Confronted with such severe financial problems, the government and the central bank generally will carry out proper fiscal and monetary policies to cope with them. According to Sloman (2000), budget deficit is defined as the excess of government spending over its tax revenue, while national debt means the total accumulation of government borrowing to finance its budget deficit. Running a budget deficit will crowd out private borrowers who are trying to finance investment, which can be illustrated in Figure 1:
Figure 1. The effect of government budget deficit (Mankiw 2007)
This figure demonstrates that when budget deficit reduces national saving, the supply curve for loanable funds shifts leftward (from S1 to S2), the corresponding rise in interest rate causes a fall in investment (Barro 1989). In the case of Greek financial crisis, crowding out effect coupled with loss of credibility reduces the economy’s long-run growth rate and raise unemployment rate (Mankiw 2007). Therefore, harsh austerity program that reduces government spending and raises taxes is urgently required (Krugman and Wells 2009). Such program can best represent the contractionary fiscal policy, which includes a reduction in government purchases of goods and services, an increase in taxes and a reduction in government transfers to deal with huge budget deficit (Krugman and Wells 2009).
On the spending side, the government will reduce its own operating expenses, consumption and social welfare while public investment is cut by more than a half (smh 2010). On the tax revenue side, Greek government has applied hard new tax evasion rules that hike consumption taxes and value added tax on fuel, tobacco and alcohol (CNN 2010). In the deficit cutting proposal, €2.4 billion additional revenue will generate from numerous tax evaders and evasive social security payments (Sills and Weeks 2010). By taking these steps, the government hopes to slash the deficit below the 3% EU limit by 2012 (smh 2010). However, the fiscal solution is difficult and politically unpopular to implement. It is estimated by the OECD that the cost of healthcare and pensions between now and 2050 will rise by 16.8 percent of GDP in Greece, which is much bigger than other EU members (Elliott 2010). Thousands of Greek civil servants went on a 24-hour strike by means of closing schools and grounding flights after the government revealed detailed measures of the deficit-reduction package (Reuters 2010). Yet positive signal shows the government’s proposal works somehow as its deficit has dropped in January (Reuters 2010).
Printing money to repay bills seems to be another way for Greece to tackle the crisis (Krugman and Wells 2009). It is, nevertheless, an expediency that will cause another problem—inflation (Mankiw 2007). According to the quantity theory of money, the quantity of money available in the economy decides the value of money (Mankiw 2007). This theory explains why a monetary injection can cause a decrease in the value of money and inflation by illustration in Figure 2:
Figure 2. An increase in the money supply (Mankiw 2007)
Figure 2 shows the injection of money shifts the supply curve rightward from MS1 to MS2, and the equilibrium moves from A to B. As a result, the price level (P) increase as the value of money (1/P) decreases and an inflation tax will be levied on everyone who holds money (Mankiw 2010). However, since Greece is a member of the European Union, whose monetary policy is made by the ECB to ensure price stability, the Bank of Greece is only responsible for implementing the Eurosystem’s monetary policy in Greece (Bank of Greece 2008). This implies the Bank of Greece should give priority to guarantee the stability of price level rather than to its own interests. Therefore, seignorage financing is unavailable for Greece. On the other hand, this highlights a major weakness in the single currency, that is the lack of an institution to act as a “lender of the last resort” and a centralized budgetary mechanism that can allocate resources among the union countries (Mankiw 2007). In fact, it is the loose EU monetary policy, which provides low-cost funding and stimulates speculation in equities that causes the huge budget deficits today (Askari and Krichene 2010).
Greece could also leave the Euro and regain its monetary sovereignty if the government cannot refinance debts. As a result, the monetary union may face the threat of collapse and the euro will disappear as a reserve asset (Askari and Krichene 2010). The consequence worries other EU members and puts them in a difficult situation. These countries can either bail out Greece or save their banks that are exposed to Greece and credit downgrade indirectly. However, the first solution seems unsolvable since Spain, Portugal and Italy, which are facing similar problems, are likely to ask for aid as well (Elliott 2010). This is something that Germany, France and other nations do not want to see and Germany initially resisted an aid package as the public strongly opposed it (Watts 2010). However, seeing that it is really hard for Greek citizens to burden such heavy debt, Greece has called for activation of joint EMU/IMF financing package of €45 billion (Watts 2010). The detailed package, which consists of 30 billion euros in loan form eurozone countries and 15 billion euros from the IMF, should be able to ensure the debt sustainability within reach and avoid restructuring (Watts 2010). The implementation of the aid plan, nevertheless, remains uncertain and eurozone countries are likely to adopt flexible approaches to assist Greece and other countries that encounter sovereign debt crisis (Willis 2010).
To conclude, severe corruption and tax evasion along with adoption of the euro and its special economy structure lead to the huge budget deficit and public debt occurred in Greece in 2009. This damaged the government’s credibility on loans and drove the economy into crisis. Greece’s financial crisis also sent the euro into trouble with the risk that the euro will depreciate and even vanish as a reserve asset. In order to tackle this crisis, the Greek government has toughly carried out austerity fiscal policies that reduce government spending and raise taxes despite its political unpopularity. As a member of the European Union, the Bank of Greece cannot use seignorage to finance Greece’s budget deficits by printing money. However, the EU and IMF are said to offer Greece a €45 billion rescue package to help Greece get through this current crisis. Yet the implementation of the bailout remains uncertain and Greece still faces the threat of going bankrupt.
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