Q&A: Greek debt crisis

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What went wrong in Greece?

Greece's economic reforms, which led to it abandoning the drachma as its currency in favour of the euro in 2002, made it easier for the country to borrow money.

Former European Central Bank vice-president Lucas Papademos has been named as Greece's interim prime minister, following days of negotiations. He will head an interim government being formed to make sure the debtstrapped country gets its latest bailout payment. His administration will also have to approve a new 130bn-euro ($177bn; 111bn) international rescue package from the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF). The three-point plan includes expanding the single currency's bailout fund to 1tn euros, banks being forced to raise more capital to protect themselves against losses resulting from any future defaults, and banks accepting a loss of 50% on money they have lent Greece. Greece and its huge debts have weighed on the eurozone for more than a year. The country has been bailed out twice - and investors still fear a default. Why is Greece in trouble? Greece has been living beyond its means since even before it joined the euro, and its rising level of debt has placed a huge strain on the country's economy. The Greek government borrowed heavily and went on something of a spending spree after it adopted the euro. Public spending soared and public sector wages practically doubled in the past decade. It has more than 340bn euros of debt - for a country of 11 million people, about 31,000 euros per person.

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. It was given 110bn euros of bailout loans in May 2010 to help it get through the crisis - and then in July 2011, it was earmarked to receive another 109bn euros. But that still was not considered enough. Another summit was called in October in Brussels to solve the crisis once and for all.

Crisis jargon buster

Use the dropdown for easy-to-understand explanations of key financial terms: Default

Default
Strictly speaking, a default occurs when a borrower has broken the terms of a loan or other debt, for example if a borrower misses a payment. The term is also loosely used to mean any situation that makes clear that a borrower can no longer repay its debts in full, such as bankruptcy or a debt restructuring. A default can have a number of important implications. If a borrower is in default on any one debt, then all of its lenders may be able to demand that the borrower immediately repay them. Lenders may also be required to write off their losses on the loans they have made. Glossary in full

How did we get to this point? The aim of the original Greece bailout was to contain the crisis. That did not happen. Both Portugal and the Irish Republic needed a bailout too because of their own debts. Then Greece needed a second bailout, worth 109bn euros. In July this year, eurozone leaders proposed a plan that would see private lenders to Greece writing off about 20% of the money they originally lent. But bond yields continued to rise on Spanish and Italian debt - leading to fears that their huge economies will need to be bailed out too. The failure of Franco-Belgian lender Dexia also added to woes - French and German banks are large holders of Greek debt. The eurozone rescue fund - the European Financial Stability Facility - was 440bn euros, nowhere near big enough to deal with that scenario.

And so, in October, the eurozone agreed to expand the EFSF to 1tn euros and got banks to agree to a 50% "haircut" on their Greek holdings. But then Greece's Prime Minister George Papandreou shocked European leaders by calling a referendum on the bailout package. That led the leaders of Germany and France, as well as the IMF, to declare that Athens would not receive its next tranche of emergency aid until the referendum had passed. Moreover, the question of Greece leaving the euro was raised for the first time by angry eurozone leaders. That forced Mr Papandreou to back down over the referendum, and he has since made way for a new cross-party unity government that is expected finally to pass the latest bailout deal. Why did the crisis not end with the Greek bailout? Although Greece's troubles are the most extreme, they highlight problems in the eurozone that also apply to other economies. Many other southern European countries ran up huge debts - government debts as well as household mortgage debts - during the past 10 years. They also enjoyed rapidly rising wage levels. Now the bust has come, it is very hard for them to repay the debts. And the high wage levels leave their economies uncompetitive compared with, for example, Germany. Because they are inside the euro, these governments cannot rely on their central bank - the ECB - to lend them the money. Nor can they devalue their currencies to regain a competitive edge. Meanwhile they are having to push through very painful spending cuts and tax rises to get their borrowing under control. But this is just pushing their economies into recession, which leads to higher unemployment, and therefore less income tax revenue and more benefit payments for the governments, compounding their financial problems. What would happen if Greece defaulted?

There has been much public opposition to the austerity programme

Europe's banks are big holders of Greek debt, with perhaps $50bn-$60bn outstanding. 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 nationalising. A crisis of confidence could spark a run on the banks as people withdrew their money, making the problem worse. Nonetheless, the Greek economy is only a small part of the eurozone, 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 eurozone countries may ultimately follow Greece's example. This effect could be even worse if Greece also 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 at the end of October. 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.

