Greece: Recent Economic Developments and Selected Issues

This paper reviews macroeconomic developments in the Greek economy in 1995 and early 1996. During that period, the economic recovery gathered strength, driven by a strong pick-up in domestic investment. Although the recovery led to a moderate increase in employment, it did not prevent an increase in the unemployment rate. Inflation continued to decelerate gradually through 1995, but picked up somewhat in the early months of 1996 reflecting in part one-off exogenous factors. These macroeconomic developments, as well as key structural measures adopted in 1995 and early 1996, are described in detail in this paper.


This paper reviews macroeconomic developments in the Greek economy in 1995 and early 1996. During that period, the economic recovery gathered strength, driven by a strong pick-up in domestic investment. Although the recovery led to a moderate increase in employment, it did not prevent an increase in the unemployment rate. Inflation continued to decelerate gradually through 1995, but picked up somewhat in the early months of 1996 reflecting in part one-off exogenous factors. These macroeconomic developments, as well as key structural measures adopted in 1995 and early 1996, are described in detail in this paper.

IX. The Greek Experience with Exchange Rate-Based Stabilization 1/

The program of economic adjustment and stabilization pursued by Greece since the early 1990s has at its center both fiscal consolidation and an exchange rate peg, the so-called “hard drachma” policy. Although the Bank of Greece has continued to announce targets for other monetary aggregates as well, the exchange rate has increasingly become the primary nominal anchor for the economy. Since its inception, the program led to an important reduction in inflation, but a substantial differential persists relative to other European countries. In 1995 the “hard drachma” policy was further strengthened in line with the government’s objective to join the European Monetary Union soon after the first round of countries: the targeted rate of depreciation of the drachma relative to the ECU was announced publicly for the first time, and it was set at 3 percent, down from 5.6 percent in the previous year. For 1996 and for the following years the rate is projected to remain broadly stable.

The purpose of this chapter is to provide some elements for evaluating the Greek disinflation program and its future prospects by examining the experience of other countries that have undertaken exchange-rate-based stabilization (ERBS) programs. The extensive literature on the subject has shown that economies tend to respond to ERBS policies along broadly similar lines, and a variety of theories have been proposed and tested to explain the observed pattern. Because most of the existing literature is inspired by the experience of chronic, high inflation countries (mainly in Latin America), the paper also review ERBS programs in three European countries with moderate inflation, i.e., Portugal, Ireland, and Italy in the 1980s and 1990s. Like Greece, these three countries belong to the European Union, and at the beginning of the 1980s had much higher inflation than their European partners. Ireland and Italy also share with Greece the burden of a high fiscal deficit and of a large public debt. In all these countries programs aimed at reducing inflation in the 1980s and early 1990s were centered around an exchange rate commitment. Thus, although some of the economic policies that accompanied disinflation were different, all four countries effectively adopted an ERBS.

1. The literature on exchange rate-based stabilization

A large literature exists on ERBS, mostly focussed on the experience of countries plagued by high and chronic inflation (inflation rates above 30-40 percent per year) and by severe macroeconomic instability. 2/ According to this literature, the most peculiar feature of ERBS’s is that the initial stages of inflation stabilization are accompanied by an economic expansion, which is usually reversed at some later stage, sometimes before and sometimes after the stabilization fails. The early expansion is in stark contrast with the conventional view—formed through the experience of moderate disinflation in industrial countries—that, although low inflation is good for growth in the long run, anti-inflationary policies have a short-term contractionary effect, and policy-makers face a trade-off between output losses and unemployment on the one hand, and inflation reduction on the other. 3/ 4/

Besides the output cycle, the empirical regularities characteristic of ERBS’s can be summarized as follows: after the exchange rate is fixed or an exchange rate target is announced, inflation falls, but convergence to the inflation rate of the peg currency is slow and incomplete; as a result, the CPI-based real exchange rate appreciates considerably, and the trade balance deteriorates. Domestic demand rises quickly, driven mainly by a boom in private consumption (especially consumption of durable goods) and, to a lesser extent, by an increase in domestic investment. National saving tends to decline even in cases in which there is substantial fiscal consolidation and, thus, the current account deficit widens, leading to an increase in foreign liabilities of the private and/or public sector. Nominal interest rates fall, while real rates fall in some cases (the Southern Cone “tablitas” of the 1970s) and increase in others (the stabilizations of the 1980s and 1990s). Strong domestic credit expansion usually accompanies the growth of consumption and investment.

Another striking feature of the ERBS’s studied in the literature is that most of the programs proved to be unsustainable, eventually leading to the abandonment of the currency peg (usually after a speculative attack) and to the resumption of high inflation and macroeconomic instability. The initial economic expansion is reversed after the plan is abandoned, and is often followed by a severe contraction. In some countries, such as Mexico in 1995, the contraction begins while the peg is still in place, and becomes one of the factors that contributes to the demise of the policy program. Interestingly, a contractionary phase also took place in the Israeli stabilization, which was successful. The duration of the expansionary phase varies considerably across stabilization episodes.

