The planners of a European monetary union would be well advised to study the reasons the pre-World War I gold standard was a successful monetary regime.
--Anna J. Schwartz (1993)
The entry of Greece into the eurozone in 2001 was widely expected to mark a transformation in the country's economic destiny. During the decade of the 1980s, and for much of the 1990s, the economy had been saddled with double-digit inflation rates, double-digit fiscal deficits (as a percentage of GDP), large current-account imbalances, very low growth rates, and a series of exchange rate crises. Adoption of the euro--the value of which was underpinned by the monetary policy of the European Central Bank (ECB)--was expected to produce a low-inflation environment, contributing to lower nominal interest rates and longer economic horizons, thereby encouraging private investment and economic growth. The elimination of nominal exchange-rate fluctuations among the former currencies of members of the eurozone was expected to reduce exchange rate uncertainty and risk premia, lowering the costs of servicing the public sector debt, facilitating fiscal adjustment, and freeing resources for other uses.
And that is precisely what happened--at least for a while. In the years immediately prior to and immediately after Greece's entry into the eurozone, nominal and real interest rates came down sharply, contributing to high real growth rates. From 2001 through 2008, real GDP rose by an average rate of 3.9 percent per year--the second-highest growth rate (after that of Ireland) in the eurozone. Inflation, which averaged almost 10 percent in the decade prior to eurozone entry, averaged only 3.4 percent over the period 2001-08. Then, beginning in 2009, everything changed as Greece became the center of a major financial crisis. Interest rates on long-term government debt soared from the low single digits prior to the crisis to a peak of 42 percent in early 2012; the country had to resort to two successive adjustment programs (in May 2010 and March 2012) with official international lenders; and the Greek government restructured its debt. Between the end of 2008 and mid-2012, the economy contracted by a cumulative 20 percent (and it continues to contract), and the unemployment rate jumped from less than 8 percent to about 25 percent. Like Odysseus's return trip home from the Trojan War, the road to Ithaca led to a Tartarean hell.
What happened? And why did it happen? To answer these questions, we begin by describing the origins of the Greek financial crisis, highlighting the crucial role of growing fiscal and external imbalances. Next, we identify what we believe was a key factor that abetted those imbalances--namely, the absence of an automatic eurozone adjustment mechanism to reduce members' external imbalances. To illustrate our argument, we compare the adjustment mechanism in the eurozone with the adjustment mechanism for the participants of the classical gold-standard regime of the late 19th and early 20th centuries. Are there major differences between the working of the gold-standard adjustment mechanism and that of the eurozone? What are the lessons that can be drawn from a comparison between the gold standard and the eurozone? We address these questions in what follows.
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The Years of Living Dangerously
As mentioned, Greek interest rates came down sharply in the years immediately prior to, and immediately after, the country's entry into the eurozone. Figure 1 shows the monthly interest-rate spread between 10-year Greek and German government bonds for the period 1998-2012. (1) The spread fell steadily, from over 600 basis points in early 1998 to about 100 basis points one year prior to Greece's eurozone entry. By the time Greece entered the eurozone in 2001, the spread had fallen to around 50 basis points; it continued to narrow subsequently, declining to between 10 and 30 basis points from late "2002 until the end of 2007. During the latter period, the absolute levels of nominal interest rates on the 10-year Greek instrument fluctuated in a range of 3.5-4.5 percent, compared with a range of 5.0-6.5 percent in the year prior to eurozone entry.
Although entry to the eurozone contributed to a period of low interest rates and rapid real growth, deep-seated problems in the Greek economy remained unaddressed, reflecting a procyclical fiscal policy; as a result, the country continued to run large fiscal and external deficits. Figures 2 and 3 show data on fiscal deficits and government debt as a percentage of GDP. Several features stand out with regard to the period 2001-09. First, fiscal deficits consistently exceeded the Stability and Growth Pact's limit of 3 percent of GDP during the entire period, rising to 9.8 percent of GDP in 2008 and 15.6 percent of GDP in 2009. (2) Second, the widening of the deficits was mainly expenditure-driven; between 2005 and 2009 the share of government spending in GDP rose by 9 percentage points (to 54 percent), with the bulk of the rise occurring between 2006 and 2009, a period that featured a government run by a conservative party. Third, beginning in 2007, the deficits underpinned an unsustainable increase in the government debt-to-GDP ratio, culminating in the crisis that erupted in late 2009.
