The Greek Sovereign Debt Crisis: A Conceptual and Empirical Analysis

Following the lead of Arghyrou and Kontonikas (2010), this paper presents an endogenous expectations-based model that conceptualizes the ongoing Greek sovereign debt crisis as a currency crisis in disguise. That is, instead of the crisis culminating in a real devaluation of the drachma, it has been diverted to, and erupted in, the bond market where it has significantly raised interest rates, reduced economic growth, and spread it to other weak EMU economies. The empirical results indicate that poor economic fundamentals and international risk did not penalize bond spreads during the pre-crisis period, but are doing so in the crisis period. The estimates suggest that for both the pre-crisis and crisis periods, contagion is generally determined by economic and financial links among countries which, under certain conditions, can spread the crisis in a “fast and furious” manner. The reported estimates also confirm Arghyrou and Tsoukalas’s (2010) theoretical model by showing that an adverse shift in expectations occurred first in November 2009 and then on January 2010, thus significantly increasing bond spreads and slowing economic growth. Finally, the paper extends previous work and presents estimates which indicate that a third adverse shift in expectations took place in May 2010 following the announcement and implementation of the ECB and IMF-sponsored adjustment package. Investors apparently concluded that the draconian austerity measures associated with the latest rescue loan package would actually make economic conditions worse by inducing a self-reinforcing downward spiral in an economy which was already reeling from weak economic fundamentals and high levels of indebtedness.