Introduction
In 2008, when the Global Financial Crisis Struck, a lot of countries faced improper functioning of the financial system both domestically and internationally. Thus, they had to select their own policies and means of coping with the crisis. However, the effect on different macroeconomic variables was far from similar between different countries. For instance, taking the Euro zone as a benchmark, one could easily notice the fact that even though the countries had the same currency, which implies common monetary policy, their development during crisis was very different. For instance, such countries as Portugal, Ireland, Italy, Greece and Spain, commonly referred to as 'PIIGS' experienced severe decreases in their output, shocks in interest rates, higher inflation etc. and these processes still continue. On the other hand, such countries as Germany or Austria have managed to quickly and successfully get back after the economic downturn. There were a lot of driving forces behind such gap between countries in the same monetary union and the cause of them can be tracked down from the past. Referring to the gap between PIIGS and Germany, the difference in fiscal policy can be described as one of the main driving forces. Having not followed the unite fiscal policy, the PIIGS countries based their actions mainly on spending and consuming whereas Germany put the biggest emphasis on increasing the level of competitiveness.
Let's shortly analyze the development of PIIGS countries from their entrance into the Eurozone. After they became members of the EMU, the risk of devaluation was gone due to common currency. That meant lower interest rates since the risk premium was reduced too. With low interest rates, the credit boom, which involved excessive borrowing, follows. When countries and private households started to borrow a lot, the consumption and levels of investment reached new heights. The PIIGS countries witnessed a rapid growth in employment, and the economies became overheated. Since there was high demand for the labor, the wages of employees became higher, thus increasing the price levels within these countries too. Inflation followed, thus, these countries experienced loss of competitiveness due to higher prices when compared to other countries. This meant that the exports went down and the current account substantially decreased. Additionally, since the demand for local products decreased, the supply had to adjust to lower requirements of output; therefore, the labor was not needed anymore. The huge loss of jobs was followed by constantly increasing level of unemployment. Having a decrease in amount of people who actually work, the governments of these countries collected less tax revenues and they had to pay a big amount of money for the benefits of the unemployed. The budgets were in deficit, therefore, PIIGS countries had to finance their expenditures by borrowing, which substantially increased the levels of debt. However, as the debt crisis started, interest rates for these countries grew due to the risk of default and there was no way of devaluing. Austerity measures and the intrusion of European Central Bank, European Commission and the International Monetary Fund (together referred to as 'Troika) were the only choice of deleveraging meaning that the countries had to follow tight fiscal policies, and the troubles would continue for quite a few years in the future, as we can see today.
It can be noticed that currently the hottest country among all PIIGS countries is Greece. Thus, in this paper we will evaluate the effect of past reckless fiscal policy on the main macroeconomic variables of Greece and its predicted tendencies in the future. Also, the Germany's influence on the development of PIIGS countries will be evaluated. Finally, we will discuss the role of dispersed fiscal policies within the EU and will shortly overview the possibility and the effects of having one common fiscal policy in the EMU.
Effects of sovereign debt crisis and austerity measures on the Greek crisis
Debt
When it comes to Greece and its debt, there are several factors worth taking a look at. Firstly, the budget deficit/surplus. In the good times until the financial crisis, the budget was always in the deficit fluctuating at around 5%, yet the financial crisis brought really extreme values for the budget of the government (Figure 1, debt). The worst case happened in 2009, when the deficit got under -15%. The reasons for such big budget deficits were (1) a huge increase in the government spending during 2008 and especially 2009 together with (2) lack of income into the budget, for which the reasons might be speculative (either shadow economy, increasing unemployment or the combination of both).
