Paradigm Lost: The Euro in Crisis

Facing the dual challenge of massive and rising debt and a loss of competitiveness, Greece faces only bad options to dig itself out from the current crisis. Of these choices, an orderly debt restructuring as soon as creditors are better prepared to deal with the shock is the least bad alternative for Greece. Given that Greece’s tax net is so small and its informal economy is presumed to be so large, however, it is conceivable, though unlikely, that an unsuspected tax windfall could materialize and alter this conclusion.

A Proliferation of Problems

Prior to the establishment of the euro, Greece was among the worst economic performers of eventual Euro area members. Annual inflation was one of the highest in the region; the Greek government paid the highest borrowing premium; and GDP growth was the slowest in Europe.

The adoption of the euro appeared to solve many of these deficiencies. Inflation fell from an average of 18 percent from 1980–1995 to just above 3 percent from 2000–2007. Over the same time periods, long-term government bond yield spreads vis-à-vis the German bund fell from 1100 basis points to less than 40.

IMGXYZ5036IMGZYXAs Greece stabilized, it quickly became an attractive destination for foreign capital. Greece’s net foreign asset position, which measures the assets Greece holds abroad minus Greek assets held by foreigners, plummeted, falling from approximately -5 percent of GDP in 1995 to around -100 percent of GDP in 2007. Awash with cheap capital, domestic demand surged and the current account balance deteriorated from -3.7 percent of GDP in 1997 to -14.4 percent in 2008.

Domestic demand growth drove up prices in Greece relative to that of the Euro area, increasing domestic labor costs and eroding Greek competitiveness. Since 1997, consumer prices have risen by 47 percent in Greece, compared to an increase of only 27 percent in the Euro area; since 2000, per capita employee compensation has grown by over 80 percent in Greece compared to an increase of 23 percent in the Euro area. The resulting loss of competitiveness has been substantial: the IMF estimates that Greece’s real effective exchange rate is overvalued by 20–30 percent.

Competitiveness was hurt further by a shift away from manufacturing sectors in favor of the expansion of service and non-tradable sectors. Though not as large as the shift in other troubled European economies, manufacturing as a share of GDP fell by 2.5 percentage points from 1997 to 2007 from a low initial level, while construction’s share grew by 2 percentage points. Over the same period, the price of services increased faster than that of goods by an average of 1.3 percentage points, compared to a difference of 0.6 percentage points in the Euro area, encouraging further misalignment toward services.

These imbalances were not without (temporary) benefits. After averaging annual GDP growth of 1.1 percent from 1980 through 1997—the slowest in eventual Euro area countries—Greece’s economy expanded at an average rate of 4.1 percent over the next ten years, the fourth fastest rate in the Euro area. Per capita GDP rose from 39 percent of that of Germany in 1995 to 71 percent in 2008.

From 1997 to 2008, Greece increased government spending per capita by 140 percent, compared to 40 percent in the Euro area.

As tax revenues rose, the government rapidly expanded spending, especially in social transfers and public sector wages. From 1997 to 2008, Greece increased government spending per capita by 140 percent, compared to 40 percent in the Euro area. Over that period, social transfer spending rose from 13.9 percent of GDP to 18.9 percent, while the aggregate Euro area decreased such spending from 17.1 percent to 16.1 percent; Greek public sector per capita employee compensation grew by 112 percent, compared to 38 percent in the Euro area.

Reflecting the economy’s rapid growth, public sector deficits remained within what appeared to be reasonable bounds—averaging 5 percent of GDP from 2000 to 2007. The picture changed markedly with the financial crisis and when markets realized Greece’s chronic failure to report accurate statistics. GDP expanded by only 2 percent in 2008 and contracted by 2 percent in 2009, pushing down tax revenues and driving up the restated deficit to 7.7 percent in 2008 and 13.6 in 2009. 

With debt ballooning from 96 percent of GDP in 2007 to 115 percent in 2009—and the IMF projecting it to reach nearly 150 percent by 2012 even under the assumption of draconian fiscal measures—Greece’s borrowing costs skyrocketed. Worries mounted that Greece would not be able to repay its loans and that the crisis would quickly infect other troubled European nations. EU and IMF leaders attempted to reassure markets with pledges of support to Greece; though initial efforts failed, later attempts, including a $145 billion support package, appears to have stabilized the situation, as it effectively covers the government’s borrowing requirement over at least the next two years. 

