Stocks rally on news of possible Greece bailout. What comes next?

Is the European Union about to put lipstick on a pig?

No, not the type of pig that can get you into hot water in a US presidential campaign. But one of the PIGS – Portugal, Ireland, Greece and Spain – whose heavy levels of debt, which have proved a drag on the euro in the past year, have earned them that unflattering moniker in European financial markets.

The PIG in question is Greece, which currently has the ugliest financial outlook of any member of the eurozone. The Hellenic Republic's problems have depressed European and other markets since the start of the year, with fears of a possible Greek government default leading to contagion – a felling of financial dominoes as investors panic and defaults in one country trigger problems elsewhere.

Ireland, for instance holds a significant chunk of Greece's debt and is facing financial problems of its own. Greece's debt burden were a key reason the euro fell to a 9-month low earlier this week.

After news agencies reported today that Germany, France, and other European financial heavyweights were considering a package of loan guarantees – a type of bailout – for Greece, US stocks and some European markets rallied. The benchmark Greek stock index rallied five percent.

The country’s debt crisis will top discussions when Prime Minister George Papandreou meets with French President Nicolas Sarkozy on Wednesday, ahead of a European Union Council meeting Thursday that investors hope will agree to a bailout.

While that's cheered up markets, Greece and a number of its peers are not out of the woods yet. They still carry some of the highest debt levels seen in Europe since WWII, as countries grapple with a high unemployment, slow growth, and the cost of government stimulus programs designed to revive their economies.

Below we look at the state of Greece's finances, and what's likely to happen next.

What’s wrong with Greece?

Massive debt.

Greece’s deficit reached 12.7 percent of gross domestic product in 2009, and the country’s debt-to-GDP ratio rose to 110 percent. That means that the country's total economic output is worth about $340 billion a year, but its current debt is $375 billion. That’s a higher debt-to-GDP ratio than in any other European country, and it has investors hesitant to continue loaning and worried that Greece will default on its loans.

Can Greece export its way out of trouble?

Not really.

The IMF has bailed out three EU countries – Hungary, Latvia and Romania – during the financial crisis of the past year or so, but they’re not eurozone nations overseen by the European Central Bank. Finland and Sweden faced similar crises in the early 1990s, but because they weren't using the euro they were able to depreciate their own currencies and export their way back to prosperity. A lower domestic currency made their exports cheaper to consumers in the US.

But as a member of the 16-country eurozone, Greece is subject to the policies of the European Central Bank.

“It is inconceivable” that the ECB would print more money and allow inflation across Europe for the mere sake of one country, says Jay Bryson, a Wells Fargo economist and author of the Feb. 5 report “The Long Road Ahead for Greece (and Others).” Because 60 percent of Greece’s exports are sold in Europe, inflation of the euro won’t help Greece sell goods to its primary market," he says.

“Greece doesn’t have the luxury of cutting monetary policy,” Bryson said by telephone Tuesday in Charlotte, N. C.. “They’re between a rock and a hard place.”

So will Greece default?

Probably not, economists say.

After a week of speculation and resultant jitters on stock markets, economists now believe that either the European Union or the International Monetary Fund will come to Greece's rescue. This is expected to come along with reductions in Greece's government spending and an increase in taxes.

“There’s clearly no risk of default. I’m very confident about it,” Nobel laureate economist Joseph Stiglitz today told Bloomberg Television.

Expectations for a financial rescue of Greece sent US stocks soaring on Tuesday, putting the Dow Jones Industrial Average up 1.7 percent, and placing the market on track for its best one-day gain in three months.

“Somebody is going to help Greece out. Whether it’s an individual member of the EU or the auspices of the IMF, I think somebody is going to extend some aid,” says Bryson of Wells Fargo.

The United Kingdom and Ireland hold about 23 percent of the total outstanding Greek debt, followed by France at 11 percent and Italy at 6 percent. Those countries are unlikely to allow their money to disappear, and will instead extend a loan on strict terms.

What would happen if Greece did default?

Greece’s economy is a small piece of the European pie, as economist Paul Krugman points out with this chart. So, on its own, Greece’s debt default wouldn’t rock the boat.

However, it would erode confidence in other countries in similar financial situations, such as Portugal, Ireland, and Spain, which is one of the world’s 10th largest economies.

“It could have a contagion affect,” says Bryson. “It could potentially be a replay of when Lehman Brothers collapsed.”

When Lehman Brothers declared bankruptcy in 2008, “The real damage was the message the failure sent—that the government might not do everything it could to prevent struggling firms from failing chaotically," writes The Economist. "This led firms to reevaluate the trustworthiness of other banks (and their obligations) and to rush for safety, and this in turn led to crisis.”

Is this the beginning of the end for the eurozone?

Very unlikely.

“I don’t think the euro’s going to blow up tomorrow,” Bryson says, adding: “It does raise interesting political discussions."

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