Current Affairs: The Greek Debt Crisis
Hello and welcome to a discussion on euro zone and the Greek crisis, the Greek debt crisis. Greece is currently $400 billion in debt which is 170% of the annual GDP of that country. Unemployment rate has gone through the roof, it has hit 25% and it is still climbing. And among the young people, under 25 years of age it has already hit 50% unemployment. 30% of the people are living in poverty and the people have started losing confidence in the banks of the country and are worried about the deposits that they have put in the banks so they will get back that money or not. Widespread unrest in rioting is happening in the country because the government is not able to give the basic requirements such as public health, education and even law and order. Because of these reasons Greece is becoming politically and economically unstable. Greece is going down a road to ruin and it has the potential to drag the rest of European Union and perhaps the whole world with it. So what has caused this Greek situation? To understand that we are going to use this discussion and our discussion is going to center on certain objectives which is what is this crisis and why is it a crisis? How did this crisis come about? Historical and the theoretical underpinnings of the crisis. Right. What led to it? Right. Are there any fundamental flaws in the concept itself that has led to the crisis and where is it going? How is the future going to play out? What are the potential options and some of the potential solutions that are in sight right now? We will look at these things in the rest of our discussion. And in addition to this we are going to look at all the relevant concepts that are required for understanding this whole mess, we can say. Is, what is it about? To understand that we look at all the relevant concepts required and at the end of the discussion we are going to look at certain questions which will help us understand the whole thing and put in a good perspective. We are going to frame questions and I would invite you to try out answering those questions in the comments section so we can have an interaction on the questions basis as well.
So now we will look at the concepts, to get a thorough understanding of what they mean and how they pan out and play out in the actual world. So the first concept we are going to look at is the concept of budgeting. What does that mean? So to understand budgeting I’m going to use a simple analogy which we consistently use in the lectures as well which is assume that a household is like a country or a country is like a household. So we look at the household and understand how a household behaves to understand how the country will behave. It’s a very simple way to understand how countries make decisions by looking at how households make decisions. So in a household what is the income? How is it generated? Income is generated by working. Nobody’s going to give money or free to a household, so income is generated by working. Working essentially means produce goods and services. Only if you produce something worth giving to somebody else you’re going to get some money for it and that becomes your income. And this income in turn can be used for spending on expenditure. This becomes the spending that is done. Now if the income is equal to the expenditure then we are having a balanced budget for that household. The household is managing its expenses while. It is staying within the confines of its own income. That is what this balanced word means here. Now suppose the, take an example where the expenditure becomes greater than the income. Then what will happen? Where is this extra money going to come from? Let’s expenditure is 150 rupees and the income is only 100 rupees. The extra 50, where is that going to come from? The only way to get that extra money is to borrow. We have to take a borrowing. So that generates debt. This debt will finance the expenditure. But the debt has to be repaid. It will, there also will be an interest component to it. The debt has to be repaid. Now, exact same concept applies to the country level as well. Now we go to the country level. The exact same concept of income, expenditure and borrowing applies to a country as well. So what this means is that the country also has income, the country also has expenditure and the country also generates debt. And the process of managing these things, how much income will I get, how much expenditure should the country do and how much that is required, managing this whole process is what is called budgeting. So budgeting is nothing but the process in which the income, the expenditure and the debt components are decided by the government. Now where does the government get its income from? The government, the country cannot go and do some work. Only people can do work and the country or the government is not people, it’s there representative, it’s a body, it’s an institution. So the people of the country do the work. They produce the goods and services and the country, the government gets some income out of them, revenue out of them by taxing them. So essentially people are saying take some of my income which I have earned for myself and spend it on certain things which is collectively useful for the people of the country. So this income is what has become tax for the government. So effective budgeting is about taxation, expenditure and debt. Now this budgeting process leads to a document called the budget itself. The budget is to be presented in the parliament. Why? Because as we just discussed, the income is not the government’s. The money is whose money? The money is the people of the country’s money. It’s their hard-earned money. So to spend that money you have to ask their permission. That asking of permission is the budget session. In the budget session the government will table the budget in the parliament and the representatives of the people who have earned the money will sanction that amount. Okay government you can spend the money. We think it’s a reasonable expenditure, you can spend the money on that. This approval process is the budget session. And once the budget has passed, this budget, budgeting process, the decision to implement these things becomes the policy of the government. And that policy about how much to tax, where to spend that money on, and how much debt to take on is called the fiscal policy of the country. The fiscal policy is the policy decision on where to spend money and where to get money from. It’s as simple as that.
Now we are going to look in more detail about government’s income, expenditure and borrowing. So to do that we are going to divide the whole discussion into two parts. One is domestic and the second is international. This is because when it comes to money and the financial market, domestic market and international market are two separate entities. They work in different manner. Because the reason is that in domestic market the income, the expenditure and the borrowing is in the domestic currency. For India’s example rupee. So the moment that borrowing, the expenditure, the spending, everything is happening in the rupee, that rupee is something that the Indian government has some power over. Indian government can control the rupee. If required the Indian government can print the rupee. That means there is some power there. Whereas in the international market, the borrowing, the lending, the spending etc. happens in some other countries’ currency. A foreign currency such as the dollar, or the yen, or the euro. The problem there is that the Indian government, the local government does not have power to control that currency. Indian government cannot print the dollar. So the international currency has to be repaid. International borrowing, or lending etc. has to be repaid in the currency of borrowing. Or one of the accepted currencies of the world. So the international market is slightly different. So we will look at both this separately.
In domestic market what is income for a country? As we discussed, taxation and some other forms of revenue. We will primarily look at taxation in this discussion. What is the expenditure for a country? Various expenses such as government programs, right, pensions, salaries etc. are some of the big expenditures of the government. The difference between these two, if expenditure becomes more than income, the difference between the two is called the fiscal deficit. It is called the fiscal deficit because if you remember the fiscal policy of the country is about expenditure and income, and the fiscal policy is generating a deficit so deficit generated through via the physical policy will be called the fiscal deficit of a country.
Now in similar fashion international. Where does the income get generated? The people of the country has produced goods and services. That goods and services goes out of the country and brings foreign currency into the country. So export, it’s nothing but the process just described, becomes the income for a country in terms of international market. And the expenditure for a country becomes imports. Because money goes out of the country. Now if imports are greater than exports, the difference between them becomes current account deficit, which is a deficit in the current account. A deficit that is in the foreign currency. Now these two are the two fundamental deficits for, required to understand the discussion today. Not to understand this well let us use a simple analogy again. Okay. We are going to look at, imagine you have a debit card and a credit card. Imagine you are using only the debit card. That means you’re essentially using only your income to fund your expenditure. You’re having a balanced situation in which you use the debit card to fund your expenditure. Now imagine you have a credit card as well. How did the credit card get issued? Because a credit card agency of the company saw your income and saw that thought that you are creditworthy, you are capable of repaying your debts. That’s why they gave you a credit card. Now suppose you start using the credit card. What are you doing? You’re essentially accumulating debt. Your expenditure is now becoming more than your income. That’s when you use a credit card. Now imagine you use only the credit card. You’re not using the debit card much or majority of the usage is now credit card. So your expenditure starts becoming much higher than your income. Now what happens to the company who gave you the credit card? The company has given you the credit card, the company notices your spending pattern here. And the company will decide this person is having too much expenditure and not having enough income. So what can it do? Either I will increase the interest rate on the credit card or I will put a limit on the credit itself. I will reduce the limit or I might even cancel the card. One of the situation can happen if I am not regular in my repayment of my debt. Now what if I actually lose my income, or my income comes down. There is a recession, I lose my job, whatever happens. In that case again the company will know this, and the company will realize that now I am a big risk. To reduce my risk again the company might either put limits on me or cancel my card. This is a very simple way to understand the rest of the discussion. Only using the income would be debit card usage. Using debt would be credit card usage. But credit card usage depends on income. You cannot have a credit card usage without having steady income and continuous repayment of debt. Otherwise we are going to have this kind of problems. Increase in interest, decreased limit on how much we can get and eventually may be being cut off from credit altogether. So this discussion is very essential for the rest of the understanding the rest of the discussion.
