How did Greece end up in its current financial crisis?
In a referendum next Sunday, Greek voters are set to decide whether Greece should accept a new bailout — with lots of strings — or whether instead Greece should default on its debts, which would likely force it to drop the euro and introduce its own currency.
For that referendum to even take place, however, Greece has to make it to next Sunday without a national bank run or an economy meltdown. So it is closing all its banks and introducing capital controls to keep people from moving their money out of the country.
In the end, if Greece decides to default, the short-term impact will be dire. Once the European Central Bank loses faith in Greece’s creditworthiness, the Greek banking system will likely collapse, draining the government of money and forcing Greece to create a whole new currency, something like a neo-drachma.
On the upside, transitioning to a new currency might actually help Greece in the long-term. Countries that have their own currencies have a lot more control over their economies, which Greece could use to build a stronger recovery.
How did we get to this point?
In 2010, when the great recession was at its fiercest, the Greek economy was foundering. European leaders put together an emergency bailout, which kept the country afloat, but the terms of the bailout agreement were probably too strict. Greece was forced to cut government spending at a time when that spending was desperately needed. As a result, the country’s economy continued to weaken, with the unemployment rate ultimately touching 28 percent.
Greek governments have been seeking new terms ever since, but every short-term solution merely sets the stage for a new showdown.
In recent days, Greece presented what it considered a comprehensive new plan, including tax increases and some savings from the state pension system. That plan was quickly rejected by creditors, who responded with their own list of requirements, including larger pension cuts.
That put Greek leaders in a difficult position. Either accept these deeper cuts, which the current government effectively promised not to do. Or leave the euro, which is also thought to be unpopular among Greek citizens. So Greek politicians threw the question directly to the voters, giving them responsibility to decide.
How would a default affect Europe?
Imagine you’re an investor watching Greece default on its debts. That might well make you less likely to buy bonds from other struggling euro countries, like Portugal. Which, in turn, could send Portugal into a Greek-like debt spiral — unable to raise money and desperate for a bailout. If a cycle like that takes hold, it could imperil countries throughout Europe.
Over the last several years, the European Central Bank has been planning for this event, promising to step in and support any country that finds itself caught in such a trap. If it acts on those promises, it should be able to stop the crisis from spreading, but as yet there hasn’t been a real-world test.
More broadly, a Greek exit — sometimes called a Grexit — would be a setback in the broader push for European integration. The euro is more than a currency. It’s a mark of pride, a symbol of Europe’s struggle to overcome centuries of internal divisions and great power wars. Greece’s departure would highlight the fragility of that whole project.
Is there a durable solution?
Cut through the posturing and fever of negotiation, and you can imagine lots of ways to prevent this default. To take one example, Europe could step back from its insistence on deep budget cuts, and instead require Greece to professionalize its government, including its famously weak system of tax collection.
Here are some underappreciated factors shaping the negotiations.
It’s not about the money
Greece’s creditors don’t actually need their money back. For them, it’s more about leverage. Greece’s lack of cash is an opportunity to push economic reforms that might not happen otherwise.
The Euro itself is a problem
For most countries, default isn’t a real concern. Even if they owe billions of dollars, they can simply print more money — which may lead to inflation, but not default. Greece can’t print money because it lacks its own currency.
In that regard, it’s more like a US state than a country. Except that in the United States, when states face big economic problems, they don’t have to negotiate a bailout. They get automatic help from the federal government in the form of Social Security payments, Medicaid support, food stamps, and other social programs. Europe lacks automatic stabilizers like these, which is a big problem for the long-term viability of the euro.
Greece might be able to stay in the EU
Not all countries in the European Union use the euro. England doesn’t, and neither does Denmark. It’s at least possible that Greece will be permitted to remain in the EU, even if it drops the euro.
What happens next?
Greece will try to keep the situation more or less stable until next Sunday’s referendum, including by closing the banks and restricting people from moving euros out of the country. If this strategy works, then the referendum should be decisive.
But if something goes wrong this week — major protests or an unexpected shock to the Greek economy — Greece may be forced to act before the referendum even takes place.