2004-2010: The Building of a Crisis

Greece's admittance into the Eurozone had its skeptics at the time it happened, and the controversy increased with the admission in 2004 that the deficit figure was fudged in order to allow Greece to join the exchange rate mechanism on January 1, 2000, which was key to the country being allowed to use the Euro when the currency was first introduced on January 1, 2002.

Between 1999 and 2007, the three Eurozone countries with the highest rates of inflation were Ireland, Greece and Spain respectively, each topping 3% per year (de Grauwe, 2009). This inflation was the first sign of the bubble that would eventually become a significant contributor to the debt crisis. Those economies each expanded rapidly in the middle part of the last decade. The following table illustrates the real GDP growth rate of the study countries in the years 2004-2010, the latter figure being an estimate (Eurostat, 2010).

Real GDP growth

2004

2005

2006

2007

2008

2009

2010*

Greece

4.6

2.2

4.5

4.5

2.0

-2.0

-3.0

Ireland

4.6

6.2

5.4

6.0

-3.0

-7.1

-0.9

Spain

3.3

3.6

4.0

3.6

0.9

-3.6

-0.4

Germany

1.2

0.8

3.4

2.7

1.0

-4.7

1.2

This table shows the size of the bubble in Greece, Ireland and Spain relative to the relatively minor bubble in Germany. The country with the most intense bubble, Ireland, saw the biggest contraction. Spain saw a steadier, more modest bubble and its decline has also been slower, steadier. Greece saw a modest bubble during the latter part of the decade, but its current debt crisis has precipitated estimates of a stronger contraction of GDP than is currently being experienced by either Spain or Ireland, which have not been forced into austerity measures as drastic as those imposed on Greece. Germany, by contrast, had a soft bubble and after one year of strong contraction has seen growth renew, a function of lower interest rates, a sound banking system and a strong export economy.

The following table illustrates the rates on the 10-year bond for Greece, Ireland, Spain and Germany (benchmark) from 2004 to 2007 (Eurostat, 2010):

10-Year Rate

2004

2005

2006

2007

2008

2009

2010

Greece

4.25

3.58

4.07

4.29

4.40

5.57

6.05

Ireland

4.08

3.33

3.74

4.04

4.25

5.01

4.80

Spain

4.10

3.39

3.78

4.07

4.22

4.11

4.01

Germany

4.04

3.35

3.76

4.02

4.04

3.09

3.29

What this chart indicates is that for the most part, spreads against the benchmark (Germany) did not increase significantly during this period for any of the study countries. Spain maintained a slight risk premium. At the height of Ireland's economic boom, it had lower rates than Germany. Greece maintained a risk premium ranging between 21 points and 31 points. In the last three years, while rates in Germany have fallen, rates in these three countries have taken a different trajectory. Spain's performance has been the best, with rates remaining relatively stable. While this has increased the risk premium over German bonds, it is not cause for crisis. While the 10-year Spanish rate spike somewhat in June and July of 2010, it has since fallen back down to 4.13% today (TradingEconomics.com, 2010). The Irish rate has increased recently, causing a widening in the spread against Germany, and the current rate of 5.31% represents a high level for Irish debt. Greece, however, shows the truest signs of crisis. The 10-year rate increased steadily into the beginning of 2010 as debt fears mounted. The Fitch downgrade was followed by an S&P downgrade to junk status and this along with concerns that even the German stimulus may be insufficient to rescue Greece has caused rates to spike to 10.26% (TradingEconomics.com, 2010). This brings the spread against the German bond to 773 points, orders of magnitude higher than the previous 21 to 31 point range from 2004 to 2007.

Inflation rates in each of these countries can be found in the following table, a measure of HICP (

harmonized index of consumer prices) annual average rate of change (Eurostat, 2010).

HICP

2004

2005

2006

2007

2008

2009

2010

Greece

3.0

3.5

3.3

3.0

4.2

1.3

Ireland

2.3

2.2

2.7

2.9

3.1

-1.7

Spain

3.1

3.4

3.6

2.8

4.1

-0.6

Germany

1.8

1.9

1.8

2.3

2.8

0.2

Each of the three troubled economies faced strong bubbles. If the same "best three-performing economies" criterion was used as per the Maastricht Treaty, that figure would have been the mean of the HICP for Germany, the Netherlands and Portugal, which comes to 2.56. Despite the consistently higher rates of inflation in Ireland, Greece and Spain only the latter two in 2008 would have failed to meet the Maastricht Criteria on the basis of inflation rates. However, the consistently high rates of inflation produced the bubble in prices that has lead not only to the debt crisis but to the claims of economists and observers that these countries will have significant difficulty recovering quickly from the crisis.

