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Why is Greece in trouble?

The Greek government went on a spending spree during the past decade. Public spending soared and public sector wages practically doubled during that time. Thus while the government was spending away its reserves it was unable to replenish the same through tax collections due to widespread tax evasion. All this has placed a huge strain on the country's economy which is in a state of constant debt.

How big are these debts?

Greece's budget deficit (the amount by which a government's spending exceeds its income) last year was 13.6% of its GDP in 2009 (Gross Domestic Product is the value of all the goods and services produced in a year). This deficit is one of the highest in Europe and more than four times the limit under euro-zone rules.

Greece's high levels of debt mean investors are wary of lending it more money, and demand a higher premium for doing so. This is particularly troublesome as Greece has to re-finance more than 50bn Euros in debt this year. As a result, the country needs as much as 45bn Euros in emergency loans from euro-zone governments and the IMF this year. The IMF loan has been approved subject to the approvals from national governments in euro-zone.

Why is it a concern outside Greece?

The euro-zone, officially the euro area, is an economic and monetary union (EMU) of 16 European Union (EU) member states which have adopted the 'euro' currency as their sole legal tender. It currently consists of Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain.

Everyone in the euro-zone and anyone who trades with the euro-zone is affected because of the impact on the common European currency. The most immediate impact is on the other euro-zone economies who have agreed to loan Greece up to 80 bn Euros over the next year. In other words, taxpayers of these countries will effectively share a part of Greece's burden.

There were also fears that Greece's troubles in the international financial markets may trigger a domino effect, toppling other weak members of the euro-zone, namely Portugal, Ireland, Italy and Spain as well - all of whom face challenges in balancing their books.

Those fears had driven up the interest rates on government debt, meaning it is more expensive for these countries to borrow on the open market. Finally, many major banks have invested in Greek debt. So the economic crisis could affect their shareholders, many of whom are ordinary investors or people who own their shares through pension funds.

What is Greece doing about it?

Greece has outlined plans to cut its budget deficit by 30 bn euros over 3 years. In order to do that, the Greek parliament has approved an initial package of austerity measures to save 4.8bn Euros. It wants to freeze public sector workers' pay and raise taxes, and it has also announced a rise in petrol prices. It also intends to increase the average retirement age in an attempt to save the cash-strapped pensions system.

How has this been received in Greece?

Not too well. There has been a series of public protests, some of them violent. Strikes have hit schools and hospitals and brought public transport to a halt.

Many public sector workers believe that the crisis has been engineered by external forces, such as international speculators and European central bankers.

So what’s the latest development to avert spreading of this crisis to rest of Europe?

To prevent that from happening, the European Union along with the European Central Bank and the International Monetary Fund (IMF) came out with a $962 bn (euro 750 bn) rescue package. The rescue package consists of euro 440 bn in guarantees from euro area states, euro 60 bn in European instruments, and euro 250 bn from the IMF, making for a total of euro 750 bn.

Loans will be given out from this pool of money to those European Union countries that are having trouble with repaying the accumulated debt. The rescue package is just short of $1 trillion at current euro-dollar exchange rates. The idea is to use some of the funds to buy up government bonds, so that the markets for these bonds stabilize.

In addition, the European Central Bank announced buying public and private bonds to lower borrowing costs and increase liquidity.

Meanwhile, the US Federal Reserve restarted its dollar swap operations, in which it offers billions of dollars overseas to boost banks' cash positions in return for foreign currency. Central banks around the world were also involved.

Why is the rescue package being worked out when only Greece is in great trouble?

This rescue effort is being worked out primarily in countries like Germany and France to whose banks the PIIGS economies owe a lot of money. As a matter of fact, Portugal owes Spain — and Spain, in turn, owes a great deal to France and Germany. Italy owes a whopping $511 bn or 20% of its GDP to France and $190 bn to Germany. Spain in turn owes Germany $238 bn and France $220 bn. Ireland owes $184 bn to Germany and $60 bn to France. Portugal owes $47 bn to Germany and $45 bn to France. And the smallest of them all, Greece, owes Germany $45 bn (euro 58 bn) and France $75 bn. Therefore, Greece is not the only country in trouble.

How will this plan work?

The economies in trouble looking to get a loan from the $962 bn pool will have to follow structural reform and fiscal management programs monitored by the IMF. The IMF is known not to lose its money anywhere. One of the norms required from countries using the euro is to maintain a fiscal deficit of less than or equal to 3% of GDP. However to make this plan work one can expect dissent among the people as they would be forced to conform to austerity measures which in turn could have adverse political ramifications for the government.

Could Greece devalue the euro?

One of the ways of handling this problem is currency devaluation. When the currency is devalued it makes goods and the services a lot of more cheaper and hence, more competitive. This in turn would mean the country could export more and earn more dollars or whatever foreign currency they had their debt in. This could then be used to pay off the accumulated debt.

But would this formula work here?

Many of Greece’s most important trading partners share the euro, so there is very little scope for a change in an exchange rate’s value to improve competitiveness. Thus, the only way Greece can improve its competitiveness is through a compression in domestic prices and costs. Thereby products made in the PIIGS countries will become competitive only if they are able to control costs. Controlling costs may mean cutting salaries of employees, which may not be palatable for politicians.

The million dollar question here is ‘Is Europe out of the woods yet’?

The main problems the European economy faces are with rigid labor markets and overblown welfare states. The problems have been compounded by a declining birth rate, which can only be mitigated by allowing freer immigration. Its problems are structural in nature, and these cannot be tackled with financial bailouts.

In fact, the package may create its own recessionary dynamics, since the main conditions attached are that economies with excess debt need to start reducing their public expenditures drastically. The political consequences arising out of this could make things tougher for these countries. Against this backdrop, it would be hasty to conclude that Europe’s troubles are over. It may take a while to set things right.

What can be the likely impact on India?

Some experts are of the opinion that India will be less affected from the downside in global growth due to its relatively balanced economic model with a large contribution from domestic demand to GDP growth. However, it will be important to have stabilization in global capital markets soon, to ensure that the growth momentum is not affected sharply because of reversal in capital inflows