The Greek crisis : a comparison with Argentina, assessing the likelihood of a default

Bachelorthesis

The Greek Crisis:

A Comparison with Argentina, Assessing the

Likelihood of a Default

Quirijn Knab, 10014470 Bachelorthesis

Universiteit van Amsterdam Supervisor: Lin Zhao Date: 5 July 2013

Abstract

This thesis is trying to compare the situation between the crisis Argentina experienced in the early 2000s and the crisis Greece is in right now. It is especially considering the option for a debt default, which Argentina exercised. In the thesis the crises in both Argentina and Greece are summarized. Then some existing literature about the subject is reviewed. Finally I have compared both crises and drawn a conclusion on the basis of the results.

The main conclusion from this thesis is that the similarities between both countries are striking. Not only were the conditions leading to the crisis very similar, the situation in the crisis is as troublesome for Greece as it was for Argentina. Therefore it can not easily be said that the situation in Greece will be saved and default here also definitely is an option.

Table of contents

Abstract Page 2

Table of contents Page 3

Introduction Page 4

Chapter 1 The Argentine crisis Page 5

§1.1 Introduction Page 5

§1.2 The crisis in Argentina Page 5 Chapter 2 The crisis in Greece Page 8 §2.1 Introduction Page 8 §2.2 The Greek crisis Page 9 Chapter 3 Reviewing existing literature Page 10

§3.1 Introduction Page 10 §3.2 Stories of the twentieth century Page 10 §3.3 A tale of a bailout Page 14 §3.4 The European sovereign debt crisis Page 15 §3.5 Explaining sovereign spreads Page 16 Chapter 4 Learn from the past Page 18 §4.1 Introduction Page 18 §4.2 Optimal currency area Page 18 §4.3 Overvaluation Page 19 §4.4 Pro-cyclical fiscal policy Page 22 §4.5 Other debt problems Page 24

§4.6 Conclusion Page 24

Conclusion Page 26

Introduction

Since the sub-prime crisis emerged in the US almost the whole world is in the grip of a recession, the result of the credit crisis following the sub-prime crisis. Some countries are affected more than others, but the damage is especially severe in Europe and the US. For now, the situation in the US will be left for others to examine and here the focus will be on Europe. One particular country in Europe to be exact: Greece. Greece is the special case. Of course for countries like Italy the crisis is very serious, but the situation is less dramatic. Greece however, will need unrealistic output growth and a huge reduction in its primary deficit. Even defaulting on half of its debt will not save the country (Feldstein, 2011). What many people in Greece and also elsewhere will ask themselves is: “Why is Greece special?” Is it by chance, bad luck, was there something else in Greece or maybe a combination of these factors that Greece is in such a bad position right now.

Of course Greece has always been the problem child of the Eurozone. Late entry because of not meeting the conditions set with respect to debt sustainability and after entry still running high deficits has always made Greece suspicious for being more vulnerable than others for negative demand shocks. But now ill fate has struck and Greece pays the price for taking excessive risk by running these high deficits. Rescue plans have been set in motion by the EMU and the IMF and the very question is: will Greece survive the crisis or will they default?

Starting in 1998, Argentina experienced a crisis which struck fast, resulting in default in the last week of 2001. The crisis in Argentina is chosen, because it was one of the largest defaults in history. Also both crises are very comparible, because of the size and the time we live in. However, although the default in Argentina is not long ago, there have still been developments, especially in the financial markets and these developments will be taking into account.

The Argentine crisis has been examined thoroughly and experts have found several causes for the default. The main conclusion of these researches: Argentina had bad luck, but the crisis was certainly not unavoidable (Hausmann, 2002). By making bad policy choices like adopting a pro-cyclical fiscal policy Argentina made itself very vulnerable to negative demand shocks, and when these shocks occurred, default was soon unavoidable (Perry, 2003). Also during the crisis chaos ruled in Argentina causing the public sector in and outside Argentina to have little fate in overcoming the crisis, which has a negative impact on the rescue missions set in motion (Hausmann, 2002).

In this thesis the comparison between the default in Argentina and the current crisis in Greece is made, trying to answer the main research question of whether default is unavoidable in Greece as it was in Argentina. I therefore study and review related literature, comparing existing literature and data with each other. The main result from this research is that the similarities

between the situation currently experienced in Greece and the default in Argentina are astonishing and that it seems, but this can not be said with certainty, that a default is unavoidable.

But first, in the next sections, the events leading to default in Argentina are described. After that the events resulting in the current situation in Greece are discussed. Then some relevant literature will be analyzed and discussed. In the chapter following the comparison between Greece and Argentina will be made and a conclusion will be drawn.

Chapter 1.

The Argentine crisis

§1.1 Introduction

In this section the events resulting in a default in Argentina are summarized and described. The focus is on facts, an opinion about the default is given later. Argentina is chosen as the country Greece is going to be compared with, because of several factors. First of all the default in Argentina was the largest in history (Arie, 2002). That makes the crisis in Argentina an example and an

excellent learning case for all other countries. Also, because this default is of such a large scale, it has been extensively researched and examined throughout the years. Therefore, a lot is known about Argentina and it is easier to compare Greece with it. Lastly, the crisis in Argentina was a relative short period ago, and therefore the times are more comparable than if Greece was compared to the Great depression in 1930 for example. However, one of the determinants of the crisis in Greece is the fast development of the financial markets which started in the same period as the Argentine crisis ended. Therefore in this thesis there will also be accounted for these developments which make the situation in Greece different from the situation in Argentina. But this will be done later.

From hindsight it is clear that a lot went wrong in Argentina and the crisis could have been prevented. Although there were a lot of social factors influencing the default as well, here the main focus is on the economics of the crisis and the politics that caused them.

§1.2 The crisis in Argentina

For Argentina it all started with the peg of the peso to the dollar. In the 1980s Argentina had just endured some periods of high (hyper) inflation and instability and was searching for a strong basis to build on a strong and stable growing economy. Under the minister of the economy

Domingo Cavallo Argentina entered a hard peg with the dollar in 1991 stating that from then on one peso will be worth as much as one dollar. The peg helped and Argentina transformed from a closed economy with a lot of government interference to an open economy with a lot of foreign

1991 to 1994 (Feldstein, 2002).

