Greece Financial Crisis

August 20, 2010

I. SUMMARY OF THE ARTICLE Since the onset of the Greek economic crisis, the European Union community has undergone numerous discussions on how to salvage the downward spiralling economy of one of their southern neighboursGreece. But before the decision to bail out Greece was enacted, a lot of opinions and recommendations were being published in the hope of shedding some light on the possible alternatives the country can look into. 3 Scenarios for the Greek Debt Crisis1 by Derek Thompson explains 3 probable paths Greece can pursue to rescue its economy: (1) Greece plods along under the protective shield of Europe's emergency fund The first of the possible paths is for Greece to dip into Europes emergency fund contributed by the eurozone countries and the International Monetary Fund. However, the author maintains that the fund will only delay Greeces hardship and will not actually solve the problem. A condition of the continued use of the emergency fund is for Greece to cut down its budget deficit from 14% to 3%, which according to the author will be very hard to do if one cannot control its own monetary policies. Greece cannot execute a currency devaluation to make its products cheaper in international markets. Therefore, it has little to expect from its exports. Thus leaving them no other choice but to decrease public spending while simultaneously increasing taxes. Doing this will further weaken the economy, sending Greece deeper into debt. According to the author, the IMF foresees an economic contraction by 6%, which could then push the government to borrow more. (2) Greek government tells foreign banks that it cannot pay back its loans on time and restructures its debt A second alternative that economists consider is debt restructuring. By restructuring, Greece need not pay 100% of its debt plus the interest, but only a portion of it. Banks who hold Greek debts will have to declare big losses, which the author stressed, could require additional rounds of bail outs from European governments. The author has however countered that even with debt restructuring, Greece would still have to face a large deficit. He supported this assertion by providing a sample scenario should Greece decide to restructure its debt by 50%. According to the author, Greece's current deficit is 14% of GDP. Interest payment[s] on the debt make up about 6% of GDP. So even if Greece restructures to pay 50 cents on the dollar, slashing its interest burden in half, they're still left with a deficit equal to (14 - [6/2] =) 11% of GDP. Another argument against debt restructuring is what the author and other economists say contagion effect. Potential investors would be hesitant to invest in countries in a similar situation. As per the article, this nervousness by investors would result to higher rates on government debt thereby making it harder for these countries to finance it. Consequently, these countries would also be more susceptible to debt restructuring which would just now lead to a cycle. (3) Greece drops the euro and moves to a separate currency that it can control
1

Article attached as Appendix A.

The last of the alternatives the aricle has presented is for Greece to leave the eurozone altogether so it can implement its own monetary policy. By doing this, Greece can devalue its currency, making its products more competitive in external markets. However, the author has argued that an effect of this is a massive bank run.

II. GREEK ECONOMIC CRISIS A. Background on Greeces Debt Crisis You cannot spend more than (what) you earnyou should not borrow more than (what) you can afford. This, according to an editorial published by the Greek newspaper Kathimerini, may be the lesson Greeks are now learning the hard way.2 Unrestrained spending of successive Greek governments over a long period may have driven the countrys budget and current account deficits.3 Greece borrowed heavily from international capital markets to finance public sector jobs, pensions and other social benefits.4 As deficits and the countrys debt burden grew, the governments just kept on borrowing. 5 When Greece joined the eurozone in 2001, it gained monetary stability and was able to borrow at lower interest rates thus, encouraging the countrys habit of borrowing. However, while government spending and borrowing increased over time, tax revenues on the other hand, weakened due to widespread tax evasion.6 From 2001 to 2009, Greece reported an average budget deficit of 6.4% per year compared to a Eurozone average of 2.6%. Current account deficits, on the other hand, averaged 9.4% of GDP per year. In 2009, Greece had an estimated budget deficit of 13.6% of GDP, with an accumulated government debt of 115% of GDP. Table 1 Public Balance (% of GDP) from 2000 to 2009 Area Eurozone (16 countries) Greece
2 3

200 0 0.0 -3.7

200 1 -1.9 -4.5

200 2 -2.6 -4.8

200 3 -3.1 -5.6

200 4 -2.9 -7.5

200 5 -2.5 -5.2

200 6 -1.3 -3.6

200 7 -0.6 -5.1

200 8 -2.0 -7.7

200 9 -6.3 -

Back down to earth with a bang, http://www.ekathimerini.com/4dcgi/_w_articles_columns_1_08/03/2010_115465

For example, see Is Greece Heading for Default?, Oxford Economics, January 29, 2010. Q&A: Greece's economic woes, http://news.bbc.co.uk/2/hi/business/8508136.stm Q&A: Greece's financial crisis explained, http://edition.cnn.com/2010/BUSINESS/02/10/greek.debt.qanda/index.html Wikipedia. 2010 European Sovereign Crisis, http://en.wikipedia.org/wiki/2010_European_sovereign_debt_crisis Back down to earth with a bang, http://www.ekathimerini.com/4dcgi/_w_articles_columns_1_08/03/2010_115465 Q&A: Greece's economic woes, http://news.bbc.co.uk/2/hi/business/8508136.stm