Various theories have been put forward to explain the cycle that accompanies ERBS programs and to identify the forces that have led to so many failures. Earlier theories (Rodriguez, 1982) focused on the effects of inflation inertia, which leads to an expansionary fall in the real interest rate first, and then to a contractionary real appreciation. Later, Drazen and Helpman (1988) and others suggested that the expansion is due to the wealth effects of fiscal consolidation. Calvo (1986) first introduced lack of credibility of the stabilization plan as the driving force of the cycle: as consumers expect the government to resume inflationary policies in the near future, they increase their current consumption and reduce their future consumption to take advantage of the low opportunity cost of holding cash balances during stabilization. Roldos (1995) and others explore the supply-side effects of lack of credibility, focussing on the investment response to disinflation. Recently, Rebelo and Vegh (1996) have simulated a general model in which all the above effects are present; they conclude that the more promising theories are those based on credibility and on inflation inertia, although even these theories seem unable to fully capture the empirical magnitude of the phenomena. Thus, in spite of the extensive research efforts and of the importance of the subject to policy-makers, the ERBS “syndrome” remains only partially understood.

2. ERBS in Ireland, Portugal, and Italy

Ireland and Italy joined the European Monetary System at its inception in 1979, thereby committing to a fixed central parity with the ECU. 5/ Although frequent realignments made the peg rather loose initially, around the middle of the 1980s the system became more stable, and the exchange rate anchor became considerably stronger. Portugal did not formally join the EMS until April 1992, but the escudo was pegged to a basket of five main European currencies since October 1990. In all three countries—as in Greece—the exchange rate commitment was seen as the central policy tool for reducing inflation, which was well above that of the other European partners.

Ireland (1982-95)

At the beginning of the 1980s Ireland had an inflation differential with industrial countries of about 10 percent, a current account deficit of 10-15 percent of GDP and a government deficit of 13-15 percent (Chart 34). The Irish pound had joined the EMS at its inception in 1979, but until 1982 the exchange rate peg did not provide a strong nominal anchor: the Irish currency depreciated slightly relative to the ECU as the deutsche mark was revalued in 1979, 1981, and 1982. Furthermore, the strength of the pound sterling and of the U.S. dollar during this period led to a substantial depreciation in nominal effective terms.

Chart 34
Chart 34

Ireland Key Macroeconomic Indicators During Disinflation

Citation: IMF Staff Country Reports 1996, 121; 10.5089/9781451816068.002.A009

Sources: IMF, World Economic Outlook; and International Financial Statistics.

a. The “failed stabilization” (1982-85)

In 1982 a political consensus emerged around the need for macroeconomic stabilization. When the government fell after a proposed tight budget was rejected, the successor government implemented an equally strong package centered on revenue increases. The primary deficit of the general government, which was 7.1 percent of GDP in 1982, was reduced to 3 percent in 1986. The overall deficit went from 14.2 percent of GDP in 1982 to 10.6 percent in 1986. The monetary stance became much tighter, with real interest rates turning from negative to positive and remaining high. Wage increases also slowed down. The outcome of the stabilization was positive both in terms of primary adjustment and in terms of inflation: the inflation differential with industrial countries fell quickly, and was down to 1 percent by 1985. Until August 1986 the currency remained stable within the EMS, and it did not participate in the frequent realignments within the system. In nominal effective terms, the Irish pound depreciated in 1983-84, but the depreciation was reversed in the following two years.

As in the ERBS experiences studied in the literature, also in the Irish case the real effective exchange rate in terms of CPI appreciated significantly. The cumulative appreciation in 1982-86 was 17 percent. However, thanks to wage moderation, competitiveness measured by the ULC-based real exchange rate continued to improve. 6/ Also, in contrast with the ERBS syndrome, the early phase of stabilization was accompanied by a recession: GDP growth was only 1.4 percent on average in 1982-86 (below the industrial countries’ average), and it resulted in a massive increase in unemployment and emigration (Dornbusch, 1989). Thus, in Ireland disinflation was achieved at a substantial output cost. Also, the current account deficit improved strongly, but it was still at 3 percent of GDP in 1986. The improvement was brought about mainly through a decline in the investment rate. National saving grew in 1982, but then it declined somewhat in 1983-86 despite the improvement in public sector saving. Finally, slow GDP growth and high real interest rates undermined fiscal stabilization in spite of the strong primary adjustment: the debt-to-GDP ratio continued to grow and reached over 125 percent of GDP in 1986.

b. The expansionary fiscal contraction (1986-95)

A new phase of the stabilization program began in 1986, centered around a new budget involving strengthened fiscal adjustment. This time, the adjustment was to come mainly through expenditure cuts, including a partial hiring freeze in the public sector, cuts to the public investment program, and cash limits on spending (Honohan, 1992). A tax reform was also enacted which expanded the tax base and lowered marginal tax rates. The net effect was a small reduction in tax revenues. Another element of the second phase of stabilization was an exchange rate realignment: after sterling experienced substantial losses relative to EMS currencies, in August 1986 the Irish pound was devalued by 8 percent relative to the ECU. The devaluation—which was quite small in effective terms—did not lead to a revamping of inflation. To the contrary, the rate of price growth continued to fall, and by 1988 it was below the industrial country average. 7/ After the realignment, however, the CPI-based real exchange rate began to depreciate, and by 1993 the index was back to its 1982 level. The real appreciation that occurred at the inception of the stabilization program was thus completely reversed.

