There is just no way that you can turn on the news these days and not hear something about Greece and how it’s slowly deteriorating the European financial system. If you’re someone who simply has no idea what’s going on, don’t worry. I don’t blame you one bit. European politicians (with the help of the media, of course) have turned this into a huge mess that’s particularly difficult to decipher. My job here is to give you a quick and dirty summary of everything you need to know to understand one of the most important events that’s happening in our generation (and also give you something to talk about at interviews of course). Let’s get started.
It all starts with the Euro
In 1999, most countries in the EU adopted the euro (see accurate representation: Figure 1) as their common currency. This allowed smaller and poorer countries, such as Spain, Italy, Ireland, Portugal and Greece, to borrow money at the same low interest rates as financially stable nations such as Germany, even though the poorer countries’ inflation rates were much higher. This essentially gave them free reign to borrow as much money as they wanted.
One can even argue that many of the EU’s current difficulties are inherent consequences of the adoption of the euro as a common currency. When a small economy such as Greece or Portugal shares a currency with an economic powerhouse such as Germany, the smaller economy will inevitably face difficulties competing in the world market. Usually, when a small country has issues with competitiveness, it can devalue its currency, making its goods cheaper and appealing to the rest of the world. However, in the case of the euro, many small countries were forced to fight an uphill battle against a stronger currency and their economic fundamentals suffered as a result.
How did Greece get into this mess in the first place?!?!
That’s a great question. I could literally sit here all day talking about every single politically driven poor economic decision that Greece has made in the past decade. But luckily, I’ve managed to narrow it down to a few crucial ones:
- The strong euro and low interest rates fueled credit growth: The adoption of the euro allowed Greece to borrow money at unnaturally low interest rates. The country developed a dependence on deficit spending as a means of maintaining a high standard of living that the population really didn’t deserve.
- Poor fiscal discipline: Since 1974, the Greek government catered to a population with a very socialist mindset, which led to the creation of many welfare programs. The tax revenue could not finance these welfare schemes, so the government secretly borrowed money each year. Since 1993, the government has consistently carried a public debt to GDP ratio of more than 100% (in 2010 only 10 other countries shared this dubious honor–the US had 62.9% according to the CIA Factbook), and under normal circumstances, no sane investor would have lent them money at such low rates. But lucky for Greece, the government was able to cook their fiscal accounts and disguise most of their numbers, which allowed them to borrow more money than they should have been able to borrow (see Figure 2).
- Culture of tax evasion: Taxes. They suck. But we still pay them because its what keeps our beautiful country running. Greece, on the other hand, is a unique case. Greece has a deep-rooted culture of tax evasion that dates back to the Ottoman rule when people evaded taxes as a form of resistance. Unfortunately, this cultural mindset has spilled into the 21st century where citizens refuse to pay if they feel that they’re not getting the public service that’s worthy of their crazy high taxes. And let’s be real here–they’re not. The Greek public sector is bloated and inefficient and definitely does not provide the services that a 40% tax rate would command. Now, for the past decade Greece has been consistently running a budget deficit of 5% (much higher than the 3% EU average), but if tax evasion had been completely eradicated, some estimates suggest that Greece would have run deficits of only 1% (which, by the way, would have been great).
- Failure of European regulators: For my final reason, which I believe is the most important, I must point my finger at European politics. The Maastricht Treaty, otherwise known as the treaty that created the EU, specified the ‘convergence criteria,’ which basically states that only economically sound countries can enter the EU. Economically sound, as defined by the treaty, means that the annual government deficit does not surpass 3% (remember, Greece ran a deficit of 5%) and government debt does not exceed 100% (see Figure 3 for a good lol). Without going too deeply into the politics of this, I’ll just say that European regulators failed to keep Greece in check and by the time they realized it was time to do so, it was too late.
A Greek Default? What’s that?
Simply put, Greece has no more money. Nothing. Not a cent. And they still owe a lot of money to a lot of different people. If you take a look at Figure 4 below, J.P. Morgan estimates that by 2012, Greece will owe the IMF and Europe a combined €100 billion and the market, and to private investors, €262 billion.
During a sovereign default, a nation cannot pay its government debt anymore, but if the debt is restructured efficiently, the country can avoid a nightmare scenario. Restructuring can take the form of extending the loan period, reducing coupon payments, or reducing the principle payout at the end of the loan.What the Troika (see below) has currently been working on is how to restructure this debt through haircuts in order to help Greece obtain sustainable debt levels. Unfortunately, European politics have severely slowed this process down and, quite honestly, a default just seems more and more imminent each day.
There are some journalists and economists out there who actually say that the effect of a Greek default on the world economy would be minor, but that’s just laughable. Sure, Greece is a tiny country with a GDP of only $300 billion compared to say, the U.S. whose GDP surpasses $14 trillion, but we can’t forget a key word here – CONTAGION. A default would have the same impact on European banks that Lehman had on American banks. It can simply be summed up as a “crisis of confidence.”
Yes, a Greek default wouldn’t really be the worst outcome for the Greek economy in the long run. Think about it, they could drop the euro and return to the drachma, which in turn would be severely devalued. Now this wouldn’t be the best news for tourists, per se, who want to go abroad, but this would be great for Greek exports, which would become super cheap relative to other Eurozone countries.
The issue here is that the effects of a default would not be limited to Greece. Investors would question who’s next in line to default. Is it Italy? Is it Spain? At that point it really wouldn’t matter. In order to avoid big losses, euros would flow from the “at risk” countries to the “safe” countries, which would reduce the value of the sovereign debt of the riskier nations. As a result, bond prices would plummet and interests rates would rise, adding on to their debt levels. And if those debt levels became unsustainable, those countries would have to default along with Greece. What does this all mean? Quite simply, the worst-case scenario would be the death of the European Monetary Union.
What effect would a default have on the U.S.?
1. American banks and investment houses hold enormous amounts of sovereign bonds in some of the most stricken countries. As the contagion spreads across Europe, borrowing costs will rise for Ireland, Italy, Portugal, and Spain adding to their debt loads, leading to further losses on the debt that’s held by the U.S.
2. If Europe’s economy goes into recession, American exports will suffer. The EU as a whole is America’s largest trading partner, and exports will inevitably decrease as the Euro depreciates against the dollar.
So what happens now?
Right now, it really is just a waiting game. We’ll see if the Greek citizens agree with the new bailout plan proposed, which is essentially a voluntary 50% haircut (see below) on all Greek debt. Some economists say that it’ll work; others say that the goal of the plan, which is to reduce Greece’s public debt to GDP to about 120% by 2020, still isn’t good enough. There’s not much I can say on the matter, but what I do know is that if there is a disorderly Greek default, I’m pretty sure that my visual representation below of how it will play out is fairly accurate.
If you have any questions or simply disagree with anything I said, feel free to send me an e-mail at Mohammed.Islam@tufts.edu. And of course, if you enjoyed reading this post or simply want to get more involved with the Tufts Economics Society, please e-mail us at firstname.lastname@example.org and let us know.
Good luck with the start of the semester!
Title Image: courtesy of illobbista.wordpress.com/
Figure 1: courtesy of re-define.org
Figure 2: courtesy of “The New Yorker”
Figure 3: courtesy of Eurostat
Figure 4: courtesy of the Financial Times
Definitions You Ought to Know
Troika: a slang term used to group the three organizations (European Commission, the International Monetary Fund, and the European Central Bank) which have the most power over Greece’s financial future
Haircut:a percentage that is subtracted from the face value of assets that are being used as collateral