Right before the Argentine crisis there were some other crises which didn't immediately affect Argentina, but caused the Emerging Market Bond Index (EMBI) to rise strongly. The EMBI is an index which tracks total returns for traded external debt instruments (Lexicon, 2010). This strong rise resulted into a fall in foreign investment and capital flows. This was extremely harmful because Argentina had a history of current account deficits and these deficits caused a dependency on international investment. Also because of an open-investment policy most of the big companies in Argentina were owned by foreigners. These three events combined resulted in a higher country risk for Argentina, thus higher borrowing rates (Hausmann, 2002).

Then, in 1998, Argentina's terms of trade worsened because of a fall in the prices of

agricultural product. In addition there was a recession in Brazil, which is one of the most important trading partners for Argentina, causing exports to shrink. In 1999 the Brazilian Real was devaluated resulting in another hit for the Argentine exports, which was reflected by falls in real GDP of 3,4% in 1999, 0,8% in 2000 and 4,4% in 2001. This resulted in a trade weighted exchange rate which was 20% higher than it was 10 years before. Also, the peg to the US dollar did not help either. Because of the strength of the dollar, the exports deteriorated even further (Pilbeam, 2006).

Starting in the late 1998s there was a period of bad politics in Argentina. First there was political distress about a new president which made economic reforms difficult. After that some unfortunate statements made by politicians pushed up the country risk and the economy stagnated. Tax revenues fell and the government decided on a significant tax increase, known as the first

impuestazo from the Spanish word for tax: impuesto. The hope for the tax increase was that it would

significantly reduce the current account deficit and raise public trust in the economy. Some economist then would argue that this would cause country risk to reduce, cut interest rates and aid recovery. Unfortunately the negative effect was that activity was reduced and this outweighted the positive effect of the increase.

During the year 2000 more political instability about the failed plan to change the economic situation arose, making it hard to handle the economic situation. The public sector was pessimistic and the IMF didn't believe that it would get any better as well. Eventually expenses had to be cut, including public sector salaries. This was necessary to keep the deficit in line with the requirements for the IMF program. First of all, this caused the economy to depress even further along with a negative impact on fiscal revenues deteriorating the current account more. This in turn increased concerns about debt sustainability, pushing up country risk and interest rates, reducing investments, feeding back to depressed economic activity: a vicious circle (Hausmann, 2002).

At the end of the year 2000, Argentina's minister of the economy Machinea negotiated a package from the IMF, some Banks and the Spanish government to ensure funding for the next to

two years, known as the blindaje. This appeared to calm the nerves of international investors. But soon after the package was obtained, Machinea resigned, which wasn't boosting trust in the Argentine market. He was replaced by Lopez-Murphy who immediately started cutting in public wages. This was not really popular so soon after he was forced to resign as well. Lopez-Murphy then was replaced by former minister of the economy Cavallo who tried something else, namely pressuring the central bank to relax its banking regulations, introducing subsidies (plan

competividad) and try to gain more flexibility with the exchange rate regime. Also a tax on financial

transactions was introduced, which helped to reduce the deficit and pretty much neutralized the other measures taken.

But the central bank only wanted to cooperate a little with the relaxations, which resulted in the president of the central bank being removed, which in turn increased country risk. Also the introduction of the euro into the currency board basket was greeted with distrust, which was actually just what was demanded for, more flexibility and thus was ironic. This caused the country risk to increase up to 1000 basis points over US treasury bills. A huge debt swap was arranged, the

mega-canje, the largest known in history. Mussa (2002) characterized the debt swap as an act of

desperation. Its result was less debt due in the coming three years but a higher effective interest. The EMBI fell, so perhaps there was a small net gain. This suggests that the whole operation did reduce Argentina's country risk, but the market was disappointed by its terms. The debt swap and the new exchange rate basket with the euro in it were disliked by the public and enhanced the country risk even more. The public thought these measures were weakening Argentina's position with the IMF, but the IMF still offered Argentina help. But still private investors were nervous and the financial system lost bank deposits again: country risk rose up to 1600 basis points (Hausmann, 2002). Guidotti (2001) explained the lack of trust came from the fact that the public not only considered the measures taken not to be very credible, but also that the announcements revealed how bad the situation initially was.

Game theory explains the situations at that moment in Argentina, with an equilibrium ending in all foreign private investors leaving Argentina. This because each private investor was unsure about whether to invest in Argentina or not, and did not know what every other private investor was going to do. But then the announcements for the mentioned measures came and from that private investors could make that no one was going to invest in Argentina (Binmore, 1992). This triggered a run on banks and people began to withdraw their funds. Argentina immediately took action and started to negotiate with the IMF again. After a few stressful weeks there was an agreement on August 21 and the country risk was reduced somewhat to 1400 basis points. The run eventually amounted to up to 8 billion dollar (10 percent of all deposits) and because of the enduring high risk a credit crunch which hit the real economy very hard occurred. The private sector now had

absolutely no access to any money which depressed the fiscal revenues for the government. The IMF was going to require Argentina to restructure its debt, which led to country risk increasing to up to 3000 basis points. Restructuring meant at this point of time just default and domestic investors became nervous. Another bank run occurred and massive demonstrations and riots led to the

downfall of first minister of the economy Cavallo and then to the downfall of the whole De La Rue Government. This marked the official default and devaluation of the currency of Argentina

(Hausmann, 2002). After the default there was an economic recovery in 2004 and 2005 (see figure)(Pilbeam, 2006).

Data from IMF (2013)

Chapter 2.

The crisis in Greece

§2.1 Introduction

As is read in the summary above about Argentina, a lot of factors resulted into one of the biggest defaults in history. Only a decade later, another much bigger crisis is ruling the global economy and some countries are hit harder than others. Among other countries, Greece is affected very severely by the crisis which had its roots in the US. But the main question then is why Greece is hit so much harder and whether this could have been prevented or at least eased. And, that's what this paper is researching, could Greece have known from the earlier default in Argentina that their country was especially vulnerable to things like this and were they taking too much risk. In this

2000 01 02 03 04 05 06 07 08 -15 -10 -5 0 5 10 15 Argentina Development of GDP Percentage change in GDP Year P er c ent age c hange

section a summary of the events resulting in the current situation in Greece is given and from that one can see the first similarities with the crisis in Argentina.