Now, coming back to the analogy with the government. What is the government’s debit card? The normal revenue, such as tax revenues. But what is the government’s credit card? How does the government borrow? How does the government borrow? The government’s credit card is something called the bond market. The bond market is the place the government goes to when it wants money. The debt accumulated through bonds is called sovereign debt. It’s called sovereign debt because it is debt which is accumulated by a sovereign entity which is a government, it’s not an individual debt. Sovereign debt is a much higher class of that because it essentially guarantees repayment. Now we will understand. Now let’s quickly look at what is, look at what is meaning of bonds. What it means? Essentially bonds are nothing but me telling you “please give me some money now, I will give it back to you later and I will give you higher amount. Please give me 100 Rupees now, I will give you 110 Rupees later. Because I really need the money right now.” That is a bond. They are issued by the government and are effectively promissory notes. Okay. They are sold, promissory notes which promise to repay the face value at maturity. Now to understand this let’s look at an example. Let’s imagine the government of India wants 100 rupees right now. The government of India wants Rs.100. Let’s imagine the interest rate in the market is 10%. So the government of India will say I will issue a bond which is worth Rs.110 and I will issue it at Rs.100. So you can give me Rs.100 now and I will give you Rs.110 at maturity, let’s say six months. So effectively what has happened? Government of India has received the Rs.100, this can be spent and the Rs.110 has to be paid back only at a later date. Now this is the fundamental and the most essential ways in which government can raise money if the tax revenues is not enough. The most fundamental way of borrowing. Which means that the governments will do everything in its power to repay this. This Rs.110 is guaranteed. It is supposed to come back because governments are very careful about maintaining their trust which is why these government bonds are also called gild-edged securities, which means gold embroidered, gold edged, because they are so safe. There is a very safe investment option. Because of their so safe investment options we have some people who always invest in this. One example is pension funds, insurance companies etc. invest in government bonds because it gives a safe return. There is no risk involved. In addition to that some other companies, some other agents like banks etc. always invest in government bonds because they are required to under CRR norms, SLR norms etc. which we will discussing in the banking segment of our economy lectures. Now in this example, what is the meaning of this interest rate? Where does the interest rate come from? How is the interest rate determined? Who determines the interest rate? The market determines the interest rate. How does the market determine the interest rate? Based on supply and demand. Now, supply and demand of what is always an important question whenever we discuss supply and demand. Supply and demand of loanable funds i.e. money that can be lent. Now if money is more what will happen? Demand, supply has increased. If supply increases, the price of the money comes down or the interest rate comes down. So, examples of when it becomes more, if investors are very confident about the particular government they are investing in then supply increases and interest-rate comes down. Similarly if there is a lot of money in the market, if the investors have access to a lot of money, then again supply increases and interest rates come down. That means when the investors are confident in the government and there is a lot of money in the market, it is easy for the government to get money through bonds. Whereas the opposite happens, suppose investors have less confidence in the markets, then, or has less money in hand because of economic recession etc. then the interest rate starts climbing, because supply has come down. And then it becomes difficult for the government to raise money as well. When does this confidence come and go? The confidence increases when they can see that the government is performing well, generating a lot of income, GDP growth is happening, income is increasing, then the confidence increases. Just like the credit card example right? When your salary goes up your credit card limit goes up. Same way and the interest rate comes down actually. So same way when the investor confidence increases when the governments’ country is doing well. Investor confidence decreases when the country is doing bad. So when the country is doing well it becomes easy to get more money. The country is doing bad it becomes difficult to raise money through the bond market. That is how the bond market functions. This is how the government’s credit card works.
Now the strong economies of the world, right, which are dominating the world such as the US, the UK etc. have an advantage here. Because they are strong economies the confidence in them will always be high. They will never default on their bonds. Whereas the weak economies, because the investors might not have full confidence in them, whenever the global downturn happens, the weak economy suffer, because they are the ones who loses the confidence fast. So the weak economies are always in danger from investor confidence going down and the bond market becoming unstable for them. So weak economies, what can happen is that for some reason the investor confidence can go down and then they can have a crisis, because the debt is not easy to get anymore. And this is what is going to be discussed in the rest of the Greek crisis. We have already covered everything that is required as a conceptual level for understanding the Greek crisis.
Now we will look at the crisis itself and apply the same concepts we have seen here. The very simple idea of income versus expenditure. If expenditure is more than income you need to borrow and the borrowing is through bonds and the bonds depend on confidence in your capacity to repay and amount of money in the market. Which means if you’re only, if you are posting good numbers in terms of GDP etc. and you’re having good policies in place, investor confidence will be there, only then you can keep on borrowing. Simple concept is that. Now we will move forward.
Let’s imagine a scenario. There is a country A. This country A has always have expenses greater than income. Which means its debt is keeping on increasing. It has recently been inducted into a rich club, a rich neighborhood, and the country has now got access to better credit cards because of the rich club. Because the credit card agencies think that the club will help the country out in case of trouble. So the country is not having good income and is spending too much. But it’s part of a rich club so the credit card agencies think or the investors think that the country is a safe bet so they allow more credit to country. So the country starts borrowing more and more. Debt keeps on increasing and it starts increasing spending also. Because it’s wants to compete with its neighbors. It wants to live a luxurious life just like its neighbors. So expenditure increases, income is also increasing but not at the same rate. Now this means that the debt keeps on mounting. At some point the investors or the market starts feeling that something is wrong here. The market feels, starts feeling that something is wrong here. They start feeling there is a risk involved here which means it’s danger time for them. And because of whatever the reason the overall global economy slows down or whatever the reason, the investors decide to reduce credit or make it more expensive. Interest rate starts going up. When this happens the country now has to borrow more and more at a very high rate. The country has, do not have enough income to cover its expenditure. So it wants to maintain expenditure, it should keep on borrowing. This borrowing keeps on happening, at some point the country will hit a crisis. At this crisis point it can ask IMF to come and help it but even that is only a delaying measure. At some point you have to post good income numbers. Without that you cannot repay the expenditure you are having. So the crisis is looming. Now what does a normal country do in such a circum… circumstance? Now in a crisis like this is a monetary crisis normally a country will use monetary policy. The monetary policy it can use goes as follows. It can print more money or somehow increase the money supply in the economy. Not as we discussed earlier when money supply increases the investors become more you know lenient. They become more eager to give out their cash. Some money supply increases will lead to interest rates reducing. So the interest rates were increasing which was causing a debt crisis but we can get the interest rates down by increasing money supply and this can help bring down the debt again. So normally this is how a country would react. But let’s imagine a country which does not have an independent monetary policy. Then what will happen? Then the crisis starts escalating. Because fiscal measures, one way we can also increase revenue is by increasing taxation or we can cut down expenditure by reducing government programs. But those fiscal measures tend to be unpopular, not at all popular with the people. People don’t like more taxes, people don’t like if peop.. government is not spending on education, public health, law and order, infrastructure, road etc., people don’t like that. So it causes unpopularity. It can cause unrest in the country. It can cause a lot of problems in the country. Whereas the country does not have a monetary policy option so the country is stuck. This is exactly where Greece is right now. So this is a conceptual understanding of any country if put in a situation like that would have ended up in the same kind of situations. So this process can lead us to a situation of high taxes, low GDPI, high unemployment and high debt. That is where country A would end up if it does not have a monetary policy and cannot implement the fiscal policy properly right now. This is exactly where Greece is. To understand how Greece reached the situation we have to understand why it does not have a monetary policy of its own. For that we have to look at the history of the European Union and the history of Greece involvement in the European Union, and we will look at that soon. This is a Greek debt versus GDP chart. If you can see the debt is keeping on increasing, the GDP is keeping on decreasing. This is what country A was also going through. So we’ll understand why Greece is in a situation like this, in which the debt is increasing and the GDP is decreasing.
