Introduction
Historically, the two major recurring macroeconomic imbalances of the Greek economy are related to the twin deficits in the fiscal and the current accounts.
The fiscal balance and the current account balance have been persistently negative almost throughout the history of modern Greece. Consequently, the twin deficits have been associated with long periods of fiscal and monetary instability, inflation, excessive foreign borrowing, periodic external debt crises and defaults and lower investment and growth rates.
As I demonstrate in a recent paper issued by the Hellenic Observatory (GreeSE Paper no. 189), fiscal and monetary instability in the history of modern Greece was mainly the result of either the pursuit of the ‘grand idea’, as in the second half of the 19th century and the first quarter of the 20th century, or the pursuit of the redistribution of income and wealth and the creation of a welfare state through public borrowing, as during the 1980s.
Large fiscal imbalances led either to excessive accumulation of government debt and/or to excessive monetary financing, undermining the credibility of the currency and the domestic financial system, causing currency depreciations and inflation, and crowding out private investment.
In addition, throughout the history of modern Greece, periods associated with easy access to international borrowing led to excessive fiscal and external borrowing, due to the insufficiency of national savings relative to investment, and, ultimately, to sovereign debt crises and/or defaults.
The 1950s and 1960s were the only prolonged period in which the problem of the twin deficits was addressed effectively. As a result, during that period Greece enjoyed high economic growth, low inflation, and external balance.
Financing Fiscal Deficits
To finance fiscal deficits, governments have two main options:
First, borrowing through capital markets, either domestically or from the rest of world, by issuing bonds.
Second, borrowing from the domestic central bank. This causes new base money to be issued and amounts to monetary financing, usually called seigniorage.
Inflationary Finance
In periods during which Greek governments did not have access to borrowing from capital markets, either because Greece was excluded from international capital markets, or because of the insufficiency of domestic savings, they resorted to borrowing directly from the central bank, initially the National Bank of Greece, established in 1841, and, after 1928, the Bank of Greece, established in that year.
Table 1
In such a case, the government sells bonds to the central bank in exchange for new banknotes with which to make its excess payments. Thus, deficits are financed through seigniorage, i.e., revenue from printing money. However, sooner or later, the increase in the money supply implied
by resorting to seigniorage revenue leads to inflation, which is a tax on the money holdings of the
domestic private sector. Hence, in the medium term, seigniorage turns out to be a form of taxation, the inflation tax.
The periods of sustained high fiscal deficits and Inflation in the history of modern Greece are summarized in Table 1.
In the 1833-1898 period, fluctuations in inflation were significant, but periods of high inflation were short-lived and were usually followed by periods of equally sharp disinflation. Even in periods of suspensions of the convertibility of the drachma into silver and temporary monetary expansions because of wars, inflation seldom exceeded 20%, and was usually followed by an equally sharp disinflation. As a result, the average inflation rate during 1833-1898 was only about 2% per annum.
Inflation was tackled during the adjustment period in which Greece’s public finances were under the supervision of the International Financial Commission, established in 1898.
Since the outbreak of World War I, inflationary episodes have been more severe and more persistent. Annual inflation rose to 56.6% in 1917, following Greece’s entry into World War I and peaked at 94% in 1922, the final year of the Asia Minor campaign. During World War II, the occupation, and its aftermath (1941-1945), Greece experienced five years of hyperinflation. Even if one were to ignore the period of hyperinflation during the triple occupation of 1941-1944 and the subsequent civil war of 1944-1949, average annual inflation during the 1899-1939 period was slightly in excess of 10%, five times higher than during the previous historical cycle. Periods of low inflation included Greece’s short-lived participation in the international gold standard (1910-1913) and the interwar gold exchange standard (1928-1931).
In the 1950s and the 1960s Greece experienced a true economic ‘miracle’. The average annual growth rate of real GDP per capita more than tripled to around 6%, inflation remained particularly low by the international standards of the period and there were no balance of payments or external debt crises.
However, since the early 1970s there was a significant deterioration in Greece’s economic performance. The average annual growth rate of real GDP per capita fell back to around 2%, while, before euro area accession, there was a long period of fiscal and monetary instability and persistently high inflation. Between 1973 and 1993 average annual inflation rose to 18%, as opposed to only 3.5% in the 1953-1973 period. After euro area accession, inflation has been tackled, but persistent fiscal and external imbalances led to a major external debt crisis in 2010 and an unprecedented economic depression, perhaps the deepest and longest peacetime depression in the history of modern Greece.
External Borrowing and Sovereign Debt Crises and Defaults
Debt financing is directly more costly for a government, as it must pay interest on the existing stock of debt.
A key feature of developing economies is that their domestic savings are often not sufficient to finance the investment opportunities that arise in them or government deficits and debts. Therefore, developing economies, like some developed economies too, often resort to borrowing from international money and capital markets to finance investment and promote economic growth or fiscal deficits which cannot be financed otherwise. However, unlike the main developed economies, the international debt of developing economies is usually contracted in foreign currency, and not in their own currency. This has been the case for Greece throughout its history.
High external borrowing in foreign exchange makes an economy vulnerable if conditions, or even expectations, change in international financial markets. If international investors start to believe that a country may not be able to continue servicing its foreign debt, i.e., that it may ‘default’, they will stop financing the country bringing about a foreign debt crisis, even if the country is in fact solvent. It is the same process that brings about crises in fixed exchange rate regimes. Loans in foreign currency or bonds in foreign currency that are maturing are not renewed, or international investors demand higher premia, causing a rise in the debt service cost of a country in foreign currency. This can precipitate a sovereign debt crisis or a ‘default’.
