The Causes of Greece’s Debt Crisis

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from NCPA,

The entry of Greece into the eurozone in 2001 was widely expected to mark a transformation in the country’s economic destiny. Then, beginning in 2009, everything changed as Greece became the center of a major financial crisis, say Harris Dellas, director of the Institute of Political Economy at the University of Bern, and George S. Tavlas, a member of the Monetary Policy Council of the Bank of Greece.

Dellas and Tavlas draw two main suggestions as to why this happened to Greece.

First, the durability of a monetary union is crucially dependent on the existence of a well-functioning adjustment mechanism. In Greece, there was no mechanism to adjust money and credit growth, causing it to run large current account and fiscal deficits without taking remedial policy measures. [Even if] the adjustment mechanism [is] imperfect, [it] worked to mitigate the buildup of external imbalances.

Second, adherence to a hard peg is no panacea and cannot be sustained without the support of credible fiscal institutions. In the eurozone, the market’s perception that Greek sovereign debt represented a safe investment — probably founded on the expectation of a bailout by core countries — suppressed the effect of sovereign credit risk on Greek interest rates. At the same time, low interest rates greased the wheels of fiscal expansion by sending the message that there was no price to be paid for the buildup of sovereign debt. Hence, external imbalances were essentially … self-perpetuating in the eurozone due to the perception of an absence of credit risk.

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