The public debt followed the same trend as the government deficits, except for the fact that its amounts and later on followed consequences were much harsher. Since 2000 the debt was either fluctuating around 100% of GDP or making a slight increase (Figure 2, debt2). The reasons for that lie within the snowball-formula for debt accumulation (Hugh, 2010):
http://static.seekingalpha.com/uploads/2010/1/19/saupload_debt_formula.png
According to the formula, the level of accumulated debt mainly depends on three variables: inflation, interest rate and GDP growth rate. Quite low interest rates, a bit larger GDP growth rates and inflation meant that the debt was little by little adding up. It reached the critical point in 2009 when the economy went into recession (Figure 2, debt2); however, the cuts on spending were not made. Thus, spending had to be financed with something, and that was debt. It had a major peak in 2011, when it went around 170% of GDP. However, the Greeks did not stop excessive spending and, therefore, had to continue to borrow more on extremely big interest rates. Finally, these disastrous actions were stopped by the intervention of Troika and their bailout package. A big part of Greece's debt was taken off; thus, the bond investors lost lots of their initial investment and bared excessive losses.
Not only the public debt faced such enormous increases, the private debt did too. When the crisis struck, ordinary Greeks faced reduced wages. However, they could not logically adjust their consumption rates and reduce the overall consumption in response to decreased incomes. Thus, they had to finance their consumed goods and services by employing debt. It can be seen from the graph (Figure 3,debt3) that the overall level of debt rose gradually from 60% of GDP in 2000 to 120% in 2011; thus, it doubled in a period of 10 years, which is enormously high.
Thus, both the private and the public sectors faced incomprehensible amounts of debt which some day will have to be repaid. That is, they sacrificed the country to many years of trouble in the future.
Deleveraging
Deleveraging can be described as a process when the debt levels are reduced in terms of equity levels. It is a common approach in corporate finance; however, it can be perfectly applied in macro analysis as well. Then, the debt is the actual debt of a country and GDP is considered to be as the proxy for equity. Historically, four types of deleveraging have occurred most of the types: austerity, massive defaults, high inflation, real GDP growth. Thus, theoretically, Greece had 4 options of deleveraging its economy (McKinsey Global Institute, 2010).
Austerity (i.e. belt-tightening)
It is an approach based on a very tight fiscal policy. Analyzing the past application of austerity for different countries and adjusting the results for today's economies, an approximate of 6 to 7 years of deleveraging is required for it to become a successful tool of coping with high levels of debt. During this time, an average of 25% of debt/GDP ratio could be reduced. This method deals with the debt crisis straightforwardly; however, it severely affects the overall health of the economy too. Greece decided to follow this procedure as one of the means against extremely high levels of debt and has put the most emphasis on this tool.
Default
It is an approach based on shutting down the whole economy and renewing it completely. High levels of debt can be written off and the country then adjusts its monetary policy. However, when a country defaults, the general situation in the economy is still extreme, financial functions are disrupted. Consequently, the proper functioning of the economy is stopped.
High inflation
In case the economy creates really high inflation, the debt levels that the country is obliged to pay to its creditors loses its value. However, at the same time the economy also loses its competitiveness. Therefore, for Greece, which is trying to regain competitiveness and boost its GDP level by exports, high inflation policy would worsen the situation even more.
Real GDP growth
Real GDP growth can be achieved via several tools: either expansionary fiscal policy or increased competitiveness and a boost of exports. Currently, Greece is trying to follow this way by reducing the pensions and wages; therefore, they expect their prices to fall and make them cheaper to foreigners. As a consequence, exports should increase substantially, which would result in an increased gross domestic product.
Development of real GDP
In terms of real GDP, two different phases of its development can be distinguished in the period between 1996 and 2012 (together with Eurostat's prediction about 2013) (Figure 4, gdp1). Up until 2007 Greece was experiencing an increase in its GDP growth which mainly came from the increasing private consumption of households (Figure 5, gdp2). However, when the Global Financial Crisis struck, the GDP rates started to shrink significantly, and Greece, together with the Eurozone countries, lost a major share of their output. Interestingly enough, most of the Euro countries started to increase their GDP in 2010 whereas Greece fell into even deeper decline due to applied austerity measures. The investments within the country shrank significantly as a constitute of GDP and was very volatile in terms of its growth, in some years declining up to 30% and bouncing back by 20% increase (Figure 6, inv). Looking at the causes of such GDP decrease and its possible continual in the future, two dragging features can be distinguished: extremely volatile and sharply decreasing investment and loss of competiveness, which resulted in the net exports going down. Speaking about the future of GDP development in Greece, there are different speculations: even though that statistical databases (Eurostat, 2012) predict that the output of Greece will stop declining in 2013 and start to climb up, in this situation Greece does not have the commanding role, meaning that they should follow the requirements raised by Troika, and at least several more years of tight fiscal policy and strict austerity measures should follow in the nearest future (Walker, 2012).
