The three actors in Greece's drama

The crisis that started in Greece has culminated into a crisis of the Eurozone as a whole. How did we get into this mess? To answer this question it is useful to distinguish the three actors that have played a role in the development of the crisis.

Greece

The role of Greece can be summarised in just a few sentences. Mismanagement and deception by the Greek authorities made the crisis possible. The Greek government now struggles with a huge credibility problem, which makes the resolution of the crisis difficult, because "nobody trusts these guys anymore”. Any announcement by the Greek government about its intention to redress the budgetary situation will be met by great scepticism for years to come.

The financial markets

The destabilising role of financial markets has been illustrated dramatically again. Periods of euphoria alternate with periods of depression amplifying movements in asset prices that are unrelated to underlying fundamentals. This is not new, of course, but the speed with which this has occurred is baffling. Just a year ago, the sovereign bond markets were gripped by a bubble leading to record-low levels of long-term interest rates at a time when governments were adding unprecedented amounts of new bonds in the market. In a few weeks time, the situation turned around dramatically and bond markets crashed in a number of countries.

The rating agencies take a central position in the destabilising role of the financial markets. One thing one can say about these agencies is that they systematically fail to see crises coming. And after the crisis erupts, they systematically overreact, thereby intensifying it. This was the case two years ago when the rating agencies were completely caught off guard by the credit crisis. It has again been the case during the last few months. The sovereign debt crisis started in Dubai. Only after Dubai postponed the repayment of its bonds and we had all read about it in the Financial Times, did the rating agencies realise there was a crisis and downgrade Dubai's bonds. Having failed so miserably in forecasting a sovereign debt crisis, they went on a frantic search for other possible sovereign debt crises. They seized upon Greece, which of course was a natural target. But they did not limit their search to Greece. They 'visited' other countries, mostly southern European countries and started the process of downgrading. This in turn led to a significant increase in government bond rates in these countries.

Thus, it can be said that the rating agencies make systematic 'type I' errors during periods of euphoria, i.e. they fail to cry wolf, when there are wolves in the forest. During periods of depression they make systematic 'type II' errors, i.e. they cry wolf all the time, when most of the wolves have left the forest. As a result, they amplify the destabilising movements in the financial markets.

All this would not be so bad were it not that it prevents clear thinking about how to reduce budget deficits and government debt levels. The source of the explosion of government debt levels is the unsustainable levels of private debt prior to the financial crisis. During the boom years, the private sector added a lot of debt. Then the bust came and the governments picked up the pieces. They did this in two ways. First, as the economy was driven into a recession, government revenues declined and social spending increased.

Second, since part of the private debt was implicitly guaranteed by the government (bank debt in particular), the government was forced to issue its own debt to rescue private institutions. The present scare about excessive government debts risks setting in motion the so-called 'Fisher paradox' (Fisher, 1932). As governments are forced by rating agencies to reduce their debt levels, the further deleveraging of private sector debt is made impossible. The private sector can only reduce its debt if the government is willing to increase its own debt. Forcing the government to reduce its debt level today while the private sector also tries to reduce its own debt level leads to a self-defeating dynamics in which neither theprivate nor the public sectors succeed in reducing their debt. This dynamics then also pull down the economy into deflation. This dynamics that was analysed by Irving Fisher in the 1930s does not seem to be part of the intellectual tool kit of the rating agencies.

The eurozone authorities

The crisis was allowed to unfold because of hesitation on the part of and ambiguities created by both the eurozone governments and the European Central Bank (ECB). The eurozone governments failed to give a clear signal indicating their readiness to support Greece. The failure to do so mainly resulted from disagreements among member state governments concerning the appropriate response to the Greek crisis. The ECB, in turn, created ambiguities about the eligibility of Greek government debt to act as collateral in liquidity provision. As is well known, the ECB relies on ratings produced by American rating agencies to determine the eligibility of government bonds as collateral. Prior to the financial crisis, the minimal rating needed to be eligible was A- (or equivalent). In order to support the banking system during the banking crisis, the ECB temporarily lowered this to BBB . At the end of 2009, however, the ECB announced that it would return to the pre-crisis minimal rating from the start of 2011 on. Since the Greek sovereign debt had been lowered to BBB , this created a big problem for financial institutions holding Greek government bonds, which now face the prospect that their holdings of Greek government bonds may become extremely illiquid. No wonder so many market participants dumped Greek government bonds, precipitating the crisis. Similar uncertainties about the future ratings of other eurozone government bonds hang as a Damocles sword over the government bond markets in the eurozone.

This is an abridged version of the original article.

Paul De Grauwe is Professor of Economics at Leuven University and Senior Associate Research Fellow at CEPS