Download The Economics of Austerity and the Vicious Spirals of Greece

The Economics of Austerity and the
Vicious Spirals of Greece
Nikolai Vike
Master´s thesis for the degree
Master of Economic Theory and Econometrics
Department of Economics
UNIVERSITY OF OSLO
May 2016
II
The Economics of Austerity and the Vicious
Spirals of Greece
III
© Nikolai Vike
2016
The Economics of Austerity and the Vicious Spirals of Greece
Nikolai Vike
http://www.duo.uio.no/
Trykk: Reprosentralen, Universitetet i Oslo
IV
Summary
After Greece joined the European Monetary Union in 2001 the country accumulated many
macroeconomic and financial vulnerabilities. Easy access to international funds at low
borrowing costs in combination with high economic growth reduced the real value of debt
and stimulated to increased borrowing by governments in several euro-countries in order
to finance fiscal deficits which further worsened their current-account deficits, especially
in Greece and Portugal. Greece’s large and negative current-account balance made the
country especially prone to a financial crisis as the country relied heavily on foreign capital
inflows. After the financial crisis in 2008, capital inflows into Greece froze and the country
had to reduce its deficits. In 2009, new revisions about earlier reported macroeconomic
numbers where revealed and they turned out to be much worse than earlier reported. Fiscal mismanagement and deception through misreported statistics throughout the period
from 2001 when Greece joined the euro harmed investor confidence when the true numbers were revealed, hence increasing borrowing costs and raised the spreads on sovereign
bonds. The sharp decline in capital inflows from surplus countries in combination with
soaring interest rates on sovereign debt made it impossible for Greece to re-pay its debt.
Since then, Greece has received three bailout packages from the IMF and the European
community. The loans where disbursed in smaller amounts conditional on whether Greece
managed to satisfy several conditionality criteria which were included in the deal. Greece
had to reach strict fiscal targets underway which forced the country to implement a mix
of structural reforms and fiscal austerity. The goal of this thesis is to analyse and discuss
the effectiveness and risks associated with such policy in crisis-stricken Greece, using two
different macroeconomic models.
Based on the standard definition of sustainable debt by the IMF, chapter two shows
in this model with a risk premium extension by Mehlum (2012) that, by increasing the
primary surplus through austerity in order to achieve a sustainable debt level, interest
rates on bonds will increase as a response to the austerity and the uncertainty that such
measures represent. By extending the model to include a negative relationship between
austerity and economic growth, the model contains an unstable equilibrium at a lower
level of the debt stabilizing primary surplus than otherwise. The model can be used to
show that a significant debt relief could eliminate the unstable equilibria and the threat of
V
a vicious spiral in the market for sovereign debt. However, in the extended version of the
model this is not the case. With a negative relationship between austerity and growth, an
unstable equilibrium still exists even after the debt relief. Thus, any significant adverse
economic shock to any of the variables in the model could force Greece back into difficulties. The model implies that, in order to avoid a vicious spiral in the market for sovereign
debt, Greece needs a debt restructuring in order to stay away from the crisis zone where
risk premiums and growth reductions are continuous threats. In order to remain in the
good and stable equilibrium, Greece needs economic growth. The model shows how the
ECB instrument of outright monetary transactions could eliminate the bad equilibrium
by promising to intervene in the market for sovereign debt and secure a maximum price
on bonds. The very existence of the instrument could eliminate the fear of a vicious spiral
and the promise of intervention could be enough. However, the extended version of the
model shows that, as long as there is a negative relationship between the debt stabilizing
primary surplus and growth, the promise of intervention is no longer enough and the ECB
could be forced to intervene.
According to Gali et al. (2007), Christiano et al. (2011), DeLong and Summers
(2012), Auerbach and Gorodnichenko (2012) among many others, there is much to gain
from fiscal stimulus during a recession as the fiscal multiplier exceeds unity. Based on a
Keynesian model as shown in Holden (2015), chapter three shows how the extraordinary
circumstances of the Greek crisis might result in a distress premium which somewhat
offsets the positive effects from debt-financed fiscal stimulus. The interlinked crises of
sovereign debt, growth and banking, in combination with the insecurity and distress associated with a possible Grexit, could give rise to so much distress that any debt-financed
fiscal stimulus could loose its effect through increased distress premiums. Normally, as
shown by DeLong and Summers (2012), fiscal stimulus during a recession will increase
expected inflation and reduce the risk spreads - further reducing the real interest rate.
However, the IS-DP-model could imply the opposite. Next, by using a model by Mehlum
(2014), chapter three further discusses how austerity during a recession could result in a
total collapse of the economy as a result of continuously increased recession premiums.
Fiscal austerity could also reduce the beneficial effects from the ECB instruments of targeted longer-term refinancing operations and the corporate sector purchase programme.
The ECB is increasing supply of credit in an environment where fiscal austerity depresses
demand. Fiscal austerity also brings with it severe political and social effects. As argued
by Sinn (2014), even though fiscal austerity could improve Greek competitiveness if also
surplus countries are willing to simultaneously reduce their advantage in trade, differential
inflation could lead to a rebalanced eurozone. But this is difficult to achieve in a monetary
union with a central bank that follows a mandate of achieving price stability. This thesis
suggests that fiscal austerity during a recession implies several risks and should be delayed
VI
until Greece is no longer threatened by all the possible adverse effects discussed throughout. The Greek crisis contains so many interlinked vulnerabilities that a solution calls
for bold and coordinated measures beyond austerity. Any beneficial effects that austerity
might imply could in all likelihood not be achievable in a distressful economy threatened
by vicious spirals and social strife.
VII
Preface
Even though writing this thesis has been a demanding challenge, it has most of all been
an enjoyable and inspiring time. The process brought me from writing my basic bulletpoints at Blindern in early January to proudly making my final notes while sitting in an
Athenian garden-café with a good view over the Acropolis in late April. When I found
myself among the monuments of the Acropolis or in front of the Greek Parliament it
really hit me how ironic it is that Greece - the birthplace of democracy - is now the
European center stage of economic and political drama. First of all I would like to thank
my supervisor, Professor Halvor Mehlum, for helping me formulate a research question
which perfectly fitted my interests and ideas, and for his excellent guidance throughout
the semester. I would like to thank my brother, Magnus Ripegutu Vike, for sharing his
linguistic expertise. I would also like to thank my fellow students and good friends, Snorre
Solli, Kjetil Tveit Moen, and Suzanna Rye for commenting on earlier drafts of the thesis
and for kind and motivating words throughout the process.
VIII
Contents
List of Figures
X
List of Tables
XII
1 Introduction
1
2 The Greek Crisis and Recovery: Fiscal Corrections with Adverse Effects
in the Market for Sovereign Debt
4
2.1
Fiscal Aspects of Monetary Integration: Why the Experiment Should Work
4
2.2
What Went Wrong? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6
2.3
An Overview of the Greek Debt Crisis . . . . . . . . . . . . . . . . . . . .
7
2.3.1
An Unbalanced Eurozone
7
2.3.2
Greece after 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.4
. . . . . . . . . . . . . . . . . . . . . . .
The Sustainability of the Greek Sovereign Debt . . . . . . . . . . . . . . . 17
2.4.1
Examples of Models of Debt Crises . . . . . . . . . . . . . . . . . . 17
2.4.2
The Algebra of Sustainable Debt and Some Theories on Debt Accumulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.4.3
The Vicious Spiral between Investor Confidence, Growth, and Sustainability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.4.4
Outright Monetary Transactions . . . . . . . . . . . . . . . . . . . . 28
3 Vicious Spirals in the Real Economy
3.1
32
The Effectiveness of Fiscal Stimulus during Crises . . . . . . . . . . . . . . 32
3.1.1
The Fiscal Multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.1.2
The Interlinked Crises of Greece and the Distress Premium . . . . . 35
3.2
Fiscal Austerity and Prior Actions: Distortionary Tax Increases and Government Spending Cuts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
3.3
Fiscal Austerity: A Temporary Recession or Another Vicious Spiral? . . . 44
3.4
3.3.1
The Fiscal Multiplier and the G-T Contradiction . . . . . . . . . . 44
3.3.2
The Recession Premium and the Armoury of the ECB . . . . . . . 46
Expansionary Fiscal Contractions and the Confidence Fairy . . . . . . . . . 49
IX
3.5
3.6
Beyond the Keynesian Effects: Social and Political Effects of Austerity in
a Recession . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
The Way Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4 Conclusion
58
Bibliography
62
Appendices
68
A The Model
69
X
List of Figures
2.1
2.2
Source: Eurostat. Average general government budget balance between
2003-2007 as percent of GDP . . . . . . . . . . . . . . . . . . . . . . . . .
8
Source: Eurostat. Current Accounts in the Eurozone in 2007 as percent of
GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9
2.3
Source: Macrobond. Quarterly evolution of Greek public debt . . . . . . . 12
2.4
Source: Macrobond. Greek unemployment rate . . . . . . . . . . . . . . . 13
2.5
Source: Macrobond. 10-year yields on government bonds among four european countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.6
Source: Eurostat. Evolution of Greek gross government debt as percent of
GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.7
The possibilities of a vicious spiral and the effects of a debt relief in the
case of (i) fixed rate of interest (ii) risk premium . . . . . . . . . . . . . . . 26
2.8
Alternative (iii): The vicious spiral between investor confidence, growth,
and sustainability and the effects of a debt relief . . . . . . . . . . . . . . . 28
2.9
The effects of Outright Monetary Transactions . . . . . . . . . . . . . . . . 29
3.1
Typical (Y, i)-diagram with a fixed exchange rate . . . . . . . . . . . . . . 33
3.2
IS-DP: The effect of a positive shock to government expenses with distress
premium in a monetary union . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.3
Source: European Commission AMECO database. The evolution of indirect taxes, direct taxes and social contributions in Greece as percent of
GDP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
3.4
Source: European Commission AMECO database. The evolution of Greek
total general government expenditures as percent of GDP between 2008-2016. 43
3.5
Source: European Commission AMECO database. The convergence between Greek total expenses and revenues as percent of GDP between 2008
- 2016. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
3.6
IS-RP: The effect of a negative shock to government expenses with an
endogenous recession premium in a monetary union . . . . . . . . . . . . . 47
XI
List of Tables
2.1
Source: The Bank of Greece, Eurostat, and AMECO. Economic Statistic
Table for Greece between 2007-2016 . . . . . . . . . . . . . . . . . . . . . . 16
XII
Chapter 1
Introduction
The Greek debt crisis led the country into a recession in late 2009 with a debt-to-GDP
ratio at an unsustainable level. As a member country of the European Monetary Union
(EMU) Greece could not use monetary policy as a stabilizing tool and was therefore left
with internal devaluation after the financial crisis hit Europe. The resulting sharp decline
in wages and GDP growth made it even more difficult for Greece to honour its debt.
Greece was therefore forced to negotiate an adjustment programme in 2010 in order to
receive a bailout package from other European governments and the IMF (International
Monetary Fund). But Greece fell into deeper recession and the first bailout package would
later be followed by two more. The programmes included several conditionality criteria of
structural reforms where fiscal austerity was inevitable. Those programmes were supposed
to improve the unsustainable debt level, reduce the primary deficits, safeguard financial
stability and modernize the State. While the programme did result in lower primary
deficits, it also led to social and political turmoil and further macroeconomic instability.
From 2009 and up until the end of 2015, primary deficits have been reduced from 10 to 3
percent of GDP. However, during the same period unemployment rose from 12.7 percent
to 25.1 percent and wages were cut. In addition, bond yields soared while the debt-toGDP ratio continued to increase and real GDP growth continued to decline, as if there
was a vicious spiral. Every country that spend beyond their means will eventually face
a period of cuts. But as the Greek debt crisis has shown - austerity pushed too far may
create significantly adverse effects and disturbances during the period of adjustment.
According to the classical Keynesian theory, cuts or increases in taxes and government expenses are driven by a multiplier which further magnifies the original action.
Thus, countries facing a downturn should use expansionary fiscal policy, and use contractionary fiscal policy only to cool down an overheated economy. However, in order to
minimize the amount of financial aid, Greece’s creditors such as the IMF and the European Financial Stability Facility (which later evolved into the current European Stability
Mechanism (ESM)) required the Greek government to agree on fiscal consolidation in
1
order to get the debt level and primary deficits under control as fast as possible. Strict
fiscal discipline might not only mean minimized costs for the creditors, but it could also
create expansionary effects in the Greek real economy. This policy proved to be costly
for all parts as the austerity brought with it severe adverse economic, political and social
effects. From a Keynesian point of view, some of the actions taken have been contradictory and inefficient - pushing Greece closer to a bad equilibrium than towards prosperity.
The economics of austerity seems to trigger a polarized debate among economists. Some
argue that a combination of structural reforms and fiscal consolidation is the cure that
will save a country from further misery. Structural reforms may create a more productive economic base, while austerity measures provide a signal of a commitment to restore
fiscal discipline, hence lay the foundations for optimistic expectations and expansionary
effects (Fels and Froehlich, 1986; Hellewig and Neumann, 1987). More importantly, since
the European debt crisis was a result of significant imbalances in current accounts and
competitiveness, internal devaluation and austerity are required in order to truly fix the
underlying problems that lead to a crisis in the first place (Sinn, 2014). However, others
argue that the difference between reforming a bad administrative structure and economic
austerity has been lost in crude financial thinking and suggest that the way of practising
fiscal policy should return to the Keynesian way of thinking about economics, where austerity should be used as a mechanism to cool down an overheated economy, and should not
be analysed without considering the adverse political and social costs that are doomed to
follow if used during a recession (Stiglitz, 2002; Krugmann, 2013; Wolf, 2014; Sen, 2012,
among others). The goal of this thesis is to discuss these opposing views and cast more
light on the relative costs and benefits associated with each. Was the Greek crisis a result
of excessive spending over income? Did the austerity measures prove to be successful in
restoring growth and improving the underlying conditions which lead to a crisis in the
first place? How does fiscal austerity affect public finances? How does a fiscal expansion
affect the Greek real economy in a recession? How does fiscal austerity affect the Greek
real economy in a recession? These questions will be discussed in this thesis.
The thesis is structured as follows: chapter 2 gives a short overview of the Greek
debt crisis and discusses key macroeconomic variables of Greece and how they developed
during the last decade. The next section takes a closer look on the algebra of sustainable
sovereign debt and the theories of strategic debt accumulation and self-fulfilling debt equilibria. Then I analyse the evolution of public debt by applying a model which captures
the links between debt, interest rates, growth, and investor confidence and discuss the
factors which might trap the debt level in a bad equilibrium. The analysis builds on a
model by Mehlum (2012) and is extended by modelling the link between austerity and
economic growth. Chapter 3 starts by briefly discussing the Keynesian model as described
by Holden (2015) and the fiscal multiplier before further discussing the the factors which
2
could make the multiplier large or small in times of crisis. Next, I introduce a variable
of distress and analyse why expansionary fiscal policy in Greece might work insufficiently
when the fiscal stimulus is financed by foreign loans which only increases the debt level
and adversely affects a banking sector in distress. This variable might also be a function
of several other extraordinary circumstances of the Greek economy, making a positive fiscal multiplier somewhat offset by the negative effects from continuously increased distress
premiums. The next section gives a short overview of the austerity measures and prior
actions Greece has implemented in order to receive bailout packages from the IMF and the
ESM. Then the Keynesian model is further extended to include an endogenous recession
premium as suggested by Mehlum (2014) in order to model an environment where fiscal
austerity during a recession creates a vicious spiral in the real economy. The chapter
further discusses the theory of expansionary fiscal contractions and other theories which
provides some arguments in support of austerity during a downturn. Finally, the chapter
discusses some political and social adverse effects of austerity. Chapter 4 concludes and
will shed more light on the polarized debate which characterizes the economics of austerity.
Keywords: Fiscal austerity, recession, current account, sovereign debt, risk premium,
economic growth, vicious spiral, debt-to-GDP ratio, government expenses.
3
Chapter 2
The Greek Crisis and Recovery:
Fiscal Corrections with Adverse
Effects in the Market for Sovereign
Debt
2.1
Fiscal Aspects of Monetary Integration: Why the
Experiment Should Work
The Maastricht Treaty of 1992 sets the ground rules for the European Monetary Union.
Some of the criteria of sound fiscal policy that must be satisfied in order to join the union
are that each member country’s annual government deficit must not exceed 3 percent of
GDP, and that the debt-to-GDP ratio is not exceeding 60 percent, as later defined in the
Stability and Growth Pact of 1997. Member countries that achieve those goals over the
medium term will make it possible for the automatic stabilizers to play freely1 . This is the
”preventive arm” of the pact. The Stability and Growth Pact also contains a ”dissuasive
arm” through the ”Excessive Deficit Procedure” (EDP) which ensures a correction process
in every country that fails to satisfy the conditions. The dissuasive arm further contains
a set of sanctions that will be imposed on any member state that fails to implement the
EDP in due time. Dornbusch (1997) analyses whether so much attention to fiscal issues is
at all relevant in a monetary union. By using an application of the Barro-Gordon model
where the authorities minimize a loss function for a given expected rate of inflation, it
serves to show how such an often used modelling framework implies how debt is a risk
1
The pact allows the time horizon to vary, depending on country-specific circumstances such as the
level of debt and the growth rate. Such country-specific medium-term budgetary objectives (MTOs)
adds flexibility to the pact. However, one could argue that such flexibility may give rise to opportunistic
interpretations, discussions and conflicts.