The large and widening fiscal deficits contributed to growing current account deficits. There are two main series on the Greek current account. One is compiled by the Bank of Greece, based on information on international transactions reported by commercial banks. The other, used in the national accounts and by the European Union, is derived from customs information, (3) Both series are plotted in Figure 4. Both show that the deficit was large (in relation to GDP) upon Greece's entry in the eurozone, and grew even larger in the following years. The Bank of Greece data show that the current account deficit rose from about 7 percent of GDP in 2001 to almost 15 percent in 2008, before declining to about 14 percent in 2009. The national account series shows the current account deficit rising from 11.5 percent of GDP in 2001 to almost 18 percent in 2008, before declining to about 15 percent in 2009.
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Figure 5 compares the current account positions of Greece, Germany (the center country of the eurozone), and the eurozone as a whole, based on national accounts data to ensure consistency. The reason that we compare Greece with Germany will become clear later when we discuss the adjustment mechanism in the eurozone. Two points are important to mention. First, during the period 2001-09 the current account of the eurozone as a whole was roughly in balance. Second, the current account of Germany went from essentially a balanced position in 2001 to a surplus of around 6 percent of GDP in 2008, a swing of some 6 percentage points, almost the same percentage as the increase in Greece's current account deficit during the same period. (4)
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Figures 6 and 7 show the relative contributions of the public and private sectors, respectively, to the evolution of the current account balances of Greece, Germany, and the eurozone as a whole. Again, several points stand out. In the case of Greece, the widening of the current account deficit was caused entirely by the behavior of the public sector; (5) net public saving (relative to GDP) fell from around minus four percent in 2001, to minus 15 percent of GDP in 2009. During the same period, net private saving (relative to GDP) in Greece rose, from about minus 7 percent to around minus 1 percent of GDP. For Germany and the eurozone as a whole net public saving increased from 2001 through 2007, before declining in 2008; net private saving rose in both Germany and the eurozone as a whole.
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The global financial crisis that erupted in August 2007, following the collapse of the U.S. subprime mortgage market, initially had little impact on Greek financial markets. Spreads on the 10-year instrument, which were in a range of 20-30 basis points during January-July of 2007, remained in the vicinity of 30 basis points for the remainder of 2007 and the first few months of 2008 (Figure 1). With the collapse (and sale) of Bear Stearns in March 2008, spreads widened to about 60 basis points, where they remained until the collapse of Lehman Brothers in September of 2008. The latter event brought spreads up to around 250 basis points during the first few months of 2009, but they gradually came back down to about 120 basis points in August and September of 2009.
Then came a double shock in the autumn of 2009. Two developments combined to disrupt the relative tranquility of Greek financial markets. First, in October the newly elected Greek government announced that the 2009 fiscal deficit would be 12.7 percent of GDP, more than double the previous government's projection of 6.0 percent. In turn, the 12.7 percent figure would undergo further upward revisions, so that the outcome was a deficit of 15.6 percent of GDP. Second, in November 2009 DubaiWorld, the conglomerate owned by the government of the Gulf emirate, asked creditors for a six-month debt moratorium. That news rattled financial markets around the world and led to a sharp increase in risk aversion. In light of the rapid worsening of the fiscal situation in Greece, financial markets mad rating agencies turned their attention to the sustainability of Greece's fiscal and external imbalances. The previously held notion that membership of the eurozone would provide an impenetrable barrier against risk was destroyed. It became clear that, while such membership provides protection against exchange-rate risk, it cannot provide protection against credit risk.
The two shocks set off a sharp and prolonged rise in spreads, which continued into early 2012. As shown in Figure 1, the spread on the 10-year sovereign widened from about 130 basis points in October 2009, to...