The euro zone. The euro zone is a economic union. It’s an economic and monetary union. One component of the euro zone is the EU. The EU is an economic union. The meaning of the word economic union is that it allows free movement of goods, services, people etc. throughout the location. So we can have movement across markets. So we have an integrated market situation. That is what an economic union means. It allows easy trade to happen. Now this process of moving towards the euro zone happened in three phases. The first phase was just to integrate the country, allow customs to be read used etc. so that market can start functioning well. The second phase is integrate it even better. Right. Reduce, increase labor mobility, people can go across the countries. Go from here to here etc. without passports. That kind of situation was phase 2. Phase 3 is for the entire place to have a single currency of euro. That is phase 3. A single currency, the advantage is that it will allow create to happen even better. Transaction cost reduces. That is the third phase. So this is the definition of a currency union, which is the third phase of the euro zone. ERM second stage. After that comes the third stage which is the integrated currency phase or a currency union. It’s an agreement among members to share a common currency which allows the single monetary policy and a single exchange policy. So countries will not have independent monetary policy or an independent exchange policy. That’s what a euro zone means. Now if you notice here not all members have joined the euro zone. These are the members in the euro zone. United Kingdom has opted out of the euro zone. And Netherlands also has not really implemented the euro zone yet. But the rest, all these countries in mainland Europe and Ireland has adopted euro as a single currency. They do not have their own currencies anymore. This is a concept of a single currency union. Now the question is, is this currency union, euro zone, economically valid? A lot of economists have come up with some criteria to make an area an optimum currency region, or an optimum currency area. Only if these criteria are met we can say that, that area is capable of behaving with a single monetary policy, is capable of having a single currency. Now if you look at the euro zone, we will see that these are the criteria. Labor mobility across the region is set to be moderate. Why is that moderate? Suppose there is a person in Greece. He wants to have job in Germany because Germany is really doing well, Greece is not doing well. Of course he does not require passport, he can just go to Germany. But can he get a good job in Germany? The problem is that there is language barrier and there is cultural barrier. He does not know German. There is not a single language in the whole Europe. So without knowing German he cannot work well in Germany. So labor mobility is only moderate. It is not proper. Which is one of the important criteria for having a single currency zone. Without that a single currency zone can’t really work very well because labor mobility is not there. Similar inflation rates, not there. Germany is having very low inflation rate, Greece is having very high inflation rate. Capital mobility means money should be able to easily move across regions. This is very good in Europe. Money transactions, the financial markets are well integrated and this is happening very, very smoothly. Price and wage flexibility, which means the wages and price should be able to adjust according to requirements. This is not so good in Europe, especially in southern sides of Europe, Italy, Greece, Spain, Portugal etc. the price and wages sticky. They’re not moving as fast because of government regulations primarily. The minimum wage laws, hire and fire policies, labor reforms, labor unions, all these things are causing price and wage flexibility to not so well adjust in the case of the South. The North is having more liberal policies in labor laws etc. so flexibility is higher there. Fiscal and political integration, safety net for losing economies means that these things would mean some economies are going to be growing fast such as Germany. Some economies might be having some recessions are some problems such as Greece and Spain etc. Fiscal and political integration mean that Germany will be able to send funds to Greece in case required. A safety net, this is hardly there. In fact it was one of the founding principles of the euro zone that there will not be any transfer of funds. There will not be any bailouts itself. They thought of countering that by putting strict entry requirements etc., but a bailout was not even a possibility that is considered until 2010 when a bailout actually came into being. Until that time it was said that bailout was not possible in the euro zone. So fiscal and political integration is not there. So again one more criteria is not satisfied. Finally similar business cycle, which means if one country is booming the other countries also have to be booming. Only then the monetary policy can adjust. The monetary policy essentially means that that we are trying to control the business cycle. If the country is growing very fast we want to use the monetary policy to bring it down a bit. If there is a recession we want to give lose money policy to help it come up again. But if two countries, the same euro zone, which is having only one monetary policy, say Greece is going down, the rest of Europe is going up, or Germany is going up, then what monetary policy can be used? We don’t have a single monetary policy to use anymore. So that problem is there right now. Germany is going a bit like this, Greece is going a bit like this. So again not satisfied. Only moderate levels is there. Lot of the big countries go in the same path but some of the weaker economies are going in different paths in terms of business cycles and that is again causing a problem. So as we can see most of the optimum currency requirements are not being met here. That means euro zone is not an optimum currency region. So economically based on this is a model by Mundell which is a very famous model, it’s a accepted model. This model states very clearly that euro zone is not an optimum currency region. In fact, if you examine each country in euro, you will also find that lot of countries itself are not optimum currency regions. But our idea was that by integrating we can create an optimum currency region. For that we have to, some of the checkmarks here has to be converted into tick marks. Only then we can have that. And that we will see going forward how that can be done. Optimum currency region is by Mundell. So as we can see a lot of economists have very openly stated that Europe is not an optimum currency region. It is have separate nations speaking different languages, with different customs, having citizens feeling far greater loyalty, nationalism is still strong in Europe. Which means that common market is not probably a good idea or probably is not implemented well. Whereas Matt O’Brien says it’s a doomsday device for turning every recession into a depression. Because a recession will cause one country to go down, monetary policy is not helping them escape from that decision becomes a depression. Which is exactly what is happening with Greece. The Greek current crisis is worse than the 1930’s depression of the United States. That is how bad it is for that country right now. And they are blaming it all on the euro zone itself. That’s optimum currency region it is not.