4
factor for sound monetary policy2 . The higher the level of debt, the more tempting it
is for the authorities to inflate away parts of it, and the higher is the optimal level of
inflation. Thus, limits on debt and deficits are necessary to avoid such temptations. However, Dornbusch suggests three arguments of why the focus on such limitations is overdone.
First, he argues that:
the provisions for the European Central Bank assure that the institution is
independent, cannot solicit or accept guidance, and cannot finance governments. The extra provision of no bailouts of public debts eliminates an immediate spillover effect of poor public finance to the central bank or countries‘
budgets. Thus, insistence on debt provisions is overkill, and the dash for fiscal
probity that is under way is not justifiable by a concern for sound money.
(Dornbusch, 1997, p. 222)
The no-bailout clause in the original Maastricht treaty implied that any national government that failed to meet its debt obligations had to declare sovereign default. This clause
should have had the desired effect that the euro countries should not borrow excessively.
When default is the only option if a crisis occurs, countries should not have any incentives
to borrow more than they can repay (no moral hazard). Second, he argues that:
the static game laid out above [the Barro-Gordon framework] seriously misrepresents the opportunities for inflationary strategies to accomplish debt reduction. In any multiperiod game there will be punishment, and that means
higher nominal interest rates and worsening of trade-offs. (Dornbusch, 1997,
p. 222)
As governments understand the real costs associated with this spiral, the application of
the Barro-Gordon model loses some validity. Finally, he explains how a worsening of one
country’s debt will not pose a threat to the overall stability of the union as bonds are
substitutes. The market provides discipline as investors substitute away from holding
bonds considered more risky than others. E.g. a worsening of Greek debt will be a Greek
problem as investors shift from Greek bonds to, say, German bonds. Thus, there is an
adjustment in all yields as the spread of Greek bonds over German bonds will rise. This
adjustment implies that a debt crisis in one individual country will not spread to other
euro countries. As Greece must struggle with a higher interest rate on its debt, Germany
benefits from a reduced interest rate and a beneficial ”safe-haven” response. ”Hence there
is one more reason why the insistence on fiscal criteria in the EMU is vastly overdone”
(Dornbusch, 1997, p. 223).
2
The original model is found in Barro and Gordon (1983).
5
2.2
What Went Wrong?
History shows that the no-bailout clause was not credible enough to avoid excessive debt
accumulation as several countries continued to accumulate debt after joining the union.
The low credibility of the no-bailout policy made the euro-countries realize that future
EMU-policies would not necessarily coincide with the once optimal plan of no bailouts resulting in a time-consistency problem for the EMU policymakers. When the European
debt crisis did happen, the no-bailout policy seemed no longer optimal as the costs associated with letting a highly indebted country default was larger than actually assisting
in its recovery. Letting a highly indebted country default would imply that the creditor
countries would face large economic losses. There would also be symbolic costs associated
with the failure of creating a stable and strong European union. This further damaged
the reputation of the no-bailout clause and provided countries with further incentives
for excessive spending. In addition there already existed other international economic
institutions that could provide financial assistance during times of crisis, such as the IMF
with a clear mandate of achieving global macroeconomic stability. The convergence of
bond yields between 2000 and 2009 reflected that investors did not expect any sovereign
default to occur as the costs would be to great.
Having discussed moral hazard and the time-consistency problem, this establishes a
counterargument to Dornbusch’s main message and provided a rationale for the Stability
and Growth Pact. As long as there are possibilities of large fiscal imbalances among
countries within the euro area, strong and well enforced common fiscal targets are needed
in order to ensure the singleness of monetary policy. But even with such rules in place, a
crisis did occur. This could be a consequence of the flaws within the Stability and Growth
Pact itself. Some argue that there is an asymmetric incentive structure, an incentive gap,
in the pact as there are sanctions for failing to meet the criteria but no rewards from
achieving them (see for example van den Noord, 2007). And as argued by Sapir (2007,
p. 89), national authorities may not share a sense of ownership towards the rules of the
pact, and the general population may not fully understand the rationale behind it. In
addition:
[...]the 3 percent rule is not based on rational economic analysis. It is an
arbitrary number. Thus, intelligent people (policy makers) will not subject
themselves to a rule that is perceived as unintelligent, especially when these
policymakers face strong commitments vis-à-vis their electorate during a recession. They will put the rule aside. (De Grauwe, 2007, p. 184)
Meeting the criteria was crucial for countries that wished to be a part of the EMU, but as
soon as this mission was completed, incentives changed. Then, ”the only ”stick” left to
the EU authorities was the less tangible risk of uncertain and delayed pecuniary sanctions
6
and loss of reputation. Since SGP stipulated that fiscal positions have to be close to balance or in surplus ”over the medium run”, there was no clear timetable for compliance”
(van den Noord, 2007, p. 41). This, combined with weaknesses in enforcement, prevented
the Stability and Growth Pact to work sufficiently as a preventive and dissuasive pact.
Thus, a period of fiscal convergence in the late 1990s happened as countries focused on
achieving the fiscal targets in order to join the monetary union. However, this ended in
a period of divergence during the 2000s as several member countries found it optimal to
run large deficits and increase their public spending (more on this in section 2.4.2) rather
than comply to the pact.
One of the member countries that diverged the most was Greece. Greece represents
a tragic case when it comes to sound fiscal policy and it is no secret that the country
has a long history of excessive spending, government budget deficits and high debt levels.
According to Dornbusch, paying much attention to fiscal issues is overdone, but this
turned out to be clearly wrong in the case of Greece, especially since the no-bailout
clause had little or no credibility and the dissuasive arm of the Stability and Growth Pact
were insufficient to prevent deviation. In 2010, Greece received its first bailout package
from the IMF in addition to bilateral loans from other euro governments. Since 2012
the situation became so severe that the prospect of leaving the eurozone emerged. But
was it simply the case that the Greek tragedy, and the broader European sovereign debt
crisis, was solely a problem of excessive public spending? Or was it more a problem of the
broader unbalanced economic structure of the eurozone? The next section will discuss in
more detail how Greece’s mismanaged economy ended in a nightmare for the EMU and
themselves - a nightmare in which there is no imminent awakening.
2.3
2.3.1
An Overview of the Greek Debt Crisis
An Unbalanced Eurozone
Greece joined the euro in 2001 after a long period of adjustment away from high inflation,
large government deficits and a high exchange rate relative to its trading partners. In the
following years between 2003-2007, Greece and many other euro countries experienced a
significant accumulation of macroeconomic and financial vulnerabilities as they fell for
the temptation to take advantage of the highly liquid banking system and the economic
benefits which followed after the creation of the euro. Easy access to international funds
at low borrowing costs in combination with high economic growth reduced the real value
of debt and stimulated to increased borrowing by governments in several euro countries
in order to finance fiscal deficits which further worsened their current-account deficits, especially in Greece and Portugal. Excessive public spending stimulated private investment
7
Figure 2.1: Source: Eurostat. Average general government budget balance between 20032007 as percent of GDP
which translated into larger current-account deficits, i.e. the twin deficit. In other countries, such as Ireland and Spain, the debt accumulation was mainly private as the credit
boom significantly increased consumption and investment in these countries. However,
private debt accumulation was evident also in several other euro-countries. By looking at
loans to the private sector from domestic banks and other credit institutions as percent
of GDP, Lane (2012, pp. 52-53) shows how especially Portugal, Ireland, Italy, Greece,
and Spain experienced significant increases in private credit dynamics between 1998 and
2007, while Germany’s and France’s credit dynamics were relatively stable at a high level
through the period. E.g while Greek private sector loans increased from 56.5 percent of
GDP in 2002 to 84.4 percent in 2007, German private credit dynamics were relatively
stable around 110 percent. Figure 2.1 shows the average general government budget balance between 2003-2007 among several countries in the eurozone3 . Among the countries
who would later be hit hardest by the European debt crisis it is clear that Ireland and
Spain performed remarkably well as the debt accumulation was mainly private, while Italy
was just marginally below the Maastricht criteria. Among the countries that would not
be severely hit by the crisis, i.e. Germany, Netherlands, and Belgium, the figure shows
that they all ran fiscal deficits. The large deficit in Greece was not solely a result of too
high public spending - it was mainly due to an ineffective administrative State which
made possible an extreme level of tax evasion which created a large difference between
expenses and revenues (Wolf, 2014, p. 46). In his article Why austerity is the only cure
for the eurozone the German Finance Minister Wolfgang Schäubel writes ”Whatever role
the markets have played in catalysing the sovereign debt crisis, it is an indisputable fact
that excessive state spending has led to unsustainable levels of debt and deficits that now
threaten our economic welfare” (Schäuble, 2011). However, according to figure 2.1, the
argument is not persuasive as the most well performing countries during the crisis did all
3
According to Eurostat, the general government sector comprises central government, state government, local government, and social security funds.
8
Figure 2.2: Source: Eurostat. Current Accounts in the Eurozone in 2007 as percent of
GDP
run deficits, while Ireland and Spain - who were hit hard by the debt crisis after 2007,
performed remarkably well.
Consider next the current account imbalances which developed after the adoption of
the euro. The governments and private sectors in Portugal, Ireland, Italy, Greece, and
Spain enjoyed the credit boom up until 2007 which resulted in increased inflation above the
eurozone average, increased prices and wages. Thus the countries became current-account
deficit countries with excessive spending over income, relying more on foreign capital
inflows. Other countries such as Germany, Netherlands and Belgium focused on reducing
labour costs and improve productivity so to further improve their competitiveness, making
them current-account surplus countries (see e.g. Holden, 2012; Wolf, 2014, pp. 74-85;
and Lane, 2012). Figure 2.2 illustrates current account imbalances in 2007. First of all,
the figure says something about the direction of the capital flow. High-saving-surpluscountries such as Germany, Netherlands, and Belgium invested much of their savings in
the dynamic economies of the south. According to Wolf (2014, pp. 59-85) the pattern
also suggests strengthening of external competitiveness in surplus countries and declining
competitiveness in the deficit countries:
Moreover, these losses of competitiveness were inevitably associated with longlasting changes in the structure of economies: in surplus countries, industries
that produce tradable goods and services, particularly export-oriented manufacturing, expanded, as in Germany. In countries with external deficits, the
opposite happened: businesses oriented to the domestic economy, such as construction and retail, expanded, as in Spain. (Wolf, 2014, p. 63)
And as further explained by Sinn (2014), the periphery countries lost their competitiveness
by simply becoming too expensive. The export sector has more potential for productivity
growth, thus the imbalance ran the risk of further diverging productivity. The increas9
ing difference in current accounts and competitiveness created unsustainable imbalances
where a financial crisis would have large asymmetric impacts. In 2008 a financial crisis
did hit Europe, resulting in a sudden stop of capital inflow into deficit countries. The
subsequent worsening of primary deficits was therefore in part a consequence of a crisis not the reason.
Comparing figure 2.1 and 2.2, one could argue that current account imbalances do a
better job in predicting which countries would suffer the most after a financial crisis. If
the debt crisis was fiscal in its roots, it is impossible to see from figure 2.1 that it should
be Germany who ended up as a safe haven country after the crisis. Since the problem
that led to the European debt crisis was the loss of competitiveness among periphery
countries, Sinn argues that the eurozone needs to re-balance:
The realignment is necessary to achieve debt sustainability and regain competitiveness, and competitiveness is a prerequisite for new growth. Keynesian
demand stimuli is not sustainable. At best it is an improvement in capacity
utilization. Sustainable growth, by contrast, will only result if a country is
truly competitive in the sense of being inexpensive enough, given the nature
and quality of its products, to enjoy high demand for its products from abroad
and to be an attractive business location. (Sinn, 2014, p. 5)
The challenge is that the current accounts are jointly determined so that surplus countries
would need to become more expensive in order for deficits countries to be able to regain
competitiveness. Sinn calls for an opposite Keynesian policy where deficit countries need
austerity and internal devaluation in order to regain competitiveness whereas surplus
countries could benefit from fiscal expansion and inflation. Austerity is a rough medicine
and brings with it adverse economic, social, and political effects and is experienced as a
punishment by any country who gets such a medicine imposed on them. Therefore, such
policies raise a moral question. According to Wolf: ”The surpluses entail deficits and vice
versa. Because they are jointly determined, it is logically impossible to say that countries
in deficit are responsible for their plight while those in surplus are guiltless. That is
childish moralism” (Wolf, 2014, p. 63). The deficits of Greece were made possible by
the investments from the surplus countries. This is only one aspect of the heated debate
regarding the economics of austerity. 4 .
2.3.2
Greece after 2007
At the onset of the financial crisis, Greece ran a current-account deficit of almost 15 percent of GDP and a government-budget deficit of around 10 percent of GDP. The country
4
For a more complete overview of the origins of the European sovereign debt crisis, see Holden (2012),
Lane (2012), Wolf (2014), and Abbas et al. (2014).
10
mainly relied on running a foreign-capital surplus as it ran both a current-account -and a
budget deficit after high spending by successive governments relative to revenues raised.
But as the foreign-capital surplus is very responsive to risk and uncertainty, the outbreak
of the worldwide financial crisis was the starting point for a sudden stop in capital inflow
which decreased the foreign-financial surplus, forcing Greece to lower its deficits. Since
currency devaluation is not an option in a monetary union, Greek wages fell and GDP
was reduced through internal devaluation resulting in a recession which increased the
debt-to-GDP ratio.
2009 was a critical year for Greece as new revisions about Greek debt and primary
deficits were made and published by the newly elected government led by Prime Minister
Georgios Papandreou, and it turned out to be a lot worse than earlier reported. The
budget deficit forecast for 2009 was revised from around 6 percent to GDP to around 12
percent. Fiscal mismanagement and deception through misreported statistics throughout
the period from 2001 when Greece joined the euro harmed investor confidence when the
true numbers were revealed, hence increasing borrowing costs and raised the spreads on
sovereign bonds. The sudden stop in capital inflow in combination with low investor confidence made it almost impossible for Greece to finance its deficits. Greece was the first
country to be shut out of the bond market in May 2010 when Greek government bonds
got junk status and the private capital market froze5 . The country was in desperate need
of financial aid in order to avoid default. Since then, Greece and its creditors have agreed
upon three bailout packages in total. The first package of 110 billion euro bailout loan
were agreed upon in May 2010 where 80 billion were financed in the form of bilateral
loans from by the euro area Member States and additional 30 billion came from the IMF.
The time horizon of the package was three years, but this proved to be too short a time
by far in order for Greece to satisfy the conditionality. Hence, the first package was soon
followed by a second package of 164.5 billion euro loan (an additional 130 billion plus
the undisbursed amount from the first package) agreed upon in 2012, financed by the
EFSF and the IMF. The loans were to be transferred in smaller disbursements during the
next three years given that the conditionality criteria were met. The conditionality can
be summarized into the four areas of restoring fiscal sustainability, safeguarding financial stability, enhancing growth, competitiveness and investment, and developing a more
modern State with a public administration. The last point was motivated by the fact that
Greece have had a highly inefficient tax system with a high degree of tax evasion, one of
Europe’s most generous pension systems, and an inefficient public administration with a
poor history of fiscal discipline. However, the criteria were not met, meaning that funds
were often withheld until they were (Kuttner, 2013, p. 148). When the EFSF programme
expired in June 2015, 130.9 billion euros were still outstanding. A third bailout loan of
5
Greece did not re-enter the bond market before July 2014
11
Figure 2.3: Source: Macrobond. Quarterly evolution of Greek public debt
86 billion euros, provided by the ESM and the IMF, was agreed upon in 2015 in order to
further repay the creditors, pay down interest and recapitalize banks6 .
The Greek public debt has been steadily increasing up until the bailout packages. Figure 2.3 shows the quarterly evolution of the Greek public debt from 2005-2015, reaching
an all time high of approximately 369 billion euro in December 2011. The large drop in
2012 corresponds to the component of the second bailout package which included ”Private
Sector Involvement” (PSI) which resulted in a face value loss of 53.5 percent on 97 percent of all privately held Greek bonds. According to Arslanap and Tsuda (2012), Greek
sovereign debt held by domestic banks at that time were about 15 percent of the total,
making the public sector exposed to a banking crisis and the banking sector exposed to
sovereign default. About 10 percent of the total were held by domestic nonbanks. The
debt relief put downward pressure on the debt crisis but resulted in large losses among
banks and nonbaks which held Greek bonds. Except from the PSI, the debt continued to rise after the two first packages. By dividing the the total amount into smaller
disbursements, providing them conditionally on good behaviour, clearly undermined the
effectiveness of the loans.
Figure 2.4 shows the unemployment rate between 2004-2015, being above 25 percent
between 2013-2015. The unemployment rate was averaging approximately 16 percent between 2004-2015. According to the Greek National Statistical Service, the unemployment
rate for workers between 20-24 years old exceeded 55 percent in 2013, and exceeded 70
percent for youths between 15-19 in the same year. As the budget deficit was reduced
through austerity measures during 2011-12, increased unemployment followed as a side
effect.
