Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 13 June 2013

How a Greek drama became a global tragedy

Maybe that title is too strong, but there is an arguable case that what happened to Greece in 2010 was crucial in the move to austerity not just in the Eurozone, but in the UK and US too. As most reasonable people now recognise that the global move to austerity was a terrible mistake, understanding what went wrong in Greece is important. By this I do not mean how Greece came to behave fiscally in a total irresponsible way, interesting and important though that is. These things sometimes happen, but they do not usually have global consequences. What is more important is how the Eurozone and IMF subsequently handled events, which helped turn a Greek crisis into a Eurozone crisis and more.

These events have recently been analysed by the IMF. (Subsequent references are to paragraph numbers.) All credit to them for publicly and critically analysing their role in this affair. In terms of the substance, the facts of the case are not really in dispute. There were two feasible responses to the true fiscal numbers as they began to be revealed by the Greek government. [1] The first was forgiveness, in the form a large fiscal transfer from other Eurozone governments. These governments might have noted that the Greek people did not intend its previous governments to act in such a profligate and deceptive way, and that the Eurozone had failed to put in place effective institutions to stop it happening, and as a result they could have (one way or another) paid off a large part of Greek debt as a gift. That was never likely to happen, and it did not happen. [2]

So the other feasible option was default. As the report also notes (para 55), a number of Fund programs since 2000 had started with some ‘private sector involvement’. Yet initially the Eurozone ruled this out, as the report makes clear and which coverage of the report has widely noted. Why was it ruled out by the Eurozone? The charitable explanation was a concern that once the default possibility became reality, markets would turn on other vulnerable governments. Predictably, they did this anyway. A rather more base explanation was that with default the banks in other Eurozone countries might lose a lot of money, and become even more fragile. There may also have been a bit of pride.

So what we got was a transfer of ownership of a large part of the Greek debt from the private sector to other Eurozone governments, and crippling austerity for Greece. This was not feasible: default was just postponed, but only partial default on the remaining privately held debt. Additional austerity was imposed, and Eurozone governments swore there would be no default on the debt they now owned. And so it goes on.

So why did the IMF not point out that the original plan was not feasible, and refuse to participate? That would have been a hard political call to make, but the IMF is practiced in making such calls when the economics dictates. The report talks about failures in Greek implementation, but it also recognises that the subsequent turnaround in Greece’s underlying fiscal position has been dramatic, so its difficult to believe that plans to do any more should have been taken seriously. The real problem, as I note here, was that projections for the Greek economy were hopelessly optimistic.

Why were they too optimistic? As the IMF acknowledges (para 41) and has acknowledged before, it underestimated the impact on the economy of austerity. It got the multipliers wrong. [3] Yet while the report draws a number of lessons from the episode as a whole, I cannot see any analysis of how this fundamental, and arguably critical, mistake was made.[4] Talk to most people who know anything about the basic theory involved, and they will tell you that when nominal interest rates are fixed, the starting point for the government spending multiplier should be one. [5] In a financially crippled economy there are likely to be a lot of credit constrained individuals around, so the tax or transfer multiplier is also likely to be a lot larger than normal. So numbers based on looking at the past evidence which includes times when monetary policy was able to counteract the impact of the fiscal change were always going to be seriously wrong. You didn’t need to be a nobel prize winner to work this out, you just need to ask people who have worked through the theory of fiscal multipliers. [6] Knowing a little bit about the IMF, I would love to know how this mistake came to be made. [7] [8]

The IMF document is not just about deriving lessons looking back. It also speaks to a real issue that should be being debated in the Eurozone, and that is what are the best institutional arrangements for the lender of last resort to Eurozone sovereigns (hereafter SLOLR)? As Paul DeGrauwe has pointed out, the last few years tell you that you need a SLOLR to prevent a bad equiilibrium where debt crises are self fulfilling. But should the SLOLR be the central bank, other Eurozone governments or the IMF?

What the IMF report clearly shows is that it should not be other Eurozone governments. A good SLOLR needs to be effective (in having the fire power to prevent a bad equilibrium), but it also needs to be able to know when not to intervene, but instead allow default to happen. Eurozone governments failed on both tests: they were never willing to devote enough resources to ensure they were effective, but with Greece they failed to see that default was inevitable. They have the wrong incentives to make the right decision.

