What is eurozone Crisis?

What happened to Greece economy?

While many factors are behind the debt crisis, the 2004 Athens Olympics have drawn particular attention. When it comes to overspending, Greece gets the gold medal.

Greece has been living beyond its means even before it joined the European Union, and its rising level of debt has placed a huge strain on the country’s economy. The Greek government borrowed heavily and went on spending spree after it adopted the euro. Public spending soared and public sector wages practically doubled in the past decade. However, whilst money has flowed out of the government’s coffers, its income has been hit by widespread tax evasion. When the global financial downturn hit, Greece was ill-prepared to cope. Although Greece’s troubles are the most extreme, they highlight problems in the euro zone that also apply to many other countries.

How the Greece issue will affect others?

European banks are big holders of Greek debt. An “orderly” default could mean a substantial part of this debt being rescheduled so that repayments are pushed back decades. A “disorderly” default could mean much of this debt not being repaid – ever.

Either way, it would be extremely painful for banks and bondholders. What’s more, Greek banks are exposed to the sovereign debts of their country. They would need new capital, and it is likely some would need nationalizing. A crisis of confidence could spark a run on the banks as people withdrew their money, making the problem worse. The interest rates on 10 year government bond are around 35% in Greece!

The Greek economy is only a small part of the euro zone, and the losses should be manageable for its lenders. The real risk is that a unilateral default by Greece could lead to a financial panic, as investors fear that other, much bigger euro zone countries may ultimately follow Greece’s example. Many are in the pipeline.

This effect could be even worse if Greece leaves the euro – something that was explicitly acknowledged as a possibility by the outgoing Greek Prime Minister, George Papandreou, as well as the German and French leaders.

The interconnection in the global financial system is that if one nation defaults on its sovereign debt or enters into recession that places some of the external debt at risk as well, the banking systems of creditor nations face losses. For example if Greece borrowers owed French banks $300 billion, should Greece be unable to finance itself, the French banking system and economy could come under significant pressure, which in turn would affect France’s creditors and so on. This is called Financial Contagion.

The excessive government spending, large bailout packages etc. resulted in increasing fiscal deficit for the member countries. Imbalances on the balance of payments among various member countries, monetary policy inflexibility etc. also contributed to the Euro zone crisis.

Many will remember that it was Lehman Brothers going bust that really triggered the chain reaction which sank the banks. A Greek default could cause not simply ripples but a tidal wave of consequences in Europe as financial systems are so interconnected. Such a move might be a repeat of the collapse of Lehman Brothers, which sparked a global financial crisis that pushed Europe and the US into deep recessions.

Why this happended in Euro zone?

Euro zone is not a single nation, it represents 17 countries out of 27 nations of the European Union that have adopted a common currency and a central bank, but do not have a fiscal union. Money does not automatically flow from countries with surpluses to those with fiscal deficits. So, while the euro zone as a whole has a very manageable fiscal deficit of around 4% of GDP, the prudent northern members run surpluses while the southern members have large deficits.

This shows the case for breaking up the euro zone. Either a few laggards like Greece can exit, or the zone can split into two currency zones, one for stronger northern countries and another for weaker southern ones. However, European politicians absolutely refuse at this stage to look at a euro zone split or collapse. They believe that the exit of a single member would lead to contagion and the exit of one country after another. So, they have resolved to hold firm.

Yet, this leaves unanswered the problem of how to keep highly competitive countries like Germany and Holland in the same currency union as uncompetitive ones like Greece and Portugal.