What Is the Greece 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 Greece debt crisis is the potential for this small country's debt default to weaken the European Union. Greece wants the EU to lighten its load. Germany and its bankers want Greece to reform its financial structure. The crisis warns of the danger facing other heavily indebted EU members.

Leaders have struggled for seven years to agree on its resolution. During that time, the Greek economy has shrunk 25 percent thanks to spending cuts and tax increases demanded by creditors.

Greece's debt-to-GDP ratio has grown to 179 percent.

 The crisis triggered the Eurozone debt crisis and created fears of a global financial crisis. It still throws into question the viability of the eurozone itself.  All this from a country whose economic output is no bigger than the U.S. state of Connecticut.

Latest Developments

May 2017: Prime Minister Alexis Tsipras agreed to pension cuts and a broader tax base in return for €86 billion new loans. He hopes that his conciliatory tone will help him reduce the €293.2 billion in outstanding debt. That requires the support of the German government unlikely to concede much before the September Presidential elections. Greece has paid €35.4 billion since February 2015. Greece is borrowing money to make payments on existing debt. (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.)

June 2016: On June 17, the EU's European Stability Mechanism disbursed €7.5 billion to Greece. It will use the funds to pay interest on its debt. Greece continues to enact the reforms required by the EU.  It has passed legislation to modernize the pension and income tax systems. It will privatize more companies, and sell off non-performing loans.

 (Source: "ESM Disburses €7.5 Billion to Greece," ESM Europa.)

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 lend to new ventures. (Source: "On the Front Line," The Economist, March 12, 2016.)

November 2015: Greece's four biggest banks raised the €14.4 billion required by the European Central Bank. The funds will 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 in bailout loans. (Source: "Greek Official Told to Raise $15.9 Billion to Cover Bad Loans," New York Times, October 3,1 2015.)

September 20: 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. His government must create the 2016 budget and a three-year fiscal plan. It also needed to recapitalize the banks.

 They must also make the unpopular reforms promised to the EU:  

  • Reform the pension system.
  • Merge Social Security funds.
  • Privatize the electricity transmission system.
  • Reform the tax code. Double taxes on agriculture.
  • Create a new privatization fund to manage €50 billion in assets. (Source: "Tsipras Wins," CNBC, September 21, 2015.)

July 23: The Greek Parliament passed the second round of austerity measures needed to receive the €86 billion loan from the EU. It passed the first series on July 15.  That was shortly after a referendum on July 6 where voters said "no" to austerity. Most Parliament members realized they had no choice.

Austerity measures would cause inflation. Greece must increase the VAT tax and the corporate tax rate. It needs to 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 the leftist parties and unions. Here's the text of the agreement.

The ECB agreed to recapitalize Greek banks with €10 to €25 billion, allowing them to reopen. Banks imposed a €420 weekly limit on withdrawals. That prevented depositors from draining their accounts and worsening the problem. Greece made its July 20 payment to the ECB, thanks to a €7 billion loan from the EU emergency fund. The UK demanded the other EU members must guarantee its part.

The ECB agreed with the International Monetary Fund that they must reduce Greece debt. That means they will lengthen the terms, thus reducing net present value. (Source: The Daily Shot)

The austerity measures were similar to the Greek proposal submitted by Tsipras shortly before the July 6 referendum. Tsipras promised that the "no" vote gave Greece more leverage to negotiate a 30 percent debt relief with the EU. That means it's possible voters weren't sure what they were voting on. The Greek Finance Minister, Yanis Varoufakis, was replaced by the less abrasive Euclid Tsakalotos. He still criticized the deal from the sidelines. 

Greece sustained extensive economic damage during the two weeks surrounding the referendum. Banks closed and restricted ATM withdrawals to €60 per day. It threatened the tourism industry at the height of the season, with 14 million tourists visiting the country.  (Source: BBCNew York TimesWSJFinancial Times)

On July 3, 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 they are owed. Many analysts believed this encouraged the Greek people to vote "No" on the referendum. The IMF's analysis came two days after Greece didn't make its scheduled €1.55 billion payment on June 30. Both sides called it a delay, not an official default. (Source: "IMF Raises Referendum Stakes," Wall Street Journal, July 2, 2015.)

Greece Crisis Explained

In 2009, Greece kicked off the crisis. It 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. That made it more unlikely that Greece could find the funds to repay its sovereign debt.

In 2010, Greece announced an austerity package that would lower the deficit to 3 percent of GDP in two years. It was designed to reassure the agencies it was fiscally responsible. Just four months later, Greece warned it might default, just the same.

The EU and the IMF provided €240 billion in emergency funds in return for more austerity measures. That 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 to the bailout. The EFSF was another lending facility funded by EU countries

By 2012, Greece's debt-to-GDP ratio had risen to 175 percent, nearly 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. (Source: "Greece," New York Times. "Greek Debt Crisis Timeline," BBC.)

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 exchange rate versus the euro. 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. EU countries like Slovakia and Lithuania refused to ask their taxpayers to dig into their pockets to let Greece off the hook. They had just endured their own austerity measures.

Plummeting drachma values could trigger hyperinflation, as the cost of imports skyrocket. Greece imports 40 percent 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 -- already on the brink -- would go bankrupt without loans from the ECB. Losses could threaten the solvency of other European banks, particularly in Germany and France. They, along with other private investors, hold €34.1 billion in Greek debt.

Eurozone governments own €52.9 billion. That's besides the €131 billion owned by the EFSF (in other words, 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 EU's central bank holds €26.9 billion 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 won'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 needed capital until their economies had improved. The IMF owns €21.1 billion of Greek debt, not enough to deplete it. (Source: "IMF Walks Out of Bailout Talks With Greece," Wall Street Journal, June 12, 2015.)

The difference today is the scale of defaults, which are in the developed markets--the source of much of the IMF's funds. The United States is a huge backer of IMF funding, but it's now over-indebted itself. There would be no political appetite for a U.S.-backed bailout of European sovereign debt. 

Why Are Austerity Measures Needed?

Long-term, the measures will 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, helping exports to increase.

Most important, it required Greece to reform its pension system. That absorbs 17.5 percent of GDP, higher than 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 must also require a higher contribution by employees, and reduce early retirement.  Greece could raise more revenue if it strengthened tax collection and clamped down on tax evasion. It should also raise funds by selling off off state-owned businesses, according to the OECD. (Source: "Economic Survey of Greece," OECD.)

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.)

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.

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 allowed lower interest rates and an inflow of 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.

  1. 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.
  2. There was uncertainty on exactly what sanctions to apply. They could expel Greece, but that would be disruptive and weaken the euro.
  3. 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. (Source: "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. Now, the EU must stand behind its member. Otherwise, it will face the consequences of Greece either leaving the eurozone or defaulting.