The Greek Debt Crisis: A Deeper Look

It was not for nothing that Greece abandoned its drachma in favor of the euro in 2002: loans to that government paid back in euros (NYSE:FXE) would be far more attractive to lenders than those paid back in the old currency. Also, it was widely perceived that entry into the euro zone might guarantee assistance from other members should financial difficulties arise. As a result Greece went on a public sector spending spree and the chickens it bred came home to roost in 2009, and they are still incoming.

Greece’s debt is a full blown crisis now of potentially global proportions, but how could this happen there? Greece is considered a high income country, globalized and modern. Its labor force works more hours per year than in any euro zone country except Spain. The ancient port of Piraeus is the largest container port in the East Mediterranean Sea Basin, handling more than 20 million tons of cargo in 2007. But, oftentimes governments with new credit cards (loans) behave just like individuals with them and that is what happened between 2002 and 2009.

Beginning in 2002 Greek public sector employees had a field day: their compensation packages quickly rose beyond sustainable levels, with retired employees following close behind with a comparatively low effective age for extremely generous benefits. Add to this the cost of the over-budget 2004 Athens Olympics, and low mortgages subsidized by the government.

During the same time, the country’s tax revenues …

fell sharply due to tax evasion. This, combined with the massive overspending produced a direct hit on the budget deficit. As a result, the government began borrowing heavily – billions upon billion of euros – from European banks, those loans then being repackaged and sold as complex commodities, which were much sought after. Meanwhile, the excessive spending continued, but now a large part went for servicing the growing debt, and Greece’s economy slowed down in 2008-09 due to the worldwide recession.

Enter the new Panhellenic Socialist Prime Minister George Papandreou in October 2009, with a promise to use a stimulus package to revive Greece’s stalled economy. Hopes were high for the American born grandson of a former Greek prime minister, but a new analysis of the budget deficit shocked him. He faced a budget deficit (12.7% of GDP), some four times the euro zone’s limit, compounded by Greece’s debt rating being lowered to BBB+ a few weeks later. Papandreou quickly responded with harsh austerity measures aimed at reducing the deficit to 2.8% of GDP, a plan which proved to be overly optimistic.

The failure of Papandreou’s ‘Three Year Plan’ required outside help to remedy, and the first EU bailout was implemented in April 2010, which promised $60B in new loans tied to a $33B austerity package. Citizens were disappointed and outraged by the irony of an elected socialist prime minister imposing severe spending cuts and higher taxes, and they went to the streets in mass numbers, perhaps 500,000, in May. Although most private banks in Greece passed a stress test, the government’s debt rating fell later in the year to junk status. Faced with the austerity measures, consumption spending took a hit and the economy remained stagnant; the obvious Catch-22 here is that the more governments implement austerity measures, the slower their economies grow (or the faster they shrink), and so all the harder to generate revenues to pay debts.

A second bailout followed in July 2011. This package promised $157B in portions (tranches), plus a lower interest rate and longer maturity dates on Greek bonds, in exchange for more austerity, which included new property taxes starting in September. October saw more public sector jobs and wages cut, with higher income pensions and collective bargaining rights reduced. The same month also saw a nationwide strike, which led the Prime Minister to call for a referendum on the bailout, which ignited a firestorm of criticism from euro zone finance ministers and finally caused Papandreou’s resignation on November 10. The proposed referendum was never carried out.

Meanwhile back in Western Europe …

Portugal, Ireland, and others found themselves in similar, if not as dire, straits. The European Finance Stability Facility’s fund is only so big (~ $1 trillion), and if one country were to fail, doubts about sustaining the others would grow exponentially and could cause a domino effect of massive defaults, along with a financial panic. Additionally, private banks in France and Germany are large holders of Greek public debt and a disorderly default could threaten their viabilities as well. However, the European Central Bank last month provided $632B in 3-year loans to those banks, to help deflect such a possibility.

All of which brings us to the meeting of European officials beginning Monday, January 21, in Brussels. A big deadline is March 20, when a 14.5 billion euro bond payment is due from Greece. Discussions will focus upon a debt swap for Greece (voluntarily exchanging outstanding bonds for new securities, which will cut the face value by 50 percent), along with new protection for indebted states and new budgetary rules. Officials will be considering a new centralized mechanism that will be triggered by deviations from targeted structural budgetary deficits of 0.5 percent of more. The mechanism would then initiate appropriate correction measures.

Participants at Brussels are well motivated, not only by the specter of default by Greece now and others later, but also to maintain the integrity of the euro (which price rose two percent in the week ending January 20), and the euro zone itself. A default by Greece would almost certainly lead that country to withdraw from the euro, and that is uncharted territory that no one wants to explore.