6
A complete overview of the amounts and dates of the disbursements is available at:
http://ec.europa.eu/economy finance/assistance eu ms/greek loan facility/index en.htm
12
Figure 2.4: Source: Macrobond. Greek unemployment rate
Figure 2.5 illustrates the treasury yields on 10-year Greek government bonds compared
to those of Germany, Italy, and the United Kingdom. Except from the British pound, the
sovereign debts are denominated in a common currency, the euro. This implies that the
yield curves mainly reflect the credit-risk perceptions for each individual country. From
the 1990s to the beginning of the 2000s there was a period of convergence as the countries
prepared their entry into the EMU. Greece had experienced high inflation and exchange
rates vis-à-vis its trading partners, but managed to improve its position as the country
prepared to meet the Maastricht criteria through fiscal adjustments. The interest rate
on Greek bonds converged later than the interest rate on the countries’ debt as Greece
was the last country to join the eruo in 2001. The figure shows that the interest rates
on both German and British debt have been relatively stable trough the period. German
debt has benefited from a safe-haven response as the Greek and Italian debt have been
perceived as more risky, exactly in line with Dornbusch’s argument of market discipline.
It is clear that ”Germany [one of Greece’ major creditors], the country that gave us the
word schadenfreude, has been profiting from the misfortune of others” (Kuttner, 2013,
p. 115). In the case of the United Kingdom, the country always has the opportunity to
print new money in order to pay down debt. Because of this opportunity the interest
rates on British debt have followed almost the same safe pattern as those of Germany.
The low spread on sovereign debt between 2000 and 2009 reflects how investors perceived
the credit risk within the EMU as low and a fiscal crisis as unlikely, and there were no
longer any risks associated with exchange rates - resulting in a period of harmony in
the sovereign-debt market. This probably also reflected that the no-bailout clause of the
Maastricht treaty had little or no credibility. However, a large increase in Greek yields
started in 2009-10 when the true national statistics were revealed, the capital inflow into
Greece froze, and Greece received its first bailout package. It is interesting to note how
the yields remained relatively stable during 2008 and 2009 even though the financial crisis
13
had spread to Europe. According to Lane (2012), during those years, investors may have
not fully anticipated a sovereign-debt crisis, as the main focus was on saving the banking
system. However, this changed as the distress in the banking sector soon became a problem of macroeconomic fundamentals. Even though Greece got its first bailout package
in 2010, the interest rate continued to increase until the beginning of 2012. This says
something about how investors interpreted the austerity package and its ability to save
Greece and how the austerity affected confidence. In addition, the announcement of the
PSI component of the second package and the complicated negotiations concerning its
magnitude contributed to drive the interest rate further upwards. The final agreement
on the second bailout package, the implementation of the PSI, and the announcement of
new monetary policy instruments created by the ECB who was ”ready to do whatever it
takes” to stabilize the eurozone (discussed in depth in later sections) made the interest
rate decline in 2012. Hence, even though the history is repeating itself through diverging
interest rates on sovereign debt, the divergence during the last years is happening for fundamentally different reasons than in the case of 1990. At the time of writing, the interest
rate on Greek bonds is again increasing.
Finally, table 2.1 summarizes Greek key macroeconomic numbers in a table. Especially
interesting are the government budget balance and debt-to-GDP ratio which were never
close to meet the Maastricht criteria. As austerity slowly reduced the budget- and primary
balance from 2009, the Greeks has suffered from adverse side effects such as reduced
minimum wage and increased unemployment. There were also significant side effects in
the overall growth of the economy. The annual change in real GDP growth from 2009
has been negative throughout except from 2014. Greek GDP growth had its worst year
in 2011 with a growth rate of -9.1 percent. In 2014 the real growth rate turned positive,
but at the time of writing the growth rate is again negative. The European Commission
projects a real GDP growth rate of -0.7 in 2016. The austerity measures are supposed to
improve Greek competitiveness. The current-account deficit has been almost continuously
reduced since 2008, but this is mainly a result of a larger reduction in imports relative to
the reduction in exports since 2007. According to Sinn:
The reason for the current account deficit improvements is primarily a strong
decline in imports, which did not signal an improvement in competitiveness
but was simply a result of the recession. Declining incomes and mass unemployment constituted an income effect that necessarily reduced imports.
(Sinn, 2014, p. 7)
The GDP price deflator in table 2.1 shows that prices have fallen from 2013 and onwards
relative to the 2010 base-year. Thus, cheaper domestic goods and services could shift
demand from imports towards domestic oriented goods and services. Further, the price
14
Figure 2.5: Source: Macrobond. 10-year yields on government bonds among four european
countries
15
Table 2.1: Source: The Bank of Greece, Eurostat, and AMECO. Economic Statistic Table
for Greece between 2007-2016
Year
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Nominal GDP
232.7
242.0
237.5
226.0
207.0
191.2
180.4
177.6
175.7
174.4
Public debt
239.9
264.7
300.9
330.4
356.0
304.8
319.2
317.1
314.4
322.7
103.1
109.4
126.7
146.2
172.0
159.4
177.0
178.6
179.0
185.0
Primary balance
-2.2
-5.4
-10.1
-5.4
-3.0
-3.7
-8.4
0.4
-3.5
0.5
Budget balance
-6.7
-10.2
-15.2
-11.2
-10.2
-8.8
-12.4
-3.6
-7.6
-3.4
3.3
-0.3
-4.3
-5.5
-9.1
-7.3
-3.2
0.7
-0.2
-0.7
8.4
7.8
9.6
12.7
17.9
24.5
27.5
26.5
25.1
24.0
4.5
4.8
5.17
9.09
15.74
22.81
10.05
6.92
8.86
9.41
-15.6
-15.8
-12.5
-13.11
-10.3
-4.2
-2.2
-3.0
-1.8
-1.4
92.8
96.8
99.3
100
100.8
100.4
97.9
95.6
94.7
94.7
92.7
96.7
94.6
100
105.8
108.5
106.6
104.6
96.5
98.5
817.83
862.82
862.62
876.62
683.76
683.76
683.76
Debt-to-GDP
ratio
Real GDP
growth rate
Unemployment
rate
Treasury yield on
10-year gov’ bonds
Current account
balance
GDP price
deflator
Price deflator exports
of goods and services
Minimum wage
730.30 794.02
Notes: Nominal GDP: at current prices in billion euros (AMECO). Public debt: general government consolidated gross debt in billion euro
(AMECO). Debt-to-GDP ratio: general government consolidated gross debt divided by nominal GDP at current prices (AMECO). Primary
balance: net lending or net borrowing as percent of GDP, excluding interest (AMECO). Budget balance: general government net lending or
net borrowing (AMECO). Real GDP growth rate: percentage change (in volume) on precious year (Eurostat), where the number for 2016 is
a forecast by the European Commission. Unemployment rate: unemployed persons as a share of the total labour force (AMECO). Treasury
yield on 10-year government bonds: yearly average yields expressed in percentages (the Bank of Greece), where the interest rate for 2016 is
calculated as the average rate applying from January-April. Current account balance: balance on current transactions (percentage of GDP
at market prices) with the rest of the world (AMECO). GDP price deflator: average of national growth rates weighted with current values
in euro with base-year 2010 (AMECO). Price deflator exports of goods and services: average of national growth rates weighted with current
values in euro with base-year 2010 (AMECO). Minimum wage: in EUR/month (Eurostat).
deflator for exports of goods and services has not changed much from the base year of
2010. Export prices have declined by even less than the GDP price deflator. Thus, as
the austerity has reduced the primary surplus and the current account at the expense of
unemployment and growth, little has happened to improve Greek competitiveness as the
current-account deficit has been reduced because of increased unemployment rather than
lower relative prices. ”Plainly, Greece [...] have a particular long way to go to achieve
debt sustainability, but practically none of the necessary adjustment has taken place yet,
despite the fact that the crisis has lasted already more than five years” (Sinn, 2014, p. 6).
To summarize, the fact that Greece joined the monetary union with misreported statistics about key macroeconomic variables put the Maastricht Treaty and Dornbusch arguments to a test. Greece had clearly violated the debt-to-GDP and budget deficit criteria.
However, the excessive spending and current-account deficit of Greece were made possible
16
by foreign-capital inflow from surplus countries such as Germany. ”Yes, the Greeks should
have paid their taxes and run their government more responsibly. But the fact that they
behaved in this way was really no secret. Caveat creditor - let the lender beware- is a
good motto” (Wolf, 2014, p. 182). Thus, the financial crisis, in combination with reduced
investor confidence when the true statistics of Greece went public, resulted in an asymmetric shock of huge proportions. The no-bailout condition needed to be relaxed in order
to save Greece from default, resulting in three bailout packages in total between 2010-15.
The conditionality and austerity measures agreed upon during the bailout negotiations
proved to be costly as they resulted in severe adverse effects. This triggered the debate
about whether economic recovery and structural reforms in the eurozone should indeed
be done through fiscal austerity or Keynesian expansions and debt restructuring. The
remaining part of this chapter will discuss this further.
2.4
The Sustainability of the Greek Sovereign Debt
2.4.1
Examples of Models of Debt Crises
In 2011 Greece partially repudiated on its debt after investors accepted a 53.5 percent
face value loss in their Greek debt holdings. It is the fear of such losses that drives the
interest rate on bonds. The rate of interest is dependent upon investor’s confidence in
the the country’s ability to honour its debt and the history of repudiation. A history
of repudiation gives reasons for investors to be pessimistic about the country’ repayment
ability which again opens the possibility of several equilibria and self-fulfilling expectations
in the market for sovereign debt. Calvo (1988) develops a model where he shows how
partial repudiation often is a best response for the government. In this economy, multiple
debt equilibria exist and they are a function of consumers’ expectations about future
repudiation. He models taxation as distortionary i.e. the deadweight cost of taxation
is an increasing convex function of the tax level. The fact that taxation, here the only
way to pay down debt, has a cost gives the government an incentive to renege on the
debt. But repudiation also comes with a cost which is proportional to the amount being
repudiated, and this cost is also financed by taxation. Without describing the two-period
model in detail, multiple equilibria exist because consumers’ expectations about possible
repudiation is reflected in the interest rates on government bonds. Those expectations are
based on the level of existing debt, the cost of repudiation, and the governments optimal
taxation. If the consumers believe that the level of taxation is not sufficient in order to
pay the debt in full, they will demand a higher interest rate which makes it more difficult
for the government to actually do so. Thus, debt repudiation is a self-fulfilling prophecy.
Calvo writes:
our results suggest that postponing taxes (i.e. falling into debt) may generate
17
the seeds of indeterminacy; it may, in other words, generate a situation in
which the effects of policy are at the mercy of people’s expectations - gone
would be the hopes of leading the economy along an optimal path. (Calvo,
1988, p. 648)
According to this theory there are possibilities of several equilibria. Relative to the good
equilibrium where optimistic expectations and low interest rate result in full downpayment of the debt, the bad equilibrium is Pareto-dominated as everyone would be better
off in the good equilibrium case. Though not modelling Greek default as a best response
in a game theoretic sense in the model used later in this chapter, the model builds on the
idea that the interest rate is driven by expectations which creates several equilibria in the
bond market.
Building on this theory and inspired by the Mexican debt crisis of 1994-95, Cole and
Kehoe (2000) develop a model which shows how a self-fulfilling debt crisis can be triggered
by loss of confidence in the government. For given values of fundamentals such as the
government’s debt level, its maturity, and the existing capital stock, the ability of the
government to roll over its debt is determined by the probability the investors assign to
the governments ability to repay in the future. They characterize three zones: the crisis
zone, the default zone, and the no-crisis zone. By applying this model to Greece one could
find several interesting implications. Suppose the extremely high debt level puts Greece in
the crisis zone so that a debt crisis can occur with a positive probability. Then, according
to the model, investors will anticipate a possible default, hence the price the investors are
willing to pay for government bonds is depressed. This makes it more difficult for the
government to roll over its debt and is therefore forced to reduce government spending.
In the final step of the game the consumers make an optimal decision about consumption and capital accumulation, taking future productivity and the previous moves made
by the financial markets and the government as given. If the government defaulted in
the previous period or the consumers expect a default in the future, this may harm the
governments reputation which affects the productivity of the economy in future periods.
This will in turn result in lower output and consumption and enable a subsequent crisis.
Greece is then trapped in a bad equilibrium as lower investor demand, reduced government spending, lower consumption and capital accumulation are mutual best responses
by all agents in the economy. The assumption that a debt crisis can be triggered by pessimistic beliefs among investors in the financial market gives the government incentives
to pay down its debt faster in order to avoid the spiral. Moving across the threshold from
the crisis zone to the non-crisis zone will boost investor demand, reduce interest rates
on government bonds, and increase productivity as investors and consumers no longer
assign any probability to the possibility of default. The model shows the importance of
getting the debt level stabilized at a sustainable level as this will have positive effects on
18
the overall economic performance. Countries can find themselves in very different equilibria with only small differences in fundamentals. The authors conclude that ”overall,
our model implies that the only way to avoid debt crisis is to avoid the conditions on
fundamentals that make them possible: in particular, relatively high levels of debt with
a short maturity structure” (Cole and Kehoe, 2000, p. 110). The model applied next
will focus on a similar link between debt, interest rate, and economic activity, and is thus
inspired by the body of work mainly attributable to these authors.
2.4.2
The Algebra of Sustainable Debt and Some Theories on
Debt Accumulation
This section will describe a standard model of sustainable debt as often applied by the
IMF. The notation used in this section is taken from Mehlum (2012). By definition, debt
is sustainable if the level of debt does not grow faster than the GDP and it is possible to
hold the debt-to-GDP ratio constant over time. The evolution of debt, ∆B, is determined
by down payment, H, and interest on the existing debt, r
∆B = rB − H
(2.1)
Suppose that g denotes the growth rate of GDP. Since a sustainable debt level by definition does not grow faster than the GDP, then the maximum change in public debt the
government can afford according to the definition of sustainability is given by
∆B = gB
(2.2)
Finally suppose that the amount of resources for downpayment are determined by the
size of the primary surplus, denoted a, as a fraction of GDP and rewrite the requirement
for sustainable debt into
(2.3)
gB = rB − aY
where (2.2) have been inserted into (2.1) and B denotes a sustainable debt level. It follows
that the sustainable debt ratio, S, is
S=
B
a
=
Y
r−g
(2.4)
Thus, the higher the economic growth and primary surplus, the higher the debt level
could be and still be sustainable. Consider the Greek numbers for 2015 which showed
a real GDP growth rate of -0.2 percent and a primary balance of -3.5. According to
19
the IMF, the effective interest rate7 was projected to be 2.1 percent conditional on full
implementation of the program (IMF, 2015, p. 19). By using this interest rate as an
approximation for the true borrowing costs on official Greek borrowing, this corresponds
to a sustainable debt level of approximately -85 percent of GDP8 , while the actual debt
level is 179.0! This implies that the only sustainable scenario for Greece, given the large
deficit and absence of growth, is to be a creditor - not a debtor. Thus, in the current
economic environment, Greece is extremely far from achieving a constant debt-to-GDP
ratio over time according to equation (2.4).
The fact that Greece is far from able to keep its debt-to-GDP ratio constant over
time is illustrated in figure 2.6. The figure illustrates the evolution of the Greek gross
government debt as percent of GDP compared to Germany and the entire euro area. The
ratio has been increasing almost the entire period, except from a small decline in 2012
due to the PSI and bailouts. According to the IMF, debt sustainability is defined as
an debt-to-GDP ratio less than 120 percent. In the figure, this threshold were crossed
in 2008 and the debt has been unsustainable ever since. By comparing figure 2.6 and
figure 2.3 it is clear that the drop in the debt-to-GDP ratio in 2012 is small relative to
the large drop in public debt which was made possible through the debt relief the same
year. However, table 2.1 shows an extremely low GDP growth rate of about -10 percent
of GDP. Thus, even though private holders of Greek debt accepted a face value loss which
reduced Greece’s total debt burden, the debt-to-GDP ratio was reduced by only a modest
amount because of the low growth of the Greek economy. This clearly shows how a debt
relief has a limited effect on the debt-to-GDP ratio if the economy is not able to produce
any economic growth.
At this point it is relevant to ask why and how several Greek governments could allow such an enormous debt accumulation. The elevating debt-to-GDP ratio after 2007 is
clearly a result of the sudden stop in capital inflow which significantly increased the real
value of debt as the economy went into a recession. But why the high level of debt in the
first place, besides the institutional failures of the EMU? Typical macroeconomic textbook explanations for debt accumulation is mainly about tax smoothing and the strategic
debt accumulation theory from political economy.
Consider the model of tax smoothing by Barro (1979). The intuition is that, assuming
that marginal distortion of raising tax revenues is increasing in the amount of tax revenues
raised, smoothing taxation minimizes the distortions. This implies that running a bud7
”Defined as interest payments divided by debt stock at the end of the previous year” (IMF, 2015, p.
19).
8
S=
−0.035
0.021−(−0.02)
= −85 percent.
20
Figure 2.6: Source: Eurostat. Evolution of Greek gross government debt as percent of
GDP
get deficit might actually be an optimal response by the government when anticipating a
fall in future government expenditures. When economic shocks are anticipated, such as
wars or recessions, fiscal imbalances might be preferable as changes in the tax policy creates distortions9 . This provides a rationale for debt accumulation through debt issuance.
However, Greece has shown a systematic tendency towards high deficits regardless of the
variation in government expenditures which casts some doubt on whether this model is a
good approximation for Greece.