4 5 6

13.6 Source: Eurostat Database

Table 2 Current Account Balance (% of GDP) from 2000 to 2009 Area Eurozone (16 countries) 200 0 -1.5 200 1 -0.4 200 2 0.6 200 3 0.3 200 4 0.8 200 5 0.1 200 6 -0.1 11. 3 200 7 0.1 14. 4 200 8 -1.7 200 9 -0.6

Greece

-7.7

-7.2

-6.5

-6.5

-5.8

-7.5

14. 11.2 6 p

Source: Eurostat Database (p=provisional value)

Table 3 General Government Debt (% of GDP) from 2000 to 2009 Area Eurozone (16 countries) Greece 200 0 69. 2 103 .4 200 1 68. 2 103 .7 200 2 68. 0 101 .7 200 3 69. 1 97. 4 200 4 69. 5 98. 6 200 5 70. 1 100 .0 200 6 68. 3 97. 8 200 7 66. 0 95. 7 200 8 69. 4 99. 2 200 9 78.7 115. 1

Source: Eurostat Database Both Greeces budget deficit and debt levels are well above those permitted by the EU Stability and Growth Pact (Amsterdam, 1997). Under the rules of the SGP, the ratio of government deficit to GDP should be no more than 3% and the ratio of government debt to GDP should be no more than 60%.7 Greeces reliance on external financing for funding budget and current account deficits left its economy highly vulnerable to shifts in investor confidence.8 Investor confidence had declined rapidly since late 2009 when the new socialist government of Prime Minister George Papandreou revised the 2009 budget deficit from 6.7% of GDP to 12.7% of GDP. Investors became more alarmed when the Greek authorities admitted that previous figures had been misleading.9 As a result, Greece's credit rating suffered successive downgrades from the three major rating agencies (i.e., Fitch, Moodys and S&P). With the lowest rating in the
7 8 9

European Commission - Eurostat. Europe in Figures: Eurostat Yearbook 2009 Congressional Research Service. CRS Report, Greeces Debt Crisis: Overview, Policy Responses, and Implications, April 27, 2010. Is Greece Heading for Default?, Oxford Economics, January 29, 2010.

eurozone, Greek bonds are now viewed as a highly risky investment by foreign investors.10 Consequently, Greek bond yields increased in 2010. Greek 10-year bond yields used to be 10 to 40 basis points above German 10-year bonds prior to the crisis. However, with the crisis, the spread increased to over 400 basis points in January 2010. This high bond spread further underscores investors loss of confidence in the Greek economy. 11 In April 2010, Eurostat, the Statistical Office of the European Communities, estimated Greeces budget deficit to be 13.6% of GDP - almost a full percentage higher than the 12.7% estimate previously released by the Greek government in October 2009. This further increased investor nervousness and revived questions about Greeces ability to repay its debts.12 Greeces total debt is estimated at 300 billion euros, with part of it maturing in midMay 2010. Despite the implementation of stringent austerity measures and sales of additional Greek bonds, fears of a possible default continued to spread along with speculations on other courses of action the Greeks may take. On 23 April 2010, the Greek government officially requested that the EU/IMF bailout package be activated. Greece needed money before 19 May, or it would face a debt roll over of about 8.5 billion euros. 13

B. Greece: Current Economic State Between 2000 and 2007, the Greek economy grew as GDP increased by about 4.0% per year. However, the growth dropped to 2% in 2008 and contracted by 2% in 2009, bringing the country into recession. This decline may be attributed to the global financial crisis and Greeces failure to address the fiscal problems. Unemployment rose to 9.5% in 2009 from 7.7% of the previous year. On the other hand, inflation went down by nearly 3 percentage points. Price levels show an uptrend since 2003, almost reaching the EU average in 2009. Table 4 Economic Indicators MEASURE Growth Rate of Real GDP (Volume) Growth Rate of Real GDP per Capita
10 11 12 13

200 0

200 1

200 2

200 3

200 4 4.6 p 4.3 p

200 5 1.9 p 1.9 p

200 6 4.5 p 4.1 p

200 7 4.5 p 4.1 p

200 8 2.0 p 1.6 p

200 9 2.0 p 2.2 p

4.5

4.2

3.4

5.9

4.1

3.9

3.1

5.6

Q&A: Greece's financial crisis explained,http://edition.cnn.com/2010/BUSINESS/02/10/greek.debt.qanda/index.html

Congressional Research Service. CRS Report, Greeces Debt Crisis: Overview, Policy Responses, and Implications, April 27, 2010. Congressional Research Service, CRS Report, Greeces Debt Crisis: Overview, Policy Responses, and Implications, April 27, 2010. Wikipedia. 2010 European Sovereign Crisis, http://en.wikipedia.org/wiki/2010_European_sovereign_debt_crisis

