Greece and the fiscal crisis in the Eurozone

The Editors 12 October 2010

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The saga of the Greek public finances continues. But this time, Greece is not the only country that suffers from doubts about the sustainability of its fiscal position. Quite the contrary. The public finances of most countries in the Eurozone are in a worse state today than at any time since the industrial revolution, except for wartime episodes and their immediate aftermaths. And the problems are not confined to the Eurozone, extending to other EU member states, like the UK and Hungary, Japan, and the US. This column introduces a new CEPR Policy Insight by Willem Buiter and Ebrahim Rahbari that explains how this situation came about and how it is likely to evolve during the rest of this decade.

Fiscal troubles around the world

Table 1 shows that the fiscal troubles are widespread. In fact, only a limited number of small industrial countries are in reasonable fiscal-financial shape. Canada, Germany, and the Netherlands, which are widely considered (and consider themselves) to be in reasonably good fiscal-financial condition, are so only compared to the truly dire conditions experienced by most of their peers.

At almost 115% and 14%, respectively, Greece’s (gross) government debt and budget deficit are certainly of great concern. But these numbers are somewhat less staggering, even in peacetime, when set against a Eurozone average of almost 82% for gross debt and 6% for the budget deficit. And on the whole, the fiscal situation of the Eurozone as a whole still appears to be more sustainable than that of the US, the UK, or Japan.

Table 1. Fiscal troubles around the world

 
% of 2009 nominal GDP
 
Gross debt
Net debt
Budget balance
Sturctural balance
Cyclically adjusted
Australia
15.9
-5.7
-3.9
-3.3
-2.5
Canada
82.8
28.6
-3.5
-3.2
-2.3
Czech Republic
42.0
-1.0
-2.8
-4.6
-3.7
Denmark
51.8
-5.1
-1.7
0.1
0.7
Euro area
81.8
51.7
-6.3
-3.6
-1.2
Austria
66.5
37.2
-3.4
-2.4
-0.4
Belgium
96.7
80.7
-6.0
-2.8
0.4
Finland
44.0
-63.2
-2.2
1.1
0.6
France
77.6
50.6
-7.5
-5.7
-3.7
Germany
73.2
48.3
-3.3
-1.4
0.8
Greece
115.1
87.0
-13.6
-11.7
-7.1
Ireland
64.0
27.2
-14.3
-9.9
-8.2
Italy
115.8
101.0
-5.3
-2.7
1.5
Luxembourg
14.5
 
-0.7
-4.5
-0.2
Netherlands
60.9
28.5
-5.3
-0.8
-3.0
Norway
43.7
-153.4
9.7
-7.4
-3.8
Portugal
76.8
57.9
-9.4
-7.3
-4.7
Slovak Republic
35.7
12.4
-6.8
 
 
Slovenia
35.9
 
-5.5
 
 
Spain
53.2
34.8
-11.2
-8.3
-7.1
Hungary
84.0
58.0
-3.9
-1.6
2.2
Iceland
122.7
41.0
-9.1
-7.4
-5.0
Japan
189.3
96.5
-5.9
-5.5
-4.5
Korea
34.9
-31.0
0.0
 
 
New Zealand
35.0
-8.1
-3.5
-1.4
-2.3
Poland
58.4
22.3
-7.1
-7.3
-5.3
Sweden
51.8
-23.4
-1.1
2.3
2.6
Switzerland
 
5.5
0.7
1.3
1.7
United Kingdom
72.3
43.5
-11.3
-8.6
-7.0
Unites States
83.9
56.4
-11.0
-9.0
-7.6

Source: OECD, Eurostat

The roots of the fiscal unsustainability

The fiscal sustainability problems in most advanced economies have four common roots:

  • strongly pro-cyclical behaviour by the fiscal authorities during the boom period;
  • the direct fiscal costs of the financial crisis, that is, the bailouts and other budgetary rescue measures directed at propping up the financial system;
  • the worldwide recession weakened many government revenue sources and boosted certain public expenditure categories for the usual cyclical or automatic fiscal stabiliser reasons;
  • the end of asset booms and bubbles, especially in real estate markets, plus the normalisation, from extraordinary heights, of profits and pay in the financial sector.