You might think that the Greek episode also tars the IMF with the same brush. But as Karl Whelan points out, the ECB does not come out of this episode very well either. Which is a little worrying, because with OMT the ECB is now the SLOLR. It does have back-up, but from those very same governments that got it wrong in the case of Greece. So in a future crisis, does the ECB have the right mechanisms in place to know when it should pledge to buy government debt and when it should do nothing to prevent default? While the IMF deserves credit for being publically self-critical, I cannot help but ask how long will we have to wait for a similar self-analysis of the ECB’s role in this affair?  

[1] As the IMF notes, in October 2009 a new government revised up its estimate of the 2009 deficit from 4% to 12.5% of GDP, and even this was 3% below the final estimate.

[2] In technical terms, this would have amounted to there really being just one set of Eurozone fiscal accounts. If one government gets its people into trouble, the other governments will raise taxes or cut spending to prevent default. When I was writing this paper with Campbell Leith, we ruled out this possibility as unrealistic, but I never imagined that judgement would be tested so quickly.

[3] Assuming a multiplier of 0.5 rather than 1 does not account for all the forecast error. But what remains does sound a bit like ‘we expected the confidence fairy but she did not turn up’. For example, errors “reflected the absence of a pick-up in private sector growth due to the boost to productivity and improvements in the investment climate that the program hoped would result from structural reforms.”

[4] Am I overemphasising this point? Consider this hypothetical. Using the correct multipliers, the IMF just cannot show that the original no-default programme adds up. (As the report makes clear, the actual projections only just did so.) The IMF tells the rest of the Troika that it cannot participate without some initial default. Fearing the impact that such news would have, the Europeans recognise that some default is required. Rather than spending the next year or so putting off the inevitable, the Troika instead focuses on establishing that Greece is a special case, and ensuring there is adequate support for other periphery countries on beneficial terms without crippling austerity (using the right multipliers). The rest of the world increasingly sees Greece as an isolated incident and not the beginning of a worldwide debt crisis. The other possibility, explored by Barry Eichengreen (HT Brad DeLong), is that the Greek government could have insisted on default.  

[5] In a closed economy at the ZLB it is almost certainly above one. In a monetary union, even if the government spending is entirely on domestic goods, in a model with unconstrained consumers it will be below one, but with credit constrained consumers it can be above one (see this paper by Fahri and Werning, and a forthcoming post). Ideally, from a macro point of view, you would choose to cut government spending on goods produced overseas, where multipliers could be negative. The amount that Greece spends on arms, the extent to which it has been part of the fiscal consolidation programme, and the fact that many of these arms come from other European governments is highly controversial.   

[6] Doing the analysis is what is crucial here. In this particular case it just so happens you could have asked a well known nobel prize winner who had also done the analysis. However just asking an academic who has won a nobel prize for macroeconomics but who had not done the analysis could get you into trouble.

[7] Even though the report notes that the assumed multipliers were too low, it also comments (para 46) that “The adjustment mix seems revenue heavy given that the fiscal crisis was expenditure driven”. Yet if you want to protect demand, you should (in the short run) focus on tax increases rather than government consumption or investment. So even within this document, the basic macroeconomic theory behind fiscal consolidation has still not been fully appreciated.

[8] Of course you can say that the numbers were chosen to fit the politics, and the real lesson is that the head of the IMF should not be a past and/or prospective French politician. But those within an organisation like the Fund should try and make it as difficult as possible for politics to overrule economics in this way.


  1. The problem with a generous lender of last resort is that it would bring stimulus to the periphery which would slow down the pace at which the periphery regains competitiveness. Though of course it could be argued that ten years of mild deflation is better than five years of serious deflation in the periphery.

    1. An economy in which labor is rendered dirt cheap by massive unemployment and constant downward pressure on real wages--which is the economy that the absence of stimulus to replace missing aggregate demand gives you--is not one that is going to become 'competitive'.

      The scenario you are thinking of only makes sense if the country in question has its own currency, whereby declining export prices, and the resulting injection of imported demand, can offset rising import prices.

      The path back to health for Greece as for any economy suffering a huge shortfall of demand is by way of more demand, however arranged, not by way of reduced labor costs per se. The latter approach can never overcome the paradox of thrift.

    2. In other words, stimulus, in whatever form, targeted specifically at the periphery is exactly what the periphery needs most--just as stimulus targeted at the hardest hit and most 'backward' parts of the U.S. was precisely what was needed (and, with the exception of the interregnum of '37, what was provided) to mitigate the demand shock of the Great Depression.

