The Greek debt crisis

Will Hodges on the growing concern that Greece could default on its public debt.

The size of Greece's budget deficit has raised concerns that it could default on its public debt. As Greece is a member of the Eurozone, this prospect is a serious problem for the EU. There is no existing procedure for determining what happens if a major state defaults. Any bailout package would undermine the strict guidelines set out by the Maastricht Treaty, which demands fiscal responsibility from member states. Governments are allowed to run a budget deficit of 3 per cent of GDP in any given year, with some leeway permitted. In 2009, Greece's deficit was estimated at 12.7 per cent. A rescue package would set an unwelcome precedent that countries could happily borrow and spend, safe in the knowledge that the EU would come to their rescue. On the other hand, the prospect of Greece going cap-in-hand to the International Monetary Fund (IMF) is no more palatable - such a move would seriously undermine investor confidence in the region. In the end, the Eurozone members, organised by France and Germany, promised to take "determined and co-ordinated action, if needed". However, there was no detail as to the form this action would take. Any help will be contingent on Greece complying with strict fiscal guidelines and close monitoring by the European Central Bank (ECB). The Greek Prime Minister, George Papandreou, has promised to cut public spending in order to reduce its budget deficit to 3 per cent of GDP by 2012.

How did it come to this?

While the crisis came to world's attention at the beginning of the year, Greece's problems go back a lot further. The country's inclusion in the Eurozone papered over large cracks in its economy. When the euro was introduced in 2001, the government was already wrestling with a considerable public debt burden, equivalent to 100 per cent of its GDP. Much of this has since been attributed to the country's bloated public sector. Fiscal irresponsibility was facilitated by low interest rates set by the ECB, which spurred GDP growth, and by low inflation, which allowed the government to borrow money cheaply on international debt markets. The global economic downturn, whilst not hitting Greece as hard as some countries (its GDP contracted by 1.7 per cent in 2009), was enough to tip the balance of its fragile economy. Rising unemployment led to a drop in tax revenues, pushing the country further into the red.

The crisis was exacerbated by the fact that it was largely unexpected. This is partly because Greece's relatively small economy represents less than 3 per cent of the Eurozone's collective GDP. Added to which, the outgoing Greek government had been fudging the fiscal numbers that it sent to the EU. In January, the incoming government announced that Greece's deficit, which was thought to be a relatively manageable 5 per cent of GDP, was in fact closer to 13 per cent. Suddenly alerted to the possibility of a default, bond investors reacted by demanding higher rates of interest for Greek debt, pushing bond yields up, making it more expensive for the government to borrow money and so deepening the crisis.

The lasting impact?

The promise of help from the Eurozone members was supposed to reduce concerns of a Greek default. However, the vague pronouncement has failed to reassure the markets. Greece must fulfil its commitment to reduce its budget deficit to just 3 per cent in two years. This won't be easy. The country's public sector workers are highly unionised. They have already held strikes in protest against having their pay frozen and the retirement age raised.

Most worrying is the growing realisation that the region's problems do not end with Greece. The Eurozone economy has limped out of recession and recorded growth of just 0.1 per cent for the final few months of the last year. There are growing fears over the credit worthiness of countries such as Portugal, Italy and Spain (known, together with Greece, as the PIGS) and Ireland. Together these states represent a real threat to the future of the region.