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.
Looking at data provided by Eurostat, the EU’s financial data collection authority, the level of government borrowing and spending increased dramatically between 2000 and 2009, indicating that Greece capitalized on its newfound borrowing potential.
Remember, governments and central banks increasing their leverage isn’t a problem, provided the government invests the money in pursuits that can increase its revenues through taxation. The data show a great level of inconsistency between the government’s annual revenues and the amount of debt and liabilities it incurred over the same period. Revenues and asset values peaked in 2007-2008, but spending and debt increased well into 2009, and continued to outpace revenues into 2010.
What Were They Building In There?
By and large, the second failure of the Greek government was its mismanagement of the funds it was borrowing. It did not invest in new projects that would generate economic growth and neglected curbing existing inefficiencies in its revenue stream.
Greece’s economy rests primarily in the services sector, with merchant shipping, telecommunications and tourism accounting for the majority of its economic activity. Greece’s spending trends between 1996 and 2010 indicate the majority of the government’s expenditure was in benefit assistance programs, the interest on its debts, and the compensation of its employees, all of which have little ROI. From a macroeconomic standpoint, increased public sector spending doesn’t automatically have a negative impact on the economy, because discretionary items such as infrastructure and education tend to have positive long-term impacts on economic growth. On the other hand, benefit assistance programs provide funding either through disbursement of funds to a recipient, or though subsidizing (either in part or entirely) the cost of a particular good or service. In most cases the government ROI is poor, because the quantity of taxable outputs from subisidizing a service like healthcare or providing unemployment benefits is very low. Excessive spending in these areas is negative economically unless the government increases its revenues elsewhere.
Notice the rate at which public sector spending increased in relation to investment. Over that period, social benefit spending increased 349.33 percent, compensation spending increased 292.47 percent, but funds allocated for investment increased only 231.09 percent, and as a value, are less than half of what the government paid in interest on its debts.
Outside of its management and spending issues, government revenues have been severely impaired by Greece’s pervasive tax evasion. Like most modern economies, Greece uses a combination of both direct and indirect taxation to generate revenue, and taxation makes up 50-55 percent of the state’s revenue on an annual basis. However, Greece suffers from an inefficient system of tax collection and further deficiencies in its internal revenue services demonstrated by the more than 15,000 Greeks who owe more than €37 billion in uncollected taxes to the state.Additionally, there are over €20 billion in Swiss bank accounts owned by Greek ctizens and 10,000 Greek-owned business whose operations are primarily out of the country, meaning that there are billions of Euros in revenue that the Greek government never sees. So far, Greece has achieved little success in talks with the Swiss over identifying the owners of these accounts or calculting the exact amount of money stored there.
When the Cat’s Away, The Mice Will Hide Their Debt
In Part 1, a credit contraction scenario was used to detail the effect a nation’s borrowing has on its overall standing with its creditors and what can happen when this standing falters. Selling bonds on the open market is the most common method used by central banks to raise funds without increasing inflation; but if a central or private bank needs a large sum in a short period, they request additional capital from other financial firms on what’s known at the interbank lending market. Interbank lending is a transaction (or series of transactions) that occur between banks, both private and central, where one provides capital to a specific interest rate and generally with a very short maturation period (usually less than one week). The interest rate that one bank charges to another tends to depend on the current LIBOR (London Interbank Offered Rate) and more importantly the recipient banks creditworthiness in the eyes of the lender.
Typically, the proceeds from government bonds sales appear on the national balance sheet as “loans,” because selling a bond is essentially taking a loan. If a nation incurs too much debt without significant improvment in its revenue stream, its creditors can lose confidence in its repayment ability and spark a retreat from that nation’s bonds. Bond markets are also fairly limited in the sense that only bonds and other debt securities can be traded there, in plain view of speculators, investors, other financial institutions and regulatory agencies. So if a central bank needs a fairly large sum of money quickly, and wants to trade, privately, with something other than its government’s bonds, the Interbank lending market is the ideal place, since it can trade with any other bank, and with any instrument that bank sells. As such, a central bank could acquire new capital via an instrument that wouldn’t appear as debt on its balance sheet, like a currency trade, or the rights to a given industry’s future returns.
Looking at the data, it’s curious how Greece managed to continually borrow and spend money in the amounts that it did without significant increases in the interest rates it was charged or increased concerns over its ability to repay its obligations.
Notice that despite the dramatic increases in public sector spending, and the liabilities incurred from the “securities other than shares” on its balance sheet, its interest (shown in red) remained more or less the same. How did Greece pull off such financial magic? By entering into transactions with other financial institutions (specifically American ones) that utilized instruments that wouldn’t appear as loans or short term securities on its balance sheet. In The New York Times articles titled, “Wall St. Helped To Mask Debt Fueling Europe’s Crisis” and “Banks Bet Greece Defaults On Debt They Helped Hide” several of these transaction types are described in detail; all were designed to allow Greece to access new capital while sheltering its debts away from European regulators. These instruments allowed Greece to hide billions of Euros of debt until, of course, they had borrowed more than their economy could chew and had to ask their central banker for money.
Continued in Part 4