Conclusion

  Greece has no ability to pay its €14.5 billion debt due in mid March without bail-out. And the euro zone is not willing to offer bail-out unless Greece agrees to take austerity package. So actually Greece policy makers have no choice but to agree the austerity requirement. There is no need to talk about whether Greece should take austerity measures as it has been approved by the parliament. In this post, I will discuss the impact of austerity.

  Austerity package  contains two parts: cutting spending and raising tax. Then what bad effects could be brought by carrying out austerity policy?

  In the social aspect, people will suffer a harder life when the government service and welfare are no longer at the same level as before. This pain cannot be avoided but I think that the pain it takes can be partly relieved and transferred. For example, government should solve its own corruption problem. By doing the government expenditure is reduced and people may be more willing to pay the tax because taxpayers' money is being  used more effectively. Also I suggest that the rising tax should mostly come from the rich people. Because poor people suffer most from lower level of public service. Rich people should take their responsibility and make some sacrifice as well.

  In the economic aspect, many people argue that slashing in budget and higher tax rate will result in diminishing demand which may lead to a recession.  

  However, some people do believe austerity will do some good for the future of a country's economy.

  According to Alesina and Ardagana (2009, Large Changes in Fiscal Policy), countries, which reduced deficit mainly by cutting spending rather than raising taxation, normally experienced  an above average GDP growth in the following few years after they took austerity measures.

  Unfortunately, this past evidence may not be a good guideline for Greece. The Boost of GDP in those countries is mainly due to the rapid growth in export. The increase of export actually benefit from the depreciation of domestic currency and the cheaper labor force due to the lower minimum wages. Obviously, Greece cannot control the price of euro, as a result, although the labor cost may become lower, it won't   dramatically raise the competitiveness of Greece products. Also the most important thing is that Greece economy does not heavily rely on the export. For some more detail, export only accounted for 22% of GDP in 2010, while import account for 30%. Therefore though the export may increase by certain amount in Greece after fiscal tightening, compared with the 140% percent debt Greece now own, there is no chance it can find its way out of debt simply by the increase in export.

   Is austerity just pain without gain? I think there is something that worth the sacrifice. It's a "signal effect": through taking austerity measure that Greece government and Greek people is showing that they are trying to make an effort in avoiding default and repaying debt; What's more, they are willing to pay for the mistake they have made. Without doubt this "signal effect" will help build the confidence of foreign investors on Greece. Only in this way, investors will be eager to bail-out, invest in or lend to Greece.  For example, Wen, the primer of China, said in February during his meeting with Merkel, the Chancellor of Germany, China will help the euro zone crisis countries only if they try to help themselves. 
   As a conclusion of all my post about austerity policy in Greece. I'd like to state that austerity policy is the first step Greece must take to help it get out of trouble. Although no one can assure austerity can save Greece from huge debt, by taking this measure and trying to control its bad impact, Greece can survive from this crisis in the foreseeable future.

    

Ways out of debt

  From previous post, I got a conclusion that high leverage ratio is harmful to a country’s economy. However, how can a country get rid of high indebtedness?

  (I). The simplest way of debt reduction is direct default. By refusing to pay back the debt, the debt will just disappear. Besides,by only paying part of the debt (eg. the principal) and refusing to pay the interests, the debt level will be decreased. Although many people believe that Greece will inevitably default on its sovereign debt. Still Greece should attempt to avoid default, because the cost of default is enormous. If Greece defaults on its sovereign debt it may have to leave the euro zone and the shocking impact of it is unpredictable. What's more, Greece had a default history before. By doing this again, Greece’s credit may be ruined, making it hard or even impossible to borrow from other counties in the future. So default should not be a proper solution to lower debt level. On the other way, avoid default should be an aim together with shrinking indebtedness.

  (II). Inflation, which can be regarded as an indirect form of default, is an easy way to create solvency. For Greece, unless quitting from euro zone, its currency (euro) will not depreciate just because of its demand.

  (III). Debt restructuring is the most widely used way to bring down debt in the past few decades （2011, Reinhart and Rogoff, a decade of debt. Debt restructuring can be implemented in several ways: debt swap; controlling interest rate; exploit captive domestic audience (eg. pension funds) to buy government bonds. In Greece, Debt swap is already on the way. To exchange for bailout, Greece parliament has approved a bondholder haircut deal that forces private sector bondholders to suffer a loss of 53.5% on their bonds on 23rd, February, 2012. Unfortunately, as a member of the euro zone, Greece cannot control the interest rate solely, so the second approach is not feasible. As for the third approach, obviously it will severely harm Greek people's benefit and make the government lose the last support. According to what Evangelos Venizelos (Finance Minister of Greece) said recently, Greece pension funds currently hold €1.2 billion government debt. He promised government bond will be replaced by more profitable and reliable investment. Therefore, as far as we know now, the government will not take this step in the foreseeable future.

  (IV). Austerity policy is also a prevalent way to help repay debt. It relies mainly on cutting spending and raising tax. The same with debt swap, it is also a requirement from the other euro zone countries to provide bailout. At present, Greece is continuing to enforce an austerity package such as lowering minimum wages, cutting education budget.

  Under the purpose of  lowering debt level and avoiding default , we can see that the only possible ways to decrease debt are debt swap and austerity policy. Apparently austerity policy is plays a more important role in debt reduction and it is more comprehensive. I will emphasis on how the austerity will affect the economy in the next post.

