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Greek Tragedy? The Perils of Partial Integration

November 9, 2011

The saga of Greek debt has been a regular source of discussion for many months now.  In fact, whole IB cohorts have graduated passed through my classes as the tale has dragged on.   Greece’s public and private debt add up to somewhere between 120-140 billion euro.   How did this happen?  As is common knowledge now, many countries over-borrowed in the “good years” of 2000-07.   The question is why did investors lend Greece so much when it was a small economy?

Many investors failed to distinguish between the Eurozone countries issuing bonds priced in euro.  Greek bonds were consdiered as credit-worthy as German and French ones.  And so Greece was able to borrow at much lower rates than they would have if their relative risk was factored in.  Thus Greece was able to borrow (issue bonds) to a much greater degree, and and much lower rates, than it should have.

This article from the Economist shows how bad the debt problem in Europe is, using gdp/debt ratios.

Now Greece is going back on its committments, in agonizingly slow motion.  The current deal offers a huge reduction of its obligations to pay bay investors, a discount of 50%.  This threatens all the banks bought Greek bonds, as well as the banks who lent to them– a domino effect.   So the EU (led by Germany and France) is setting aside hundreds of billions for rescue packages for the banks, as needed.  The Greeks, for their part, are being asked to agree to more severe budget cuts, cuts to public wages, pensions, and welfare payments.  In addition, they’re expected to pay higher income and property taxes.

Everyone suffers and the world moves on right?  Not so fast.  The Greeks may not go along.  Their dilemma is presented in the following articles:

Voting away your debts

and

Can Greece drop out of the European Union?

Some are aghast that Greece might reject the terms of the deal.  But, in one respect, can you blame them?  Everything our course presents about managing the economy says that during a demand-side recession governments need to enact expansionary fiscal policy, not raise taxes and cut spending.  More “austerity” for Greece is likely to deepen an already bad recession, making it more difficult to pay of their debt.

Finally, in the background, Italy’s estimated debt may be as high as 700 billion, and Spain’s up to $500 billion.  What happens with Greece may set a precedent for other big euro debtors.  But how can anyone imagine bailing out those two, with such extraordinary debt?  As one famous Italian banker put it: “Greece is too small to fail, and Italy to big to save.”

Extra:  This US radio commentator is urging Americans to be sympathetic to the Greek/EU cause.  Wrapped up in his discussion is a tidy historical perspective on the purpose of the EU.

1. How does the issue of Greek (and Italian) debt illustrate the problems of achieving only monetary union among many nations.

2. Why do you think the EU and IMF are forcing Greece to enact such a strongly pro-cyclical, anti-Keynsian policy?  Is this justified?

3.  Should Greece drop out of the Euro?  To what degree would this help or hurt the stability of the Eurozone?

4.  Explain what happens to the credit rating of countries who renege on their debts, as Greece is now doing.  How does this affect their government and companies plans to borrow money?

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10 Comments leave one →
  1. Diana VIdeanu permalink
    November 10, 2011 12:48 pm

    I think that the E.U. and the IMF are enforcing the Greeks to enact against the Keynesian beliefs simply because by acting the expansionary fiscal policy, Greece has to lower taxes and increase the government spending. Right now, Greece has no money to spend thus if they need to spend they need to borrow again. By having small taxes and no government revenue they will simply have no money to pay back the debts. By having no money to pay back to the other banks (Italy, Spain…) those banks will eventually have their own debts and no money to run on. So the EU is now trying to make Greece pay to Italy (for example) because even though Greece is in debt, having a big economy such as the Italian one in dept will be even worse – it will be too big to save.

