Greek mess: the debt crisis untangled

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June is gone, but spring has left more than just beautiful flowers and longer days. June leaves a mark in the history of world economics. On Tuesday, July 1st of 2015 Greece became the first advanced economy to default on an IMF payment, which means that it did not pay the amount that it owed, and still owes, 1.55 billion euros, to the International Monetary Fund. The Hellenic country joins an awkward list that includes nations such as Sudan, Somalia or Iraq. Full list:

Greece joins this list 14 years after Zimbabwe, the last country to default in an IMF payment prior to the Greeks. I do not want to side with any of the two parties in the dispute, this is not our goal AT ALL!  Knowing this, we cannot negate that Greece excesses through the years did put this country in the verge of default (remember that defaulting an IMF payment is not technical a default because the IMF is not considered a commercial lender), however, Europe, represented by the Troika (IMF, Central Bank, and European Commission), has also a high degree of responsibility in the current situation.

I understand that the Greek crisis must be the economic issue with more coverage from the last decades, but I find that when you ask most people about what is going on in Greece, what caused it, how is it developing, and what the consequences of the possible outcomes might be for the European, and the whole world’s economy, the average person doesn’t quite get it, and I do not judge anyone, its quite complex, and the media makes it even more! Sure, most people have heard the news and they have read some articles in a newspaper, online, or in a magazine ( just like they have heard about the Higgs boson, cold fusion or self-driving cars…). But, on average these pieces are not comprehensive and give only bits of information that do not provide a holistic view of the problem, which is the type of view that allows the person being informed to have a reasonable opinion about what is going on.

Well, this issue is way easier to understand than the Higgs boson, cold fussion or even self-driving cars, so, with this post, we try to achieve exactly this, give the average citizen the information to understand the roots, the development and the possible consequences of the conflict, with the least amount of bias possible.  The reader will find a lot of links to articles and books that go deeper in the subject, but these other articles are not a requirement to understand this post. We want to make sure that, after reading this article, everyone can better understand the conflict and the news about it, and that everyone can judge not only who is responsible but also how it might affect their world.

The Greek Tragedy – Timeline

First I would like to show the following infographic in which we lay out the timeline of the debt crisis from the moment that Greece entered the Eurozone.

The most important date here, or at least the one that marked the beginning of the great Greek crisis, is November 5, 2009. On this day the newly elected socialist PM, George Papandreou, admitted that the budget deficit could reach 12.7% of the GDP. This represented almost 4 times the one that the previous right-wing government had projected, 3.7%. In this moment the credit agencies had to downgrade Greece (assign a worst rating to the country’s debt to show the higher probability of default), since the chances of a defaultincreased a sizable amount overnight. Up to the financial crisis Greece’s cost of borrowing was, almost, at the same level as the German, which means that their debt was considered to be as secured as the German one. The following chart shows what happend before and after the crisis started and George Papandreou laid down the truth.

The relevant charts of the story

Now lets explain a little bit of the technicalities involved. We need to see what exactly happened, using charts, in order to be able to understand better the conflict. If you want a more comprehensive explanation, read the Complete history of the Greek debt drama in charts, Mat Phillips does a wonderful job in explaining with reliable data what exactly happened in Greece in the last 40 years.

We will just tell a little bit of what has happened in the last decade with three charts:

First, the Greece consolidated central government debt:

As you can see the debt-to-GDP ratio, despite of the briefly cut of debt load, has continued to increase as the GDP has been shrinking. This situation makes it harder for the Greek government to repay its debt.

Second, Greece unemployment rate:

Due to the austerity measures, the unemployment rates has surged above 25%

Finally, Greece Bank deposits:

The Greek government’s inability to reach another agreement with its creditors has prompted a slow run on Greece banks. This has concluded in the recently decision of installing capital controls.

Why did it happen?

The Greek tragedy that we are currently experiencing is a product of many years of poor political leadership, inconceivable amounts of tax evasion, high degree of corruption, disproportionate growth in government-created jobs, and finally the outrageous pension system. However, it is also consequence of the poor management of the Troika and the European Union of the Greek situation. Europe allowed Greece to cheat in their financial statements without having a proper check system in place, and also to borrow humongous amounts of cash knowing Greece’s history with debt levels. Finally, Europe imposed a tremendously harsh and quite unrealistic austerity program that resulted in a Greek economic recession. In the last 5 years the Greek economy has fallen 25%.

Now, lets start describing Greece’s role in the crisis.