Because of the inadequacy of national savings throughout Greece’s history, except for the 1960s and the 1970s, periods associated with easy access to international borrowing resulted in excessive foreign borrowing and debt and, eventually, sovereign debt crises and defaults. These are summarized in Table 2.
Pre-requisites for a Sovereign Debt Crisis or Default
There are four key pre-requisites for a sovereign debt crisis or a ‘default’:
First, high international capital mobility at the global level, which allows a country to borrow in international financial markets.
Second, a period of protracted deficits in the current account and a large increase in foreign currency denominated external debt.
Third, a destabilizing event changing conditions or expectations in international capital markets. Such an event may be a global recession that leads to higher current account deficits (by reducing the demand for exports and increasing fiscal deficits), an increase in international interest rates, a political change in the country, or all these factors.
Fourth, limited foreign exchange reserves and/or a fixed exchange rate regime.
A combination of these pre-requisites applied in the case of Greece’s international debt crises and defaults.
The ‘defaults’ of 1826 and 1844 occurred, first, because Greece was able to borrow internationally despite its extremely weak fundamentals, and second, because it was effectively lacked the foreign currency earnings with which to service the debt. In addition, the ‘loans of independence’, due to their extremely unfavorable terms, would have been impossible to service even if Greece’s economy was a regular economy and not a war economy.
Table 2
On the other hand, the ‘defaults’ of 1893 and 1932 and the debt crisis of 2010 were due to prolonged periods of high current account deficits and large increases in foreign currency debt.
They were triggered by international recessions that reduced the demand for Greece’s international exports and caused interest rates on Greece’s debt to rise. Furthermore, the defaults of 1893, 1932 and the debt crisis of 2010 were associated with Greece’s inadequate foreign exchange reserves and, in the case of the latter two, participation in a fixed exchange rate regime.
The default of 1826 resulted in the exclusion of Greece from international capital markets.
The ‘default’ of 1844 was followed by the ‘naval blockade’ of Piraeus and the establishment of an International Financial Commission of Inquiry which reported on the re-payment of Greece’s restructured debt payments.
The ‘default’ of 1893 occurred in the aftermath of an international financial crisis and recession and was followed by the establishment of an even more powerful International Financial Commission which in exchange for a new official loan imposed harsh fiscal and monetary adjustment that resulted in a short but deep recession, but eventually led to a rapid fiscal and monetary stabilization and a rapid recovery.
The ‘default’ of 1932 occurred during the Great Depression of the early 1930s and was followed by devaluation, fiscal adjustment, a prolongation of the recession, a rise in tariffs and the imposition capital controls. The devaluation, tariffs and capital controls led to a speedy recovery through an increase in domestic spending.
The debt crisis of 2010 occurred in the aftermath of the international recession of 2008-2009 and was followed by official lending and the imposition of three successive adjustment programs, designed and supervised by a ‘troika’ of representatives from the International Monetary Fund, the European Commission, and the European Central Bank. The adjustment programs were based on fiscal tightening and an internal devaluation through wage reductions. Capital flight led to extreme monetary tightening as capital controls were not used until 2015. Although they contributed to a correction of the external and fiscal imbalances that characterized the Greek economy since before entry to the euro area, this was at the expense of a ‘great depression’, that lasted for almost seven years, between 2010 and 2016. Greece eventually remained in the euro area under enhanced surveillance although it came very close to exiting it.
Conclusions
Throughout its two-hundred-year history, modern Greece was characterized by prolonged periods of low economic growth, monetary instability and sustained fiscal and external deficits. These often led to high inflation, international over-indebtedness, and sovereign debt crises and defaults.
Current account deficits have been a consequence of the shortfall of domestic savings relative to investment. The only exception was during the 1950s and the 1960s.
Until the 1950s the main drivers of fiscal deficits have been the occasional military mobilizations and wars because of the pursuit of the grand idea, the two world wars and a civil war.
After the late 1970s, the main driver of fiscal deficits has been the attempt to redistribute income and wealth and create a welfare state, in the pursuit of great equality.
Regarding the monetary and financial implications of the twin deficits, two are the main conclusions:
First, when Greece did not have easy access to international borrowing, fiscal imbalances led to monetary destabilization and inflation.
Second, when it did have access to international borrowing, fiscal deficits were generally larger, led to external deficits and, eventually, sovereign debt crises and defaults.
The monetary and exchange rate regime also mattered. Currency convertibility or participation in a fixed exchange rate regime acted as a constraint on the monetary financing of deficits but led to higher international borrowing. When this was not possible, Greece resorted to suspensions of currency convertibility and adopted flexible exchange rates. This allowed for monetary financing of the deficits and led to currency depreciations and inflation.
Historically, the twin deficits also appear to have acted as constraints on the domestic investment rate and hence the growth of real per capita income.
The 1950s and 1960s were the only prolonged period in which the twin deficits were low and did not act as a constraint on domestic macroeconomic developments. As a result, this was the only period in which Greece enjoyed high economic growth, combined with monetary stability and external balance.
In all other periods, the Greek economy appears to have been characterized by either external imbalances that led to sovereign debt crises, or high inflation and low economic growth.
*The Hellenic Observatory hosted a research seminar on the topic on 3 October 2023. For more information please visit the event page.
Note: This article gives the views of the author, not the position of Greece@LSE, the Hellenic Observatory or the London School of Economics.