Now why then, if it is not an optimum currency region, economics tells us that Euro zone is a flawed idea. Why then in spite of flaws, why did the euro zone come about? How did the EU, EU originate if not for economics? The answer is because it is a political decision. It was never an economic decision. The idea was to create a European Union for political reasons. It was a very ambitious political project. And why was that done? We will look at the history of EU to understand that. This history will tell us why political decision had to be taken which is, even if it’s economically flawed was, worth taking at that point in time. So we are going to look at the history of EU now. To understand that let’s look at how countries work in the world. How economies interact with each other. In the 20th century, and in the 19th century, majority of the countries in the world are closed economies which means they were not open to trade with each other. They were enclosed in their own small island universes and they used to live there. Now that means all trade was discouraged by all countries. This was a problem. Why is this a problem? Because an economy grows based on market demand. So if a total production of a country is absorbed by the market demand, the economy can grow. If the market demand increases, the production can increase. So that is how a country can grow. When the market increases the production grows. But the problem here is that, especially after industrial revolution, some countries in the world started having very high productions. Now there demand could not keep up with the production. In fact there is a limit to how much people can consume. So the demand could not keep up with the huge industrial production capacity, mass production capacity. This meant that they had to look for new markets, which was the only way to keep growing. And capitalism wants the country to grow faster and faster, which means new markets had to be had. So the one solution that the countries in euro specifically in the West, especially Britain etc. came up with how to get new markets. So what they will do is they will take new markets and keep their own ones closed. This philosophy was called mercantilism. So mercantilism, mercantilist philosophy is nothing but a quest for new markets that will help the industries in your country grow while keeping your economy closed to others so that their economies cannot grow. So whoever grows faster will become the dominating power in the world. That is the mercantilist philosophy. So according to this philosophy the countries in Europe started attacking each other. France and Germany, England and France, England and Germany etc. are now competing with each other to conquer each other so that they can have access to new markets. England going different places, Spain going here. This process was going on in which countries are trying to conquer each other. Why? To get new markets. The quest for new markets, which is the only reason for having new markets is to drive growth. But after some time what happens, some of these countries are equally strong. Spain and France cannot fight, cannot fight, cannot fight, they cannot fight. What is happening is that these countries, if they fight with each other, too much damage, the whole economy was collapsing there. So they decided that instead of conquering each other let us look out towards into the world. Let’s look out towards, are there other fitu, other places that we can conquer. So they started moving into the rest of the world. They started going to South America, went to North America, went to Africa, going around Africa to India, going to the Australia’s, going to the Indonesian islands Archipelago, rest of Asia, going to China etc., right? All these areas are new markets, so new demand. Which means more production here, which means growth here. So this production and growth is being driven by the demand in the market in these areas. So what is happening? Colonization is happening. India got colonized, rest of Asia got colonized, Africa, the race for Africa, the race for India, the race America. Eventually what happened? All these areas became fully colonized. All our colonized. What is the next step? There is a limit to this strategy as well. Once the whole world is colonized then how do you still grow? And especially if some countries like Germany, who is newly entering this competition, does not have enough colonies? And they want to grow as well, so they are saying we want to conquer colonies from others. So now, again fight starts breaking out. This time fight is not inside Europe, it is across the world fight is breaking out. Germany wants Africa, Britain also wants Africa, so a fight happens there. Britain wants part of India, France also wants a part of India, so a fight happens there. So these fights are breaking out in which countries are trying to acquire each other’s colonies. Russia is also involved by this time. So this game had only one outcome, of world war. That is the only way this would culminate and that’s exactly we ha…, what we got, World War I and World War II. So this process of fighting for new market, the mercantilist philosophy in which growth is being driven by other countries acquiring the market had led to a very, very bad situation. We had two world wars. And then finally Europe realized that this is not the answer. This is causing a, we are looking for a win – lose solution, which I win and you lose. Because I get the market and you don’t, I grow and you don’t. The win – lose situation eventually leads to fights, eventually leads to wars and once a war happens, of win – lose situation becomes a lose – lose situation, and Europe was devastated after the World Wars II. The entire country was ruined. So they now had to look for in, including US, had to look now for a win – win solution. So we will not look to conquer markets anymore, we will look to open up the markets. So the entire world, without conquering. The only way earlier, if France had access to India was by conquering India. But now with an open economy system we will open up the market so that France, Germany and Britain and US or India or anybody can have access to any market because all markets are open. So now the whole world becomes a potential market and competition can happen on the basis of the quality of production, not on the quality of your military might. And that kind of a situation was, is what led to globalization. Now the world was moving towards globalization but Europe was really devastated right. After the World War II, they wanted to move even faster. They wanted to integrate at least Europe first. The world also should get integrated, but the Europe should be the first thing because Europe does not want any more wars. No more wars are allowed. So they started that with something called the Schuman Declaration. This is the first step towards a moment to EU. In this first step, Schuman argued that the only way to ensure peace in Europe, which has been torn apart so much, was to bind Europe. The word is to bind Europe. Make it impossible for a war to happen. This is done by pooling coal and steel production. Which means that destinies of these regions have been completely intermixed. Now let’s imagine a situation in which Germany and France, together make coal and steel. Now they cannot fight with each other because the coal and steel production depends on each other. If Germany declares a war on France, Germany will not have coal or steel. Without coal and steel you cannot have a war. So just by tying up the coal and steel production between the two countries you are ensuring that these countries cannot fight against each other anymore. So it was a good checks and balance approach which was being developed here, which was eventually go supposed to move towards a closer and closer union and become integrated as a European Union. So European Union went to multiple stages. So first is a European coal and steel union, 1951, which is coal and steel, which is a primary ingredients of war. So effectively we are cancelling out war. The next one was European Economic Community. Here the six members come together and sign a treaty saying that we are going to be a single economic community. We are going to allow trade to happen between us without wars. We are going to trade with each other without wars. That’s what we are going to do. That is the European Economic Community. Along with this there was also an atomic treaty signed. Which has affectedly means that all these countries are going to be partners in production of ato.. atomic energy also, as well as make bombs also which is same as European coal and steel process. The game war becomes impossible because they are again tied to each other. So the idea is to make them so interdependent that they cannot fight anymore. Because if you fight with them, you also lose. So you make war a lose–lose proposition so badly that you cannot fight anymore. It is better to indulge in trade which is a win-win proposition. 1981, Greece joins, which is an important thing, i-item for our agenda discussion today. In 1985, the Schengen Agreement was signed. The Schengen visa is famous. What it means is that once you have single visa you can travel across Europe. Similar way, Schengen agreement means that all borders are now open, which means the people who are part of the European community can travel across Europe without requiring a passport or any kind of authorization. If you are a European citizen you can travel anywhere in Europe, part of the European Union. That is Schengen agreement. An important requirement for having a open single currency regime. Then comes a Single European Act which makes it a common market. Which means goods and services can transact without any customs, customs duty. No tax will be imposed on a countries’ goods just because it’s sta… traveling across the border. So this is the Single European Act. And finally in 1993 comes the Maastricht Treaty, which formally created a single European Union which is also called European Community. This involves four freedoms. Movement of goods without taxes, movement of services without taxes, movement of people without any passport requirement and movement of money again without any capital controls. These four freedoms together constitute a single market. Finally in 1999 the euro was introduced. We are moving closer and closer to a more perfect union in which a single currency is there. This is a third stage of the European monetary union, economic and monetary union. And 19 states eventually signed and euro becomes a single currency for majority of these states except for Denmark and the UK as we discussed already. And in 1998, the European central bank is established, who is going to take care of the monetary policy from now on. Also the exchange rate policy. So now the monetary policy is now taken away from all these different countries and it’s going to be done by the European central bank. This is why Greece, the country A in our discussion earlier does not have a monetary policy of its own, because it’s going to be handled by ECB which is the representative body. All the countries of EU send representatives to ECB and they together make decisions on the monetary policy and the ERP for entire continent. So this is the timeline of events. As we can see initially European service, steel community, the atomic community, economic community, Schengen rules, being ticked off. Slowly we are moving towards European community and finally 2001, everybody has joined, we have the complete European Union. So this is the timeline of events. You can make a note of this but this is not required to be by hearted or anything.