In Greece, a number of country-specific factors added to these common causes of the fiscal troubles. Following the general election, Greece’s budget deficit was revealed by the new government to be 12.7% of GDP rather than the 6.0% reported by the old government. Greece’s budgetary problems owe much to high entitlement and age-related spending, poor tax administration and a bloated public sector. These weaknesses are compounded by the growing uncompetitiveness of much of its industry, as measured for instance by relative normalised unit labour costs, by any other of a range of real exchange rate indices or by Greece’s poor showing in such surveys as the World Bank’s Doing Business 2010. Spain, Portugal, and Italy have similar structural real competitiveness problems.

Supporting Greece

In early May 2010, 10-year yields on Greek government debt topped 10%, while the spread on 5-year credit default swaps exceeded 900 basis points, and there was substantial doubt – to say the least – about the willingness of markets to finance Greece’s remaining sovereign funding needs of around €30 billion for the current fiscal year even at these very high rates. At the same time, spreads versus Bunds on debt of the governments of Spain, Portugal and Ireland also reached levels not seen since the mid-1990s amid concerns about the health of the public and financial balance sheets in these countries.

In response, three sets of measures were announced. First, the EU and the IMF announced a €110 billion support package for Greece. The failure of the Greek support package to stop the run on the sovereign debt of Spain, Portugal, and Ireland then prompted the creation of a bigger sister for the rest of the Eurozone member states by the name of the European Stabilisation Mechanism. This consists of the European Financial Stability Facility, which can raise up to €440 billion of intergovernmental money, and a further €60 billion supranational facility administered by the European Commission. Up to €250 billion of IMF money will be available to supplement the European Stabilisation Mechanism. Third, the ECB lent its own support to prevent major market disruptions, to rule out sovereign defaults it did not consider warranted by the fundamentals, and to prevent another banking crisis in the Eurozone, where many banks had unknown but potentially significant exposures to the fiscally challenged sovereigns.

The road ahead for Greece and Eurozone

The authors find Greece’s debt burden to be unsustainable, with or without the support package. Indeed, they doubt that the Greek consolidation effort will succeed in bringing down the public debt burden and restoring fiscal sustainability.

So far Greece appears to show some resolve in following through on its commitments. But even if all the promised fiscal tightening is implemented, and if the Greek economy does not contract more severely than expected, the general government gross debt will reach 145-150% of GDP by 2013. To talk of it being stabilised at that level is disingenuous. The government interest bill on that debt would be around 8% of GDP, but the primary balance would be in surplus.

The political economy of fiscal tightening is already quite complex and fraught in Greece, and the current fragile consensus for fiscal consolidation is highly unlikely to survive until 2013 and beyond. These facts and the logic of strategic default will not be lost on the markets. It is therefore likely, argue Buiter and Rahbari, that a restructuring of Greek public debt, involving both maturity lengthening and haircuts for creditors will have to take place relatively soon. Such restructuring would ideally have taken place in May 2010, as a precondition for Greek access to EU and IMF funds. Instead, a restructuring, if and when it occurs, will be against the IMF/EU agreement and would impose capital losses on Greece’s Eurozone creditors, because the loans from the Greek facility are pari passu with the outstanding Greek debt.

The current fiscal problems faced by Greece and other Eurozone countries are of a severity unprecedented in peace time. The resolution of this situation will most likely involve a combination of fiscal pain and debt restructuring, with the latter all but inevitable in the case of Greece.

Nevertheless, the Eurozone and the EU could come out of this crisis stronger than it went in. A first step has already been taken with the creation of the European Financial Stability Facility. Further steps to create a viable minimal “fiscal Europe” are needed, the authors suggest, including a burden-sharing arrangement for the recapitalisation or orderly liquidation of systemically important cross-border financial institutions, an increase in the size and duration (to eternity) of the European Financial Stability Facility, credible conditionality attached to the loans it disburses, and the creation of an Sovereign Debt Restructuring Mechanism for Eurozone state governments.

 

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Topics:  Macroeconomic policy

Tags:  eurozone, bail-out, sovereign default, fiscal sustainability

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