The Origin of the Greek Sovereign Debt Crisis

Manan Vyas explains in lay-man’s language the factors that led Greece to accumulate a government debt burden that surpasses the GDP of more than 170 nations ($467 billion) while deconstructing the political, economic, regulatory and enforcement failures of the government of Greece and the European Union.

Until 2009 Greece was just another beautiful Mediterranean country that evoked images of the stunning blue Sea, of a rich history, of Athens and the Parthenon and of a laid back populace that took things easy. However in the middle of 2009 the Greek economy was in the center of a storm after George Papandreou’s government revised the fiscal deficit estimate from 6% (for the year 2009-2010) to 12.7%. This was further revised to 13.6%. Further revelations regarding the country’s fiscal health led the three prominent ratings agencies (Moody’s, Standard and Poor’s and Fitch) to downgrade Greek debt to ‘junk’ status. By 2011 government debt was a gigantic Euro 327 billion constituting close to 140% of the economy and estimated to rise to Euro 340 billion in 2012 constituting 159% of the economy.

How did Greece accumulate so much debt?

1) Democratic government, Socialist population: To appease the left leaning electorate the newly restored Democratic government in the year 1974 introduced a wide range of welfare schemes including increased allocation towards pension schemes, healthcare, additional layers of governance, hiring of more government staff and increase in the salaries of all public staff. Greek citizens are used to the idea of heavy government spending and were supportive of the idea of “Big Government”. They initially encouraged the role of the public sector in the economy. The socialist tendencies were the first step towards fiscal indiscipline.

2) Taxation: The Greek taxation system has since long been accused of being overly complex in nature. This complexity is combined with high taxes. This combination has led to high tax evasion with the Prime Minister declaring in 2011 that Greece was losing around 30 billion Euros a year on tax evasion and evasion of social security contribution. That accounts for close to 14.6% of the  GDP. Present government revenues account for 39.1% of the GDP or 81.9 billion Euros. This means that the government is losing out on tax revenues equal to  36.6% of the gross government revenue. The Greek government ran a budget deficit of more than 5%  almost consistently through 1993, leading to a situation where the government has accumulated a debt that is more than the GDP of 170 countries including Greece. Revised estimates suggest the 2009 budget deficit was 15.6% of GDP. Had tax evasion been completely eradicated the government would be running a modest 1% budget deficit (in the year 2009) that is acceptable under any circumstances. Considering that the government has on an average been running deficits of around 5%  between 2001 and 2008, had the government even managed to reduce tax evasion by 33.3% they would be presenting a balanced budget year-on-year (between 1993-2008). Taking the more optimistic assumption, had the Greek government completely eradicated tax evasion they would have been presenting a budget surplus of 10% year-on-year (1993-2008). This surplus could have been used to reduce tax rates and simply the taxation system. Reduced tax rates would have resulted in higher levels of foreign and private investment, creation of more jobs, encouragement to entrepreneurship and subsequently a growth in the economy that would have resulted in even higher government revenues allowing the government to invest in infrastructure that would lead to long term broad based growth. I have always held the view that reduced taxes and an ultra-simple taxation system encourages 100% tax compliance and exponentially increases the level of private sector investment and kick-starts a virtuous cycle that eventually leads to higher tax revenues even at very low tax rates. I personally advocate a uniform tax rate of 10% direct tax, i.e. 10% corporation tax and 10% income tax applicable to anyone earning more than Rs 2,00,000 per annum regardless of age or gender. This would lead to a tremendous increase in the income of the people as well as private and foreign investment. The income tax department’s judicial scope must be widened and special courts to try cases on tax evasion must be setup. Further tax breaks can be given for charity and investment in infrastructure and green technology. Reformation of the taxation setup is a critical factor if India must rival China’s growth and USA’s might.

3) Culture of tax evasion: Greece is a unique case in terms of tax evasion. It has a deep rooted culture of tax evasion stemming from a historical period of foreign rule. During the reign of the Ottoman Turks in 19th century Greece, non-payment of taxes was a form of resistance with patriotic undertones. Unfortunately this culture has spilled onto the 21st century too where the citizens of the nation believe that if they are not getting public service commensurate with their high taxes, they would rather not pay. It is true, the public sector is bloated and inefficient and does not provide the service that such high taxes would command. With income tax rates almost close to 40% and indirect tax rate close to 20% the Greeks were supposed to be paying a tremendous amount in taxes. However they noticed that a substantial portion of the taxes was disappearing into the public sector in, amongst other things, the salaries of the employees. I mentioned culture of tax evasion. This may be a unusual usage, but is especially true in Greece as everybody co-operates to evade taxes. This is specific to indirect taxes. Bills are avoided in transactions, with the retailer and buyer both colluding to keep the transaction taxless and recordless. Thus unfortunately the Greek culture of paying taxes is morally skewed with the citizens resorting to an economically damaging form of resistance towards inefficient governance.