Now the problem with a monetary union, which the euro zone is supposed to be, is that every country is having separate fiscal policies. Fiscal policies, how they will tax and how they will spend. Which means monetary policy is same but every country is taxing and spending in different ways. And the GDP of a country depends on how you tax and how you spend. Which means the business cycles don’t get aligned properly. One country might be in a growth phase, another might country might be in a slump phase because their fiscal policies are not being done properly. Fiscal policy is a fundamental principle, fundamental requirement for good economic growth. Which means all the countries can’t grow properly because they are having different fiscal policies. This was a big problem. This disparate fiscal policies and Europe Union wanted to address that. So one way to address that is to take away the fiscal policy of the country as well. Monetary policy has been taken away, fiscal policy can be also taken away. So every country’s taxation and spending will be decided by the European Union itself. But that is a compromise of sovereignty which no country wants to have. So that is not possible. It was too early to do that. So that is postponed to a later stage. Instead they thought we will have membership criteria to make sure that the countries who join the European Union are some fiscally, financially, fiscally. So that there will not be too much disparity between them. They will only get those people into our rich club who are at the same wealth as us. That way, it was hoped, that fiscal policy disparity will not cause problems for the countries. The membership criteria was summarized in the Stability and Growth Pact. The idea is, we sh.. we’ll grow in a stable prosperous way, not go in different directions. How to do that? Based on criteria. So we put a maximum limit on government deficit and debt. So that nobody takes too much debt and starts going into crisis situations. And there was a surveillance arm which will look at all the budgetary policies, look at all the decisions and will try to prevent that. Try to impose some recommendations on the countries, saying that you’re borrowing too much, you are spending too much etc. And there was a dissuasive arm which is in case of excessive deficit is there, there can be a report submitted saying that this country is not following the European membership criteria. Right? If you are coming to this club sometimes you have a dress code, and there is a certain requirements, you have to carry a card, you have to have certain amount of income. Same way European Union membership required certain conditions and if you don’t meet these conditions, a sanctions can be imposed. The word ‘sanctions’ means that I put a limit on trade with your country. Your country is not accepting doing norms, the rest of the countries will not trade with you. That means you are going to have problems. So no country wants to do that. Hope was that they will all adhere to the criteria. This is also called the euro convergence criteria.
So let’s look at the criteria in detail. The first criteria is that you’ve to maintain low inflation. First criteria. Second criteria is that you should maintain low deficit. Do not spend more than you borrow. Keep it at 3% of your GDP. So the government deficit should not become too high. It should be 3%. The government debt to GDP ratio must exceed 60% which if you remember is 170% now. So it has become much, much higher than what is allowed. And if it sh.. does, the cur.. the ratio should be corrected fast. But how? Not sure. Exchange rate should be maintained with stable levels, without severe tensions, another criteria required. And long-term interest rate should be at, for the government bonds, the interest rate on the bonds should also be a certain criteria specified. Okay. These are the conditions required to be part of the European Union and it was supposed to be maintained while you’re becoming a, while you are being a part. It’s a membership criteria. There was certain follies here. The biggest follies is this 60% number. By specifying the 60% you’re essentially telling all countries, please borrow till hits 60%. So all countries have an incentive to borrow till 60% because of the minimum criteria, right. So when you are saying, suppose you say, do not do more than 3 crimes that means it becomes an incentive to do at least 3 crimes. Similarly 60% becomes an incentive. So the movement started being towards 60%. And then the even bigger folly was that there was no strict measure to implement in case the country becomes more than 60%. Then what do we do? It was not really clear. There could be some kind of trade embargo etc. but it was not enough. Lot of countries started shooting beyond the 60% mark. So penalties were not strict. Stability and Growth Pact (SGP) does not specify proper penalty measures. So this became a problem for the union. And this is one of the fundamental reasons why going forward we will see debt kept on accumulating. So countries like PIIGS – Portugal, Italy, Ireland, Greece and Spain, these countries started accumulating debt because there was no penalty measures to stop them from doing so in the first place. So as we can see Greece debt is going up, Italy debt going up, Portugal going up, Ireland debt up, Spain, Cyprus has already been bailed out once, again going up, Spain going up. Whereas countries like France, Britain, European Union in general and Germany are all stable. So some of the problem economies, the weaker economies are using the opportunity of a fresh brand new credit card to borrow more and not repay any debt whereas the stable economies are keeping it stable. They are maintaining their SGP requirements, whereas they are not. But they are not being punished in any way. Or there was no help from these to them to help them bring them back in a proper direction. That also was not there. Which was a big problem with the European Union, or the Euro Zone.
Now we are going to look at Greece. We are going to zoom in only on Greece and understand what went wrong with Greece. European Union has certain flaws. It is not a proper optimum currency region and counter that they introduce entrance criteria and membership criteria. But the membership criteria was not properly enforced. The two big problems with the European Union, just to repeat – this is very important, is that one, it is not an optimum currency region. It cannot have a only monetary policy. A fiscal policy was required, integration was required. Which was not done because it was not politically feasible at that point. Instead they look for membership criteria but the membership criteria were not strictly enforced. So there was a problem with lot of these countries going in different directions. To understand this better, we’re going to zoom only in on Greece and look at what went wrong specifically with Greece. European Union has its own flaws. But what went wrong with Greece. We will understand that now. So Greece. Greece is exposing, highlighting European Union flaws. The flaw of the European Union is made very clear by the high profile case of Greece, which is why this crisis is so important. Because it helps us understand European Union itself. And perhaps through that, even the whole of globalization as a process. What are the flaws in globalization? What can be done to stop globalization from growing, in the same kind of crisis situation as where Greece has reached right now? All those things can be understood by understanding Greece, understanding European Union and then looking at the world as a whole. So when Greece joined European Union in 2001, why did it join? There was lots of benefits to join European Union. You’re joining a rich club. So people will treat you as if you are also rich. Which means you get a credit card for free. Which has a very low interest rate and very high credit limit. Which means very low interest rate and very low borrowing cost. Which means they can start taking a lot of debt and because inflation is low and people are in general very positive about investments, GDP starts growing. In fact for a long time Greece had one of the highest growth rates in the whole European Union. Only Ireland has higher growth rate. For this many years. 2002-2008 was the golden years for European Union as far as Greece is concerned. They could keep on growing very, very fast. So if you see this is a Greek bond yields. After they joined you can see it is dipping. It was high earlier but the moment they started joining the bond yield has become very, very low. Which means easy debt. The yield here means the amount of interest you have to pay on the bond, which mean if you are taking Rs.100 bond, you only have to pay very low interest rates here. But as, we will see that eventually why it went so high. Why? This is what we are going to see in the rest of the discussion on Greece specifically. After coming so low, around 2008, it’s a, almost a jump. And we know the reason there, because 2008-09 the big economic crisis hits us. And that is why the whole thing goes bad. So even though for a time interest rates are coming down and GDP is going up, there were some problems with Greece. Even before 2008, problems are very, very clearly visible and corrective action should have been taken at that point. It was not taken, neither by Greece, nor by European Union. European Union should have enforced the SGP. The Maastricht criteria should have been enforced. Greece should have been more responsible in its behavior, in its income and expenditure. Right, in its budgetary policies, it should have been more responsible. So fiscal deficit is increasing because of low ra.. interest rate, Greece was taking on too much debt and because people were getting a lot of income, it was having too much current account deficit because imports were increasing very high. Now these two meant a lot of excessive government spending was happening. Government was being very proligatic, acting as if I am in a rich club, I am a rich person, I am going to behave like a rich person. But they were not rich. The income was not good enough. One example is the 2004 Athens Olympics. 6 billion dollars were estimated as a projected expenditure for the Olympics. 15 billion was the actual expenditure spent. The world was aghast. How can they spend so much? When the Sidney Olympics, which was equally well conducted in Australia, was done with 5 billion dollars, why does Greece need 3 times that amount? One of the examples of government profligacy. This is an example of inefficiency. Expenditure is being inefficiently done and that does not help the economy. Tax revenues were always low. People were either evading tax, government was not serious about collecting tax. The tax laws were too complicated. The tax revenues were plummeting which means income is coming down and expenditure is going up. Which is a very bad situation. GDP is increasing but tax revenues are not increasing. Then what is the point? Because government has to get some revenue which is through tax. Lot of tax evasion. A big black economy, a parallel economy is popping up. Unproductive spending and deficit generated, all the time, productive investment is not happening. Spending is going on pensions, salaries, over the top expenses. And a lot of debts were being recycled. Debt was taken, and to repay that debt some more debt was taken. This is called recycling of debt. This is what Greece was doing. All this was going on and they were able to keep on going because the world itself was in a boom phase. 