Suppose current Greek policymakers may believe that the future policy will be set
by political opponents who they disagree with, hence the current policymakers use their
position to distribute resources in a way they see most appropriate, and by doing so excessively they restrain the government spending of future governments by running strategic
deficits. Alesina and Tabellini (1990) argue that the equilibrium stock of public debt in
democracies tends to be larger than what is socially optimal because of the uncertainty of
whom will be appointed in the future. Given this uncertainty, and with sufficient polarization between political parties who disagree on the composition of public expenditures,
each party will not fully internalize the full cost of public debt. Since deficits and debt
accumulation represent future tax distortions and less scope for public spending, the party
in power is concerned about the trade-off between those negative effects with the probability of staying in office and of who is paying the bill in the future. Hence, democracies
exhibits higher deficits and debt levels than in the case of a social planner appointed for9
Within the Keynesian framework we can show that, by setting G = T and assume a balanced budget,
the multiplier increases compared to the case when keeping T fixed, implying budget deficits/surpluses
when G varies. Hence, any negative shock to the interest rate is more destabilizing when running balanced
budgets as the IS-curve is less steep in this case.
21
ever. In Greece during the last three decades, PASOK (Panhelleninc Socialist Movement)
and ND (New Democracy) alternated in power until the election in 2009. Whether the
model of Alesina and Tabellini applies to Greece in this period depends on the degree
on polarization between the two parties. According to Pappas: ”Greek polarization has
been strategic polarization, pursued deliberately by pragmatic parties competing to grab
the state single-handedly and control its resources” (Pappas, 2013, p. 40). As the deficits
and debt grew rapidly under both parties, one could argue that the model implications
could contribute in explaining parts of the excessive government spending up until 2009.
The two-party system of Greece might also have led to continuously delayed stabilization. Policymakers may agree that the deficit should be lower but still being unable
to agree on the policy which can achieve it. ”Specifically, inefficient deficits can persist
because each policymaker or interest group delays agreeing to fiscal reform in the hope
that others will bear a larger portion of the burden” (Romer, 2012, p. 617). Alesina and
Drazen (1991) develops a mathematical model and illustrate that the larger the benefits
of continuing to delay relative to accept the reform, the more likely is a war of attrition. Delayed stabilization is a function of political polarization and the authors mention
several examples of this. For example after WWII there was an agreement to reduce the
large deficits that resulted after the war but there was often much disagreement over what
groups in society that should pay in form of increased taxes, and this delayed the fiscal
stabilization in several countries. The authors assume that the pre-stabilization process is
characterized by inefficient methods of financing government expenditures and widespread
political lobbying which are direct costs for all. However, a stabilization agreement means
moving away from inefficiency which benefits all. How long the delay will last is determined by how long it takes before one political part (representing a socio-economic group)
agrees on bearing a disproportionate share of the tax increase. Agreement happens when
the cost of delay is less than or equals the cost of postponing reforms. But as the debt
level increases, so too does the difference between the payoffs for the winners and losers.
Thus, each political part will devote more time to lobbying in order to induce its rivals to
concede. The model of Alesina and Drazen assumes two polarized parts which has been
the case with ND and PASOK in Greece up until 2009. However, after the crisis, the
two-party system changed into an ”extremely polarized form of multipartism” (Pappas,
2013, p. 43) The theory is still appealing in a way that, as policy is set by several parties
representing several socio-economic groups, this may delay reforms depending on the heterogeneity between them. This has been especially evident from the complex bargaining
processes over structural reforms and austerity measures since the first adjustment programme. However, one could also argue that the scope of the current Greek crisis is of a
magnitude so great that the cost of delaying fiscal corrections clearly outweighs any gains
from delay.
22
2.4.3
The Vicious Spiral between Investor Confidence, Growth,
and Sustainability
”I will have my bond” - Shylock, in William Shakespeare’s ”The Merchant of Venice”
Subsection 2.4.2 showed how a high primary surplus only had a positive effect on the
level of sustainable debt. However, since primary surpluses represent fiscal consolidation
it may be reasonable to assume that the variable will affect both the interest rate and
economic growth. Now suppose there is a critical level of primary surplus so that if the
primary surplus needed for debt sustainability exceeds this critical level it will affect investor’s confidence. As a response to crossing this level, investors demand a risk premium
in order to be willing to buy sovereign debt. With a high level of debt in combination
with low economic growth and high borrowing costs, Greece is forced to accomplish a high
primary surplus, i.e. a high a, through austerity measures which hamper further growth
and increases unemployment. Hence, investors demand a risk premium, e(a), which again
affects the required a for sustainable debt as it increases the borrowing costs for the government.
This assumption is consistent with several empirical findings. According to von Hagen et al. (2011), their empirical strategy identifies a significant relationship between
budgetary positions and risk premiums on government bonds in the euro area countries
relative to safe haven German bonds. They use data up until 2009 and find that markets
penalise fiscal imbalances in the form of fiscal deficits and debt much more strongly than
before. During the post Lehman-crisis they find that elasticities for deficit differentials
(relative to a benchamrk country) are three to four times larger than earlier, and those
for debt differentials are seven to eight times larger (higher debt differential is often accompanied by higher interest rates and low growth, further affecting the required a and
risk premiums). The euro area countries should, they argue, pay much more attention to
their budgetary positions in order to safeguard against the high costs of public debt. For
Greece, relatively weak fiscal performance explains around half of the increase in spreads
during the financial crisis according to he authors. Laubach (2009) finds that the estimated effects of government deficits and debt on interest rates are statistically significant
and economically relevant. The risk premium increases by 4 basis points per percentage
increase in the debt-to-GDP ratio over 60 percent. This method is suggested by the IMF
staff when they forecast the future borrowing cost. In their report they suggest that:
Borrowing from the market is assumed at an average maturity of 5 years and
average nominal interest rate of 6.25 percent for the next several decades.
23
This is calibrated as follows: the market cost of Greek debt prior to the crisis
- when there was limited differentiation of risk and spreads were compressed
- was about 5 percent, to which an additional modest spread is considered.
(IMF, 2015, p. 6)
The modest spread could alternatively, they argue, be based on the empirical finding by
Laubach. An additional source of risk premium may be the the lending institutions themselves. As the IMF and the ESM are the senior creditors (they get paid back first) we
could argue that the loans contribute to continuously raise the risk premium by private
financial institutions as they know that the Greek government will use the next decades
to re-pay senior creditors. Private investors get what is left over. It is ironic if the IMF
projections of future interest rates should turn out to be underestimated since the IMF
itself may be one of the determinants behind the risk premium through its bailout packages and senior creditor status.
Having established how risk premiums may play a key role in determining the level of
sustainable debt, consider next the possibility of a link between public debt and economic
growth. According to Reinhart and Rogoff (2010) there is a negative association between
total debt and growth. They argue that, whereas the link between growth and debt
seems relatively weak at ”normal” debt levels, median growth rates for countries with
public debt over roughly 90 percent of GDP are about one percent lower than otherwise;
average growth rates are several percent lower. However, their analysis does not consider
the issue of reverse causality. Kumar and Woo (2014) run a panel regression with data
from 1970 to 2008 and provides evidence of a slowdown in annual real per capita GDP
growth of around 0.2 percent points per year on average when following a 10 percentage
point increase in the public debt-to-GDP ratio, significant at a 1 percentage level. They
further find that, by including an interaction term between initial public debt and foreign
liabilities (a dummy variable that equals 1 if foreign liabilities exceed 89 percent of GDP)
the adverse impact of debt on growth is approximately two times larger in countries where
foreign liabilities are high, such as in Greece10 . On the other hand, Panizza and Presbitero
(2014) find by using an instrumental variable approach that the link between debt and
growth disappears when they correct for endogeneity. This suggests an extension to the
model used in this chapter where, as in the case with risk premium, a high level of debt
is negatively associated with economic growth. But instead of modelling growth as a
direct function of the debt level, this model builds on the Keynesian paradigm where
debt adversely affects growth through the fiscal consolidation needed in order to achieve
the debt stabilizing primary surplus. It is important to emphasize that, since this model
does not assume a causal link from debt to growth, the link exists only because of the
10
The net external debt position of Greece crossed the 89 percent of GDP threshold in 2000:Q2 according to Eurostat
24
chosen policy of austerity and the preference for achieving sustainable debt. As Panizza
and Presbitero argue:
Our finding that there is no evidence that the public debt has a causal effect
on economic growth is important in the light of the fact that the negative
correlation between debt and growth is sometimes used to justify policies that
assume that debt has a negative causal effect on economic growth. (Panizza
and Presbitero, 2014, p. 21)
Taking these considerations into account, modify equation (2.4) into the following
expression of sustainable debt as shown by Mehlum (2012)
S=
B
a
=
Y
r0 + e(a) − g(a)
(2.5)
where I have extended the model to include a negative relationship between growth and
sustainability. In this expression r0 is the risk free interest rate, the risk premium satisfies
e(a) = 0 when a < a∗ and e0 (a) > 0 when a ≥ a∗ . This captures the link between
sustainability and investor confidence according to Mehlum (2012). In my extension I
assume that g 0 (a) < 0 when a ≥ a∗, and g 0 (a) = 0 otherwise. This captures the negative
link between sustainability and economic growth. In order to simplify the discussion,
assume that the critical threshold a∗ is the same for both the risk premium and growth.
This way of modelling sustainable debt differs from the simple equation in (2.4) as a large
primary surplus no longer has a solely positive effect on sustainable debt. Now the model
also incorporates some possible adverse effects of fiscal corrections by using the ideas of
Calvo (1988) and Cole and Kehoe (2000) where expectation-driven risk premiums give
rise to several debt equilibria within different crisis zones. By rearranging equation (2.5)
in order to get a on the left hand side the expression becomes
a=
B
(r0 + e(a) − g(a))
Y
(2.6)
which is the primary surplus needed in order for actual debt, B, to be sustainable. An
increased interest rate r0 may thus have asymmetric effects in countries with small differences in fundamentals. Assume that Germany is in the non-crisis zone by being below
the critical threshold a∗ and Greece is in the crisis zone by being above it. An increase in
r0 increases a in both countries, but the effect is more complex in Greece. Equation (2.6)
shows that a higher a leads to a further increase in the costs of borrowing in Greece but
not in Germany. Increased borrowing costs trigger more austerity and austerity adversely
affects borrowing costs. Thus, there is a vicious spiral between the two. In fact, Germany
may benefit as investors shift from holding Greek debt to holding German debt instead.
In addition, an increased a reduces growth in Greece, whereas growth is unaffected in
25
Germany. Lower growth increases the debt stabilizing primary surplus which again implies even more austerity - damaging growth even further. This is another vicious spiral.
Next, consider the following three different alternatives within the model, illustrated in
figures being different versions of the one found in Mehlum (2012):
(i) Suppose first there is no relationship between investor confidence, growth and sustainability so that equation (2.4) holds and that the interest rate on bonds is simply given
by the fixed risk free rate of interest i.e. r = r0 . This is illustrated in figure 2.7. In the figure there is only one intersection which implies a stable equilibrium point A0 . A marginal
increase in a from point A0 implies that the government runs a larger primary surplus
than what is needed in order to achieve sustainability at the given rate of interest. Then
it is optimal to reduce the surplus until point A0 . A marginal decrease in a from point A0
implies the opposite. With no relationship between risk premium, growth and sustainability, a vicious spiral is not a possibility within the model. In this setting, a debt relief from
B0 to B1 tilts the curve illustrating the primary surplus upwards - implying an even lower
optimal a in point A1 . A debt relief has a unambiguous positive effect. The larger the
debt relief, the steeper the curve becomes, hence shifting the equilibrium more to the left.
Alternative (ii): r = r0 + e(a)
r
C1
a=
B1
(r
Y
a=
− g)
B0
(r
Y
− g)
C0
r0
A1
Alternative (i): r = r0
A0
a
a∗
Figure 2.7: The possibilities of a vicious spiral and the effects of a debt relief in the case
of (i) fixed rate of interest (ii) risk premium
26
(ii) Now suppose there is a negative relationship between sustainability and the risk
premium so that the interest rate is given by r = r0 + e(a). After the threshold a∗ there
is then a kink in the interest rate curve. This is illustrated in figure 2.7. While point A0
represents a stable equilibrium, point C0 represents an unstable one. A marginal decrease
in a from point C0 implies a reduced interest rate and a good spiral towards point A0 .
A marginal increase in a from point C0 implies a jump in the interest rate which again
increases the required a - creating a vicious spiral. A debt relief from B0 to B1 tilts the
curve illustrating the debt stabilizing primary surplus upwards, just as in the previous
alternative. This implies that the good equilibrium becomes possible at lower levels of
a as in point A1 . In addition, the unstable equilibrium is moved from point C0 to C1 .
Thus, a vicious spiral is less likely and possible only at extremely high levels of a. A
large enough debt relief could fully eliminate the bad equilibrium, as illustrated by the
tilted, dashed curve. If Greece is initially in point C0 , a debt relief will push the a to
the beneficial side of the unstable equilibrium so that the good spiral would kick in and
continue until A1 .
(iii) Finally, consider the model extension and suppose that the required a for sustainability affects growth negatively. Then the curve illustrating the debt stabilizing primary
surplus will kink at the threshold a∗ as shown in figure 2.8, assuming that the threshold
is equal for both e(a) and g(a). By comparing the unstable equilibrium point C0 with the
one in the previous alternative, the figure shows that the vicious spiral is created earlier
and from lower values of a when modelling growth as a function of the debt stabilizing
primary surplus than if not. If austerity is seen as a necessity when the debt level is
large as the government tries to achieve the required a for sustainability, the fiscal consolidation directly affects interest rate and growth negatively. The austerity measures end
up making the debt level even more unsustainable by triggering a vicious spiral. In this
model, a debt relief from B0 to B1 tilts the curve representing equation (2.5) upwards as
shown in figure 2.8. The effect is identical to the ones in the previous examples up until
a∗ . However, instead of eliminating the vicious spiral after a significant debt relief, the
adverse effect on growth results in an intersection in the unstable equilibrium point C1 .
The debt relief has a modest effect in eliminating the existence of a possible vicious spiral.
But, if Greece is initially in C0 before the debt relief, the effect is still unambiguous and
sets in motion the good spiral towards A1 . But a bad equilibrium is still present in the
economy, so any large adverse shock to any of the variables in (2.6) may force Greece back
into difficulties. To conclude, if Greece is indeed in a bad equilibrium the country would
benefit greatly from a debt relief. The alternative is the risk of getting into a vicious
spiral and default as a result of a tragic hunt for sustainable debt under worse and worse
conditions.
27
r = r0 + e(a)
r
C1
r0 A1
a=
B1
(r
Y
− g(a))
a=
B0
(r
Y
− g(a))
C0
A0
a
a∗
Figure 2.8: Alternative (iii): The vicious spiral between investor confidence, growth, and
sustainability and the effects of a debt relief
2.4.4
Outright Monetary Transactions
The interest rate on Greek 10-year bonds has followed a U-shaped pattern between 2012
and 2016. The large drop in the interest rate in 2012 was mainly a result of the debt
relief and the launch of the second bailout package. But suppose that the interest rate
was affected by the optimism originated from the announcement of the OMT-programme
developed by the ECB the same year, though the programme was mainly designed to
prevent a vicious spiral in Spain and Italy by decreasing borrowing costs on Spanish and
Italian debt. The programme was developed with the aim of reducing the divergence in
bond yields and ”[...] to safeguard the monetary transmission mechanism in all countries in the euro area” (ECB, 2012). Achieving to reduce the divergence in bond yields
would not only reduce borrowing costs for governments and reduce the probability of a
vicious spiral in the market for sovereign debt, but also have positive effects in the real
economy as ”changes in long-term government bond-yields are an important driver of corporate bond yields and bank lending rates - either through arbitrage relations or through
sovereign bonds directly serving as a benchmark for the pricing of loans and other assets”
(Cæuré, 2013). By undertaking OMTs in the secondary market for sovereign bonds in
the euro area, conditional one a set of criteria the governments needed to fulfil, the ECB
could eliminate some of the ”unfounded fears” for the vicious spiral discussed above11 .
11
This is not a violation of the Article 123 of the EU Treaty as the secondary market is not considered
as direct financing of governments.
28
By promising to intervene after the client country had signed up on the austerity programme and, for whatever reason, the interest rates on the country’s bonds should still be
distressed, the ECB was implicitly guaranteeing an maximum interest rate and minimum
price on sovereign debt. Though never used, the instrument turned out have an effect on
interest rates i.e. the promise of intervention was enough. Figure 2.5 shows, for example,
how the interest rate on Italian debt fell after the announcement. If investors in the bond
market believed that the possible intervention by the ECB would result in a maximum
interest rate on bonds, this could eliminate the bad equilibrium and hence the vicious spiral. As the instrument gave the ECB a stronger role as a lender of last resort, confidence
returned which further affected the bank-sovereign link positively as the the banking sector could reduce its fear for sovereign default. Figure 2.9 illustrates the possibility where
the OMTs could eliminate the vicious spiral. In the case of alternative (ii) of the model;
r
r = r0 + e(a)
a=
C( ii)
r0
C( iii)
A0
B
(r
Y
− g)
r = rOM T s
a=
B
(r
Y
− g(a))
a
a∗
Figure 2.9: The effects of Outright Monetary Transactions
by guaranteeing a maximum interest rate through intervention in the secondary market
for bonds, the ECB could eliminate the unstable equilibrium in point C( ii) and put an
end to the vicious spiral in the case of g 0 (a) = 0. Only point A0 remains and the promise
of intervention would be enough. Consider now alternative (iii) with the adverse effect
on growth. Point C( iii) in figure 2.9 is still an unstable equilibrium which means that a
marginal increase in a from that point will force the ECB to intervene in order to stop the
spiral. The promise of intervention would no longer be sufficient. Thus, the model shows
that there may exist possible scenarios where the ECB no longer can manage to control
the diverging interest rates only though the existence of the instrument, but rather being
enforced to use it. Again, a debt restructuring and growth-promoting policies which could
29
reduce the debt-to-GDP ratio and establish the economy in A0 is preferable.