During the second phase of the Irish stabilization, labor cost competitiveness improved dramatically, as the ULC-based real exchange rate fell by 20 percent in 1986-90 after a cumulative fall of 5 percent in the previous five years. Both wage moderation and strong gains in labor productivity contributed to this outcome. In spite of the strong fiscal contraction, GDP growth accelerated substantially in 1987, although there was a temporary slowdown in 1991-93 during the European recession (which in Ireland, as in the United Kingdom, started in 1991 and not in 1992). The average growth rate in 1987-95 was 5.8 percent. Unemployment started to decline, while investment recovered somewhat in 1988-90 and then fell again afterwards. So, GDP growth did not come primarily from increased capital accumulation, but rather from improved capacity utilization, increased employment, and higher factor productivity. 8/ Also, this period saw a marked shift in the structure of manufactured production away from the traditional sectors toward new, high technology activities initiated by direct foreign investment. In these new activities, which are concentrated mainly in computers, pharmaceuticals, medical technology, electrical engineering, and food, labor productivity is more than twice that of the rest of the manufacturing sector (OECD, 1995).

On the fiscal front, after the strong expenditure measures of 1987, the government primary deficit moved into a surplus in 1988, and kept improving thereafter. The overall deficit also showed a drastic improvement, stabilizing around 2 percent of GDP after 1988. The current account moved to near balance in 1987, and started registering increasing surpluses in 1990. This was due to an increase in the saving rate that began in 1990: the average national saving rate went from 15.8 percent in 1982-89 to 19.9 percent in 1990-95. Real short-term interest rates fell somewhat in 1987-89, but rose again in 1990-93 also because of the pressure on the Irish pound within the EMS.

The Irish stabilization shares few of the distinctive features of the ERBS’s studied in the literature, and it appears more similar to conventional inflation stabilization episodes in industrial countries. Although initially there was a real appreciation as in the ERBS syndrome, the expansionary effect on output was completely absent: both output and investment fell, and unemployment skyrocketed after the first round of measures in 1982. National saving fell, but investment fell even more rapidly, so the current account improved rather than deteriorate. In contrast with the Latin American experiences, the threat to the sustainability of stabilization did not come from current account vulnerability, but rather from the continued increase in the debt-GDP ratio and from the high rate of unemployment. What is perhaps most interesting about the Irish experience is the effect on the economy of the “second dose” of the fiscal stabilization medicine administered in 1987: in this case, the new fiscal measures were followed by strong and sustained output growth, which reinforced the fiscal adjustment and by and large removed threats to sustainability. Monetary policy did not appear to ease much during this second phase. Why, then, did more fiscal adjustment have an expansionary effect in 1987?

According to Alogoskoufis (1992), two factors were crucial: the devaluation of the Irish pound within the ERM in 1986 reversed the real appreciation of 1982-86, and led to growth in the tradeables sector; and the second round of fiscal measures involved expenditure cuts and even a small tax reduction instead of tax increases. Expenditure cuts led to increased private saving, and therefore to higher growth. The problem with the latter explanation is that higher savings did not really materialize until 1990, and that, once they emerged, they financed an improvement in the current account and not an investment boom. Giavazzi and Pagano (1990) propose a slightly different explanation: in their model, a severe fiscal contraction leads to the expectation of lower taxes in the future, which raises permanent disposable income. If consumers are not credit constrained, an increase in permanent income leads to an increase in current consumption which stimulates aggregate demand. When taxes are strongly distortionary (as in the case of Ireland, where marginal income tax rates were very high after the revenue increases of the first package), the increase in private demand more then offsets the decline in public spending, and the net effect is expansionary. This explanation is supported by the fact that financial liberalization and the removal of capital controls in the mid-1980s considerably expanded the ability of Irish consumers to borrow, making current consumption more sensitive to changes in future income. Another factor that contributed to the expansion was the fall in nominal and real interest rates favored by the credibility of the exchange rate commitment. The devaluation of 1986 helped credibility by making the exchange rate level sustainable.

None of the above explanations emphasizes the drastic improvement in labor cost competitiveness beginning in 1987. This improvement has certainly benefitted the Irish tradeable sector by restoring and strengthening competitiveness, as witnessed by the excellent performance of the export sector.

Italy (1984-95)

Italy joined the EMS at its inception in 1979 and remained in it until 1992. During this period, CPI inflation was reduced from a peak of 22.1 percent in August of 1980 to a low 4.1 percent in March of 1987 and, although there was a moderate pickup later on, inflation fell below 6 percent again in 1991. (The inflation differential vis-à-vis industrial countries followed a similar pattern—Chart 35.) As in the case of Ireland, the initial period of EMS participation was characterized by numerous adjustments to the central parity. Also, important institutional changes affecting both the framework of monetary policy and the wage setting process with major effects on inflation took place during this period. Thus, the formal commitment to the EMS should not necessarily be regarded as an obvious starting point for the exchange-rate based stabilization (ERBS) strategy in Italy. For example, Ronci and Tullio (1994) find that March 1983, following a general realignment and a drastic change in French monetary policy, represents a turning point in terms of inflation determination in Italy, with German inflation becoming a key determinant. Spinelli and Tirelli (1993), on the other hand, point to 1984, when the Bank of Italy began announcing targets for M2, as the beginning of a new regime. Finally, Passacantando (1995) and Visco (1995) agree on distinguishing two periods (1980-86 and 1987-92) during the time of EMS participation, both characterized by the use of the exchange rate as a key policy tool for disinflation, but with distinctively different emphasis. Details below follow their period selection.