  2. Matei L. permalink
    November 10, 2011 12:56 pm

    Greece should not drop out of the eurozone, it would cause not only damage upon itself, but also upon all the countries that use the euro. Greece will cause an uncontrolled “domino” effect affecting most of the countries and most importantly it may cause the banks to collapse one after the other, putting the EU into a “dark ages” from a recession stand point. It is a dangerous game that Greece is playing, not accepting the proposition made by the EU from the first second. Every moment that passes causes a bigger and bigger black hole into the economy. The debt needs to be resolved as soon as possible in order to place the economy back on track. At least if Greece accepts the EU proposition, it will lead to a controlled (by the EU) economic crisis. Hopefully, Greece is smart enough to take the right decision.

  3. Fanni Csepeli permalink
    November 10, 2011 12:57 pm

    The issue of the Greek debt clearly demonstrates the problems of achieving only monetary union amongst the nations within the EU. In a common market, a common currency is applied, thus the monetary policies are set by one single central bank. If the EU would have complete economic integration then even the fiscal policies would have been thoughtfully determined by the EU. Greece and Italy’s situations are extremely bad right now, because of their irresponsible fiscal policies. They have been running government budget deficits for a long time and the interest rates for the bonds increased. This way the other members were slowly discouraged from financing their debts. Thus they stopped and these economies are now in a bad situation. Controlling the fiscal policies within the whole of EU could have prevented the irresponsible decisions of these countries.
    However, it would be a very simple evaluation to state that the EU should become a complete economic integration as that would offer many perils as well. The decisions for the fiscal policies are harder than those of monetary policies, because what’s good for another country may be very harmful for another.

  4. Radu Timis permalink
    November 11, 2011 6:31 am

    The situation clearly shows a problem of functionality in the Greek Economy and also in the EU. The problem with only achieveing monetary union does not help the EU since the EU needs consistent and coheret monetary and fiscal policies within its member countries. Economies such as Greece or Italy have spent money more than they had in reality, agreeing with many budget deficits. Banks in the same time were irresponsible because they lended money in large amounts to these governments, trusting the value of Greek investements and not taking into account and possible risk of increasing debt in the future and the incapability of paying this debt. Now the EU is forcing these nations to adopt an anti-keynsian policy because obviously these economies need to reduce their costs, raise taxes and lower salaries due to the need of reducing the very large debts, while this can only be done by reducing aggregate demand. There is no chance of hoping to spend even more to raise consumption because this will still continue to raise debt and only partially solve the problem in the short term. Greece should clearly not leave the Euro zone because this would cause great problems not only for the country itself but for other economies and financial institutions that the greek own debt to. French and German investors for example do not want government bonds in drahmas which would have a very low value, they want the bonds in euros, at the interest rate they have established with the German government. Besides this the value of the euro would decrease tremendously as there would be a greater supply of euro on the forex. The credit rating for such countries decreases fantastically and investment prospects do as well. Credit becomes so much more expensive and almost impossible to take because at very high interest rates it is not worth starting or developing a business, while in countries like Greece credits are not given anymore because of the lack of stablity and rates of return.

    • Vlad Radulescu permalink
      November 15, 2011 6:41 am

      I agree with Radu’s point about the consequences if Greece left the Eurozone. The debt should be paid, one way or the other, as not paying it would affect business, investors and the banks that lent money irresponsibly. I also agree that Greece should remain in the EU, because a lot of FDI would be lost for many years to come, due to further lack of convidence and a much depreciated new currency.

  5. Andrei Avram permalink
    November 11, 2011 6:52 am

    How Do You Quit the European Union?

    The article discusses the issue of whether or not Greece can and should drop out of the European Union. By leaving the Eurozone the Greek would be able to switch back to their old currency; the Drahma. This would allow them to sell cheaper exports as their currency would clearly be depriciated against other long existing currencies. Though this seems optimal to leave the Euro Club Greece would have to iniate a series of complicated procedures which consume a large amount of time money and nerves. The Greece situation has yet to be resolved.

