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The Greek crisis: the reasons why, and the lessons available

April 1, 2015

Greece continues to endure a severe financial and economic crisis. The main factors leading to the crisis are linked by the manipulation of accounting reports used in the governance of Greece’s participation in the Eurozone. 

Accounting chicanery helped grease the wheels for Greece’s unsustainable growth in the 2000s – and the unmasking of that charade led to the outsized exposure of Greece to the Great Recession of the late 2000s internationally. 

At their roots, the reasons for the Greek crisis share a common bond with lessons that are easily available, but sadly long unlearned, from any careful review of the US’s own financial market history.  In turn, these lessons caution us that the US may be subject to its own, similar crisis in the future.

 

Greece and the European Union – historical background

The European Union (EU) represents the current incarnation of a variety of Post-World War II economic and political agreements among European countries, with cooperation gaining greater headway across the continent following the fall of the Berlin Wall in 1989.  The EU represents the most ambitious and comprehensive integration effort to date – but the Greek crisis has unmasked some fissures under the surface.

The most notable event in trade, legislative, judicial and monetary cooperation arrived in 1992, in the Maastricht Treaty.  This treaty established the newly-named European Union.  The European Union is best described as an effort to establish and promote freer trade in a market system for sovereign nations.  And the common market now has a common currency, the Euro, first introduced as a unit of account in 1999. 

Greece did not initially meet the criteria for membership, the four main features of which included statistics like a budget deficit % GDP, government debt % of GDP, inflation rates, and sovereign interest rates.  But Greece was the first new country to adopt the Euro in 2001, one year before Euro notes physically entered into circulation.

 

Government reporting of fiscal data

In order to adopt the Euro, after joining the Eurozone in 2000, Greece still had to convince the Eurozone that it could qualify, including a period of “austerity” to develop compliance with the Maastricht criteria for membership.  But some of that apparent austerity was the result of misleading accounting.  And ironically, around the same time that Enron taught the world how to lie about debt with derivatives, Greece entered into a series of dubious transactions helping them meet the Maastricht criteria – at least on paper.

Greece’s entry and continued membership in the Eurozone may have included some false premises, but it wasn’t as if banks and European authorities were blameless and/or hoodwinked.  The Eurozone financial system and its lenders – including large American banks backed by U.S. taxpayer-funded public capital -- tolerated the charade. 

In a July 2003 article for Risk Magazine (“Revealed:  Goldman Sachs’ megadeal for Greece”), Nick Dunbar reported on how Greece announced in late 2001, after adopting the Euro, that it had pledged to reduce debt servicing costs by means that included “the extensive use of derivatives.”  Cross-currency swap transactions with Goldman Sachs reportedly were designed to lead to up-front cash payments from Goldman Sachs to Greece along with favorable early-year results, in exchange for a large “balloon” longer-term cash flow in the reverse direction.  Dunbar characterized the transaction as effectively a long-term loan, albeit one not captured in debt statistics.

“There is no doubt that Goldman Sachs’ deal with Greece was a completely legitimate transaction under Eurostat rules. Moreover, both Goldman Sachs and Greece’s public debt division are following a path well-trodden by other European sovereigns and derivatives dealers. However, like many accounting-driven derivatives transactions, such deals are bound to create discomfort among those who like accounts to reflect economic reality.”

Was late 2001 the first time Greece and Goldman arranged cosmetic financing easing compliance with Maastricht criteria?  It isn’t entirely clear, from the media record, but it does seem clear that Greece wasn’t the only party applying cosmetics to help seal the deal.

In a February 2010 article in the New York Times “Wall St. Helped to Mask Debt Fueling Europe’s Crisis,” Louise Story, Landon Thomas Jr. and Nelson D. Schwartz described late-2009 transactions for Greece proposed by Goldman Sachs that mirrored what the Times reported as transactions that did take place “just after Greece was admitted to Europe’s monetary union.”

“The deal, hidden from public view because it was treated as a currency trade rather than a loan, helped Athens meet Europe’s deficit rules while continuing to spend beyond its means.”

These authors also drew a direct parallel from the nature of these transactions as “akin to the ones that fostered subprime mortgages in America … as in the American subprime crisis and the implosion of American International Group, financial derivatives played a role in the run-up of Greek debt. … In dozens of deals across the Continent, banks provided cash upfront in return for government payments in the future, with those liabilities then left off the books.”

In a March 2012 article for Bloomberg (“Goldman Greece Loan Shows Two Sinners as Client Unravels”), Nicholas Dunbar and Eilsa Martinuzzi also described financial transactions that effectively “disguised” loans – but not forever, and at a price.  Through these complex transactions, Greece ironically purchased the appearance of fiscal discipline with greater long-term obligations.  Deals designed to improve reported financial conditions actually helped undermine financial strength. 

While working on their article, Dunbar and Martinuzzi obtained an apparently frank appraisal of the transaction in an email response from a Goldman Sachs representative:

“Fiona Laffan, a spokeswoman for the firm in London, said the agreements were executed in accordance with guidelines provided by Eurostat, the EU’s statistical agency. “Greece actually executed the swap transactions to reduce its debt-to-gross-domestic-product ratio because all member states were required by the Maastricht Treaty to show an improvement in their public finances,” Laffan said in an e-mail. “The swaps were one of several techniques that many European governments used to meet the terms of the treaty.” …”

While interviewing officials for this article, Dunbar and Martinuzzi also reported on a statement from Eurostat in early 2012 that Greece did not report to Eurostat on these transactions in 2008, when Eurostat first began to stop allowing the use of swaps with “off-market rates” to manage their reported debt levels.