2002-2008, the world was going up. So as long as the economy is going up, people are not too concerned about small issues. They let it pass. This is some of the causes of trouble. A lot of red tape, a lot of corruption, aging population, rising health and pension cost, no financial discipline by government. Spending like anything. And worsening external debt situation. As you can see, across Euro Zone this was happening and then comes 2009. The sub-prime crisis. This becomes the tipping point. The sub-prime crisis happened in the US because the US banks were lending again to people who were not capable of having that kind of debt. At some point they could not repay that debt. So the crisis developed there. We are not going into details there but again a similar kind of situation. The sub-prime lenders there were given extra loans because it was estimated that they could repay it. But they could not and it developed into a crisis. Same way Greece was being given loans, even though it could not. Because it is part of a rich club. And that again led to a crisis. Now sub-prime crisis led to a economic crisis, money supply decreased drastically. The economy starts going down. People are more concerned. Risk off behavior starts getting speaked. They now they want to move away from all risk. Greece is risky, move away from it. Portugal is risky, move away from it. And what happens in bonds? When the supply of money dries up, the interest rate increases because it will give more and more interest rate to get some borrowing. So the debt, cost of these countries is going up, debt is going up. On top of that, even though GDP is growing earlier, now the main industries of Greek collapses. The main industries of Greece are what? They are tourism, shipping and some amount of agriculture. Now all these industries depend on a good global economy. When the rest of Europe and US is in a recession, which tourist is going to come and spend money in Greece? Tourism declines. Shipping industry is primarily for trade. Because of the economic crisis, the trade was declining, so shipping industry also suffers. Agriculture again requires foreign markets. Again declines. So the main industries decline. In addition to that, a new government comes into power at that time and that government unfortunately or fortunately declared that the previous government was fudging data. SGP requires regular reporting of debt, GDP to debt ratio, your budgetary policies etc. The previous government was supposed to be fudging that data, cooking the books. So double the amount of debt is there, collected at Greece and they were not reporting that. Which means the criteria, which was supposed to stop bad fiscal policy had completely failed. European Union has completely failed in enforcing the required membership criteria and that was going to cause a problem for the whole European Union. And it’s starting with Greece. So jittery markets try to exit Greek bond market. Now this is a clear failure of policy from both European Union and from Greece. It is not by any one party alone. When recession strikes, and debt becomes more expensive, what happens? You cannot get more debt. At the same time you cannot raise more tax revenues. Because tax and GDP are linked to each other. Only when GDP increases, tax can increase. In a recession GDP is going down. If you start increasing tax at that time, GDP will go down even further. So you cannot do anything there with tax. And recession is there. So you cannot really in cut down on government spending as well because people are getting unemployed. People require more government help. So it is a wrong time to do that. So fiscal policy becomes toothless. This is the word that is used in economics. It becomes toothless. It cannot, it does not have a bite anymore. Because we cannot borrow. The only way government could have spent money, public spending should have actually increased, that was to borrow. But we can’t borrow. Because we are in a debt crisis as well. So in a debt crisis and in a recession when it comes together it becomes a toothless fiscal policy. And in on to top it off Greece does not have a monetary policy. The monetary policy is with the ECB. And the European Union as such is not in a crisis at that time. It is not in a recession. It is going stable and there was no issue of debt problems there. So the monetary policy measures are not taken by ECB. ECB should have gone for a loose money policy which would have increased the amount of money supply in the economy which should have brought down the interest rate and allowed some of these PIIG countries to be able to borrow again. So that they can fund their government expenditure and increase the GDP and get back on track. But they could not do that. So we have a situation where fiscal policy is not there and monetary policy is not there. Why fiscal policy is not there? Because Greece was profligate. They should not have done, got into a situation like that. But once they got into a situation like that which was also allowed by huge lack of enforcement and proper monitoring. Monetary policy is not there which is again a flaw. So these two policies are first of all separated and both are toothless now. Monetary policy because ECB is actually not doing anything. Which means the interest rates and exchange rates cannot respond to the needs of the Greek economy. Without it respond to the needs of the Greek economy, Greek economy could not prosper. So again we are looking at the same chart again. So as you see this is the graph that is being followed. After the 2008 crisis, the yield is going up. Common bond yields are going up. Whereas if you notice here, which is France and Germany, their yields are going down yet which means they are not in a debt crisis. They don’t require anything right now. Their GDP is fine, everything is fine. The monetary policy is actually looking for a growth oriented, inflation containing policy, which means they are not going to be have a loose money policy because they want to contain inflation. Whereas for these countries they would have required a loose money policy but it is not being down. And this is what happens then. Unemployment starts going through the roof. Because GDP is declining, government cannot spend and there is a debt crisis. Which means there is no jobs for people anymore. Production has completely collapsed. The biggest industries are gone -tourism, shipping. So unemployment starts going up. Whereas for these countries it’s stable. So they are not too worried about unemployment because ECB takes care of the whole European Union. It is not looking at only individual economies. Which is again a big flaw. So in the end what has happened is that Greek has hit it a high debt crisis and it’s not able to pay back its loans. Which means it was at the brink of defaulting on a loan. Now the problem with a rich country like Greece defaulting on loans is that, that upsets the markets a lot. The market will start thinking which other country is going to default now. I should start pulling out that as well. So it becomes a self-fulfilling prophecy in which they are worried because of default and they cause the interest rate to go up which increases debt which again increases chance of default. This should not happen.
So European Union decided to step in after the crisis in 2010. And they arranged for a bailout for Greece. The word bailout means I owe somebody some money. I am not able to repay it. So somebody else gives me some money so that I can repay this person. This is a bailout. This bailout was arranged by the Troika. It’s a 3 institutions, that’s why it’s called Troika. The European Commission, European Central Bank, and IMF together put in money so that Greece can repay its debts to different banks and different investors. This was 120 Billion in first round and second round another 130 Billion was sanctioned. But this sanction won’t come for free. Because I am giving somebody money I have to make sure he can repay it. So to be able to for the Greece to repay it and come out of debt crisis, certain austerity conditions were imposed. Austerity means like being like a sanyasi. No luxury nothing. So austerity conditions were imposed. Some of the austerity conditions imposed were reduce government pensions and salaries. Socially was the easiest condition to be imposed. Bring down the government pensions and salaries. This allows reducing in the government expenditure. Reduce expenditure in government services such as public health, such as you know major programs etc. Do some privatization of government assets so that government can generate more income and use that to repay debt. All this is about reducing expenditure and increasing income. That is the fundamentals here. This is because now, an important point to note is that during the first bailout most of the Greek debt was held by French and German banks which is why they were so concerned they came for the bailout. Because the French and German banks hold all the debt so if the Greek does not repay the French and German banks will have a problem there. How are they going to give the money back to the depositors? So if you think about it, it could even be argued that this was not a Greek bailout. It was a bailout of the French and German banks who had given loans without proper thought. And it is now not able to recollect it and they have received a bailout. We can also think like that and there is a lot of argument in that direction as well in economic circles. This bailout was sanctioned by IMF projections. IMF projected that the income is going to keep on increasing. At some point Greek will be able to repay the debt. But this projection was flawed. Greek was not able to climb out of its problems. GDP kept on going down, not up as IMF predicted. And this meant that the first bailout was a failure. Because Greek could not escape from the debt crisis. The income was not increasing. As you can see IMF projection was this, the actual is this. So Greek GDP went down instead of going up which meant they could not repay the debt crisis. Which meant the bailout did not solve anything. The debt crisis was still there at the end of the first two bailouts. Now till 2014 was the limit for the first two bailouts so at the end of 2014 the problem was going to recur again and that’s exactly what happened.
