If one had to trace the origin of Europe’s sovereign debt contagion, there’s a strong case for Greece as its index patient. Granted, Greece was not the first nation in the Eurozone to experience heightened levels of unemployment, a sharp contraction in GDP growth, or to be officially in recession. Those honors also belong to Ireland. Instead, Greece is the index patient because it was the first country global markets used as a barometer for how the European financial authorities would respond to and attempt to manage overleveraged banking sectors within their jurisidiction. Essentially, Greece was the test. And European leadership largely failed.
In 2008, economic conditions in Greece were a mere footnote to the growing global recession, thanks to fears over the health of the American banking sector. It wasn’t until the Bank of Greece made a request for 45 billion euros that regulators or investors really examined the situation. What they found was a country whose financial sector was drastically overextended, with a government that had facilitated borrowing far exceeding EU regulations, not to mention the inability of the Greek economy to produce enough profit for repayment. Greece was soon subject to a swift wave of credit downgrades from all three ratings agencies, and was forced to implement stifling austerity measures in exchange for new capital from the European Central Bank, which sparked a political crisis and deepened its recession.
At present Greece faces a set of economic challenges that have two main causes. First, it is clear that the government accumulated large debts and resorted to unscrupulous monetary and legislative policies to disguise the severity of their condition from European regulatory authorities. Second, the European Central Bank was overlate involving itself to assist the troubled Greek financial sector and pursued policy that exacerbated already poor conditions.
Oh The Debts They Incurred!
As discussed in Parts 1 and 2, it is not uncommon for governments to seek outside funding from foreign sources in order to finance projects on their balance sheet in lieu of raising taxes or employing their central banks to raise inflation. Ordinarily, this funding is beneficial because it’s invested into sectors of the general economy that can increase government revenue while the tax and inflation rates remain the same. But if a nation’s debts grow to levels that put its ability to repay in doubt, its standing amongst its creditors decreases, inciting elevations in the interest rates it’s charged for new loans. From 2000 to 2010, Greece’s government borrowed extensively to support increased spending on its public sector programs, and this period of borrowing and spending raised its debt to levels that far exceeded both its revenues and valuable assets.
Prior to its entry into the Eurozone, the Bank of Greece (Greece’s central bank), was an independent central banking authority that could unilaterally raise inflation to provide the government with additional capital when necessary. When Greece entered the Euro-area in 2000, the powers of the Bank of Greece had to be changed to fall in line with EU regulations, meaning that the central bank lost its ability to regulate the money supply or set its own interest rates and the government could only raise or lower taxes in tandem with the EU’s guidelines for income, VAT and corporate rates.
Despite the new restrictions on its central bank, Greece gained increased borrowing potential because of the nature of the Eurozone. Before the debt crisis, investors presumed the Euro-area as safe for investment since Eurobonds were thought to be the sum of debt obligations of the currency union as a whole, and were backed by the European Central Bank, whose working capital consisted of funds from seventeen different economies. Thus Greece, as a member state, could borrow more because it was issuing bonds that took advantage of market perceptions of the Euro-area as a whole, instead of its economy on its own.