The Greek crisis: A story of self-reinforcing feedback mechanisms

Juselius, Katarina; Dimelis, Sophia Working Paper The Greek crisis: A story of self-reinforcing feedback mechanisms Economics Discussion Papers, No. 2018-65 Provided in Cooperation with: Kiel Institute for the World Economy – Leibniz Center for Research on Global Economic Challenges Suggested Citation: Juselius, Katarina; Dimelis, Sophia (2018) : The Greek crisis: A story of selfreinforcing feedback mechanisms, Economics Discussion Papers, No. 2018-65, Kiel Institute for the World Economy (IfW), Kiel This Version is available at: https://hdl.handle.net/10419/182384 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/4.0/ Discussion Paper No. 2018-65 | September 13, 2018 | http://www.economics-ejournal.org/economics/discussionpapers/2018-65 The Greek crisis: A story of self-reinforcing feedback mechanisms Katarina Juselius and Sophia Dimelis 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 (Structural slumps, 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. The authors find that the strongly increasing real bond rate and unemployment rate together with a persistently appreciating real exchange rate and a deterioration of competitiveness in the euro-zone 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. 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. JEL C32 E24 E31 E65 Keywords Greek crisis; unemployment; CVAR analysis; structural slumps; nonconstant natural rate; self-reinforcing adjustment Authors Katarina Juselius, University of Copenhagen, Copenhagen, Denmark, [email protected] Sophia Dimelis, Athens University of Economics and Business, Athens, Greece Valuable comments from Elias Tzavalis, Helen Louri Dendrinou and Vangelis Vasilatos are gratefully acknowledged. Citation Katarina Juselius and Sophia Dimelis (2018). The Greek crisis: A story of self-reinforcing feedback mechanisms. Economics Discussion Papers, No 2018-65, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2018-65 Received July 6, 2018 Accepted as Economics Discussion Paper September 12, 2018 Published September 13, 2018 © Author(s) 2018. Licensed under the Creative Commons License - Attribution 4.0 International (CC BY 4.0) 1 Introduction From 2008 to 2013, Greece experienced one of the most severe recessions in Europe with a fall in real output of 26% and unemployment reaching 26%. While 2017 marked the …rst time that real GDP growth exceeded 1% since 2007, the crisis measured by low economic activity was still unfolding on its tenth year. So why was the recovery so slow and which were the mechanisms triggering the Greek crisis? A number of explanations have been proposed in the literature of which the most popular ones refer to initial macroeconomic imbalances (e.g. …scal de…cits, external de…cits), deteriorating competitiveness, current account imbalances, and the strong external dependence combined with the sudden lending stop.1Apart from these, chronic structural problems in the economic and political system combined with badly designed policies to deal with them - often forced upon Greece by national, supranational and international institutions - have also been proposed.2Also, some scholars argue that the contraction was more severe than initially expected because typical features of the Greek economy, such as the low quality of the Greek institutions, were largely overlooked in the many reform programs (see Economidis et al., 2017, Philippopoulos, 2014). In the same vein, Kollintzas et al. (2017) attribute the dismal growth in Greece to its ‘insiders-outsiders’ society by showing that the high public sector wage premium and self-employed taxation gap signi…cantly contributed to the sovereign debt crisis. But, while the above explanations are relevant for understanding the build-up of the Greek crisis, the severeness of the Greek problems cannot be fully understood without accounting for the mechanisms triggered by Greece becoming an eurozone member in 2001. Because …nancial markets incorrectly considered risk to be evenly distributed in the euro area, the Greek bond rate dropped to unprecedented low levels as Greece entered the eurozone. This resulted in a strong increase in credit-…nanced demand, mostly for imports and contributed to a wage and price spiral both in the private and the public sector, creating huge current account imbalances. 1See, for example, Gibson et al. (2014), Honkapohja (2014), Christodoulakis (2015), Galenianos (2015), Bournakis et al. (2017), Ioannidis and Pissaridis (2015) and Meghir et al. (2017). 2For example, Meghir et al. (2017) provide a detailed analysis of the pathologies that made Greece vulnerable to the crisis with special focus on the product and labor market regulations and the …nancial system. 