Chart 35
Chart 35

Italy Key Macroeconomic Indicators During Disinflation

Citation: IMF Staff Country Reports 1996, 121; 10.5089/9781451816068.002.A009

Sources: IMF, World Economic Outlook; and International Financial Statistics.

a. 1980-86: weak commitment to the exchange rate target

During this period the government pursued a flexible exchange rate policy, as the lira was realigned on five occasions between 1981 and 1985; these adjustments, however, were less than fully accommodative. As shown by Gressani and others (1994), disinflation in this period was the result of (i) a combination of policies including exchange rate, monetary, and incomes polices, as well as management of regulated prices; and (ii) exogenous factors such as a gradual decline in oil prices, particularly in 1985.

Among the most important changes in the policy stance during this period was the adoption of a restrictive monetary policy stance, conducted largely through non-market-based instruments: between 1980 and 1981 the discount rate was increased from 15 to 19 percent; credit ceilings were tightened and the share of total assets that commercial banks were obliged to invest in T-bills was increased. In subsequent years the tight monetary stance was accompanied by a move toward market-based instruments of monetary control. Also, in July of 1981 the Bank of Italy ceased to play the role of residual buyer of T-bills issued to finance the budget deficit and in 1984 the Bank began announcing targets for M2, which were exceeded only slightly in 1984-85 and met in 1986. Capital controls provided room for monetary targeting in the short run.

The wage setting framework changed substantially during this period and wage growth provided important support to the disinflation effort. In December 1981 trade unions agreed to restraining wage growth the following year in exchange for a government commitment to adopt certain fiscal measures and to limit growth in publicly regulated prices. In 1983 an agreement was reached which linked wage increases for 1983-84 to the government’s announced inflation targets for those years, and reduced by 15 percent the coverage of wage indexation. In 1984 a proposal by unions to restore the previous indexation mechanism was rejected by referendum and a new system was enacted by the government in 1986. This system reduced the frequency of adjustments from four to two a year and limited full indexation to the minimum wage, while the excess of actual over minimum wages was to be adjusted only partially.

Regulated prices increased faster than inflation in 1980-84, largely due to the need to improve the financial situation of public enterprises. However, from 1984 onwards, increases in regulated prices had to be limited at or below the targeted inflation rate as a result of the commitments made by the government in the context of the 1983 and 1984 wage agreements.

In spite of the loose exchange rate anchor, most of the disinflation was achieved in this period. Inflation had reached a peak of 22.1 percent in August 1980, amidst the second oil shock, and began a gradual fall thereafter, aided by the gradual decline in international oil prices, 9/ reaching 4.2 percent at the end of 1986.

The Italian economy did not experience the typical cycle induced by ERBS during this period. Given the numerous realignments, real appreciation between 1980 and 1985 was limited to 4.5 percent in terms of CPI and to less than 1 percent in terms of ULC. In 1986, and largely due to an appreciation of the NEER brought about by the depreciation of the U.S. dollar, the CPI-based REER appreciated by 7 percent while, as before, the ULC-based REER appreciated only slightly. In addition, GDP growth averaged 2 percent in 1980-86 (down from an average 4.8 percent in 1978-79), and remained below the industrial countries’ average for most of this period. The current account, which averaged 0.8 percent of GDP in 1977-79, worsened to a deficit of 2.9 percent in 1980 and to 3.3 percent in 1981, but improved gradually to a small surplus of 0.3 percent in 1986. The worsening of the current account in 1980-81 reflected mainly a fall in national saving. From 1982 on, national saving hovered around 21 percent of GDP, reflecting stable private and public saving rates. Real investment actually registered negative growth rates during the worldwide recession of 1981-83 leading to a decline in the investment rate from over 27 percent in 1980 to 23½ in 1982, and remaining roughly at that level until 1986.

b. 1987-92: strong commitment to the exchange rate target

According to the work by Passacantando and Visco cited above, 1987 marks the beginning of a “credible” exchange rate commitment. The lira remained broadly stable within the EMS and the government signaled its stronger commitment to the exchange rate with the adoption of narrower bands in January 1990 and the liberalization of capital movements. However, the stronger commitment to the exchange rate and the relatively tight monetary policy stance were not accompanied by an increased fiscal effort and a sufficiently tight incomes policy. These imbalances in the policy framework slowed down the pace of disinflation and contributed to fuel an ERBS-induced expansionary cycle.

Monetary policy remained tight during the period and was conducted mainly through market-based instruments. The period was also characterized by financial innovation and capital deepening, including the introduction of competitive-bid auctions for government paper, screen-based secondary markets for government securities and interbank deposits, electronic systems for clearing, and the introduction in 1991 of 10-year Treasury bonds. Moreover, additional steps were taken in the area of central bank independence, as the governor of the Bank of Italy was entrusted with the responsibility to set the discount rate independently (1992). Overall, monetary policy was effective at sustaining the exchange rate, although the task was facilitated in part by the relative relaxation of the German monetary policy stance after the stock market crash of October 1987 (Bini Smaghi and Micossi, 1989).

Although the government managed to reduce somewhat the primary deficit, the public debt continued to grow throughout the period and government dissaving remained broadly unchanged at around 6 percent of GDP. 10/ Similarly, incomes policy was not restrictive enough. Very generous public sector wage increases in 1990 and 1991 were imitated by the private sector, and the effort to further reform the wage indexation mechanism registered no concrete achievements until the formal start of new negotiations in June 1991. Sarcinelli (1995) has suggested that this lack of supportive policies led to a policy imbalance that triggered sizeable capital inflows complicating monetary management and illustrating the fact that further disinflation could not have been achieved by a tighter monetary policy alone.

