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Understanding the Downfall of Greece's Economy

Investopedia logoInvestopedia 03-07-2015 Matthew Johnston
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Greece has defaulted on its debt. While some are saying that Greece has simply fallen into ‘arrears’, its missed payment of €1.6 billion to the International Monetary Fund (IMF) signals the first time in history a developed nation has missed such a payment.

Such an unprecedented event has left many wondering how Greece’s situation ever got so messy. While some may think that Greece would have been better off never having joined the Eurozone, the fact of the matter is that the Greek economy was suffering structural problems prior to adopting the single currenc. However, rather than helping Greece to surmount its problems, Eurozone membership merely acted as a band aid covering a festering wound that would soon become infected. Greece could have benefited from a better designed Eurozone, but instead suffered from maltreatment of its deadly infection.

Greece before the Euro

Before acceptance into the Eurozone in 2001, Greece’s economy was plagued by several issues. During the 1980s the Greek government pursued expansionary fiscal and monetary policies. But, rather than strengthening the economy, the country suffered soaring inflation rates, high fiscal and trade deficits, low growth rates and several exchange rate crises.

In this dismal economic environment, joining the European Monetary Union (EMU) appeared to offer a glimmer of hope. The belief was that the monetary union backed by the European Central Bank (ECB) would dampen inflation, helping to lower nominal interest rates, thereby encouraging private investment and spurring economic growth. Further, the single currency would eliminate many transaction costs, leaving more money for deficit and debt reduction.

However, acceptance into the Eurozone was conditional, and of all the European Union (EU) member countries, Greece needed the most structural adjustment to comply with the 1992 Maastricht Treaty guidelines. The treaty limits government deficits to 3% of GDP and public debt to 60% of GDP. For the rest of the 1990s Greece attempted to get its fiscal house in order to meet these criteria.

While Greece gaining acceptance to the EMU in 2001, it did so under false pretenses as its deficit and debt were nowhere near being within the Maastricht limits. In 2004, the Greek government openly admitted that its budget figures had been doctored in order to join the Eurozone. Greece’s hopes were that, despite premature entrance, membership to the EMU would help boost the economy, allowing the country to deal with its fiscal problems after the fact. (See also, When Global Economies Converge.)

Eurozone Membership: Sweeping Problems under the Carpet

Greece’s acceptance into the Eurozone had symbolic significance as many banks and investors believed that the single currency effaced differences between countries as structurally disparate as Greece and Germany. Suddenly, Greece was perceived as a safe place to invest, which significantly lowered the interest rates the Greek government was required to pay in order to borrow money. For most of the 2000s, the interest rates that Greece faced were similar to those faced by Germany.

These lower interest rates allowed Greece to borrow at a much cheaper rate than before 2001, fueling an increase in spending. While helping to spur economic growth for a number of years, which created the sense that Eurozone membership was the needed medicine for Greece’s economic ills, the country still had not dealt with its deep-seated fiscal problems which, contrary to what some might think, were not primarily the result of excessive spending.

At root, Greece’s fiscal problems stem from a lack of revenue. As a percentage of GDP, Greece’s social spending expenditures were 10.3% in 1980, 19.3% in 2000 and 23.5% in 2011, whereas Germany’s social expenditures during these same times were 22.1%, 26.6% and 26.2%, respectively. In 2011, Greece was below the EU average of 24.9% in social expenditure. The real problem for Greece is that revenues are much less than expenditures.

Much of this lack of revenue is the result of systematic tax evasion, and it is primarily the wealthier classes, including bankers, lawyers and professional workers, that are responsible. Generally self-employed, these workers tend to under report income while over reporting debt payments. The prevalence of this behavior reveals that, rather than being a behind the scenes problem, it is actually more of a social norm, and tackling the issue is easier said than done.

Lack of Independent Monetary Policy

While Eurozone membership has helped the Greek government to borrow cheaply, helping to finance its operations in the absence of sufficient tax revenues, the single currency has highlighted a structural difference between Greece and other member countries, notably Germany, and exacerbated the government’s fiscal problems. Compared to Germany, Greece has a much lower rate of productivity, making Greek goods and services far less competitive.

The adoption of the euro only served to highlight this competitiveness gap as it made German goods and services relatively cheaper than those in Greece. Giving up independent monetary policy meant that Greece lost the ability to devalue its currency relative to that of Germany’s. This served to worsen Greece’s trade balance, increasing its current account deficit. While the German economy benefits from increased exports to Greece, banks, including German ones, benefit from Greek borrowing to finance the importation of these cheap German goods and services. But, as long as borrowing costs remained relatively cheap and the Greek economy was still growing, these issues could be ignored. (See also, What's the difference between monetary policy and fiscal policy?)

The Global Financial Crisis

The global financial crisis that began in 2007 would see the true nature of Greece’s problems surface from beneath the carpet under which they had been swept. The recession served to weaken Greece’s already paltry tax revenues, causing the deficit to worsen.

In 2010, U.S. financial rating agencies stamped Greek bonds with a 'junk' grade. As capital began drying up Greece was facing a liquidity crisis, forcing the government to begin seeking bailout funding. These bailouts, however, would come at a severe cost: austerity.

Bailouts from the IMF and other European creditors were conditional on Greek budget reforms, namely cuts to spending and increasing tax revenues. These austerity measures have created a vicious cycle of recession, with unemployment reaching 25.4% in August 2012. Not only does this weaken tax revenues, making Greece’s fiscal position worse, but it is creating a humanitarian crisis; homelessness has increased, suicides have hit record highs, and public health has significantly deteriorated. Such severe austerity measures amidst the worst financial crisis since the Great Depression, far from promoting economic growth, are proving to be another nail in Greece’s coffin.

The Bottom Line

Far from helping the Greek economy back on its feet, the bailouts have only served to ensure that Greece’s creditors are paid while the government is forced to scrape together what little its citizens have left to give. While Greece had structural issues in the form of corrupt tax evasion practices, Eurozone membership allowed the country to hide from these problems for a time, but ultimately served to be an economic straitjacket, creating an insurmountable debt crisis as evidenced by the recent default. Whether this default means expulsion from the Eurozone or not is still uncertain, but regardless, the Greek economy has many challenges ahead.

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