What Is the Greek Debt Crisis?

Understand the Greek Debt Crisis in 5 Minutes

Greek debt crisis
Greece's financial pressures may force it to abandon the Greek euro. Photo: Eduard Andras/Getty Images

The Greek debt crisis is the dangerous amount of sovereign debt the Greek government owes.  It became dangerous when a possible debt default threatened the European Union.

Since 2008, EU leaders have struggled to agree on a solution. During that time, the Greek economy shrank 25 percent thanks to spending cuts and tax increases demanded by creditors. Greece's debt-to-GDP ratio grew to 179 percent.

The disagreement is a matter of which countries lose out more.

Greece wants the EU to lighten its load by forgiving some of the debt. The EU, led by Germany and its bankers, wants Greece to reform its government and financial structure.

The crisis triggered the eurozone debt crisis and created fears of a global financial crisis. It threw into question the viability of the eurozone itself. It warns of what could happen to other heavily indebted EU members. All this from a country whose economic output is no bigger than the U.S. state of Connecticut.

Greece Crisis Explained

In 2009, Greece announced its budget deficit would be 12.9 percent of gross domestic product. That's more than four times the EU's 3 percent limit. Rating agencies Fitch, Moody's and Standard & Poor's lowered Greece's credit ratings. That scared off investors. It also drove up the cost of future loans. Greece didn’t have a good chance of finding the funds to repay its sovereign debt.

In 2010, Greece announced a plan to lower its deficit to 3 percent of GDP in two years. Greece attempted to reassure the EU lenders it was fiscally responsible. Just four months later, Greece warned it might default, just the same.

The EU and the International Monetary Fund provided 240 billion euros in emergency funds in return for austerity measures.

The EU had no choice but to stand behind its member by funding a bailout. Otherwise, it would face the consequences of Greece either leaving the eurozone or defaulting.

Austerity measures required Greece to increase the VAT tax and the corporate tax rate. It must close tax loopholes and reduce evasion. It should reduce incentives for early retirement. It has to raise worker contributions to the pension system. A significant change is the privatization of many Greek businesses, including electricity transmission. That reduces the power of socialist parties and unions. Here's the text of the agreement.

Germany, other EU leaders and bond rating agencies wanted to make sure Greece wouldn't use the new debt to pay off the old. Germany, Poland, Czech Republic, Portugal, Ireland and Spain had already used austerity measures to strengthen their own economies. Since they were paying for the bailouts, they wanted Greece to follow their examples. Some EU countries like Slovakia and Lithuania refused to ask their taxpayers to dig into their pockets to let Greece off the hook. These countries had just endured their own austerity measures to avoid bankruptcy with no help from the EU. (Source: “From Lithuania, a View of Austerity’s Costs,” The New York Times, April 1, 2010.)

The loan only gave Greece enough money to pay interest on its existing debt and keep banks capitalized. The measures further slowed the Greek economy. That reduced the tax revenues needed to repay the debt. Unemployment rose to 25 percent and riots erupted in the streets. The political system was in an upheaval as voters turned to anyone who promised a painless way out.  

In 2011, the European Financial Stability Facility added 190 billion euros to the bailout. Despite the name change, that money also came from EU countries.

By 2012, Greece's debt-to-GDP ratio had risen to 175 percent, almost three times the EU’s limit of 60 percent. Bondholders finally agreed to a haircut, exchanging $77 billion in bonds for debt worth 75 percent less. (Sources: "Greece," New York Times. "Greek Debt Crisis Timeline," BBC.)

On June 27, 2015, Greek Prime Minister Alexis Tsipris announced a referendum on austerity measures. He promised that a "no" vote would give Greece more leverage to negotiate a 30 percent debt relief with the EU. On June 30, 2015, Greece missed its scheduled 1.55 billion euros payment. Both sides called it a delay, not an official default. Two days later, the IMF warned that Greece needed 60 billion euros in new aid. It told creditors to take further write-downs on the more than 300 billion euros they are owed. (Source: "IMF Raises Referendum Stakes," Wall Street Journal, July 2, 2015.)

