Euro and Greece Explained

7/28/2019 Euro and Greece Explained

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Theuro&GreeceExplained

I n d i a n a U n i v e r s i t y N o v e m b e r 2 0 1 1

On January 1, 1999, eleven Europeancountries officially adopted the euro(symbolized by ), replacing their nationalcurrencies. At first, the euro applied only

to electronic transactions, but on January 1, 2002, eurobanknotes and coins replaced paper Deutschmarks,francs, and other European currencies. Theintroduction of the euro was seen as the biggest step inEuropean integration so far, and as a sign that theEuropean national economies were becoming more

closely tied together. Just after the euro celebrated itstenth birthday, the euro was in serious trouble, asGreece received its first bailout in May 2010.

The story of Greece is a good example of thebenefits and costs of a common European currency.To explain Greeces rise and its downfall, it is helpfulto compare Greece with the largest country that usesthe euro, Germany.

THE BEGINNING OF THE EURO

The process for countries belonging to the

European Union (EU) to replace their nationalcurrencies with the euro began in 1992 with thesigning of the Treaty of Maastricht (named after atown in the Netherlands). On January 1, 1999, elevenEU Member States officially started using the euro.They had met the five necessary criteria, including theStability and Growth Pact (Box 1). In 2001, Greeceofficially joined the Eurozone.

Since then, Slovenia (2007), Cyprus (2008),Malta (2008), Slovakia (2009), and Estonia (2011)have all adopted the euro, bringing a total of 17

countries into the Eurozone. Denmark, Sweden, andthe United Kingdom decided not to join the euro in

1999, but every country that has joined the EU since2004 has been required to eventually adopt the euro atits national currency.

The argument for replacing a national currencywith the euro is economic simplicity. When thesecountries used their own currencies, if a business ortourist wanted to buy something in another countrythey would have to exchange their money for that ofthe other country. Since exchange rates change overtime, this means that something could cost one priceone day and a different price the next. It is also harder

to know if you are getting a good deal if prices are indifferent currencies. Finally, when you exchange

Box 1: The Stability and Growth Pact

In order to make the euro work with 17 different countries, all members had to meet the two

requirements of the Stability and Growth Pact:1. Government Deficit: No greater than 3% of GDP annually

2. National Debt: Less than 60% of GDP

These requirements were designed to prevent a country from not being able to pay its government debtand to ensure that one governments actions did not harm the other Eurozone members by weakening

the euro.

Figure 1: The EU Member States

Other EU members

Eurozone countries


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money, you must pay a fee. It was hoped that havinga single currency for most of the EU wouldencourage Europeans do business with companiesacross Europe and allow Europeans to travel easilyto other EU countries. This occurred as planned, and

the economies of EU member states grew during thefirst ten years of the euro.In 1999, Denmark, Sweden, and the United

Kingdom decided not to adopt the euro. These threecountries were already among the most economicallyadvanced in the EU, and they were worried about nolonger being able to control their currency. In theEurozone, the European Central Bank (ECB) inFrankfurt, Germany, would control the monetarypolicy for all of the Eurozone. The ECB is similar tothe US Federal Reserve System, and it controls thesupply of money. The UK had the additional reasonnot to join because its currency, the Pound, wasalready globally used in trade and finance, whichbenefited the British economy.

Greece became the 12th member of theEurozone in 2001, and at the time this appeared to be

a good decision. Much of the Greek economy isbased on tourism, and the euro made it easier fortourists from Germany, France, and other Europeancountries to visit Greece. Companies and banks alsobecame more willing to invest in Greece, because it

used the same currency as Germany and France.After all, Greece had to meet the same rules asFrance and Germany to join the EU in the first place(Box 1). The Greek economy did very well for mostof the 2000s (Figure 2), in part due to having theeuro has its currency.

LOSING COMPETITIVENESS

Although it was not obvious at the time,many sectors of the Greek economy did not benefitfrom the euro. It was now easier to move goods andmoney across the Eurozone, but the euro alsomagnified differences between economies. Many ofthe northern European countries that used the eurohad higher rates of productivity than Greece. Forexample, the average German worker produced moreof a type of good per hour than the average Greek

Box 2: Losing Competitiveness and Exchange Rates

To help understand changes in

productivity, think about two workersone

Greek and one Germanwho both make

cups. Imagine that in 2000 (before Greecejoined the Eurozone), a German makes 5

cups an hour at 5/hour, while a Greekworker produces 5 cups and is paid 5

drachma/hour (we will use the symbol fordrachma).

