So we can define the financial crisis as follow:
A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities.
So what's the problem in Greece?
Years of unrestrained spending, cheap lending and failure to implement financial reforms left Greece badly exposed when the global economic downturn struck. This whisked away a curtain of partly fiddled statistics to reveal debt levels and deficits that exceeded limits set by the Euro zone.
Greece adopted the euro (€) as its currency in January 2002. The adoption of the euro provided Greece (formerly a high inflation risk country under the drachma) with access to competitive loan rates and also to low rates of the Eurobond market. This led to a dramatic increase in consumer spending, which gave a significant boost to economic growth. Between1997-2007, Greece averaged 4% GDP growth, almost twice the European Union (EU) average. As with other European countries, the financial crisis and resulting slowdown of the real economy have taken their toll on Greece’s rate of growth, which slowed to 2.0% in 2008. The economy went into recession in 2009 and contracted by 2.0% as a result of the world financial crisis and its impact on access to credit, world trade, and domestic consumption--the engine of growth in Greece.
High growth and low interest rates had masked major fiscal and structural weaknesses that were aggravated by the global financial crisis and ensuing recession. As a result of a high 2009 fiscal deficit (recently revised upwards by Eurostat to 15.4% of GDP from 13.6% of GDP), mounting aging and entitlement costs, and deteriorating competitiveness resulting from higher than Euro zone-average inflation and rigidities in product and labor markets, markets in early 2010 began to question the sustainability of Greece’s public debt (2009 debt recently revised upward by Eurostat from 115.1% of GDP to 126.8% of GDP). Ever-increasing market doubts and pressures resulted in higher and higher borrowing costs throughout the winter and spring of 2010. Eventually, unsustainable borrowing costs caused Greece to lose market access, forcing the Prime Minister on April 23, 2010 to request an emergency assistance program from his Euro-area partners and the International Monetary Fund (IMF). In early May, the Greek parliament, Euro-area leaders, and the IMF Executive Board approved a 3-year €110 billion (about $145 billion) adjustment program to be monitored jointly by the European Commission, the European Central Bank, and the IMF. Under the program, Greece has promised to undertake major fiscal consolidation and to implement substantial structural reforms in order to place its debt on a more sustainable path and improve its competitiveness so that the economy can re-enter a positive growth trajectory. Specifically, the 3-year reform program includes measures to cut government spending, reduce the size of the public sector, tackle tax evasion, reform the health care and pension systems, and liberalize the labor and product markets. Greece has committed to reduce its deficit to fewer than 3% of GDP (the ceiling under the EU’s Maastricht Treaty) by 2014.
The effect of the crisis on Greece:
The global crisis and the consecutive recession caused an increase in unemployment to 9.4% in 2009 (from 7.7% in 2008). Unemployment is expected to continue to increase, reaching 11.8% in 2010, 14.6% in 2011, and 14.8% in 2012, before beginning to decrease in 2013 to 14.3%. Foreign direct investment (FDI) inflows to Greece have dropped, and efforts to revive them have been only partially successful as a result of declining competitiveness and a high level of red tape and bureaucracy. At the same time, Greek investment in Southeast Europe has increased, leading to a net FDI outflow in some years.
Greece has a predominately service economy, which (including tourism) accounts for over 73% of GDP. Almost 9% of the world’s merchant fleet is Greek-owned, making the Greek fleet the largest in the world. Other important sectors include food processing, tobacco, textiles, chemicals (including refineries), pharmaceuticals, cement, glass, telecommunication and transport equipment. Agricultural output has steadily decreased in importance over the last decade, accounting now for only about 5% of total GDP. The EU is Greece’s major trading partner, with more than half of all Greek two-way trade being intra-EU. Greece runs a perennial merchandise trade deficit, and 2009 imports totaled $64 billion against exports of $21 billion. Tourism and shipping receipts together with EU transfers make up for much of this deficit.
The effects of the Greek financial crisis on the Eurozone:
-Allowing the Greek crisis to lead to default, risks leading to contagion that will affect other government bond markets in the eurozone.
-And following up on the previous statement, such a contagion to other government bond markets will affect the banking sector in the Eurozone. Many banks have started to recover from the banking crisis by arbitraging the yield curve, i.e. by borrowing short from the central bank at very low interest rates and investing in longer term government bonds. The steepness of the yield curve has been an important source of profits for the banks. A crisis in the government bond markets, i.e. sharply declining bond prices, would lead to large losses on the balance sheets of the banks. This could trigger a new banking crisis in the Eurozone.
-The Greek government bond crisis. If not stopped, the crisis will lead to increases in government bond yields in a significant number of Eurozone countries. This will put pressure on the governments of these countries to sharply contract fiscal policies, leading to deflationary effects and risking pulling down the Eurozone economies into a double-dip recession. Such an outcome would not only be bad news for the unemployed, but would also make it even more difficult for the Eurozone countries to reduce their budget deficits and debt levels.
-The crisis has exposed a structural problem of the Eurozone that has been analyzed by many economists in the past. This is the imbalance between full centralization of monetary policy and the maintenance of almost all economic policy instruments (budgetary policies, wage policies, etc.) at the national level.
Put differently the structural problem in the Eurozone is created by the fact that the monetary union is not embedded in a political union. This imbalance leads to a dynamics of creeping divergences between member states and no mechanism to correct or to alleviate it. These divergent developments have much to do with the fact that important economic decisions (decisions about wage agreements, budgetary policies, social policies, credit regulations, etc.) are decided at the national level.