§2.2 The Greek crisis

For Greece it all started with the entrance to the euro. In the year 2000 Greece's entrance to the euro was ensured and prosperous years followed in the period from 2001 to 2008. The economy grew more than the rest of the euro area, inflation stayed low and unemployment rates fell. The only thing to worry about was that the government was still running high deficits, but due to the high growth rate, debt stabilized around 100% debt to GDP. In Europe the average was 70% of GDP. This higher amount of debt was due to bad policies by the governments during the 1980s and 1990s. The current account deteriorated as a result of high deficits, accounting for 17% of GDP in 2007. This is partly because of a loss in competitiveness causing large foreign capital inflows. Competitiveness fell, because of traditionally wages are very inflexible in Greece and did not adjust downwards when was needed. Also Greece is known for its notorious bureaucracy, unnecessary expenditures and tax evasion, but this had never caused any real problems until now, when it appears to be the very weakness of the Greek system, causing the seriousness of the current crisis (Alogoskoufis, 2012).

In the summer of 2007 the sub-prime crisis erupted in America and soon started affecting the economy in the US. Starting with the bankruptcy of Lehman Brothers in 2008, all over the world, including Europe and Greece, credit markets began to crumble, firms began to deleverage and the stability of the banking sectors was questioned. At that point the yield on a 10-year Greek

government bond against the German bund rose from 25 basispoints to 65 basispoints up to August 2008. The crisis affected the whole economy: trade, investment, consumption and unemployment all worsened.

Only because of the crisis the vulnerabilities of the financial system in Europe became visible. Enormous risks were taken by banks and other financial institutions taking up bad loans and buying risky mortgage packages from the U.S. This caused asset bubbles to develop and all over Europe cracks in the system appeared. From September 2008 to March 2009 the yield rose sharply to 285 basispoints due to the global credit crunch. There were also rises in the yield in other EMU countries, but the most important ones were in Ireland and Greece.

From April 2009 to November 2010 the markets somewhat eased and the yield on Greek bonds fell to 121 basispoints. The government announced to overshoot the debt by 6.7% and there were elections in this period. Also the new government submitted the proposed public budget to the European Commission. But it was obvious that the Greek government was struggling, illustrated by their high deficit in 2009 of 15,4% of GDP. The new government claimed that the previous

government was running to high deficits, but they couldn't reduce the expenditures either further deteriorating the fiscal balance. The budget for 2010 presented by the new government seemed surrealistic and the yield began to rise again to 586 basispoints.

On 25 March 2010 the first bailout was launched. The EU and the IMF agreed on two loans for Greece which summed up to 45 billion euro's, 15 billion, by the IMF and the rest by

EU-members and with an interest rate of about 5%, higher than the market rate. Part of the deal was that Greece would do anything they could to make the fiscal situation in their country better, and this would be monitored closely by the European Commission. The plan was called the European Support Mechanism and since then Greece was excluded from international financial markets, protecting them against further speculative attacks resulting from the confidence crisis. However, this agreement did not cause the market to have more faith in the Greek economy and on 23 April 2010, after the budget deficit was adjusted to 13,6% of GDP, Greece asked for official help from the EU and the IMF (Arghyrou, 2010).

Finally, in July 2011, it was clear that the Greek economy would not be back on track anytime soon and the eurozone countries decided on additional loans together with the IMF and the private sector for Greece of 64 billion euro's. Additionally, the interest rates on the loans were lowered and the maturities were extended. Later, in October, the EU pressured private investors to write off 50% of their investments in Greece, because it would have been unrealistic to expect those loans to be returned. In November the Greek prime-minister resigned after he failed to get the support of the people of Greece in a referendum and an internationally respected Greek banker became the new interim prime-minister (Alogoskoufis, 2012).

Chapter 3.

Reviewing existing literature

§3.1 Introduction

In this section four existing articles related to the topic are reviewed. These papers will be discussed and interpreted. Because the Argentine crisis is a long time ago, there is a more general opinion about the ins and outs of this default. That is why it is particularly interesting to investigate more into the events in Greece, and examine what the opinions of other economists are about this crisis. The focus in this chapter is therefore on the crisis in Greece.

§3.2 Stories of the twentieth century

Introduction

Obstfeld (2011) discuss the differences between the current global crisis and the crises experienced in the twentieth century. One of the main statements in this paper is that less developed countries are more vulnerable to crises than developed countries are. Argentina, a less developed emerging market economy (EME), thus has an excuse for their crisis starting in 1998. Greece however is seen as a developed country and thus it is peculiar under the previous statement that they suffer so deeply from the current crisis. This paper tries to understand why Greece as a developed country is hit hard by this crisis and tries to give an explanation for this phenomenon. It does so by comparing 'normal' crises with the crisis we're currently in.

This paper is relevant because it can help explain why Greece is one of the main victims of the eurocrisis, exactly one of the questions this thesis wants to answer. The crisis in Greece proves to have similarities with crises in less developed countries, such as the crisis in Argentina. There are several factors contributing to the fact that EME's are usually more vulnerable to crises than

developed countries, but mostly it is because institutional quality is generally lower than in developed countries (Gourinchas and Obstfeld, 2011).

Weaknesses

Other weaknesses for EME's are that governments in these countries often pursue a pro-cyclical fiscal policy. As can be read in chapter 1 this was also the case in Argentina, but apparently this policy is not unique to EME's. As can be read in chapter 2, the Greece government also pursued a pro-cyclical fiscal policy. In chapter 4 the problems with this policy are discussed thoroughly.

Another weakness not only applicable to EME's like Argentina but also to Greece mentioned by Gourinchas and Obstfeld (2011) is that to avoid inflation which both countries endured,

countries peg their currencies to a bigger currency, the dollar and the euro in this case. A problem often encountered with a peg is that the country pegged to the currency wants to leave the peg, because a devaluation is needed to regain competitiveness (Perry, 2003). But in many cases

countries are trapped, because a high amount of debt is issued in the currency they're pegged to and a devaluation by leaving the peg causes debt to grow immensely resulting in certain default

(Feldstein, 2002). This was the case in Argentina and it is the case in Greece.