A 2011 article in Der Spiegel titled “The Ticking Time Bomb:  How the Eurozone Ignored Its Own Rules” described the early enthusiasm and confidence in the historic currency arrangement, including investor optimism about sovereign debt.  This environment helped Greece borrow at rates only slightly higher than other Eurozone countries, including Germany.

 

Other creative accounting – and financing

Greece was not alone in using measurement techniques aggressively to meet Maastricht criteria.  In an April 2009 article for Vox titled “The politics of the Maastricht convergence criteria,” Paul De Grauwe argued that

“… “creative accounting” permitted these countries to hide the true level of the budget deficits. For example, these countries took over pension funds of state companies and booked the assets of these funds as current revenues while failing to book the future additional pension liabilities. As a result, the budget deficits were artificially and temporarily lowered. All this occurred while the European Commission gave its stamp of approval. It is no exaggeration to conclude that the budget deficit numbers were falsified, thereby allowing countries like Belgium, France, Italy and Greece to obtain free passage into the Eurozone.”

But creative accounting for government programs mattered more for Greece than other countries, and for a simple reason.  Government employment and spending accounted for a significantly larger share of the Greece economy than other countries in the Eurozone.  Creative accounting helped promote the large but unsustainable growth in Greek government programs, and the Greek economy. 

It should be noted that the Greek economy had another significantly large industry, relative to other countries, that proved quite sensitive to the crisis in the Eurozone generally – tourism. 

 

The Greek crisis – factors underlying its severity

Here are six factors responsible, then, separately and together, for the severity of the crisis in Greece:

  • Fiscal imbalances arising from persistent government spending above government revenue.  Greece purchased short-term gains with longer-term pain, as persistent government deficits were funded with debt now compressing the government, and the economy.  It takes (at least) two to tango, however, and the financial system was very willing to purchase the debt the Greek government was offering, despite the now-evident longer-term consequences.
  • External imbalances arising from persistent domestic spending on imports beyond revenue earned from exports.  The accumulation of debt in Greece was not limited to the government, as the economy as a whole funded a deficit in its trade account with borrowing from the rest of the world.  Again, this wasn’t entirely Greece’s decision, as the rest of the world was willing to extend this credit – until it wasn’t. 
  • A high share of government in the overall economy.  Government spending constituted a high share of overall spending in the Greek economy, and the fiscal crisis in its government very naturally helped account for the fact that the broader economy suffered to a greater extent than other countries impacted by the Great Recession internationally in the late 2000s.  Much of the world has begun to recover from that massive crisis, however, while Greece has not.
  • Greek bank holdings of Greek government bonds.  The Greek government has accounted for a high share of the overall Greek economy, and one industry particularly exposed to (if not initially responsible for) the fiscal crisis in the Greek government was the Greek banking industry, which held a relatively high share of Greek government bonds in total assets.  In turn, the severe contraction in confidence in Greek banking and financial markets has played a key role in the extended and continuing crisis in confidence in Greece more generally. 
  • Reporting of fiscal data governing Greek participation in the Eurozone. This is a key, and perhaps the most important factor, in our view.  We are not just talking about complex derivatives transactions here.  There appears to have been a systematic understatement of deficit and debt levels reported by Greece to the Eurozone before and in the early years of the introduction of the Euro (see p. 44).  In turn, Greek government financial data was revised dramatically in the mid-2000s – before the Greek crisis really got underway.  Today, Eurostat does not report public debt levels for Greece before 2006, and the IMF and Eurostat failed to respond to questions I left with them in late May-2015 why this is the case.
  • Loss of trust.  The Greek crisis has punctured public confidence, in markets and in government.  Confidence in finance depends on the integrity of data underlying transactions.  Financial markets channel the flow of savings into investment, a key role in economic growth, and the collapse in confidence in institutions moving money from savers to investors has now weighed on Greece for years. Once punctured, that confidence is hard to rebuild.  The loss of trust has shown up in the spike in spreads for Greek government debt in recent years, as well as riots in the streets.  And Greece had some of the worst results in the Eurozone in the most recent Transparency International survey of public attitudes toward corruption in government.

But whose “fault” was it?  As noted above, lenders outside the country were willing to play the game, too – and a game with scorecards collected and communicated by Eurostat. 

 

Eurostat

The Member States of the European Union report government financial data to a European Commission statistical organization called Eurostat.  In turn, Eurostat provides data to the EU.  Eurostat doesn’t simply take what it is given and pass it on, however.  Eurostat also plays a role in evaluating the quality of the financial reporting it receives.

In 2002-2004 Eurostat refused to validate Greece’s data on several occasions -- after Greece had joined the EU and well before the Greek financial meltdown. Debates ensued over these decisions, but as a practical matter, the European (and market) governance mechanism chose not to take these warning signs as seriously as they should have. Greek and other people are now paying the price for those decisions.

 

Conclusion

Unreliable and untruthful practices relating to government accounting laid the foundation for the Greek financial crisis.  The crisis endures, today, in large part to a sustained collapse in confidence – internally, among the countries citizens, and externally, among the country’s creditors.

Can the United States learn from those lessons to help safeguard a healthy, growing future for itself? 

Yes, and no.

Lessons from Greece are directly applicable to the United States, in a variety of interesting ways.  We will outline those lessons in our next article. 

But the basic takeaways are already available to the United States, if it chose to take an honest and hard look at its own financial history.  Yes, Greece can help us understand our own weaknesses, but they have already been exposed for their own accord.  Greece is a highlighter, a pen underlining key sentences for emphasis.

 
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