Greek Debt Crisis

So, who cares about the Greek debt crisis? It’s a small country, a long ways away.

Answers:

Greece as a Country: “We care!”

The Euro currency countries: “We care!”

Europe Generally: “We care!”

U.S. and International Financial Community: “We care!”

Stock Investors: “We care!”

All right, already.  Here’s why they care.

The background

Through a series of missteps over the last 10 years the Greece government amassed a large government (or sovereign) debt, and then disguised it from its citizens, lending institutions, its Euro partners, and international financial organizations. The recession exacerbated the problem, threatening to push the Greece government into bankruptcy. Annual deficits as a percent of GDP or total national debt as a percent of GDP are higher but not that different from the United States, but in contrast to the U.S. the global investment community has very little confidence in Greek bonds and the ability of the government to repay them. That means Greece has to pay much higher interest rates on its debt, if it can borrow money at all.

What Can Greece Do?

When faced with larger government deficits, policy makers typically turn to two economic “levers” – fiscal policy and monetary policy. On the fiscal side the government can cut spending and/or raise taxes. Both of these actions have met strong resistance in a country used to heavy subsidies of middle class citizens and notoriously poor tax collection records.

Monetary policy can be an effective tool – often because it does not require the approval of the legislature or the voters. Normally a central bank can inject funds into the economy (electronically “printing” money) and use that to pay debts. This injection of money can also lead to the devaluation of the local currency. While devaluing doesn’t sound appetizing it can be very effective, since it encourages more exports and more tax revenues, and because it makes it easier to pay off debts denominated in the local currency.

BUT, Greece can’t execute its own monetary policy. It is a member of the Eurozone – using the Euro as its currency rather than the drachma. As a result Greece cannot unilaterally change the supply of its currency. It does not have control over monetary policy. To make matters worse for Greece, the Euro has held a fairly high value against other world currencies – just opposite of the direction Greece needs to help with its problems.

EuroEuro

How Does the Crisis Affect the Euro?

The Euro is a common currency, currently used by 22 European countries. Decisions on the supply of the Euro are made by a representative body at the European Central Bank.

When a member country, like Greece, threatens to default on its loans, global investors pull funds out of Greece and the Eurozone. This reduces the demand for euros, and causes the value of the euro to fall. This is a mixed blessing. Countries often prefer a strong currency, but a weaker one can encourage exports. Europe is an export driven continent.

Joining the Eurozone initially, countries have to prove that their economies and government budgets are healthy. It is like welcoming someone new onto a lifeboat. You prefer the new person to be healthy. It appears that Greece hid or obscured its economic reports when applying for membership and now its fellow lifeboat members are not happy.

Commentators, such as Paul Krugman, have argued that Greece should never have been allowed in the Eurozone. They also argue that the Euro common currency is flawed if monetary policy is directed centrally, but fiscal policy remains with individual countries. Macroeconomic theory suggests that both need to work in concert, and the slow, deliberative and political style of the European Central Bank is not well suited to crisis management. Here’s one of many Krugman posts on the crisis.

Why the Large Bailouts by European Governments?

Other European countries, particularly those who share the use of the euro currency, want to stabilize the currency in their own self-interest. In additional many of the large banks and financial institutions in Europe hold Greek debt. If Greece defaults on that debt, those institutions are in trouble. France and Germany have been two of the largest contributors. French voters have been relatively quiet about the bailout, but German politics are much more sensitive to the issue. Chancellor Merkel of Germany has to balance the need to preserve the Eurozone economy against the indignation of German taxpayers who feel little affection for Greece.

European policymakers also worry about other members of the Eurozone – including Spain and Ireland. These two countries have stressed economies for reasons different than Greece. Neither of them had profligate government spending, but both have been hit particularly hard by the recession. Additional stresses on Europe could tip these countries further into trouble.

Why the International Community and Stock Investors Worry

The source of concern in the stock markets and among international investors is mostly fear of default. Large financial institutions and other holders of Greek debt would be seriously hurt. If a Greek default pushed other European countries like Spain and Ireland over, the impact grows significantly.

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