The country which has come to epitomize the sovereign debt crisis is Greece. The problems faced in Greece
have been replicated to some extent in Ireland, Spain, Italy and Portugal. In 2009, Greece announced that
its deficit would reach almost 13 per cent of GDP, double the amount it had forecast a year previously.
product (GDP). In fact its debt was 115.1 per cent of its GDP (remember that the original Stability and
Growth Pact rules laid down that debt should not exceed 60 per cent of GDP). The budget deficit rose to
nearly 14 per cent – well beyond the 3 per cent required as the terms of membership of the European
794 PART 15 INTERNATIONAL MACROECONOMICS
Monetary Union. Other members of the EU, notably Germany, accused Greece of being ‘profligate’ and
living beyond its means on the back of its membership of the euro area.
Greece had to raise around
€50 billion in 2010 to meet its debt obligations. On 19 May 2010 it needed
to pay
€8.5 billion to bondholders. On 25 January 2010 the Greek government went to the markets to
borrow money in the form of its first bond issue of the year. In the event, the issue was oversubscribed
as investors sought to pick up the bonds. Why? A simple reason, the interest on the bonds had to be
high to persuade investors to take the risk. It was reported that the issue was valued at around
€5 billion
with a coupon of 6.12 per cent. Given that interest rates around the world at that time were at record low
levels this was high. The spread between the interest Greece had to pay to borrow compared with the
Germans was almost 4.0 per cent. The wider the spread on different financial instruments (the difference
in the coupon of similar bonds in this instance), the more the market is factoring in the risk of default on
the bonds considered more risky – the Greek bonds in this case.
In February and March of 2010, the Greek government had tried to take a stance on public spending,
proposing major cuts in jobs, pensions, wages and services. Greek workers took to the streets in protest.
It seemed as though the government would find it difficult to implement the sort of fiscal cuts necessary
to build confidence with the markets and on the back of the announcements about the increasing size
of its debt and the deficit, by April it seemed likely that it would find it difficult to raise further money to
meet its obligations. Ratings agencies steadily cut the country’s ratings until by late April, Greek debt was
officially classed as ‘junk’.
The spread between Greek and German bonds continued to rise into April reaching 19 per cent on two-
year bonds and 11.3 per cent on ten-year bonds. The nervousness on the financial markets over Greece’s
debt problems began to spread to other European countries. It became a real possibility that Greece
would default and be forced to leave the euro. This fear led to a sharp drop in the value of the euro – if there
is an expectation that the price of something is going to fall then there is a possibility of making some
money and that is exactly what happened in February 2010. Data from the Chicago Mercantile Exchange
(CME) showed that short positions against the euro from hedge funds and traders rose sharply. Traders
took positions on the expectation that the euro would fall in value. Traders taking out contracts that the
price of the euro would fall could exercise these contracts and make a profit if and when the euro fell in
value. Data from the CME showed that over 40,000 contracts had been taken out against the euro with a
total value of around
$8 billion.
The crisis began to gather momentum and the markets looked to other EU governments to organize a
bail-out. On 10 April 2010, the finance ministers of the euro area announced an agreement on a package
of loans to Greece totalling
€30 billion. Greece said that it did not intend to use the loans and instead rely
on its ‘austerity measures’. The extent to which Greece could deliver on these austerity measures was
something the financial markets were not convinced about.
A week later the Greek Prime Minister, George Papandreou, finally bowed to what many thought was
the inevitable and announced that Greece would take advantage of the emergency loans. Negotiations
took place with the EU and the IMF on the structure of these loans, which were predicted to rise to
€100 billion.
Whilst it was generally accepted that Greece needed the financial support there were questions raised
about the terms under which the loans were to be given. The German government was financing a pro-
portion of the loans with
€8.4 billion being spoken of as a possible figure. In order to appease German
taxpayers who were not supportive of bailing out the ‘profligate Greeks’, Chancellor Angela Merkel, under
pressure from German taxpayers to take a strong line, insisted on very strict terms and a condition that
the Greek government make significant cuts to public spending. The argument that Greece has exploited
the free rider problem within a common currency area as we outlined in the previous chapter seemed to
be strong. For many Greeks, there was a feeling that their future was being dictated by outsiders, most
notably the Germans. The Germans argued that it was unfair that its taxpayers should have to suffer to
bail out a country which had clearly not played by the euro rules. On May Day, traditional worker protests
had a new focus and the extent and severity of the violence which broke out shocked many. Austerity was
clearly not going to be easy to implement and the strength of feeling against the Germans was clear. The
Greek government was being squeezed from all sides. The financial markets were nervous that the prob-
lems in Greece would spread to other high debt countries (so-called ‘contagion effect’) and there were
fears that the crisis could tip Europe back into recession.
