Greece and the Euro Monetary System

PXS kindly recommended a very insightful Economics blog ( which mainly discuss the current predicament and solutions that the EU countries are facing, in particular Greece, Ireland, Spain and to some extent Italy.

Among the very insighful articles you will find there and worth a good read, there is an article entitled “A Greek Tragedy” where the author explains analytically the Greek situation. A very interesting part of the article concerns Greece and the Euro Monetary System.

Greece and the Euro Monetary System

[…] Greece joined the EMU two years later on January 1, 2001 and threatens to undermine the stability of the entire system.

The following graph shows the recent history for annualised Greek GDP growth. All data is available from the National Statistical Service of Greece, although I used a combination of OECD MEI data and the Greek Statistical Office data (for most recent observations). The European Commission is forecasting the Greek economy to contract by 1.1 percent this year and 0.3 percent next year, before growing 0.7 percent in 2011. If there is no major fiscal intervention, then this will have serious labour market consequences.


The next graph shows annual Greek employment growth from March 1999 to September 2009. The plunging real output level is having a clear impact.


Finally, Greece has endured a persistently high unemployment rate for many years. In recent years, it fell to a decade low of 7.5 per cent but this was in part a reflection of a declining labour force growth rate.

Clearly, unemployment is now rising again and in September 2009 it stood at 9.3 per cent and rising. Underemployment is also rising. Taken together, the real data is not encouraging. If the EC GDP growth forecasts are correct then the official unemployment rate will rise substantially given that labour force growth in the year to September 2009 was around 1.1 per cent and has averaged around 0.9 per cent per annum over the last decade.

With modest productivity growth combinined with the new entrants, GDP growth has to be over 1.5 per cent and closer to 2 per cent per annum to produce enough jobs such that the unemployment rate starts falling. That is a long way off on present trends.


The problem is this. The Greek government facing a major worsening of its economic situation has done what any reasonable fiscal authority would do and that is to expand its budget deficit. A significant proportion of the rising deficit is being driven by its automatic stabilisers which is normal and sensible.

The financial market reaction is also being conditioned by the fact that after the October election, the incoming PASOK socialist government in Greece, which smashed the conservative New Democracy into opposition, revealed that the budget deficit was in fact 12.5 percent of GDP rather than around 6.0 per cent as had been held out by the conservatives.

Clearly it is also about 4 times higher than the Eurozones’s SGP and because GDP growth has not collapsed completely (below 2 per cent) the outcome will be classified as an “excessive deficit”.

You can easily appreciate the nonsensical nature of the SGP fiscal rules in this situation. With GDP growth falling and unemployment rising the deficit will continue to increase as a result of the automatic stabilisers. In this environment prudent government fiscal policy will increase the deficit even more especially given the inflation rate is falling sharply and at November was 1.2 per cent per annum.

Initially, the government said that it would make cuts and the financial markets assumed that the ECB would provide liquidity if needed. However, in recent days the financial markets have shifted gear by increasing the spreads on 10-year Greek government bonds compared to the German Bunds, which are the benchmark asset in the Eurozone. The spread is now above 221 basis points (Monday) whereas in early October it was around 130 basis points.

Credit default swaps covering Greek government debt has also risen from 124 (October 5) to 191 basis points (December 7).

The major reason for the spreads widening is that the ECB has revealed that the Greek central bank (an integral part of the Eurosystem) has:

… tried to discourage local banks from receiving 12-month funds at the ECB’s facility on December 16. Local banks are major buyers of Greek government bonds, using the ECB’s facilities …

Note: this claim was in the financial press (Source). I have not been able to find anything at the Bank of Greece or the ECB to verify it. I am still searching. If anyone can point to an official communiqué it would be helpful.

But what it means is that the local banks will now find it “more difficult to bid for large sums of Greek government bonds” (Source) which will force the Greek government into international capitla markets for funds.

The Greek central bank is thus forcing higher borrowing charges on the Greek government in some misguided attempt to impose “market discipline” on them.

