How the Greek debt crisis was created
By: Alisa Hunt, Academic Program Manager for Post’s Master of Science in Accounting program
Currently Greece suffers from a poor tax system: an overly complex pension system: lack of administrative efficiencies, extreme debt, unemployment; and a dissatisfied populace. To understand how they got to this place a little history is in order.
Greece has only come to a place of peace since the 1980s when they signed an agreement ending years of civil war. Prior to the civil war (and part of the cause), Greece was constantly being occupied by conquering forces, each bringing their own governments and taxation systems.
So, Greece is fairly new to having its own government and systems, and they have not yet worked out all the bugs.
Let’s start with looking at the impact of conquering governments and taxation. Greek citizens were in the habit of finding ways to hide income and thus reduce their taxes, especially since the taxes were paid to conquering regimes. This habit has carried over to modern day. Currently about a third of the Greek people are self-employed, and it’s commonly believed that their income is about 92 percent more than what they report to the government for taxes.
With a citizenry that habitually hides income and does not pay its taxes, the government is woefully underfunded. Governments make money by collecting taxes, and they need to collect more than they pay out—that’s basic accounting rules if we want to have a net income! Add to this a massively over-complex set of tax rules and you now have a heavy administrative burden in order to administer and collect the taxes that they do collect.
Greece has several layers of Value Added Tax (comparable to the U.S.’s sales tax), with many areas having reduced rates to encourage people to live in those areas, and there is not consistency in the application of the tax. This causes increased administration to monitor and collect the taxes, thus adding to the cost –in some cases costing more to collect the taxes than the taxes collected.
Along with the hiding of income, complex tax rules and increased administrative costs, we can add the pension system to Greece’s problems. Like with the tax rules, Greece’s pension system is very complex. They don’t necessarily have high pension amounts, but they do have several complex rules with exceptions that allow for many early retirements. And even with less than generous pensions, they still have about 30 percent more in total pensions than the British government, which has been doing this for a much longer time. With the higher amounts in pensions and the administrative costs, Greece has even more money going out.
We can see that with less money coming in than going out the next thing to follow is debt. And yes, they did have to borrow in order to cover the fact that more money was going out than coming in. Many countries borrow money at various times, but most work on ways to pay this back, by implementing efficiencies, collecting taxes and cutting back. With the problems mentioned above, such as a relatively new government and a populace used to hiding income, Greece ended up having to continuously borrow and very little was being paid back.
In addition to the above, Greece has a poor tradition of accounting. Greece has very few local accountants. Since most people are trying to hide income, becoming an accountant is not high on the list of career choices for a Greek citizen. With fewer accountants, a country will also have fewer accounting rules and less transparency and accountability. Greece does not use the International rules for accounting for a public sector, since they barely use any rules.
With the lack of good accounting rules, it was easy for Greece to understate its debt.
Enter the European Union. Greece decided to join the EU for political reasons rather than financial reasons. Joining the EU added stability and validity to Greece’s government, making them a player in the European scene. In order to join the EU, Greece was required to have low debt levels – below 3 percent. Greece, having several decades of inefficiencies and problems had a much higher debt level than the 3 percent—more like 5 percent.
Because of a single monetary unit, it was necessary for the EU to have requirements to entry. The EU needed to make sure that a country struggling could not pull down everyone else. If all countries participating were in a similar place financially, then no one country would pull the rest down. Greece understated their debt.
When the financial crisis of 2008 hit, a country that was struggling was likely to be hit harder than other countries. This was the case with Greece. It was also around this time that a new government uncovered the under-reported debt. In order to keep Greece from pulling down all the other countries the International Monetary Fund (IMF) decided to bail out Greece.
The bailout was supposed to be followed by austerity measures, increased tax collections, and efficiencies. The bailout money was used to pay foreign investors, so it did not flow back into Greece’s economy. Greece was unable to clean up its act in the five years following the bail out – much due to a lack of transparency and good accounting – causing them to once again be in a position of needing a bail out.
Could this all have been avoided? In retrospect, we can see that better accounting of income would have produced more taxes being able to be collected. Better accounting of costs would have allowed for better management decisions on pensions and taxes. If Greece had been able to overcome its political environment and add good accountants and good accounting systems, then these problems they are currently in would have been avoided, or at least would have had less impact.