Sudden stops in foreign lending is another weakness mentioned by Gourinchas and Obstfeld (2011). Because of financial fragility and weak government policies EME's frequently are faced with suspicious foreign lenders who will in times of need stop lending money to these countries. This will cause problems for EME's to pay back their short term debt and eventually may cause default. As Arghyrou (2010) already explained this was exactly what Greece had to face and is another peculiar similarity between Greece and EME's.

implies that wages and prices can not adjust to the state of the economy. Especially in a recession when a downward adjustment is needed, it seems very hard to implement such an adjustment. Hausmann (2002) and Alogoskoufis (2012) show that in both Argentina but also in Greece wages and prices appear to be rigid causing a higher vulnerability for crises.

And not only EME's seem to have characteristics that make them vulnerable for crises. Also what are accepted to be strong characteristics of developed countries can be weak points in a crisis. Because of rapid growing financial markets in developed countries, balance sheets also grew very fast. When in crisis a rescue is needed, costs are very high when balance sheets are big, whereas in less developed countries balance sheets are smaller and costs will turn out to be lower. Greece also seems to deal with this problem since there too a lot of credit was distributed resulting in high balance sheets (Tradingeconomics, 2013).

Methodology

These results are substantiated by the model Gourinchas and Obstfeld (2011) made. In this model the variables output, domestic credit, the current account, external leverage, the real interest rate, the real exchange rate and international reserves are used. Also included are some fiscal variables. With these variables the probability of a default is modeled. Data of 57 emerging economies and 22 advanced economies is used for the estimations. First results show that both EME's and advanced economies tend to have a significantly higher positive output gap in the period before a banking crisis, although the results for the advanced economies are less significant because of the plain fact that there were less banking crises. In the current crisis this was no exception.

With currency crises however, the output gap tends to be slightly negative for advanced economies and even bigger for EME's. This can be explained by the fact that a banking crisis is often caused by fast growth of the economy combined with a lot of unsustainable credit. A currency crisis however is often preceded by loss of confidence in a country, which is caused by

disappointing growth numbers. A hard peg also plays a crucial role in a currency crisis most of the time. Furthermore the estimates suggest a slower recovery in advanced economies following a banking crisis. In the current crisis this slowdown is even larger than in previous banking crises.

Findings for inflation suggest that inflation is higher before any types of crisis than it is in normal times in EME's. In this crisis however, although it rose slightly in the period from 2003 to 2008, inflation was a lot less than it was in previous crises. In advanced economies inflation in the period prior to a crisis does not differ a lot from normal times. Both fiscal situation and interest rates are surprisingly enough not significant in this model.

To measure internal leverage the ratio of domestic credit to output is taken. As said earlier, in the period preceding a banking crisis this ratio grows fast. External leverage is defined as the

ratio of a country's total assets to its gross liabilities. This means that when leverage is high, a large part of the country's assets are financed by external debt. For external leverage it is interesting to see that in EME's in the recent crisis, in contrast with previous crises and defaults, it was lower than in normal times. For advanced economies however, the external leverage in 2007 was one third higher than it is in normal times.

Also evident for both EME's and advanced economies are the sudden stops in capital moving towards the country prior to a crisis. Currency deprecations are often observed in a crisis but an appreciation is noticed before the crisis. In the current crisis however, movements in

currency are smaller than in previous crises. Lastly, for foreign exchange reserves it can be said that these were low in the period before a crisis (Gourinchas and Obstfeld, 2012).

The results

To estimate the result the following variables are entered into the model: the ratio of public debt to output, the ratio of domestic credit to output, the ratio of the current account balance to output, the real exchange rate and the output gap. The model is estimated over the period 1973 to 2010. Because there were not enough banking crises for advanced economies, the first model for banking crises does not perform well. The model for currency crises on the other hand is

performing. One of the significant variables is the real exchange rate. According to the model, a 7% depreciation is associated with a reduction of 5.5% in the probability of a crisis on a three year basis. Also significant is the level of domestic credit. An increase of domestic credit of 23% of GDP increases the probability of a crisis with 3.1%. The estimates for the current account are that when it improves with 3.9% the crisis probability reduces with 1.8% (Gourinchas and Obstfeld, 2012).

For EME's like Argentina three variables are important: the ratio of domestic credit to output, the real exchange rate and the ratio of official reserves to output. When the credit to GDP ratio increases by 9%, the probability of default increases with 11.5% over the next three years. And when the currency depreciates by 19%, the probability of default falls by 4.3%. Finally, short term debt also has a significant effect on the probability of default. An increase of 5% of GDP of short term debt increases the probability of default with 6.4% on a three year time horizon (Gourinchas and Obstfeld, 2012)

All these results are consistent with the above mentioned theory and therefore provide a valuable insight into what helps determining an economic crisis. Several vulnerabilities are revealed and as can be read in chapter four these vulnerabilities most of the time were not unfamiliar for both Greece and Argentina.

§3.3 A tale of a bailout

In this section the paper “The Political Economy of the Greek Debt Crisis” by Ardagna and Caselli (2012) is discussed. Subtitled “A Tale of Two Bailouts” this paper analyzes the necessity of the two bailouts Greece enjoyed: one in May 2010 and one in July 2011 (Ardagna, 2012). The information about the first bailout is very relevant to this article and will be addressed in this section. One very noticeable item in this paper is the fact that Greece is part of the European Union (EU) and Economic and Monetary Union (EMU). This makes the situation in Greece different from the situation in Argentina, because other parties besides Greece have interests in the situation because of this union.

In their paper about two bailouts Ardagna and Caselli (2012) argue that the first bailout in May 2010 was very understandable. For Greece the bailout was necessary because without one the country would have definitely defaulted on its debt. This, because Greece was excluded from the international financial markets and the government was running deficits larger than 10% of GDP. A default will not only have consequences for Greece but also for the other countries in the EMU. Of course the EMU countries had a lot of money invested in Greece and they will never see it back when there is a default. Germany, for example, has claims for 31 billion dollars in Greece and France even has 57 billion dollars. But for Germany this is only 0.3% of total foreign claims and for France it is only 0.55%, thus this is not even the most important reason why the EMU is very adverse of a Greek default (Ardagne and Caselli, 2012).