Annual Average Inflation Rate (HICP)a Comparative Price Levels (EU-27 = 100)b Employment Rate Unemployment Rated
c

2.9 84. 8 56. 5 11. 2

3.7 82. 3 56. 3 10. 7

3.9 80. 2 57. 5 10. 3

3.4 85. 9 58. 7 9.7

3.0 87. 6 59. 4 10. 5

3.5 88. 2b 60. 1 9.9

3.3 89. 0 61. 0 8.9

3.0 90. 7 61. 4 8.3

4.2 94. 0 61. 9 7.7

1.3 97. 4 61. 2 9.5

Source: Eurostat Database (p=provisional value; b=break in series)

a

HICP = Harmonized Indices of Consumer Prices

Comparative price levels are the ratio between Purchasing Power Parities (PPPs) and market exchange rate for each country. PPPs are currency conversion rates that convert economic indicators expressed in national currencies to a common currency, called Purchasing Power Standard (PPS), which equalizes the purchasing power of different national currencies and thus allows meaningful comparison. The ratio is shown in relation to the EU average (EU27 = 100). If the index of the comparative price levels shown for a country is higher/lower than 100, the country concerned is relatively expensive/cheap as compared with the EU average.
b

The employment rate is calculated by dividing the number of persons aged 15 to 64 in employment by the total population of the same age group.
c d

Unemployment rates represent unemployed persons as a percentage of the labor force.

With Greece taking a step towards comprehensive structural reforms to address its current debt crisis and restore competitiveness, the Organisation for Economic Cooperation and Development (OECD) in its Economic Outlook No. 87, provided the following projections for Greece:

Source: OECD Economic Outlook No. 87

III. ANALYSIS OF PROPOSED SCENARIOS

A. Greece Leaves the Euro i. Eurozone Monetary Policy The Maastricht Treaty The Maastricht Treaty or the Treaty of the European Union (TEU) was signed last February 7, 1992 by the members of the European Community. The Treaty introduced the Economic and Monetary Union (EMU), which decided the introduction of a currency the Euro, following a three phase scheme14: (1) From 1990-1993, their objective is to establish a completely free circulation of capitals; (2) From 1994-1999, member countries should establish coordinated economic policies that would follow a convergence criterion: reduction of inflation and interest rates, control of government deficit and debt and a stable exchange rate. At this stage, the European Council gave a definitive name to the new European unique currencythe Euro. (3) From 1999-2002, the establishment of a European Central Bank that will be responsible for fixing of exchange rates and the introduction of the single currency. One of the objectives of the Treaty is social and economic cohesion among diverse regions and countries of the community. This led to the creation of a Cohesion Fund, which was created in 1994. A financial aid will be provided to the less developed regions to focus on the development of infrastructures and the environment. The European Union (EU) and the Economic and Monetary Union (EMU) All European Union member states form part of a single market called the Economic and Monetary Union. The role of the EMU is to oversee economic integration 15, given by the following:
Coordination of economic policy-making between Member States Coordination of fiscal policies, notably through limits on government debt and deficit An independent monetary policy run by the European Central Bank (ECB) The single currency and the euro area Economic governance under EMU Within EMU there is no single institution responsible for economic policy. Instead, the responsibility is divided between Member States and the EU institutions. The main actors in EMU are: The European Council sets the main policy orientations

The Council of the EU (the 'Council') coordinates EU economic policy-making and decides whether a Member State may adopt the euro
14 15

http://www.historiasiglo20.org/europe/maastricht.htm http://ec.europa.eu/economy_finance/euro/emu/index_en.htm

 The 'Eurogroup' coordinates policies of common interest for the euro-area Member States The Member States set their national budgets within agreed limits for deficit and debt, and determine their own structural policies involving labour, pensions and capital markets The European Commission monitors performance and compliance The European Central Bank (ECB) sets monetary policy, with price stability as the primary objective.