Agreed Adjustment Measures

In order to receive the support package, Greece was required to agree to a number of adjustment measures that fall into three general categories:

Fiscal Policy: Fiscal policy adjustments aim to begin reducing the debt-to-GDP ratio by 2013 and bring the government deficit below 3 percent of GDP by 2014. The total adjustment—11 percent of GDP—is composed of reductions in spending of 5.3 percent of GDP, tax increases of 4 percent, and structural reforms that are expected to add 1.8 percent of GDP. The measures are frontloaded with the largest adjustment planned for 2010.

The adjustment required of Greece represents more than annual government spending on military defense, health care, and education combined.

Structural Reforms: Reforms will be implemented to enhance government productivity and transparency, increase wage flexibility in the private sector, and improve the business climate and competition across Greece.

Financial Sector Policy: Greek banks have been hurt by concerns over sovereign debt, of which they hold large amounts, and have lost access to international markets for wholesale funding. Support will be provided by the EU and IMF to ensure that banks are adequately capitalized.


The EU–IMF support package is, first and foremost, a lending facility and addresses concerns over Greek liquidity. Any durable improvement in the Greek situation must come from fiscal adjustment. At 11 percent of GDP, however, the adjustment required of Greece is massive and represents more than annual government spending on military defense, health care, and education combined. These cuts are likely to accentuate the deep recession in the private sector and to result in wage and price deflation, which in turn will take a major toll on output growth and on tax revenues. Given Greece’s relatively closed economy, which funnels most government spending back into the domestic market, the multiplier effects of fiscal consolidation in Greece on output are expected to be especially large.

The IMF projects that Greece will need to maintain a primary balance of 6 percent of GDP and annual GDP growth of 2.7 percent to reduce its debt-to-GDP ratio to 120 percent by 2020, which is still 5 percentage points more than the current level. Of all Euro area countries, from 2000–2007, Belgium had the highest average primary balance at only 4.7 percent and a growth rate of just 2.2 percent annually. Given that Greece is a less competitive and less diversified economy than Belgium, the prospects for Greece to achieve annual growth of 2.7 percent against a background of such large-scale fiscal consolidation are at best dim. 

Furthermore, if GDP growth stagnates, as is possible given Greece’s loss of competitiveness and the severity of the austerity measures undertaken, and if debt reaches 150 percent of GDP as projected, a primary balance of 6 percent of GDP will only reduce the debt level if interest rates remain below 4 percent. Given that ten-year Greek bond yields averaged 4.25 percent from 2002 to 2007—a time when the Greek economy was growing, worries over sovereign default were minimal, and Greek bonds were not rated as “junk”—it is difficult to believe that Greece will not pay significantly more for any debt it issues after the EU–IMF package expires in 2012.  

Debt restructuring is necessary, but may not be sufficient to place Greece back on a sustained growth path.

Under such conditions, debt restructuring is necessary, but may not be sufficient to place Greece back on a sustained growth path. Greece will need to rely increasingly on exports to restart growth, but this strategy faces significant obstacles—primarily Greece’s severe loss of competitiveness. Debt restructuring could actually intensify this loss by implicitly improving Greek wealth and increasing domestic demand. Furthermore, the external environment may not be especially propitious for Greece, which sends about two-thirds of its exports to the rest of the EU, where fiscal austerity programs are being widely adopted.

Restoring competitiveness will require wage reductions, deflation, and increases in productivity, but these measures take time—and will severely test Greece’s social fabric. If these efforts prove unworkable with a reasonable timeframe, abandoning the euro while remaining in the EU may prove to be Greece’s only other viable option.

Finally, there is one caveat to this assessment. Greece is known to have a large informal economy, large scale tax evasion, and wholly inadequate statistics. As Greece widens its tax net, a tax revenue windfall of unprecedented magnitude is possible, albeit unlikely. If this occurs, one should see the results over the next twelve months or so, when the political momentum behind the fiscal adjustment effort is greatest. By then, wise creditors will have prepared for the haircut to come. 

Bennett Stancil is a junior fellow in Carnegie’s International Economics Program.