How did Greece get into this mess?

Dimitri Papadimitriou | June 30, 2010

People often say that the problem in Greece is profligacy. Greece, the story goes, is a nation living beyond its means. Reading the press, in fact, one gets the impression that Greeks must enjoy one of the highest standards of living in Europe while making the frugal Germans pick up the tab.

In reality, Greece has one of the lowest per capita incomes in Europe, much lower than the Eurozone 12 or the German level. Furthermore, the country’s social safety net might seem generous by US standards but is truly modest compared to the rest of Europe. As to borrowing, Greece is far from unique in its level of overall indebtedness as a percentage of gross domestic product.

So what’s the real problem? It all started when Greece embraced the Euro, which some saw as the country’s salvation. But as is so often the case, what once seemed a strength turns out to be weakness. The same might be said of Greek social programs; once seen as a pillar of the state, in hard times they automatically swell government deficits.

Remember that as Europe slid into recession, tax revenue fell and social transfer payments (such as unemployment benefits) rose, opening a larger gap between tax receipts and spending. The same thing happened in the United States. But the United States controls its own monetary policy. In Greece, which is stuck with the Euro, yawning deficits began to worry investors. With borrowing costs soaring, the country has embarked on an austerity program. Unfortunately, If the government lowers its deficit during a recession through spending cuts or tax increases, the strategy is destined to fail.

Cutting wages and pensions, as the recent presidential decree declared, which is a large part of the imposed EU/IMF plan, or raising taxes for that matter, will only make budget deficits bigger by lowering national income and tax revenue. This will mean lower effective demand, which will exacerbate the already bad unemployment situation and potentially lead to more civil disturbances. Some analysts estimate that unemployment will increase by 6 percentage points as a result of the austerity package.

More importantly, Greece continually imports more than it exports, and its firms and individuals spend more than they save (much like some large countries in North America that I can think of). Now, any country’s current account deficit plus its private sector deficit equals its government deficit. During recessions the private sector cuts spending and tries to save more. This automatically takes the government further into deficit territory as social programs grow and taxes fall. Bear in mind that when the current account goes into a deficit, which is a leakage out of private sector income, it means that unless the government deficit rises by the same amount, the private sector’s saving will fall. In the context of Greece’s high current account deficit, its private sector has been running a deficit for the past decade.

Even though the macroeconomic accounting identity linking the sectoral balances is not a theory, it is a good way to analyze policy proposals. When some analyst says that Greece needs to lower its budget deficit to 3% of GDP, then looking at the sectoral balances one must ask, what will need to happen to the balances of the other sectors for this to take place? For example, in 2009, the Greek current account deficit was about 10 percent of GDP. The budget deficit including swaps was about 13 percent of GDP allowing the private sector to save at 3 percent of GDP. Without the option of currency depreciation, it is hard to imagine that Greece can boost its exports (and/or reduce imports) to the point of a balanced or surplus trade account—a swing of 10 percent of GDP. If the budget deficit is to be lowered to 3 percent of GDP to comply with the Eurozone’s Stability and Growth Pact limit, firms and households will need to run a deficit of 7% if there is no change to the current account balance.

In other words, without a massive adjustment of its current account balance, the austerity plan can succeed only if the country replace public deficits with private deficits, and private debt buildup at this rate would certainly be unsustainable. It looks like Germany’s disciplined fiscal policy has been able to accomplish precisely this. Low levels of German government debt have been offset by high levels of private debt—arguably, more unsustainable than public debt. Ireland, Spain and Portugal are in a similar situation. Greece, on the other hand, has allowed its private sector to operate with somewhat lower levels of debt as the government’s deficit has risen relatively more. Indeed, the “profligate” Greeks have less private debt than that of their neighbors—which could place them in a better situation to withstand this crisis.

Still, financial crises and recessions inevitably lead to larger public deficits and debts. The private sector deleveraging that occurs in recession must be accompanied by public sector leveraging unless the current account moves to the surplus side.