    3. Amileoj has it right. The dynamics of a real exchange rate adjustment to competitiveness within a single currency, means the most indebted nation (Greece) must face the highest real interest rates over that path. Very unstable dynamics. A demand injection to help restore balance between private desired saving and investment is surely the only option?

  2. Greece is simply F'ed if they donot get their government situation in order. The government has always been dysfunctional but now has been found out.

    If you look at the economic assets of the country (earning capacity obo sources/assets, not obo of former GDP figures what you do), that simply never can support a GDP par capita that they have now. And it is in a sector of the worldmarket where competition is growing with the speed of sound (read salesprices down). Add a government sector parasiting on that (taking half and not even delivering 15% added value, to take S'Pore as reference (talking about best practices).
    No basis to earn that much money (like before), and unable to turn the situation around (or organise what they have properly). They stil have almost double the number of civil servants per capita of Holland (sort of same size) and it still doesnot work. Government spends still more per capita than a lot of well run EMs earn per capita and it is total crap.

    The problem is twofold:
    -they simply donot have the organisation the transform macro money into working policies, allthough the cost of the present organisation is 10s% of GDP too high. The only thing they might be able to is getting back to the original point if the can get finance from that. But nobody is going to do that as the original point was based on lying and overborrowing (aka totally unsustainable).
    -they have been found out as dysfunctional and show themselves unable to turn the situation around or even get it under control.
    Nobody will invest in such a country, unless it is covered by long term guarantees by the Germanys. And does are not going to happen.

    Just see it as it is: a relatively remote from worldmarkets, close to 3rd world country in development, with a reasonable (but not more than that) educated and skilled population, hardly natural resources, in a continent with very limited growth potential. Seen from that angle GDP is still double or so compared to the peers with which they will have to compete. And its government sector would be still dysfunctional and very expensive compared to the competition in that group.

    The mistakes you make are:
    -that basically assume that it can work (which is not supported by the facts, they simply cannot get the things organised);
    -you take as a zero the high GDP per capita, when the country was heavily on financial steriods (which will never happen again).

    On competitiveness like nearly all economist you are also missing the clue. A lot of the economic earning capacity will be destroyed this way. So 'growth' will have to come from new investments. Seen what they have themselves in house that will have to come from abroad (there are only so many bottles you can fill).
    Which makes the investment decision a completely different one from extending an existing investments. Really new stuff. Seen from that angle Greece is still:
    - way too expensive on wagescosts (compared to its competition);
    - related costs are still at Western European level (you look at wagescost as reference for general pricing not only for wages alone);
    - high tax enviroment;
    - not top notch educated/skilled population with language problems internationally;
    - logistic costs that make moving goods from Greece to say Rotterdam more expensive than from China.
    Simply total crap over the whole board.

  3. Part 2

    Bottom will be much deeper than wages competition now shows. Nobody puts his money there, when there are alternatives (still cheaper) than Turkey or Rumenia arund.
    In a nutshell it is completely dysfunctional (both organisational and economical) for the league it wants to play in. So it will be relegated (and they can be happy if it is only one divivsion).
    The issue is more how to organise that relegation. Of course we have ideas how that should be done with keeping basic services in tact. However seen the fact that they have shown themselves totally unable to organise buttering a sandwich expect no organisation or something very close (aka a big mess).

    The country is a goner. Imho a complete waist to spend scarce resources for rescue on from an Euro-rescue perspective.

    1. Perhaps you say this because you want to save those scarce rescue resources for the rescue of the Netherland after it takes longer than anticipated for the real estate market to hit bottom?

      Otherwise, sounds like you're making a case that Greeks are poor lazy southerners. Now, where have I heard that before?

    2. Well, fine, don't "waste" your resources on them. Just don't expect them to repay their debts or to stay on the Euro, because both those things will be impossible once Greece is cut off.

    3. Or to buy goods and services from Germany, the UK, France,etc.

      The 'German' plan was for Germany to be an export powerhouse to the rest of Europe, and then to invest those earnings in the rest of Europe to make even more money.

      If the rest of Europe is broke, and in a depression,....

  4. They did not got the multipliers wrong, I believe that they were on a search for a number to fit a predetermined agenda, so as to have a "scientific" justification.

    I am saying this because my own research some time before Greece applying for the bailout, there was no evidence for the multiplier to be such low. Both from some theoretical models as well as from some econometrics. Indeed, only with the usual frictionless RBC model calibrated for Greece multipliers was low.