On July 6, 2015, Greek voters voted "no."  The instability created a run on the banks. Greece sustained extensive economic damage during the two weeks surrounding the referendum. Banks closed and restricted ATM withdrawals to 60 euros per day. It threatened the tourism industry at the height of the season, with 14 million tourists visiting the country. The European Central Bank agreed to recapitalize Greek banks with 10 euros to 25 billion euros, allowing them to reopen. Banks imposed a 420 euros weekly limit on withdrawals. That prevented depositors from draining their accounts and worsening the problem. (Source: BBCNew York TimesWSJFinancial Times)

On July 15, the Greek Parliament passed the measures anyway. Otherwise, it would not receive the 86 billion euros loan from the EU.  The European Central Bank agreed with the IMF that they must reduce Greece debt. That meant they would lengthen the terms, thus reducing net present value. Greece would still owe the same amount, it could just pay it over a longer time period. (Source: "The Daily Shot," July 17, 2015.)

On July 20, Greece made its payment to the ECB, thanks to a 7 billion euros loan from the EU emergency fund. The United Kingdom demanded the other EU members guarantee its contribution to the bailout.

On September 20, 2015, Greek Prime Minister Alex Tsipiras and the Syriza party won a snap election. It gave them the mandate to continue to press for debt relief in negotiations with the EU. But they also had to continue with the unpopular reforms promised to the EU. (Source: "Tsipras Wins," CNBC, September 21, 2015.)

In November 2015, Greece's four biggest banks privately raised 14.4 euros billion as required by the ECB. The funds would cover bad loans and return the banks to full functionality. Almost half of the loans banks have on their books could default. Bank investors will contribute this amount in exchange for the 86 billion euros in bailout loans. (Source: "Greek Official Told to Raise $15.9 Billion to Cover Bad Loans," New York Times, October 3,1 2015.)

In March 2016, the Bank of Greece predicted the economy would return to growth by the summer. It only shrank 0.2 percent in 2015. But the Greek banks were still losing money. They were reluctant to call in bad debt, believing that their borrowers will repay once the economy improves. That tied up funds they could have lent to new ventures. (Source: "On the Front Line," The Economist, March 12, 2016.)

On June 17, 2016, the EU's European Stability Mechanism disbursed 7.5 billion euros to Greece. It planned to use the funds to pay interest on its debt. Greece continued with austerity measures. It has passed legislation to modernize the pension and income tax systems. It will privatize more companies, and sell off nonperforming loans.  (Source: "ESM Disburses 7.5 Billion Euros to Greece," ESM Europa.)

In May 2017, Prime Minister Alexis Tsipras agreed to cut pensions and broaden the tax base. In return, the EU would lend him another 86 billion euros. That allows Greece to make payments on its existing debt. Tsipras hopes that his conciliatory tone will help him reduce the 293.2 billion euros in outstanding debt. But the German government is unlikely to concede much before the September presidential elections. Greece has paid 35.4 billion euros since February 2015. (Sources: "Greece Debt Timeline," The Wall Street Journal, May 5, 2017. "Greek Austerity Deal Opens Up Potential Path Out of Bailout," The Wall Street Journal, May 5, 2017.)

In July 2017, Greece was able to issue bonds again. It plans to swap notes issued in the restructuring with the new notes as a move to regain investors' trust.

Causes of the Greece Crisis

How did Greece and the EU get into this mess in the first place? The seeds were sown back in 2001 when Greece adopted the euro as its currency. Greece had been an EU member since 1981 but couldn't enter the eurozone. Its budget deficit had been too high for the eurozone's Maastricht Criteria. 

All went well for the first several years. Like other eurozone countries, Greece benefited from the power of the euro. It lowered interest rates and brought in investment capital and loans.

In 2004, Greece announced it had lied to get around the Maastricht Criteria. The EU imposed no sanctions. Why not? There were three reasons.

France and Germany were also spending above the limit at the time. They'd be hypocritical to sanction Greece until they imposed their own austerity measures first.

There was uncertainty on exactly what sanctions to apply. They could expel Greece, but that would be disruptive and weaken the euro.

