Is Greece different? Adjustment difficulties in southern Europe

Daniel Gros, Cinzia Alcidi, 22 April 2010



The Southern members of the Eurozone are often lumped together because they all have overvalued currencies and twin deficits – fiscal and external current account (De Grauwe 2010).

Our analysis shows, however, that these countries are quite heterogeneous. Portugal and Greece share a key feature, namely an extremely low rate of national savings, which implies that they have to rely continuously on large inflows of capital to finance consumption (see Gros 2010). By contrast, Spain and Ireland have substantially higher savings rates, but are more exposed to financial markets because their construction booms went hand in hand with a huge expansion of financial activity. In short, for Greece and Portugal the problem is insolvency; for Spain and Ireland illiquidity. Italy seems different from both these subgroups in that its savings rate is higher than even in Spain and Ireland and its foreign imbalances are much smaller.

Greece has become the focal point of attention of financial markets because it has the largest deficit (13 % of GDP) and public debt (120 % of GDP), which is almost entirely held by foreigners. If the country loses the confidence of foreign investors the remaining alternatives are either default or a massive bail out by the EU.

The (internal) fiscal adjustment

It is often remarked that until recently financial markets seemed to provide Greece, and other southern Eurozone members, with ample financing, although its current-account deficits and the approximate size of its public debt were well known. However, this was during a period when Greek GDP was growing in nominal terms by over 7% and nominal (long-term) interest rates were between 3.5% and 4%.

The sustainability of public finances requires that the primary deficit is large enough to offset the so-called “snowball effect”, i.e. the difference between the interest and the growth rate. In this respect, the situation has changed radically. During the boom phase, i.e. until 2007 the growth rate of nominal GDP was for Greece at 7.4% –more than 3 percentage points higher than the cost of public debt (around 4.1% on 10-year government bonds during that period). The government could thus run a primary deficit of 3%-4% of GDP and still keep the debt-to-GDP ratio constant – sustainability did not seem to be an issue.1 However, with the bust came much lower growth prospects and a much higher risk premium. Greece is now paying more than 7% on this government debt, about 5 full percentage points more than nominal GDP growth, which is now expected to be only 1.5%. This implies that Greece now needs to have a primary surplus of 6% of GDP just to keep the debt-to-GDP ratio from increasing even further. As shown in Table 1, the total swing in the primary balance is thus about 10% of GDP.

The adjustment required by the EU is therefore not only needed to satisfy the parameters of the Stability Pact, but also to put Greek public debt on a sustainable path. The adjustment in the primary balance required for sustainability is clearly much smaller for Portugal, Spain, and Italy (all 3-4 % of GDP), which explains at least partially their much lower risk premiums.

Table 1. Primary balance adjustment required to offset snowball effect

Snow ball effect
Difference Boom to Bust
Primary balance adjustment required to offset snowball effect (% GDP)
Debt/GDP (2009)

Source: European Commission (AMECO) and authors’ calculation.

Can it be done?

Can the fiscal adjustment needed for sustainability calculated here actually be achieved without putting these economies in a depression? A first benchmark for the cost of the fiscal adjustment in terms of output fall can be obtained using the standard fiscal multiplier. To keep things simple, we follow the simplest Keynesian macro model imaginable: an open economy, where exports are determined by foreign demand (and hence exogenous in the short run) and imports vary proportionally with domestic income. In this case the Keynesian multiplier effect is simply given by: 1/(s+m), where s is the savings rate and m the marginal propensity to import (see Gros 2010 for more details).

Column 2 in Table 2 shows that Greece has the highest multiplier as it is the country with the lowest degree of openness (about 25 %) and the lowest savings rate (12% of GDP on average, compared to 24% in Germany), while Ireland is the country with the smallest. Column 3 then shows the overall impact of the fiscal adjustment on output. In the case of Greece (but perhaps also Spain or Ireland) it is clearly so large as to be politically unfeasible. This judgment would not change even if one takes into account that the adjustment would be stretched over a number of years (three in the case of Greece) and adjusted for the cumulative effect of trend growth over this period. For Greece, even assuming a trend growth rate of 3% per annum, the overall predicted fall in GDP would still be around 15%.