The instrument was created in order to reduce the interest rate on sovereign debt.
However, in the model used here, low economic growth is a main determinant behind the
bad outcomes. Since the implementation of the instrument is conditional on austerity and austerity negatively affects growth - there is indeed a contradiction. The plan does
not add up as the adverse effects of fiscal corrections imposed in order to get assistance
through the OMTs reduces growth and makes the implementation of the instrument only
more unlikely as the fiscal targets become harder to achieve in the first place. ”If a country
were to violate the conditions of its agreed programme, ECB support would cease. But
this would also be when the market’s panic was greatets” (Wolf, 2014, p. 57). Instead of
sending a clear message that speculating in sovereign debt does not pay, the instrument
loses its credibility as the the countries need to sign up on the austerity programmes
beforehand. As governments and private investors see this contradiction, the instrument
loses its credibility and interest rates may again elevate. Thus, the U-shaped yield-curve
on Greek sovereign debt.
In the debt sustainability analysis (DSA) for Greece, developed by the IMF staff, the
conclusion is that the Greek debt may become sustainable in the future but will remain
highly vulnerable. They write that ”with debt remaining very high, any further deterioration in growth rates or in the medium-term primary surplus relative to the revised baseline
scenario discussed here would result in significant increases in debt and gross financing
needs [...]. This points to the high vulnerability of the debt dynamics” (IMF, 2015, p. 10).
This analysis is based on a set of underlying assumptions about future macroeconomic
variables where e.g. the analysis assumes that real GDP growth will grow steadily up to 3
percent in 2018 and the primary surplus will stabilize at 3.5 percent in 2018 and onwards,
conditional on full implementation of the programme. If this should not be the case, IMF
suggests that doubling the maturity on existing and new loans, with further financing
needs and debt relief, would be needed. This is in line with the model where a debt relief
could generate a far more achievable debt stabilizing primary surplus. By providing a
large enough debt relief to Greece so the country could exit the crisis zone, Greece could
relax the focus on fiscal consolidation and rather develop expansionary policies directly
enhancing growth. Some economists argue that this should have been done long ago. E.g.
according to Kuttner: ”Had Merkel backed Greek recovery and reform from the outset,
or even left open the possibility of aid, there would have been far less downward pressure
on the bonds. Instead, she adamantly refused to help, virtually inviting the speculative
attacks” (Kuttner, 2013, p. 134). However, there are many theoretical reasons for why a
debt relief is not considered a solution which was briefly touched upon in subsection 2.3.1
which referred to Sinn (2014). The debt-equilibrium model has only provided a first step
30
in order to say something about the risks of fiscal austerity as way of recovering.
This chapter analysed some of the adverse effects that fiscal austerity could have on
the public finances. But how does austerity during a recession affect aggregate demand
and supply? Does fiscal consolidation have different effects when used during recessions
than if used during normal times? Is there a possibility for a vicious spiral also in the
real economy? How, and to what extent, could the pressure on the public finances affect
aggregate demand? In order to fully tackle the debate on fiscal austerity, the next chapter
will discuss these questions using a classical demand-driven Keynesian model before a
more concluding discussion follows.
31
Chapter 3
Vicious Spirals in the Real Economy
3.1
The Effectiveness of Fiscal Stimulus during Crises
3.1.1
The Fiscal Multiplier
In order to analyse how fiscal stimulus and fiscal austerity affects the real economy in
a recession, this chapter leaves the debt-equilibrium model of the previous chapter and
instead builds on a demand-driven Keynesian model as presented in Holden (2015). The
building blocks and the derivation of the Investment - Saving relation (the IS-curve)
is described in the appendix of this thesis1 . Since Greece is a member country of the
European Monetary Union it implies that the country has a fixed exchange rate against
all other member countries within the union. Uncovered interest rate parity holds and the
expected rate of devaluation inside the monetary union is ∆E e = 0 so that (A.7) becomes
i = iF (F for foreign) where the ECB is the institution conducting monetary policy on
the behalf of the entire block of EMU countries. This section uses the IS-equation given
by (A.10)
Y =
1
(z C − c1 z T − c2 (i − π e ) + z I − b2 (i − π e )+
β
1 − c1 (1 − t) − b1 + a1 + a3 Y n
G + z N X + a2 E − a3 (1 + π e − β + z π )
and the Phillips Curve given by (A.8)
π = πe + β
Y −Yn
+ zn
Yn
In a figure, this corresponds to a horizontal curve representing the fixed interest rate and
an IS-curve which is decreasing in the interest rate since ∂Y
< 0. This is illustrated in
∂i
figure 3.1
1
All equations referred to as (A.#) in this chapter is found in appendix A.
32
i
RR0
iF
IS0
Y
Y0
Figure 3.1: Typical (Y, i)-diagram with a fixed exchange rate
This framework can be used in order to analyse the effectiveness of fiscal stimulus in
the real economy, which is the main goal of this section. Since fiscal policy is the only
policy tool left for Greece to use, discussing the size of the fiscal multiplier is a necessary
startingpoint. First, consider what the multiplier might look like in Greece during a
recession. Since Greece has not yet fully returned to the bond market, assume that the
country must rely on assistance from other member states of the eurozone in order to
fund the stimulus. A shock to G gives
1
∂Y
=
>0
∂G
1 − c1 (1 − t) − b1 + a1 + a3 Yβn
where c1 and b1 are assumed not to be so large that the multiplier becomes negative.
Expansionary fiscal policy, then, gives increased GDP. The multiplier can become large
through two important mechanisms.
The first one is through the stabilizing mechanism given by c1 (1−t). c1 is the marginal
propensity to consume (MPC) and describes by how much consumption increases after a
marginal increase in after tax disposable income. The lower the tax rate, t, the smaller
part of the increase in income is confiscated by the government so the higher is the positive consumption response in the multiplier. Total private disposable income increases less
than the initial GDP increase because total taxation increases and total welfare expenses
decreases as economic growth reduces unemployment - an automatic stabilizer. It is no
secret that much of Greece’s economy operates in a semiformal setting which results in
significant tax evasion. This implies that the t in the multiplier overestimates the actual
rate of tax collection by the government. Taking into account the significant tax evasion
implies much stronger consumption response after the shock, i.e a lower automatic stabilizer. However, as will be discuss below, tax evasion also implies significant losses of
33
government revenues which only worsen the pressure on public finances. The second effect
which increases the multiplier is through the accelerator effect captured by the marginal
propensity to invest parameter b1 . Increased GDP improves the expectations for future
sales, hence firms invest in more capital in order to meet those expectations. It is reasonable to assume that the marginal propensity to invest is low in the Greek economy as the
private sector bankruptcies and uncertain economic prospects severally reduce the expectations of future sales and hamper the environment for investments. However, increased
GDP may increase profits which again makes it easier to finance further investments - an
effect called the financial accelerator.
There are in addition two mechanisms which reduce the multiplier. The first is through
increased imports captured by the propensity to import parameter a1 . Some of the increase in demand will be focused towards foreign goods, and this reduces net exports. The
n
second effect is through a3 Yβn . In the Phillips-curve, the term β Y Y−Yn would be negative in
Greece as the level of GDP is below its potential (the AMECO database reports a Greek
output gap of -8.1 percent of potential GDP in 2015). This implies significant slack and
unused capacity in the economy. Increased GDP through fiscal stimulus will narrow the
negative output gap which further reduces the deflationary pressure, resulting in reduced
net exports. By how much the effect from the output-gap to inflation increases inflation
depends on the size of the pass-through parameter β. The higher the β, the more passes
through and the lower the deflationary pressure becomes. According to Keyens: ”In an
open system with foreign-trade relations, some part of the multiplier of the increased investment will accrue to the benefit of employment in foreign countries, since a proportion
of the increased consumption will diminish our own country’s favourable foreign balance”
(Keynes, 1936, p. 120). This is what Sinn (2014) warns to be artificial and unsustainable
Keynesian stimuli. The European sovereign debt crisis was triggered by a competitiveness problem, and reduced net exports after a fiscal expansion does nothing to tackle the
underlying problem. Greece’s tradable goods need to become cheaper, but fiscal stimuli
generates the opposite effect.
Many economists have attempted to estimate the size of fiscal multipliers and the
underlying parameters after the Great Depression. Carroll et al. (2014) calibrate c1 in
fifteen European countries and find that the annually average (aggregate) value of the parameter in each country significantly depends on the inequality distribution within each
country and is higher among the poorest and unemployed. They also find that c1 depends on whether the income shock is transitory or permanent, and the distribution of
wealth between liquid and illiquid assets which determines the fraction of wealth that can
be adjusted in order to smooth consumption. The authors calibrate a Greek average c1
ranging from 0.1 to 0.35 depending on the measure of wealth. Matching the distribu34
tion of liquid assets they find that Greece has the highest average estimate together with
Spain with 0.35 and 0.38 respectively. The estimate for the unemployed is 0.62 and is the
largest of the sample. Since Greece (together with Spain) has the largest Gini-coefficient,
calculated for the level of net wealth/liquid assets, the relative consumption response to
fiscal stimulus is among the largest in the sample because of the large proportion of low
income households. In another study, by extending a classical DSGE model to include
sticky prices and hand-to-mouth consumers (or rule-of-thumb consumers) who behave in
a non-Ricardian fashion, Gali et al. (2007) find that the multiplier effect is larger the
larger the share of this kind of consumers - which is more the case during recessions. This
immediately suggests a policy response where, in order to ensure a high annually average
c1 as possible in the Greek economy during transitory income shocks, the fiscal stimulus
should be targeted at the poorest and unemployed part of the population. By using panel
estimation, Auerbach and Gorodnichenko (2012) found that the multiplier is much greater
during a recession than during an expansion, exceeding unity in the former state of the
world. ”The results [...] suggest that fiscal policy activism may indeed be effective at
stimulating output during a deep recession, and that the potential negative side effects of
fiscal stimulus, such as increased inflation, are also less likely under these circumstances”
(Auerbach and Gorodnichenko, 2012, p. 92). Similar findings can be found in Christiano
et al. (2011) and DeLong and Summers (2012) among others. See e.g. Ramey (2011) for
an overview on earlier literature on the fiscal multiplier.
Based on this discussion it turns out that there is much to gain from using expansionary
policy in Greece during a recession, especially if the stimulus is targeted at the poorest
part of the population. However, every crisis is unique and in the case of the current
Greek tragedy there might be more to it than this.
3.1.2
The Interlinked Crises of Greece and the Distress Premium
The fact that Greece is in a recession and experiences significant pressure on both the
banking sector and on its sovereign debt suggests an extension to the Keynesian model
in Holden (2015). Suppose now the interest rate entrepreneurs and households face is
determined by the interest rate set by the ECB and the risk premium given by the
relation
i = iF + d
(3.1)
where the risk premium, d, is an increasing function of distress which is supposed to
capture how the banking sector interprets the sustainability of the fiscal stimulus. Assume
that the distress variable is the same for all entrepreneurs and households and is dependent
on the sustainability of the economy in line with the theory in the previous chapter.
35
Call equation (3.1) the DP relation (the distress premium relation - inspired by Mehlum
(2014)). ”During a boom the popular estimation of the magnitude of both these risks,
both borrower’s risk and lender’ risk, is apt to become unusually and imprudently low”
(Keynes, 1936, p. 145). Thus, according to Keynes, the estimation of risk varies with the
business cycle. During times of economic distress, then, the risk premium may increase
to be ”unusually and imprudently high”. As discussed above, the literature suggests that
fiscal stimulus could be very beneficial in a crisis situation. On the other hand, the model
includes a distress-effect which could offset this through shifts in the DP-curve. How
might these two forces work together - applied to the Greek tragedy?
No autonomous central bank and semi-sovereignty: De Grauwe (2011) argues
that the reason for the diverging interest rates on sovereign debt between Spain and the
UK is because Spain has lost its capacity to issue new debt in a currency over which they
have full control, which is not the case in the UK who has its own central bank. Of course
this applies for all Member States in the eurozone. The fact that Greece does not control
its own central bank makes the Greek economy highly vulnerable to speculative attacks
against sovereign debt. Debt matters in a monetary union, and significantly so. This was
discussed in depth in chapter 2. However, the main point I want to emphasize here is that
the only policy tool Greece has left is fiscal policy. But since Greece is shut out of the
bond market, the only way for the government to make use of this tool is dependent on the
grace of other eurozone countries and their willingness to assist. Those governments are
overly concerned over minimizing their financial assistance and eliminate any incentives
for moral hazard which makes conditional loans the only alternative provided. Greece has
become a semi-sovereign where the only chance for fiscal stimulus is by receiving foreign
loans which only increases the debt-to-GDP ratio - causing economic distress as it puts
more pressure on the debt-part of the crisis. One could also argue that each debt-financed
stimulus package comes at the expense of less democratic sovereignty. The more Greece
is at the mercy of its creditors, the more unattractive the Greek banking sector might
become because of the anticipation of social and political turmoil in the future.
Debt, growth and banking: The unfortunate institutional features of the EMU has
then led Greece to rely on foreign debt. The distress caused by this might be reflected in
several aspects of the crisis. The Greek crisis is threefold: negative growth, unsustainable
sovereign debt and illiquid banks. These three aspects of the economy are interlinked and
interact with one another in many ways, as discussed by Shambaugh (2012). For example,
”the problems of weak banks and high sovereign debt are mutually reinforcing, and both
are exacerbated by weak growth but also in turn constrain growth” (Shambaugh, 2012,
p. 157). While Greece remains in a recession with three such interlinked crises, it is likely
36
that economic distress will remain significant even after the implementation of measures
that could solve one of them. Such connections would likely create very bad conditions in
order for expansionary fiscal policy to work sufficiently without the necessary coordination
with this and other policy instruments. Greek banks suffer from low liquidity and are
also dependent on new recapitalization trough bailout packages from foreign creditors2 .
In their Covered Bond Programme Prospectus for 2016 the Greek financial institution,
Alpha Bank Group, writes that:
Since the end of 2009, the severity of pressure experienced by the Hellenic
Republic in its public finances has restricted the access of the Issuer to the
capital markets for funding because of concerns by counterparty banks and
other lenders[...] As a result, maturing inter-bank liabilities have not been
renewed, or have been renewed only at higher costs. (Alpha Bank, 2016, p.
40)
As the fiscal stimulus comes at the expense of more pressure on the public finances, this
may further magnify this effect as banks cut back on interbank lending and lending to
the private sector by raising the interest rate. Borrowing at higher interest rates to replace funds that where provided much cheaper before increases the risk for insolvency.
An increased debt-to-GDP ratio might be interpreted as an increase in the probability
of sovereign default, and as described in the previous chapter, changes in long-term government bond-yields are an important driver of bank lending rates as sovereign bonds
are directly serving as a benchmark for the pricing of loans and other assets (Cæuré,
2013). The risk premium as a function of distress may increase as a response - making
a self-fulfilling prophecy more likely through increased number of non-performing loans
(NPLs), private bankruptcies, and reduced growth. Lower growth may result in falling
asset prices which damage the bank’s balance sheets and worsen their competitiveness
with foreign banks even further:
[...] worsening macroeconomic conditions and increasing unemployment, coupled with declining consumer spending and business investment and the worsening credit profile of corporate and retail borrowers, the value of assets collateralising secured loans, including houses and other real estate, could decline
significantly. Such a decline could result in impairment of the value of the
Issuer’s loan assets or an increase in the level on non-performing loans, either
of which may have a material adverse effect on business, financial condition,
results of operations and prospects. (Alpha Bank, 2016, p. 40)
Lower growth again increases the real value of debt and so the story goes. In addition, tax
evasion puts even more pressure on public finances which damages the credibility of the
2
The 3rd bailout package of 86 billion euro from the ESM and the IMF with a duration of three years
(2015-18) includes up to 25 billion euro for bank recapitalization.
37
administrative capacity of the government. Greece could surely benefit from a structural
reform in the tax system and an improvement to its administrative structure since a more
effective and fair tax system could potentially strengthen the credibility of the State. This
confidence could further divert over to the financial sector an be reflected in lower distress
premiums.
Projection errors: One could argue that economic distress is also dependent on how
the economy is presented by reviewers and media. This is particularly interesting considering the IMF and their projections. Since the first bailout package the IMF has repeatedly
been overestimating the projected economic growth rates of Greece which implies that
the IMF has repeatedly underestimated the debt-to-GDP ratio and the need for a debt
relief (Mehlum, 2015). This have resulted in continuous revisions and disappointments
which do nothing but damage the perceived sustainability and credibility of Greek public
finances. When confronted by the question of why the situation is worse than projected,
the typical argument is that it is due to delayed implementation of the agreed reforms by
the Greek government. Thus, by basing their projections on statistical methods which
repeatedly fail and rather blame the Greeks for their underperformance, one could argue
that the IMF is providing another reason for distress and uncertainty which the economy
could have been far better without.
