5 Minute Tute – Greek Debt Crisis

Why is the Greek debt crisis so extreme?

There are three crises in the Euro at the moment. Firstly, a competitiveness crisis: many countries allowed inflation to exceed German levels from 2000 to 2007, making them pretty uncompetitive. Next, a banking crisis: the private sector in several countries borrowed too much before the recession. This led to housing and construction bubbles, and helped cause the competitiveness problem. Finally, a government debt crisis, where governments borrowed too much. In fact, only one country started the recession with a serious government debt problem – Greece. The fiscal problems in Ireland and Spain are the result of the public sector bailing out the banks following the banking crisis. So the crisis is so extreme for Greece because its the only country that has all three problems at once. In addition, they reinforce each other. Because it is uncompetitive, Greece can’t solve its debt problem through growth. A partial default on its government’s debt has worsened the position of Greek banks, which owned part of this debt.

How beneficial have the successive austerity packages been for the Greek economy?

There is a strong argument that they have not been beneficial at all. Some austerity in Greece was clearly required, but pushed too far too soon and there was a danger that the economy would collapse, and the electorate would revolt. That is exactly what has happened.

How likely is a Greek exit from the Eurozone now?

It’s certainly possible. There is a game of chicken going on between Greece and the rest of the Eurozone, and Germany in particular. Both have a lot to fear if Greece is forced to exit, so each side is hoping the other will back down first. The problem with such games is that if neither side gives enough, the outcome is worse for everyone. If Greece leaves, could contagion spread to other countries? With great difficulty. Although Greece is the worst case country, the same conditions could easily arise elsewhere. The key to preventing contagion is the European Central Bank. Eurozone national governments cannot print their own currency, and so are at much greater risk of default on their debt. The ECB needs to start acting as though it were each country’s central bank, underwriting government debt so that investors continue to lend to periphery countries. It should also strengthen the vulnerable economies by raising German inflation targets relative to the rest of the Eurozone. This will make the peripheral countries more competitive, enhancing their growth prospects.

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For the rest of Europe, would it be better for Greece to stay or leave?

If Greece was forced out of the Euro, it would default on its remaining debt, which is largely owned by Euro economies. Exit would also increase the risks of contagion. Banks in some periphery countries would be particularly vulnerable. Probably the only positive thing would be that the threat of contagion might finally force the ECB to underwrite the fiscal positions of the periphery countries, and for the Eurozone to develop a banking union to deal with insolvent banks. The benefits of Greece leaving are far less clear. Some say that using additional funds to support Greece within the Euro is throwing more money at an intractable problem, but that does not make much economic sense. There are certainly serious structural problems in Greece, but it is better to change these with a combination of carrot and stick, rather than with overwhelming austerity.