2 Thus, Greece borrowed heavily to pay for unproductive consumption and excessive wages. Hence, the resulting de…cits hit the country hard when the crisis unfolded. In contrast, foreign lenders were largely rescued in spite of being badly exposed. For example, Wyplosz (2017) argues that the Great Financial Crisis was rooted primarily in excessive risk-taking by …nancial intermediaries –a result of the poor regulation and supervision that emerged in connection with …nancial liberalization. A contributing cause of the external lending problem was, therefore, that …nancial 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 …nance its debt with low interest rate loans up to the crisis - even though the size of the …scal imbalance must have made severe macroeconomic adjustment seem inevitable. When the …nancial markets learned their mistakes, Greece experienced the harsh consequences of strongly increasing interest rates and sudden lending stops. The Greek misfortune was that most of its external borrowing had been used for unproductive spending, much of it closely tied to large and persistent public de…cits that, given the rapidly increasing interest rates, became extremely harmful. Excessive public spending …nanced by external borrowing was generally considered the most serious obstacle for getting the Greek economy out of the crisis. See for example Gourimchas et al. 2016. But, rather than a pure sovereign debt crisis, Hyppolite (2016) argues that the Greek crisis is best viewed as an external debt crisis driven by a real estate bubble and unsustainable foreign capital ‡ows.3 Thus, while there seems to be a well researched narrative about the underlying causes of the crisis, less is known about internal and external transmission mechanisms causing the rapidly increasing unemployment rate over this period. We believe, therefore, it is of considerable interest to uncover the dynamic mechanisms among unemployment, prices, interest rates, and external imbalances that contributed to the severity and the length of the crisis. A similar aim can be found in Juselius and Juselius (2012) that used the Cointegrated VAR (CVAR) model to uncover important relationships among unemployment, prices and interest rates in connection with the Finnish crisis in the beginning of 1990s. In many ways the economic mechanisms leading to the Finnish crisis were similar to the ones of the Greek crisis: the deregulation 3He shows this using a new dataset that evaluates and breaks down national wealth accumulation in Greece since 1997. 3 of the Finnish credit market in 1986 resulted in lower loan rates, a booming housing market and the build-up of a serious house price bubble that …nally burst in 1991. House prices dropped by roughly 60 % and unemployment rose from a record low of 2 % to almost 20 %. These are huge ‡uctuations but of similar magnitudes as in the Greek crisis. Unlike the Greek economy, Finland managed to get out of the crisis in approximately three - very hard - years by devaluing the Finnish markka by 33 %. Also, unlike the Greek experience, the Finnish unemployment came down much faster, albeit stabilizing at a somewhat higher level compared to the pre-crisis period. One important …nding in the Finnish study was an empirically strong Phillips curve relation with a non-constant Phelpsian natural rate of unemployment measured by the real bond rate. The results generally provided support to the structural slumps theory by Edmund Phelps (1994) combined with the theory of balance sheet recession by Richard Koo (2010). The present paper takes a similar approach as Juselius and Juselius (2012), but recognizes that the Greek crisis, while similar in many respects, di¤ers strongly in others such as in the source of the debt (private/public, external/internal) and in particular the exchange rate regime. The fact that Finland was able to devalue its currency while Greece was not, is likely to have made all the di¤erence. It is one reason why the comparison with Finland is interesting. The prolonged period of policy uncertainty following the outbreak of the Greek crisis clearly aggravated the deepening and the extension of the Greek crisis. Also, the failure of the 2012 sovereign debt restructuring (known as Private Sector Settlement, PSI) further weakened investors’con…dence. Unlike the Finnish analysis we therefore include a variable measuring con…dence in the Greek economy. Also, the development of the Greek competitiveness within and outside the eurozone is likely to be very important for the crisis mechanisms, so these are also included in our model analysis. Because of the severity of the crisis, we expect the macroeconomic dynamics both during, before and after the Greek crisis to be utterly complex. Our approach di¤ers therefore from most papers that have empirically studied the Greek crisis by not taking the simple route of choosing