A Greek default however, is feared to set in motion a domino effect where other weak countries like Ireland, Portugal and maybe even Spain will be excluded from the international financial market, pushing them into a possible default as well. Not only this is an unwelcome outcome for the countries concerned, but also it is very unfavourable for stronger countries in the EMU, because this will mean that their own financial system will be hit terribly. Not only domestic investments in Greece will be lost, but also investments in the other defaulting countries.

Another party to handle against possible Greek default is the European Central Bank (ECB). The ECB's power depends on the size of the EMU and a default by Greece implies a strong

possibility for Greece to leave the euro. And as discussed above, a Greek default can push other countries into default, causing them to leave the euro as well. This will leave a significantly smaller euro area and a very less powerful ECB (Ardagne and Caselli, 2012).

The noticeable thing here is the fact that Argentina never entered a Monetary Union. Earlier mentioned problems both countries encounter have to do with a hard peg. Both countries have one but only Greece has actually entered an EMU. This means that for Argentina the US, the country Argentina pegged its currency to, has had less interest in the whole situation in Argentina and

therefore the incentive to bail out Argentina was a lot smaller for the US. This may be the lucky charm for Greece, but as the rest of this thesis will tell, the situation is still troubling.

§3.4 The European sovereign debt crisis

Debt

In his paper about the euro crisis Lane (2012) explains his theory about how the sovereign debt crisis in Europe came about. Although the focus in his paper is on the whole euro zone, the focus here will be reduced to only Greece. In Greece there were some factors making the country, along with the rest of the euro zone, vulnerable to crises. The argument starts with the always relatively high debt to GDP level Greece had since 1990. Never below the in the European rules specified 60% and elevated to worrisome levels since 2007, debt has always been a problem for Geece (Lane, 2012). However, since the entry of the euro zone spreads on Greek bonds have always been low and close to the German bonds (Arghyrou, 2010). This is why there were never any real worries; economic growth was good and the financial environment was supporting. This masked the vulnerabilities developing in this period.

Joining the euro area meant for Greece that their banks could raise funds from international sources, instead of borrowing in a currency like the dollar, pound or Deutschmark, which brings along exchange rate risk. This meant easier access to credit in Greece and along with the low interest rates resulting from the entry of the EMU, loans to the private sector rose from 31.8% of GDP in 1998 to 84.4% of GDP in 2007, most of it for consumption or property.

Related to this were the persistent current account deficits Greece was running since 1993. Only getting bigger, by the end of 2007 the current account deficit accounted for 11.1% of GDP. Striking to see is that the overall EMU current account deficit always was close to zero, implying that other countries like Germany were running large surpluses (Lane, 2012). This will result in differences between weak countries like Greece and stronger countries like Germany only getting bigger, making it more difficult for the EMU to pursue one policy. Running these deficits also brings other risks along. One risk in particular is that there will occur a sudden stop in capital flows towards the country, meaning that the deficits will have to be reversed into surpluses quickly, which proves to be very costly (Freund, 2007).

When comparing to Argentina there are some differences between the countries. Starting with the debt to GDP level, Argentina's level of debt in the period before the crisis was quite low, only 35.1% of GDP in 1998. When comparing the status of the current account there are more similarities, although these are not really convincing either. Argentina also was running deficits for several years in the period before their crisis, but they were not a high as they were in Greece; on average roughly 2.5% of GDP from 1991 to 1997 (IMF, 2013). This however could explain the

vulnerability to the sudden stop in foreign capital flows Argentina eventually endured. In the next section there will be sought for more similarities between the two countries.

Fiscal Policy

Lane (2012), among many other economists, argues that one of the vital mistakes the Greek government has made is that they failed to tighten fiscal policy during the boom period from 2003 to 2007. Because of low interest rates interest costs on debt, the Greek government could have seized the opportunity to consolidate more. But this was not the case and instead of spending less, the money was used for tax cuts and more public investments. When in 2008 the global crisis started, investors immediately started to question the sustainability of the large deficits ran by the Greek government and the amount of credit outstanding. This caused capital to flow out and credit conditions to tighten, which in turn triggered the sovereign debt crisis in Greece (Lane, 2012).

Argentina also pursued a so called pro-cyclical fiscal policy. When times were good in the period before the Argentine crisis, the government did not cut expenditure. On the contrary, the Argentine government remained a net lender (IMF, 2013). In the next chapter, the problem with pro-cyclical policy is extensively explained. For now we stick to Lane's research.

The crisis

When the crisis had started, it soon became evident that the countries with the above

mentioned weaknesses were hit the hardest. Greece was one of these countries and investors began to draw back capital. Political flaws caused the budget deficit to be much higher than expected and the spreads on Greek bonds began to rise. Combined with the already high level of debt, the situation now was really troublesome. What followed was the above described bailout and an exclusion from the bond market. As with Argentina, austerity conditions were mandated by the IMF and the EMU in return for the bailout.

§3.5 Explaining sovereign spreads

Literature

In the last paper examined in this chapter Gibson, Hall and Tavlas explain the movement in Greek sovereign spreads since Greece entered the euro zone. They use several variables for their model and the results are quite interesting: in the period before the crisis spreads were to low and in the crisis spreads are to high, according to their model.

The reason for this research was the striking increase in spreads on Greek bonds. In 2005, spreads were only 3.5%, whereas in 2010 they were almost 12%. The entry of the euro zone seemed to be extremely beneficial for Greece. Besides the interest rates going down, the inflation also went

down and the growth rate of the economy was stable and relatively high. Although the effect on these variables was positive, government budget deficits and deteriorating competitiveness were still reasons for concern.

Of course, at the end of this chapter, almost everything there is to say about Greece is said. Therefore the literature part can be short and it will be finished with a small part about the

competitiveness. Due to relatively high inflation when compared to the rest of the EMU, wages and prices also grew faster than they grew in the rest of the EMU. This caused competitiveness to decline and the current account deficit to grow (Gibson et al., 2011).

