The Greek debt crisis made simple

The Greek debt crisis has dominated the news for a while now, yet surprisingly few people seem to actually understand what all the fuss is about. I thought a great topic to start of this new blog with would be a very simple explanation of the Greek debt crisis, so that even those with zero understanding of macro economic policy can wrap their head around it.

Basically Greece has built up a large and generous welfare state which it can not afford, and has instead paid for it with borrowed money. This practice works well for a while but as the debt grows so does the probability that Greece will fail to pay back it's loans. As this prospect of default becomes more and more likely, the interest Greece has to pay on its debt rises since investors want to be compensated for the risk they take when lending to Greece. The rising interest rates in turn makes it near impossible for Greece to afford its massive debt.

Here is where the EU and the IMF comes in with their rescue packages. This "rescue" basically means letting Greece borrow large amounts amounts of money at an affordable interest rate. In return for these loans Greece is expected to deeply cut spending and raise taxes in order to stop the growth of the debt, liberalize its economy in order to increase productivity with the hope of generating economic growth which would make future debt repayments easier and selling off state owned companies and land to free up money for debt repayment, a process also hoped to increase efficiency leading to economic growth.

If Greece does as it is told, this is supposed to increase the likelihood of Greece being able to repay its debt, bringing down interest rates making Greece's debt affordable once more, in effect solving the Greek debt crisis.

The problem is that this is not working. The Greeks are either unwilling or unable to go far enough to fix their economy so investors continue to see Greek debt as risky and demand a high interest rate that reflects this. The European response has been to simply let the Greeks borrow more cheap money from them, but most economists seem to believe that a restructuring is inevitable. Pretty much Greece acknowledging that its debt is simply too large and it will only pay back parts of it.

The risk with this and why Europe is so keen on helping Greece is that if Greece defaults on its loans, this will make the prospect of other debt ridden countries also defaulting on their loans seem more real, forcing up the cost of their loans worsening the European debt crisis.