a priori a few exogenous causes and then forcing this assumption on the model. We argue that it is seldom possible to know from the outset - and especially not in a complex crisis period - which variables are empirically endogenous (purely adjusting) and which are exogenous (purely pushing). Like Juselius and Juselius (2012), our approach relies on a full system 4 CVAR model in which all systematic aspects of the data have to be satisfactorily described. Spanos (2009), for example, argues that a convincing test of the empirical relevance of an empirical model has to be carried out in the context of a fully speci…ed statistical model that works as an adequate, though approximate, description of the Data Generating Process given in its entireness. A CVAR model that has passed all basic speci…cation tests, is essentially a summary of the most important empirical facts over the sample period and, thus, quali…es for such a statistical model. A model that has not passed such checks may - and often does - produce totally misleading conclusions. See Juselius and Franchi (2007) for an illustration of a real business cycle model. To achieve scienti…c objectivity, we argue therefore that data cannot be constrained from the outset in a theoretically pre-speci…ed direction, as it then would be impossible to distinguish between results which are due to the assumptions made and results which are genuine empirical facts. The basic idea is to let the data speak as freely as possible about the mechanisms that caused the crisis and why it lasted so long. This is unlike approaches in which the data from the outset are silenced by prior restrictions as discussed in Hoover et al. (2008). The paper is organized as follows: Section 2 discusses broadly the Phillips curve with a Phelpsian natural rate based on Phelps (1994). Section 3 discusses the empirical mechanisms over the sample period based on a graphical display of the data. Section 4 introduces the empirical model, reports misspeci…cation tests and determines the important reduced rank indices based on ML tests. The results show that data are approximately I(2) over this period. Section 5 reports the estimates of the long-run structure and Section 6 concludes. 2 The structural slumps theory and the nonconstant natural rate 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. According to this theory, ‡uctuations in the real interest rates and real exchange rates play an important role in explaining 5 the persistent long swings in the observed unemployment rates. The theoretical implication for a standard Phillips curve is that the natural rate of unemployment becomes a function of real interest rate and real exchange rates. While Phelps (1994) assumed that real interest rates and real exchange rates were stationary,4empirical evidence often …nds that they are indistinguishable from a unit root process. Juselius (2013) argues that the structural slumps theory based on imperfect knowledge expectations would be more adequate to explain the long persistent movements in the data.5 In an imperfect knowledge world, the nominal exchange rate is primarily determined by …nancial speculation whereas prices of tradable goods, being determined in very competitive customer markets, are not likely to be a¤ected by speculation - energy, precious metals and, recently, grain may be exceptions in this respect. Hence, relative prices would ‡uctuate much less than nominal exchange rates and real exchange rates would inherit the persistent swings of nominal exchange rates. Figure 1, panel (f), illustrates such persistent swings in the real e¤ective exchange rate of the euro relative to the Greek trading countries outside the eurozone. Relative prices within the eurozone have also exhibited a pronounced upward persistence as shown in panel (e). The nominal bond rate was also strongly a¤ected by …nancial behavior, in particular after the market became aware of the unsustainability of the Greek debt. Figure 1, panel (c) shows the dramatic increases of the long-term Greek bond rate at the beginning of the crisis. Since the nominal bond rate ‡uctuated much more than price in‡ation, the real interest rate inherited the persistent swings of the nominal interest rate. Hence, the strongly increasing real bond rate together with an appreciating real exchange rate and a deterioration of competitiveness in the eurozone is likely to have significantly aggravated the existing structural imbalances in the Greek economy. As the lack of con…dence in the Greek economy grew steadily, the scene was set for a monumental structural slump a la Phelps (1994). How would all this a¤ect the Greek unemployment. As Greek enterprises had lost much of their previous competitiveness after a long period of permanent shocks to relative costs, a real depreciation would have been the obvious cure. But, as an eurozone member, Greece had given up the possibility to use the exchange rate as a policy tool. Unless Greece left the euro she could not 4This is because the theory was based on model consistent rational expectations 5Frydman and Goldberg (2007) show that …nancial behavior under imperfect knowledge can drive asset prices, such as nominal exchange rates and long-term bond rates, persistently away from long-run benchmark values. 