What does all this mean to the UK? According to figures from the Bank for International Settlements, UK banks hold a relatively small $3.4bn worth of Greek sovereign debt, compared with banks in Germany, which hold $22.6bn, and France, which hold $15bn. When you add in other forms of Greek debt, such as lending to private banks, those figures rise to $14.6bn for the UK, $34bn for Germany and $56.7bn for France. The UK government's direct contribution to any Greek bailout is limited to its participation as an IMF member. However, any knock-on from Greece's troubles would exacerbate the UK's exposure to Irish debt, which is larger. And if it led to a major financial crisis, as well as a deep recession in the eurozone - the UK's main trading partner - the damage to the UK economy would be substantial

The eurozone has agreed a new "fiscal compact"

Eurozone leaders have agreed to a tough set of rules - insisted on by Germany - that will limit their governments' borrowing each year to just 3% of their economies' output. This is supposed to stop them accumulating too much debt, and make sure there won't be another financial crisis.

But didn't they already agree to this back in the '90s?

Hang on a minute. They agreed to exactly the same 3% borrowing limit back in 1997, when the euro was being set up. The "stability and growth pact" was insisted on by German finance minister Theo Waigel What happened?

Italy was the worst offender. It regularly broke the 3% annual borrowing limit. But actually Germany - along with Italy - was the first big country to break the 3% rule. After that, France followed. Of the big economies, only Spain kept its nose clear until the 2008 financial crisis; the Madrid government stayed within the 3% limit every year from the euro's creation in 1999 until 2007. Not only that - of the four, Spain's government also has the smallest debts relative to the size of its economy. Greece, by the way, is in a class of its own. It never stuck to the 3% target, but manipulated its borrowing statistics to look good, which allowed it to get into the euro in the first place. Its waywardness was uncovered two years ago.

3/9 Italy
Worst offender

5/9 Germany
First to break rules

6/9 France
Offender

9/9 Spain
Top of the Class

But the markets have other ideas

So surely Germany, France and Italy should be in trouble with all that reckless borrowing, while Spain should be reaping the rewards of its virtue? Well, no. Actually Germany is the "safe haven" markets have been willing to lend to it at historically low interest rates since the crisis began. Spain on the other hand is seen by markets as almost as risky as Italy. So what gives?

So what really caused the crisis?

There was a big build-up of debts in Spain and Italy before 2008, but it had nothing to do with governments. Instead it was the private sector - companies and mortgage borrowers - who were taking out loans. Interest rates had fallen to unprecedented lows in southern European countries when they joined the euro. And that encouraged a debt-fuelled boom.

Good news for Germany...

All that debt helped finance more and more imports by Spain, Italy and even France. Meanwhile, Germany became an export power-house after the eurozone was set up in 1999, selling far more to the rest of the world (including southern Europeans) than it was buying as imports. That meant Germany was earning a lot of surplus cash on its exports. And guess what - most of that cash ended up being lent to southern Europe.

...bad news for southern Europe

But debts are only part of the problem in Italy and Spain. During the boom years, wages rose and rose in the south (and in France). But German unions agreed to hold their wages steady. So Italian and Spanish workers now face a huge competitive price disadvantage. Indeed, this loss of competitiveness is the main reason why southern Europeans have been finding it so much harder to export than Germany.

...and a nasty dilemma

So to recap, government borrowing - which has ballooned since the 2008 global financial crisis had very little to do with creating the current eurozone crisis in the first place, especially in Spain (Greece's government is the big exception here). So even if governments don't break the borrowing rules this time, that won't necessarily stop a similar crisis from happening all over again.

Spain and Italy are now facing nasty recessions, because no-one wants to spend. Companies and mortgage borrowers are too busy repaying their debts to spend more. Exports are uncompetitive. And now governments - whose borrowing has exploded since the 2008 financial crisis savaged their economies have agreed to drastically cut their spending back as well. But...

Cut spending...
...and you are pretty sure to deepen the recession. That probably means even more unemployment (already over 20% in Spain), which may push wages down to more competitive levels - though history suggests this is very hard to do. Even so, lower wages will just make people's debts even harder to repay, meaning they are likely to cut their own spending even more, or stop repaying their debts. And lower wages may not even lead to a quick rise in exports, if all of your European export markets are in recession too. In any case, you can probably expect more strikes and protests, and more nervousness in financial markets about whether you really will stay in the euro.

Don't cut spending...

...and you risk a financial collapse. The amount you borrow each year has exploded since 2008 due to economic stagnation and high unemployment. But your economy looks to be chronically uncompetitive within the euro. So markets are liable to lose confidence in you - they may fear your economy is simply too weak to support your ballooning debtload. Meanwhile, other European governments may not have enough money to bail you out, and the European Central Bank says its mandate doesn't allow it to. And if they won't lend to you, why would anyone else?