There are a lot of competing narratives going around as to why Greece is in such trouble relative to the rest of the eurozone. A lot of this centers on whether Greek fiscal profligacy or poor credit controls by foreign banks was the main cause of the Greek debt crisis. Let me throw my hat into this ring with a few comments. What I write below will generally shade toward the problem being one of structural fiscal deficits and an ECB monetary policy that was inappropriate for the eurozone periphery as a whole and Greece in particular.
Now, this is designed to be a quick post. So I am not going to be able to summon the statistical data that a longer-form post has but I may do at a later date. But let me start out with the data I showed you on Credit Writedowns in 2010 when I asserted that Spain is the perfect example of a country that never should have joined the euro zone. What stood out for me at that time was the degree to which Spain and Ireland had both primary and absolute fiscal surpluses during the private sector credit booms in the 2000s while Greece did not. I am less familiar with Portugal and I know Italy did not have a big private sector binge. So I will leave them out here. These are the charts I used in 2010 for Spain, Ireland and Greece:
Concentrating on private debt first, what you see with these charts is that in contrast to Spain and Ireland, where there also were substantial private sector binges Greece’s fiscal record during a massive private sector credit binge was pretty awful. What the fiscal record tells you is that, despite a massive increase in private debt that should have resulted in an equally massive shift in the fiscal position as it had in Spain and Ireland, in Greece the fiscal position remained deeply negative, well over the Maastricht 3% hurdle at all times. To me that speaks volumes to why Greece is in dire straits and the others are not.
What does that mean in a eurozone context? Well, the eurozone countries are currency users. They are not monetarily sovereign and that means they need to get euros just like anyone else, especially given the no-bailout clause and the institutional restrictions on the ECB. With a large fiscal deficit during the cycle peak, it means you as a government have much less fiscal space to play with when a downturn hits. It means that the fiscal adjustment path to a primary surplus is enormous. And given the debt deflation this policy path creates, the adjustment will be even larger because debt and interest costs will soar as a percentage of output as the economy shrinks.
Look at pre-debt deflation government debt levels that I presented in 2010 after the first wave of crisis had ended.
The numbers were much lower as a percentage of GDP everywhere. But the bailouts in Portugal, Ireland, Greece, and Spain caused those levels to skyrocket. And for Greece, where government debt was already at enormous levels relative to GDP, it meant that the path to fiscal adjustment was Herculean, as a recent chart from Bruegel notes.
This is prima facie evidence that fiscal management issues were a primary cause of the problem for Greece in stark contrast to Ireland and Spain. Yes, private debt soared in Greece in the period up to the financial crisis. But it started from a low base and was not at levels in other developed countries where you would expect a financial crisis. However, once the fiscal adjustment began, these private debts became toxic as debt deflation set in and the economy and banking system collapsed. Today, non-performing private loans on the balance sheets of Greek banks are a serious problem. I would even say that private debt in the context of weak aggregate demand is now the big problem for Greece. But this is a problem created by a financial crisis and the debt deflation of private and public sector cutting spending all at once.
I reckon the main differences to Ireland and Spain then are high structural deficits and the gross level of public and private debt when the financial crisis began. In Greece, the private debt levels were not high but structural deficits were so high that they had no fiscal space and a much deeper debt deflation ensued. High government debt levels left no room for manoeuvre and Greece was rendered insolvent. By contrast, in Spain and Ireland the private debt levels were extreme and a debt deflation took hold when things went into reverse. But the public debt levels were manageable enough to deal with the loss socialization that the bank bailouts entailed, without a default. And so Spain and Ireland have recovered somewhat while Greece has not.
That’s my primary narrative.
I do have one other point to make and it is regarding the title of this post. The question is whether foreigners caused the Greek debt crisis. I just gave you a cogent explanation of what did cause the crisis. None of it had anything to do with French, German or British banks. Where they come into the picture is mainly in lending to the Greek government.
Let me ask you a question. Say you are a risk manager at a European bank in a system where the risk weighting for sovereign debt is very favourable compared to other assets of a similar quality for capital to be set against sovereign debt assets on your bank’s balance sheet. And say the ratings agencies are telling you that countries within the eurozone are highly rated with a low probability of default. Are you more likely to allow your fund managers load up on debt from countries with the highest yield spreads to German bunds or make sure they shun those assets? Remember, their portfolio returns are measured every quarter against their peers. And they could get fired if they don’t do well. What do you think you would do?
In my view, the whole notion that foreign banks erred by lending to Greece, Italy, Spain and so on because they didn’t do a proper credit assessment is wrong. Hindsight is 20/20. And you can say these guys screwed up. But this is the same strategy that had been working for 15 years, even during the pre-euro period of spread convergence. Many a fund manager went into retirement based on bonuses that were paid out due to that strategy. And they were deemed a success. It’s revisionist thinking to say all of these people were out to lunch and hadn’t assessed the risks properly. If you’re talking about German banks getting into property loans in Spain and Ireland, I see your point. But to the degree European bank risk to Greece was concentrated in sovereign debt purchases, it makes no sense to me to blame the whole Greek debt crisis on reckless foreign lenders.
Greece is about poor fiscal management that was exacerbated by an interest rate policy geared to a slow-growth core Europe. When the cycle turned down after the housing bubbles popped, not only was the periphery left out to dry because ECB policy was not geared to them, they also had to make big fiscal adjustments to avoid default. Without any kind of fiscal offset on a EU-wide basis, Greece was bound to run aground. And it did.