6 count on exchange rates to restore lost competitiveness. But, unlike Finland in the nineties, the large proportion of external debt would have made such a choice extremely costly. Thus, Greek enterprises, facing domestic wage costs in excess of the foreign ones, may not have had other options than to improve labor productivity. This could, for example, be achieved by introducing new technology, by lowering domestic wage (extremely di¢ cult) or by laying o¤ the least productive part of the labor force and producing the same output with less labor. In all those cases unemployment rate would take the burden of adjustment. In line with Phelps (1994), our empirical analysis is centered around a Phillips Curve with a non-constant natural rate: p=b1(uun);(1) where the natural rate of unemployment, unis potentially a function of the real e¤ective exchange rate, reer; relative producer prices with respect to the eurozone, relc; market con…dence, conf; and the real bond rate, r: Figure 1 shows the data over the sample period 2004:5-2017:1. Panel (a) pictures the Greek in‡ation rate that, in spite of a strong seasonal pattern, looks reasonably stable. Panel (b) shows how unemployment declined in the period preceding the crisis as a result of the overheated Greek economy, only to increase to record levels a few years later. It illustrates the force with which the crisis struck the Greek economy similarly as in the case of Finland. After topping in 2013, unemployment has slowly started to come down but at the end of the sample it is still at a very high level. Panel (c) pictures the bond rate and its extreme growth as the crisis unfolded. Panel (d) shows the con…dence variable and its decline until approximately 2012 after which it was rising up to 2015 when the election of a new government - hostile to structural adjustment programs - caused it to drop dramatically. As it seemed almost impossible for Greece to honor its external debt, foreign lenders panicked and stopped lending. This almost pushed Greece over the edge and aggravated the very crisis the lenders feared. Panel (e) pictures the relative producer cost between Greece and Germany and shows its steady increase up to roughly 2012, when it started leveling o¤ until 2014 after which it gradually started to decline. Panel (f) pictures the Greek e¤ective real exchange rates and shows its steady real appreciation, mirroring the increase in the relative costs in panel (e). 7 2005 2010 2015 0.00 0.02 0.04 Inflation rate (a) 2005 2010 2015 0.1 0.2 Unemployment rate (b) 2005 2010 2015 0.01 0.02 0.03 Bond rate (c) 2005 2010 2015 -0.75 -0.50 -0.25 Confidence rate (d) 2005 2010 2015 -0.1 0.0 Relative costs (e) 2005 2010 2015 90 100 110 Real exchange rate (f) Figure 1: Graphs of the data 8 in‡ation rate, the next on the bond rate, the third on unemployment rate and the last one on the con…dence rate. 1. a Phillips Curve type of relation: pt=0:02ut+z1;t;11 2. a self-reinforcing relation between unemployment rate and the bond rate: bondt= 0:02ut+z2;t; 3. a natural rate relation associating unemployment rate with the relative producer price between Greece and Germany and with the real e¤ective exchange rate: ut= 0:87relCt0:62reert+z3;t: 4. a relation associating a measure of con…dence with the relative producer cost between Greece and Germany and with the real e¤ective exchange rate: conft=0:97relCt+ 1:83reert+z4;t. Cointegration is a measure of co-movements and as such is silent about causality, but combined with the coe¢ cients it is possible to infer where in the system long-run adjustment has taken place. Whether the variable iis error-correcting or error-increasing in response to an equilibrium error measured by cointegration relation j, can be inferred by checking whether ijij <0(error-correcting behavior) or ijij <0(error-increasing behavior) for signi…cant values of ij:If only one ijij is signi…cant in cointegration relation j; then it provides some evidence of a causal link, if several are signi…cant, then this provides evidence of joint feed-back e¤ects. Such a check shows that 1. in‡ation rate, but not unemployment rate, is signi…cantly adjusting to the …rst relation, the Phillips curve, consistent with the theoretical prior; 2. both unemployment and the bond rate are adjusting to the second relation signifying strong dynamic feed-back e¤ects between the two. 11The small coe¢ cient of unemployment rate in the …rst and second relation can be explained by data transformations. In‡ation is measured as the monthly di¤erence of logCPI (a very small number) and bond rate is measured as the annual rate divided by 1200 to give a corresponding monthly measure. Unemployment rate is measured as percentage unemployment rate divided by 100 which is approximately 30 times as large as the measurements of in‡ation rate and the bond rate. If standardized data had been used the coe¢ cient of 0.02 would instead have been 0.6. 