Financial crisis and debt crisis

  The current European sovereign debt crisis happened right after the global financial crisis in 2007? Is this just a coincidence or is there causal relationship between financial crisis and debt crisis? 
   Financial crisis may lead to a debt crisis in at least two ways.

   (I) When there is a financial crisis, obviously the income will be lower than before and thus may influence the government revenue. Below is a graph shows how the Greece government revenue changed from 2001 to 2010.

Data source:  IMF world economic outlook database, September 2011

  Greece revenue rose consistently from €59.98 billion to €94.395 billion until 2008 which is the time that the global crisis occured. It is not hard to guess that Greece government had faith in the continuing growth in revenue before 2008. This confidence may be one reason of why they dare to use so much debt.
  However, when the US. Sub-prime mortgage bubble bust and influence the whole world, the Greece revenue suddenly decreased by 7%. This out of expectation change definitely influence its solvency.

   (II). Banks and other financial institutions are always in trouble during a financial crisis. As a lender of last resort government usually has to bail out these institutions. If the government does not have enough reserves to offer the bail out. It may raise the money through debt. The leverage ratio of the government will be increased and this may cause a debt crisis in the future.

     The idea that financial crisis may lead to debt crisis has been proved by Reinhart and Rogoff (2011, From Financial Crash to Debt Crisis). They suggest that bank crisis often happens before or at the same time with debt crisis, and bank crisis can also help predict sovereign debt crisis. 

     Debt crisis which may be caused by financial crisis will heighten financial crisis reversely. For example, banks that hold large amount of government bond will be in big trouble when the government has insolvency problem. Situations will be even worse for the institutions who have issued CDS(Credit Default Swaps) because they have to repay the arrears for the government. Another possible way that will influence financial system is that under the rule of "sovereign ceiling", which means domestic banks and  other institutions can not get a higher credit rating than the country, it will be very costly and difficult for banks and other institutions to borrow money cross the boarder. Therefore it will be very hard for them to keep liquidity.
     Apparently, financial crisis and debt crisis are closely associated with each other, and they are both harmful to economy. I will try to figure out how to bring down debt level and avoid default in the next post.

       

Excessive Debt Will Damage the Economy

As was suggested in the previous post, all the advanced economy has been consistently building an increasing level of debt. What is the effect of using huge debt? I'd like to talk about how excessive debt can damage the economy.
First, too much debt may stunt economy growth. According to Reinhart and Rogoff (2010, Growth in Time of Debt), 90% of GDP can be regarded as the ceiling "safe" level of debt. Countries with debt level above this threshold generally have lower GDP growth rates; one percent lower than countries that hold debt account for 30% to 50% of their GDP. This difference rises to two percent when compared to countries whose indebtedness is smaller than 30% of their GDP.
Second, high debt level means that the economy is unstable and vulnerable. The main reason for why so many developed countries are using huge debt is because of the low interest rate. Developing countries are willing to offer their money at a low cost. However, the interest rate can change rapidly and it is very hard to predict the change. Graph below shows how the long-interest rate changed dramatically in the last 12 months. Unfortunately, leverage ratio cannot be decreased in the same speed. So, it's very risky to hold huge debt.

Data source: ECB and European commission

Obviously we are facing a debt crisis now. Is there any relationship between financial crisis and debt crisis? I will talk about this in the next post.

Too Much Debt

  As has discussed before, the main purpose for enforcing austerity policy is to rein deficit by reducing spending or even rising taxation in some cases. It is straight forward to understand that deficit is caused by government spending more money than its revenue. But how can the government get the exceeding money? The main approach is through debt. According to Reinhart and Rogoff (2011), the level of public debt in developed countries has been rising rapidly in recent years and has now reached the highest level since the Second World War. I would like to focus on the situation of Greece to check the amount of debt it used from 1980 to 2010, comparing with its domestic gross product.

data source: IMF world economic outlook database, September 2011

  From the figure above we can find out that Greece has been consistently using more and more debt over the last three decades. Interestingly the leverage ratio has risen sharply since 2007 and reached a peak of 142.757 percent of GDP in 2010. Such a high rate of debt creates huge instability and uncertainty. And this finally triggers the sovereign debt crisis. But why is Greece using so much debt known it is very risky to do this? It is partly due to the fact the interest rate stays at quite a low level in recent years and it is believed that government should benefit from this low cost lending to expand its economy. However, is this true and is it worth to do so? Is there any historical evidence to support this? I will try to figure it out in the next post.

Austerity Ahead

According to incomplete statistics, the most frequently mentioned word in the World Economic Forum ,which is held in Switzerland last month, is "Austerity". What is Austerity? The basic idea of Austerity is that government spend less and sometimes together with raise tax rate to help reduce the deficit. The latest news said that Greece government has agreed a budget cut of 3.3 billion euro to meet the austerity requirement of eurozone to provide a second bail out package. However as soon as the government had announced the statement, protest activities by people full of anger spread all over Greece. Why? Usually the thing come together with austerity measures is a lower level of public welfare, obviously Greek people won't be happy about this. Photo below show how angry they are. Why does the eurozone stay firm to require Greece to take these austerity measures? It is said that austerity measures are like painful medicine, but can this painful medicine cure the disease? I will try to find out the answers in the next few posts.