One meme often repeated about the Greek ‘tragedy’ is that the large current account deficits during the Euro area were fuelled by equally large government deficits. The profligate state was the source of the increase in foreign claims and made the equilibrium unstable since, given the large share of foreign ownership of government securities, a loss of financing would impact on both the current account (and the ability of the Greek economy to import goods) and the government budget (and the ability of the Greek government to finance deficit spending). In my view, the actual data paint a different picture.

The current account was mainly financed through private sector credit flows. These, very large annual flows, were originated by the domestic banking sector and allowed the private sector to finance an expanding trade deficit. The table below shows data for the period between 1999 and 2007 (when private credit expansion was at its height):

It is quite clear that private credit flow was usually at least twice as large as general government net lending. A simple scatter plot leads to an R² of 0.67:

It’s impressive how low the error term of the computed equation is, meaning that credit flows explain almost all of the current account movement. A similar exercise using government net lending leads to an R² of only 0.17 while the error term is quite large and equal to 3.41.

What seems to have actually happened is that domestic private credit flows financed imports. On a second phase, The Rest of the World (RoW) invested these flows in government securities instead of claims on the private sector. As a result, one can maintain that the expansion of net interest payments to the RoW, mainly in the form of government securities coupon payments, were the direct result of the private credit expansion. In any other case, the relevant securities would have been acquired by the domestic sector and consisted net income, rather than a net outflow.

This is quite evident in the RoW asset flows available in BoG financial accounts:

Although the cumulative current account deficit between 2000 and 2008 was almost €193bn (and another €31bn in 2009), most of it was ‘invested’ by the RoW on government securities, with the residual being only €62bn (and even a negative €2bn in 2009). While in the case of countries such as the USA, the RoW ended up acquiring claims on the private sector (in the form of various ABS paper), in the Greek case the foreign sector kept its ‘investment position’ as claims on the government sector, claims for which a large, liquid market existed and which were the main monetary instruments of the central bank.

In my view, such an ‘equilibrium’ was inherently more stable than an alternative one were the RoW held mainly claims on the private sector. As long as the central bank was determined to maintain stability in the government securities market, an adverse external financing shock could be avoided, something which would not be possible in the case of claims on the private sector, since in that case their underlying credit risk would be elevated due to the economic recession, lower real-estate prices and other factors.

On a related note, summing current account deficits since 1995 up to 2011 leads to a figure of -€276.4bn which should roughly correspond to the NIIP at historical costs. On the other hand, the NIIP in 2011Q4 according to BoG data was -€179.6bn, almost 100bn (48% GDP) lower. Based on historical financial accounts flows, at the end of 2011 the RoW should have held around €113bn of government securities, while the NIIP shows a figure of €71.6bn. The ‘internal devaluation’ has also had an ‘external’ effect on RoW claims.