15 It shows that the bond rate has increased as the level of unemployment has increased and that the unemployment rate has increased as the bond rate has increased; 3. only unemployment is very signi…cantly adjusting to the third relation, suggesting that it is our best candidate for a non-constant natural rate relation; and 4. only con…dence rate is very signi…cantly adjusting to the fourth relation, suggesting a causal link from ‡uctuations in relative producer prices and the real exchange rate to con…dence in the Greek economy. In all cases, the adjustment represents equilibrium-error-correction. The remaining signi…cant coe¢ cients show that unemployment rate has adjusted very strongly to all relations except for the …rst Phillips curve relation. Thus, the results show very clearly that unemployment rate is the variables that has taken the burden of adjustment over this period. In the I(2) model, the static equilibrium error, 0xt;is a very persistent process implying there are forces preventing the variables to equilibriumcorrect in the short run. In this case, the econometric logic tell us that changes in system variables, d0xt;will co-move with the persistent equilibrium error, 0xt;to produce a dynamic long-run relation, 0xt+d0xt; that is stationary. As mentioned above, the dcoe¢ cients can be interpreted as a measure of the dynamic adjustment (either error-correcting or errorincreasing) of the changes of the variables. Error-increasing behavior is of particular interest in crisis periods as it suggests self-reinforcing adjustment behavior in the system. We shall pay special attention to such evidence in the detailed discussions of the dynamic relation. The …rst dynamic relation (the Phillips curve relation) is given by: pt+ 0:02ut= 0:002(bondtpt)+0:12ut0:09conft +0:17relC + 0:04reer 0:004 + u1t where u1tis a stationary process pictured in Figure 7, panel (a). The results show that an equilibrium error in the Phillips curve relation, pt+ 0:02ut;is associated with a positive change in the real bond rate, with a positive change in unemployment rate (an error-increasing e¤ect), with a drop in con…dence, with an increase in relative producer prices and with a real appreciation of the euro with respect to Greek prices. 16 Table 3: The estimated long-run structure Test of restricted structure 2(6) = 4:67[0:59] p u bond conf relC reer t 11:00 0:02 [12:3]      d10:002 [3:4] 0:12 [3:4] 0:002 [3:4] 0:09 [2:8] 0:17 [3:3] 0:04 [2:1] 0:004 [5:9] 11:10 [7:15]  0:08 [2:53] 0:71 [2:05]   2 0:02 [4:61] 1:00     d20:01 [3:7] 0:29 [3:7] 0:01 [3:7] 0:36 [5:1] 0:31 [2:4]  0:00 [1:8] 20:13 [3:24] 0:14 [7:59]     31:00   0:87 [8:31] 0:62 [162:45]  d30:08 [4:0] 4:32 [4:0] 0:09 [4:0] 4:71 [5:3] 5:07 [3:0]  3:04 [7:4] 3 0:01 [3:57] 0:01 [3:85] 0:26 [3:14] 0:04 [1:99]   4   1:00 0:97 [3:29] 1:83 [150:0]  d40:23 [4:4] 12:65 [4:4] 0:26 [4:4] 6:33 [2:8] 19:53 [4:2] 6:90 [3:9] 8:93 [7:1] 40:01 [2:57] 0:01 [5:58]  0:13 [5:02] 0:01 [1:92]   * stands for an coe¢ cient with a t-ratio of less than 1.3 In the long-run, the coe¢ cients show that in‡ation has been signi…- cantly error-correcting consistent with the Phillips curve hypothesis whereas the bond rate has been error-increasing to the change in the bond rate, signifying its almost explosive behavior in the crisis period. Thus, the Phillips curve has moved away from long-run equilibrium values because of the selfreinforcing adjustment behavior of the unemployment rate partly caused by a strongly increasing bond rate. Finally, the relative producer price has been error-correcting to the changes in relative price, but not very signi…cantly so. The second relation is given by: bondt0:02ut= 0:01(bondtpt)0:36conft+ 0:31relC +u2;t where u2;t is a stationary process pictured in Figure 7 panel (b). The results show that the disequilibrium between the bond rate and the unemployment 17 rate can be explained by an increase in the real bond rate (an error-increasing e¤ect), a drop in con…dence and an increase in relative producer prices. Both unemployment and the bond rate are error-correcting in the long run. This relation can predominantly be seen as a crisis relation signifying the almost explosive behavior of both the bond rate and the unemployment rate, but with the bond rate leading the race as