Now we look at the latest developments. What all things that has been happening recently. 25th June, 2015 was supposed to be the next xxxx when the bailout deal was supposed to expire unless Greece agrees to the new austerity conditions. This became a problem. Because after the previous austerity measure a new government came into power. It’s called a Syriza government. Now this is a leftist party. A leftist party which does not want to be part of the European Union anymore. It wants to exit. The rightist party in Greece wants to be a part of European Union. Now they decided that we don’t want to be really part of this anymore. It is better to avoid austerity than to beholden to some other country who is telling us what to do. And the people were getting very, very unrestful, riots were breaking out. So government had a lot of support for this. So this led to a suspension of bailout. So the new government came and told that we are not going to repay. This meant that IMF etc. suspended the payments. Now this payment was suspended, Greek has no real income. It has huge expenditures, huge interest payments going out but no real income coming in. So this meant that Greek banks were not having enough capital with them. This lead to bank runs. People are worried about where, what if the bank is not able to give me back my deposits? This lead to bank runs. A huge crisis was happening. After a big drama on referendum on exiting Euro Zone, and almost default etc. finally the deal has in fact been approved by the Greek government finally. So Greek government initially told we will not do this deal, we will not the austerity measures but after enough negotiations, they have finally agreed to it. This is called prior actions. There are certain austerity conditions they are supposed to meet after which they will do that. We will get more details on this as we move forward to the next few months.
Now the important question is why did Greece eventually agree? Because Greece had no real option. There was no way Greece could actually exit the Euro. Because if Greece had exited the Euro, they would have a very bad situation in which no, they cannot get anymore international debt. They cannot transact in the international economy because imports require foreign exchange and that is the kind of situation which would have been very, very bad for Euro Zone, for your Greece. So Greece was caught in between two demons. One is being part of Euro Zone and tightening austerity even more, reducing luxury even more. In fact not even luxury because basic services are being destroyed. Versus exiting the Euro Zone and having a very bad condition in which there is no hope for any help at all. So Tsipras was the head of the party, had to actually decide to be part of it. So eventually the deal was signed. So Euro Zone still exists and Greece is part of that.
We are going to look at what could have been done, or what should be done to make this fundamentals of the European Union better. Greece has exposed certain very important flaws in the European Union. But as we have seen European Union was a ambitious political project aimed at stopping war in this world and that is a worthy project to pursue. So Greece has exposed certain flaws doesn’t mean we should give up on the European Union. We should use the new knowledge to improve it. We should make it a more perfect union. How to do that? We have seen clearly that monetary policy is not responsive to disparate needs. Different countries have different needs. Monetary policy is not responsive to that. That is a big problem. And the different countries have different needs because fiscal policies xxxx are not coordinated properly within the EMU and is also not monitored and enforced properly. So this is a problem. A proper union which is a fiscal plus monetary union can solve this problem. We will not have disparate policies going on. An example is USA or India etc. which is actually a union of states. Let’s look at an example of USA. In USA, initially when the states came together, the federal government did not have too much power in terms of fiscal matters. It was primarily a common market. That’s what it was. But this led to a lot of problems later on. It led to defaults by some states, it led to war, it led to trying to repossess assets, eventually it led to a civil war itself. After that US decided we want a more perfect union and US decided to move towards a more fiscally integrated, politically integrated single country. And that is what they achieved. So solution for their problem of disparate policies was a fiscal union. Which is exactly what is required for Euro Zone as well. Now the good thing is that this is what is envisioned in the Euro Zone as well going forward. It is not politically feasible yet but these are the stages that Euro Zone is supposed to evolve through according to a EMU reform plan which is supposed to start from 2015 and continue till 2025. They started with economic union as we already saw. The next step was financial union in which the financial market is integrated. The third step is supposed to be a fiscal union in which we are going to ensure taxation and expenditure policies are under certain brackets. Or perhaps even controlled by single entity. That would be a fiscal union. Which is the third next stage, potential stage. After achieving common market, after achieving common currency, the next step would have been common fiscal policy, common taxation, common spending etc. And then if a problem was there in Greece, Germany would have funded that. And finally a political union in which there is democratic accountability. The people in Greece has no say in what happens in Germany. But in a political union, just like people in Kansas have a say in what happens in Washington, people in Greece will have a say on what happens in the capital of Europe, which is Germany for the time being. So that will be a political union. This would could be a potential future and this is where Euro Zone could be going.
Now if we look at this, Germany is so high. Greece is right here. Very small. This is how small the Greek economy is in comparison to the rest of Europe. Then why is the Greek crisis such a big deal? Again Greece, such a small percentage of the European economy. Then why again? Why be so concerned about Greece? Why is it a crisis? Because if we look at the future there are certain problems that can happen. One problem is that risk of contagion. Which is if Greece exits, other, the investors might get worried about Portugal, Spain etc. and there also debt starts increasing and that contagion can spread. And that becomes a domino effect in which one domino falls, next domino falls and everybody falls down. We don’t want that. Europe is worried about that. That is one reason why Greek crisis was a big problem and bailout happened at that time. But important thing is that at that time there was a lot of cross exposure. French banks were exposed to Greece debt etc. but now those problems are sorted out. So it’s no longer a Euro Zone crisis. It is no longer a Euro Zone crisis economically. Politically it still is. Now let’s look at what will happen to Greece in the future? Different scenarios. One is if default happens then what is going to happen? The one option is that default happened, Greece does not have any money anymore. So how does it do transaction? Without money an economy cannot grow. One option is that it can bring back the older currency of Drachma. If it brings back the Drachma it can use the Drachma. It can print its own Drachma and finance its own economy. But Drachma will be highly devalued. So there will be capital fright. All the investors will escape from Greece thinking that I don’t want Drachma, thank you very much. I want Euro itself. Also if you take the Drachma you have to exit the Euro Zone. Because it’s a, not a two way street. If you, if you enter the Euro Zone you cannot come out of it. That is a deal. So if you take a separate currency again you are out of the Euro Zone. You cannot be part of it anymore. So Drachma is a potentially disastrous solution for Greece. And the other option is austerity is adopted. Then what could happen? The worst situation is GDP continues to drop then how can Greece ever repay. Just like IMF projection was supposed to be like this, it can still go like this and then Greece will continue to be in default all its, for, for the foreseeable future. The one source of hope is that Greece might be able to emulate some country like Sweden which was able to austerity measures and still increase GDP. It did that by doing it very, very democratically, making sure that the pain is equally distributed. Rich and the poor are equally affected. In fact the rich is more affected than the poor. That way by maintaining basic services and only cutting down unnecessary expense, it is possible to use austerity to still have growth. So we can hope that Greece goes in that path. But that would require a much more accountable, much less corrupt government. And that is again something that is not easy to achieve. The long-term effects of a Greek exit could mean more exits. Because once it becomes clear that the Euro Zone is a two-way street, in which people can enter and exit, then the investors who were giving such low rate interest loans would be very, very scared of giving such low rate loans. They will stop giving those loans which means that Greece, Portugal, the other PIIGS economy etc. might be the next to exit. The weakest economies might start exiting and each of them might become isolated, just like Greece is going to become. And that could become a political risk. We would be going back to what we originally wanted to avoid. Which is a world in which isolated economies compete with each other for markets. We don’t want that. We want a world in which the markets are open for everybody to compete together equally, without having to use military might. But we might go back to that if exits keep happening and countries kind of exit from the global economy as well, not just from European Union. European Union is an economy. European economy. Greece could exit from that. But if Greece exits from that, it can’t really transact to the rest of the world as well. Which would mean effectively exiting from the globalized system itself. And if more and more countries are doing that we are going back to a dangerous world. And we do not want that. Integrated, interconnected countries do not fight each other and that is the kind of world we want. And that would require European Union to reform itself by imposing stricter measurement criteria, stricter enforcement criteria and getting people with country’s fiscal policies on track and eventually moving towards a fiscal union in which debts will be shall be forgiven and it won’t be a debt anymore. It will be a transfer payment to that country which is requiring it. Because it will be a single political union. That is the future.
