Also published in modified form, at,
Blog of the Hellenic Observatory, London School of Economics, February 15. 2021
VoxEU-CEPR Research-based Policy Analysis and Commentary from Leading Economists, February 23, 2021
After the great depression of 2008-2016, following the international recession of 2007-2009 and the debt crisis of 2010, the Greek economy has entered another deep economic recession in 2020. While the economy appeared to be on a modest recovery since 2017 it was hit by a new major international economic shock due to the Covid-19 pandemic.
As for every other country, the immediate problem is how to deal with the health and short-term economic effects of the pandemic. However, the crisis has also led to a significant deterioration in Greece’s medium-term economic outlook, due to its high government and external debt.
Greece appears to have experienced a very deep recession in 2020 and even under optimistic assumptions, a full recovery will take some time beyond 2021. In addition, the recession and the cost of the measures to mitigate it have led to a further sharp rise of Greece’s already exorbitantly high public debt.
In contrast to what happened in 2010, Greece is not alone in its predicament. Furthermore, the crisis has mobilised the EU to promote the Recovery and Resilience Facility, a temporary Community budget mechanism of € 672.5 billion. This will certainly help to address some of the effects of the crisis on both the real economy and the public debt of financially vulnerable member states such as Greece. During the 2010 crisis, the cost of adjustment was passed-on exclusively to national states, and especially to the peripheral countries of the euro area.
Increasing public borrowing in order to support the economy in the short term is certainly the right solution, both globally and for Greece. However, the increase in borrowing shifts many of the problems to the future. As in the aftermath of wars, in the aftermath of a major economic downturn such as the current recession, a country must tackle the problem of debt repayment, or at least the reduction of its public debt to GDP ratio.
So how does one pay for the cost of the pandemic? By analogy, the question is similar to the question in Keynes’ famous 1939 essay on ‘How to Pay for the War’.
There are three alternative methods of dealing with a large increase in public debt such as the one that is taking place during this crisis. First, is the significant increase in taxation and reduction of primary government spending immediately after the crisis is over, through a policy of ‘austerity’. The second is the restructuring or even the partial write-off of the debt. The third is ‘gradual adjustment’, which is effectively the continuous postponement of significant debt reduction, with the hope that the debt will gradually shrink in relation to GDP through economic growth and inflation.
Greece experienced austerity mainly in the period between 2010 and 2018. The great international recession of the period 2007-2009 led to an increase in Greece’s public and external debt, and the austerity of the period 2010-2018 led to a ‘great depression’, a dramatic decline in GDP, rising unemployment and rising social inequalities. Due to the ‘great depression’, the debt to GDP ratio shot up instead of falling, despite the significant and front-loaded fiscal adjustment. From 103% of GDP in 2007, at the beginning of the international recession, and 127% of GDP in 2009, after the international recession was almost over, in 2018, with the end of the adjustment and austerity programs, public debt had skyrocketed to 186% of GDP. Despite the huge costs paid by workers, the self-employed, retirees and the unemployed, the effects of austerity on public debt have been disappointing. Graph 1, on how Greece’s debt usually rises in periods of recession and stagnation and is only stabilized in periods of recovery and growth, does not require much additional comment. The debt to GDP ratio rose along with unemployment during the recessions of the early 1980s and the long period of stagnation until 1993, and then rose again significantly during the great international recession of 2007-2009 and the Greek depression of 2010-2016.
Graph 1: Public Debt and Unemployment during Periods of Growth, Stagnation and Recession in Greece
Greece also experienced the second method of dealing with debt, the restructuring and partial write-off of its debt, in 2012. Despite the concomitant problems, the results were somewhat better. There was a temporary halt to the rising debt and the cost of servicing it was reduced, resulting in more benign debt dynamics. In addition, the cost was paid by holders of Greek government bonds and the shareholders of Greek banks, presumably wealthier than the low-paid, the pensioners and the unemployed.
However, it is doubtful whether this can be repeated in the current context. First, a large part of Greece’s debt is now official debt held other sovereigns through the ESM. Second, the debt problem created by the current crisis is global and does not only affect Greece or the peripheral economies of the euro area, as during 2010-2011. It is highly unlikely that the core euro area economies will risk losing their credibility to current and future investors through debt restructuring or write-offs, or whether, given the rise in their own public debt, they will accept to shoulder part of the cost of debt restructuring of economies of the periphery such as Greece.
This leaves us with the third method, that of ‘gradual adjustment’. This is how the public debt of the US, Britain and other European economies fell relative to GDP after World War II. This is also the way in which Greece had stabilised its debt-to-GDP ratio during the period of recovery and growth 1994-2007. However, this solution has an important pre-condition: The nominal yield of government bonds must remain lower than the sum of GDP growth and inflation for a relatively long period.
In the first thirty years of the post-war period this was achieved internationally through rapid economic growth and ‘financial repression’. The latter required significant state intervention in financial markets and capital controls in order to keep interest rates low.
In the case of Greece during 1994-2007, this was achieved through the reduction of interest rates and the economic recovery caused by the so called ‘convergence play’, i.e the prospect of joining the euro area and then through euro area participation itself. Interest rates fell rapidly and remained low because of the significant reduction of the risk and devaluation premium and inflationary expectations. This, caused an increase in both consumption and investment and acceleration of economic growth. Unfortunately, it also caused a persistent widening of the current account deficit, which was the root cause of the debt crisis of 2010.
The ‘gradual adjustment’ method has proven to be very effective in tackling large increases in public debt for the major industrial economies, usually after wars or deep recessions. Britain’s experience after the Napoleonic Wars and World War II, as shown in Graph 2, is a prime example. On the contrary, the austerity after World War I or after the Great Recession of 2008-2009 led to further increases in the debt-to-GDP ratio of Britain.
Graph 2: Public Debt, Wars and Recessions in Britain, 1792-2016
Can a policy of ‘gradual adjustment’ after the current crisis be successful in an age of liberalised financial markets and capital movements? If it could, a significant part of the cost of the adjustment would be passed on to the presumably richer investors in government bonds, as well as to future generations, who would have had the benefits of higher economic growth. The problem is whether interest rates can remain low for the long period of time required for ‘gradual adjustment’ to succeed. This may require a policy of interventions in financial markets, in addition to the accommodating monetary policy of central banks. In addition, this solution carries the risk that economies will remain vulnerable for a long time to the risk of a new financial crisis. Obviously, Greece would not be able to implement such a policy on its own. This would require the adoption of a ‘gradual adjustment’ policy for the whole of the euro area.
In conclusion, these are the three options for Greece to deal with the increase in its debt after the current crisis. None of the three is painless and each has different redistributive effects, involves different risks and has different external prerequisites. What is certain is that when the pandemic subsides, all economies will have to tackle the debt problem with a combination of the above three methods. Greece will have to adapt to the policy of the rest of the euro area.
In any case, it is important that the Greek government does not abandon the reformist growth agenda on the basis of which it was elected in June 2019 because of the pandemic. A dynamic and sustainable recovery after the crisis will greatly help Greece tackle its debt problem, whatever is decided at the euro area level. But it is equally important that all Greek political parties contribute as much as possible to the promotion not only of the immediate measures to support the economy in the midst of the crisis, but also of the reforms that are necessary in the medium term for the dynamic recovery of the Greek economy. Otherwise, the credibility of growth enhancing reforms will be limited and the reforms will prove ineffective.
© George Alogoskoufis