Explainer: The Greek debt crisis and bailout referendum

Juan Paez-Farrell, Lecturer in Economics at the University of Sheffield, explains the Greek debt financial crisis ahead of the bailout referendum on Sunday July 5.

Explainer: The Greek debt crisis and bailout referendum

by Juan Paez-Farrell, 3 July 2015

Since 2008, the Greek economy has contracted by over a quarter with the unemployment currently exceeding 25 per cent. Youth unemployment is even higher. With sovereign debt at over 180 per cent of GDP, the Greek government has sought the help of international institutions in the form of the Troika (the European Commission, the ECB and the IMF). While this help has been forthcoming – albeit with many strings attached – tensions and disagreements between the Syriza government and the Troika now mean that Greece has never been closer to leaving the Euro.

Prior to the start of the crisis in 2007-2008, Greece had already endured many years of economic mismanagement, with the country running persistent budget deficits since the mid-1990s. It is also one of the reasons why it joined the Euro in 2001 and not at the outset in 1999. However, membership of the single currency enabled Greece to enjoy interest rates similar to those other Eurozone members, including Germany, as the possibility of a Greek default was not taken seriously. One consequence of this is that over the period 2001-2007 the Greek economy grew by 30 per cent. If much this growth was unsustainable, then the ensuing collapse brings Greece back to the level where it would have been without the ‘boom’.

Early in the crisis, the majority of Greek debt was held by French and German banks – so a Greek default could have led to widespread effects throughout Europe. The first rescue package occurred in 2010 and it enabled these banks to reduce their exposure to Greek debt while imposing strict deficit reduction targets and structural reforms on the Greek government. Although the IMF’s own research concluded that private sector holders of debt should have incurred losses and that the structural adjustment would be insufficient to enable to the government to service its debt, the economy began to improve in 2014.

The election of Syriza was centred on a rejection of fiscal consolidation and based on debt write-downs that were accompanied by heterodox negotiating tactics. However, it is important to note certain facts that are not always evident.

If Greece votes in favour of the agreement – which, ironically, has already expired - it is probable that the Troika will reward Greece with some further implicit debt reduction. Syriza has fought very hard to get better terms from its creditors but in the process the uncertainty this has created has paralysed the country.

Juan paez-farrell, lecturer in economics

While Greece’s debt, at over 180 per cent of GDP, seems utterly unaffordable, the country’s interest payments – as a proportion of GDP – were less than those of Italy, Portugal or Ireland. This is the result of several restructurings on the part of the Troika that had the effect of reducing Greece’s actual (if not nominal) debt burden. Given that Portugal and Ireland also had to endure the impact of their own crises, any debt cancellation would set a precedent.

The second aspect concerns credibility. It would be preferable to implement structural reforms once the economy picks up but during an economic recovery politicians may find that this can then be postponed. The Troika is well aware of this ‘time inconsistency’ and that is the reason it is only willing to support the Greek government in stages, while the structural reform is being implemented. The alternative risks the debt cancellation without any further reform. Lastly, for all the mistakes that the Troika may have made, without their support Greece would have defaulted in 2010.

What will happen next? Greece has now defaulted on its loans to the IMF and it will have to repay these before it can access the international capital markets again. If Greece votes against the agreement with the Troika this weekend, it is will not necessarily have to leave the Euro - but the government will have to finance its spending without any borrowing and is likely to introduce IOUs to pay its employees and for services. This would cause an enormous amount of disruption and a very sharp crisis would ensue. European exposure to a Greek default would be very limited as this was dealt with during the first bailout and the ECB would intervene if necessary. It is also likely that any periphery countries that suffered contagion – Ireland, Portugal, Spain or Italy – would be supported.

If, instead, Greece votes in favour of the agreement – which, ironically, has already expired - it is probable that the Troika will reward Greece with some further implicit debt reduction. Syriza has fought very hard to get better terms from its creditors but in the process the uncertainty this has created has paralysed the country.