Now what are the implications for India? One is, Europe is one of the biggest export markets. Close to 129 Billion dollars is our merchandise engagement with Euro Zone. Which means that if Euro Zone goes into economic crisis our exports might become very, very unsteady. Which would be a bad situation because our export market is already unsteady, rupee is unsteady. So this could be a problem for India and exports might crash to that zone. Similarly capital movement might happen. A lot of Euro Zone money is there in India because of having a loose money policy there. Because of that a lot of this money, the investors might become, have a risk off behavior and the money might exiting the Indian economy, which will again put pressure on the rupee and the rupee value might decline. Which means effectively the rupee will become less expensive relative to dollar. Which means a rupee could go from 60 to 70 to 80 etc. That kind of situation can happen. This will also mean less investment in the Indian economy. So again a bad problem for India. But luckily we have enough of reserve, foreign exchange reserve as a buffer. We have 300 plus billion dollars as a reserve so even in case this problems happen or our export reducing, and capital movement going out we will be able to hold the rupee steady. Our chief economic advisor is saying that we will be able to hold it steady and so it is not as big a problem for India as it could have been.
Now a few outrageous hopes for the future of EU. One is that, we are still looking at the future. One is that, Greece was able to apply austerity measures and still grow and eventually able to repay its debt and come out of crisis. Very difficult situation but if they sought out their structural problems, sort out their corruption, sort out their profligate spending, and use it for constructive measures, then they can do that. That is one. Payback. Greece is able to payback. The second is that Greece is not able to payback. Greece is still in debt, right. But eventually the European Union becomes a single fiscal union, a single political union and Greece is not having to pay back the debt anymore. Greece becomes part of European Union and Greece became only a lesson to be learned, not someone to be taught a lesson. Greece taught European Union a lesson and European Union learns that lesson and becomes a fiscal union, instead of pushing Greece away just because it exposed some flaws. That would be a good solution, but is many, many years down the line. Perhaps decades down the line. Now just to illustrate this, imagine what would have happened if Bihar was having the same problem as Greece? If Bihar was a proctate and wanted some money it would ask the government of India and the government of India would borrow that money and give it to Bihar. Bihar does not have to give the money back to India. Bihar only has to prove to India that we are using the money well. There is no debt obligation there. Same for Mississippi or Kentucky in US. US government will give the money required. Now how is the Indian government able to raise that debt money? Indian government is able to raise that debt money because it is a big economy, it is a strong economy so the investors are confident in India. So investors are willing to give to the country. Investors would not have given to Bihar, but it will give to India. And India can use that to give to Bihar. And make sure that Bihar is on track and use the income from the rest of the rich country to repay the debtors so there is no debt crisis. Bihar would never fall into a debt crisis. At the same time Bihar could never have a situation in which it goes and spend profligately, spends on all kinds of expenditure etc. because the government of India will keep a track on that. That is what I mean when I say a fiscal union is required. Monetary union is there. If there is a problem in acquiring crisis, government of India can use the monetary policy to bring down interest rates and solve that problem. Mone.. Government of India can continue to get the debt it wants and use that debt to finance the growth of Bihar. At some point Bihar will also reach that stage and then both can grow at the same time. This is because union of India is a fiscal and a monetary union. Same for United States. Europe, the only way to solve this kind of problems would be to go towards a more perfect union and that is the future. That is a future because that is essential as a demonstration that globalization can work. Because globalization is a more perfect union for the world. Eventually we might have a situation in which rich countries and poor countries, disparity is not there. Because the rich countries can sponsor the poor countries and bring them up to a same level. Just like what we are envisioning for Greece. This is why Euro Zone crisis is so important. This is why it is in fact a crisis. In fact a crisis even though it is not an economic crisis because the political aim wants to reach that perfect union and Greece is showing up certain flaws of enforcement, of monitoring, and lack of speed in progress towards achieving that. These things, the hope is that this Greek crisis would become the spur for the rest of Europe to understand that we are to move faster towards union, not move away from union. So instead of European Union breaking apart because of Greece, we should hope that Greece becomes an incentive, an impetus for European Union to become even stronger. And then with that as a model we could have an Asian union, we could have a Eurasian union, we could have a American and Asian union. And eventually we could have a world union, in which it’s a single fiscal and political entity. It’s the potential for the future and Euro Zone is that dream. It should not collapse because of one mistake. We should hope that this happens.
Now with that we conclude our discussion. We are going to look at a few potential questions that can help us understand the crisis better. I would encourage you to add more questions. Your answers etc. in the comments stream so we can discuss it further or you can discuss it amongst yourself.
Static type of questions. Two potential questions I have listed here, just to give you a sample of what kind of questions can come. You can frame your own questions. I advise you to frame as many questions as possible because that will help you understand even better.
What is the phenomenon known as a Bank Run? What is Bank Run? A Bank Run is a situation in which the depositors lose faith in the bank that it can pay back its deposits, so all depositors go and start taking back their money and the bank does not have money to give money to all depositors because lot of the money has gone as loans and the bank starts collapsing. Because everybody is taking back their money. That is what a Bank Run is. What are the causative factors that might trigger such an event? A lack of confidence in the banks. So it’s very important to have a robust banking system. We will have to construct a proper answer. We are not going to do it here. As I told you are welcome to do it in the comments in an essay type answer.
Static Analytical question. What is the principle behind the European Union? Here you will have to go back to the historical underpinnings. Also discuss the optimum currency region and discuss how small, small countries in European Union and not optimum currency regions so we can help them better by making them part of a bigger union and politically and economically the European Union could help the whole area prosper. Trade prospers which actually happened for a while. We should also mention some problems which were there in European Union and then discuss the effects on world economy. Which is that European Union, the fact that it was a success also helped propel globalization, the Washington consensus etc. So again I would invite you to answer in the comment section.
Dynamic types of questions. What is a Sovereign Debt Crisis? Critically examine the Greek crisis which is exactly what we have done in now, in our current discussion.
Dynamic Analytical question. Is cutting spending during a recession a sound financial policy to adopt? The current bailout is still based on austerity measure which is asking Greece to cut spending while it is in a recession. Is that a logical, a useful question to ask of Greece? Shouldn’t Greece be told, I will reduce, have a loose money policy for you so that you can increase spending but on the right things, or expenditure switching at least. Can something be done about that? That is what this question is asking. Should the EU explore alternate policies? Instead of asking austerity measures all the time which has already been demonstrated as not working. Should there be alternate measures? And how can Greece overcome its economic difficulties in the long run? Here we will have to talk about corruption, increasing efficiency, making sure expenditure happens in the right areas and making sure that European Union exercises better controls.
So these are some of the potential questions that can come. So exercise your mind in framing more questions and answering them. Thank you very much for joining us. This was the Euro Zone and the Greek Crisis. Hope you understood it well and hope it will be a relevant question in the exam as well. Thank you very much.