High interest rate premia on Greek public debt reflect two things, according to research by Roberto De Santis and colleagues to be presented at the Royal Economic Society''s 2015 annual conference. First, the fact that fiscal adjustment in Greece has historically taken place at a higher deficit threshold compared with the rest of the Eurozone''s periphery. And second, the urgent need for Greece to proceed with structural reforms to strengthen its growth prospects and therefore tackle its fiscal position.
The new study compares budget deficits before and during the crisis in four peripheral euro area countries – Greece, Ireland, Portugal and Spain, which together account for 17% of the Eurozone''s GDP. Among the findings:
• On average, the Greek government initiated budget cuts when its deficit reached 4.9% of its GDP, compared with 5.1% for Ireland, 3.22% for Portugal and 3.12% for Spain. According to the European Union treaty, member states are expected to start adopting budget cuts once their deficits exceed 3% of GDP.
• Just prior to the crisis when the Eurozone was doing well, the Greek government only initiated budget cuts when its deficit reached 5.32% of GDP compared with 4.08% for Portugal, while Ireland and Spain were cutting government spending despite a budget surplus.
• Greece, Ireland and Portugal did not raise taxes sufficiently when their economies were doing well. Therefore, during recessions, budget cuts and low economic growth further reduced their tax revenues.
• Greece faces high interest rates from international lenders because of its poor record on responding to budget deficits in a timely manner, and controlling government bureaucracy, which affects public services and growth initiatives.
The authors propose:
''Greek policy-makers could commit to a ''dual mandate'' of debt repayment in terms of GDP growth and governance improvement as follows:
If Greece records positive GDP growth but no improvement based on government effectiveness, then the cost of servicing the Greek debt should be higher compared with the case where Greece records both positive growth and an improvement in the index.
''This commitment will provide a strong signal that Greece ''means business'' and therefore address some of the concerns of its lenders.''
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The recent financial crisis has exposed fundamental weaknesses in Europe''s economic and monetary union (EMU), leading to extraordinary measures to provide financial support to four peripheral euro area countries – Greece, Ireland, Portugal and Spain. As these economies, taken together, account for around 17% of Eurozone GDP, concerns over the sustainability of their policies have the potential to destabilise the whole euro area and challenge the credibility of the common monetary policy.
The authors analyse the sustainability of fiscal policy in the euro-periphery countries by estimating budgetary disequilibria thresholds above which fiscal adjustment occurs. Their endogenously estimated thresholds often exceed the 3% deficit threshold considered by the European Growth and Stability Pact (ESGP).
In fact, it is shown that the fiscal adjustment to budgetary disequilibria that takes place in ''good'' times is remarkably different from the adjustment during ''bad'' times. The authors find that the threshold estimate for the budget deficit that leads to different fiscal correction regimes is on average 4.90% for Greece, 5.10% for Ireland, 3.22% for Portugal and 3.12% for Spain.
But over the pre-crisis EMU period, such thresholds were on average equal to 5.32% for Greece and 4.08% for Portugal, while Ireland and Spain even made adjustments when the budget balance was in surplus. Noticeably, the thresholds for Greece and Portugal are rather high compared with the ESGP criteria.
The results also suggest that during a financial crisis, the deficit threshold is relaxed for Ireland and Spain, while it is reduced for Portugal. By relaxing the deficit threshold (in an attempt to stave off deep recessionary pressures), Ireland and Spain rely on business cycle improvements to push up tax revenues.
Looking at the effects of the economic cycle, the authors find that fiscal policy authorities in Greece, Ireland and Portugal fail in expansionary times to exploit the improvement in economic activity to raise their tax revenues. Consequently, during contractionary times, corrections become more costly as tax adjustment becomes a priority in an attempt to restore fiscal discipline.
The current account of the countries in the sample also fails to satisfy the sustainability condition, and the authors document the presence of non-linearities in its adjustment.
All in all, these estimates raise sustainability concerns mainly for Greece. In fact, the current stand-off between Greece and its international lenders has taken place in an environment of rising interest rate premia only for Greece. High premia, in the view of the authors, reflect two things.
First, history matters. Indeed, the fact that fiscal adjustment in Greece has historically taken place at a higher deficit threshold compared with the rest of the Eurozone''s periphery is priced in by the financial markets.
Second, the urgent need for Greece to proceed with structural reforms to strengthen its growth prospects and therefore tackle its fiscal position. Indeed, the government effectiveness index (compiled by the World Bank), which captures perceptions of the quality of the civil service and the degree of its independence from political pressures, reveals the problem. The index currently ranks Greece at the 66.9th percentile. On the other hand, Ireland, Portugal and Spain are all ranked above the 83rd percentile.
With this in mind, Greek policy-makers could commit to a ''dual mandate'' of debt repayment in terms of GDP growth and governance improvement as follows: if Greece records positive GDP growth but no improvement based on government effectiveness, then the cost of servicing the Greek debt should be higher compared with the case where Greece records both positive growth and an improvement in the index. This commitment will provide a strong signal that Greece ''means business'' and therefore address some of the concerns of its lenders.
''Fiscal Policy Adjustments in the Euro Periphery: New Evidence from Non-Linear Models with State-Varying Thresholds'' by Roberto De Santis (European Central Bank), Gabriella Legrenzi (Keele University, CESifo and Rimini Centre for Economic Analysis) and Costas Milas (Liverpool University and Rimini Centre for Economic Analysis). Please note that the views expressed in this paper are those of the authors and do not necessarily reflect those of the ECB or the Eurosystem.
