Questions and answers about the crisis in Greece

AP News
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Posted: Sep 15, 2011 1:47 PM
Questions and answers about the crisis in Greece

Its economy is smaller than that of many U.S. states. It's better known for olive oil and souvlaki than high finance. It last strode global affairs 2,400 years ago, when men wore togas.

Yet everyone is suddenly worried about Greece.

Stocks have whipsawed on signals that the country will or will not default on its debt. Economists are adjusting their estimates for economic growth in Europe and the U.S. based on what happens by the Mediterranean Sea.

The fear is that if Greece defaults, it could plunge Europe into recession and set off a cascade of mistrust and selling akin to what happened during the financial crisis in 2008.

How likely is that? No one is sure. Greece says it won't default, and Germany and France have pledged support. But the news keeps getting worse, and amid the confusion and uncertainty, investors are frightened.

Here are some questions and answers to cut through the swirl of figures and rumors and, perhaps, better assess the risks:

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Q: What's a default?

A country is considered in default when it stops paying principal and interest to its lenders. For Greece, those lenders include European banks that own its national bonds. If Greece defaults, the banks would have to absorb big losses. That would make it more difficult for them to loan money, and that could push Europe, already weak, into a deep recession.

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Q: What's being done to make sure it doesn't happen?

A: Bailouts and more bailouts. Last year, other European nations and the International Monetary Fund agreed to lend Greece 110 billion euros, or about $150 billion. A second aid package hammered out in July would help Greece avoid having to ask jittery bond investors for more money. But the bailout needs approval from 17 European legislatures, and that is not assured. German voters, in particular, are wary of sending more money to their free-spending neighbor.

On Thursday, the European Central Bank, the U.S. Federal Reserve and three other national central banks announced they would supply European banks with unlimited three-month loans.

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Q: How did Greece get into this mess?

The government spent too much, didn't collect enough in taxes and had to sell lots of bonds to make up the difference. For most of the past decade, Greece has run up budget deficits well beyond limits set by the European Union, a group of 27 nations that allow goods and workers to cross their borders freely.

When Greece fell into recession two years ago, bondholders worried they wouldn't get their money back. To make sure they do, the EU is lending money to Greece, essentially allowing it to use new debt to pay off old debt.

Keeping Greece afloat will be tough. Like a loan officer at the bank who checks your salary and what you owe before deciding how much to lend to you, bond investors and other lenders to governments like to look at how much a country makes each year. And Greece looks like a bad bet. Its publicly held debt is more than 140 percent of its annual economic output, or gross domestic product. U.S. debt is 67 percent.

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Q: What can Greece do about it?

A: Governments, unlike companies, have an easy way to raise money to pay their creditors: taxes. Greece announced a temporary property tax Sunday. Unfortunately, Greece's economy is shrinking faster than previously estimated, and new taxes won't bring in much more money if the people and businesses paying them are making less money themselves.

Investors are so nervous about Greek finances that they are demanding more than 100 percent interest to lend money to Greece for one year.

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Q: Why should I care if such a small country can't pay its bills?

A: Greece is a tiny player in Europe. It has a $305 billion economy, about the size of Maryland's and 2 percent of the whole EU's. And if it does default, it will have plenty of company. In the past 30 years, 20 European and Latin American countries have stiffed their creditors, some repeatedly. The list includes Turkey in 1982, Mexico in 1994, Russia in 1998 and Argentina in 2001.

But Greece shares a currency, the euro, with 16 countries. "It's not just a country floating out there that happens to default," says Steve H. Hanke, an economist at Johns Hopkins University. "The whole monetary union gets thrown into doubt."

Most important: If Greece defaults, investors will worry that two much larger EU members, Italy and Spain, might follow. And whether a default happens or not, just the fear of it could lead investors to sell a country's bonds, which would drive up their yields, or what that country has to pay to get investors to buy them. Countries need to sell bonds to finance their budget deficits or to pay off old bonds that are maturing. If they have to pay higher yields, it just makes the financial mess they're in worse.

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Q: But China, India and Brazil are supposed to be the new economic engines of world growth. Doesn't Europe matter less now?

A: Those economies may be growing fast, but they're still not as big as the EU, which together accounts for 20 percent of the world economy. China, the second largest national economy in the world, accounts for less than 10 percent.

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Q: How does all this affect the United States?

A: For the U.S., a European recession would come at an especially bad time. Europe buys about 20 percent of U.S. exports. And exports have been a big driver of U.S. economic growth recently. With the U.S. slowing, it can't afford a downturn in such a crucial market.

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Q: What about the euro? Does having a common currency help or hurt Greece's chances?

A: On balance, it's helping. One reason Greece is getting so much help from its neighbors is that their fates are tied to the euro, too. In exchange for the first bailout, last year, Greece agreed to spending cuts and other fiscal reforms. But it hasn't held up its side of the deal, and it is running out of money again.

But the euro hurts Greece, too. If Greece still had its old currency, the drachma, it would be plummeting in value now as investors pulled money out of the country. But that would also make it easier for Greece to sell goods abroad because they would cost less for foreigners in their stronger currencies. A surge in exports would help Greece grow again.

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Q: Is fear of a repeat of the global financial crisis in the fall of 2008 making European troubles seem worse than they are?

A: Maybe. What happened then was frightening, but rare. Like a body suddenly short of oxygen, the economy suffered because banks stopped making short-term loans to each other. If banks can't get loans, they can't lend to companies, and if companies don't have money to do business, they can't buy supplies or pay workers. International trade can stop. That's why some people thought not just stocks but capitalism itself could collapse.

Banks can't just use cash from depositors to loan out to companies. The deposits are a small fraction of what banks need to lend.

Three years after the crisis, investors are worried whether banks can get short-term loans again. U.S. lenders don't want to give money to European banks, and those banks are wary of lending to each other, too. So some have had to turn to the European Central Bank for cash.

"We're talking technical plumbing issues," says Johns Hopkins' Hanke. "But beyond that, it's a confidence thing. If everyone gets afraid, no one will spend."

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Q: Aren't banks in better shape than they were during the financial crisis?

A: Generally, yes. But the threats to American banks keep changing. Earlier this month, for instance, the U.S. government sued banks for selling bad mortgage securities to U.S.-controlled housing agencies. It's unclear how much the banks might have to pay. A hit from Europe would come at a bad time.

"Our financial system is still very frail," says Kenneth Rogoff, an economist at Harvard University. Bank stocks are nearing their levels during the financial crisis. "They're not in a position to take big losses."

The good news is that U.S. banks hold much less in Greek government bonds than European banks do. But the financial crisis showed that danger can lurk in unexpected places. For instance, banks have sold investors a type of insurance policy known as a credit default swap that will trigger billions of dollars of payouts if Greece defaults. They've also used the swaps to wager billions of dollars more that Ireland, Portugal and Spain will keep paying their bonds, too.

The use of these swaps has fallen a lot since the financial crisis, so losses may not amount to much. But in a complex and interconnected financial system, it's difficult to assess the bets riding on Europe and who made them. And that uncertainty means investors are prone to sell first and ask questions later.