The model

In a model using monthly data from January 2000 to September 2010 several variables are used to explain the spread and the difference from the actual spread on Greek bonds. To see which variables are good to use to explain the spread, the model is tested. The variables used are the debt to GDP ratio and the deficit to GDP ratio, because these will reflect the fiscal situation in Greece. Also used for the fiscal situation is the revised number for the above mentioned ratios, because almost always the first documented ratio is incorrect. Gibson (2011) and her colleagues believe this will be of an important influence on their results.

Another variable believed to explain the spread on bonds is the competitiveness of the country. To measure this, the relative price in Greece is taken as a variable. Also the trade and current accounts are included. To assess the economic activity a growth variable provided by the Bank of Greece is used (Hall, 2003). The last effects to be analyzed are the effects from the oil price. This because Greece is the most oil dependent country in the euro zone and from the past it can be said that the oil price is an important indicator for macro-economic variables. The main focus for the methodology used is a VAR system (Gibson et al., 2011).

Results

The VAR residuals pass a range of LM tests and seem to be well behaved (Gibson et al., 2011). The Trace and Maximum Eigenvalue test both reject the hypothesis of no cointegration. The results provide support for significance of relative prices, economic activity, oil prices and the variable for revised fiscal ratios. The other variables were insignificant, because they are correlated with the existing variables.

When entered into an OLS regression the variables all seem to behave correctly. For an idea of the relative importance of the variables the following results are provided. When there is a change in one standard deviation, relative prices have the largest effect on the spread of Greek bonds: 225 basispoints. This implies that competitiveness is a very important factor for the riskiness

of a country. Economic activity has an effect of 138 basispoints on the spread, which is also very significant. The fiscal news variable has a smaller effect of 54 basispoints and lastly the effect of oil prices is only 17 basispoints, but it is nonetheless significant (Gibson et al., 2011).

Comparing the spreads predicted by the model with the actual spreads gives interesting results. In the first period ranging from the end of 2004 to the beginning of 2005, spreads predicted were about 120 basispoints higher than they actually were. They remained about 100 basis points higher and began to rise when the crisis started due to the revised fiscal account variable. Then in May 2010 actual spreads overtook the spreads predicted by the model fast and by September 2010 they were 400 basispoints higher than the predicted ones (Gibson et al., 2011).

These possible under- and overvaluations may have had an important role in the current crisis Greece is in, but this has not yet been examined. One theory can be that in the period when the spreads might have been to low, the Greek government had more favourable lending conditions and had therefore lent too much. The overshooting of the spreads could have just been a reaction to restore spreads into equilibrium.

Chapter 4.

Learn from the past

§4.1 Introduction

In this section a comparison between the situation right before and in the crisis is made between Argentina and Greece. The focus is on certain data and facts for Argentina, which will be checked for Greece. The following things are compared: the conditions for an optimal currency area, the developments of the real effective exchange rate, the net foreign asset position and fiscal policy conducted in both countries. These factors were determining in the crisis for Argentina and therefore here is checked how these factors perform in Greece. From this comparison a clear picture of the situation in Greece will be formed. As the rest of this chapter will tell, there are a lot of similarities of what went wrong in Argentina and Greece. Maybe the whole situation could have been prevented, but since that is not what the paper is about, the focus here is on similarities and possible consequences resulting from the similarities.

§4.2 Optimal Currency Area

The comparison is started with problems resulting from a hard peg, which both countries had. The main idea behind a hard peg is that it's beneficial if there is an optimal currency area (OCA). This implies several requirements: first of all there must be a significant amount of trade with the country to which the currency is pegged to (EMU for Greece, US for Argentina). Secondly

there should be no significant asymmetric shocks, like when some countries in the OCA are

booming while others are in recession. And if there is an asymmetric shock there should be enough space for wages and labour to adjust and capital to be transferred from countries who are doing well to countries that are doing less well. The first criterion was not met in Argentina since the US only accounted for 15% of Argentina's total trade (Perry, 2003) In the case of Greece exports to the EU were 44% of total exports and imports from the EU were 46% of total imports, so here the first requirement is satisfied (HSA, 2013).

However, the other criteria were not met in both instances. In Argentina wage and price flexibility were limited (Perry, 2003) and in the EMU there is evidence of asymmetric shocks in the form of less developed countries like Greece having slower growth, labour productivity and being less competitive when compared to stronger countries as Germany. Also capital transfers in the euro zone were limited up to the crisis. In fact, the opposite happened in the years before the crisis. Research at the Global Financial Integrity shows capital was floating from weaker to stronger countries, instead of the other way around (Kar, 2011). Finally there was no room for wages and labour to adjust in Greece. Labour mobility was limited and wages are sticky due to labours unions and laws.

Due to the failure of meeting these criteria one can state that both in Argentina and in Greece there is no OCA. This implies that both countries are open for speculative attacks, as is read in both the summaries from Argentina and Greece.

§4.3 Overvaluation

These bad conditions for an OCA caused the REER to appreciate considerably in both Greece and Argentina. Alberola (1999) shows that the REER in Argentina appreciated sharply from 1990 to 1994, then depreciated a little and then rose again from 1996 to 2001 (See figure 1). The effect of this appreciation can be seen in the export level of Argentina during this period. Although exports grew over the whole period, the growth was less than the growth in comparable countries. Also the link between exports and the REER is quite obvious. When the REER appreciated, export performance fell. In the brief period of depreciation, exports boomed. This appreciation does not necessarily mean that the peso was overvalued; many economist argue that the valuation was correct during the first period. However, in the last 5 years of this period, thus from 1996 to 2001, the consensus is that the peso was overvalued. This can be seen clearly (See figure 2) when the real overvaluation of the peso in the period 1990-2001 is estimated econometrically. According to these estimations the real REER was 53% higher than it is in equilibrium in 2001 (Albero, 1999).

Data from Alberola (1999)

from 2005 to 2012 (see figure 3) and although there is no clear evidence for an overvaluation (see figure 4), Plecita (2011) argues that before Greece joined the EMU the drachma was undervalued, so it can be argued that the REER appreciated more for Greece than for the rest of the euro zone. This is reflected in a decline of Greece exports peeking in 2009 with an astonishing 19.4%. In the rest of the euro zone the decline was only 12.7%. Econometric research suggests that Greece needs a depreciation of 27% in order to bring back the REER to it's equilibrium value (Cline, 2011).

