Name: Divyansh Khare

Roll number: B23194

Assignment 5
Case: Mismanagement of Fiscal Policy: Greece’s Achilles’ Heel

Case background
The case discusses Greece's economic struggles resulting from decisions made at a specific
time to conceal the country's economic health by creating an illusionary facade of development,
public investment, and manipulated fiscal reports. Greece's penchant for borrowing money is
not a recent phenomenon; they initially borrowed funds from private investors for their
independence from the Ottoman Empire. Subsequently, every government prioritized spending
to secure voter support, fostering a culture of macroeconomic populism.
Despite receiving bailouts from other countries and the IMF, Greece misallocated these funds
by using them to pay off debts, waive taxes, and lower interest rates instead of generating
alternative revenue streams. Greece became heavily reliant on external economies, functioning
on borrowed money, leading to a severe impact during the 2008 financial crisis.
Additionally, Greece faced a crisis with its risky bonds, heavily reliant on other countries. Any
disruption in the flow of funds could have led to defaults, damaging Greece's credibility in
international markets and causing a sharp rise in inflation rates. The country's dependence on
external assistance and a lack of sustainable economic policies left it vulnerable to financial
turmoil and jeopardized its long-term economic stability.

Critical issues and challenges

Governments embracing populism in Greece had significant consequences on the country's
economic health. Structural reforms necessary for economic stability were delayed, and the
primary revenue source, consumer spending, discouraged saving and investment. The
government's practice of offering money at negative interest rates further fueled spending,
while tax cuts, high wages, and generous pensions were employed to secure votes,
consolidating the government's power over the years. Despite receiving bailout funds and
assistance from international entities like the IMF, the money was directed towards debt
payments and distributing cash to the public instead of fostering development and creating
sustainable income sources to manage debts effectively.
Moreover, Greece's premature entry into the EuroZone had detrimental effects. To join the
European Union, specific criteria needed to be met, including a deficit not exceeding 3% of the
GDP and capping public debt at 60% of the country's GDP. Greece fell significantly short of
these standards and admitted to manipulating fiscal deficit and public debt figures to gain EU
entry. Once part of the EU, Greece was perceived as a safe investment hub, attracting funds at
low interest rates. However, the country's spending habits escalated rapidly, leading to a
revenue deficit. Tax exemptions for private companies and guaranteed debt payments
exacerbated the financial strain.
Furthermore, Greece's heavy reliance on external financial sources became glaringly apparent.
The government, focusing on borrowing, created a dependency on funds from other countries,
and when Greece joined the European Union, its bonds were initially considered reliable.
However, this dependence backfired during the 2008 US financial crisis. Greece's vulnerability
was exposed as the crisis drastically lowered Greek bond prices, resulting in their rejection in
international markets. This overreliance on external markets left Greece in a precarious
situation, highlighting the urgent need for sustainable economic policies and reduced
dependence on borrowed funds.

Case analysis and interpretations

Greece's aspiration to join the European Union held the promise of prosperity, yet the reality
fell short of expectations. While they gained access to funds at interest rates equivalent to those
in Germany, the utilization of these funds proved problematic. Instead of investing in the
country's development and increasing revenue, the money was primarily channeled into paying
off existing debts, boosting consumer spending, and securing votes. During their time in the
EU, Greek bonds gained significant traction and were regarded as secure as German bonds.
These bonds offered a steady stream of money for the Greek government, ensuring financial
stability. However, this scenario hinged on the credibility of Greek bonds, which took a severe
hit when their prices plummeted, resulting in a decline in investor interest.
Exiting the European Union seemed to be the optimal solution for Greece. Reinstating the
drachma as the national currency was proposed as a means to reduce unemployment by 25%
and invigorate the economy. Greece could potentially convert its euro-denominated debts into
drachma, allowing for debt repayment through the printing of more money, subsequently
decreasing the euro's exchange rate. Additionally, this move could lead to reduced export prices
and attract tourists due to cheaper rates. While this solution appeared beneficial for Greece,
foreign investors and debt holders remained wary, fearing potential losses. Moreover, the
devaluation of the drachma could trigger hyperinflation, given Greece's high import rates,
leading to soaring domestic prices and instability. Consequently, the country might face
difficulties attracting Foreign Direct Investment (FDI), relying instead on leasing agreements.
Greece's economic struggles led to three significant bailouts. The first, in 2010, required Greece
to reduce its government deficit by 12.5% of GDP within three years. However, the fiscal
deficit reported in 2010 far exceeded the figures presented, making it apparent that Greece
could not meet the agreed-upon 30-billion-euro fiscal deficit target. The second bailout in 2012
involved a 74% haircut for private Greek bondholders, amounting to 130 billion euros. Greece
was tasked with reducing its debt-to-GDP ratio from 160% to 120% by 2020. This effort began
to show results, with economic growth at 0.7%, a shift in voter support towards left-wing
parties, and an increase in demand for Greek bonds. Nevertheless, the bonds remained
classified as junk status, and the debt-to-GDP ratio rose to 175%, posing a continuing
challenge.
The third bailout, crucial for Greece, stemmed from a 1.7-billion-dollar default on US
obligations. The IMF offered an 86-billion-euro bailout, subject to specific terms and
conditions. Greece negotiated its terms, agreeing to labor law reforms, tax reforms, an increase
in the budget surplus to 3.5%, reductions in public spending, and privatization of public assets.
These conditions were imposed to diversify Greece's revenue streams and pave the way for
economic recovery and stability.