If Greeces exchange rate with

Germany was 1.00 equal 1.00, then the two workers makes the same amount of money. Assumingthat all other things are equal, the costs of the Greek and German cups are thus the same. However, if

the exchange rate is 2.00 = 1.00, than a Greek cup is produced at half the labor cost of a Germancup, clearly an advantage for the Greek company. To see this mathematically:

Cost in euros = cost in drachma x exchange rate0.50 = 1 x 1/2

If the exchange rate was 1.00 = 2.00, then a Greek cup would cost twice as much as a German cup

(2.00 = 1 x 2/1).By 2010, Greek wages have risen faster than productivity. The cost of a Greek cup is more

than that of a German cup. If Greece still used the drachma instead of the euro, and the exchange rateof1.67 = 1.00 then the two cups could cost the same (0.60 = 1 x 1/1.67). However, Greece

can no longer influence its exchange rate.

To have Greek cups costs the same as German cups, the Greek cup company now only has twooptions: it can increase the number of cups made each hour or else decrease wages in order to Greek

cups. Both of these options are harder than simply changing the exchange rate.

Table A2000 2010

Greek German Greek German

cups/hour 5 5 10 20

wages/hour 5.00 5.00 10.00 12.00

cost to make 1 cup 1.00 1.00 1.00 0.60


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worker in the same industry. In addition, during the2000s, wages increased in Greece (and many otherEurozone members) faster than in Germany.

Historically, this problem was less importantbecause a country could devalue it currency. Byreducing the value of its currency, a country likeGreece could still sell its products more cheaply thanits competitors even though the costs of producingthe good was increasing (see Box 2). However,Greece could not use this strategy, as it no longer hadany control over its new currencythe euro. Thus,while Germany, which accounts for 20 percent of thetotal Eurozones economy was becoming moreproductive, Greece was at a disadvantage, as itsproductivity was not increasing faster thanGermanys. This loss in productivity meant that, overtime, many Greek firms became less profitable andfound it harder to compete with German and othercompanies.

FISCAL BENEFITS FROM THE EURO

Greek workers becoming less productive thanother Eurozone countries is a problem in itself,Greece found itself facing another problem in 2010.Since Greece was now using the euro, many banksand other investors thought that the Greek economywas similar to the German economy. After all,Greece had to follow the same rules about the size ofits government deficit and government debt as theother members of the Eurozone. In addition, whenGreece signed the Treaty of Maastricht, it agreed to a

no bailout clause. This meant that it would beGreeces problem if it could not pay its debts, as theother Member States were not responsible to giveGreece money if it could not pay its bills and loans.

Thus, everyone expected that Greece wouldfollow the rules. Banks and other investors wanted tobuy Greek government debt, since they thought thatGreece had become a much safer place to invest thanit had been before 2001. The interest rate that theGreek government had to pay in order to borrowmoney declined dramatically. For much of the 2000s,the interest rate that Greece paid was almost thesame as what Germany had to pay (see Figure 3).This meant that investors thought that the chance ofGreece not being able to pay for its debt and defaultwas almost the same as Germany, even though theGerman economy was much stronger and its debtwas smaller.

Since Greece was able to borrow much morecheaply than before it adopted the euro, it was able toborrow a lot more money than previously. Much ofthis money was used to pay for improvements to

Greeces infrastructure, such as building new bridgesand roads. This would help the Greek economy foryears to come as it was now faster to move goodsand people across the country. Unfortunately, someof the money was spent less wisely. For instance,Athens hosted the Summer Olympics in 2004, andthe Greek government spent billions of euros on thegames. The Olympics did bring tourists and euros toAthens, and Athens built new subway system as partof hosting the Olympics. Not everything, however,

Figure 3: Interest Rate on Greek and

German Government BondsFigure 2: Change in Greek

Economy (Percent of GDP)


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helped the Greek economy in the long run. Forexample, the Olympic Stadium is now rarely used.The Greece government debt continued to grow andstarted to grow significantly faster than the economyafter 2009 (see Figure 4).

THE FINANCIAL MARKETS RESPONDWhen the global financial crisis began in

2008, the Greek economy began to shrink (seeFigure 2) and enter a recession, like most economiesin the world. The Greek government now had tospend more money, as it had to provide assistance tounemployed Greeks. At the same time, tax revenuesdecreased. Unemployed people pay less taxes sincethey are no longer working. Also, property such ashouses and factories often become less valuable in arecession, meaning that the tax revenue on thisproperty also decrease.