Data from “Tradingeconomics” (2013) and Plecitá (2011).

Both overvaluations stem from changes in the Net Foreign Assets position of the countries. Comparing those, the patterns are frightening familiar. In both Greece and Argentina there was a considerable decline in net foreign assets position, which in turn calls for a depreciation of the currency. These declines in Net Foreign Assets were due to a growing current account deficit. In Greece the deficit accounted for up to 14.9% of GDP in 2008 and in Argentina the deficit was almost 5% of GDP in 1998. Roubini (2001) states that the deficit would be much higher if there wasn't such a high unemployment rate. Unemployment rates reached 22% of the labour force in 2002 in Argentina and 24% in Greece in 2011.

Other problems with a hard peg are that adjustments to the economic situation have to be done via the domestic price level, because adjustments can't be realized via the exchange rate. So if there is a need for a depreciation, as is the case for Greece and was for Argentina, the only thing that can be done is to drop the domestic price level, deflate. There are a lot of cost considered with deflation which all lead to lower economic activity. First of all investments will be delayed, because people expect prices to decrease and their money will be worth more in the future. Secondly

because of competition, prices have to decrease and firms will be forced into cutting back costs, resulting in loss of jobs and higher unemployment. Also important in this case is that both countries are highly indebted and a deflation will result in a higher value of their debt, because their debt is issued in foreign currency and this will result in even more difficult repayments of the debt. Lastly, because the real interest rate is the nominal interest rate minus inflation, deflation will always have a positive effect on the real interest rate. Since it is hard to lower the nominal interest rate below zero, it is a heavy task to conduct an expansionary monetary policy with low real interest rates, stimulating investment, when there is deflation. This is why adjustments are preferred to be done

via the exchange rate mechanism and when not necessary a decrease in the price level is to be avoided.

All this results in the conclusion that both Argentina and Greece were/are in need of a depreciation with respect to their pegs. This is the result of high net foreign liabilities. The problem with depreciating is that this is not possible without leaving the current peg. For Argentina this happened in 2002 when the peso depreciated from 1 peso per dollar to 4 pesos per dollar. For Greece it won't be that simple, since a depreciation will mean that Greece will have to drop the euro.

§4.4 Pro-cyclical fiscal policy

As is made clear from the summary of events in Argentina resulting in the default,

politicians did not always make the right decisions solving the crisis and preventing Argentina from going bankrupt. In this section the most important mistake is evaluated and compared to the

political situation in Greece. An important indicator for political behaviour is the amount of debt a government decides to hold, because when this amount becomes unstable because of bad politics, a default will be unavoidable.

Since 1995 the fiscal balance in Argentina worsened significantly. Even though

economically things were pretty good in Argentina (GDP grew 8.11% in 1997 (IMF, 2013)) the Argentine government still ran large deficits (a deficit of 2.91% in the structural balance (IMF, 2013)). The problem with the deficits in Argentina thus is that they were not counter cyclical: correlation between the cyclical component of government expenditures and GDP is 0.83

(Cabalerro, 2004). This pro-cyclical policy was partly because of the peg against the dollar. Because of this peg, monetary and exchange rate policy is not possible anymore and the only thing left to do for the Argentine government was to use government stimulation to let the economy run smooth. Pro-cyclical policy is a problem because when there is a recession and the government has to cut expenses, because of the pro-cyclical policy, aggregate demand falls and the economy will shrink even further. This will reduce tax income since total income falls and expenses like unemployment benefits increase and will make it even harder to tighten fiscal policy. As can be read in the

summary of events in Argentina during the impuestazo taxes were increased and public sector salaries were cut, in a desperate attempt to keep the debt amount sustainable. When later Cavallo tried to stimulate the economy it was of course too late.

Pro-cyclical fiscal policy was also the case in Greece. Before the crisis the Greek government was investing and spending a lot, stimulating credit and the fiscal balance was

deteriorating. In the period 2000-2007, when everything was still going well in Greece, GDP grew on average by 4.2% ( Athanassiou, 2009) but in this whole period the government was running

deficits of for instance 6.04% of GDP in 2006, more than double the allowed percentage in the Stability and Growth Pact (IMF, 2013). Now, in the crisis, the Greek government is working hard to cut back as many expenses as possible, in a desperate attempt to keep the debt burden in proportion. This is a very difficult task, because of the reasons stated earlier, and this is supported by empirical data from 2011 where the government had to cut back 4.1% in expenditure but the actual primary deficit only shrank by 1.7% (Weisbrot, 2012).

Why both the Greek and the Argentine government did not have the means to invest during the crisis and pursue a counter-cyclical fiscal policy rather than a pro-cyclical one, was because both countries were severely indebted before their crisis started, due to earlier pro-cyclical policy. Interest payments on debt appear to be enormous and form a heavy burden. Interest payments in Argentina alone rose from 2% of GDP in 1995 to 5.4% of GDP in 2001 and only half of this

increase can be attributed to the increase in interest rates; the other half was because of the immense growth of the national debt which grew from 35% of GDP in 1997 to 165% of GDP by 2002.

In Greece, the debt burden is currently more than 150% of GDP, while in 2005 it only was 100% of GDP, still higher than the average of the euro zone. Also the interest rate paid on debt has increased significantly because of the crisis, as can be read in the summary about Greece. The percentage paid above the rate paid on a German bond has risen from 0.25% at the beginning of the crisis to 5.86% by 2010. These two factors combined result in significantly higher interest payments on the debt, which have risen according to the European Commission (2013) from 5.2% of GDP in 2009 to 8.3% of GDP in 2013. This puts a lot of pressure on the finances of the Greek government.

§4.5 Other debt problems

These enormous amounts of debt bring other problems along as well. As is stated earlier, there is proof that both REERs in Argentina and Greece were/are overvalued. The problems that an overvalued REER brings along are mentioned, but one problem is still not accounted for.

