Greece Faces Debt Crisis

The collapse of Lehman Brothers in 2008 transformed a credit crunch into a full-blown financial panic that all but brought down the Western banking system। Similarly, financial turmoil in Greece may seem like a technical problem but it threatens to turn into a human catastrophe. The country is laboring under a mountainous national debt of 300 billion, amounting to 124 per cent of the Gross Domestic Product (GDP).

Bailout Package
A bailout package amounting to 45 billion has been negotiated with the European Central Bank and the International Monetary Fund (IMF), but there are big doubts about whether Greece can service that debt। Standard & Poor's, the international ratings agency, has downgraded Greece's credit rating to junk status. A credit downgrade means that a country is regarded as a riskier place in which to invest. Greece will now find it even more difficult to service its debt, as foreign investors demand higher interest rates. Stock markets fell sharply yesterday, while the euro fell to its lowest level against the dollar for a year.

Amid the concerns of British voters in the general election, high finance in Greece may seem a distant problem। But it matters for the entire European Union (EU). Political unrest in Greece is spreading. The country's budget deficit amounts to 13.6 per cent of GDP, some four times the allowable limit under the euro zone's rules (known with unintended irony as the Stability and Growth Pact). The Socialist Greek Government has pledged to cut the deficit to fewer than 3 per cent by 2012. It plans to do this by cracking down on tax evasion, reductions in public sector pay, a higher retirement age and privatization of utilities.

Credit Card Rates
Athens' austerity pledge is dramatic। As far as the financial markets are concerned, it is also not credible. Ten-year government bond yields have now risen above 11 per cent. Interest rates on two-year bonds are not far from 20 per cent. Ordinary Greeks will pay a heavy price and may seek to compensate with inflationary wage demands. The costs of borrowing for consumers and businesses are already at levels comparable to credit card rates in this country.

As the crisis has intensified in Greece, international investors have also become more worried about the debt positions of other economies in Southern Europe। Yields on Portuguese long-term government bonds have risen to almost 6 per cent, and in Spain they are above 4 per cent: the highest level since the euro was launched a decade ago. Both of these economies have structural problems -- Spain is suffering the aftermath of a crash in the housing market -- but neither is as extended in its borrowing as Greece. The fear of regional contagion is powerful, however, and Portugal and Spain have both suffered downgrades in their credit ratings this week.

There are two scenarios that investors fear especially। One is that the country will look at the fiscal retrenchment ahead and decide instead to default on its debt. The second is that it might then attempt to ease its economic pain by electing to leave the euro zone altogether.

Increasing Interest Rates
If Greece does default, the consequences for financial markets would be huge। Investors in the neighboring economies would flee। Contagion would spread to the bond markets of Southern Europe, pushing up interest rates and threatening what is at the moment a weak and uncertain European recovery. It would also be a further financial hit to international banks that hold Greek sovereign debt. In short, Europe might face not just the second bout of a double-dip recession, but also a second stage of the banking crisis. This is not only a Greek or even a euro zone problem.

Immediate Task
The immediate task is to ensure that Greece is able to service its short-term debts by providing the bailout money agreed in principle by the EU and the IMF। But there is an important obstacle. Germany, the biggest EU contributor, is reluctant to take part. With public opinion on its side, Berlin has delayed approval of the bailout package. You can see its point. Prudent German taxpayers do not readily understand why they should meet the bill for another country's profligacy.

However, the bailout is essential, and may well require substantially greater sums than the current package envisages। The first responsibility for coping with Greece's crisis lies with the other members of the euro zone, and Germany and France in particular. The episode illustrates the most pressing problem in today's global economy.

Boosting Domestic Demand
There are huge imbalances between countries that have high savings and have lent them out, and countries that have lived beyond their means by attracting those savings। Germany has been a beneficiary of these imbalances, by being able to grow through its exports while doing little to reform the inefficiencies of its domestic economy. On a bigger scale, this relationship also characterizes the economic links between the US (a huge debtor nation) and China, whose savings surplus was recycled in the US economy and sparked the consumer boom that eventually led to a crash.

If the global economy is to recover sustainably, rather than experience continued boom and bust, the imbalances will have to be addressed। The debtor countries need to save more.

The countries with savings surpluses need to boost domestic demand। Greece's crisis is in microcosm, and extreme form, a parable of the stresses in the global economy. A bailout is a palliative compared with these imbalances; but it needs to be done.

Unmitigated Failure
There is another reason that Germany and France need to aid Greece: they are all part of a currency union। Greece joined the euro zone in 2001; its experience has been an unmitigated failure. As its interest rates converged on the euro zone's at the start of this decade, it enjoyed a boom in consumption, for which it is now paying. But as Greece no longer has its own currency, it cannot ease the pain by allowing the exchange rate to adjust.

A currency depreciation would allow real incomes to fall, by raising import prices। But within a monetary union the only way in which Greece can address its debt problem is by a savage deflation. It will cause human misery.

Consequence of Euro Membership
If the principal countries in the euro zone wish the project to succeed, they cannot abdicate the responsibility for bailing out its weakest member to the IMF। The United Kingdom stands outside the euro zone, and that is where it should remain। Looking at the Greek situation and the constraints on Athens as a consequence of euro membership, the United Kingdom must surely count its blessings. But the stresses within the euro zone are not a major cause. The member states of the EU are the main British trading partners. If financial contagion spreads there, then recession will return here. And the next British Government, also contending with a huge budget deficit, will find its policy options severely limited in dealing with the crisis.