Euro In support of the provisions of the 1992 Maastricht Treaty, the European Union introduced a single currency called Euro last January 01, 1999 and started circulating bank notes last January 01, 2002. An EU member country can only participate in the currency upon meeting a set of strict economic criteria, such as a budget deficit of less than 3% of their GDP, a debt ratio of less than 60% of the GDP, low inflation, and low interest rates. Its aim is to bring economic integration among EU member countries by enabling them to trade, borrow and transact at a lower price. For example, Spain can import from Germany without having the risk of foreign exchange losses due to fluctuations. In the same way, Greece can borrow from France with lower rates as a result of the single currency. Countries that have the most benefit from Euro in terms of the interest rate are Greece, Ireland, Portugal, Spain and Italy as they gained easier access in borrowing capital. Lower interest rates would also mean more investments, more jobs, and lower mortgages. Some studies associate increased investments and trade in the Eurozone due to the introduction of the Euro. But as any other new system, the Euro also has some disadvantages. One is the presence of economic differences. Goods of a poorer country tend to be more expensive versus their previous legal tender, which in turn makes their products uncompetitive and affect their exports deeply. Another issue is the presence of strict Maastricht criteria that makes it harder for some nations to comply with. Lastly, because the European Central Bank (ECB) controls the monetary policies of EU countries, their sovereignty over their economies weaken16 as they can only resort to fiscal policies in steering their economy. European Central Bank The European Central bank (ECB) was formed in 1998 under the Treaty of Amsterdam to administer the monetary policies for the 16 nations which adopted the Euro called the Eurozone. This organization works hand in hand with the European System of Central Banks (ESCB) for each member country. Yet, the ECB is an independent entity. Its decisions should not be influenced by any Central Bank or government in the Eurosystem. The European Central Bank is made up of three major decision making bodies. First is the Executive Board, which is responsible in implementing monetary policies, instructing national central banks, and facilitating the day-to-day operations of the ECB. Second is the Governing Council, considered as the highest decisionmaking body, which defines the monetary policies and fixes the interest rates at which commercial banks can obtain money from the Central Bank. Lastly, the General Council is in charge of coordinating ECB activities and preparing for future expansion
16

http://news.bbc.co.uk/2/hi/special_report/single_currency/25081.stm

plans of the Eurozone. Its main objective is to manage the Euro currency and maintain price stability for member countries. The nations are required to keep the inflation rate close to but below 2% in the medium run so that it will not severe the countries purchasing power. They manage to keep the inflation rate within this range by two ways: by controlling the money supply and monitoring price trends. With this in mind, they also monitor fluctuations in output and employment. Effects of ECB Policies on Greek Economy By knowing that the main objective of the ECB is to maintain price stability, we will know the effects of their policies to an ailing economy like Greece. One factor that aggravates lesser economies like Greece is the existence of one-size-fits-all monetary policies.17 The European Central Bank (ECB) sets all monetary standards for all 16 member countries with various economies. Surely, the disparities in the countries economic performances will pose as a great challenge for the unified currency as the policy for an affluent country may not be the best strategy for a poor country. With Germany and other wealthier nations dominating the ECB, it tends to focus more on sustaining their economic growth, rather than support countries with lagging economies. This in turn will further increase the gap between these nations. In addition, the stringent fiscal criteria of the union may prove to be strenuous to lesser counties. It even drove some nations, Greece for example, to misrepresent their debt and deficit numbers in order to meet these requirements. Another problem of the Euro is that instead of helping lesser economies improve their performances by its low interest rates, it led to excessive debt and consumption by these countries. In short, some benefits of this currency were not realized. Greeces adoption of the Euro also has disadvantages. Since they cannot devalue their currency, their exports remain uncompetitive as opposed to their high level of imports. Also, their lack of control over their monetary policies resulted to excessive public spending, which in turn led to a balloon of public debt. With the mandate of the Union, Greece is now trying to raise taxes, as this country is known for high instances of tax evasion, and reduce public spending. Yet it comes with the risk of putting the nation into deeper recession by affecting national consumption. But with respect to the present Greek Debt Crisis, it seems that the ECB tends to adjust their standards in order for Greece to meet some financial criteria. For some years now, they have been reducing their collateral requirements to maintain the ratings of Greek debt. It even went as far as suspending the minimum credit ratings for collateral eligibility in the case of the debt instruments issued and guaranteed by Greece. The justification for this decision is that the Greek government has presented a financial program to the European Commission, the ECB, and the IMF that will strengthen the countrys financial performances. Based on the evaluation of these decision-making bodies of the program, they have deemed the exemption as an appropriate move, and implemented the suspension last May 03, 2010. Economists say that this strategy may be attributed to the fact that a possible Greek default will create a financial shock to the entire European Union. It may also subject other countries with economic difficulties, like Portugal, Ireland,and Spain to the risk of contagion.
17

http://www.nytimes.com/2010/03/29/opinion/29Starbatty.html?_r=2&ref=european_monetary_union

