The Origins of Greece's Debt Crisis

The Greek debt crisis continues to occupy headlines in global financial news almost a decade after recognition. The crisis has been brewing for so long, that a refresher on what caused it in the first place might be in order.

The debt crisis originated from the Greek government's fiscal profligacy ("profligacy" is defined as wasteful and excessive expenditure). When Greece became the 10th member of the European Community on January 1, 1981, its economy and finances were in good shape, with a debt-to-GDP ratio of 28% and a budget deficit below 3% of GDP. But the situation deteriorated dramatically over the next 30 years.

In October 1981, the Panhellenic Socialist Movement (PASOK), a party founded by Andreas Papandreou in 1974, came into power on a populist platform. Over the next three decades, PASOK alternated in power with the New Democracy Party that was also founded in 1974. In a continuing bid to keep their voters happy, both parties lavished liberal welfare policies on their electorates, creating a bloated, inefficient, and protectionist economy.

For instance, salaries for workers in the public sector rose automatically every year, instead of being based on factors like performance and productivity. Pensions were also generous. A Greek man with 35 years of public-sector service could retire at the ripe old age of 58, and a Greek woman could retire with a pension as early as 50 under certain circumstances. Perhaps the most infamous example of undue generosity was the prevalence of 13th- and 14th-month payments to Greek workers. Workers were entitled to an additional month's pay in December to help with holiday expenses and also received one-half month's pay at Easter and one-half when they took their vacation.

As a result of low productivity, eroding competitiveness, and rampant tax evasion, the government had to resort to a massive debt binge to keep the party going. Greece's admission into the Eurozone in January 2001 and its adoption of the euro made it much easier for the government to borrow. This was because Greek bond yields and interest rates declined sharply as they converged with those of strong European Union (EU) members like Germany. For instance, the yield spread between 10-year Greek and German government bonds plunged from more than 600 basis points in 1998 to about 50 basis points in 2001. As a result, the Greek economy boomed, with real GDP growth averaged 3.9% per year between 2001 and 2008, the second fastest after Ireland in the Eurozone.

But that growth came at a steep price, in the form of rising deficits and a burgeoning debt load. This was exacerbated by the fact that these measures for Greece had already exceeded the limits mandated by the EU's Stability and Growth Pact when it was admitted into the Eurozone. For example, Greece's debt-to-GDP ratio was at 103% in 2000, well above the Eurozone's maximum permitted level of 60%. Greece's fiscal deficit as a proportion of GDP was 3.7% in 2000, also above the Eurozone's limit of 3%.

The jig was up shortly after the financial crisis of 2008-09, as investors and creditors focused on the colossal sovereign debt loads of the US and Europe. With default a real possibility, investors began demanding much higher yields for sovereign debt issued by the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) as compensation for this added risk.

Up until then, the PIIGS' sovereign debt risk had been camouflaged by their wealthy neighbors in the north, such as Germany. By January 2012, the yield spread between 10-year Greek and German sovereign bonds has widened by a whopping 3,300 basis points, according to research by the Federal Reserve Bank of St. Louis.

Source: tradingeconomics.com

As Greece's economy contracted in the aftermath of the crisis, the debt-to-GDP ratio skyrocketed, peaking at 180% in 2011. The final nail in the coffin came in 2009, when a new Greek government led by Papandreou's son George came into power and revealed that the fiscal deficit was 12.7%, more than twice the previously disclosed figure, sending the debt crisis into a higher gear.

The Greek debt crisis had its origins in the fiscal profligacy of previous governments, proving that like individuals, nations cannot afford to live way beyond their means. As a result, Greeks may have to live with stiff austerity measures for years.