The EU wanted to strengthen the power of the euro in international currency markets. A strong euro would convince other EU countries, like the UK, Denmark and Sweden, to adopt the euro. (Sources: "Greece Cheated," Bloomberg, May 26, 2011. "Greece Joins Eurozone," BBC, January 1, 2001. "Greece to Join Euro," June 1, 2000.)

As a result, Greek debt continued to rise until the crisis erupted in 2009.

What Happens If Greece Leaves the Eurozone

Without an agreement, Greece would abandon the euro and reinstate the drachma. That would end the hated austerity measures. The Greek government could hire new workers, reduce the 25 percent unemployment rate and boost economic growth. It would convert its euro-based debt to drachmas, print more currency and lower its euro exchange rate. That would reduce its debt, lower the cost of exports and attract tourists to a lower-cost vacation destination.

At first, that would seem ideal for Greece. But foreign owners of Greek debt would suffer debilitating losses as the drachma plummeted. That would debase the value of repayments in their own currency. Some banks would go bankrupt. Most of the debt is owned by European governments, whose taxpayers would foot the bill.

Plummeting drachma values could trigger hyperinflation, as the cost of imports skyrocket. Greece imports 40 percent of its food and pharmaceuticals and 80 percent of its energy. Many companies refused to export these items to a country that might not pay its bills. The country couldn't attract new foreign direct investment in such an unstable situation. The only countries that have signaled they would lend to Greece are Russia and China. In the long run, Greece would find itself back to where it is now: burdened with debt it can't repay. 

Interest rates on other indebted countries might rise. Rating agencies would worry they'd leave the euro also. The value of the euro itself might weaken as currency traders use the crisis as a reason to bet against it. 

What Happens If Greece Defaults

A widespread Greek default would have a more immediate effect. First, Greek banks would go bankrupt without loans from the European Central Bank. Losses could threaten the solvency of other European banks, particularly in Germany and France. They, along with other private investors, hold 34.1 billion euros in Greek debt.

Eurozone governments own 52.9 billion euros. That's in addition to the 131 billion euros owned by the EFSF, essentially also eurozone governments. Some countries, like Germany, won't be affected by a bailout. Even though Germany owns the most debt, it is a tiny percentage of its GDP. Much of the debt doesn't come due until 2020 or later. Smaller countries face a graver situation. Finland's portion of the debt is 10 percent of its annual budget. (Source: "Finland Lays Out What's At Stake With Greece," Breitbart, July 7, 2015.)

The ECB holds 26.9 billion euros of Greek debt. If Greece defaults, it won't put the future of the ECB at risk. That's because it's unlikely that other indebted countries would decide to default. 

For these reasons, a Greek default wouldn’t be worse than the 1998 LTCM debt crisis. That's when Russia's default led to a tidal wave of defaults in other emerging market countries. The IMF prevented many defaults by providing capital until their economies had improved. The IMF owns 21.1 billion euros of Greek debt, not enough to deplete it. (Source: "IMF Walks Out of Bailout Talks With Greece," Wall Street Journal, June 12, 2015.)

The differences would be the scale of defaults and that they are in developed markets. It would affect the source of much of the IMF's funds. The United States wouldn’t be able to help. While a huge backer of IMF funding, it's now overindebted itself. There would be no political appetite for an American bailout of European sovereign debt. 

Why Austerity Measures Were Needed

Long term, the measures would improve Greece's comparative advantage in the global marketplace. The austerity measures required Greece to improve how it managed its public finances. It had to modernize its financial statistics and reporting. It lowered trade barriers, increasing exports.

Most important, it required Greece to reform its pension system. Before, it absorbed 17.5 percent of GDP, higher than in any other EU country. Public pensions are 9 percent underfunded, compared to 3 percent for other nations. Austerity measures required Greece to cut pensions by 1 percent of GDP. It also required a higher pension contribution by employees and reduced early retirement. 

Half of Greek households rely on pension income, and one out of five Greeks are 65 or older. Youth unemployment is at 50 percent. Workers aren't thrilled about paying contributions so seniors can receive higher pensions. (Source: "Unsustainable Futures: The Greek Pensions Dilemma Explained," The Guardian, June 15, 2015.)