The bailout of Greece and the instability of the Eurozone

Abstract

The euro has been sliding against the US dollar for weeks. Concerns about the public finances of eurozone countries Portugal, Ireland, Greece, and Spain, the so-called «PIGS,» have emerged in financial markets. Greece is facing the severest crisis, with its 10-year bond yield approaching 7%. The Greek government estimates its budget deficit at 12.7% of GDP in 2009. Gross government debts amount to 113% of its GDP. If the interest rate Greece has to pay for its debts keeps rising, the country may have to default on its obligations.

In an attempt to recoup confidence in the future of the country, the Greek government has announced a freeze on public salaries, a reduction in the number of public servants, and an increase in taxes on gas, tobacco, alcohol, and big real-estate properties. This should help to reduce the deficit to 8% in 2010. However, the markets do not trust this solution.

While the increase in taxes will cause new problems for the Greeks, other problems remain unaddressed: The huge public sector has not been substantially reduced. Wage rates remain uncompetitive as a result of strong labor unions.

Moreover, it is not clear if the government can stick to these small spending cuts, as there will be a general strike in February. In December 2008, Greece experienced riots against comparatively minor political reforms. As the majority of the population seems to be against spending cuts, the government may not be able to prevent the bankruptcy of the country.

For years, the Greek government has demonstrated rather thriftless spending behavior. This was exacerbated when Greece started to pay lower interest rates on government bonds by virtue of having entered the European Economic and Monetary Union.

Greece’s interest rates were subsidized due to an implicit guarantee from the strong members of the eurozone, who were expected to support weaker members in times of trouble. During the first years of the euro, interest rates on Greek bonds were thus reduced; they approached German bond yields. Greece spent wildly but paid interest rates like a much more conservative country. Meanwhile, the Greek economy and voting public adapted to government spending subsidized by low interest rates.