If Greece were to leave the Eurosystem, if such scenario is possible, it would create more harm than good for the European Union. When they shift to a devalued new currency to gain competitiveness in the market, their debts in Euro will be more expensive, and will further increase the probability of default. With Greeces debt approaching 300 Billion, a default would be the largest sovereign collapse since World War II, dwarfing those in Russia and Argentina. 18 This situation is being avoided at all costs as massive write-off of debts by several countries may result to a recession in the Eurozone similar to the Global Financial Crisis in 2008. ii. Own Monetary Policy Scenario 3 of the article by Derek Thompson talked about Greeces option to leave the euro zone. As discussed above, being part of the euro zone entails having the same interest rates and monetary policies as all other members of the European Monetary Union. This constrains Member States from creating their own monetary policies to boost their economy. According to the article, Greece needs to restore economic competitiveness by lowering wage costs and prices which could be done thru devaluation. The implications of having a common currency area were discussed by Olivier Blanchard in Chapter 21 of his book, Macroeconomics (5th Edition). According to the author, having the same monetary policies would work only if countries have the same macroeconomic shocks. Blanchard also discussed the conditions in achieving an optimal single currency area as explored by Robert Mundell. One requirement set by Mundell is that the countries experience similar shocks which would lead them to choose roughly the same monetary policy. The other circumstance is that if ever the shocks that the countries experience are different, then there should be high factor mobility. This means that workers can move from areas that are doing poorly or to areas that are performing well. With this movement of the workers from one place to another, they are helping the countries to adjust to shocks by putting the unemployment rates back to normal. Because of these two Mundell conditions, Blanchard says that the adoption of the common currency area may not be the best option for the Europe as it does not seem to meet either condition. First, the countries have experienced different shocks in the past which would require different monetary policies. Next, Europe, unlike the United States, has a low labor mobility brought about by the language and cultural differences across countries. As an example, Blanchard cited Portugals problem of having low output and a large trade deficit. He pointed out that without the option of a devaluation, achieving real depreciation may require years of high unemployment and downward pressure on wages and prices. This situation resembles the current economic crisis in Greece. With this, we will try to discuss the third scenario presented by Thompson, wherein Greece opts to leave the euro and devalue its currency.

18

Is Greece Heading for Default?, Oxford Economics, January 29, 2010.

Blanchard defines devaluation as a decrease in the exchange rate in a fixed exchange rate system. The more general term for the decrease in the exchange rate is depreciation. To explain the relation of lowering the exchange rate to the improvement of output, Blanchard started by defining the real exchange rate () as the nominal exchange rate (E) multiplied by the price level of domestic goods (P) divided by the price level of foreign goods (P*), or:

EP P
*

Next, he defined net exports (NX), as the difference between exports (X) or the foreign demand for domestic goods and imports (IM/) or the domestic demand for foreign goods. Moreover, he explained the factors affecting exports and imports using the expression below:

NX = X (Y , ) IM (Y , ) /

(+) , (-)

(+) , (+)

The determinants of exports include foreign income and the real exchange rate. Foreign income has a positive effect on exports which means that higher foreign income leads to higher foreign demand for goods (both foreign and domestic) and thus, higher exports. The real exhange rate, on the other hand, affects exports negatively such that an increase in the real exchange rate will increase the price of domestic goods relative to foreign goods, which in turn, will increase demand for foreign good, hence, decreasing exports. Imports, on the other hand, are affected positively by domestic income. Higher domestic income leads to an increase in domestic demand for goods (both foreign and domestic), and therefore, higher imports. Likewise, the real exchange rate has a positive effect on imports. Looking more closely at the effect of depreciation on the trade balance, a lower would lead to: 1. Higher exports, X - With this, a lower exchange rate would mean that the prices of domestic goods are relatively lower than the prices of foreign goods. This would increase foreign demand for domestic goods, and thus boost exports. Higher exports would lead to higher net exports. 2. Lower imports, IM On the other hand, a decrease in the real exchange rate would make domestic goods less expensive relative to foreign goods, shifting domestic demand towards domestic goods. This leads to a reduction in the quantity of imports.

3. Higher IM/ - The real exchange rate () does not only affect the quantity of imports (IM), but also the relative price of foreign goods in terms of domestic goods (IM/). Given IM, a decrease in , will increase IM/. This means that it would now cost more to purchase the same amount of imports. According to Blanchard, for trade balance to improve following a depreciation, exports must increase enough and imports must decrease enough to compensate for the increase in the price of imports. Furthermore, he introduced the Marshall-Lerner condition, where a real depreciation leads to an increase in net exports. Going back to the article, the third scenario explores the possibility of Greece leaving the euro and devaluing its currency. According to the author, this course of action will allow Greece to increase its exports, and thereby infuse money into the economy. How is this possible? If Greece was not part of the euro zone, then it can depreciate its domestic currency (drachma). Assuming that the Marshall-Lerner condition holds, the depreciation will make foreign goods relatively more expensive than Greek goods, leading to a shift in demand (both domestic and foreign) towards Greek goods. This would then stimulate domestic production, increase domestic output, and consequently, improve trade balance. However, it is important to note that this process takes time. As demonstrated by the J-curve, the trade balance initially deteriorates as the quantity of imports (IM) and exports (X) remain fairly unchanged despite a real depreciation. Over time, the market adjusts and IM decreases while X increases. This causes net exports to grow, and eventually the trade balance improves beyond its initial level. Since a depreciation initially leads to a decline in net exports, it also initially reduces output. As such, the Greek government may need to use a combination of depreciation and fiscal policy in order to improve trade balance without sacrificing output. How then could Greece devalue its currency if it decides to leave the Euro and return to its original currency, the drachma? This could be done by looking at the effects of an expansionary monetary supply. Blanchard gave a discussion on the implications of a contractionary monetary policy in an open economy. We shall use this as a basis in evaluating the effect of the reverse policy of monetary expansion. In Blanchard's discussion, he pointed out that since money supply s is not a factor in the IS relation, we only need to look at the effects of an increase in money stock (Ms) in the open economy to the LM curve. This could be seen in the diagram below:

Graph taken from Macroeconomics (5th Edition) and edited to show the effect of a REVERSE contractionary monetary policy, or a monetary expansion

As can be seen above, due to an increase in money supply, the LM curve shifts down from LM to LM resulting to change in the IS-LM equilibrium from point A to A , which causes an increase in output from Y to Y and decrease in interest rate from i to i. To explain, an increase in money supply decreases interest rate which encourages higher investments leading to higher expenditure which pushes output up. This then leads to further increase in output, Y, due to the multiplier effect. This increase in Y leads to an increase in the demand for money which lowers interest rate. This decrease in interest rate only tempers the initial increase brought about by the monetary expansion and the net effect will still be a lower interest rate. Because of the interest parity relation, the decrease in i led to a decrease in the exchange rate from E to E and thus a depreciation. To explain the relation of lowering the exchange rate to the further improvement of output, Blanchard started by defining the real exchange rate or, e, as the nominal exchange rate, E, multiplied by the price level of domestic goods, P divided by the price level of foreign goods or:

Next, he defined net exports (NX), as the difference between exports (X) or the foreign demand for domestic goods and imports (IM/e) or the domestic demand for foreign goods. Moreover, he explained the factors affecting exports and imports using the expression below:

EP P
*

NX = X (Y , ) IM (Y , ) /

(+) , (-)

(+) , (+)

The determinants of exports include foreign income and the real exchange rate. Foreign income has a positive effect on exports which means that higher foreign income leads to higher foreign demand for goods (both foreign and domestic) and thus, higher exports. The real exhange rate, on the other hand, affects exports negatively such that an increase in the real exchange rate will increase the price of domestic goods relative to foreign goods, which in turn, will increase demand for foreign good, hence, decreasing exports.An increase in total exports will decrease net exports. Imports, on the other hand, are affected positively by domestic income. Higher domestic income leads to an increase in domestic demand for goods (both foreign and domestic), and therefore, higher imports. Likewise, the real exchange rate has a positive effect on imports. Looking more closely at the effects of depreciation, a lower e for Greece would lead to: I. Higher export, X - With this, a lower exchange rate would mean that the prices of domestic goods are relatively lower than the prices of foreign goods. This would encourage foreign countries to import from Greece and thus boost its exports. Higher X would lead to higher NX. II. Lower imports, IM On the other hand, a decrease in the real exchange rate, will make price of foreign goods expensive in Greece. This would make the Greeks want to purchase more of local products thus discourage imports. III. Higher IM/e - The real exchange rate (e) does not only affect the quantity of imports (IM), but also the relative price of foreign goods in terms of domestic goods (IM/e). Given IM, a decrease in e, will increase IM/e. This means that it would now cost more to purchase the same amount of imports. According to Blanchard, for trade balance to improve following a depreciation, exports must increase enough and imports must decrease enough to compensate for the increase in the price of imports. Furthermore, he introduced the Marshall-Lerner condition, where a real depreciation leads to an increase in net exports. Going back to the article, the third scenario explores the possibility of Greece leaving the euro and devaluing its currency. According to the author, this course of action will allow Greece to increase its exports, and thereby infuse money into the economy. How is this possible? If Greece was not part of the euro zone, then it can depreciate its domestic currency (drachma). Assuming that the Marshall-Lerner condition holds, the depreciation will make foreign goods relatively more expensive than Greek goods, leading to a shift in demand (both domestic and foreign) towards Greek goods. This would then stimulate domestic production, increase domestic output, and consequently, improve trade balance.

