, Italy, Spain, Portugal, Ireland). Let the FUKD (or FUKDE, as Edward Hugh has called them, i.e. France, UK, Deutchland ) keep the EU for themselves. Sorry UK, you’re not to blame. You did the right thing staying out of the euro. And let the Germans sell an island (in the North Sea) and a monument (as they have suggested to the Greeks), because they are also now above the 3% deficit-to-GDP ratio. Did I say German monument? What monument???Now how can Europe, which owes even its name to Greece, exist without Greece, that’s another question.Apart from the so-called “moral hazard” in helping Greece, there is also a moral deficit in the EU