Abstract
While there seems to be a well established consensus about the underlying causes to the Greek crisis, less is known about internal and external transmission mechanisms that ultimately caused unemployment to increase rapidly over this period. Motivated by the structural slumps theory in Phelps (1994), the paper attempts, therefore, to uncover the dynamic mechanisms behind prices, interest rates, and external imbalances that contributed to the severity and the length of the crisis. We find that the strongly increasing real bond rate and unemployment rate together with an persistently appreciating real exchange rate and a deterioration of competitiveness in the eurozone have contributed to persistently growing structural imbalances in the Greek economy. As the lack of confidence in the Greek economy grew steadily, the scene was set for a monumental structural slump. We find strong evidence of (i) a Phillips curve relation with a non-constant natural rate being a function of relative costs and the real exchange rate; (ii) a vicious circle of strongly increasing bond rate and unemployment rate; and (iii) a relation associating confidence with the development of relative costs and the real exchange rate. Over the crisis period, all variables exhibited self-reinforcing feedback adjustment somewhere in the system except for inflation rate. Unemployment took the burden of adjustment when the bond rate sky rocketed, competitiveness deteriorated, and confidence fell.
Highlights
The aim of the structural slumps theory, developed by Edmund Phelps in the early nineties, was to explain how open economies connected by the world real interest rate - set in a global capital market - and the real exchange rate - determined in a global customers market for tradables - can be hit by long spells of unemployment
The results show that the nonstationary equilibrium error in the Phillips curve relation, z1,t = ∆pt + 0.02ut, is associated with a positive change in the real bond rate, in the unemployment rate, in relative producer prices, in the real exchange rate, and with a negative change in the market confidence rate
The results show that the nonstationary equilibrium error in the bond rate/unemployment rate relationship can be explained by an increase in the real bond rate, a drop in the market confidence rate and an increase in relative producer prices
Summary
From 2008 to 2013, Greece experienced one of the most severe recessions in Europe with a fall in real output of 26% and a rise in unemployment of 26%. Because financial markets incorrectly considered risk to be evenly distributed in the euro area, the Greek bond rate dropped to unprecedented low levels This led to a strong increase in credit-financed aggregate demand (mostly demand for imports) which caused huge imbalances in the current account and contributed to an accelerating wage and price spiral both in the private and the public sector. A contributing cause of the external lending problem was, that financial markets mistakenly assumed that current-account imbalances of the member countries no longer mattered in the eurozone This may explain why a high external debt country like Greece was able to finance its debt with low interest rate loans up to the crisis - even though the size of the fiscal imbalance must have made severe macroeconomic adjustment seem inevitable.
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