Grexit: Another important reason for distress is the looming shadow of Grexit which
has been widely discussed since 2012. If Greece were to leave the EMU and reintroduce the
drachma as its currency, this would lead to a significant increase in all euro denominated
debt - making the situation even more unsustainable. The drachma would certainly
depreciate against the euro and hence reduce the value of all euro-denominated deposits
in Greek banks, increase inflation and reduce the purchasing power of the average Greek
citizen. ”A new currency would be sure to depreciate sharply. Inflation would soar. In the
medium run, however, order would presumably be restored in some way, even at enormous
cost” (Wolf, 2014, p. 305). In order to lower the exchange rate, interest rates need to
increase which in turn will make it more difficult for the Greeks to pay off their debts.
The Bank of Greece could print money in order to repay debt, but this will increase
inflation and interest rates further and maybe end in a hyperinflation as in Germany
after WWI. Many argue that a Grexit could be a better alternative rather than internal
devaluation as the low value of the drachma will boost exports and tourism without facing
union resistance against wage cut proposals. An open devaluation could circumvent such
resistance. This is exactly what Sinn suggests when he argues that:
The possibly fatal problems resulting from wage and price cuts of the order
38
required to achieve competitiveness could be avoided by exiting the euro and
devaluating the new currency formally, because that is in effect a coordinated
wage and price cut relative to the prices of other countries. It would redirect
demand away from imports to domestic products, increase demand for the
country’s exports and reduce the euro value of the country’s internal debt
along with the euro value of internal prices, thus avoiding the balance sheet
distortion for firms and indebted private households. (Sinn, 2014, p. 9)
However, one could argue that the negative impact on the banking sector makes it difficult to expand the export sector in the first place. As discussed in section 2.3, the
significant current account imbalances which evolved after the creation of the euro forced
deficit countries to become more domestic oriented while the surplus countries developed
an advantage in trade. Thus, the Greek export sector lags behind and is dependent on
investment to expand. With a Greek banking sector in distress, such an expansion may
prove to be challenging. The prospects of losing parts of your deposits led to a bank run in
Greece in 2012, where the Greek citizens withdrew euros in fear of losing them otherwise.
This magnifies the problem of already weak liquidity among Greek banks. As long as the
Grexit discussion continues, the uncertainties and grim prospects associated with such a
scenario will make Greek banks in constant need of recapitalization and investments in
order to remain liquid and solvent. Because of the prolonged negotiations between the
Greek government and the creditor institutions before the agreement of the ESM bailout
package, capital outflows were significant as the financial market feared a disagreement
and a possible Grexit further down the road. ”The loss of confidence exacerbated the economic sentiment indicators and private sector financing conditions, causing a significant
outflow of deposits in the Greek banking sector of approximately 48 billion euros from 30
September 2014 to 30 September 2015” (Alpha Bank, 2016, p. 39). As there are several
reasons for not investing in Greek banks as long as Grexit is a possible scenario, this
will prolong the banking crisis which is interlinked with the crises of growth and sovereign
debt - hindering an effective use of expansionary fiscal policy. A single departure from the
eurozone may also create further distress within the countries that remain in the union.
”If countries in difficulties leave, it is just an exceptionally rigid fixed-currency system.
So any departure would have a destabilizing effect: people would trust in the eurozone’s
survival even less and the economic benefits of the single currency would dwindle” (Wolf,
2014, p. 305). This could further increase the costs of inter-bank-lending and hamper
economic activity throughout the eurozone.
Finally, consider the effects in a figure. All the above mentioned aspects and reasons
for economic distress which could lead to higher interest rates implies that the original
positive shock to government expenses will be reduced by a positive shift in the DP-curve.
Thus, as in the previous chapter where the unsustainable economy ended in a vicious spi39
ral, such a spiral may also be created in demand-driven Keynesian economy as a banking
sector in distress responds to the increased probability of default with continuously increasing risk premiums. Figure 3.2 illustrates this. The economy starts out in point A
i = iF + d
DP3
C
iF
A
DP2
DP1
B
DP0
IS1
IS0
Y
Yd Y0
Y1
Figure 3.2: IS-DP: The effect of a positive shock to government expenses with distress
premium in a monetary union
with GDP equal to Y0 . Then a shock to G implies a positive fiscal multiplier which leads
the economy to point B in the figure with a corresponding level of GDP given by Y1 .
Further, even if increased government expenses increases GDP and inflation as predicted
by the Keynesian setup, the risk premiums due to economic distress in a unsustainable
economy might offset those effects. A country like Greece could end up in point C with
a corresponding level of GDP given by Yd instead. Assume that d = 0 in Germany. Is
it the case that any Greek borrower could simply borrow at lower costs by undertaking
a loan in a bank in Berlin rather than in Athens? The risk premium any borrower has
to pay is dependent on the overall creditworthiness of the borrower, hence all non-Greek
banks will also include a distress premium if lending to a Greek citizen operating in a
vulnerable Greek business environment. The overall macroeconomic distress and risks in
the Greek economy are common risk factors for all Greek consumers and investors and is
a problem not circumvented by undertaking loans in banks outside Greece. It is the common negative effects the unsustainable economy of Greece have on the creditworthiness
of Greek consumers and investors which creates differences in individual borrowing costs
within the union - not regional differences per se.
According to Christiano et al. (2011) and DeLong and Summers (2012), increased
government spending will increase expected inflation. With a nominal interest rate stuck
at the zero lower bound, this implies a reduced real interest rate which increases consumption and investment further and gives an even larger multiplier during a recession.
40
However, with a distress premium the real interest rate is not necessarily reduced since
r = i − π e = iF + d − π e
(3.2)
so if increased expected inflation happens at the same time as an increased distress premium, the real interest rate might remain constant or even increase. This is in contrast
to the argument by DeLong and Summers (2012) who argue that the risk spreads will fall
after an increase in government spending as a more prosperous economy implies a lower
price of bearing risk.
This section has made use of the classical Keynesian paradigm with a distress premium
extension. Because of the considerable slack in the economy with idle workers and free
resources, in addition to a larger fraction of cash-to-mouth individuals, the fiscal multiplier
after a shock to government expenses could be highly productive without any trade-off in
the form of too high inflation. However, the specific Greek circumstances discussed above
might trigger an offsetting mechanism through increased risk premiums in the banking
sector. As the Alpha Bank describes; the severity of pressure experienced by Greece
has restricted the access to the capital markets, and maturing inter-bank liabilities has
only been renewed at higher costs. Thus, adding a variable of distress seems like a valid
extension to the model. Moreover, reduced net exports might worsen competitiveness
which was one of the underlying reasons for the crisis. Before discussing some policy
suggestions which could ensure a better outcome with d = 0, the next sections will
discuss and analyse the actual policy that dominates current European economic policy,
namely fiscal austerity.
3.2
Fiscal Austerity and Prior Actions: Distortionary
Tax Increases and Government Spending Cuts
According to IMF’s definition, prior actions are measures that a country agrees to take
before the IMF’s Executive Board approves financing or completes a review. They ensure
that the programme has the necessary foundation to succeed, or is put back on track
following deviations from agreed policies 3 . Greece is in principle free to design the prior
actions as long as the actions are sufficient to reach the budgetary targets defined by
the creditors. However, according to the Memorandum of Understanding the Greek government must commit to consult and agree with the Troika beforehand. As the Greek
government targets to reach primary surplus targets in line with the last bailout agreement of 0.5 percent of GDP in 2016, 1.75 percent of GDP in 2017 and 3.5 percent of GDP
3
The complete factsheet is available at: https://www.imf.org/external/np/exr/facts/conditio.htm
41
Figure 3.3: Source: European Commission AMECO database. The evolution of indirect
taxes, direct taxes and social contributions in Greece as percent of GDP.
in 2018 and onwards (EC, 2015a), the government has implemented and planned several
austerity measures in order to achieve them. This section will briefly look at how the
contractionary policies are currently designed.
As a part of the adjustment programme, Greece committed to reform the tax system in order to broaden the tax base and reduce the significant level of tax evasion. In
addition to the structural tax reform, the government also committed to impose several
austerity measures through tax hikes. For example, the government targeted to reach a
net revenue gain of 1 percent of GDP annually by increasing reduced VAT rates on many
items such as restaurants (from 13 percent to 23 percent) and hotel accommodations
(from 6.5 percent to 13 percent), as well as a broad batch of consumption goods (from 13
percent to 23 percent). In addition, exemptions for Greek islands that are popular tourist
destinations were removed except from on the most remote ones. For Greek businesses
which are struggling to create profits in a period of low demand and limited access to
credit, the most drastic measure is probably the increase in the corporate income tax
rate from 26 to 29 percent which will likely worsen the business environment. The tax
hikes and austerity measures also include; increased advance payments on profit taxes
from 75 percent to 100 percent; increased solidarity tax rate on wealth for high income
earners; a phasing out of the preferential tax treatment for farmers in addition to cuts in
their subsidies; an increase in the tax on luxury goods such as vessels and private jets;
a phasing out of special tax treatments in the shipping industry. Figure 3.3 illustrates
the evolution of the different sources of government revenues between 2008 and 2016.
The figure shows that indirect taxes contribute the most to government revenues. Both
indirect taxes through increased VATs and social contributions through pension reforms
have resulted in upward trends since the prior actions of 2015. Direct tax revenues from
income and wealth have declined since 2012. This is not surprising as the tax base has
been reduced due to the high unemployment rate. However, taxation and transfers are
42
Figure 3.4: Source: European Commission AMECO database. The evolution of Greek
total general government expenditures as percent of GDP between 2008-2016.
costly to administer and they effect the optimal consumption, -labour, and -investment
decisions of firms and households - creating distortions. Hence the tax hikes may prove
to be more costly for the Greek government than first anticipated. Even though the theory of distortionary taxation is not a necessary part in the Keynesian model used in this
chapter, this is certainly something a Minister of Finance needs to consider in the real
world. Many economists, such as Barro (1979), have showed how optimal tax policy is to
smooth taxation over time, as a euro of increased tax revenue to the government is worth
less than a euro because of the distortions it creates. Therefore, as the events of the 1970s
and 1980s suggest very strongly, when governments become strapped for funds, they tend
to rely more heavily on bonds’ issuance rather than taxation (Calvo, 1988). But Greece
does not have this possibility at the time of writing.
On the spending side the Greek government target to reduce military spending by
200 million euro in 2016. Additional savings corresponding to 1 percent of GDP will
be achieved by reforming the pension system, mainly by creating strong disincentives to
early retirement, gradually phase out solidarity grants and increase the health contributions for pensioners from 4 - 6 percent on average. Gradual budget cuts have been made
in several other areas since 2010 e.g. in health care. ”In late 2012, the health system,
squeezed by budget cuts, failed to pay doctors even their basic salaries” (Kuttner, 2014,
p. 137). As a consequence, more and more health care costs shifted towards patients. The
effects of austerity on the health sector is a general illustration of how fiscal consolidation
affects the overall economy. Figure 3.4 illustrates the evolution of total general government expenditure as percent of GDP between 2008-2016. Greece experienced a strong
expenditure growth up until 2011. However, after the first bailout in 2010 the expenses
declined from about 50 percent of GDP to 45 percent and remained at a stable level from
2013. The austerity has resulted in yet a downward curve in 2016 , pushing expenses
below 45 percent of GDP. Figure 3.5 shows the convergence between total expenses and
43
Figure 3.5: Source: European Commission AMECO database. The convergence between
Greek total expenses and revenues as percent of GDP between 2008 - 2016.
revenues (including capital taxes) which implies a continuously reduced primary deficit.
According to the Keynesian model, contractionary policy can be achieved by increasing
taxes and cutting in government expenses. As Greece do both as prior actions in order
to achieve a primary surplus so to further receive bailouts, the implication is significantly
reduced growth according to the model. The next section analyse this further, where the
main focus will be on the risks of a vicious spiral in the real economy.
3.3
Fiscal Austerity: A Temporary Recession or Another Vicious Spiral?
3.3.1
The Fiscal Multiplier and the G-T Contradiction
Section 3.1 showed that expansionary fiscal policy has the potential to be highly productive, but the beneficial effect runs the risk of being offset by increased distress premiums.
The conditionality of the bailout packages reflects that the creditors are very aware of this
inefficiency, thus they demand that Greece implement structural reforms to restore fiscal sustainability, safeguarding financial stability, enhancing growth, competitiveness and
investment, and develop a more effective and modern State. Of course, should Greece
manage to implement such reforms the country could greatly benefit from d = 0 so that
the effectiveness of the fiscal policy would be enhanced. However, as discussed in section
3.2, the implementation of bold reforms is combined with strict rules regarding fiscal targets. From the creditors’ point of view, the period of adjustment must be accompanied by
a period of austerity. Fiscal consolidation through increased taxation, cuts in pensions,
and labour market reforms are some of the criteria Greece needs to satisfy in order to
increase the primary surplus enough to satisfy the creditor’s targets and receive further
44
loans. How might the multiplier look in this case? Suppose the tax reform is implemented
so that the tax rate t in the model is relatively higher than previously, and that the incidence of tax evasion is reduced. Then the government reduce its expenses. The model
then implies
−1
∂Y
=
<0
∂G
1 − c1 (1 − t) − b1 + a1 + a3 Yβn
so a reduction in government expenses reduces GDP with the same multiplier effects as
previously. According to the Phillips-curve, Greece would then experience an even larger
output gap, increased deflation and idled workers as GDP falls further below its potential. Increased unemployment reduces government revenues through a reduced tax base
which implies less tax revenues and social contributions to the government. Moreover,
more unemployed people require welfare expenses. Thus, the reformed taxation system
in Greece will now make little difference. There is a contradiction in this regard. The tax
reform was supposed to increase tax revenues to the government, but in combination with
a negative shock to G the effect will be somewhat offset through lower growth, increased
unemployment -and welfare expenses. According to the model, if the goal is to ”restore
fiscal sustainability”, increased taxes and cuts in government expenses are contradictory
actions. What Greece is in fact doing is to increase the tax rate and reduce the tax base
at the same time.
However, net exports are expected to increase as imports are reduced. As already
discussed to some extent, this is an argument in support for austerity in the deficit countries of the eurozone. As Greece’s reduced imports are other countries’ reduced exports
this will also affect the country’s trading partners. Fiscal consolidation could increase
the Greek trading surplus although it is at the expense of the country’s trading partners
and its own citizens. If Greece is to improve their competitive position, surplus countries
must accept to reduce their position by increasing overall demand for imports. Again one
could propose the argument that reduced prices on Greek goods is not necessarily followed
by increased exports as a Greek banking sector in distress is unable to provide the sufficient capital needed in order to expand the export sector. Banks with insufficient funds
may not be able to support the parts of the economy which are to create economic growth.
In their paper Growth Forecast Errors and Fiscal Multipliers, Blanchard and Leigh
(2013) ask whether forecasters have underestimated fiscal multipliers after the outbreak
of the debt crisis. Earlier evidence suggested that the fiscal multiplier averaged 0.5. By
regressing growth forecast errors on fiscal consolidation forecast made early in 2010, they
find a negative and significant relationship. The coefficient on the forecast of fiscal consolidation is -1.095, ”implying that, for every additional percentage point of GDP of fiscal
consolidation, GDP was about 1 percent lower than forecast” (Blanchard and Leigh, 2013,
45
p. 8). If the earlier literature used growth projections that implicitly assumed multipliers
more consistent with normal times, this might have led to the repeated projections errors.
Again, one could refer to the literature in the section about expansionary fiscal multipliers
where all suggested that multipliers during recessions are relatively larger. This is indeed
not good news for austeritarians. As emphasized by Christiano et al. (2011) and DeLong
and Summers (2012); with the ECB interest rates in the zero lower bound the central
bank can no longer offset the negative effects of austerity. Then the fiscal consolidation
becomes especially efficacious. And yet, even though a vast empirical literature suggests
that austerity is associated with large negative multipliers, austerity is still the dominant
view in current European policymaking. Before discussing the theory of expansionary
fiscal contractions which gives additional support to such policies, the next subsection
suggests a model that shows how austerity in a recession might lead to total collapse.
3.3.2
The Recession Premium and the Armoury of the ECB
A relevant and important question to ask when assuming that the Greek recession will be
temporary while the economy adjusts to its new structure and implement fiscal consolidation at the same time is how long is temporary and are there any risks of being stuck in a
bad equilibrium? Section 2.4.3 and and 3.1.2 showed that a bad equilibrium was possible
in the market for sovereign debt and in the real economy respectively. Now consider a
final scenario. Leave my extension of the RR-curve given by equation (3.1) for now and
rather assume that the endogenous risk premium is a decreasing function of GDP when
the economy is in a recession, as shown by Mehlum (2014). Denote potential GDP as Y ∗ ,
so that if GDP is less than this level the economy is in a recession. Use that

iF + e + e (Y ∗ − Y )
0
1
i=
iF + e
0
if Y < Y ∗
if Y > Y ∗
(3.3)
which Mehlum (2014) calls the RP-relation (risk-premium relation) and is horizontal when
the economy is not in a recession, but decreasing in Y otherwise. If e1 is large, the part
of the RP-curve which is decreasing in Y will be steep. Thus, the curves might intersect
twice. Figure 3.6 illustrates this.
Consider first the IS0 -curve with two intersections in point A0 and B0 . If Greece is
in the good equilibrium A0 to the right of the threshold Y ∗ , an increase in the recession
premium e would simply shift the RP-curve upwards and the multiplier will be equal to
the one in section 3.1. However, if Greece is in the bad equilibrium B0 to the left of Y ∗ ,
the total effect on GDP will be greater after a shock to the recession premium. This can
46
i
B0
A1 A0
RP0
IS0
IS1
Y
Y
Y
∗
Figure 3.6: IS-RP: The effect of a negative shock to government expenses with an endogenous recession premium in a monetary union
be seen from the multiplier which is slightly different than before:
−(c2 + b2 )
∂Y
=
<0
∂e0
1 − c1 (1 − t) − c2 e1 − b1 − b2 e1 + a1 + a3 Yβn
This multiplier is greater than the earlier ones of this chapter. The adverse effect on
growth results in even higher risk premiums which adversely affects consumption and
investment, captured by c2 e1 and b2 e1 .
