City University of New York (CUNY) CUNY Academic Works All Dissertations, Theses, and Capstone Projects Dissertations, Theses, and Capstone Projects 9-2017 Three Essays on the European Sovereign Debt Crisis with a Special Focus on Greece Flora Leventi The Graduate Center, City University of New York How does access to this work benefit ou?y Let us know! More information about this work at: https://academicworks.cuny.edu/gc_etds/2319 Discover additional works at: https://academicworks.cuny.edu This work is made publicly available by the City University of New York (CUNY). Contact: [email protected] THREE ESSAYS ON THE EUROPEAN SOVEREIGN DEBT CRISIS WITH ASPECIAL FOCUS ON GREECE by FLORA LEVENTI A dissertation submitted to the Graduate Faculty in Economics in partial fulfillment of the requirements for the degree of Doctor of Philosophy, The City University of New York 2017 ii © 2017 FLORA LEVENTI All Rights Reserved iii This manuscript has been read and accepted by the Graduate Faculty in Economics in satisfaction of the dissertation requirement for the degree of Doctor of Philosophy. Professor Merih Uctum Date Chair of Examining Committee Professor Wim Vijverberg Date Executive Officer Professor Merih Uctum Professor Wim Vijverberg Professor Tao Wang Supervisory Committee THE CITY UNIVERSITY OF NEW YORK iv ABSTRACT THREE ESSAYS ON THE EUROPEAN SOVEREIGN DEBT CRISIS WITH ASPECIAL FOCUS ON GREECE by FLORA LEVENTI Advisor: Professor Merih Uctum This dissertation consists of three chapters where I examine several aspects of the European so- vereign debt crisis. The first chapter focuses on systemic risk. Following the financial crisis of 2007-08, both in academic as well as policy circles, much of the research has focused toward the systemic importance of financial institutions. Parallel to that research, but to somewhat lesser extent, there have been improvements in our understanding of how risk is transmitted from the fi- nancial system to the real economy. This chapter investigates a related yet distinct manifestation of systemic risk, namely systemic sovereign risk. Using data on sovereign credit default swap spreads from 11 euro member countries the study seeks to examine how the sovereign risk of one member country can affect others, as well as the overall impact in the system. The proposed work is based on the approach of Adrian and Brunnermeier (2010), used to assess systemic risk contributions among financial institutions. Focusing on sovereigns rather than financial institutions, this work will expand a small but growing body of literature examining the recent European sovereign debt crisis. In the second chapter I present a brief overview of the stylized facts for the Greek economy starting from the period after the end of the military dictatorship and the transition to democracy up until early 2016. In the third chapter I revisit the issue of fiscal sustainability in Greece in a retrospective framework, meaning that our interest lies in evaluating the sustainability of past fiscal policies and whether v these can lead to a sustainable fiscal path. My empirical analysis uses annual data from 1970 to 2015 from a single source (AMECO). The econometric methodology is divided into two parts. In the first part, I focus on the sustainability of government debt using unit root tests that allow for structural breaks. In the second part, I test for cointegration between government revenues and expenditures with two procedures, namely the Bounds test of Pesaran and Shin and Johansen’s test. The results from both the unit root tests and the cointegration tests indicate Greek fiscal policy is unsustainable. In order to account for structural breaks, I employ the methodology of Bai (1997) and Bai and Perron (1998) and incorporate the breaks when testing for cointegration between government revenues and expenditures. The methodology employs the Dynamic OLS framework of Stock and Watson (1993). Even when I account for structural breaks, I find no evidence of strong form sustainability between the two series. However, my results do not reject the weak form sustainability of Quintos (1995). I argue that evidence of weak form sustainability for Greece can be interpreted as a higher risk of unsustainability, which can be used to explain Greece’s current fiscal distress. Acknowledgments This work is dedicated in memory of my father. His passion for knowledge and excellence helped me build and accomplish my own dreams, even though I was not fortunate enough to have him by my side through my studies. Thank you for instilling in me the beauty of the “road less travelled”. My profound appreciation and gratitude goes to my mother, without whose support and count- less