However, it is important to note that this process takes time. As demonstrated by the J-curve, the trade balance initially deteriorates as the quantity of imports (IM) and exports (X) remain fairly unchanged despite a real depreciation. Over time, the market adjusts and IM decreases while X increases. This causes net exports to grow, and eventually the trade balance improves beyond its initial level. Since a depreciation initially leads to a decline in net exports, it also initially reduces output. As such, the Greek government may need to use a combination of depreciation and fiscal policy to improve trade balance without sacrificing output. The discussion above shows the positive effects on Greece if they decide to leave the Euro. However, there is also a disadvantage if they decide to do so as discussed in an article by Robert Plummer. He explored the possiblity of taking a eurozone holiday wherein Greece leaves the monetary union temporarily, returns to the drachma, sets its exchange rate as one euro to one drachma and then devalues by nearly a quarter. The author stressed the importance to returning to the Euro when the time is right, which is after a few years or when the exchange rate is around 1.3 drachmas to the euro, to be able to cut labor costs and boost export. However, since Greece's debts would remain denominated in euros, the devaluation would just increase the size of Greece's debt mountain.19 In addition, and as also discussed in the article by Derek Thompson, this scenario will neither be the best option for the whole Euro zone. Allowing Greece to leave might lead to a massive bank run, for fear of investors that their euro-denominated deposits might turn in rapidly depreciated drachmas.20 It is also said by some observers that allowing Greece to leave the Euro might set a precedence to be followed by others which would ultimately lead to the break-up of the monetary union itself21 or the shrinkage of the euro zone to include only the richer countries only.22 In the end this option might not be possible for Greece since the European Union stressed that it will keep the Eurozone together and dismissed talks of countries leaving the EU. 23 B. Greece Plods Along Fiscal Policy What does Greece do to escape the crisis? The country now, definitely harbours along the rescue package the EU and IMF are administering them. Since the outbreak of Greeces financial crisis, the country has relied on the bailout package that will be allotted to them by the European Union and the International Monetary Fund. In late 2009, Greece budget deficit and government debt were plotted to 13.6% and 115.1%, respectively, of the countrys total Gross Domestic Product. The budget deficit and the government debt, respectively, exceeded the 3% and 60% target deficit and external debt set by the EUs Stability and Growth Pact. Chart A: Government Debt and Budget Deficit as A Percentage of GDP
19 20

Greece crisis: Is there an exit, http://news.bbc.co.uk/2/hi/business/8648456.stm 3 Scenarios for the Greek Debt Crisis http://theatlantic.com/business/archive/2010/05/3-scenarios-for-the-greek-debtcrisis/56536/ 21 Q&A: Greece's economic woes, http://news.bbc.co.uk/2/hi/business/8508136.stm 22 3 Scenarios for the Greek Debt Crisis http://theatlantic.com/business/archive/2010/05/3-scenarios-for-the-greek-debtcrisis/56536/ 23 Q&A: Greece's economic woes, http://news.bbc.co.uk/2/hi/business/8508136.stm

Source:

Is Greece Heading for Default?, Oxford Economics24

Many say that the debt crisis and the high budget deficit are not caused by the incompetence of euro, but are caused by Greeces reckless fiscal policies. Analysts claim that ever since Greece entered the European Union, the country has experienced a substantial increase in living standards through a combination of community aid and the social policies of the Panhellenic Socialist Movement (PASOK) that were based heavily on borrowing. Public debt rose from 39% of GDP in 1980 to stand at 112% in 2004. 25 Analysts also assert that when Greece penetrated the euro zone in year 2002, its fiscal policy loosened up. On its first years with the euro zone, Greece borrowed profoundly on its neighboring countries for public spending. This led to the remarkable increase in consumer spending, which in a way boosted its economy. Greece also spent heavily on public wages, which significantly increased during the past years. Aside from that, its pension system was very generous that its people are retiring in an early age, benefitting from bountiful pension amounts. Chart B shows the debt of Greece in different countries, in billions of dollars. France loaned the utmost amount of money to Greece, amounting to 73 billions of dollars. The second highest chunk of debt Greece loaned amounted to 59.1 billion dollars, from Switzerland. Chart B: Greeces Debt (in billion dollars) to its Neighboring Countries

24 25

Is Greece Heading for Default?, Oxford Economics, January 29, 2010. Greece in Figure, Outlook for 2007, http://www.inv.gr/

Source: Eurostat Press Release Euro Indicators , October 22, 2009

Chart C shows the amount of Greeces total government spending as weighted against its total revenue, beginning year 2002, when the country entered the euro zone until 2009. It can be noted that significant increases in spending are made every year. As compared to the total revenue of Greece each year, total government revenues rise and fall. Over the past six years, while the central government expenditures increased by 87%, revenues grew by only 31%. 26 The weakening of tax revenue collections is one of the primary causes of stumpy government revenues. Chart C: Govt Revenue versus Govt Expenditure (in million euros)

Source:Govt Revenue, Expenditure and main Aggregates, Eurostat, 17-08-2010

Greeces Fiscal Policy Response Greece has put forward plans to lower down its budget deficit from 13.6% to 8.7% of its total GDP at year-end 2010, and to less than 3% to year-end 2012. This is in response to the bail out package the Eurozone and the IMF is imparting Greece.
26

Greeces Debt Crisis: Overview, Policy Responses, and Implications, http://www.scribd.com/doc/33261052/R41167

On 2 May 2010, the Eurozone countries, together with the International Monetary Fund agreed to a 110 billion loan for Greece, conditional on the implementation of harsh Greek austerity measures.27 The following austerity measures were agreed upon by Greece with the European countries and the IMF: IV. Public sector limit of 1,000 introduced to bi-annual bonus, abolished entirely for those earning over 3,000 a month. V. An 8% cut on public sector allowances and a 3% pay cut for DEKO (public sector utilities) employees. VI. Limit of 800 per month to 13th and 14th month pension installments; abolished for pensioners receiving over 2,500 a month. VII. Return of a special tax on high pensions. VIII. Changes were planned to the laws governing lay-offs and overtime pay. IX. Extraordinary taxes imposed on company profits. X. Increases in VAT to 23%, 11% and 5.5%. XI. 10% rise in luxury taxes and taxes on alcohol, cigarettes, and fuel. XII. Equalization of men and women's pension age limits. XIII. General pension age has not changed, but a mechanism has been introduced to scale them to life expectancy changes. XIV. A financial stability fund has been created. XV. Average retirement age for public sector workers has increased from 61 to 65 XVI. Public-owned companies to be reduced from 6,000 to 2,000.
Source: 2010 European http://en.wikipedia.org/wiki/2010_European_sovereign_debt_crisis sovereign debt