2 grafikai prie gdp, growth development ir sudetis jo
Long term interest rates
The 10-year government bond rate development is presented in the graph below (Figure 7, int). As it can be observed, before the Global Financial Crisis, long term interest rates were fluctuating a bit. Most of the fluctuation can be attributed to ordinary processes of financial system: changes in inflation, growth, such processes as self-fulfilling expectations, etc. However, the major change in the interest rate values seems to have happened in 2009, when the peak of the crisis was reached. Within two years the interest rate got six times higher (~30%) than its usual historical value (~5%). Therefore, according to financial literature, some of these risks could have had a big impact on such interest rate increase:
Interest rate risk
Reinvestment risk
Call risk
Default risk
Liquidity risk
Exchange rate risk
Having the example of Greece, one can distinguish the main features that caused such a huge increase in long term interest rates. Having high currency risk would have resulted in huge increases in the interest rates for all Eurozone countries; thus, having a unite currency eliminates this risk. Also, call and reinvestment risks were non-existent due to lack of callable bonds and almost no possibilities of Greece repaying the bond-buyers earlier. Therefore, default and liquidity risks were the major force in the upswing of the long term interest rates for Greece. Additionally, since Greece experienced several major downgrades by rating agencies, this was also a reason for extremely high risk premium on their government bonds.
Inflation
When it comes to inflation, volatility is the word that perfectly describes the situation in Greece. It seems that since 1997 inflation kept a trend of random walk, employing both huge increases and decreases each year (Figure 8, inflation). However, it has always stayed well above the average of the Euro Area countries, meaning that the price level in Greece was above the price levels in other Eurozone countries. Thus, during the past decade Greece had always lower levels of competitiveness when compared to other countries. This explains the negative external balance that has been present over years.
As it is seen from the types of deleveraging that Greece has chosen, one of them includes increasing the level of GDP via increasing exports. Thus, in order to achieve this, they have to increase their competitiveness. This can be done by seeking lower prices, which means that the inflation should go down. However, the level of a decrease in prices should be kept under control since reaching negative levels of inflation, i.e. deflation, would affect the economy negatively when compared to the benefits of such low prices (Krugman, 2010). Firstly, the economy would slow down since now holding money in a pocket would be considered a positive investment if the prices are expected to continue to fall in the future. Additionally, deflation would have a completely opposite effect on high levels of debt when compared to high levels of inflation, i.e. it would increase the value of debt. Finally, the decrease in prices would come together with a decrease in wages - something that is happening in Greece at the moment. Thus, unless workers accept the lower wages, they are quickly made redundant and the level of unemployment within the country quickly increases. Therefore, even though some people would think that in order to boost the competitiveness as much as possible, deflationary levels of prices should be targeted, theory suggests keeping the prices with a low level of inflation in order to keep tackling the current crisis.
As it is seen from the graph (Figure 8, inflation), the highest levels of inflation during this crisis were recorded in 2010 whereas they were significantly reduced during 2011. Seeing the most recent data (Trading Economics, 2012) one can see that in this sphere the measures have been effective since the prices continue to fall.
