Financial Stimulus and Austerity

Question 1

The Greek Sovereign Debt Crisis

Answer 1

Greece had a high country and currency risk premium prior to joining the euro and had a history of defaulting on its debt. When it joined the euro, exchange rate risk fell, so the currency risk premium fell, and it was thought too big to fail, so the country risk premium fell and Greece enjoyed interest rates similar to Germany, allowing it to go on a spending spree. In 2010, an EU report found that Greece had gotten around the 3% deficit cap and other measures in the 1992 Maastricht Treaty designed to prevent profligacy through creative accounting. This caused fears of default, interest rates to soar, and sudden stop of capital flows. They needed a €110 billion bailout, but requested another in 2012 after most of the money was put towards pensions and wages and not to debt reduction. In 2012, the Troika issued another bailout of €130 billion, but this was tied to austerity conditions, and in June 2015, another bailout was required after Greece defaulted on IMF payments, but when further austerity was demanded, the Greek public voted against the deal. Greece eventually agreed to Troika demands and got an €86 billion bailout

Question 2

Greek Demands in June 2015

Answer 2

• Debt Relief – 30% write-off of outstanding public debt
• Postpone all debt repayments for 2 years
• Postponing austerity –Austerity measures were sapping AD from the economy – further austerity will worsen the recession. They should be postponed until economic recover begins

Question 3

Troika Demands

Answer 3

• An immediate reduction in public debt to sustainable levels
  § Tax increases (VAT)
  § Spending cuts (wages and pensions)
  § Sale of state assets
• Improved Greek labor market competitiveness through supply-side reforms
• Alternative of Grexit