evidenced by its error-increasing behavior. The third relation is given by: ut0:87relCt+ 0:62reert=0:09(bondtpt)4:3ut+ 4:7conft 5:1relCt+ 3:04 + u3;t where u3;t is a stationary process pictured in Figure 7 panel (c). The results show that the deviation from the natural rate of unemployment relation (Phelps, 1994) can be explained by (i) a negative e¤ect from a change in the real interest rate (a change in the latter is likely to go together with an appreciated value of the real exchange rate), (ii) a negative e¤ect of a change in unemployment rate (an error-correcting e¤ect), (iii) a positive e¤ect of a change in con…dence (a positive change in the latter is likely to go together with a declining level relative prices), and (iv) a negative e¤ect of a change in relative producer prices (an error-increasing e¤ect). The latter shows that in the medium run, the persistent deviations of unemployment from its nonconstant natural rate was strongly a¤ected by the error-increasing behavior of relative producer costs. However, in the long run, the coe¢ cients show that relative producer prices are error-correcting (53 = 0:04);whereas the remaining variables - unemployment, the bond rate and con…dence - are all error-correcting. The forth relation is given by: conft+ 0:97relCt1:83reert=0:23(bondtpt)12:7ut +6:3conft19:5relCt6:9reert +8:9 + u4;t where u4;t is a stationary process pictured in Figure 7 panel (d). The results show that a deviation from a long-run con…dence relation can be explained by a negative e¤ect from an increase in the real bond rate, a negative effect from an increase in the unemployment rate, a negative e¤ect from an 18 Table 4: The estimated coe¢ cients to the medium-run relations Loadings to 0 1xt0 2xt0 3xt0 4xt 1231 3 2pt1:12 [5:97] 0:36 [2:50] 0:13 [2:50] 2ut0:13 [1:49]  0:43 [6:56] 0:16 [6:31] 2bondt0:10 [2:54] 0:98 [17:51] 0:05 [1:77] 0:02 [1:96] 2conft 3:78 [1:50] 2:08 [1:54] 0:67 [1:32] 2relCt1:19 [2:80] 0:70 [2:16]  increase in the relative price (an error-correction e¤ect), a negative e¤ect from a depreciation of the real exchange rate, and …nally a positive e¤ect of a change in con…dence implying equilibrium increasing behavior in the medium run. However, in the long run, the coe¢ cients show that con…- dence is error-correcting (44 =0:13) and so are the remaining variables - in‡ation, unemployment and relative producer prices. Table 4 reports the medium run responses to changes in the static equilibrium errors, 0xt. As before, error-increasing coe¢ cients are in bold face. We …nd error increasing behavior in the unemployment equation as a response to the change of the …rst equilibrium error, (p+ 0:02u)and in the con…dence and relative producer price equations to the change of the natural rate equilibrium error, (u0:87relC +0:62reer):These e¤ects may capture the gradual deterioration of con…dence and relative costs as a result of the strongly increasing bond rate and unemployment rate. Altogether, the results provide strong evidence of many self-reinforcing feed-back mechanisms during the Greek crisis period. Unemployment was found to be error-increasing to the Phillips curve relation in the medium run (both in levels and changes), but error-correcting to the second and third relation; the bond rate was error-increasing in the medium run to the natural rate relation between in‡ation and the bond rate; con…dence was errorincreasing to the fourth relation but error-correcting to the third relation; relative prices were error-increasing to the third relation but error-correcting to the fourth relation. The only variable that has not shown any evidence of error-increasing behavior is the Greek in‡ation rate. This gives empirical support to the structural slumps theory combined with imperfect knowledge 19 expectations as discussed in Section 2. Considering the wild ‡uctuations over this period, the results are remarkably good. The signs of the coe¢ cients are as expected, the estimated relations are plausible as a description of dynamic transmission mechanisms in a period of severe crisis. While one should be careful not to over-interpret the medium-run e¤ects, d0xt+0xt=  = I12;as they are often more unstable over time than  = 0;the plausibility of the coe¢ cient estimates gives credibility of the results. Whether the results will hold also when the crisis is …nally over is a more di¢ cult question. We believe that the pronounced persistence of the equilibrium errors is likely to disappear and the corresponding error-increasing adjustment dynamics to become more insigni…cant, but that many of the estimated long-run relations may remain empirically signi…cant. If the equilibrium errors become less persistent, the data will probably become approximately I(1). 