4) Government spending focussed on consumption expenditure: Greek government expenditure is equal to 49% of the GDP or approximately 104 billion Euros year-on year. Government expenditure is categorised into two parts – investment exp. and consumption exp. Government expenditure stimulates further consumption and investment in the economy that stats a virtuous growth cycle. However every government tries to maximise its investment expenditure as this has a long lasting positive impact. For example, investment on roads, schools and dams. However the Greek government was spending a large portion of its revenues on interest payments. The exact figure of sums spent on interest payments is not available due to secrecy of the government in borrowing so that it would not attract attention to the massive deficits that it was running. However it is known that approximately 75% of non interest spending was diverted towards salaries of public sector employees, pensions and social benefits (of the entire population). After deducting interest and social benefits it may be concluded that less than 20% of government revenues were being diverted into long term investment expenditure. This figure works out to be around 21 billion Euros as compared to say 83 billion Euros on interest and welfare.

5) Structural Defects: Inefficient public sector administration combined with layers of regulation, governance, bureaucracy, high wages and a complex taxation system combine to serve as a deterrent to investment. It is not surprising to observe that tourism and shipping dominate the economy as these are areas where Greece has an exceptional natural advantage due to geography. Greek performance in other sectors is not impressive and certainly not enough to rival advanced European neighbours such as Germany, France and Italy. Despite this Greece was able to attain an impressive per-capita GDP of $29,000 which placed it at 17th in Europe, ahead of 27 other European countries including Portugal and Poland. The Greeks were enjoying a lifestyle that they did not deserve. Essentially it was a party that lasted three decades and finally reality has dawned. Thus domestic protests in Greece against austerity measures raise indignation across Europe where hard-working and educated citizens bear the burden of bailing Greece out of its fiscal mess.

6) Under ground Economy: The formation of an underground economy occurs to circumvent taxes and regulation. In Greece the business atmosphere was so stifling that it spawned an unrecorded economy. Greece ranks 107th on the World Bank Ease of Doing Business Rank. The under ground businessmen had several advantages. By dealing with similar unrecorded dealers they bought raw materials for lower rates by avoiding the hefty VAT. Subsequently they were able to sell their products at a cheaper rate and keep all the profits for themselves by not paying any taxes. This gave them a distinct advantage over legitimate tax-paying businessmen. The fundamental problem was the lack of risk premium. Risk premium is a concept introduced when discussing illegal activities with financial motives. For examples the risk premium involved with staging an armed robbery and looting a bank is enormous. While the robbers may get their hands on millions of Euros overnight the risk associated with getting caught is so high that few rational citizens would consider such an activity. This is a credit to the Greek police force. However the risk premium associated with evasion of formal  registration of business and evasion of tax is extremely low. This is a major discredit to Greek enforcement agencies such as the income tax department and the Greek judicial system. This means that while the financial benefits are enormous – avoiding regulation allows faster business decision making, lower cost of raw materials, fewer quality checks and the most obvious advantage, almost zero income tax - the risk premium is low. This means that it pays to be a part of the underground economy. Many Greek businessmen have observed this risk-returns trade off and subsequently the Greek underground economy is today equal to anywhere between 25 to 37% of the actual economy.

7) Fraudulent Government and Fiscal Indiscipline: Arguably the most important reason for Greece to accumulate the gigantic mountain of debt that was the precursor to the crisis we now refer to as the European Sovereign Debt Crisis. Successions of Greek governments are culpable for accumulating debt beyond levels that the Greek nation was capable of paying. The Greek economy is a paradox. It stimulated the economy through several years of stable economic conditions to arise at a situation when the government is withdrawing expenditure in a recession while all other nations are stimulating the economy. The Greek economy is in a place where it suffers the double blow of the recession and withdrawal of government expenditure at the same time which exacerbates the recessionary nature of the economy. In 1974, with the advent of the democratic government that pandered to a population with a socialist mindset the government introduced a host of welfare schemes. Since the government had introduced welfare schemes that the taxation revenue could not cover up it secretly borrowed every year from a host of private and foreign investors. The finance ministry presented a budget with little deficit while secretly borrowing on the side. The Greeks were oblivious to the government’s secret undertakings and obviously believed that the economy was in a healthy condition. The government’s borrowing programs did however suck credit from the market leading to decreased supply for the private sector which pushed up the cost of borrowing. As the government was usually considered a safe borrower by its lenders, it never suffered from higher interest rates while the private sector found it harder to borrow.  As and when the debt burden loomed too large the government would resort to monetary expansion or currency devaluation both of which would reduce the value of the debt. The Greek government debts were denominated in domestic currency (before 2001) so that devaluation of currency would reduce the value of the debt in foreign currency. Inflation, spurred by monetary expansion would have a similar effect, reducing the real value of the debt while leading to the growth of the economy. Since 1993 however the government has consistently carried a public debt to GDP ratio of more than 100%. Cooking up the fiscal accounts however allowed the government to keep borrowing more from across the world at reasonable rates. The political dimension must be understood. Whenever a new government would ascend to power they would be presented with the legacy of the debt burden. The ruling party leaders would have the option of drastically cutting back on a large portion of the welfare measures undertaken without fiscal backing or it would have the option to keep quiet about it and continue borrowing. Drastically cutting back on the welfare would have been political suicide though it was the only sensible economic option to follow. Throw open the nation’s messy public finances for all Greek citizens to see and explain the need for drastic fiscal measures. This would require political courage and astute leadership. Unfortunately for Greece its leaders decided to take the easier path and continued borrowing even as the gap between revenue and expenditure mounted, the interest burden mounted and the public debt to GDP ration expanded. When the revelation finally came in 2008-2009, it was already too late.

