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Can Greece pull it off?

Will the Greek rescue package be enough or is restructuring inevitable? In this column, members of the European Economic Advisory Group argue that even if the sovereign debt crisis is resolved, Greece must deal with its unsustainable current-account deficit. This requires an unenviable choice between internal and external depreciation and a government strong enough to take on the country’s rife tax evasion.

By the third quarter of 2009 Greece had experienced the smallest drop in GDP relative to its peak level in 2008 among all Eurozone countries. It appeared that the country would be able to weather the global economic crisis with only a small dent on its stellar growth performance over the last decade. However, during the spring of 2010, it became clear that this performance was based on an unsustainable public and private spending spree that was reflected in the double-digit government budget and current account deficits. The Greek government was in serious financial trouble and needed massive support. In May 2010, a gigantic rescue package was put together by the European Commission, the ECB, and the IMF, in order to help Greece and reduce the risk of contagion to other EU member states.

Will this rescue package meet its intended goals and prove sufficient to help Greece onto a sustainable path without the need for further support after the current package expires in June 2013, or is restructuring inevitable as some observers claim (Eichengreen 2010b)?

The roots of Greece’s troubles

The roots of the fiscal crisis for Greece can be traced to the 1980s, when government spending experienced a huge expansion without a countervailing increase in government revenues. During the 1990s recorded deficits fell considerably. However, despite moderate deficits between the mid-1990s and the mid-2000s and fast growth in nominal GDP, government debt increased relative to GDP (Figure 1). The rise in the debt-to-GDP ratio was to an important degree due to off-budget activities. During the 1990s various outstanding liabilities were consolidated into the government debt. In 2009, the accumulated effect of these off-budget items had contributed to the outstanding debt relative to GDP by more than 60 percentage points (Moutos and Tsitsikas 2010). A successful return to sustainable public finances, assert the EEAG experts, requires full control of the development of these off-budget items.

Figure 1. Greek debt and deficits

Source: EEAG 2011,and provisional data (Ameco) for 2010.

At least as worrisome as the fiscal situation is the external balance. Compared to any other EU15 country, Greece experienced the strongest decline in national savings over the past decades – net national saving went from 20% of GDP in the mid-seventies to minus 12% in 2009. As a consequence, the current-account balance gradually deteriorated, and during the last decade, the deficit was consistently above 10% of GDP (Figure 2). After 2004, current-account deficits added almost 50 percentage points to net foreign debt relative to GDP, which stood at around 100% at the end of 2010. This huge debt build-up accumulated over a relatively short period of time. This period of fast foreign debt accumulation coincided with the decline in interest rates and rise in capital inflows which Greece experienced as a result of its admission to the Eurozone. Alas, the opportunities offered by this decline in real interest rates to reduce the excessive government debt were not used wisely by successive Greek governments.

Figure 2. Greek external balances

Source: EEAG 2011, and provisional data (Ameco) for 2010.

Compared to other Eurozone countries faced with acute fiscal and current-account problems, a number of features of the Greek economy pose particular difficulties. Greece has a very high share of self-employed, accounting for around one-third of total employment – the highest share in the OECD. Under-reporting of income is likely to be much higher among the self-employed, reducing the effective size of the tax base. Under-reporting also has distributional consequences. For example, more than 40% of self-employed doctors practising in the most lucrative (for medical professionals) area of Athens reported an income below €20,000 in 2008. Such under-reporting undermines popular support for needed fiscal consolidation.

Fighting tax evasion must be a key focus for future reform. However, since this may not be easy to accomplish through direct administrative measures, changes in the structure of taxation can be used to shift resources to sectors less prone to tax evasion. To this end, further increases in VAT rates, coupled with reductions in social security contributions, should be considered. Such budget-neutral policies reduce the effective tax advantage of non-traded activities, which constitute the bulk of tax-evading entities, e.g., service providers. It can therefore foster a transfer of resources to the export sector from the low-productivity, non-traded sector. Thus, this policy in combination with direct measures to fight tax evasion could over time help restore both fiscal and external balances.