Inflation actually accelerated from 4.1 percent in March of 1987 to 6.8 percent in October of 1990 and declined gradually to 5.1 percent in August of 1992, right before the lira was forced out of the ERM. Real appreciation was more pronounced this period: the CPI-based REER appreciated by more than 10 percent between the end of 1986 and August 1992, while the ULC-based REER appreciated by almost 8 percent. At the same time, GDP growth accelerated, mainly on account of fast growing consumption and investment (especially in 1987-88). The national saving rate fell gradually throughout the period and, despite a moderate decline in the investment rate in 1991-92, led to a continuous, albeit moderate, widening in the current account deficit from 0.3 percent of GDP in 1987 to 2.3 percent in 1992.

The events of the fall of 1992 are well known: following the rejection of the Maastricht treaty by Denmark, strong exchange rate pressures arose that culminated with the exit of the Italian lira and pound sterling from the ERM. In the case of the lira, a large nominal depreciation followed. The weakness of the currency was fueled in subsequent years by extreme political uncertainty, and has begun to reverse only recently. Despite the lira’s exit from the ERM, the success brought about by the first phase of ERBS was not lost. Fiscal adjustment strengthened and thanks to wage moderation in the context of the 1993 agreement, and partly due to the European recession of 1992-93, the effects of the depreciation were not passed on to prices. Furthermore, inflationary pressures remained under control also after economic growth resumed in 1994-95.

Portugal (1990-95)

After accession to the EU in 1986, Portugal experienced a period of fast economic growth sustained by large EU transfers and private capital inflows. At the end of the decade, the income gap with the rest of Europe was considerably reduced, but the expansion had been accompanied by a sizeable real appreciation. Inflation stood at 13.4 percent, 8.4 percentage points above the average of industrialized countries (Chart 36). In contrast with Ireland, Italy, and Greece, Portugal did not have a serious fiscal problem at the beginning of stabilization: the general government was running a primary surplus of 3-4 percent of GDP, the deficit was between 2 and 5 percent, and the stock of debt-to-GDP ratio was 68 percent in 1990.

Chart 36
Chart 36

Portugal Key Macroeconomic Indicators During Disinflation

Citation: IMF Staff Country Reports 1996, 121; 10.5089/9781451816068.002.A009

Sources: IMF, World Economic Outlook; and International Financial Statistics.

In an attempt to fight inflation more decisively, in October 1990 the Portuguese authorities pegged the escudo to a basket of five main European currencies. The monetary policy stance became quite restrictive, and interest rate differentials with Europe were kept high. In the following two years, the escudo remained stable and even appreciated somewhat in nominal effective terms. Nonetheless, inflation declined only gradually, and by 1992 it was still at 8.9 percent. As in other ERBS experiences, inflation was fueled by price growth in the nontradeables sector, while the tradeable sector, under the pressure of foreign competition, was forced to reduce the pace of price increases (OECD, 1993). The CPI-based real exchange rate appreciated by a cumulative 16.5 percent between 1990 and 1992. The real exchange rate measured on the basis of unit labor costs appreciated even more substantially (by over 30 percent), as the strong wage growth continued in spite of the stabilization plan. In contrast with the pattern typical of ERBS’s, in Portugal the real appreciation did not lead to a marked deterioration of the trade balance and/or of the current account balance: the current account registered a small deficit in 1991 and was in balance in 1992. Also, the ERBS was not accompanied by a strengthening of output growth; rather, real GDP growth—albeit still above the average of industrial countries—began to slow down in 1990, and reached an 8-year low of 1.7 percent in 1992.

Rebelo (1992) investigates the sources of the real exchange rate appreciation in the early stages of the Portuguese stabilization by simulating a simple general equilibrium model. The hypothesis behind the study is that the appreciation was an equilibrium phenomenon determined by three separate factors: the transitional growth of the Portuguese economy toward a steady-state with a higher capital-labor ratio; 11/ stronger productivity growth in the tradeables sector than in the non-tradeables sector (the Balassa-Samuelson effect); and an increase in government consumption biased toward non-tradeable goods. 12/ Rebelo finds that these three factors together can explain an appreciation of at most 2.5 percent in the year following the stabilization. In practice, the appreciation in 1991 was of 6.8 percent, suggesting that other forces were also at work, including possibly distortions in the price and wage-setting mechanisms and/or lack of credibility of the plan.

The Portuguese ERBS reached a new stage in April of 1992, when the escudo formally joined the ERM with a fluctuation band of 6 percent. This move, however, was followed by three separate devaluations of the central parity in November 1992, May 1993, and March 1995. The realignments took place in the context of widespread turmoil on foreign exchange markets, and were not associated with a specific weakness of the Portuguese currency. The devaluations of 1992-93 led to a cumulative depreciation of the nominal effective exchange rate of 12 percent relative to the 1992 peak. As in the Italian and in the Irish case, the depreciation had virtually no effects on inflation, which continued its steady decline. The net effect on the real exchange rate was a partial reversal of the appreciation of the previous years. By 1995, however, the CPI-based index was still 13 percentage points above its 1990 value.