8) European Regulators – The Big failure: The Maastricht Treaty was signed on the 7th of February 1992 and was subsequently the basis for the formation of the European Union. It specified ‘convergence criteria’; economic criteria that regulated the entry of only economically sound countries into the European Union. The criteria relevant to this scenario are ‘Annual Government deficit’ and ‘Government Debt’. While the Maastricht Treaty stipulated an annual government deficit rate of under 3%, the government debt was supposed to be under 60% for entry to the European Union. At the time of entry to the European Union (EU), Greek government debt exceeded 100%. Between 2001 and 2007, at a time when Greece was part of the EU its annual government deficit exceeded 5% every year. The Eurozone average deficit was 2%. Consequent to its high government spending the Greek economy grew at an average rate of 4.3% per annum as compared to 3.1% p.a. for the Eurozone. Debt, interest rates and trust are mutually dependent. Debt depends upon interest rates. Interest rates depend upon trust. And trust depends on the ability to repay. Lenders discharging debt to Greece in the period between 2001 and 2007 assumed that the Greek government was adherent to the criteria set by the Maastricht Treaty. The treaty’s criteria ensured that only fiscally healthy nations were admitted into the EU. Thus when Greece was admitted it was naturally accepted that the regulators of the European Union had taken the necessary steps to ensure that Greece was compliant. Thus trust was generated by entry to the European Union. It may be inferred that the creditors trusted the European Union regulators. Thus they assumed that Greece was fiscally sound and lent at low rates that would generally go to very strong European economies like France and Germany. The low interest rates fueled the demand for debt as the Greek government continued borrowing, either to finance deficits or to roll-over maturing debt that it was in no position to repay. In 2004 the European Commission initiated an excessive deficit procedure against Greece when Greece stated that for the year 2003 the deficit was 3.2%. At that time it was noted that the quality of the public data was not satisfactory and that Eurostat had not verified the figures at the time of joining the EU. Subsequently it was exposed that Greece had been violating the 3% limit every year since it joined the Euro and its public debt had been above 100% at the time of joining the EU. The European Commission finished their proceedings in 2007 convinced that permanent measures had been taken and that the country’s deficit would be 2.6% of the GDP in 2006 and 2.4% in 2007. The Commission also proclaimed that it was satisfied with the Greek statistical organisations that had pledged to improve the quality of their data. However the European Commission must be blamed for ignoring the vast mountain of debt that Greece had already built up by that time. Had the Commission paid closer attention to the alarming public debt situation it would have consulted the European Central Bank as well as the governing council of the European Union and concentrated efforts in the period of 2004-2007 would have perhaps allowed the Greek government deficit to come down to a more acceptable 75% of GDP. The Greek economy was growing so the government had more leeway to reduce budget layouts and to reduce a few unnecessary social welfare schemes. It could have reformed the economy and aggressively taken up tax evasion as a priority issue for fiscal health. It wasn’t to be however. There was no focussed pressure on Greece to reform and show results. The 1997 Stability and Growth Pact stated that if a country exceeded the deficit and after that did not adhere to the European Union’s corrective measures then it was liable to be fined 0.5% of its GDP. Sadly this rule was never implemented. 30 instances of excessive deficit procedures have been taken (in the European Union) but never has financial sanction been imposed. Had financial sanction been imposed on the Greek economy, or other stringent measures taken, the debt burden could have been controlled. The European Commission again woke up in 2009 (a good 5 years after it had imposed deficit proceedings) to the fact that the Greek budget was not under 3%. The data that the European Commission received revealed a fiscal deficit of 3.5%. This figure was subsequently revised to 12.7% by the Greek government and to 13.6% by international agencies. Between 2004 and 2009 the European Commission had failed to take action against a rising fiscal deficit fueled by creditors that trusted these very same regulators to ensure fiscal discipline in the European Union.

Summary of Failures:

• Greek government: Fiscal indiscipline and fraud. Drove up interest rates. Misguided policies and inefficient administration. Did not invest in infrastructure or education.
• Income tax department of Greece: Could not prevent tax evasion that made up 14.6% of the economy and 36.6 of government revenue.
• Enforcement agencies and judicial system of Greece: Could not play a role in tax evasion and evasion of social security contribution evasion. Should have been able to drive up the risk premium associated with tax evasion, failed to do so.
• Greek bureaucracy: Discouraged the private sector with excessive regulations. Could not encourage foreign investment.
• People of Greece: Evading taxes is morally wrong. A large number of Greeks failed to recognise this as a part of their code of ethics and morals. Ironically these are the same people that violently protested in 2010 when reality finally caught with up with them and the government implemented long over-due budget cuts.
• Eurostat and European Commission: As trusted and credible international bodies they both failed in enforcing stringent regulations. They could potentially have prevented the situation from getting snowballing into a much wider crisis that threatens the very existence of the European Union.