I am borrowing this story from Matthew Lynn a contributor in HistoryToday. You can read the post about the economic record of Greece through history in the article “Greek Economics drachmas debt and Dionysius“. Matthew summarizes a paper that the economist Charles Bullock wrote in 1929. The paper tells the story of Dionysius the Elder. Dionysius ruled Syracuse (currently Sicily), a Greek city-state, from 407BC until 367BC. He was known for launching expensive military campaigns, keeping an extravagant, and expensive, court, and for a few other excessive habits. It got to the point that he run out of cash and no one would lend him any. However, Dionysius thought of a magnificent plan, he ordered (as you know tyrants had a lot of power in those days) all money handed over to the government upon pain of death in order to re-mint every one-drachma coin into a two-drachmae coin. Dionysius then used these freshly minted coins to pay its debt. Moral of the story? Well, as you can see, Greeks have quite the experience at finding uncommon ways to deal with their debt! Remember, I do not want to take sides, I am just stating some true historical facts so we can understand better how did we get to the current situation, and come on! This one is pretty funny. On a more serious note it is really important to remember that Greece has been in default for almost half of the time since it got independent from the Ottoman Empire in the 1830s… Tim Worstall has more to say on his post for Forbes magazine “Greece Has Been In Default For 50% Of Its Time As An Independent Country“.

On to the first point that explains why Greece is in the current situation!

Tax Evasion and Corruption

It seems that the instinct not to pay taxes that Greek citizens posses dates back to the times of the Ottoman Empire domination. Some Greeks even called the unpopular tax on property imposed by the European Union as a part of the austerity plan, the haratsi, a clear reference to the tax imposed by the Ottomans. You can read more in the following article about the book that explains this and other reasons for the crisis: “How The Greeks Ate Their Way To Ruin“.

Tax Evasion has been coined as “a national sport” by Greek politicians. Exorbitant figures have being uncollected, up to $35 billion per year. We need to add here that Greece has the highest rate of self-employment, almost 33%, which assists in the possibility to evade taxes.

According to the Transparency International Greece’s Agreement Assessment made in 2012 there are many factors that confluence and aid the sustention of the high degree of corruption. These are:

• Weak enforcement of the rule of law
• Significant lack of audits
• Nonexistence of a code of conduct
• Lack of transparency in government activities
• Inefficient bureaucratic system
• Broad discretionary powers
• Government impunity
• Lack of public awareness.

Greek politicians and officials take much of the blame as they used civil services and other public sector agencies to exchange political favors for votes and influence. However, it is not only a problem of politicians…

• On the island of Zakynthos, half a thousand people received blindness benefit when they didn’t have any type of vision impediment.
• There were, at a point, 8,500 Greek pensioners claiming to be over 100 years old. Family members were cashing checks of dead people.
• Even agencies like Okana, which deals with drug addiction, has been found to have abused funds in a colossal scale
• In 2010 many professionals with high-paying jobs such as doctors and lawyers were still reporting incomes under 15,000 euros.

And the list goes on and on and on.

Disproportionate growth in government-created jobs

We can illustrate this problem giving the growth numbers during the 80s. The employment in the public sector grew at a 4% or 4 times as fast than in the private sector, as the OECD stated in 2001.

Also, Eurostat stated that public payroll expenses rose in Greece from 38% of the state revenue to a whooping  55% in the year 2000s.

Outrageous pension system

Brian Hayes gives a great extensive summary of how the unsustainability of the pension system in Greece in his article “What’s the issue with the Greece’s pensions system?“. Some of the most shocking statistics that it discusses are the following:

• Greece currently spends 4-5% more than the European average servicing its pension system
• The pension system gets more than 50% of its revenue from the state budget, last year 14 billion euros.
• Before the bailout the Greek system required only 35 years of contributions rather than the 40 years which is generally needed to get a full pension, so most Greeks were early retiring in their 50s.

Other reasons that contributed to the current situations can be listed:

• Growing unemployment
• Bad implementation of reforms
• Power of Greek Unions
• Declining Labor Standards

So what could have Europe done better?

There are many things that Europe didn’t get right in this crisis. There are many theories on why these mistakes were made. For the sake of simplicity we can discuss the major two mistakes that Europe made and that are in direct relationship with the current situation in Greece; the decision to provide a bailout, and the harsh austerity measures imposed in Greece.

The bailout

As Karl Whelan stated in his article “Greece, The Euro and Gunboat Diplomacy“: “Europe’s governments and the IMF made an enormous mistake in bailing out Greece’s private creditors in 2010 and then overseeing a botched debt restructuring in 2012.”

What happened in this bailout is the following. Greece owned a lot of money to private banks and it could not repay this amount. Europe, instead of letting Greece default, provided a massive bailout so the country could pay the private lenders, which left Greece under the political subjugation of the EU. The EU and its members, along with the IMF and the European Central Bank, believed that if Greece was able to adjust its economy by following the austerity measures, the debt could be repaid. However, they were shortsighted, and maybe blinded by their reasons to save Greece, because what they did was just to push the inevitable down the road. Greece lacked then, and lacks now, the means to repay this debt, and what before would only have been a credit event and a minor problem is now an European, and even international, nightmare.

