How the Greek crisis unfolded

The economics team at NAB has put together a great slide pack explaining the evolution of the Greek debt crisis (link). My view is that the ultimate role of Governments is to improve the well-being of the people. However, the action of Euro-zone Governments in the Greek crisis has been the complete antithesis of this, highlighting the political immaturity of the Euro-zone experiment. And despite all of the pain inflicted on Greece, their position is worse and very unlikely to recover. Looking forward, Greece's only options would seem to be withdraw from the Euro-zone or wait for a miracle.

NAB shows that net capital inflows to the peripheral Euro nations (PIGS—Portugal, Ireland, Greece, Spain) increased substantially up until the Global Financial Crisis in 2007-08.

• Following the creation of the Euro-zone, private capital flowed out of the core countries of Northern Europe into the periphery, seeking better returns in PIGS. Although currency risk had been eliminated within the Euro-zone, investors under-estimated the risks to their funds and many of the funds were not used effectively.

• The GFC triggered a reassessment of risk, and consequently net capital inflows to PIGS dropped from €250b in 2007 (largely from Germany and the Netherlands) to around €130b in 2008. By 2013 to substantial capital inflows had turned into capital outflows.

• For Greece, net capital inflows accounted for almost 15 per cent of GDP in 2008, plummeted in 2012 and 2013, and is now a substantial capital outflow.

Such economic shocks have a severe impact on activity in capital importing economies. 

• While foreign capital flowed in, these countries could spend more than they produced—running very large current account deficits. Once the inflow of capital stopped they could no longer fund these deficits and had to either get financial support from bodies like the IMF or cut their spending back into line with their income. 

• The inflow of capital had boosted economic activity in PIGS and allowed them to run much higher rates of price and cost inflation than the Euro-zone core. In effect, firms in PIGS were steadily losing competitiveness against their rivals in core countries like Germany, Belgium or the Netherlands. Both the core and peripheral economies now shared the same money, preventing high inflation peripheral economies from using the time-honoured response of currency devaluation to regain lost competitiveness. 

• Once the peripheral economies were unable to attract foreign private sector capital, they had to drastically improve their trade balance—requiring a combination of improvements in their competitiveness and cuts in domestic spending. As currency devaluation was no longer possible and Euro-zone core inflation was minimal, the only response was cuts in nominal prices and wages as well as efforts to lift productivity.

• Greece has seen the biggest falls in prices and (particularly) wages of any peripheral economy since the Euro-zone crisis began—reflecting the unequalled severity of its economic downturn. Unfortunately, this has not led to the surge in exports that was the anticipated result of these cuts in wages and prices.

The Greek Government was also affected by the massive change in funds availability.

• The unwillingness of private investors to put money into Greece meant that the Greek Government faced problems in funding its big budget deficit and rolling over its stock of debt as existing maturities expired. 

• With a budget deficit equal to around 15% of GDP in 2009, this sudden lack of access to new funds required a drastic program of austerity—increases in taxes and cuts in public spending

• The Greek Government has made considerable progress in cutting its deficit—cutting the headline deficit to 3.5% last year and securing a surplus on its non-interest budget balance.

The austerity measures imposed on Greece by its creditors have been disastrous.

• The austerity programs have had a far worse impact on economic activity in Greece than was initially expected or than in other Euro-zone peripheral economies. GDP in Ireland, Spain and Portugal has started to recover but Greek output has stayed flat.

• GDP has fallen by around 25% from its pre-global financial crisis level and the cumulative loss in output in this Greek GDP downturn will easily exceed what was experienced in the Great Depression in the US, UK or Australia. 

• Even worse, there does not seem to be an end in sight for the Greek Depression. 

• Besides their intended target of lowering nominal wages, austerity programs have depressed all incomes (nominal or real). Nominal wages have declined by around 20% since early 2010 and the impact on household incomes has been exacerbated by big falls in employment.

• Household disposable income has fallen by over a third and households have been forced to deplete their wealth by large scale dis-saving (consumption spending being well above household disposable income).

•  Greek house prices have fallen by around 40% from their pre-crisis peak and buyers have shifted toward smaller, older and more affordable homes. Falls in commercial real estate (CRE) values have also been around 40%. Rents have declined sharply with Athens retail rents almost halving and office rentals declining by over 30%.

• This decline in collateral values has put pressure on a banking system already struggling with a jump in the level of overdue loans to around 40% of all bank credit. Almost 30% of mortgage loans are non-performing as are a third of business loans. The legal system makes creditor repossession and resale a long process—and this has been one of the areas targeted for reform by Greece’s Euro-zone creditors.

The IMF and Euro-group severely under-estimated the scale of the downturn that the austerity program would have on the Greek economy. 2010 calculations suggested primary budget cuts worth 12% of GDP would trigger a 3-year recession worth 8.6% of GDP. These fiscal cuts eventually saw output collapse by around 25%—far worse than expected.

The IMF and Euro-group were slow to realise the scale of their error, although similar policies of austerity applied in Europe in the 1930s and Argentina in the 1990s had also led to collapsing output and eventually proved politically impossible to sell to the population. Consequently, the high risk of producing an economic depression should have been recognised.

Despite all the efforts that have been made to improve the budget balance and the creation of a depression, key headline indicators like the government debt/GDP ratio show that the debt situation remains worse than before.