Greece: No escape from the inevitable

Lars Feld, Christoph Schmidt, Isabel Schnabel, Benjamin Weigert, Volker Wieland

20 February 2015



‘Austerity has failed’ is the most popular narrative of many commentators, especially in the Anglo-Saxon world and in the European periphery (e.g. Stiglitz 2015, Wolf 2013), and it now serves as the principal argument for the Greek government in its request to renegotiate the adjustment part of the European rescue package (for an introduction to the austerity debate, see Corsetti 2012). This narrative is factually wrong and ignores the reasons underlying the Greek crisis.

To understand that fiscal consolidation was inevitable and would have been an integral part of any policy option, it is instructive to recall the situation in 2009/10. At the end of 2009 the then newly elected Greek government revised its projected budget deficit figures – an announcement that sent financial markets into turmoil. At that time, Greece’s macroeconomic fundamentals were simply catastrophic. After years of fiscal profligacy the budget deficit stood at 15% of GDP – with the primary deficit (when ignoring interest payments) at 10% – and the debt ratio amounted to 127%. The current account deficit stood at 10% of GDP, while net international debt amounted to 87%.

Given these fundamentals there was only one policy option – Greece had to balance its budget, and the current account needed to be turned into a surplus, to be able to service both its private and public debt. Defaulting on outstanding debt would not have obviated the need to rebalance the economy and the fiscal position, since the budget deficit was huge even without considering interest payments.

With the adjustment programme, Greece entered into a loan agreement with its European partners, which was designed to allow Greece to stretch the economic adjustment over time (European Commission 2012). Funding was supplied in exchange for fiscal consolidation and economic reforms. What particular kind of reforms would be implemented and who would bear the cost of adjustment was entirely determined by the Greek government. Reforms only had to add up to a sufficient overall adjustment.

The implementation plans devised by the Greek government were to be supervised by the creditors, aka the Troika, but not dictated in detail. This supervision merely served the objective of ascertaining that the chosen combination of fiscal consolidation and economic reform would deliver the aggregate adjustment that was necessary to bring Greece back on a sustainable growth and debt path. From the perspective of the (democratically legitimised) parliaments of the creditor states, there was hardly any alternative to such an arrangement combining generous loans with careful supervision.

A counterfactual world

For an economy in the dismal Greek situation, it essentially made no difference that it remained a member of the Eurozone – in any case, adjustment was unavoidable, and it would be painful and accompanied by strong social tensions. The adjustment process of countries that experienced debt and currency crises follows a very similar pattern. This is irrespective of whether they successfully defended a fixed exchange rate or allowed their exchange rate to devalue in order to support external economic adjustment. In all cases we observe a crisis-driven current account adjustment in connection with a deep slump and subsequent recovery of GDP (see Figure 1). Nearly all countries depicted here experienced sharp increases in unemployment, which started to decline only when growth picked up.

Figure 1. The impact of debt and currency crises on the current account and growth

Source: IMF.

It is particularly instructive to consider the adjustment of the Baltic states, which defended their fixed exchange rates and, in the case of Latvia, received balance-of-payments assistance from the EU and the IMF in exchange for an adjustment programme (see Purfield and Rosenberg 2010). Since in all these cases painful adjustment was inevitable and costly, one should take the combination of the rescue packages and adjustment programmes as what they really are – a device helping to avoid a sudden fiscal and current account adjustment with even larger immediate pain. This also holds for Greece. Necessary steps were stretched over time, and growth-enhancing reforms should compensate the loss in demand previously financed by public debt. Thus, the root cause of the painful adjustment is past profligacy and not the adjustment programme.

Adjustment progress: The glass is half full

During the past five years Greece indeed underwent serious reforms and fiscal consolidation. Progress has been remarkable but incomplete, such that the economy is still far away from a self-sustaining growth path. In the autumn of 2014, Greece finally achieved a primary surplus and positive, albeit tepid growth of real GDP. The detailed and carefully drafted reports by the Troika provide a balanced account of the reform progress and remaining requirements. What Greece needed most in these circumstances was a visible display of reliability. After all, uncertainty had still been hampering domestic and foreign investors from engaging in Greece.

Unfortunately, any sign of stability has effectively been wiped away by the new Greek government. Blaming the recent capital flight from Greece and the sharp increase in government yield spreads on anything else but the election-campaign announcements and post-election decisions of Syriza would be ludicrous.

Debt relief is unnecessary for Greece

In the context of sovereign debt, debt sustainability has to be understood primarily as (a society’s) willingness to pay. In the current situation the question whether the Greek government is exercising its sovereign prerogative to declare a (partial) default is most of all a matter of how the Greek government is assessing the trade-off between the instant relief generated by declaring default and its future ability to attract new lenders. Contemplating default would only be sensible if this avoided a negative spiral that would otherwise force the debtor to accumulate ever more debt to service the debt already accumulated.

Two aspects dominate this issue: the debt already incurred vis-à-vis the economy's current income (i.e. the debt-to-GDP ratio), and the difference between the interest rate and the growth rate of income. Economies might in fact be able to sustain a very high debt ratio if the relevant interest rate is low compared to the growth rate. In this respect, Greece is not overburdened, mainly due to the debt restructurings already conducted in March 2012 for private creditors (Private Sector Involvement, PSI) and in November 2012 regarding public creditors. Even more important than the PSI was the willingness of Euro-member states to provide Greece with loans maturing as late as decades away and carrying very low interest rates, partially even deferring interest payments to the future as well. As a result, Greece enjoys quite palatable debt service requirements, with an average interest rate of 2.3% and interest payments of 4% of GDP, and the major share of interest payments is even deferred until the early 2020s. This is in fact substantially lower than the debt service requirements faced by some of its lenders, such as Italy, with an average interest rate of 3.3% and interest payments of 4.3% of GDP. A debt relief of public creditors could not substantially improve the comfortable state of the Greek government, let alone be justified easily vis-à-vis its lenders.

