Greece deal could be a world-saver

On Friday, European leaders from the 16 countries that use the euro currency announced a back-up plan to provide Greece with money if needed.

The plan involves a compromise of European taxpayers fronting up with most of the cash, with the International Monetary Fund (IMF) – usually preoccupied with poorer countries – providing the rest.

The importance of the plan cannot be underestimated. Its aim is to stop the Greek government from going bankrupt, and thereby avoiding a domino bankruptcy effect to four other European countries that could cripple the economy of Europe – and possibly the entire world.

A summary of Greece’s problem

Since they adopted the euro currency in 2001, Greeks have been enjoying an extravagant life. High government spending on services and benefits was dangerously combined with a culture of tax evasion.

Naturally, the government ran up a significant budget deficit: 13% of GDP – twice as much as the government’s creative accounting had previously claimed.

To fund this deficit they borrowed large sums of money from lenders, incurring a huge government debt.

Now banks and investors (known simply as the market) have stopped believing Greece can afford to pay them back. Due to this belief and perceived risk, Greece has to pay a substantially higher price for any more money it borrows.

A higher price on borrowing is the last thing Greece needs. In fact, that alone could cause them to default on their current loans and push them into bankruptcy.

If Greece defaulted, the market would suddenly have more reason to suspect the other indebted countries of Portugal, Ireland, Italy and Spain may do as well. Their cost of borrowing would rise, potentially pushing them into bankruptcy.

If this happened, these countries would enter a period of extreme stinginess in order to return their economies and governments to healthy financial order.

This would result in lower spending and higher unemployment. Lower demand would sink in and filter through the whole continent.

And with ‘Europe’ being the world’s biggest economy, this lack of demand could impact the global economy and offset momentum provided by the economic engines of China and India.

On top of all this, the euro currency would suffer a severe drop in value and reputation.

This catastrophe is what Friday’s announcement is hoping to avoid.

The game plan

Given it would all be triggered by a Greek bankruptcy, European leaders have offered Greece a money fund of last resort.

The simple aim of this is to send a loud and clear message to market lenders: you will get your money back no matter what.

So with lower risk of default, the logical hope is that the price of further Greek borrowing will go down. Ideally this means they can afford to borrow from the market, and won’t need Europe’s emergency funds – rendering the whole thing a hypothetical tool that never gets used.

Greece doesn’t get a free ride though.

The government still has to reign in its ridiculous deficit by cutting spending and making sure people pay their taxes. These ‘austerity’ plans have already been announced – much to the anger of ordinary Greeks who have protested heavily in recent months.

The agreement also outlines a new set of rules and penalties to punish those who endanger the euro currency in the future.

But for now, it’s the back-up plan that provides the crucial safety net.

According to the plan, for its future borrowing (this year alone will amount to €54 billion) the Greek government must firstly go to the market. If successful, everybody’s happy and things carry on as normal.

If the market offering is deemed “insufficient” by experts from the European Central Bank (meaning if Greece can’t get all the money at a reasonably-priced interest rate) Greece turns to the back-up plan.

The back-up plan states that euro-zone governments (Germany, France, Netherlands etc) will lend Greece the majority of the money needed, but at above average euro-area interest rates to incentivise Greece to return to market funding as soon as possible.

The IMF will top-up the rest (roughly a third), and will also provide its (tough) expertise in advising the Greek government back to financial health.

The first test of this plan will take place in the coming weeks when the Greek government makes a bond issue (a call to the market to lend it money at a fixed interest rate of return).

This will dictate whether the plan has worked in easing the market’s concerns and restoring its confidence to lend Greece money again.

It’s a useful plan, and it could save the European and world economies. But for Greeks, there is still a long and painful way to go before they can start living anything like they did in the naughty ‘noughties’.

By The Casual Truth

Photo – French President Nicolas Sarkozy and German Chancellor Angela Merkel