As in Italy, the devaluation of 1993 was accompanied by a deep recession. Employment declined for the first time since 1986, the unemployment rate reached 5½ percent, and wage growth slowed down substantially. The real exchange rate measured in terms of relative labor costs was essentially stable in 1992-94. The combination of a weak economy, wage moderation, and improved competition in the retail and financial services sectors resulted in a decline in the rate of inflation in the non-tradeables sector, which, in turn, brought about a decline in the overall inflation rate (OECD, 1995). The 1993 recession was accompanied by a deterioration in the fiscal position due to a decline in tax receipts and to the unwillingness of the government to further weaken domestic demand through expenditure cuts. The primary balance of the general government, which had been in a surplus since 1984, registered a small deficit in 1993, while the overall deficit reached 7 percent of GDP. In 1994 and 1995 output growth resumed, but it remained slow by Portuguese standards; the fiscal imbalance remained substantial, and the debt-to-GDP ratio continued to grow.

The Portuguese stabilization shares some important features with the early Irish experience: the real appreciation was significant in spite of a steady decline in domestic inflation, output growth was negatively affected, and no deterioration of the current account took place. However, in Portugal the exchange rate realignments of 1992-93, while they partially reversed the real appreciation of the earlier years, did not bring about a spectacular resumption of growth as in the Irish case. One of the reasons may be that labor cost competitiveness, while it ceased to deteriorate, did not register the marked improvement experienced in Ireland. Also, the fiscal policy stance was quite different: while Ireland enacted strong expenditure cuts with immediate positive effects on the deficit, the debt-to-GDP ratio, and domestic interest rates, in Portugal the fiscal deficit deteriorated markedly in 1993. Thus, the main long-term benefit of the Portuguese stabilization program appears to be on the inflation front, where the differential with inflation in industrial countries has continued to decline, reaching a low of 1.7 percentage points in 1995.

3. Greece’s experience with exchange rate-based stabilization: in perspective

The brief overview of the Irish, Portuguese, and Italian experience with ERBS programs shows that, as in the Latin American stabilizations studied in the literature, in the early stages of the program the real exchange rate tends to appreciate, as domestic inflation, especially in the non-tradeable sector, converges to the rate of inflation of the peg currency only gradually. However, while in Italy stabilization was eventually accompanied by the usual acceleration of output growth (led by strong domestic demand) and by a current account deterioration, in Portugal, and especially in Ireland’s first stage, disinflation led to a reduction in output growth and had no clear-cut effects on the current account. So, in the latter two countries disinflation had an immediate cost in terms of output; in Ireland, the longest of the three stabilization episodes, the recession was followed by a strong output expansion accompanied by low inflation and a current account surplus.

All three countries at some point were forced to devalue the exchange rate, either through a realignment of the central parity within the EMS or—as in Italy in August 1992—by exiting the system. The devaluations, however, did not lead to a reversal of inflation stabilization as in many Latin American experiences: inflation either continued along its downward path or it increased only modestly. A possible explanation is that, in contrast with Latin America, devaluations did not have an immediate negative fiscal impact (due to the large share of foreign currency-denominated debt), so the government was not forced to resume inflationary financing of the deficit.13/ Another factor contributing to low inflation in the aftermath of the devaluation was slow wage growth due to depressed conditions in the labor market and to the abandonment of automatic wage indexation mechanisms earlier on in the program.

How does the Greek stabilization compare with the prototype ERBS in the literature and with the experience of the other three high-inflation European countries? In the 1980s the Greek economy was characterized by progressively large budget and current account deficits and an inflation rate well above that of other European countries. In 1985-87 an attempt at stabilization lost political support and was abandoned, and macroeconomic imbalances worsened in the following two years. In a renewed attempt at stabilization, in the middle of 1989 the Bank of Greece began to follow the “hard drachma” policy, by which the drachma was allowed to depreciate relative to the ECU by less than the full inflation differential.

As shown in Chart 37, until 1994 the policy provided Greece with a relatively loose nominal anchor if compared with the Irish, Portuguese, and Italian stabilization: the drachma continued to depreciate at fairly fast rates (ranging from 11.5 percent to 7.2 percent) both relative to the ECU and in nominal effective terms. Although inflation began to fall in 1990, progress was slower than in the other three countries, and in 1994, four years into the stabilization, the differential vis-à-vis industrial countries still stood at 8.5 percent (Chart 38). The weaker currency peg allowed Greece to avoid the strong real appreciation typical of ERBS programs: after four years of stabilization, the real effective exchange rate of the drachma (CPI-based) had risen by a modest 4.4 percent.

Chart 37
Chart 37

Selected Countries Nominal Effective Exchange Rate

Citation: IMF Staff Country Reports 1996, 121; 10.5089/9781451816068.002.A009

Sources: IMF, World Economic Outlook; and International Financial Statistics.
Chart 38
Chart 38

Selected Countries International Comparison of Key Macroeconomic Indicators

Citation: IMF Staff Country Reports 1996, 121; 10.5089/9781451816068.002.A009

Sources: IMF, World Economic Outlook; and International Financial Statistics.