One of the solutions opted to restore the REER to equilibrium is to drop the hard peg and devaluate. This is a realistic option both in Greece and Argentina; it actually happened in Argentina after their crisis. But here is the problem. Because a huge amount of the debt in Argentina was denominated in dollars, a devaluation would mean that this amount of debt is still due and very expensive. The fear of the Argentine government was that when they would devaluate it would cause the government, firms and individuals to go bankrupt because the value of their debt would increase so much. This will also inflict damage to the banks in Argentina causing them to collapse too. Higher unemployment will be the result and this will cause an even deeper recession for the country (Feldstein, 2002).

same, because also in Greece most of the debt is denominated in the currency they will abandon, the euro in this case. At the end of April 2010 Greece's total debt accounted for 319 billion dollar, almost all of it, over 98%, was euro denominated (Buchheit, 2010). If the Greek government decides to leave the euro and opt for a devaluation, expectations are that the amount of debt becomes unsustainable, and private bankruptcies and total default will follow.

§4.6 Conclusion

The situation in Greece has a lot of similarities to the default in Argentina a little more than a decade ago. Not only both countries have been or are in a very peculiar situation, but also both can blame themselves for it for a big part. Of course they had a lot of bad luck, but some countries are because of the policies they pursue more vulnerable to bad luck than others. Because of pursuing risky policies this was the case in Greece and in Argentina.

In this chapter several factors are compared and this gives a good indication about what is going on in Greece right now. For starters there are some issues with the peg both countries adopted. Commonly agreed on in economics is that before adopting a hard peg the conditions on a optimal currency area (OCA) should be met. This means that before pegging your currency to another one first of all the country to whom the other currency belongs should be one of the main trading partners. This is proven not to be the satisfied in Argentina, but Europe is the main trading partner in Greece. This means that maybe the peg in Greece was not as bad as an idea as it was in Argentina. But there are other conditions that need to be met for an OCA to work. Asymmetric shocks were present in both instances and adjustment mechanisms were absent. These are reasons for abandoning a hard peg, because it just does not work in your advantage as much as it would when the conditions are met.

This peg also caused other problems. Because the national currency in both Greece and Argentina could not adjust to the economic situation, the Real Effective Exchange Rates (REERs) soon were overvalued. An overvalued currency means that exports are to expensive for the rest of the world and drop. Money was moving out of the countries and the current account deficits were increasing. Debt was improving to unsustainable levels and the Net Foreign Asset positions declined.

Another, maybe even more important, factor that caused the debt to increase so much is the policy the governments adopted in the period before the crisis. Because both governments did not tighten the fiscal policy when economic times were better in the period before the crisis, debt levels of both countries even grew when there was not even a recession. Here the peg also causes

problems because monetary policy is not able to pursue, but the government has more influence in deciding when to spend money. Because this money was spent during the better times, there was

none left when there was a recession. Suddenly both governments had to cut back expenses, but because the debt already was to large, debt kept on increasing because of the enormous interest burden, which became even larger because of the higher interest rates there were demanded because of the increased risk.

These factors have caused the severe crisis and eventual default in Argentina. One would have guessed that the Greek government would have learned from this default, but this was not the case. Almost everything that went wrong in Argentina also went wrong in Greece. Therefore one could say that the crisis in Greece is very similar to the default in Argentina. But now back to the main question: is a debt default in Greece unavoidable? Of course this question can not be answered without a doubt, but because of all the facts in this thesis it is not unreasonable to think that a default is a serious outcome of this crisis. This means that the debt Greece has will not be paid back for the total sum or at least a part of it. It will also give Greece the chance to leave the euro area and devaluate so they have a healthier exchange rate, helping them to establish a better economy. Also they will not be tied to the monetary policy pursued by the EMU anymore, so the need for fiscal policy to stimulate the economy is less present (Weisbrot, 2011). Less advantageous consequences for Greece will be that a lot of countries will bear a grudge against Greece, because they lost their money. This causes these countries to be less willing to help Greece build up their economy and spend money on investments in Greece.

Of course no one can predict what actually will happen in Greece and what will happen if they default. Here only a very reasonable scenario is pictured and the stupidity of the Greek government is exposed. Now the only thing left to do is wait for what actually will happen.

5. Conclusion

This thesis has compared the crisis in Greece with the default from Argentina in 2002. It has done so, because the crisis in Greece has proven to be very serious and the default from Argentina has shown to be good to compare Greece with. From this examination the thesis has tried to answer the question whether the situation in Greece is so similar to the crisis Argentina experienced and whether a default may be a possible outcome.

First, in chapter 1, the events leading up to the default in Argentina are carefully

summarized. The chapter has a neutral tone and no judgment about what happened in Argentina is made. However, even when being neutral, it is hard to ignore the fact that a lot of the decisions made by the Argentine government were not smart. The little bad luck needed to push Argentina into default was there, and this marked the largest default in history.

In chapter 2 the crisis in Greece is summarized. Here is read that this crisis is almost as bad as the Argentine crisis. The tone is also neutral, but nevertheless it can not be avoided to see that the government here also has made some fatal mistakes. However, maybe the situation in Greece can still be saved. The EU and the IMF have made some rescue packages to bailout Greece which gives hope for default to be avoided.

Then, in chapter 3 some existing literature about the subject is analyzed and processed. Because the opinion about Argentina is quite the same for most economist, this was not the most interesting thing to discuss. For Greece however, because the crisis here is fresh and still going, it is very interesting to hear what other economist think about this crisis. That is why most of the content of this chapter is about Greece. However, there is also a contribution made in this chapter by

comparing what the authors say about Greece with the case of Argentina.

Chapter 4 is what the thesis is all about. In this chapter I have compared the crucial factors leading to the crisis in Argentina with the data for the same factors of Greece. The results lead to an astonishing conclusion. Apparently Greece has not learned from the default in Argentina and many of the conditions to survive a severe crisis are not met. The similarities between the factors resulting in the default in Argentina and the same factors now present in Greece are striking. This is why the conclusion of this paper is that due to the lack of response on several indicators for the

vulnerabilities in Greece, a default is not unthinkable anymore. These indicators were also present in Argentina and therefore this possible default could have been avoided. For now, only time can tell whether it will actually result in default for Greece.

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