Labour market
To begin with, the labour market in Greece has experienced dreadful numbers and trends, and they are expected to reach new heights in the future. Most importantly, the levels of unemployment are expected to rise even though at the moment they are at their highest peak. Until the austerity measures, the level of unemployment was just above the average level of unemployment of European Union countries (Figure 9, unempl). However, tight fiscal policy and, most importantly, reduced wages resulted in harsh numbers in people's employment. A sharply increasing gap between unemployment levels between the EU and Greece explains that the crisis in most of the EU countries was managed well and that the amounts of needed labour force are growing quite fast whereas austerity drags Greek people down, especially the youth with little work experience, much deeper.
Reducing wages could be seen as a tool of internally devaluing the economy in order to achieve competitiveness and export more goods and services. However, as the development of real effective exchange rate shows, internal devaluation has not been achieved as the REER is still higher when compared to its value in 2006 (Figure 10, reer) (Weisbrot & Montecino, 2012).
Having in mind the constantly increasing level of unemployment, one should take into account the social benefits that the unemployed receive from the government. Thus, even though the government is expected to shrink its spending due to austerity measures applied, additional costs arrive and they should keep increasing as the time passes, unless the situation is improved dramatically.
Possible GDP drivers:
Private consumption
As it is seen from the graph (Figure 11, private cons), until the crisis the Greeks were consuming more than most of the other countries in the Eurozone. However, when the crisis struck, the consumption was decreased more than in other countries. However, as it was explained before, the household consumption still exceeds their income; therefore, a gradual increase in private debt (Figure xx, ) has been recorded for the past several years. A question arises: can Greece build up its GDP via private consumption? Taking into account the recent austerity measures that have become even harsher, also the fact that the marginal propensity to save has increased over the past few years the answer is clear. The Greek people have a lot of debt that has to be repaid; their incomes are continuing to decline; they are saving a lot. Therefore, if the marginal propensity to save increases, the marginal propensity to consume automatically goes down. So, in the next upcoming years, one should not expect Greeks to start consuming a lot. The employment conditions are not expected to bounce back to at least reasonable rates, the wages are expected to be cut together with the pensions for the elderly; thus, private consumption will definitely not be the driving force in regaining the growth in gross domestic product.
Public consumption
Another type of GDP boost could be public consumption. However, in Greece it faces the same and even harsher problems than private consumption. Not only does Greece have larger debt which tends to increase due to budget deficits that are still continuing, but there is an extremely high interest rate on the debt too. Due to high levels of debt, the government has no other option than to save. Additionally, it needs to finance its basic needs; thus, the ordinary loan packages from Troika have to be received. This means that the austerity measures will become even harsher and the government spending will have to be somehow reduced. Borrowing money in the bond market is a dangerous decision too since the country is facing extremely big interest rates and if the amount of bonds sold to investors keeps increasing, the investors are exposed to several financial risks, especially liquidity risk and default risk. Also, gathering money from the bond market would result in huge interest rates which should be outweighed by a huge increase in GDP due to government spending. However, having in mind the latest trends in GDP growth, this seems to be unreasonable. Finally, the country has no capacity to spend without borrowing, and borrowing additional flows of money would simply kill the country; thus, a conclusion that public consumption cannot be the driving force for increasing the GDP of Greece can be drawn.
Investment
The investments within the country have been very volatile over the past several years. However, during the crisis a downward trend in investments can be observed (Figure 6, inv). That is logical since contracting output within a country scares the investors as they do not see enough demand for new goods and services. Additionally, the growth prospects within the country are very vague. A company might take a shot in investing into a country if she saw some potential of generating decent cash flows in the nearest future. However, if the country which is being considered to be invested into is Greece, the future prospects are really unclear. Thus, there should not be that many companies willing to invest into a country whose actions and destiny are that unclear. Additionally, even the biggest companies in the country (e.g. Coca Cola) have already left the Greek market due to unfavorable conditions on investing and operating in the country (ICN, 2012); thus, the reluction for investing into the country can be clearly seen.
