Stages of Debt Crisis

Stages of the Sovereign Debt Crisis

The four stages of Sovereign Debt Crisis can be identified for Greece as follows:

Stage #1: Escalating Budget Deficits

During a financial crisis, Government spending increases in an attempt to stabilize the economy and stimulate further economic activity. Tax revenues are reduced and fiscal surplus (government spending or deficit spending) turns into structural budget deficits. Structural budget deficits are typically bad management since the economy is operating at NAIRU (economy is operating at its potential). As seen from Figure 13, unemployment rate was higher than NAIRU for a period leading up to the Recession for Greece and peaked in 2008 just before the Recession hit Greece. These deficits kept piling on, adding to National debt.

Greece has, in particular, violated the Euro Zone’s Growth and Stability Pact budget deficit criterion of no more than 3% of GDP from 2001 to 2006, but finally met that criterion in 2007-08, before exceeding it again in 2009, with the deficit reaching 15.4% of GDP.

Stage #2: Ballooning Debt

When economies are contracting or if the economic growth rate is slow, controlling and reducing the deficits becomes challenging. Governments have to incentivize bonds (high interest rate long term bonds) and borrow for foreign markets and economies. The mushrooming deficits turn into growing debt.

As the debt levels reach closer to the GDP of the nation the borrowing costs along with market scrutiny tend to escalate. The budget deficit in Greece has grown at an alarming rate and the National Debt stands ~30% higher than its GDP

Stage #3: Downgrades

When deficits and debts rise and economic activity show no signs of reducing fiscal problems, the credit worthiness of the government falls under intense scrutiny resulting in downgrades. Figure 2 shows the increase in budget deficit and contracting GDP in Greece. Therefore Greece’s sovereign debt rating has been downgraded to junk...