Table 2. The impact of fiscal adjustment with simplistic Keynesian multipliers

Keynesian multiplier:
Primary balance adjustment required to offset snowball effect (% GDP)
Impact of fiscal adjustment on output relative to baseline, in %

Note: The marginal savings rate, s, is computed as the ratio of the increment in private savings relative to the increment in GDP over the period 2002-07; similarly the marginal propensity to import, m, is computed as the ratio of the increment in imports relative to the increment in GDP over the same period. Source: European Commission (AMECO) (AMECO) and authors’ calculation.

One objection to these simplistic multipliers is that strong fiscal consolidation could increase demand through a non-Keynesian effect (see Giavazzi and Pagano 1990 and 1996 and Giavazzi et al. 1999). Alas, this is unlikely to be the case for Greece because this would work via the interest rate channel (a reduction in the fiscal deficits is expected to reduce the domestic interest rate and therefore stimulate demand); but this channel cannot work in the case of Greece given that interest rates (which are still low for domestic borrowers) can at best be kept from increasing. If there are any ‘non-Keynesian’ effects in Greece they are likely to add a further negative element given that the increasing sovereign risk premium will sooner or later affect the cost of capital for the private sector as well2 (thus depressing consumption and investment further).

The external adjustment

In principle one could argue that in a monetary union the current account does not matter and the very concept of “foreign” debt loses its meaning. However, this is a theoretical point which becomes irrelevant when financial markets decide otherwise and ration credit to the government or in general residents of a country. As this is happening right now with Greece (and might be the case soon for other countries as well) one needs to address the issue of how Greece and other countries could stabilise their external accounts.

The first question here is how to measure the external position of a country? Table 3 shows the usual ratios, based on gross debt - the decisive variable in a crisis because this is the amount that has to be serviced and refinanced (often at much higher rates). The Table suggests that Greece and Portugal are to be in a much worse situation than Argentina, both in terms of the standard ratio of debt to GDP and debt to exports. Their debt ratios are much higher than those of Argentina in 1999, two years before it defaulted (see Calvo et al. 2003).

Table 3. Gross External Debt ratios in 2009 (q3)

Total Gross External Debt as % GDP
Total Gross External debt as % of Exports
Government & MA gross external debt % of Tax revenue

Source: National central banks, European Commission (AMECO), IFS (for Argentina) and authors’ calculations
Note: *The sector break down of the external debt is not available for Argentina; the ratio of total external debt to tax revenue in 1999 was 660%.

One could argue that net debt is the more important concept in the longer run, because over time foreign assets could be sold to retire foreign debt. On this account, as shown in Table 3, the indebtedness of most countries appears to be much smaller. Yet, the indebtedness of Greece and Portugal remains very high by most standards (see Table 4) and is, especially in the case of Greece, fundamentally a problem of the Greek Government and not so much one of the private sector.

The experience of Argentina has shown that even a country with very low net external debt (much lower than Greece) can run into trouble. Its government had borrowed heavily from international capital markets whereas its citizens had preferred to send their money abroad rather than paying taxes at home. Argentina defaulted because the government was not able to tax the wealth its citizens had squirreled abroad. The Greek government might find itself soon in a very similar position. This is why the gross debt figures are the more relevant ones in a time of crisis.

Table 4. Net external debt ratios in 2009 (q3)

Net External debt
(cumulated CA 1990-2009) as % of GDP
Total Net External debt as % of Exports
Government & MA % of Tax revenue

Source: Idem
Note: *The negative number means that Italy is net lender

This point is to some extent different for Portugal whose gross external debt is larger than the Greek one but the government is not the largest borrower, the private sector and especially banks count for almost two thirds of the total external debt (more than 100% of GDP). This provides both some insurance against a run on the public debt and a source of vulnerability should the banks in Portugal be cut off from interbank funding.