  6. Vlad Radulescu permalink
    November 15, 2011 6:33 am

    A monetary union refers to a common monetary policy among nations. In the case of the EU, most of the burdens seemed to have been highlighted by a spoiled, uncontrolled fiscal policy that increased nations’ dept an an alarming level. While this is a responsibility of European governments, I think this monetary union is harder and harder to control as the number of member nations increases. It simply happens that the probability of ineffective fiscal policies increases. I think Greece would be better off by leaving the EU, because it would get rid of its debt and fix its current account deficit. Even though there might be high inflation in the beginning, Greece would have an opportunity to reform itself. Nevertheless, on an even larger scale, I think Greece should stay in the EU, because if it were to leave, other countries even bigger, such as Italy and Spain, might follow. THe only difference is that a collapse of the Italian economy will have much bigger repercussions. For the sake of the EU, I believe the current players should not leave and maybe, in the future, become a completely integrated economy.

  7. November 15, 2011 7:06 am

    The issue of Greek and Italian debt are two perfect examples of how countries can fail to achieve monetary union. Greece, more specifically, through its heavy spending and hence budget deficits, is now at an impasse and may either choose to stay in the European Union at the risk of even higher debt levels on the long run, or to exit the EU and implement expansionary fiscal policy. Both the EU and the IMF currently encourage Greece to adopt an anti-keynesian policy because it needs to raise taxes, reduce costs and lower wages in order to reduce the very large debts. The best approach towards this would be to reduce aggregate demand. Although personally I would advise Greece to try and stay in the EU for as long as possible, it would be perfectly understandable should its government decide otherwise. As a general rule, countries reneging on their debts are found untrustworthy as a government and economy and this can have very serious repercussions. Should the Greek government choose to borrow money from another state, it may find that, due to its reputation concerning debts, it will have trouble finding anyone to borrow the money from.

  8. Nele Schuldt permalink
    November 17, 2011 10:32 am

    If Greece drops out of the Euro Zone, the Euro will plunge in its value dramatically and eventually might lead to the dissolve of the entire Euro zone. This has huge implications on all other countries involved with the Euro. First of all, an entirely new economic system might have to be established, where rules and regulations concerning free flow of trade etc. will be re-evaluated. Furthermore, if the Euro is dissolved, every other country needs to go back to their own currency, causing large amounts of one-off costs when having to switch all systems to the new currency. For Greece, there may be short run advantages, as they can devalue their currency so greatly, that exports will rapidly increase and thus help pay back some of its debt. However if Greece separates itself from the Euro, the banking systems will be affected to such an extent, that other governments may not be able to help rescue the banks. What I personally find hard to understand is the fact that other governments are willing (and forced) to help Greece out of its debt misery, partially by paying themselves and partially by pressing banks to reduce the debt by as much as 50%. Riots in Greece have gone against a harsher austerity budget however to some degree, Greece must be held responsible for the mistakes of the past. In Italy’s case, it is hard to hold them responsible equally, as much of their misery is caused by the weak Euro, which came as a result of the global recession.

  9. Nele J. Schuldt permalink
    November 17, 2011 10:32 am

    If Greece drops out of the Euro Zone, the Euro will plunge in its value dramatically and eventually might lead to the dissolve of the entire Euro zone. This has huge implications on all other countries involved with the Euro. First of all, an entirely new economic system might have to be established, where rules and regulations concerning free flow of trade etc. will be re-evaluated. Furthermore, if the Euro is dissolved, every other country needs to go back to their own currency, causing large amounts of one-off costs when having to switch all systems to the new currency. For Greece, there may be short run advantages, as they can devalue their currency so greatly, that exports will rapidly increase and thus help pay back some of its debt. However if Greece separates itself from the Euro, the banking systems will be affected to such an extent, that other governments may not be able to help rescue the banks. What I personally find hard to understand is the fact that other governments are willing (and forced) to help Greece out of its debt misery, partially by paying themselves and partially by pressing banks to reduce the debt by as much as 50%. Riots in Greece have gone against a harsher austerity budget however to some degree, Greece must be held responsible for the mistakes of the past. In Italy’s case, it is hard to hold them responsible equally, as much of their misery is caused by the weak Euro, which came as a result of the global recession.

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