5 Concluding remarks Motivated by the structural slumps theory in Phelps (1994) we present empirical results relevant for a more elaborate understanding of the deep and prolonged Greek crisis starting roughly in 2008. Based on a cointegrated VAR analysis, the data were found to be approximately I(2) over this period consistent with prolonged imbalances from equilibrium states due to self-reinforcing feed-back mechanisms. The latter is likely to be a sign of an approaching economic crisis. At the core of the Greek crisis we identi…ed a critical relationship between the bond rate and the unemployment rate. When the crisis erupted, the bond rate increased strongly and unemployment started to increase, the increase in unemployment rate caused the bond rate to increase further and unemployment to follow suite, and so on. This vicious cycle was orchestrated by a continuous fall in the con…dence rate that kept deteriorating until relative producer costs stopped increasing around 2012. The empirical results showed that all variables, except CPI in‡ation, exhibited error-increasing behavior somewhere in the system. This feature is likely to have aggravated the crisis and e¤ectively prevented good policy solutions. Thus, the Greek recession seems to have grown out of many imbalances that were allowed to develop over a too long time. But, while accruing imbalances may counterbalance 20 each other to some extent, a balance that is maintained by several imbalances is a very fragile balance. A large shock somewhere in the system, is su¢ cient for the whole thing to collapse as demonstrated in 2008 when the …nancial crisis hit Greece - and the world economy - with unprecedented force. The results of the paper support the following narrative of the Greek drama: As Greece joined the euro, the level of interest rate dropped to previously unprecedented levels; low interest rates and easy access to foreign capital caused credit …nanced consumption - public as well as private - to soar. As a result, wages and prices were rising and the Greek competitiveness was consequently deteriorating. As external and internal imbalances grew, the …nancial market realized that risk was not equally distributed among the eurozone countries and that the Greek external debt was largely unsustainable. The dramatic rise of the Greek bond rate increased the cost of investment and production and made it very costly just to maintain previously accumulated imbalances. The consequence was that unemployment skyrocketed. Since the euro rate was determined by factors mainly outside the control of Greece, she was stuck in a situation with no feasible options: a dramatic lowering of wage costs is politically almost impossible; leaving the euro would have been extremely costly due to the large proportion of external debt. The prolonged period of policy uncertainty following the outbreak of the crisis contributed to the drop in con…dence of the Greek economy and to the increase of the already high unemployment rates and the depressed state of the economy. An important lesson to be learnt from the results of this paper is that imbalances in the economy - whether internal or external - can be intolerable costly if they are allowed to accrue over longer periods. Hence, a reliable monitoring system, that signals the build-up of crucial macroeconomic imbalances well ahead of the outbreak of a crisis, is likely to lower the probability of a similar disastrous drama in the future. 6 References Baker, S.R., Bloom, N. and S.J. Davis (2016). "Measuring Economic Policy Uncertainty", The Quarterly Journal of Economics, 131(4), 1593-1636. Bloom, N., Floetotto, M., Jaimovich, N., Saporta, I., and S. Terry (2014). "Really Uncertain Business Cycles", Working Paper, Stanford University. Bournakis, I., Tsoukis, C., Christopoulos D.K., and T. Palivos (2017). 21 Political Economy Perspectives on the Greek Crisis, Debt, Austerity and Unemployment, Palgrave, Macmillan. Christodoulakis, N. (2015) "Greek crisis in perspective: Origins, e¤ects and ways-out". In (ed.) Garett Jones Banking Cries, Perspectives from the New Palgrave Dictionary. Dennis, J. G., H. Hansen, S. Johansen, and K. Juselius (2006). CATS in RATS. Cointegration Analysis of Time Series, Version 2. Estima: Evanston, Illinois, USA. Doornik, J. A. and D. F. Hendry (2001). GiveWin. An Interface to Empirical Modelling (3rd edn.). Timberlake Consultants Press: London. Doornik, J. and K. Juselius (2017). Cointegration Analysis of Time Series Using CATS 3 for OxMetrics. Timberlake Consultants Ltd. Economidis, G., Papageorgiou, D. and A. Philippopoulos (2017). "The Greeek Great Depression: A General Equilibrium Study of its Drivers". In (eds.) Bournakis et al. Political Economy Perspectives on the Greek Crisis, Debt, Austerity and Unemployment, Palgrave, Macmillan, pp. 205-221. Frydman, R. and M. Goldberg (2007). Imperfect Knowledge Economics: Exchange rates and