Most developed countries, including the United States, United Kingdom and Japan, are in a similar situation in terms of their deficit and debt positions. But they have their own currencies. In the Eurozone, the issue is that the Stability and Growth Pact requirements are not rooted in any sensible theoretical arguments or empirical evidence. Countries have different export profiles and private-sector saving rates, and these influence the public sector’s balance. For European governments to be able to comply with the Stability and Growth Pact requirements at all times, they would need to abandon most of their social protection policies so that spending on the safety net does not rise in recessions. This would be counterproductive, to say the least. The bottom line is that the non-discretionary nature of Greece’s deficit does not leave many options for the government during bad times.


8 Responses to “How did Greece get into this mess?”

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  1. Comment by Edward Hall — July 5, 2010 at 5:06 pm   Reply

    Thank you Dimitri for the informative article,

    I’m curious to hear what Greece should do given the bind that they are in. Though there are many lessons to be learned, their situation seems almost hopeless given their constraints. What kind of actions should they be taking to recover?

    Great post, I will share it with friends who may be interested

    • Comment by Dimitri — July 6, 2010 at 9:09 am   Reply

      Thank you Ed. Greece clearly has very few options left. In a previous post, on June 1, I suggested that debt restructuring with or without consent by the EU-IMF can save the country a lot of money (about 140 billion euros), giving some breathing room to the government–especially if the EU agrees to have banks treat the restructured bonds as “held to maturity” so the banks can carry the debt at par on their balance sheets without a haircut. The consent of the EU-IMF would avoid the domino effect that may come from Portugal, Spain and Italy.

  2. Comment by Johann Heuchert — February 28, 2012 at 9:58 pm   Reply

    The explanations are very academic. They leave out the serious, endemic disfunction of the Greek State. Too many over-payed, state-empoyees. Too many inefficient state-owned business, which work at a huge loss, like in communist countries. Too many tax-evaders and corrupt tax-collectors. Too generous a retirement system that bankrupts the state.
    Do I have to say more?
    Furthermore the foolish assumption that states can not go bankrupt!?!

  3. Comment by Amy — March 25, 2013 at 1:51 pm   Reply

    I heard Greece does (did not) take taxes automatically from a persons paycheck and that people were expected to go pay their taxes on their own. This seems like a flawed system, did that have anything to do with the economic situation if it is true?

  4. Comment by Tom — May 11, 2015 at 1:58 pm   Reply

    Nice biased article. You did a very good job of dancing around the real issues Greece is in this situation while trying to lessen their predicament by comparing them to other countries that they don’t compare to. All those words and not a single explanation as to why they have such a low private debt ratio, hmmmm, could it be because of all the social programs the government paid for which would also explain their “HIGH” debt ratio. What really shows your bias is that you didn’t even make an attempt to explain the governments lack of revenue to pay for those services. It’s understandable though why you would want to hide the fact that it has been nearly impossible for the government to collect taxes for years. Every elected government for the last several cycles have sworn to make people pay their taxes, to no avail, including this newly elected ultra-liberal government. So do you think maybe that between these two “little” issues is why Greece might be in this “little” predicament? Maybe? Maybe you missed the rioting in the streets because the old government was going to start cutting social programs to try and reverse the slide to bankruptcy. I also noticed that you didn’t mention any of that as well. But I will give you credit, you used all the big words, you just used them poorly.

  5. Comment by Gail N — June 30, 2015 at 9:58 pm   Reply

    yep, the Guardian article nailed it. other countries are on the edge too.

    • Comment by Michael Stephens — July 1, 2015 at 10:32 am   Reply

      Patrick T and Gail N,
      That Guardian article is flawed precisely because “other countries are on the edge too,” as you point out. If fiscal management were essential to the crisis, Spain would have been just fine (it was running a budget surplus and its debt-to-GDP ratio was a puny 27% of GDP).
      The Guardian article also manages to discuss Greek government “profligacy” entirely through quotes and anecdotes. If the author had bothered to include a little data, it would have been helpful. To that end, here’s some useful context on this question of profligacy:

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