The Greek debt conundrum, explained

The Greek parliament will vote on further austerity measures Sunday – the latest effort to alleviate a crisis that has careened between an EU bent on austerity and a resistant Greek public.

For almost two years, the Greek government and European Union officials have been convening in meeting rooms to figure out how to rescue the Greek economy as protesters throng the streets of Athens, angry over growing austerity. Meanwhile, the possibility of a default looms. 

Why is the Greek economy in trouble?

Greece has very high sovereign debt – in 2011 the state owed around €350 billion ($461.6 billion), or 160 percent of GDP, the highest rate in Europe. It has also lost the trust of private investors – it can’t borrow anymore to meet its obligations. 

When Greece joined the eurozone in 2001, it misreported its real level of public borrowing in order to meet the entry guidelines. It got access to cheap capital, because the euro offered  much lower interest rates than the drachma. Money poured into the country and wages, particularly in the public sector, rose significantly, although at the same time tax evasion and corruption were endemic.

In 2009, newly elected Prime Minister George Papandeou revised the budget deficit figures, implying that his predecessors had "cooked the books." Greece's credit ratings started to slide. In the same year, the Greek government estimated the size of the black market, the untaxed economy, to be about 30 percent of the declared economy.

In 2010 Greece’s debt rating was lowered to “junk” status and the interest rates on Greek bonds rose to a level that made borrowing unsustainable, requiring Greece to seek international help from the European Union and International Monetary Fund. The country was told that it had to undergo severe budget cuts and tough austerity measures – a cure, some critics say, that has become part of the problem.

“Greece is trying to massively reduce its public borrowing without anything to offset these measures, like [devaluing] the currency,” says Simon Tilford, Chief Economist at the London-based Centre for European Reform. “So the cuts in spending become self-defeating because the economy is contracting faster than they can implement cuts.”

Could Greece go bankrupt?

In a sense, it already has. “Under no plausible scenario could Greece service its public, and, for that matter, its private debts,” says Mr. Tilford. “It is fair to say that, yes, Greece is insolvent.”

For months now, the Greek government has been negotiating with its private creditors about the size of a "haircut," a debt forgiveness that the EU, the European Central Bank (ECB) and the IMF have demanded before they give more financial aid to Athens. A restructuring of Greek debt – the deal negotiated at the moment foresees a write-off of about 70 percent – amounts to what is referred to as an orderly default.

But the deal hasn’t been finalized yet. Some private banks and hedge funds oppose it, possibly in hopes of getting back a larger share by holding out or on cashing credit default swaps, insurance policies against default.

On March 20, Greece needs to pay back €14.5 billion ($19.1 billion). If it does not get fresh money until then, it will have to declare bankruptcy – a “messy” default.

It is something the founders of the eurozone did not even consider. The treaties regulating the currency union have no provisions for such a procedure, nor for a member leaving or being forced out of the union.

What has Europe and the international community done to help Greece?

 The political will to keep the eurozone project intact and the fear of contagion – the flight of investors from other eurozone members seen as vulnerable, like Spain and Italy – have for a long time made a Greek default anathema in European capitals. After lengthy negotiations, a first bailout package worth €110 billion ($145 billion) in loans was agreed to between the EU and IMF in 2010, linked to demands for reform of the Greek public sector and cuts in the budget. Realizing that more money was needed, a second bailout package was agreed on in 2011, but payments will only start once Greece has implemented more austerity measures.

The ECB has bought €50 billion ($66 billion) worth of Greek government bonds so far, but it has refused to be part of the haircut deal negotiated with private investors.

European leaders have repeatedly considered limiting Greece’s economic independence. The German finance ministry floated a plan to install a commissioner in Brussels controlling the Greek budget, but dropped the idea amid fierce opposition from Greece and other eurozone countries. German Chancellor Angela Merkel and French President Nicholas Sarkozy earlier this week proposed the creation of a frozen account, into which Greece should pay revenue in order to service creditors.

But only a far reaching debt write-off, including the ECB, could give Greece the breathing space it needs to recover, according to Thomas Klau, Senior Policy Fellow at the European Council on Foreign Affairs in Paris. “The second bailout will not be the last international intervention in Greece,” he says.

What has Greece done to solve the crisis?

 “We have seen astonishing fiscal austerity in Greece,” says Mr. Tilford. “They might not have done enough in terms of structural reforms, but the cuts in public spending are unprecedented.”

All in all Greece has adopted five austerity plans since 2010 (the latest, agreed to by the coalition government this week, is due for a parliamentary vote this weekend). Athens has pledged cuts in spending amounting to €40 billion ($53 billion) and the sale of public assets is expected to raise another €50 billion ($66 billion). Up to 150,000 public sector jobs are to be scrapped until 2015, while pensions will be cut and the minimum wage reduced. But in regards to all these targets, Greece is lagging behind in the implementation. 

“The Greek government is defeated by its own administration,” says Mr. Klau. “There is so much resistance and incompetence in the bureaucracy that it is fair to say, Greece is currently the only EU country that does not have a functioning administration.” It is this lack of government, Klau argues, which prevents much needed reforms from being implemented, much needed investments from being made, and the country from improving its competitiveness. “The whole rescue operation for Greece could fail.”