Fiscal Adjustment in Greece: In Search for Sustainable Public Finances

This paper analyses Greek fiscal sustainability. This topic lies in the core of all discussions about a potential exit of the country from the euro area, and - more in general - about the design and long-run sustainability of the monetary union. We analyse Greek fiscal sustainability using empirical analysis and combine a retrospective and a prospective view. In the retrospective part of the paper, econometric tests on solvency and sustainability of the Greek budget show that the Greek public finances were not on a sustainable path even before the global crisis broke out in 2009. Clearly, the ensuing economic and fiscal crisis that Greece experienced since that time has added additional pressure on the urge to regain fiscal sustainability. Thus, an important question is how Greece may regain fiscal stability. In a next step, we therefore set out a forward-looking scenario-analysis to investigate how Greek public finances may evolve during the medium and long-run. Simulations for the period between 2011 and 2030, using a stylised model of the Greek public finances, provide a number of interesting insights and policy implications. A first result is the importance of the interest rate versus growth factor for the dynamics of the fiscal variables in the longer run: a small reduction in interest rates or a small improvement of growth delivers important gains in limiting or even preventing the "debt snowball" effect that we still observe quite significantly in a status quo baseline scenario. Given that interest rates and economic growth are only very indirectly under control of policymakers, regaining long-run sustainability will require a long period of fiscal consolidation, resulting in substantial expenditure reductions with accompanying economic, political and social costs. Furthermore, fiscal prudence requires being very cautious regarding projections on interest rates and growth, and considering the possibility that both interest rates could get higher than projected and growth rates lower than expected. In a "best case" scenario, the fiscal consolidation is significantly supported by growth, interest and primary balance improvements. At the same time, a "worst case" scenario where all these parameters turn adverse, imply a rapid derailment of Greek public finance and most likely a rapid default in practical terms. Debt-restructuring and debt forgiveness may have beneficial effects in the short-run; these effects are, however, temporary if not at the same time also the underlying structural determinants of fiscal sustainability are changed. A final simulation points to the importance of the risk-premia dynamics in sustainability of public finances. A scenario where this risk-premia disappears (or is largely reduced) would provide strong support to fiscal sustainability as it mitigates the non-trivial adverse impact of speculation in international bond markets about a Greek default.

van Aarle, Bas and Marcus Kappler (2011), Fiscal Adjustment in Greece: In Search for Sustainable Public Finances, ZEW Discussion Paper No. 11-080, Mannheim.