Net exports
An increase in current account, and consequently in the GDP can be achieved mainly by improving the exports; therefore, increasing the competitiveness. However, there are several constraints that prevent Greece from easily doing that. Firstly, the country has the unified currency, so it neither can devalue nor depreciate its currency against others. Additionally, as the inflation in Greece is higher than in other EMU countries, the countries that are also bouncing back after the crisis find the goods and services of Greece to be too expensive. Moreover, as the country simply cannot have its own monetary policy, it is constrained only on devaluing internally by decreasing wages and, consequently, prices within the country. However, this has not happened yet and it would take quite a lot of time in the future for it to effectively take place. Furthermore, coping with high inflation would improve the current account temporarily; however, the increase in GDP would eventually put upward pressure on prices and, as a result, inflation would soon return. Therefore, almost no actions are available for the Greeks to improve their level of GDP in the nearest future.
Germany
One of the reasons for the crisis in the PIIGS countries is Germany, more precisely the competitiveness that this country has regained through the last decade. Germans managed to do it because they had strong relations between labor unions, employers and the government. It can be explained in several points. Firstly, Germany employed the low-working-hours rule meaning that if the sales drop significantly, the companies have to reduce the working hours of their employees, so that they are not laid off, and the difference in income is covered by the government (Gold, 2010). Additionally, Germany perfectly benefited from the collapse of the Soviet Union by establishing production units in Eastern Europe countries, where there is cheap, yet skilled labor force (Marin, 2010). By not making their employees redundant domestically and by producing at cheap cost, it guaranteed huge amounts of export to foreign countries. Also, a strong presence of small and medium enterprises (SME's) guaranteed quality and innovation at lost cost (Herzog, 2010). Having employed more than half of the working force in Germany, SME's guaranteed them safe working places. Also, having low cost work force in the Eastern Europe, Germany had a chance to provide low cost, yet innovative goods and services, which had high demand in the foreign countries. Finally, paying much attention to education and training of the employees, different companies managed to raise their own employees and develop innovative products.
Fiscal Policy
The euro crisis has revealed the imperfection of the euro zone. At the moment some countries in the euro zone are on the opposite sides: some of them have their economies under control and their financial systems function properly; some of them, on the other hand, do not know what to expect from tomorrow and are on the edge of collapse. Having common monetary policy, the countries have to make their own fiscal decisions, which in some cases proved to be unsustainable. Thus, a logical solution of implementing the same fiscal policy would prevail. However, when it comes to common fiscal policy for the euro zone, several issues should be discussed.
Firstly, in order to understand the concept of fiscal policy and its impact on the economy, it should be overviewed at the national level. For a single country, the fiscal policy is crucial in order to help to correct deficit bias (1), prevent the economy from unsustainable developments of debt (2) and improve the size together with the composition of the government spending and tax revenues (3). In order to achieve the proposed things, a set of certain and well defined rules is needed. However, when it comes to the level of Eurozone, fiscal policies of different nations take up a completely different meaning and importance. For instance, borrowing by one of the member countries can lead to passing the cost of borrowing to other members of the EMU; thus, in severe cases of excessive borrowing, all member countries experience upward pressure on interest rates; thus, they all undertake part of the risk in case the situation becomes unstable. Therefore, the monetary policy in the EMU is central; however, decentralized fiscal policies can be regarded as a threat to the union, especially in time of fiscal deterioration of several countries (González-Páramo, 2004).
The benefits and drawbacks of common fiscal policy
The issue whether or not the Eurozone needs a common institution deciding upon a common fiscal policy has been a harsh debate, especially in the times of the crisis of the euro area. The promoters of common fiscal policy argue that its introduction would ensure long-run sustainability via income redistribution channels: the budgets and taxes would be decided centrally, so the worst performing countries would be prevented from getting into deep deficits. If this policy was in effect, the money from the best performing countries would be redistributed to those in need of external finance; thus, the union would be more interrelated and prevention policies, in case of rapidly expanding crises, would exist. Additionally, as the European Union's budget is already involved in redistribution of cash flows, the system can be adopted and it would not be completely new to the system. Furthermore, looking at the future, one can see that the economies in Europe are quickly ageing; thus, fast solution regarding the pension systems and their adjustments will be needed. Finally, China with its super competitiveness and product innovations is regarded to as one of the threats to the European Union mostly in terms of competitiveness (Ripard, 2012). Thus, in order to keep the positions and remain competitive, the euro zone should decide on the fiscal policy of the member countries centrally.