Why did Europe felt the necessity of bailing out Greece? There are many theories, some more plausible than others. Lets list some of them:

• The European political elites felt that a default of a member state would damage the success story of the European Union.
• European governments used the loans to Greece to make sure that German and French banks were protected from a possible contagion from a Greek default. This theory assumes that these banks had a significant exposure to Greek sovereign debt, however it is not quite clear that they actually had this exposure.
• The misconception that a Greek default will cause another Lehmans type of contagion The ECB had this conception and it didn’t doubt to communicate it openly.

I am not giving validity to any of the above-mentioned theories; I am just mentioning them so those of you who want to know more about the topic have a good starting point. These theories are analyzed and discussed deeper in the previously mentioned article by Karl Whelan.

The austerity plan

Economy as a body of knowledge was born in the XIX century, so it is fairly young and economists can make mistakes. It seems that the IMF economists made a mistake. It seems that the IMF has been overly optimistic when judging how good austerity programs are for indebted economies. Olivier Blanchard and Daniel Leigh wrote a paper (Growth Forecast Errors and Fiscal Multipliers) in 2013 stating that:

In advanced economies, stronger planned fiscal consolidation has been associated with lower growth than expected, with the relation being particularly strong, both statistically and economically, early in the crisis. A natural interpretation is that fiscal multipliers were substantially higher than implicitly assumed by forecasters.

What this means is that austerity measures are not as good as the economists thought they would be. As some of you may know, Paul Krugman, the economics Nobel price has been advocating for this idea since the first years of the European crisis.

The reason that the paper gives for these overstatements is that economists at the IMF undervalued the fiscal multiplier. What is this fiscal multiplier? Lets use it in the context that we are treating and you see how easy it is to understand. Almost every economist believes that spending cuts and tax hikes hurt growth. The real issue is how much these measurements hurt growth, which is known as fiscal multiplier and a really important number for fiscal policy. Imagine that a tax increase raises revenues 100 euros in average but reduces the economic output by 50 euros,  this will mean that the fiscal multiplier is 0.5.  Since the benefits of the increase are higher than the drawbacks, the tax increase will shrink the deficit. However, if the decrease in output is higher than the increase in revenues, hence the fiscal multiplier is higher than 1, then the austerity measures can be counterproductive. This is what a lot of economists believe that happened, and is still happening in Greece. The debt burden in Greece has increased since 2010 not due to a increase in the level of debt, but due to a shrinkage in the GDP.

It seems that the lenders requirement of implementing crushing spending cuts and tax increases contributed to the surge in unemployment and the decrease in living standards. This point, the decrease in living standards, has been one of the main issues through the 5 years of austerity. The measurements left nearly a million people without access to healthcare, which resulted in rising infant mortality rates, soaring levels of HIV infection, the return of malaria, and a spike in the suicide count.

How does the current situation look like in Greece?

The Greek government has officially imposed capital controls in order to contain the possible bank runs. If Greeks take enough cash out of their country’s banks, these banks will lose the capability to make loans, which will result in a financial crisis.  This is why the ATM withdrawals are limited to 60 euros a day (this number has been decreased to 50 because the 20 euros bills are running out), per account. Transfers from a Greek account to a foreign account are currently banned as well. Despite of the fact that pension and wage payments have not officially being halted, some pensioners have not been able to retire their last payment and there are almost permanent lines in front of banks.

An association of Greek hotels warned last Monday these measurements are already hurting the tourism industry. Some gas stations are running out of fuel and the Greek government has made the rides on metro, tram, bus, and trolley bus free in the Athens area, where about 40% of the population lives. This measurement is costing the government 4 million euros per week, as the Transport Minister Christos Spirtzis communicated.

Many small businesses are reportedly running out of cash and the entire Greek business community is having difficulties to import anything, of course without raw materials, the Greek industry won’t last long. The telegraph reported that “holidaymakers in Greece will be unable to buy food or medicine within days if a deal is not reached to reopen the banks.”

What can we expect?

Now, Greece, Europe, and the rest of the world are waiting for the result of the referendum. This is what the Greeks will be voting for:

Here an infograph developed by the CNBC that explains what are the possible paths depending on the result of the referendum.

The most prominent economic scholars look divided in this particular issue. Paul Krugman and Joe Stiglitz both vigorously support the no, others such as Costas Meghir believe that the only option is the yes. We don’t have the appropriate knowledge to judge which result would be better for Greece and Europe. However we see the following possible consequences.

If YES wins

If the Yes wins, there will be a possible change in government on Greece, the economic situation will come back to the state previous to this last episode and Greece will suffer the consequences of even more austerity measures. It is really hard to tell how this will end. It looks like the civil unrest will continue and another episode will occur in a not far future date if the Troika and Greece cannot agree in a growth pact.

If NO wins

In this case, we believe that the Troika won’t back down on its requirements and Greece will run out of euros on Monday. The government will have to run a parallel currency to be able to pay salaries and resume the normal business activity. Jérémy Cohen-Setton explains the mechanics of a parallel currency system in its post “The Economics of a Parallel Currency“. The Grexit will be really close if a No wins.