sacrificies, I would not have been able to complete or even begin this work. I am also indebted to my uncle, who contributed the most to the completion of my studies. I would like to thank Victor, for his patience and support during the last phases of this work. Much of my time that rightfully belonged to him, was spent working on my thesis. I am very grateful to the members of my committee for their patience and support, especially given that I was away from New York during the most critical stages of my dissertation. Also to Professor Herron for sharing his thesis LaTeX template along with very helpful comments. Last, but certainly not least, many thanks to my lifelong friend Konstantis whom I would have never been able to compile the final document without! vi Contents Contents vii List of Tables x List of Figures xii 1 Conditional risk in the euro-zone: Using CDS data of European sovereigns to quantify interconnectivity 1 1.1 Introduction . .1 1.2 Statement of the Problem . .2 1.3 Background of the Study . .3 1.3.1 The characteristics of credit default swaps . .4 1.3.2 The joint dynamics between bank and sovereign CDS spreads . .5 1.3.3 The relationship between sovereign CDS and bonds spreads . .7 1.3.4 Sovereign CDS spreads and economic fundamentals . .9 1.3.5 Contagion and spillover effects among sovereigns . 11 1.4 Conditional risk in the euro-zone . 14 1.4.1 Introduction and background . 14 1.4.2 Data description and sources . 19 1.4.3 Results: Baseline model . 20 vii CONTENTS viii 1.4.4 Results: Model with lagged risk factors . 21 1.4.5 Higher stress regime . 22 1.4.6 Conclusions . 24 1.4.7 Comparison of results with similar studies . 25 1.5 Extensions . 27 1.5.1 Quantile examination . 27 1.5.2 Different conditioning events . 28 1.5.3 Different time periods . 30 2 The Greek sovereign debt crisis: A brief historical account 55 2.1 Introduction . 55 2.2 The Greek economy after WWII and up until the early 1990s . 56 2.3 The Greek economy from the mid-1990s and up until the mid-2000s . 60 2.4 The Greek economy during the late 2000s and up until early 2016 . 75 3 Fiscal sustainability in Greece: Evidence from 1970 - 2015 88 3.1 Introduction . 88 3.2 Statement of the problem . 92 3.2.1 Motivation . 94 3.2.2 Stylized facts . 94 3.3 Background of the Study . 100 3.3.1 Literature review . 100 3.3.2 The concept of sustainability . 105 3.3.3 Theoretical background . 106 3.4 Methodology: Empirical tests on fiscal policy sustainability . 110 3.4.1 Fiscal policy sustainability using government debt series: Unit Root tests . 110 CONTENTS ix 3.4.2 Fiscal policy sustainability using government revenues and expenditures: Cointegration tests . 112 3.4.3 Fiscal policy sustainability using government revenues and expenditures: Cointegration tests in the presence of structural breaks . 121 3.4.4 Data description and sources . 128 3.5 Results . 129 3.5.1 Unit Root tests . 129 3.5.2 Cointegration tests . 131 3.5.3 Cointegration tests in the presence of structural breaks . 133 3.6 Conclusion . 138 A Data sources for Chapter 2 153 Bibliography 154 List of Tables 1.1 Descriptive statistics of the series . 44 1.2 CoRisk metric for changes in sovereign CDS spreads baseline model evaluated at q = 0:95, Apr 2008 - Jun 2014 . 45 1.3 CoRisk metric for changes in sovereign CDS spreads model with one lag, evaluated at q = 0:95, Apr 2008 - Jun 2014 . 46 1.4 CoRisk metric for changes in sovereign CDS spreads baseline model evaluated at q = 0:99, Apr 2008 - Jun 2014 . 47 1.5 CoRisk metric for changes in sovereign CDS spreads, model with one lag evaluated at q = 0:99, Apr 2008 - Jun 2014 . 48 1.6 Systemic Importance . 49 1.7 Vulnerability . 50 1.8 GDP, public debt and corresponding country weights . 51 1.9 CoRisk metric for changes in sovereign CDS spreads, evaluated at q = 0:95, Apr 2008 - Jun 2014 . 52 1.10 CoRisk metric for changes in sovereign CDS spreads: core and periphery model evaluated at q = 0:95, Apr 2008 - Jun 20 . 53 1.11 CoRisk metric for changes in sovereign CDS spreads, evaluated at q = 0:95, subs- amples . 54 x LIST OF TABLES xi 2.1 Main aggregates of general government, 1995-2004 (as percentage of GDP) . 72 2.2 Main aggregates of general government, 2005-2014 (as percentage of GDP) cont. 73 2.3 Main macroeconomic indicatorsa ........................... 84 2.4 Main aggregates of general government, 2015 (as percentage of GDP) . 86 2.5 Elections and governing parties: 1974-2015 . 87 3.1 Descriptive statistics of the series . 141 3.2 Lag selection using Information Criteria . 142 3.3 Zivot-Andrews Unit Root tests for Public Debt - Model A . 142 3.4 Zivot-Andrews Unit Root tests for Public Debt - Model B . 143 3.5 Zivot-Andrews Unit Root tests for Public Debt - Model C .