As a result, the Greek Government needed toborrow even more money to pay its bills. Its budgetdeficit and hence its debt increased dramatically after2008. In addition, banks and other investors werenow weaker due to the poor state of the globaleconomy. These investors now started to realize thatthe Greek economy was not the same as the Germaneconomy and that Greece was borrowing a lot ofmoney for the size of its economy. For instance, in2000, Greek government debt became larger than theGross Domestic Product (GDP) of Greece, whichmeans that its government debt was now more thanthe total annual output of the Greek economy.

The Stability and Growth Pact was supposedto prevent a country from having such a high level ofdebt, but by 2005, the rules were no longer reallyenforced. France and Germany (the two largestmembers of the EU) had broken the rules in 2004,

and instead of being punished, they rewrote the rules.As a result, Greece no longer had to follow theStability and Growth Pact for the next six years.

International investors now demanded theGreek government pay a higher interest rate on themoney it borrowed, because they were becoming lesssure that Greece would be able to pay back all of itsdebt (Figure 4). The problem soon began to spiralout of control. It was now more expensive for Greeceto borrow money, but it still needed to borrowmoney. Not only was the government spending morethan it received in taxes, but Greece also had to payfor all of the money it borrowed before. Finally,since interest rates were increasing, it had to borrowmore for the same amount of money (See box 3 foran example).

TOUGH TIMES

Since Greece was part of the euro, its options

Figure 4: Greeces debt

(percentage of GDP)

Box 3: Interest Rates

Imagine that the Greek government needs to borrow 1 billion (that is 1,000,000,000). In2008, Greece could expect to pay an interest rate of about 4 percent for 10 years to borrow thismoney. Thus, Greece will actually pay a total of about 1,480,000,000. The math is below:

Total amount = principle x (1 + interest rate) number of years

1.48 billion = 1 billion x (1+0.04)10

Next, imagine that Greece must borrow another 1 billion, but it is 2010 and the interest rate

for a 10 year loan is now 7 percent. Greece would now have to pay a total of 1,970,000,000 or480,000,000 more than the previous year. In fact, by 2011, Greeces debt was about 340 billion and

investors were asking for Greece to pay more than an interest rate of more than 25 percent. Clearly,Greece could not borrow at this rate for very long.


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for solving these problems were much more limitedthan if it still used its old currency, the drachma. Bybelonging to the Eurozone, Greece no longercontrolled its own monetary policy. For instance,Greece could not just print more money to pay for its

debts, since it no longer controlled the printingpresses. Nor could Greece just devalue its currencyto make its debt cheaper for itself. Devaluing thecurrency would mean that it would take fewer eurosto pay for its debt in dollars. Again, this powerbelongs to the European Central Bank, not Greece.Since Greece only accounts for two percent of thetotal Eurozone economy, in the beginning of thecrisis the European Central Bank was moreconcerned with the large Eurozone economies suchas Germany than the relatively small economy of a

country like Greece.Thus, Greece really only had two options to

solve its financial problems. The first was for theeconomy to grow. This would make the governmentdebt smaller compared to the Greek economy.However, as previously explained, the Greekeconomy was becoming less productive compared toother Eurozone countries. The Greek economywould have to become more competitive comparedto other EU members in order to spur growth. Notonly would this require Greeks to make difficult

changes, but Greek debt was growing at such a fastrate that it would be difficult for the Greek economyto grow faster than its government deficit.

The second option was for the Greekgovernment to introduce an austerity program. TheGreek government would spend less money whileincreasing taxes. This would reduce the size of thegovernment deficit, meaning the government wouldhave to borrow less. Eventually this plan wouldallow Greece to pay for its debt. To decrease the sizeof the Greek government budget, the government

was forced to make many unpopular decisions. Forinstance, the retirement age was increased, as manyGreek workers could retire at 55. Governmentemployees saw their paychecks cut. The governmentalso stopped hiring new workers, and then startedfiring workers. While these were salaries that thegovernment did not have to pay, it helped increaseunemployment without producing economic growth.

The Greek government increased taxes tohelp pay its debt, but this solution did not work well

either. Tax collection is very low in Greece, soincreasing taxes does not mean that people actuallypaid the new taxes. The result was that thegovernments income from taxes did not increase asmuch as hoped. In fact, the economy went into sharp

decline producing even less revenue and highercosts.