This means that to satisfy the ECB, the government will have to further reduce spending (or raise taxes) to pay for the rising interest service payments and pursue significant fiscal contraction. The ECB President has been making bullying-type statements about the need for Greek fiscal consolidation.

All this fits in with the desires of the conservative press. In terms of solutions, the Kathimerini English Edition (Monday November 23, 2009), says that:

… the answer is clear: First, it will have to reduce the 2010 budget deficit by including more spending restraint, i.e. by eliminating all subsidies to the railways and Athens transport companies as well as the privatization of some state companies.

Secondly and more important, it will have to come up with a credible medium-term plan to control primary spending and do away with public sector waste, while broadening the tax base by tackling tax evasion. To be credible, the plan has to be binding and this will require the consent of the two major political parties at least. In such a plan, the reform of the social security system will have to take a prominent role.

In addition, all this will have to be done within the next six to eight months.

The Greek finance minister however is clearly bowing to the pressure from the financial markets. The Government is claiming it will shave some 2.6 per cent of GDP off the deficit in 2010. Their first attack appears to be public sector pay and employment. The finance minister told the media yesterday (Source) that:

The government is proceeding with a plan … We will do all that’s needed to bring the deficit down in the medium- term. We will submit a supplementary budget if needed … [there will be] … fair fiscal consolidation …

This statement follows the decision by Fitch Ratings to downgrade Greek government debt to BBB+. S&P have already downgraded their rating and are threatening a further downgrading in the coming weeks.

So what does that mean? In previous blogs I have written that the ratings agencies are irrelevant to sovereign debt. Please read my blog – Ratings agencies and higher interest rates – for more discussion on this point. So for Japan, which has been regularly downgraded by the cretinous agencies, some of whom have now been found to have given favourable ratings in return for payment, the ratings are irrelevant.

But for a member state of the EMU the situation is different. First, they are not sovereign, having surrendered that status when they entered the union and agreed to the Treaty with its oppressive rules that were designed to hamper the reasonable conduct of fiscal policy.

Second, the one avenue for funding within the community may be closed to Greece as a result of the downgrading. What am I referring to here? Like all agreements, flexibility to bend rules always seems to be in there somewhere. The EMU Treaty is no exception.

The ECB responded to the crisis by relaxing its quality conditions on loans to member governments. Previously, its minimum required rating was A- but it relaxed this last year to BBB-. The ECB has said it will revert back to A- by the end of 2010.

As an aside, in my recent book with Joan Muysken – Full Employment abandoned, we show how this loan facility effectively means that the ECB guarantees national government debt as long as it is of a sufficient “quality”. I suspect the ECB will always guarantee it anyway if push comes to shove.

The way this loan facility works is that the banks can pledge bonds issued by their government to get loans from the ECB. If the ratings agencies downgrade the Greek sovereign debt further, then the ECB may cut off this source of funding.

But if the central bank is choking off this facility as above, the ratings assessments are irrelevant anyway.


Is the Greek government close to default? Answer: not even near it. The ECB will not allow that to happen. It would destabilise the Euromonetary system. The financial crisis has exposed the cracks in the arrangement. But as long as the citizens do not revolt as the real sector is squeezed the ECB will keep funding the Greek government.

The reality is with the real economy heading south at a rate of knots, the budget deficit will prove difficult to cut. If the Greek government actually succeeds in making discretionary cuts it faces a backlash from the automatic stabilisers.

It is possible that there is so much waste in the system – that is, spending that is in some way phantom. My take is that all spending is probably adding to aggregate demand whether it is corrupt, wasteful or otherwise. So it will be difficult to cut the deficit without seriously damaging the real economy even further.

The alternative is to leave the EMU and restore currency sovereignty. Even though this would be a difficult transition back to the Drachma it would be a path worth taking in my assessment.

I would also relieve all voluntary constraints which force debt-issuance and restore domestic demand and employment. But that will not be an option the Greek government takes. Their northern neighbours will make it very difficult for them to do that even if it means compromising the rules of the EMU.

They know that if Greece leaves, the next cab on the ranks looks like being Portugal.

That is enough for today.


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