Question

Case Study 2: Since the debt crisis began in 2010, the various European authorities and private investors have loaned Greece nearly 320 billion euros. In the same year, the Greek government had to inform the European Commission on how it would control its budget deficit and improve the performance of its economy. The government’s debt is so high that agencies assessing the creditworthiness of the government downgraded it (which would mean more interest has to be paid to raise finance). Proposals were likely to include a 10% cut in government spending. European Commission give the biggest financial rescue of a bankrupt country in history. As of January 2019, Greece has only repaid 41.6 billion euros. It has scheduled debt payments beyond 2060.The question arises here, how did Greece and the EU get into this mess in the first place? The seeds were sown back in 2001 when Greece adopted the euro as its currency. Greece had been an EU member since 1981 but could not enter the eurozone. Its budget deficit had been too high for the eurozone's Maastricht Criteria. All went well for the first several years. Like other eurozone countries, Greece benefited from the power of the euro. It lowered interest rates and brought in investment capital and loans. In 2004, Greece announced it had lied to get around the Maastricht Criteria. The EU imposed no sanctions. Why not? There were three reasons. France and Germany were also spending above the limit at the time. They would be hypocritical to sanction Greece until they imposed their own austerity measures first. There was uncertainty on exactly what sanctions to apply. They could expel Greece, but that would be disruptive and weaken the euro. The EU wanted to strengthen the power of the euro in international currency markets. A strong euro would convince other EU countries, like the United Kingdom, Denmark, and Sweden, to adopt the euro.As a result, Greek debt continued to rise until the crisis erupted in 2008.

Questions1. Outline two possible economic objectives of the Greek government.2. Explain why the government’s budget deficit might be in a large deficit.3. What would the effect on aggregate demand be if the government cut public spending by 10%?4. What actions can the government take to increase national income growth in Greece?5. If the Greek economy is in recession what would you expect to be the effect on:a) Inflation?b) Unemployment?c) Imports?Explain your

Answer 1

Ans : 1.The main economic objectives of the government during this debt crisis should be to correct the fiscal and external imbalances to restrore the confidence in the sustainability of public finances.

• Fiscal Adjustment

The Greek government is committed to implement fiscal consolidation measures of around 11% of GDP in cumulative terms. Income policy and a reform of social security system is needed to restore the fiscal adjustment. The tax efficiency and social security system needs to be secured and financial sector stablity should be the main objectives of the government. Financial Stability Fund (FSF) must be set up to maintain the stability of the banking system by providing equity capital in the event of decline in capital buffers.

• To reduce the budget deficit and to decrease the cost of debt

The main focus should be to modify the structure of debt and to reduce the borrowing cost of debt in order to restore the sustainability in the long run. There must be a face value debt relief along with other measures by the EuroGroup that can provide some support to the debt crisis. To improve tax efficient collection and to include more cheaper surces of debt like borrowing from the corporate sectors at a low interest rate or to enhance the austerity measures must be included in the objectives.

2. Government budget deficit was in large deficit because of the different internal factors like poor GDP growth, Government debt, budge compliances , data authentacity etc. Greece's GDP growth was poorly affected due to the downturn in tourism and shipping. Government debt and deficit increased by a large amount due to various reasons like the recession in 2008, low tax collections due to which the government borrowing increased by a large amount more than the expected. Data credibility was also an issue because the persistent misreporting and the lack of credibility was literally an issue which led to the increase in the cost of debt because omre interest rates need to be paid to borrow funds now because now the cost of funds increased due to misreporting of data. Tax evasion and corruption was also an issue because this led to decrease in government revenue.

3. If the government cut public spending by 10% then it depends on the monetary policy and the state of the economy whether the Aggregate Demand (AD) will decrease or not. A cut in government spending generally leads to decrease in AD, we expect a fall in AD but if the consumer spending is increasing then only the growth rate of AD is reduced, we can't expect AD to reduce. Also if there is loose monetary policy then there are chances that the real GDP is not reduced due to the fall in AD. In case of Greece it can be said that the reduction in the government spending might have a negative impact on the AD because of high government deficit and tax inefficiencies it can be the case that the there is large disposable income left with the public. AD will reduce or not it depends on the monetary policy and the state of the economy.

4. To increase national income growth in Greece, the government can take following measures:

• Initiate long term structural reforms : It is necessary to take long term structural reforms in tax administration, Social security sector and financial sector in order to stabilize the economy and to boost the spending and growth
• Loose Monetary policy: It can be one solution in order to tackle the problem of the liquidity due to shortage of funds to help the economy and to boost the private sector to speed up the investment, make sure that the capital is available to them at a lower cost.
• Boost electonic payments to reduce tax evasion: It is a vital step to tackle the tax evasion. The tax allowances or deductions must be made available only when the payments are made electronically, to make it mandatory by law that all business must be PoS device to make sure that payment is done electronically.
• Bank recapitalization: To make the sufficient funds available to the banks it is necessary that the banks must be provided with enough capital so that lending activities go on and growth is maintained, investors get enough capital and get sufficient funds.

5. If the economy is in recession it means the real GDP is at low level and the production of goods and services is at a low level, so that the consumer spending and AD is low and purchasing powe of the people is low and the people don't have enough money to spend and the production of goods and services is low. so Inflation is low.

Unemployment: The production of goods and services is low because of lack of AD and lack of avaliablity of funds people are not able to get the jobs. During the recession the unemployment is high because the firms are cutting back their production and inventories and so on.

Imports: Due to lack of AD, recession comes in, and if there is lack of demand then the people might not be getting enough income and not the production of goods is more, so imports will be low and the economy's overall Real GDP reduces to a low level.