On the fiscal front, after the elections in April 1990, an economic plan was enacted that aimed at stabilizing the debt/GDP ratio by turning the primary deficit into a surplus mainly through revenue measures. Also, wage indexation was abolished, and an austere incomes policy was enacted. The program was successful in terms of primary adjustment: the deficit fell from 6 percent of GDP in 1990 to 1.4 percent in 1993, and by 1994 it had turned into a surplus of 2.1 percent. This turnaround was comparable to the Irish and the Italian (post ERM) ones. As in Ireland and Italy, however, the strong primary adjustment accompanied by disinflation did not lead to a definite improvement in the fiscal accounts: the overall deficit fell somewhat, but by 1994 it was still at 12.7 percent of GDP (down from 16.1 percent in 1990), and the debt-to-GDP ratio continued to climb. This was because nominal interest rates remained high and real rates increased due to the tight stance of monetary policy and to the abandonment of “financial repression” as a form of government financing. Furthermore, in Greece the burden of interest payments grew because of additions to the stock of public debt through the assumption of publicly-guaranteed liabilities of the private sector (SM/95/179).

GDP growth was dismal throughout the stabilization period: after zero growth in 1990, economic activity picked up in the following year, but output was virtually constant again in 1992 and fell by 1 percent in 1993, when most of Europe went into a recession. Growth resumed but at a fairly slow pace in 1994. Thus, the more gradual approach to disinflation adopted by the Greek authorities relative to Ireland, Portugal, and Italy does not appear to have led to a more favorable growth outcome. Labor cost competitiveness improved in the first three years of stabilization thanks to a tight incomes policy and to a weak labor market, but it started to deteriorate in 1994 when growth resumed and labor market conditions became tighter.

The Greek experience with ERBS entered a new phase in 1995, when the Bank of Greece, in accordance with the government’s convergence program, further tightened the exchange rate anchor. The exchange rate target was announced officially, and the drachma was allowed to depreciate relative to the ECU by only 3 percent (end of the period); the target for 1996 and beyond is of near stability. In spite of the tighter exchange rate, the fall in inflation continued along its previous trend in 1995, and even picked up in early 1996. Correspondingly, the real appreciation of the exchange rate accelerated. Nominal and real interest rates fell, and output growth accelerated led by strong investment growth. On the fiscal front, the primary adjustment continued in 1995, but it is expected to slow down somewhat in the following years. The deficit fell more substantially in 1995 thanks to sharply lower nominal interest rates. In spite of the improved government savings, however, the national saving rate fell, and the current account returned to a deficit. Tighter conditions in the labor market and strong firm profitability led to generous wage settlements which worsened labor cost competitiveness, reversing some of the gains achieved in the first phase of stabilization.

This overview suggests that, as the exchange rate peg becomes tighter, the Greek stabilization is beginning to show some of the characteristics of the standard ERBS programs described in the literature and shared by the Italian experience in 1986-92: faster output growth led by domestic demand, strong real exchange rate appreciation, and a widening current account deficit. The experience of other countries suggests that these developments, if allowed to persist, can threaten the sustainability of the exchange rate policy and, in some cases, they can compromise the broader objectives of macroeconomic stabilization. Early corrective measures, such as stronger fiscal adjustment to control aggregate demand growth and a return to wage moderation, could be useful in limiting the risks that the stabilization program may have to face in the future.

List of Recent Staff Studies

  • 1995: SM/95/179, 7/25/95

    • An Index of Coincident Economic Indicators for Greece

    • Private Saving Behavior in Greece

    • Inflation, the Budget Deficit and Debt Dynamics

    • Competitiveness and External Performance

  • 1994: SM/94/173, Supplement 1, 7/6/94

    • Appendix I: Greek Manufacturing 1980-92 in European Perspective

    • Appendix I: Money Demand in Greece

    • Appendix III: Exchange and Trade Issues

    • Appendix IV: Data Issues

  • 1993: SM/93/112 (5/24/93)

    • Appendix I: Social Security Reforms

    • Appendix II: Financial Liberalization

  • 1991: SM/91/91 (5/14/91)

    • Chapter HI: Investment and Potential Growth

    • Chapter IV: Domestic Structural Issues

    • Chapter V: International Issues

    • Chapter VI: Inflation and the Private Savings Ratio: Theory and an Application to the Case of Greece

  • 1990: SM/90/99, Supplement 1 (6/11/90)

    • Public Pension Expenditures in Greece: Long-Term Developments and Prospects


  • Alogoskoufis, G. (1992), “Fiscal Policies, Devaluations, and Exchange Rate Regimes: The Stabilization Programmes of Ireland and Greece.Economic and Social Review, 23, 225246.

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  • Ball, L. (March 1993), “What Determines the Sacrifice Ratio?NBER Working Paper No. 4306.

  • Bini Smaghi, L. and S. Micossi, (1989), “Managing Exchange Markets in the EMS with Free Capital.Banca Nazionale del Lavoro Quarterly Review, June.

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  • Calvo, G. (1986), “Temporary Stabilization: Predetermined Exchange Rates.Journal of Political Economy, 94, 148166.

  • Calvo, G. and C. Vegh (1994), “Stabilization Dynamics and Backward-Looking Contracts.” Journal of Development Economics, 5984.

  • Dornbusch, R. (1989), “Credibility, Debt, and Unemployment: Ireland’s Failed Stabilization.Economic Policy, 8, 173210.

  • Drazen, A. and E. Helpman (1988), “Stabilization with Exchange Rate Management under Uncertainty.” Economic Effects of the Government Budget, MIT Press, Cambridge, MA.