THE BAILOUTSUnfortunately, while these austerity measures

caused hardships among the Greek people andcaused them to protest in the streets, the program didnot solve the Greek governments financialproblems. The interest rate on Greek bondscontinued to increase and Greece still needed toborrow more money, but Greece could no longer

afford these loans. In May 2010, Greece was forcedto accept a bailout worth 110 billion ($145 billion)from the EU, the European Central Bank, and theInternational Monetary Fund (IMF). This moneywould help Greece continue to pay its bills for threeyears. In return for the money, Greece was supposedto continue its austerity program, make its economymore competitive, and privatize many of thecompanies owned by the Greek government.

Although this bailout bought Greece sometime, the Greek economy did not recover. In fact, it

remained in a recession and shrank in 2010 and2011. Thus, its debt continued to increase until it wasalmost 160 percent of GDP, making it one of thehighest ratios in the world. In July 2011, the EU andothers agreed to give Greece another 109 billion(then $157 billion), but it soon became clear thateven this extra money would not solve Greecesproblems.

Investors were now starting to worry aboutother countries in the Eurozone. Ireland and Portugalhad already received bailouts of 85 billion ($117

billion) and 78 billion ($110 billion) in November2010 and April 2011 respectively. At the same time,people were starting to worry about Italy and Spain.Italy has the third largest economy in the Eurozoneand its economy is about 6.5 times the size ofGreece. Italy also has the third largest governmentdebt in the world, worth 1.9 trillion ($2.5 trillion)by 2011.

Spains problems were different. Its debt wasactually close to the 60 percent limit of the Stability


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and Growth Pact. Its economy was very weak, asunemployment rose above 20 percent in 2010 and itsbanks needed more money. Investors feared that theSpanish government would need to borrow moremoney to help its banks. People worried that if

Greece were to default, Italy or Spain would be next.Investors would also take their money out of thesecountries or increase interest rates for their debt,since they also used the euro. Like Italy, Spain ismuch larger than Greece, and the collapse of Spainor Italy would be a disaster for the Eurozone andmight even led to the breakup of the currency area.

CONCLUSION

The EU was never designed to manage acrisis like the one it is currently facing, as the EU

budget is very smallit is capped at about 1.25percent of the total GDP of the 27 member states. In2011, the budget of the EU was only 142 billion(about $200 billion). The US Federal budget was$3.82 trillion (about 27 percent of the total USGDP). The Stability and Growth Pact (Box 1) andthe no bailout clause were supposed to preventsomething like the current crisis from happening, butthese rules were broken years ago. As a result,countries like Greece found themselves in troublewhen their economies were no longer growing, and

the EU was not able to help them out. Thus, thiscrisis has continued for over a year and draggedadditional countries onto the European Debt Crisis.

GLOSSARY

Austerity: The government policy of reducingspending, benefits, and/or public services, often todecrease a deficit.

Bailout: Giving money (sometimes a loan) to a

company or government to prevent it from runningout of money.

Default: The failure to pay back a loan.

Devalue: To reduce the value of a currency relativeto other currencies.

European Central Bank: The central bank that isresponsible for managing the euro currency.

European Union: A group of European countries(currently 27) that have agreed to make commondecisions and abide by common agreements in manyareas.

Eurozone: The group 17 EU Member States(currently 17) that use the euro as their officialcurrency.

Exchange rates: The rate at which one currency willbe exchanged for another.

Government deficit: The amount of money that agovernment spends in a year which exceeds its taxrevenue.

Gross Domestic Product (GDP): The value of allgoods and services produced within a country in ayear.

Integration: In the European Union, integration iswhen Member States agree to give sovereignty andpowers to the European Union as a whole.

Interest rate: The rate that a borrower must pay toreceive a loan, in addition to the principle.

Monetary policy: The process a government (or inthe Eurozone, the European Central Bank) uses tocontrol the supply of money.

National debt: The total amount of money that thenational or Federal government owes (also know asthe same as sovereign debt).

Privatization: When a government sells a businessor asset it owns to private investors.

Productivity: The efficiency of production, usuallymeasured in amount of something produced dividedby inputs such as labor or materials.

Recession: The general slowdown in economicactivity. Recession often means that the economy isshrinking.

Euro and Greece Explained

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