Greece's debt crisis: not over yet

Protesters clash with riot police in front of the Greek Parliament on June 29, 2011 in Athens, as lawmakers voted on a massive austerity package demanded by international creditors.</p>

Protesters clash with riot police in front of the Greek Parliament on June 29, 2011 in Athens, as lawmakers voted on a massive austerity package demanded by international creditors.

Today, as Greek citizens rioted in the streets, the country’s parliament passed an austerity package demanded by European officials. The vote paves the way for Europe to free up $17 billion in bailout funds that the country needs to pay its debts this summer.

This is good news for the global economy. Failure to pass the measure would have triggered a financial avalanche reminiscent of autumn 2008, when Lehman Brothers crashed, nearly burying the global economy. If Greece were allowed to default, panic would have spread through the markets. Financial institutions would have stopped lending to each other, out of fear that the billions in toxic Greek debt that banks have on their books would prevent loans from being repaid. Stock markets would have tumbled. Americans would have once again lost a fortune on their 401k retirement plans. And ultimately, experts say, the U.S. Federal Reserve Bank — the world’s lender of last resort — would have been called in to rescue the global economy once again.

Passage of the austerity package was by no means certain. Protestors and police this week have exchanged tear gas, rocks and fire bombs. The sharp budget cuts and tax increases — intended to cut spending by $20 billion and raise an extra $20 billion in revenues — will bring job losses, school closures and other painful measures. Among the critics of the package was the country’s central bank governor, George Provopoulos, one of Greece’s most powerful financial officials. Over the weekend, he lashed out at a last minute $7.8 billion tax increase, calling it excessively burdensome on taxpayers.

Provopoulos statement was dangerous, increasing the likelihood that members of parliament would reject the austerity plan. But in the end, he told the Financial Times that there was no choice but to pass the measure: “For parliament to vote against this package would be a crime — the country would be voting for its suicide.”

Ironically, many analysts believe that Provopoulos was right, that the austerity plan demanded by the European Union and the International Monetary Fund as a prerequisite for further bailout funds will make matters worse.

“By insisting on more austerity measures, they're just making the patient sicker,” says Laurent Jacque, a professor of international business at Tufts University’s Fletcher School. “They've put a noose around neck of Greek economy, and they're tightening and tightening it. The patient is going to drop dead.”

At a time when Greece needs to come up with as much money as possible to pay its debts, austerity threatens to stifle the economy. Over the past year, cuts have fueled a deep recession in Greece, reducing tax revenues, Jacque explains.

That brings us to the bad news: while parliament averted short-term disaster by agreeing to the austerity plan, the Greece’s crisis is by no means solved. Athens debt burden is about 160 percent of its gross domestic product. That means that if the Greeks were to stop eating, shopping and spending and dedicate every dollar they earned to paying off their government’s debt, it would take more than 19 months to pay it off. Obviously, that’s not going to happen. The fact of the matter is that Greece is effectively bankrupt, and stands virtually no chance of paying back its loans in entirety. Standard and Poor’s confirmed this earlier this month when it gave Greece the world’s lowest credit rating.

How did Greece get into this mess? How did a country with a population slightly larger than Los Angeles and an economy the size of Oregon’s manage to bring a dagger to the throat of the world economy?

The simple answer is that its government spent too much and collected too little in taxes. The country has generous social programs and pensions, and a bloated and inefficient public sector. Meanwhile, tax cheating is rife.

In fact, the problem is more complicated than that — as are the potential solutions. Greece had plenty of help in digging this hole for itself.

Some of that help came from a familiar actor, Goldman Sachs, which orchestrated a financial sleight of hand that enabled Greece to hide its extravagant ways. Before adopting the single European currency in 1999, policymakers anticipated the possibility that crises like the current one might steamroll across borders. To prevent this, officials enacted regulations restricting how much money countries in the euro zone could borrow. Every government was supposed to comply with the restrictions in order to qualify to use the euro, and they were continue complying indefinitely.

(Watch: The Daily Show tackles the debt crisis)

As 2001 approached and Greece was poised to adopt the currency, its government exceeded the euro zone’s restrictions. Rather than enacting painful spending cuts or raising taxes, it essentially resorted to creative accounting, with the help of Goldman. The Wall Street firm engineered a financial deal known as a cross-currency swap. The effect of the deal was to hide Greece’s debt on Goldman’s balance sheet, letting the country qualify for euro zone membership. As financial journalist Nicholas Dunbar explains in The Devil’s Derivatives (forthcoming from Harvard Business Review Press), Goldman made a handsome profit on the deal. Greece, in turn, got to enjoy all the benefits of the euro. It could borrow in the vast European financial markets at rates that it could never qualify for on its own — a privilege that reduced its borrowing costs, worsening its profligacy.

But Goldman Sachs and Greece did not act alone.

Eurostat, the European agency charged with checking countries' financial books, actually approved of the Greece-Goldman accounting trick, and Italy is said to have used the same trick several years earlier, according to Dunbar. “According to sources familiar with the deal, Eurostat even gave advance approval of Goldman’s contract with Greece (six years later, the agency would deny any knowledge),” he writes.

Also aiding Greece’s debt habit were some of Europe’s biggest banks. By 2004 it was widely known that Greece had cooked its books and that its financial condition was not nearly as sound as advertised. Still, major banks like France’s giant BNP Paribas and Germany’s Commerzbank bought billions worth of the ill-fated bonds. 

How could they be so foolish?

Two reasons. First, the banks didn’t have to worry about foreign currency risk — the bonds were denominated in euros, the currency that they needed, not in drachmas that might be depreciate, driving down the value of their investments. Moreover, Greece’s bonds paid a higher interest rate than those of more fiscally conservative countries, so banks were able to earn more — if, that is, assuming Greece could pay them back.

In other words, Europe’s big banks and pension funds bought Greek debt, ignoring the risks, because it was profitable. “It was a search for yield,” says Terry Connelly, Dean of the Ageno School of Business at Golden Gate University. “Who’s going to be the guy that stands up in the room at Credit Agricole or Deutsche Bank, and say ‘guys, we’ve got to stop making all this money?’ Everyone understood that Greece was borrowing itself into oblivion, but nobody cared enough to blow the whistle, including the Germans." 

Which brings up a key point: the Eurocrats aren’t so much bailing out Greece as they are bailing out themselves. The continent’s banks, and in particular the European Central Bank, are the biggest holders of Greek debt. Another major loss would be difficult to endure so few years after the last crisis.

In a reprise of the 2008 crisis, Greece's toxic bonds are tangled in a web of debt and complex derivates such as credit default swaps (essentially, insurance on debt) that could ensnare banks and financial institutions far and wide. The difference this time around, however, is that Europe — which lacks strong central institutions like the US Federal Reserve — is less well-equipped to untangle the mess quickly, explains Connelly.

So while Greece's bonds will be paid this summer, there are many billions of dollars worth of debt that remain outstanding over the next several years. Greece stands almost no chance of being able to pay these in full, and if economists are right, austerity will only worsen matters by crippling the country's economy. So if Europe balks at rescuing its errant Mediterranean partner, or if it fails to come up with an orderly plan enabling Greece to default, everyone stands to lose. And because American financial institutions are intricately tied in with Europe, the pain would be felt on this side of the ocean as well.

Stay tuned, this Greek drama is not over yet.

Follow author David Case on Twitter @DavidCaseReport.