Beware of ‘political contagion’

Compared to 2010, negotiations with Greece take place in a substantially changed institutional environment and under very different economic circumstances. In 2010 a Grexit – Greece leaving the Eurozone to return to its own currency – in all likelihood would have led to contagion in sovereign debt markets of other member countries. In fact, the rescue package put together for Greece could not prevent Portugal and Ireland from losing market access soon thereafter and having to request financial support as well. At the time, member states displayed an impressive commitment to preserving the integrity of the currency union.

Today the situation is very different. First, and above all, the newly established institutional framework, most importantly the Banking Union and the ESM, already provides a strong proof of such a commitment. Second, Greece’s main creditors are the member states, and the European banking sector is in much better shape than in 2010. Third, member countries to which contagion spread in 2010 and afterwards, notably Ireland, Portugal, and Spain, but also Italy, are in a much better economic situation, mainly due to fiscal adjustments and structural reforms. Fourth, the ECB announced the outright monetary transactions (OMT) programme and started a quantitative easing (QE) programme. Given this progress, it is highly unlikely that international investors will again start doubting the integrity of the Eurozone – with or without Greece remaining a Eurozone member. Hence, the impact of Greece leaving the Eurozone seems manageable.

Yet despite these changes, the new Greek government is playing the Grexit card in current negotiations, obviously betting on generating contagion fears. But the Greek negotiators could hardly err more. In today’s situation, a Grexit, even if unintended by the Greek government, has the potential to even strengthen the institutional framework and the integrity of the Eurozone rather than spark chaos outside Greece.

Europe and the Eurozone are built on contracts concluded between and ratified by democratic countries that cannot be changed unilaterally by any future government. However, as Europe is a union of sovereign states, each country always has the option to abandon these contracts, which in the current context means exiting the Eurozone and the EU. Any meaningful change to the adjustment programme in the sense that the overall adjustment path is altered – again, the concern is not the domestic policy mix – would not only stipulate demands from other crisis countries. More importantly, it may severely question and harm the credibility of the newly created or reformed institutions, and raise doubts about their ability to manage the current crisis and help prevent future ones. A monetary union of otherwise sovereign states needs hard budget constraints. If the institutions created to reinstall these constraints failed their first serious test, this would be terrible news for the future of the Eurozone.

The contagion to fear at this time concerns politics. Suppose the Eurozone were to adopt the Greek government’s view that the austerity and structural reform approach they have pursued jointly since 2010 was wrong, and were to reverse course. This would strengthen radical political forces in other member countries. Several governments might well be replaced by parties falsely promising that market-oriented reforms and fiscal adjustment could be avoided. In all likelihood, investors’ trust in the Eurozone’s commitment to create conditions for sustainable growth would be lost. Such ‘political contagion’ could well trigger massive capital flows out of the Eurozone as a whole and call its future existence into question.

A way forward

What shall Greece do? Certainly, the worst move would be to return to the economic structures that it displayed as late as 2010. Especially relying on a large share of state employment would be a recipe for disaster. The Greek public needs to realise that things could actually become much worse than they are now, particularly if membership in the Eurozone could not be assured. Instead of looking back, Greece needs to continue building a functioning state and a functioning market economy.

A case in point is the tax system. The Troika has helped install an effective system of tax collection, which had not existed before and is still in the making. In that sense, it has supported the Greek authorities in collecting taxes from wealthy Greek citizens, as planned by Syriza, rather than preventing it. Greece is suffering very hard times. But the real tragedy is that it elected a government that threatens to exacerbate the situation and spoil the looming economic recovery, on the basis of a thoroughly wrong assessment of its current bargaining situation and the policy alternatives available for achieving sustainable growth in Greece and the Eurozone.


Corsetti, G (2012), “Has Austerity gone too far?”,, 2 April. 

European Commission (2012), “The Second Economic Adjustment Programme for Greece”, European Economy – Occasional Paper 94.

Purfield, C and C B Rosenberg (2010), “Adjustment under a Currency Peg: Estonia, Latvia and Lithuania during the Global Financial Crisis 2008–09”, IMF Working Paper 10/213.

Stiglitz, J E (2015), “A Greek Morality Tale”, Project Syndicate, 3 February. 

Wolf, M (2013), “How Austerity Has Failed”, New York Review of Books 60(12), 11 July. 



Topics:  Europe's nations and regions Exchange rates International finance Macroeconomic policy

Tags:  greek crisis, structural reform, German Council of Economic Experts, Greece, debt, public debt, government debt, sovereign debt, eurozone, austerity, fiscal consolidation, troika, political contagion, debt sustainability, banking union, ESM, Grexit, ECB, quantitative easing, Outright Monetary Transactions, interest rates, interest payments

Director, Walter Eucken Institute; and Professor of Economic Policy, University of Freiburg

President, RWI Essen and CEPR Research Fellow

Professor of Financial Economics, University of Bonn; Member of the German Council of Economic Experts; CEPR Research Fellow

Secretary General, German Council of Economic Experts

Endowed Chair of Monetary Economics, Institute for Monetary and Financial Stability, Goethe University Frankfurt; CEPR Research Fellow