    This does not necessary mean that I am in disagreement over the sustainability of the debt, or that stimulus might worked. I am just trying to understand those calculations.

    My puzzle though is what Blanchard, as research director of IMF, was thinking on this. I cannot believe that Blanchard was also such naively "optimistic". I will feel very disappointed if O. Blanchard was also in support of that projections.

    Many Thanks

    1. I am with you regarding the multipliers!

      Please, get my email here ( and lets continue the conversation through email.

  5. "I cannot help but ask how long will we have to wait for a similar self-analysis of the ECB’s role in this affair?"

    You are going to have to wait for all eternity. I don't know why people outside the eurozone don't get it : the fundamental assumption of the eurozone design is that THE ECB IS ALWAYS RIGHT. So if something goes wrong it is necessarily someone else's fault.

  6. I think that the IMF should refuse to participate in any further bailouts, unless the ECB raises its target inflation rate, to say 4%. They are used to dictating terms to sovereign governments; they do it all the time. The ECB is the relevant monetary authority for the bail-out countries. And a little boost from inflation and devaluation would help the whole situation.

    It would also give the Germans a way out of letting domestic political concerns dictate crisis management.

  7. It seems that Europe stumbled into a sub-optimal handling of the Greek crisis. However, let us not pretend that there were any easy options.

    As you rightly observe, forgiveness was not politically feasible.

    Immediate default was, in retrospect, probably the least bad alternative.

    However, it was hardly a pain free option.

    When you default on your debts people stop lending you money. Since the Greek government was running a massive budget deficit, default would have meant immediate austerity far harsher than anything the troika has imposed. In addition, since Greek banks held a lot of government debt, default would likely have resulted in the simultaneous collapse of the Greek banking system.

    For the other Eurozone countries, the risks associated with a Greek default were frighteningly large. The very real possibility of a Europe wide banking crisis was not, contra to your dismissal, something any sane leader would take lightly. Furthermore, establishing that Greece was a "special case" is something more easily said than done.

    So the Eurozone's leaders opted for something of a muddle through strategy. This wasn't completely crazy.

    Firstly, the strategy had some option value. Postponing default allowed for the possibility, if the Eurozone economy improved, of a somewhat smaller, partial default at a later date (hasn't really worked out this way, but in 2010 it was at least a possibility).

    Secondly, it gave some breathing space for the European banking system to prepare for default and the possible follow-on consequences (though it's not clear how effectively this breathing space has been used).

    Thirdly, it allowed the creation of circumstances that would force an effective forgiveness strategy. Governments propping up Greece in the short term end up owning the majority of Greece's debt, which Greece will ultimately default on. The end result not unlike if Greece's debt had been forgiven upfront.

    Fourthly, putting conditions on the loans required to keep Greece solvent in the short term would force the dysfunctional Greek government to tackle structural reform (though the results on this front have been profoundly disappointing).

    Put yourself in the position of a Eurozone leader in 2010. Would you really have signed off on an immediate Greek default?

    Me thinks not.

    1. You argue well, but none of these arguments really stand up.

      1) This sounds like delay in the remote hope that something will turn up. Never a good strategy, but one that politicians with high discount rates are always too attracted to.

      2) The general consensus with banks that are too large to fail is that they should be dealt with immediately by direct state support, as happened (with one exception) in the US and UK. As you say, European policymakers have not done this, so why would they have wanted this option? More likely they just hoped the problem would go away.

      3) Again, if this was the intention, then subsequent developments are strange indeed e.g. threatening Greece with forced exit

      4) The argument here seems to be that if Greece had defaulted it would have been under less pressure to undertake necessary structural reforms. But an even more effective strategy, if that is the goal, is not to provide any funds at all - as you say earlier, with primary deficits this would have forced a much more painful immediate adjustment.

      So I think what happened was not muddling through to give time to develop a proper strategy - it was just muddled thinking.

    2. Q.e.d.

      Hanno Achenbach

  8. @ Deepish Thinker14 June 2013 10:12

    Excellent post - far better than anything Simon Wren-Lewis, Paul Krugman, or Martin Wolf have ever written on the subject.

    Hanno Achenbach

  9. It is sad that people still think that size matters.

    I am aware of several regions in Europe that have worst indicators that Greece.

    Those regions if were not integrated in larger regions (called countries) where the national budget compensates their lack of competitivity they would be exposed as "Greece".

    So they are more but more zombies economies in Europe.

    However, that is the path designed by those interested in a Global Government!

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