Risk, Princeton. NJ: Princeton University Press. Frydman, R. and M. Goldberg (2011). Beyond Mechanical Markets: Risk and the Role of Asset Price Swings, Princeton University Press. Frydman, R. and M. Goldberg (2013). "Change and expectations in macroeconomic models: recognizing the limits to knowability". Journal of Economic Methodology 20: 118-138. DOI: 10.1080/1350178X.2013.804677. Galenianos, M. (2015). "The Greek Crisis: Origins and Implications", ELIAMEP, Crisis Observatory, Research Paper No 16. Gonzalo, J. (1994). “Five alternative methods of estimating long-run equilibrium relationships”, Journal of Econometrics, 60(1-2), pp. 203-233. Gourinchas, Pierre-Olivier, Philippon, Thomas and Vayanos, Dimitri (2017). "The Analytics of the Greek Crisis, (in eds.) Eichenbaum, M. and J. A. Parker: NBER Macroeconomics Annual 2016, 31, University of Chicago Press.Gibson, H.D., Hall, S.G., Tavlas, G.S. (2014). "Fundamentally wrong: market pricing of sovereigns and the Greek …nancial crisis". Journal of Macroeconomics 39,405–419. Hommes, C.H. (2013). Re‡exivity, expectations feedback and almost self-ful…lling equilibria: economic theory, empirical evidence and laboratory experiments. Journal of Economic Methodology 20: 406-419. DOI: 10.1080/1350178X.2013.859426 22 Honkapohja, S. (2014). "The euro area crisis: a view from the North". Journal of Macroeconomics 39, 260–271. Hyppolite, P-A (2016), "Towards a theory on the causes of the Greek depression: An investigation of national balance sheet data (1997-2014)", ELIAMEP Crisis Observatory, Research Paper No 22. Ioannides Y.M. and Pissaridis, C.A (2015). "Is the Greek crisis one of supply or demand?" Brookings Papers on Economic Activity, Brookings Institution, Washington, 349-373. Johansen, S. (1995). Likelihood-Based Inference in Cointegrated Vector Autoregressive Models, Oxford. Oxford University Press. Johansen, S. (1997). "Likelihood analysis of the I(2) model", Scandinavian Journal of Statistics, 24 (4), 433-462. Johansen, S., K. Juselius, R. Frydman, and M. Goldberg (2010). “Testing Hypotheses in an I(2) Model With Piecewise Linear Trends. An Analysis of the Persistent Long Swings in the Dmk/$ Rate,”Journal of Econometrics. Juselius, K. (2006). The Cointegrated VAR Model: Methodology and Applications. Oxford: Oxford University Press. Juselius, K (2011). "Time to reject the privileging of economic theory over empirical evidence? A reply to Lawson," Cambridge Journal of Economics, vol. 35(2), pages 423-436 Juselius, K. (2013). "Imperfect Knowledge, Asset Price Swings and Structural Slumps: A Cointegrated VAR Analysis of Their Interdependence”, (eds.) E. Phelps and R. Frydman, Rethinking Expectations: The Way Forward for Macroeconomics, Princeton University Press, Princeton. Juselius, K. and Franchi, M. (2007). Taking a DSGE Model to the Data Meaningfully, Economics,?? , 1, 4, http://dx.doi.org/10.5018/economicsejournal.ja.2007-4 Juselius, K and M. Juselius. (2013) “Balance sheet recessions and timevarying coe¢ cients in a Phillips curve relationship: An application to Finnish data”, in (eds.) N. Haldrup, M. Meitz & P. Saikkonen, Essays in Nonlinear Time Series Econometrics. Oxford University Press, Oxford. Juselius, K., and J. Ordóñez (2009). “Balassa-Samuelson and Wage, Price and Unemployment Dynamics in the Spanish Transition to EMU Membership”.Economics: The Open-Access, Open-Assessment E-Journal, 3, 4, http://dx.doi.org/10.5018/economics-ejournal.ja.2009-4 Kollintzas, T., Papageorgiou, D., Tsionas, E. and V. Vassilatos (2017). "Market and Political Power Interactions in Greece: An Empirical Investigation", Paper presented at te 73rd Annual Congress of International Institute 23 of Public Finance (IIPF), Tokyo Aug. 2017. Koo, R. (2010). "The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession", John Wiley & Sons, Hoboken, USA. Krugman, P. (1986). Pricing to Market when the Exchange Rate Changes, NBER Working Paper 1926, Cambridge Massachusetts. Krugman, P. (1993). Exchange Rate Instability. The MIT Press, Cambridge Mass. Meghir, C., Pissaridis, C.A., Vayanos, D., and N. Vettas (eds) (2017) Beyond Austerity: Reforming the Greek Economy, MIT Press. Phelps, E., S. (1968). “Phillips Curves, Expectations of In‡ation and Optimal Employment over Time.” Economica, n.s., 34, no. 3 (1967): 254– 281. Phelps, E. (1994). Structural Slumps, Princeton University Press, Princeton. Philippopoulos, A. (2014). "Comment on “The Eurozone Crisis: Phoenix Miracle or Lost Decade?”Journal of Macroeconomics 39, 309-312. Spanos, A. (2009). "The Pre-Eminence of Theory versus the European CVAR Perspective in Macroeconometric Modeling." Economics: The Open- Access, Open-Assessment E-Journal, 3, 10: 1–14. http://dx.doi.org/10.5018/economicsejournal.ja.2009-10 Wyplosz, C (2017). "The De…cit Tango", Long Reads, Project Syndicate, August 11. 24