July 21, 2015

Greece: how did it come to this?

How Greece and other Euro periphery economies got into trouble and how Greece failed to get out of it.

How Greece and other Euro periphery economies got into trouble and how Greece failed to get out of it

Following the creation of the Euro-zone, private capital flowed into the periphery economies – boosting activity and allowing much higher rates of price and cost inflation than the core. Once the flow stopped, these economies had lost competitiveness, and since they couldn’t devalue the Euro, the only response was cuts in nominal prices and wages as well as efforts to lift productivity.

The unwillingness of private investors to put money into Greece also meant that the Greek Government faced problems in funding its big budget deficit and rolling over its massive stock of debt as existing maturities expired. This led to austerity measures, which drove the Greek economy into depression.

The IMF and Euro-group severely under-estimated the scale of the downturn that the austerity program would have on the Greek economy, and were slow to realise the scale of their error. Too much austerity was delivered too quickly, leading to an implosion in activity – meaning debt to GDP is higher today than before austerity commenced.

The July 12 agreement came with very harsh terms – implementing more austerity, further reforms in sensitive areas and intrusion into Greek sovereignty. That the Greek government accepted the deal reflects its weak bargaining position.

A Greek default poses much less risk to the Euro-zone banking system than in 2010. Greek debt is primarily held by European institutions and the IMF, with private investors far less exposed than in 2009 – reducing the contagion risk to other periphery economies.

The handling of the Greek financial crisis has been a major political and presentational failure for the Euro-zone and its institutions. It has provided more ammunition for critics of the Euro-project – which up until now has been supported by most voters, but that may now be less assured.

For further details, please see the attached document.

Greece – July 2015 (PDF, 528KB)