The loan package will be realized by Greece in three installments, depending on the austerity progress the country is implementing. The first loan package was already released, May 2010. Greeces dependence on the bail out package tendered to them by the European Union and the International Monetary Fund makes them beleaguered by the austerity measures set by EU and IMF. As a result of the austerity measures, Greeces economy contracted for a seventh quarter and unemployment rose as the wage-cuts and tax increases that aim to trim the European Unions second-biggest budget deficit deepened a recession.28 Consumer confidence was also at its worst level in 10 years. Inflation rate in July also reached 5.5% because of the tax increases in fuel, alcohol and tobacco. Re-

27

2010 European sovereign debt crisis, http://en.wikipedia.org/wiki/2010_European_sovereign_debt_crisis

28

Greek Economy Shrinks for Seventh Quarter as Unemployment Increases to 12%, By Maria Petrakis - Aug 12, 2010 5:54 PM GMT+0800Aug 12, 2010 5:54 PM GMT+0800 http://www.bloomberg.com/news/2010-08-12/greek-economy-probably-shrank-in-secondauarter-on-austerity-higher-taxes.html

ports quoted a 46% budget deficit reduction in Greece for the first half of 2010, as a result of the restructuring of labor and pension systems. C. Greece Restructures Its Debt Basically, restructuring of debt is just a much more pleasant way of saying defaulting partially. As discussed in the earlier section of this paper, Greece currents budget deficit is now at 13.6% of GDP with a public debt/GDP ratio of 115%. If Greece decides to restructure its debt, banks holding Greek debts would have to declare big losses as well thereby affecting the banks reserves. A phenomenon such as this would be costly to repair. According to a publication by Oxford Economics29, approximately 187 billion of Greek public debt is held mostly by Eurozone banks and a partial default could mean billions of euros lost on top of what was lost during the previous financial crisis. When this happens, the publication also maintains that this could cause a second wave of serious credit restriction by European banks.30 In addition to this, a massive bank run might force governments to intervene by adopting fiscal expansionary policies. If a government of a country experiencing a massive bank run decides to sell government bonds for financing, interest rates shoot up because of higher demand for credit in the financial markets. This would make borrowing more costly for smaller economies, making it more difficult for them to finance their own budget deficits. Another implication of debt restructuring as mentioned by Derek Thompson is the contagion effect. The incentives to invest in countries in a similar situation are decreasing as potential investors may think that a default might be inevitable for them as well. The author has identified 3 countries which are on the running to become the next Greece: Portugal, Spain and Ireland. If such a thing happens, these countries might find it very hard to finance their own (increasing) debts; adding to that the possible higher interest rates caused by credit restrictions and expansionary fiscal policies. According to Oxford Economics, Portugal, Spain, Ireland and Greecess (PIGs) combined public debts account for around 1.2 trillion or 13% of the eurozones GDP.

29 30

Is Greece Heading For Default?, Oxford Economics, February 2010. Ibid.

Therefore, a Greek partial default affects not only its own economy but other economies as well, especially those within the eurozone. Since their markets are interconnected, a default in one country might possibly lead to a future default in others. As Oxford Economics stresses it, a Greek partial default might lead to a deeper recession in the near-term31 which may have possible spill-over effects to other economies.

Conclusion
As a member of the European Union and with its current financial crisis, Greece is powerless to decide on its own monetary policy. Leaving the Euro zone is not a better idea either. The latter requires a tedious and expensive process, of which Greece cannot afford on its current financial position. Who would want to leave the stable euro currency for a devalued drachma? Aside from that, the European countries might not let Greece just leave the eurozone as it would definitely cause a break down in the global financial markets. In addition, it would defy the very goal of the European Union: an ever closer Europe through a political, economic and monetary union. The best option so far is what Greece is doing right now. For the time being, the country should continue to cling to the support of its family countries and the IMF. Although the government is currently experiencing strikes and attacks from its people due to huge cuts in its government spending and increase in taxes, it must hold its position to be able to continue to receive the aid given by its neighbors and the IMF. After the repayments of its debts and in the long run however, Greece must strictly observe fiscal discipline in order to prevent a repeat of its crisis. It must continue to monitor its public spending and improve efforts on tax collection.

31

Is Greece Heading for Default?, Oxford Economics, January 29, 2010.