Why you should care about Greece's economic failure

    Photo by peterbarabas on Flickr, licensed under the Creative Commons.

    Greece, especially fifth century B.C.E. Athens, is supposed to be the birthplace of European culture. This was the time of Sophocles, Aeschylus and Socrates, the beginning of democracy and the production of cultural marvels that still amaze to this day. So why is Greece in the 21st century threatening the world economy with a debt crisis which could start a wave of defaults across Europe, a collapse of the Euro and has necessitated almost $1 trillion in support from the E.U and the International Monetary Fund to shore up the European economy?

    Greece’s national economy is a total basket-case that habitually ran deficits when the economy was growing, is notoriously poor at collecting taxes and was on the verge of defaulting on its debts (until the rescue plan was voted through, which should shore up Greece’s finances for now). The country’s financial woes could have touched off a wave of defaults in other economically vulnerable European countries, such as Spain, Portugal, Italy and Ireland.

    When the Greek Parliament proposed austerity measures that, while probably hurting the economy in the short term, are necessary to get their finances in line, there was massive rioting in Athens and a bank was firebombed, which killed three. And while no one denies that insolvency, the risk of debt default and the necessary austerity can be very, very painful for a populace, it is strange to think that Greece, of all countries, could touch off such far-reaching economic panic, including the rapid devaluation of the Euro.

    The fundamental problem lies in the fact that European economies are very interconnected. For example, much of Greece’s debt is held by French and German banks. If Greece can’t service its debts, the German and French economies would take a huge hit in their financial sectors. And as we all learned from Lehman Brothers, even if a relatively small firm (or country) goes under, in an interconnected financial system, these problems can lead to huge, unforeseeable ripple effects.

    The other risk is contagion. If Greece can’t be dealt with, then investors might freak out about the aforementioned other European countries that also have debt problems, even if they (like Spain) didn’t have horrible macroeconomic policy before the worldwide recession. These doubts could drive up interest rates, making the accumulated debt even more expensive. This is basically what happened when Thailand had a financial crisis in 1997 which touched off a a larger crisis in Southeast Asia that ended in currency devaluation and economic contraction across the region. Contagion fears have naturally been popping up since the world economy took a dip; when Dubai had a debt crisis in November of last year, Abu Dhabi quickly bailed its fellow emirate to head off any greater crisis.

    So what’s Greece to do? They have to reduce their debt-to-GDP ratio and overall public and private debts. The best way to do this is to increase economic growth, but the strict austerity being imposed by the E.U. and their debt-holders makes that difficult. The other thing they can do is try to increase exports. There are usually two ways for a country in economic crisis to do that: cut nominal wages to make their goods more competitive, or inflate their currency so that foreigners can buy more stuff. Perhaps Greece can do the former, but they certainly cannot do the latter.

    Because they are part of the E.U., their hands are tied. As economist Carmen Reinhardt put it, “From Greece’s perspective, its goods and services are uncompetitive on world markets. But many of its most important trading partners share the Euro, so there is no scope for a change in an exchange rate’s value to improve competitiveness with them” thus leaving the only option of “a compression in domestic prices and costs.”

    The option that dare not speak its name is restructuring the debt, which is basically reaching an agreement with bondholders to pay only a portion of the outstanding debts. However, with this option, the problem remains that the international financial markets become skittish and are unlikely to lend very much in the future. It can also touch off the contagion effect mentioned earlier.

    Such a restructuring could be disastrous both for European and world economies, as well as the Euro as a whole; if Greece restructured and left the Euro, the common currency could be dead. And because there is so much political and economic will on behalf of big European countries like Germany and France in the common European currency, they almost certainly won’t let this happen.

    This, of course, is not just a European problem. These crises can happen anywhere — Mexico in 1994, Southeast Asia in 1997, Argentina in 2002 — and can quickly spread in unpredictable ways. The massive downturn in Southeast Asia that started in Thailand spread to Russia, which had a ruble crisis a year later, which lead to massive losses of the hedge fund Long Term Capital Management, which then needed a Federal Reserve organized bailout. Thankfully, the European Union is doing its best to prevent an unpredictable chain of economic failures, but Greece’s situation is a reminder that, whether we like it or not, we’re all tightly interconnected in strange, volatile ways. The entire situation may be a Greek tragedy, but it’s one in which we’re all living.


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