This analysis shows that the adjustment difficulties in the southern part of the Eurozone vary enormously. Greece stands out because it has the highest adjustment need on all accounts. Its fiscal adjustment looks particular challenging given its magnitude and the likely impact on domestic output for such a closed economy. The key question for the future of the Economic and Monetary Union is now how the system will be able to handle the case of a member country which might not be able to make it alone.


Calvo, G A, A Izquierdo and E Talvi (2003), “Sudden Stops, the Real Exchange Rate, and Fiscal Sustainability: Argentina’s Lessons”, Volbert Alexander, Jacques Melitz and George M von Furstenberg (eds), Monetary Unions and Hard Pegs: Effects on Trade, Financial Development and Stability, Oxford University Press, pp. 151–81.
De Grauwe, Paul (2010), “A Greek Endgame”, Centre for European Policy Studies.
Giavazzi F and M Pagano (1990), “Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries” in NBER Macroeconomics Annual 1990, Volume 5
Giavazzi F and M Pagano (1996), “Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience”, NBER Working Paper 5332.
Giavazzi, F, T Jappelli and M Pagano (2000), "Searching for non-linear effects of fiscal policy: Evidence from industrial and developing countries", European Economic Review, Elsevier, 44(7):1259-1289, June.
Gros, D (2010), “Adjustment difficulties in the Gipsy club”, CEPS working Document No. 326/March 2010.

1 The exact level of this ratio is difficult to pin down given the repeated massaging of the figures, but this does not matter in this context.
2 For international financial markets the rating (and thus risk premium) of the sovereign is usually the benchmark applied to private-sector entities of that country. This implies that Greek banks or large companies are likely to have to pay an even higher risk premium.



Topics: Europe's nations and regions
Tags: Eurozone crisis, fiscal crises, Southern Europe



Using a simple debt sustainability framework, such as that developed by John Cuddington ( one can draw some pretty interesting conclusions. I start with a fiscal deficit of 13% of GDP, a total debt stock of EUR 300bn, and I assume Greece will be able to finance concessionally at 5.5% per year.
First, to have a benchmark for the subsequent analysis I looked at the fiscal effort required by Greece to bring debt-to-GDP onto a sustainable footing, assuming no liabilty management.
It turns out the effort is immense. Greece must implement a six-year program with a cumulative fiscal correction of 23% of GDP, while at the same time suffering an average contraction of 2% of real GDP each year of the 6 years of adjustment (the first three years alone will have -5% real GDP growth each year).
Despite this collosal effort, Greece's debt-to-GDP ratio does not peak until 2014 (at 184% compared to 125% today) and does not drop below today's levels until 2024. Only by 2035 does it reach 60% of GDP.
I conclude that even a very serious country would have immense trouble bringing its debt profile onto a sustainable footing under these terms. 
Next, I looked at what happens to Greece under more realistic assumptions about the fiscal effort. I assumed that Greece does about half the fiscal effort of the scenario described above, thus cutting its fiscal deficit by an average of about 2.5% of GDP per year over the six year adjustment period. Average growth over the 6 years contracts by 0.8% per year, bad, but not ludicrous. My feeling is that a very determined Greek government could do this with a mammoth effort. Sadly, even with this material and sustained effort, debt to GDP never falls and by 2024 debt has risen to 225% of GDP and reaches nearly 400% of GDP by 2035.
The conclusion is clear: A realistic Greek fiscal effort is not sufficient to fix the problem. By implication, there has to be laibility management.
So how much does debt have to fall?  Assuming that Greece does its level best on the fiscal side, how big a haircut does Greece have to implement on bond holders in order to achieve the modest objective of making debt to GDP stable at 80% of GDP. The anwer turns out to be EUR 200bn! Given Greece's total debt stock of EUR 343bn this year, a EUR 200bn haircut amounts to a 58% haircut, or, say, 60% for a nice round number. I am surprised by the size of the haircut, my gut had told me that 40% would be enough.
Given the size of the haircut, is it even realistic to hope that Greece can term out its debt without a haircut?

Research Fellow at Centre for European Policy Studies

Director of the Centre for European Policy Studies, Brussels