Consider next the IS1 -curve which is a consequence of fiscal consolidation. Had Greece
been in the good equilibrium A0 to begin with, the fiscal contraction had led the economy
to point A1 without any adverse effect on the recession premium. The only implication
would be a lower level of GDP. However, assume that Greece is in a recession which
implies that the economy was described by the unstable point B0 before the austerity.
Since this is an unstable equilibrium, the shock to G sets in motion a vicious spiral. This
is illustrated by the dashed line stemming from point B0 . The vicious spiral will continue
until Y where the IS-curve would be vertical. Towards this point, firms go bankrupt and
the banks face more severe liquidity problems as the number of non-performing loans
increases. Then the banks cut back on lending by raising the interest rate. This makes it
more difficult for the remaining firms in the market to get access to credit and the number
of bankruptcies increases further. Unfortunately it seems like that this is a real concern
among Greek financial institutions. The Alpha Bank reported in 2016 that:
The financial recession in The Hellenic Republic materially and adversely affected the liquidity, business activity and financial condition of borrowers,
which in turn led to increases in non-performing loans[...] Should GDP continue to decline, further increases in non-performing loans are likely. (Alpha
47
Bank, 2016, p. 39)
The spiral may force banks into insolvency, and when the economy reaches Y , economic
activity is so low that there is no longer a financial market. In other words, austerity
pushed to far may result in a longer-than-anticipated recession. Nobel laureate economist
Joseph Stiglitz expresses similar concerns in his book Globalization and its discontents
where he writes that ”a crisis can give rise to an vicious cycle wherein banks cut back on
their finance, leading firms to cut back on their production, which in turn leads to lower
output and lower incomes” (Stiglitz, 2002, p. 114). The combination of a debt crisis,
growth crisis, and banking crisis creates expectations of future economic difficulties which
may be self-fulfilling as they add fuel to the fire. According to Stiglitz:
The IMF model - as in the models of most of the macroeconomics textbooks
written two decades ago - bankruptcy plays no role. To discuss monetary
policy and finance without bankruptcy is like Hamlet without the Prince of
Denmark. At the heart of the analysis of the macroeconomy should have been
an analysis of what an increase in interest rates would do to the chances of
default[...]. (Stiglitz, 2002, p. 110)
As investors recognize the spirals and the looming shadow of default upon both the
government and private sector, investors might drive their capital out of the country. Unfortunately, capital has a tendency be withdrawn from economies that need it the most.
Corporations withdraw capital from Greek businesses and less affluent Greek households
would rather save their money in their mattresses. Instead of preventing the escape of
capital from peripheral countries such as Greece towards safe countries such as Germany
and Switzerland, deepening Europe’s regional distortions, Europe’s leaders exacerbated
this effect through austerity (Kuttner, 2013, p. 113).
The monetary policy decision of the ECB announced in March this year included new
instruments that could ease the pressure on European banks and foster new lending. The
extension of the ”Targeted Longer-Term Refinancing Operations” (TLTRO II) is meant to
ease the private sector credit conditions and to stimulate credit creation by offer funding
with four-year maturity at a interest rate as low as the rate on the deposit facility at
the time of allotment. Separate borrowing limits depend on the quantities of outstanding
loans and net lending. This implies that banks that are active in lending to the real
economy will have the opportunity to borrow more from the programme. In addition,
the ECB increased the combined monthly ”Asset Purchasing Programme” (APP) by 20
billion euros (from 60 to 80 billion) where the purchases will include euro-denominated
corporate bonds. This is called the ”The Corporate Sector Purchase Programme (CSPP)
and is intended to have a positive effect in the real economy. ”This comprehensive package
will exploit the synergies between the different instruments and has been calibrated to
48
further ease financing conditions, stimulate new credit provision and thereby reinforce
the momentum of the euro areas economic recovery and accelerate the return of inflation
to levels below, but close to, 2 percent” (ECB, 2016). The fact that the instruments
are complementary increases their effectiveness as the CSPP directly affect demand for
investment while the TLTROs increases the banks ability to lend. However, while the
ECB provides additional funds into a banking sector in distress, the Greek government is
forced to reduce private purchasing power through austerity which constrains aggregate
demand. One could argue that the TLTRO-instrument will prove less effective in Greece
as the recession has forced 1.2 million Greeks into unemployment so that banks cannot find
any use of the money. Again, the argument that solving one crisis while worsening others,
applies. The expansionary monetary policy would most likely proven to be relatively
more effective in stimulating credit demand had the highly indebted European countries
been allowed to create a proper environment for investment at the same time instead of
hamper growth. The president of the ECB himself, Mario Draghi, said during the press
conference that:
In particular, actions to raise productivity and improve the business environment, including the provision of an adequate public infrastructure, are vital
to increase investment and boost job creation[...]Fiscal policies should support
the economic recovery, while remaining in compliance with the fiscal rules of
the European Union. (ECB, 2016)
But in order to remain in compliance with the fiscal rules of the European Union, several
euro-countries, especially Greece, must contract their economies to a large extent. The
official fiscal targets of the EMU could work as a preventive arm in order to put a lid on
excessive spending during normal times. However, fiscal targets are extremely risky as
means to recover from a deep recession. If the analysis of this thesis holds, an analysis
much in the spirit of Nobel laureates such as Joseph Stiglitz (2002) and Amartya Sen
(2012), it is rather worrying that the ECB thinks that austerity and recovery are complementary.
3.4
Expansionary Fiscal Contractions and the Confidence Fairy
So far the only argument in support for austerity as a way of recovery emphasized the importance of restoring competitiveness, as argued by Sinn (2014). This section will briefly
mention some other arguments. In the discussion of why the beneficial effect of expansionary fiscal policy might be somewhat offset I assumed only that the extraordinary political,
49
social, and economic circumstances in Greece could be reflected in a risk premium in the
banking sector. Arguments regarding precautionary saving and preferences for consumption smoothing did not play a role. However, those arguments are central themes within
the theory of expansionary fiscal contractions which give additional support to austerity
economics. Those economists who call for austerity base their theory on what Krugman
(2013) ridiculed as the ”confidence fairy”. For example, the permanent income hypothesis
(PIH) implies that only a permanent increase in G will have an effect on consumption.
Assuming that all individuals are perfectly rational and prefer to smooth consumption
over their entire life cycle, a transitory shock to G would imply approximately no change
in consumption behaviour as the increase in transitory income is spread over the entire life
cycle, making each financial addition to each year vanishingly small. Whether the fiscal
policy is productive is dependent on how investors and households perceive the shock as
permanent or transitory. Preferences for consumption smoothing might lead to precautionary saving if the private sector expects an expansionary fiscal shock to be transitory,
hence further expecting tax hikes in the future since the government needs to pay back
what it borrowed. As future tax hikes reduce future profits and increase the probability
of weaker firms going bankrupt, households and firms may behave precautionary and save
the transitory income provided through G rather than use it to increase their consumption and investment. According to Barro: ”[...]rearrangements of the timing of taxes - as
implied by budget deficits - have no first-order effect on the economy” (Barro, 1989, p.
51). Some economists argue that a large public debt overhang causes precautionary saving so that the fiscal multiplier is near zero or negative if the debt-to-GDP ratio exceeds a
certain threshold. Ilzetzki et al. (2013) found that the fiscal multiplier in highly indebted
countries is close to zero as the financial fragility motivated precautionary behaviour.
They operate with a debt-to-GDP ratio threshold of 60 percent which would certainly
apply in Greece. Keynes himself mention the effect of precautionary savings when he
wrote that ”the propensity to consume may be sharply affected by the development of
extreme uncertainty concerning the future and what it may bring forth” (Keynes, 1936,
p. 94).
So if expansionary fiscal policies can be contractionary if the debt is large enough,
can it be that contractionary policies might be expansionary? There are many interesting
discussions and empirical evidence of expansionary fiscal contractions which contradict
the implications of the Keynesian model. Fels and Froehlich (1987) argue in support
of the ”German view” which implies that, reducing deficits by keeping a lid on public
expenditure growth, the public sector can make room for the private sector to expand,
depending on the magnitude and persistence of the cuts. Hellewig and Neumann (1987)
argue that expansionary fiscal contraction might be possible through the indirect effect
of expectations. If the design of the fiscal corrections is well understood and the plan
50
for the future is credible so that the lower level of public expenditures (and thus lower
taxation in the future) will last, then private households may interpret the cut in public
spending as a startingpoint for a time of stability, hence raising their current and planned
consumption. Giavazzi and Pagano (1990) and Alesina and Ardagna (2010) tested the
hypothesis. The former study shows how fiscal contractions in Ireland and Denmark in
the 1980s resulted in increased consumption; cases where the German view has a serious
claim to empirical relevance. The latter study shows, by studying cases of fiscal adjustments in OECD countries between 1970 and 2007, that several deficit reductions have
been associated with expansions rather than with contractions. But these studies looked
at countries with floating exchange rates where the beneficial effect through increased
exports after a depreciation of the currency contributed to the expansion. This is not
possible for a singe country within the EMU.
The theory of expansionary austerity hinges on the requirement that the financial
market and private households interprets austerity as ”good news”. When the above
sections discussed the Keynesian model, expectations played only a minimal role through
expected inflation. In austerity economics, expectations is the central theme. Krugman
writes:
First, our [the Keynesian types] expectations argument is a hope; theirs [the
austerity types] is a plan. I want the Fed, the Bank of Japan, etc. to target
higher inflation, in the hope that it might help, but it’s a hope and meanwhile
we need to fight demands for fiscal austerity and even push for stimulus.
The expansionary austerity types, on the other hand, are (or were) actually
counting on the supposed rise in confidence to avoid what would otherwise be
nasty recessions, which have in fact materialized. (Krugman, 2013)
Making expansionary austerity into a general theory may prove to be dangerous as its
effectiveness in the bottom line depends on interpretation. Even though empirical support
that this in fact did happen in Denmark and Ireland in the 1980s, the words credibility
and expectations are crucial when discussing its external validity. Given that the current
crisis in Greece is much more severe and the content of the fiscal corrections are different
than compared to Denmark and Ireland in the 1980s, the external validity of this finding
may not hold as the credibility of government policies and expectations about future economic stability may be significantly reduced. Hence, contrasting theories and empirical
evidence on what kind of fiscal policy is the most appropriate to implement in order to
recover from a recession are many. Before concluding this chapter, the next section briefly
discusses some non-economic and broader aspects of austerity.
51
3.5
Beyond the Keynesian Effects: Social and Political Effects of Austerity in a Recession
Shortly after the agreement of the third programme in 2015, The European Commission
published an Assessment of the Social Impact of the New Stability Support Programme for
Greece (EC, 2015b). The document discusses how the the burden of adjustment is spread
across society and what measures will help mitigate social hardships. It concludes that
full implementation of the ambitious reforms will increase potential GDP and strengthen
competitiveness. This would increase the tax base and government revenues which further would provide possibilities for future government investments - creating a positive
spiral. The validity of the positive estimates within this document is conditional on full
implementation of ambitious reforms, which is to say that there must be no adverse political and social affects during the time of adjustment that would hinder the process. As
the German Finance Minister Wolfgang Schäubel simply summarized during the World
Economic Forum in Davos this year: ”It’s the implementation, stupid!”
However, the adverse social and political effects of austerity have been evident since
the first adjustment program in 2010. The policies have resulted in a critical social tension
which follows as the country’s citizens interpret the imposed austerity as a broken social
contract between the government and its citizens it is supposed to protect. Since the
reason for the European debt crisis was the extremely unbalanced competitive positions
between surplus -and deficit countries within the eurozone, and not the fiscal position
of each country per se, the fact that Germany as the largest surplus country of all now
forces economic austerity upon Greece generates enormous tensions. The belief that the
European sovereign debt crisis was a result of irresponsible fiscal policies has shifted current eurozone policymaking towards austerity. ”This view is not only misleading, but
dangerous. That it is held by the eurozones’s strongest country is frightening” (Wolf,
2014, p. 75). The different fates after the crisis have resulted in a tense eurozone where
the loosing countries, now under the mercy of the well-off surplus countries, feel that their
democratic sovereignty is under attack. This may be be hard for the Greek citizens to
accept - further leading to political chaos. Since 2009, Greece have had six different prime
ministers and heads of care taking governments4 . Of course, any democratic government
is doomed to face a major challenge convincing the public that further austerity is the key
to recovery, especially when the hard policies are imposed by EU officials beyond direct
democratic accountability.
4
George Papandreou (2009 - 2011), Lucas Papademos (2011 - 2012), Panagiotis Pikrammenos (May
2012 - June 2012), Antonis Samaras (2012 - 2015), Alexis Tsipras (January 2015 - August 2015) Vassiliki
Thanou-Christophilou (August 2015 - September 2015) and again Alexis Tsipras (September 2015 -).
52
According to Nobel laureate economist Amartya Sen, ”the disdain for the public could
hardly have been more transparent in many of the chosen ways of European policymaking” (Sen, 2012). He argues that austerity generates so many adverse effects on
people’s lives that one need to look beyond the pure Keynesian effects that cuts in public spending have on aggregate demand and growth and also take seriously what such
an austeritarian attack on the Greek welfare state represents in terms of social justice.
According to Gøsta Esping-Andersen’s Why we need a new welafare state; the longer
the economic hardship lasts, the more severe is the social consequences while ”citizens
become entrapped in exclusion of inferior opportunities in such a way that their entire
life chances are affected” (Esping-Andersen, 2002, p. 6). Thus, insufficient focus on job
creation runs the risk of having severe consequences for the unemployed since unemployment implies personal costs which may endure long past the immediate loss of a job. The
dynamic social effects of a longer-than-anticipated recession could imply a lost generation
of Greece as the hardships experienced among the Greek youths correlate with a problematic employment career later in life, which increases the chances for old age poverty.
”And considering ongoing pension reforms, most of will come to full fruition thirty or
forty years down the line, it is equally reasonable to believe that these very same youth
will face welfare problems as they reach pension age in, say, 2050” (Esping-Andersen,
2002, p. 7).
Riots and political turmoil increases the probability of capital fleeing the country and
worsen the economic conditions as business -and investor confidence is damaged by the
insecurity. A high unemployment rate among youths, combined with the risk that productivity might deteriorate as high quality workers seek jobs elsewhere in Europe which
makes it difficult for new businesses and institutions in Greece to find qualified human
capital, could further affect the long-run development of Greek institutions. By treating
Greece as a semi-sovereign by imposing austerity and demands for better institutions
might generate adverse forces that makes the dream of institution-building into a ineffective and distorted obsession.
Especially the cuts associated with pensions and health have triggered social tensions.
While the pension policy has remained generous and unaltered during the period of declining GDP, government spending on pensions stand about 15 percent of GDP in 2015.
However, as unemployment has elevated, unemployed families may rely on the pensions
of retired family members. Cutting pension, in combination with planned tax hikes, may
thus trigger personal crises and further insecurity among the unemployed. The discontent
over the removal of tax breaks and subsidy benefits for farmers, and increased pension
contributions for the self-employed led to several riots in the beginning of 2016. Farmers
rallied in demonstrations in Athens and started a blockade of highways across the country.
53
According to Kentikelenis et al. (2014), the health sector was hit by austerity measures leading to severe adverse health effects among the population as health care costs shifted
from the government to the patients, resulting in a reduction in health-care access despite of the rhetoric of ”maintaining universal access and improving the quality of care
delivery” in Greece’s bailout agreement. In addition, since the social health-insurance
is linked to employment status, the increasing unemployment rate raises the number of
uninsured people which force them to seek out help from non-governmental organizations
mainly targeting the refugee crisis. The rapid socioeconomic change has lead to increased
demand for mental health services, but service providers have scaled back such operations
because of budget cuts. They point out several additional adverse effects such as the increased number of children receiving inadequate nutrition and the increased suicide rate,
and conclude that ”although the adverse economic effects of austerity were miscalculated,
the social costs were ignored, with harmful effects on the people of Greece” (Kentikelenis
et al., 2014, p. 751).
Imposed conditionality may create hostility if the way the conditionality is imposed
does not consider the important aspects discussed in this section. The riots and demonstrations in Greece the last year is a clear evidence of this. Many economists express their
concern for the recent development of extremist political views and resentment throughout Europe. ”Anger and frustration, in many different forms, have generated tensions
among countries with different fortunes within the euro zone, and have also empowered
extremist politics of a kind that Europe expected to leave behind” (Sen, 2012). A more
bold statement was expressed by Wolf who writes that ”Europe is under way of the ideas
of Heinrich Brünig, German chancellor between 1930 and 1932, whose disastrous policy
of austerity prepared the way for Adolf Hitler” (Wolf, 2014, p. 291). Thus, arguing that
”it’s simply the implementation, stupid” is as misleading as it is dangerous.