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  • Giavazzi, F. and M. Pagano (1990), “Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries.” NBER Macroeconomics Annual, Elhanan Helpman, Assaf Razin, and Efraim Sadka (eds), MIT Press, Cambridge, MA.

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  • Giavazzi, F.; and L. Spaventa (1994), “Italy: The Real Effects of Inflation and Disinflation.” The Italian Economy: Heaven or Hell, M. Baldassari (ed.), St. Martin’s Press.

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  • Easterly, W.When is Stabilization Expansionary?” Economic Policy, forthcoming.

  • Froot, K. and K. Rogoff (1992), “The EMS, the EMU, and the Transition to a Common Currency.” NBER Macroeconomics Annual 1991, MIT Press, Cambridge MA.

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  • Gressani, D, L. Guiso, and I. Visco (1994), “Disinflation in Italy: An Analysis with the Econometric Model of the Bank of Italy.” The Italian Economy: Heaven or Hell, M. Baldassari (ed.), St. Martin’s Press.

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  • Honohan, P. (1992), “Fiscal Adjustment in Ireland in the 1980s.” Economic and Social Review, 23: 285314.

  • International Monetary Fund, (1995), “Portugal-Recent Economic Developments.” IMF Staff Country Report No. 95/124.

  • Kiguel, M. and N. Liviatan,The Business Cycle Associated with Exchange Rate-Based Stabilizations”. The World Bank Economic Review, 6, 279305.

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  • OECD, (1995), Economic Surveys, Ireland. OECD, Paris.

  • OECD, (1993, 1995), Economic Surveys, Portugal. OECD, Paris.

  • Passacantando, F. (1995), “Monetary Reforms and Monetary Policy in Italy from 1979 to 1994, “The Quest for Monetary Stability”, revised version of the paper presented at the conference held in Rio de Janeiro September, 1994.

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  • Rebelo, S. (1992), “Inflation Convergence in Portugal.Bank of Portugal Working Paper, No. 1192.

  • Rebelo, S. and C. Vegh (1996), “Real Effects of Exchange Rate-Based Stabilizations.” NBER Macroeconomic Annual 1995, MIT Press.

  • Reinhart, C. and C. Vegh (1995), “Do Exchange Rate Stabilizations Carry the Seeds of Their Own Destruction?mimeo, IMF.

  • Roldos, J. (1995), “Supply-Side of Disinflation Programs.” IMF Staff Papers, 42, 158183.

  • Rodriguez, C. (1982), “The Argentine Stabilization Plan of December 20th.” World Development, 801811.

  • Ronci, M., and G. Tullio (1994), “Macroeconomic Policy and Credibility: A Comparative Study of the Factors Affecting Brazilian and Italian Inflation after 1970.mimeo, Fundacao Getulio Vargas.

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  • Sarcinelli, M. (1995), “Italian Monetary Policy in the ‘1980s and ‘1990s: The Revision of the Modus Operandi.” Banca Nazionale del Lavoro Quarterly Review, No. 195.

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  • Spinelli, F., and P. Tirelli (1993), “Italy.” Monetary Policy in Developed Countries, Ch. 11, Michele Fratianni and Dominick Salvatore (eds), Greenwood Press.

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  • Vegh, C. (1992), “Stopping High Inflation.IMF Staff Papers, 39, 3, 626695.


Prepared by E. Detragiache and A. J. Hamann.


Among others, important contributions to this literature are Calvo (1986), Drazen and Helpman (1988), Kiguel and Liviatan (1992), Vegh (1992), Rebelo and Vegh (1996), Reinhart and Vegh (1995).


A recent study by Easterly (forthcoming) finds that countries moving from high to moderate inflation tend to experience an output expansion also if they adopt a money-based stabilization program. This evidence suggests that the output response depends more on the initial level of inflation than on the nature of the nominal anchor.


For a recent contribution on the output cost of disinflation in moderate inflation countries, see Ball (1993).


Until then the Irish pound was pegged to pound sterling.


Due to measurement problems, the ULC-based REER is likely to overestimate the real depreciation of the Irish pound.


The central parity of the Irish pound relative to the ECU was devalued again by 10 percent in January 1993 after sterling was forced out of the ERM. As in 1986, the devaluation had little effect on domestic inflation.


It should be pointed out that in Ireland GDP growth has typically exceeded GNP growth, as a result of relatively higher growth in the mostly foreign-owned modern sector.


The international price of oil imported by OECD countries decreased from US$36.5 in 1980 to US$27.5 in 1985, and it fell below US$10 in 1986.


As pointed out by Visco (1995), not only was fiscal adjustment slow and incomplete but, more importantly, resolute structural measures to curb expenditure items greatly in need of reform (pensions, medical care, public employment and local governments) were repeatedly delayed.


If factor markets are competitive, as the capital/labor ratio grows, so does the wage/rental rate ratio. If, in addition, the non-tradeables sector is relatively labor-intensive, then the relative price of non-tradeables (the real exchange rate) increases during transitional growth.


This latter determinant of real exchange rate appreciation has also been explored by Froot and Rogoff (1992) for EMS countries.


Ireland had a sizeable foreign currency debt, but the devaluation was small and was accompanied by strong additional primary adjustment.

Greece: Recent Economic Developments and Selected Issues
Author: International Monetary Fund