The Greek Crisis and the Future of the Eurozone

by Paul De Grauwe


EuroIntelligence
March 11, 2011

The crisis that started in Greece culminated into a crisis of the Eurozone as a whole. There is no doubt that the major responsibility rests with the Greek authorities who mismanaged their economy and deceived everybody about the true nature of their budgetary problems. The solution of the problem will therefore necessitate drastic changes in Greek economic and budgetary policies. This being said, there is more than one villain in the play. The financial markets and the eurozone authorities also bear part of the responsibility for letting this crisis degenerate into a systemic crisis of the eurozone.

The destabilizing 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 the time when governments added unprecedented amounts of new bonds in the market. In a few weeks time the situation turned around dramatically and bond markets in a number of countries crashed. It is a repeat of a sad story. Financial markets are first blinded and see no risks, until the wake-up call and then they overreact making the resolution of the problem more difficult.

The rating agencies take a central position in the destabilizing role of the financial markets. One thing one can say about these agencies is that they systematically fail to see crises come. 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 was again 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 FT, did the rating agencies realize there was a crisis and did they downgrade Dubai’s bonds. Having failed so miserably in forecasting a sovereign debt crisis, they went on a frantic search of possible other sovereign debt crises. They found Greece which of course was a natural target. They did not limit their search to Greece but “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.

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