The choice the Eurozone authorities face today is between two evils. The first one arises from moral hazard. Bailing out Greece is bad because it gives a signal that irresponsible behavior will not be punished. The second evil arises from the contagious effects of letting Greece default on the banking system and macroeconomic policies in the Eurozone. Authorities have to choose for the lesser evil, which in this case is the second one. This is also what they did when they bailed out the banks that had been at least as irresponsible as the Greek government.
While there can be little doubt that the crisis must be stopped now rather than later, much doubt has been voiced that the European Union, or for that matter the member countries of the Eurozone, have the means to do so. Doubts have been voiced at the legal level and at the level of the financial capacity of the union to organize a bail-out.
The legal skeptics argue that the no-bail out clause in the Treaty forbids the member states of the union to provide financial assistance to another member state. But this is a misreading of the Treaty. The no-bail-out clause only says that the European Union shall not be liable for the debt of governments, i.e. the governments of the Union cannot be forced to bail-out a member state. But this does not exclude that the governments of the EU freely decide to provide financial assistance to one of the member states. In fact this is explicitly laid down in Article 100, section 2. Thus euro zone governments have the legal capacity to bail out other governments.
There can be equally little doubt that the Eurozone member countries have the financial capacity to bail-out Greece if the need arises. It does not cost them that much. In the event that Greece were to default on the full amount of its outstanding debt, a bail-out by the other euro zone governments would add about 3% to these governments’ debt. A small number compared to the amounts added to save the banks during the financial crisis.
One can conclude that the member countries of the Eurozone have the legal and financial power to bailout Greece. Up to now the only obstacle has been political, i.e. the lack of consensus among the different member states about the necessity to do so. One can only hope that this political obstacle will go away soon. The Greek government of course has the key to eliminate the obstacle by providing a credible budget cutting policy. This seems to be the case today after the new round of budget cutting measure. It is unclear though whether the other EU countries are willing to take up their part of the deal.
There is one important element missing, though. This is an announcement by the ECB about its collateral policy. As argued earlier, the uncertainty about what the ECB will do in the coming months with Greek government debt remains. The ECB should clearly signal that it will continue to accept Greek government debt as collateral, independently of the ratings concocted by the agencies.
The experience we now have with the ECB policy regarding the eligibility of government bonds as collateral in liquidity provisions leads to the conclusion that there is an urgent need for the ECB to change this policy. More precisely, the ECB should discontinue its policy of outsourcing country risk analysis to American rating agencies. The latter have a dismal record. As argued earlier, they have made systematic mistakes, underestimating risks in good times, and overestimating risks in bad times.
Relying on these agencies to decide about such a crucial matter as the selection of government bonds, is simply unacceptable. It helps to destabilize the financial markets in general and the Eurozone in particular. Surely, the ECB should not be a primary source of financial instability in the Eurozone. The ECB is better placed to do the job of analyzing the creditworthiness of member countries of the Eurozone than the rating agencies. It has a pool of highly skilled analysts who are equally capable if not more so than the analysts working for the rating agencies.
This structural problem has to be fixed before we are hit by the next crisis. But that is also the hard part. There is today in the Eurozone no willingness to move forward into a more intense political union. Even the thought of adding just 0.1% to the European Union budget makes some countries extremely jittery. Thus, a very small scale fiscal union that would transfer just a few percentage points budgetary and tax responsibilities appears to be out of the question.
One is led to the conclusion that the inability to create a more intense political union in the eurozone will continue to make the latter a fragile construction, prone to crises and great turbulence each time such a crisis must be resolved.
While a grand plan for political unification does not seem to be possible, smaller but focused steps towards such a future union can be taken. Two such steps are worth mentioning here. One is the idea of creating a European Monetary Fund (EMF), an idea put forward by Daniel Gros and Thomas Mayer. The EMF would be a new European institution which would obtain its funding from countries with excessive budget deficits and debt levels. In times of crisis it would have the means to support countries in need of financial assistance, while at the same time it would have the authority to impose conditions for the granting of financial assistance. Another idea is to create new common Euro government bonds in which each country would participate pro rata of its capital share in the ECB. In order to deal with obvious moral hazard problems, the interest rate each of the participating countries would have to pay would depend on the interest rates each of these governments pay when they issue bonds in their own markets. Thus the more profligate governments like Greece would have to pay a higher interest rate than the more orthodox governments. The common bond interest rate would then be the weighted average of these national interest rates. Such a scheme would go a long way in pacifying the fears about moral hazard implicit in common bond issues; fears that are very strong in countries like Germany. In addition, by creating a new bond market with sufficient size it would also be attractive to outside investors, creating a liquidity premium that would profit everybody, including Germany.
These proposals are only small steps towards political unification. They have the important quality of being signals of a determination of the members of the eurozone to commit themselves to a future intensification of the process of political union. Such signals are of crucial importance today. They make it clear that the members of the eurozone are serious in their desire to preserve the eurozone. Without these (or similar) steps there can be little doubt that the Eurozone has no future.
References: www.wikipedia.com www.cnn.com Financial Policies and the Prevention of Financial Crises in Emerging Market Countries (Frederic S. Mishkin) www.nber.com www.state.gov The Greek crisis and the future of the Eurozone Paul De Grauwe www.econ.kuleuven.be www.almasryalyoum.com www.thedailynewsegypt.com http://www.youtube.com/watch?v=p9vkWntC0xo (Alkahera alyoum may 2010) (AlFajr newspaper 14/7/2011)