Macroeconomic tools and theories

1. Gross Domestic Product
Gross Domestic Product (GDP) represents the overall market value of goods and services
produced within a country during a specific timeframe. It essentially serves as an economic
report card, reflecting the nation's financial well-being. In the case of Greece, which primarily
relies on consumption revenue, evaluating the production of goods and services within its
borders becomes crucial in assessing the country's development. This metric not only provides
insight into Greece's economic progress but also allows for comparisons with other nations,
revealing Greece's current standing in the global economic landscape.
GDP=C+I+G+NX
Considering the Greek government's struggle to generate revenue from consumption, it is
essential for them to explore alternative income sources, such as investments. However,
investing funds also poses challenges, which can be assessed through GDP analysis. To address
this, the government should consider initiating public projects instead of providing loans to
private entrepreneurs. By focusing on public ventures, Greece can potentially create a stable
and diversified revenue stream, fostering economic growth and stability.
2. GDP Price deflator
This metric can gauge the variations in the prices of domestically produced goods and services.
When taxation is enforced rigorously and money is lent at positive interest rates, it alters the
spending patterns of the population. Monitoring these behavioral changes through the price
deflator proves invaluable, allowing policymakers to adapt strategies based on the economic
situation.
3. Public expenditure vs Revenue
Analyzing the Greek fiscal deficit involves comparing public expenditure to revenue. Greece's
public expenditure rose sharply from 10.3% in 1980 to 23.5% in 2011, while Germany's
increased from 22.1% in 1980 to 26.2% in 2011. Despite their proximity in terms of public
expenditure, Greece lagged significantly behind Germany in revenue generation relative to
expenditure. The high fiscal deficit in Greece can be attributed to this disparity between public
expenditure and revenue, highlighting the underlying reason for Greece's fiscal challenges.
Learnings
The crisis stemmed from human actions and negligence, not natural forces or flawed computer
models. Financial leaders and overseers of the financial system disregarded warnings, failing
to comprehend and address escalating threats within a vital system crucial to the well-being of
the American people.
This was a substantial oversight on their part, not a mere mistake. An illustrative case is the
Federal Reserve's failure to prevent the influx of toxic mortgages, which it could have done by
implementing reasonable mortgage-lending standards.
The Federal Reserve had the exclusive authority to act but chose not to. Financial institutions
engaged in creating, purchasing, and selling mortgage securities without evaluating or caring
about their quality, relying on billions in borrowing backed by subprime mortgage securities,
and investors and major firms depended heavily on credit rating agencies without adequate
scrutiny.
Additionally, the crisis was exacerbated by severe failures in corporate governance and risk
management at critical financial institutions, which excessively indulged in risky ventures with
insufficient capital, relying heavily on short-term financing.
These institutions, preeminent investment banks and bank holding companies shifted their
focus to speculative trading activities, disregarding prudence and accumulating substantial
risks by supporting subprime lenders and generating trillions in mortgage-related instruments,
including synthetic financial products.
Although the natural economic cycle is inevitable, a crisis of this magnitude could have been
averted.