a. What gave rise to sovereign debt crisis in Greece?
Answer- Conditions in Greece prior to Eurozone pact were already grave. For more than a decade the economy was not doing well and it was trying to meet its end and was living beyond its means. Annual budget deficits and loose fiscal policies continually led to increase in sovereign debt. Apart from this there were no prompt measures taken to balance the budget during different phases of the economic cycle.
And after all this the Eurozone membership of Germany compounded the debt problem. Banks and other financial institutions across Europe purchased the increasing supply of Greek government bond willingly. And due to these cheap and easily available funds there was increased in spending in Greece. E.g. Public sector wages increased and Greece funded Athens Olympics.
Another reason that gave rise to increased government debt was loop holes in taxation system of Greece. The incentives to reform tax system and eliminate tax evasion were not appropriate as a result the Greek treasury and government revenues declined. Budget was further drained by bank bailouts. Greece’s major sources of revenue were shipping and tourism. They were badly affected by the downturn as revenues fell up to 15% by 2009 (Greek Ministry of Finance, 2010).
The main reason behind this debt was lack of fiscal discipline and effect of strong economies like Germany on Greece’s economy. The great recession further aggravated the problem due to lack structures in Greek economy (Higgins & Thomas, 2011). Fiscal imbalances started to develop from 2004, the government expenditures increased to 87% however, the overall increase in tax revenues was only 31%. In 2010, approximate tax evasion losses for Greek government amounted to over $ 18 billion (Bloomberg Businessweek, 2010). The overall GDP growth was lower in 2008 in Greece than anticipated.
By 2009 Greece’s sovereign debt had become 130 percent of its GDP .In 2011 and 2012 Greece’s economy shrank by 6.9 and 6% respectively. The situation became so bad in Greece that it had to seek help from International Monetary Fund as well as other European Union members. there were two major views that gave rise to this sovereign debt crises one was adoption of single currency by countries of different economies and the other was absence of a fiscal union amongst Eurozone countries (Keiser, 2015).
b. Why can sovereign debt crises and bank crises be mutually reinforcing?
Answer- sovereign debt crises and bank crises are mutually reinforcing as they are interlinked (Edmond A, 2012). The increased government debts led to distrust amongst investors and borrowers and thus it became more difficult for the government to raise further debts. The sinking value of Greek bonds was a repercussion of increased sovereign debt in Greece.
Due to this high sovereign risk the bond prices had to be lowered and as a result Greek bond reached junk bond status which impacted banks adversely. Financial institutions suffered significant balance sheet losses on their sovereign debt holdings. As a result of Great Financial Crisis (GFC) banks were already finding it difficult to raise the capital and the situation got worsened by collapsed value of their bonds.
The distrust amongst investors and depositors rose due to this situation and they became reluctant to not only deposit their money but also started withdrawing their funds to move them to stronger economies such as Germany. As a result of these withdrawn funds it became difficult for the banks to give away loans and hence, the credit became tight and banks became weaker (Helena.S, 2010).
The capital dried up and loan defaults increased that led government to raise more debt and hence a vicious circle of increasing debt and insolvency of banks continued. The Greek economy now became prey to mutually reinforcing cycle of sovereign debt crisis and banking crisis that led to complete devastation of Greece economy.