Another key economic...

The rates in Ireland and Spain in particular have shot high as the result of the global economic slowdown. The importance of unemployment is that it not only creates a social ill that must be remedied, but it also provides a systemic barrier to economic recovery, in particular if that unemployment becomes structural in nature itself.
The final key economic variable is the level of public debt as a percentage of GDP. These figures, again compiled from Eurostat (2010) are as follows:

Borrowings as % of GDP

2004

2005

2006

2007

2008

2009

2010

Greece

-7.5

-5.2

-3.6

-5.1

-7.7

-13.6

Ireland

1.4

1.6

3.0

0.1

-7.3

-14.3

Spain

-0.3

1.0

2.0

1.9

-4.1

-11.2

Germany

-3.8

-3.3

-1.6

-0.2

0.0

-3.3

Again, these figures show the depth of the crisis in Greece, Ireland and Spain. While the former two were able to show strong financial performance at the height the bubble, a collapse in inflows has resulted in significant increases to the national deficits in the past couple of years. By contrast, Greece never saw strong financial performance during its bubble, and has continually increased the amount of federal borrowing since 2004, which combined with Olympic-related borrowing means that Greece has increased its borrowing ever since being admitted into the Eurozone.

Causes and Consequences Associated with the Increase in Sovereign Risk

The economic analysis above indicates that each of the three countries faces a crisis that is slightly different. The situation in Greece is by far the worst in terms of debt and deficit. Greece has never been able to meet the Maastricht criteria. Indeed, while it showed improvements in 1999 sufficient to convince the European Central Bank to allow it into the Eurozone, its performance began to deteriorate almost immediately. Greece is currently facing a GDP that continues to decline, even as other nations show signs of recovery. More importantly, its sovereign risk has increased significantly, such that long-term rates on its bonds are in line with junk status.

For Greece, addressing the problem will be difficult. Financial markets have demanded austerity measures to indicate that Greece is finally going to live up to its debt and deficit obligations. Only by working towards these obligations will the high cost of borrowing come down. These measures, however, will only serve to increase unemployment, making the recovery more difficult by adding to the level of structural unemployment. Part of the problem for Greece is the fact that it is in the Eurozone. Typically, a country facing such a crisis could devalue its currency in order to make the country more competitive in export markets, spurring recovery (Krugman, 2010). Instead, it has no power to improve its international competitiveness through monetary measures. Instead, Greece is likely going to require further bailouts, Eurozone inflation or both in order to spur some sort of recovery amid strict public sector austerity measures (Ibid). Some measure of deflation in Greek prices will also be required, and as of January 1, 2010 Greece still had positive inflation (Eurostat, 2010).

Ireland and Spain face crises less of debt than unemployment. While their borrowing costs have increased, neither country is in danger of insolvency and the increase in sovereign risk is unlikely at this point to precipitate a crisis. Both countries are experiencing short-term deflation and high unemployment, however. Both measures are required at present to undue some of the inflation caused by the bubble, however both measures increase the long-term risk by increasing structural unemployment and by stalling infrastructure and private sector investment. Eventually, for Ireland and Spain to address their unemployment problems, they will need to attract investment without further deflation and with reduced levels of infrastructure investment. It is for this reason that the current crisis in Ireland and Spain may have long-term negative impacts even though both economies have the potential to perform well if and when the European economy in general begins to improve.

With respect to the Eurozone's future, Greece is the biggest concern. One major bailout from Germany has failed to lower sovereign risk and if anything markets believe that more such bailouts will be required. Ultimately, Germany's strength helped to fuel the boom in Europe, particularly in the Spanish real estate sector, so such transfers are required in order to reduce Germany's strength while reducing weakness in Greece (and possibly, eventually, Spain and Ireland as well). There is the risk that the Greek situation will become worse. Greek voters and workers may make further austerity untenable for elected officials. Germans may refuse to subsidize Greece in the future. Greece may have difficulty bringing labor costs and prices down to a level where the country is again competitive in export markets, particularly if the Eurozone sees a strong recovery. This could force Greece to leave the Euro, which brings with it the potential for…