Economic, financial ramifications felt around the globe
By: Steve Paulone, Director of Post’s Graduate Business Programs
One aspect of the recent problems in Greece and the collapse of their economy is the concept of economic and financial contagion. Since economies are so interdependent, what used to be contained within a certain geographic area is now felt worldwide. In the past, if the Greek economy collapsed it would obviously affect the nation’s economy and financial structure and possibly have some side effects with major trading partners and debt holders.
In the past debt was incurred when trade happened, there were few ways to borrow against your future income on a national basis. Now countries borrow to finance their expenditures in many different ways due to increased need to lend capital; what is felt in Greece affects everyone from the hedge funds in Connecticut to the Sovereign funds in Dubai and China and the entire European Union, of which Greece is a part. The interdependencies are brought about by the increased financial liquidity worldwide and the advent of a common European currency.
The increased capital liquidity is brought about by the creation of new financial instruments and open markets to enable increased growth worldwide. Also, the creation of market mechanisms in the former Soviet Union and China, as well as the financial engineering of Wall Street and Hong Kong, have given governments, organizations and individuals access to capital in amounts never experienced before worldwide.
The common currency of the EU relies on economic cooperation and rules to keep everyone in the union in sync with baseline expectations so everyone pulls their economic weight. This means that every country needs to keep their borrowing, spending, inflation and productivity in control. One problem with this is that small economies like Greece have less flexibility than the larger economies of Germany and France. We have to keep in mind that Greece is an island country and must import much more than it can ever produce in exports, so it is limited with traditional opportunities for economic expansion. Greece must change their entire structure to expand their economy to a knowledge-based economy from a basically agrarian economy.
The additional problem is the loss of autonomy, it is one thing to make your own way to a different economic future; it is another all together to have external governments and debtors dictate what you can and cannot do to put your house back in order.
Finally, what we see also is a lack of faith in financial institutions and governments. Currency, trade and financial systems ultimately rely on trust. Trust that people, organizations and ultimately governments will pay back their debts. When that does not happen the entire system unravels and now that system is worldwide.
The Moral Hazard behind a Greek bailout
By: Philip Dawson, Academic Program Manager for Post’s Finance program
The concept of Moral Hazard is well understood in the Insurance Industry. Simply put, Moral Hazard refers to the possibility that the existence of ‘insurance,’ or some degree of external financial certainty in response to a situation of high risk, will result in an entity assuming inordinate risk due to the ‘insurance’ or financial certainty provided by the insurance. We’ve seen this in the collapse of Lehman Brothers’ and Bear Sterns here in the U.S. We’ve also seen our sovereign government intervene to save larger institutions who were deemed “too big to fail,” which in essence saved a more broad and devastating collapse of U.S. and Global markets. It occurs to me that Moral Hazard may be an underreported part of the fabric of the Greek Economic Collapse.
The Greek Debt Crisis is not the first sovereign debt crisis to occur in the Eurozone. In 2009, the nations of Ireland, Spain, Portugal and Greece began reporting ‘irregularities’ in accounting which complicated the already mounting sovereign debt levels of those nations. While the existence of the Eurozone had practical validity from the standpoint of standardizing a currency across the Zone, the continual practice of providing relief of the bad actors by the larger more economically viable group, may in fact be only perpetuating the irresponsible level of sovereign debt and borrowing that bring us to this point in the first place.
Irresponsible reporting of sovereign debt in Greece specifically has led investors to lose confidence in the government, and in particular in the Greek / Euro Sovereign Bonds. This situation led to a widening of bond yield spreads and an increase in the cost of premium of risk insurance (credit default swaps) negatively impacting the price of these bonds to retail and institutional investors. Ultimately, the biggest challenge the Greek government faces now is that it needs to figure out a way to begin to consistently and reliably pay back its debt to the International Monetary Fund. Failure to do so, throws the Euro as a currency into question.
And so the circular logic returns. In the case of Greece, the risk of not bailing out the indebted nation (leading to high levels of inflation, temporary weakness in the valuation of the Euro, spikes in Eurozone interest rates and cost of capital due to weaker currency, increased unemployment as companies have to adjust to weaker GDP) outweighs the risk of default in this perverse way. And so the stronger economies bear the brunt of outsized debt incurred by the Greek Government. Moral Hazard at its’ finest.