However, the critics of common fiscal policy state that all Eurozone needs is just increased labor mobility. That is, by removing barriers between workers' migration and implementing wage flexibility, asymmetric shocks can be solved. Additionally, the institution's ability of raising a huge budget and distributing it is taken into account. By this, the critics refer to possible disputes between the member states and the willingness of some states to keep the current power and influence.
How should the common fiscal policy look like?
Currently, several features about the possible way of operation of the common fiscal policy are distinguished. Firstly, the rules of the possible common fiscal policy have to be as transparent and simple as possible in order for effective monitoring and investigation of the way the funds are used. Also, the simplicity in the policies should be combined with their strictness. Simple rules would guarantee that all member states and the general public understand the way in which the institution responsible for common fiscal policy would be operating, whereas the strictness could ensure the fiscal discipline. However, flexibility of the rules should be taken into account too, since this would allow adjustments during severe, unexpected and unusual events.
Why there is no common fiscal policy yet?
However, the common fiscal policy has not happened and is not expected to take place in the nearest future due to three reasons (Lynn, 2010). Firstly, by introducing it all member countries would lose their own fiscal policies. This means that the countries would lose their national features and become only small parts of the European Monetary Union. They got into the Eurozone only in order to get into the monetary union and do not want to lose their sovereignty. Secondly, at this particular moment the timing for unified fiscal policy is bad due to austerity times in some of the euro zone countries. Thus, since even in the financial upswing times it would have been difficult to create fiscal union, now, when the spending is being cut severely, it would be almost impossible to implement. Finally, no exact and possibly successful enforcement mechanism has been proposed which would create an effective and well-functioning fiscal union.
Would the situation be different in case common fiscal policy existed?
It makes people only wonder, what would the euro zone be like in case the common fiscal union was present several years ago. Spain and Ireland got into the crisis by relying on the real estate price bubble and banking profits, Greece built its existence mainly on sharply increasing debt (The Economist, 2011). If the governments would not have tried to tackle the problems themselves, one should believe that unified actions against the crisis would have brought a better situation than the Eurozone is in at the moment. A common and prudent fiscal policy within the Eurozone would have probably at least partly projected the upcoming dangers and the result that is today would have definitely not been that harsh. Even thought there are quite a few caveats for the fiscal union creation in the future, it could be a tool of key importance in tackling such crises in the future. Of course, the project needs to be developed a lot, yet the idea should work and it might be the missing detail in the most effective functioning of the European Monetary Union. Thus, the authors of this paper stick to the opinion that the Eurozone should survive, even though it will take harsh measures and some of the economies will suffer, and in order to provide efficient functioning in the future, some kind of consensus for the common fiscal policy has to be undertaken.
Conclusions
In this paper, several things were discussed. Firstly, the authors looked at the roots of the current Eurozone crisis and evaluated its level via the example of Greece. The conclusion of continuing with austerity measures as the most appropriate policy in slowly recovering from the crisis was analyzed as the best option to follow. Additionally, the roots of Germany's increased competitiveness were analyzed and its impact on the PIIGS countries was evaluated. Finally, the authors analyzed the reckless fiscal policies that were employed by some of the countries in the euro zone in the past and have caused the nowadays crisis. The highly discussed unified fiscal policy was discussed as well: its pros and cons were overviewed.
The authors conclude that such institution could be of key importance in the future development of the Eurozone. Its implementation and working principles should be carefully analyzed; however, the idea itself seems to be prudent enough to have helped to cope with the current crisis in case such institution existed before. Therefore, looking at the future and the upcoming difficulties in the fiscal sector, the project should be given much thought as it might be the key mean in solving further crises similar to the one we are experiencing today.