Greece has an extraordinarily high share of services in total exports, of which a large share is shipping services. Net exports of services (including shipping) have been consistently more than 5% of GDP. In contrast, net goods exports have been registering very large deficits, sometimes exceeding 15% of GDP. The deficit in the trade balance on goods and services was on average above 10% of GDP during the last decade, a reflection of the fact that Greece’s supply-side structure is tilted towards producing non-traded goods and services (Engler et al. 2009). A real exchange-rate depreciation will therefore have a very limited and delayed effect on the current-account deficit via substitution effects. An expansion of the export sector sufficient to restore a sustainable external balance is not likely to occur soon. Instead, the required adjustment will most likely have to come from a fall in imports, via reductions in wealth and income. The conclusion is that it is likely that Greece will see a number of years with output far below potential and very high unemployment rates.

The challenge of public debt

Although such a development might help in reducing the current-account deficit, it makes it more difficult to achieve fiscal balance, and to arrest the accumulation of public debt. It also creates the danger that the politico-economic equilibrium may shift against further contractionary measures which the bailout package calls for when the budget deficit reduction targets are not met. In the opinion of the EEAG experts, it is thus unlikely that, with normal debt instruments, the Greek government will be able to return to private markets, at default-avoiding interest rates, for all its borrowing needs when the bailout package expires in June 2013.

A new kind of government bonds, which are described in detail in Chapter 2 of the 2011 EEAG Report, might offer a solution to Greece. These bonds provide security to investors by being convertible – after a limited and well-defined haircut – into replacement bonds that are partially secured by the European Stability Mechanism. Using such bonds, Greece should be able to refinance its debt in the market at acceptable interest premiums over safer bonds.

Regardless of whether Greece’s sovereign debt crisis will be resolved, there remains the problem of how to get rid of the huge and unsustainable current-account deficit. There are, in principle, only three options: i) exiting the euro and introducing a devalued drachma, ii) a radical internal depreciation, with Greek prices and wages falling sharply relative to those in the rest of the Eurozone, and iii) an ongoing transfer programme from the EU to finance the deficit. The EEAG Report discusses these options in detail.

  • The authors rule out the third alternative of ever-continuing transfers from the EU to Greece as a viable solution.

A key argument against transfers is that they are very unlikely to help a region with structural problems to gain international competitiveness, as demonstrated by the negative experience of the transfers to eastern Germany over the last two decades.

  • The first two options, external and internal depreciation, both impose very large costs and will not work quickly.

Both will increase the burden of foreign debt expressed as a share of GDP and will have deleterious effects on the balance sheets of many firms and financial institutions.

  • An internal depreciation as large as required can certainly not be achieved without a painful and sustained contraction of the economy and higher unemployment.
  • An external depreciation is likely to be preceded by rumours that can cause a bank run and lead to a currency crisis, thus precipitating effective supply failures (Eichengreen 2010a; Calvo and Reinhart 2001).

There is therefore no alternative that is clearly more palatable than the other in every respect. The choice is between two evils, whose consequences can be mitigated only by the seriousness with which the Greek government tackles tax evasion.


Calvo, G and C Reinhart (2001), “When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options”, in P Kenen and A Swoboda (eds.), Key Issues in Reform of the International Monetary System, International Monetary Fund, Washington, DC.
EEAG (2011), The EEAG Report on the European Economy, CESifo, Munich 2011
Eichengreen, Barry (2010a), “The euro: Love it or leave it?”, VoxEU.org, 4 May.
Eichengreen, Barry (2010b), “It is not too late for Europe”, VoxEU.org, 7 May.
Engler, P, M Fidora and C Thimmann (2009), “External Imbalances and the US Current Account: How Supply-Side Changes Affect an Exchange Rate Adjustment”, Review of International Economics, 17:927-941.
Moutos, T and C Tsitsikas (2010), “Whither public interest: The case of Greece’s public finances”, FinanzArchiv/Public Finance Analysis, 66:170-206.


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