3.6
The Way Ahead
Chapter 2 concluded that a debt relief would certainly help in avoiding a vicious spiral in
the market for sovereign debt. However, even such a drastic measure would be of limited
help in an economic environment without growth. In similar vein, this chapter suggests
that an expansionary fiscal policy with the aim of boosting growth is limited as long as
banks are undercapitalized, the sovereign debt is unsustainable, and general prospects
regarding Greece’s economic and political future continue to be pessimistic, as all this
translate into a distress premium. Austerity then? Unless the confidence fairy proves to
be real, this could as well end in a total collapse of the economy. To conclude: the Greek
crisis consists of many interlinked vulnerabilities, hence a solution calls for bold and co54
ordinated measures. Just calling for austerity imply too many and too great risks. Even
Sinn, though arguing that Greece needs austerity in order to regain growth and a stronger
competitive position, realizes that the task is dangerous and even impossible when he says
that ”to achieve such cuts in relative prices, one can try extreme austerity programmes to
depress wages, but the result in all likelihood will be mass unemployment that tears at the
very fabric of society” (Sinn, 2014, p. 8). Moreover, building future EMU-policies on the
argument that the eurozone needs to rebalance through differential inflation will generate
major challenges for the ECB with a clear mandate of achieving price stability. Creditors
must accept a debt restructuring. The ECB must continue with its monetary expansion
without having to be bumping against the austeritarian wall. Greece needs financial aid
which should be targeted at the most vulnerable societal groups. Yes, Greece needs to
improve its competitiveness, but this analysis has shown that the timing of austerity matters. The vicious spirals are in part consequences of ill-timed austerity which creates the
worse conditions possible for implementation of structural reforms.
Greece could certainly benefit from institutional reforms. By fighting tax evasion, creating a more fair and understandable pension system, and by developing a more effective
administrative structure overall would do nothing but good. However, based on the theory and model implications of this chapter one could argue whether there is any reason
at all to mix such reforms with fiscal austerity during a recession. While the ECB is developing instruments with expansionary effects that improve the supply of credit, further
reducing the distress in the banking sector, the European policy shift towards austerity
depresses aggregate demand. While the Greek government is fighting tax evasion in order
to increase its revenues, the austerity increases unemployment and reduces the tax base.
Reforming the pension system by, for example, increasing the retirement ages, is done in
tandem with pension cuts. Bank-recapitalization in order to support the environment for
investment is done in tandem with increased corporate tax rates, increased VAT rates,
and subsidy cuts. The list of contradictions goes on - creating difficult conditions for
reforms to be successfully implemented in the first place. Sen provides an elegant analogy
in order to emphasize this important point:
[...] it is as if a person had asked for an antibiotic for his fever, and been given
a mixed tablet with antibiotic and rat poison. You cannot have the antibiotic
without also having the rat poison. We were in fact being told that if you want
economic reform then you must also have, along with it, economic austerity,
although there is absolutely no reason whatsoever why the two must be put
together as a chemical compound. (Sen, 2015).
As section 3.3 showed, one of the key arguments in support of economic austerity is
55
the signal it shows. Austerity signals discipline which supposedly should have a positive
effect on aggregate demand and investment. Further, the desire of creditors to minimize
bailouts and get their loans repaid as fast as possible implies a tragic hunt for primary
surpluses through austerity in the debtor country in order to get the debt level down at
a sustainable level. Those plans failed in the case of Greece due to the adverse effects
thoroughly discussed in this thesis. The fact that the creditors continuously repeat in
their reviews and reports that, if the programme where to be implemented as agreed, no
further debt relief would have been needed and Greece would have achieved sustainability in the long-run (see e.g. IMF, 2015), is thus both too simplified and too unfair (in
addition, such statements are not productive in restoring investor confidence).
Of course, a country that has spent beyond its means for too long must ultimately face
a period of austerity. However, the austerity imposed on Greece in order to complete the
necessary reforms may have been counterproductive and yielded too much unnecessary
pain for the citizens. And most importantly; the timing could not have been worse. This
thesis suggests that the IMF and the European policymakers should return to the classical
Keynesian way of thinking about economics and support structural reforms through policies which boost aggregate demand in order to safe-guard the level of growth necessary
to avoid the vicious spirals and minimize all disturbances associated with the economic
adjustments. Rather than attacking basic social rights and forcing Greece into a recession
which is likely to last for years, the creditors should focus on assisting Greece in achieving
proper job creation and full employment. By ring-fencing health and social budgets while
relaxing the fiscal targets, Greece could reform the productive base by fighting tax evasion
and corruption, stimulate the economy for investments, modernize the State and public
administration while not generating too much unnecessary pain to its citizens. If Greece
is allowed to implement such reforms and regain its administrative credibility without
too much pressure on every other aspect of the economy during the process, the country
would be in better shape to develop a competitive export sector in the future. And it
makes little sense to require that Greece must become more competitive if the surplus
countries refuse to sacrifice some of their advantage in trade. Finally, the Greeks do not
live out of fiscal targets or interest rates - they live out of work and wages. As the Greek
Prime Minister Alexis Tsipras told the Economic Forum in Davos this year: ”We must
all understand that, next to balanced budgets, we must also have growth[...]We need to
be more realistic, and show more solidarity too” (Elliott et al., 2016). There is nothing
rational about a ”recession in the short-run”. The damage done to Greek workers after
periods of high interest rates, such as bankruptcies and increased unemployment and social insecurity, are not necessarily reversed for those individuals when the interest rates
are lowered. This thesis has shown that, bailouts after austerity and recession, only contribute to the problem. Though Greece has an enormous debt level, the main problem is
56
the one of bad administrative arrangements. ”The distinction between reforms of bad administrative arrangements and austerity have been lost in crude financial thinking” (Sen,
2012). A debt restructuring, expansionary fiscal- and monetary policy, and structural
reforms may save Greece. However, if the chosen policy is austerity, Greece is much likely
to remain in a bad equilibrium for years. According to Stiglitz:
Founded on the belief that there is a need for international pressures on countries to have more expansionary economic policies - such as increasing expenditures, reducing taxes, or lowering interest rates to stimulate the economy today the IMF typically provides funds only if countries engage in policies like
cutting deficits, raising taxes, or raising interest rates that lead to a contraction of the economy. Keynes would be rolling over in his grave were he to see
what has happened to his child. (Stiglitz, 2002, pp. 12-13)
In a time where Greece’s creditors even debate between themselves whether the austerity
measures are too strict, Greece’s hardship continues.
57
Chapter 4
Conclusion
After the financial crisis there has been a European policy shift towards fiscal austerity.
The financial crisis triggered an European sovereign debt crisis where Greece was hit especially hard. Hence, Greece had to agree on undertaking hard austerity policies in order
to receive the necessary bailout packages. Thus, the Greek crisis and recovery represent
an interesting case of how fiscal austerity works as a stabilization policy. The fact that
Greece has been undertaking austerity measures since the first bailout package in 2010
without any significant changes in economic performance during the subsequent six years
has raised the question about whether austerity, rather than Keynesian expansions, is
indeed an optimal policy. This thesis has analysed this question by looking at historical
data and discussing the possible effects of austerity and fiscal stimuli by applying two
formal models. The findings are as follows:
Was the Greek crisis a result of excessive spending over income? Between 2003-2007,
Greece experienced a significant accumulation of macroeconomic an financial vulnerabilities as the country took advantage of the highly liquid banking system and the economic
benefits which followed after the creation of the euro. Greece, together with Ireland,
Spain and Portugal, enjoyed the credit boom up until 2007 which resulted in increased
inflation above the eurozone average, increased prices and wages. Thus, those countries
became current-account deficit countries where businesses oriented to the domestic economy with lower potential for productivity growth. The deficit countries then had to rely
more on foreign capital inflows from surplus countries such as Germany, Netherlands and
Belgium. The surplus countries, on the other hand, focused on reducing labour costs and
improving productivity and competitiveness. Those imbalances in competitiveness made
the current-account deficit countries especially prone to a financial crisis. The sudden stop
of foreign capital inflow triggered by the financial crisis of 2008 forced Greece to reduce
its deficits through internal devaluation which had adverse effects on growth and employment. The subsequent worsening of primary deficits was therefore in part a consequence
of the crisis - not the reason. The recession and worsening of public finances caused by the
58
highly unbalanced eurozone shifted European policymaking toward austerity in order to
restore the credibility of public finances in the crisis-stricken countries, and to re-balance
the relative competitive positions which was an underlying reason for the sovereign debt
crisis to happen in the first place.
Did the austerity measures prove to be successful in restoring growth and improve
the competitive position? By looking at historical data, section 2.3.2 discussed to what
extent fiscal austerity has worked in improving Greek public finances, competitiveness
and growth during the last six years. Since 2010, Greece has indeed managed to turn a
negative primary balance into a positive one and the general government budget balance
is expected to finally be in accordance with the Maastricht criterium. But the costs have
been significant. A vicious spiral between sustainability, risk premiums and growth got
Greece shut out of the bond market and the country has not yet fully returned. And even
though the stock of public debt has somewhat decreased, the debt-to-GDP ratio is larger
now than in 2010 because of the significant adverse effects austerity has on economic
growth. The unemployment rate has stabilized around a tragic 25 percent level. The
competitive position of Greece has not changed much as the improvement in the currentaccount deficit is mainly a result of reduced import and recession - not lower relative
prices on Greek tradables. The price deflator for exported goods and services shows little
improvement relative to the 2010 base-year. For Greece, it has been six years of trying
to do the impossible. Alas, the data shows few signs of improvement.
How does fiscal austerity affect public finances? Section 2.4.3 presented a debtequilibrium model based on the standard IMF definition of sustainable debt with a riskpremium extension as found in Mehlum (2012). The data showed that years with austerity
measures have resulted in lower growth. Therefore, I further extended the model to include a negative relationship between austerity and economic growth and showed that a
bad and unstable debt-equilibrium is more likely in such an environment. Thus, an economy trapped in such an equilibrium could benefit greatly from a debt relief. However,
even though a debt relief could shift the economy from a bad equilibrium to a good one,
the bad equilibrium is still present in the economy so that any large adverse shock to
any of the variables in the model could force the economy back into difficulties. Such a
spiral did happen in Greece which got the country shut out of the bond market in 2010.
According to the model, this could have been prevented if Greece’s creditors had backed
Greek recovery from the outset rather than forcing on more austerity which adversely
affected interest rates and growth - generating a vicious spiral. If a debt relief is not an
option because of the fear of future moral hazard, the alternative is the risk of getting
into a vicious spiral and ultimately default as a result of the tragic hunt for sustainable
debt under worse and worse conditions.
59
How does a fiscal expansion affect the Greek real economy in a recession? Section
3.1 used a demand-driven Keynesian model and discussed the mechanisms of how a fiscal
expansion could result in increased demand and investment, increased GDP, lower unemployment and reduced deflationary pressure. But according to the model, a positive shock
to government expenses also affects prices and exports in the opposite direction of what
is necessary in order to improve the competitive position. I further introduced a distress
premium and showed how the positive effects of a fiscal expansion could be offset by a
higher distress premium in the banking sector. Thus, even though classical Keynesian
theory suggests that a fiscal expansion could be highly beneficial during a recession, the
extraordinary circumstances of the Greek recession could prove otherwise. The adverse
effect on competitiveness, more pressure on public finances, increased distress premiums,
a larger number of non-performing loans, and the worrisome prospects associated with a
possible future Grexit are all important factors which could give support to the argument
that a fiscal expansion alone is not an optimal policy.
Hoe does fiscal austerity affect the Greek real economy in a recession? By presenting an endogenous recession premium as suggested by Mehlum (2014), the Keynesian
model showed in section 3.3.2 how there could exist a bad equilibrium if the RP-curve
is steep enough. An economy in a recession which is trapped in this equilibrium could
be forced into a vicious spiral between higher recession premiums, a larger number of
non-performing loans and lower growth if austerity is used as a stabilization policy. Thus,
austerity alone and pushed too far - in similar vein to the debt-equilibrium model - could
result in a total collapse of the economy. The chapter lastly discussed some other aspects
of austerity. On one hand, austerity during a recession could be expansionary if the public
interprets the austerity as a signal of future discipline and stability. On the other hand,
the social and political costs of austerity could be severe, as it has been in Greece since
2010.
Thus, the analysis has shown that there are gains and distortions associated with both
policies. Neither fiscal expansions nor austerity in isolation could lead to an effective recovery in Greece. The Greek crisis consists of many interlinked vulnerabilities, hence a
proper stabilization policy needs to be characterized by bold and coordinated measures
beyond austerity and bailout loans. Yes, Greece needs austerity in order to achieve a better competitive position and restore credibility in its public finances. But the discussions
and models of this analysis have suggested that the timing could not have been worse.
As discussed in section 3.6, there is a mismatch between policies, and as long the ECB
develops expansionary monetary instruments, Greece could have benefited greatly from a
debt relief in order to ease the pressure on the debt-part of the crisis. Shifting resources
60
from debt-repayment towards job creation and welfare policies could complement the expansionary monetary policy and create a solid growth foundation in order to develop a
stronger competitive position later on.
61
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Appendices
68
Appendix A
The Model
Consider the IS-RR-PC framework for an open economy as found in Holden (2015)1 :
Y = C + I + G + NX
(A.1)
C = z c + c1 (Y − T ) − c2 (i − π e )
(A.2)
I = z I + b1 Y − b2 (i − π e )
(A.3)
T = z T + tY
(A.4)
N X = z N X − a1 Y + a2 E − a3 P
(A.5)
In (A.1) aggregate output equals aggregate demand in equilibrium and is the accounting
identity that corresponds to the calculation of a country’s GDP where Y is GDP, C is
private consumption, I is private investments, G is government expenses, and N X is the
net exports.
(A.2) is the consumption function that shows total consumption for a given level of
income Y . The parameter c1 , the marginal propensity to consume, is restricted to satisfy
0 < c1 < 1. The parameter c2 , the marginal effect after a change in the real interest rate,
is restricted to satisfy c2 > 0. This equation captures that private consumption is increasing in disposable income. In addition, the real interest rate is given by r = i − π e i.e. the
nominal interest rate minus expected inflation. Let z C capture other effects that affect
consumption such as total household wealth, the income distribution, and expectations
about future disposable income.
(A.3) is the investment function where 0 < b1 < 1 and b2 > 0. The marginal propensity to invest parameter b1 shows by how much private investments increase with one unit
increase in GDP. b2 captures by how much changes in the real rate of interest affect private
1
Investment-Saving - Interest Rate Rule - Phillips Curve-model.
69
investments. z I captures other factors that might affect investment such as technology,
access to finance, and expectations about the future.
(A.4) shows net taxation, T , as an increasing function of Y where the tax rate, t,
satisfies 0 < t < 1. T increases in Y as increased GDP implies lower unemployment, a
larger tax base, and fewer welfare expenses.
(A.5) shows net exports, N X, as a decreasing function of Y and the price level, P .
Increased Y increases imports while increased P reduced exports. N X is increasing in the
exchange rate, E, as a higher exchange rate implies that domestic goods become relatively
cheaper for foreigners. The parameters satisfy 0 < a1 < 1 and a2 , a3 > 0.
The real equilibrium GDP can be written on reduced form by inserting equations (A.2)
- (A.5) into equation (A.1):
Y = z C +c1 ((1−t)Y −z T )−c2 (i−π e )+z I +b1 Y −b2 (i−π e )+G+z N X −a1 Y +a2 E −a3 P
and solve for Y
Y =
1
(z C − c1 z T − c2 (i − π e ) + z I − (i − π e ) + G + z N X + a2 E − a3 P )
1 − c1 (1 − t) − b1 + a1
(A.6)
Next, consider the three equations:
i = iF +
∆E e
E
Y −Yn
+ zn
Yn
Y −Yn
e
P =1+π +β
+ zn
n
Y
π = πe + β
(A.7)
(A.8)
(A.9)
(A.7) represents the uncovered interest rate parity approximation which shows the
nominal interest rate, i, as a function of the interest rate in the country of which the cure
rency is pegged, iF , plus the expected rate of devaluation, ∆E
. In the case of a currency
E
∆E e
union, E = 0 so that i = iF holds in all member countries within the union.
(A.8) is the Phillips-curve where inflation, π, is increasing in expected inflation, the
output gap and exogenous supply shocks, z π . The higher expected inflation and output
70
gap the higher are the wages and hence the firm’s costs. This leads to higher mark-ups
Yn
and higher prices. The parameter β is defined as β = b AL
where the parameter b satisfies
b > 0 and A is the productivity of the labour force, L. β shows by how much inflation
increases with one unit increase in the output gap.
−1
. By setting P−1 = 1
(A.9) shows the price level. Define price growth as π = P −P
P−1
one simply get P = (1+π). Hence, (A.9) is derived by inserting (A.8) into this expression.
In order to derive the IS-curve, insert P from (A.9) into (A.6) and find
Y =
1
(z C − c1 z T − c2 (i − π e ) + z I − b2 (i − π e )+
1 − c1 (1 − t) − b1 + a1
Y −Yn
N
e
G + z X + a2 E − a3 (1 + π + β
+ z n ))
n
Y
which further gives
Y =
1
(z C − c1 z T − c2 (i − π e ) + z I − b2 (i − π e )+
β
1 − c1 (1 − t) − b1 + a1 + a3 Y n
G+z
NX
e
(A.10)
π
+ a2 E − a3 (1 + π − β + z )
which is the IS-curve where aggregate demand determines the value of aggregate supply.
Slope:
−(c2 + b2 )
∂Y
=
<0
∂i
1 − c1 (1 − t) − b1 + a1 + a3 Yβn
which implies that there is a negative relationship between GDP and the interest rate.
71