Understanding the Downfall of Greece's Economy

What Is the Story Behind Greece's Downfall?

In 2015, Greece defaulted on its debt. Some said Greece simply fell into "arrears." However, it missed a €1.6 billion payment to the International Monetary Fund (IMF), making it the first developed nation to have missed such a payment.

In 2001, Greece joined the Eurozone, which to some, precipitated Greece's downfall. However, the Greek economy suffered structural problems before adopting the euro as its currency.

Greece Before the Eurozone

Before acceptance into the Eurozone in 2001, Greece’s economy was plagued by several problems. During the 1980s, the Greek government pursued expansionary fiscal and monetary policies. However, rather than strengthening the economy, the country suffered soaring inflation rates, high fiscal and trade deficits, low growth rates, and exchange rate crises.

In this dismal economic environment, joining the European Monetary Union (EMU) appeared to offer a glimmer of hope. The belief was that the monetary union backed by the European Central Bank (EBC) would dampen inflation, help to lower nominal interest rates, encourage private investment, and spur economic growth. Further, the single currency would eliminate many transaction costs, leaving more money for the deficit and debt reduction.

Conditional Acceptance

However, acceptance into the Eurozone was conditional. Of all the European Union (EU) member countries, Greece needed the most structural adjustment to comply with the 1992 Maastricht Treaty guidelines. The treaty limits government deficits to 3% of GDP and public debt to 60% of GDP. For the remainder of the 1990s, Greece attempted to get its fiscal house in order to meet these criteria.

Greece was only able to gain admission to the EMU by misreporting the size of its deficit, as the country's finances were nowhere near within the Maastricht limits. Greece was hoping that despite its premature entrance, membership in the EMU would boost the economy, allowing the country to deal with its fiscal problems.

Greece Enters the Eurozone

Greece’s acceptance into the Eurozone had symbolic significance as many banks and investors believed that the single currency effaced the differences among European countries. Suddenly, Greece was perceived as a safe place to invest, which significantly lowered the interest rates the Greek government was required to pay. For most of the 2000s, the interest rates that Greece faced were similar to those faced by Germany.

These lower interest rates allowed Greece to borrow at a much cheaper rate than before 2001, fueling an increase in spending. While indeed spurring economic growth for a number of years, the country still had not dealt with its deep-seated fiscal problems which, contrary to what some might think, were not primarily the result of excessive spending.

Many of Greece’s fiscal problems stemmed from a lack of revenue due to systematic tax evasion. Generally, self-employed, wealthier workers tended to under-report income while over-reporting debt payments. The prevalence of this behavior reveals that rather than being a behind-the-scenes problem, it was actually more of a social norm that was not remedied in time.

Greece's Competitiveness Gap

Eurozone membership helped the Greek government to borrow cheaply and to finance its operations in the absence of sufficient tax revenues. However, the use of a single currency highlighted a structural difference between Greece and other member countries, notably Germany, and exacerbated the government’s fiscal problems. Compared to Germany, Greece had a much lower rate of productivity, making Greek goods and services far less competitive.

The adoption of the euro only highlighted the competitiveness gap as it made German goods and services relatively cheaper than those in Greece. Having given up independent monetary policy, Greece could no longer devalue its currency relative to that of Germany. This served to worsen Greece’s trade balance, increasing its current account deficit.

While the German economy benefited from increased exports to Greece, banks, including German banks, benefited from Greek borrowing to finance cheap imported German goods and services. As long as borrowing costs remained relatively cheap and the Greek economy was still growing, such issues continued to be ignored.

Greek Financial Crisis and Bailout

The global financial crisis that began in 2007 exposed the true nature of Greece’s financial strife. The recession weakened Greece’s already paltry tax revenues, which caused the deficit to worsen. In 2010, U.S. financial rating agencies stamped Greek bonds with a "junk" grade. As capital began to dry up, Greece faced a liquidity crisis, forcing the government to seek bailout funding, which they eventually received with staunch conditions.

Bailouts totaling €289 billion from the International Monetary Fund (IMF) and other European creditors were conditional on Greek budget reforms, specifically, spending cuts and higher tax revenues. These austerity measures created a vicious cycle of recession with unemployment reaching 25.7% in August 2012.

These measures, applied amidst the worst financial crisis since the Great Depression, proved to be one of the largest factors attributing to Greece's economic implosion. Tax revenues weakened, which made Greece’s fiscal position worse. Austerity measures also created a humanitarian crisis: homelessness increased, suicides hit record highs, and public health significantly deteriorated.

Greek citizens voted against additional EU austerity measures in July 2015. Afterward, Greece began to recognize improvements in its economy. The nation's unemployment rate went from a record high of 28% in 2014 to 13.2% in 2021.

The country's GDP has also been wildly volatile. For instance, Greece's annual year-over-year GDP growth went from a -10.1% in 2010 to 1.8 in 2019. Unfortunately, it has been inconsistent since then. Greece's year-over-year GDP growth was -9% in 2020, 8.4% in 2021, and 5.9% in 2022.

The Bottom Line

Far from helping the Greek economy to get back on its feet, bailouts only served to ensure that Greece’s creditors were paid while the government was forced to scrape together paltry tax collections. While Greece had structural issues in the form of corrupt tax evasion practices, Eurozone membership allowed the country to hide from these problems for a time but ultimately created an economic straitjacket and an insurmountable debt crisis evidenced by the country's massive default.