So how did we get here, and what does this mean for Greece, Europe and the rest of the global economy? The short answer is (1) with a currency that's a doomsday device for turning recessions into depressions, and (2) it shouldn't be the end of the world. And the longer one, well, here it is.
What's the situation in Greece right now?
Greece's immediate problem is that it's supposed to pay the International Monetary Fund 1.5 billion euros on Tuesday, but it doesn't have 1.5 billion euros. It doesn't have anything. It's broke. Now it did have a bailout from the European Commission, European Central Bank and International Monetary Fund — what's known as "the troika" — that would have given it the money it needed to pay, well, the troika back. But that deal fell apart after the IMF in particular insisted that Greece cut its pensions by 1 percent of gross domestic product, and Greece responded that it was only willing to cut them half as much and make up the difference with higher taxes on businesses. Greek Prime Minister Alexis Tsipras was willing to do austerity, but he wasn't willing to do it on terms that would hurt his poorer voters more than most. So he called a referendum for Sunday on whether he should accept their offer.
Then all hell broke loose. The real issue isn't that Greece's government is about to miss a debt payment. It's that Greece's banks are facing the mother of all financial crises. There's been a slow-motion bank run the past few months — a bank jog, really — that's picked up pace the past few days as it's looked like there wouldn't be a deal. That's because people are worried that Greece would be forced out of the common currency without one, and their old euros would get turned into new drachmas that wouldn't be worth anywhere near as much.
So Greeks swamped their ATMs on Saturday to take out whatever money they could. At one point, more than a third of the country's ATMs had run out of cash. Now, Greece's banks were already in a precarious enough position that they depended on ECB-approved emergency loans just to stay afloat, so they would have needed even more to survive this run. But on Sunday the ECB announced that, unless there's a bailout agreement in place, then there won't be any additional emergency loans for them. That left Athens no choice but to close the country's banks for a week, limit ATM withdrawals to 60 euros a day and prevent people from moving their money abroad in a capitulation to this panic.
Wait, so Greece and Europe don't disagree about how much austerity Athens should do, they disagree about what kind of austerity it should do? And that's why there isn't a deal?
That doesn't make a lot of sense. Why can't the two sides come to some kind of compromise if they're so close to one?
They might. In fact, that's still the most likely outcome. Greece's government is making a last-minute request for a new bailout, and Europe has been offering at least minor concessions. Why might something like this happen? Well, the only thing the Greeks hate more than cuts to their pensions is the thought of leaving the euro. That's why betting markets think it's much more likely than not that the "yes" side will win the referendum. There'd probably have to be new elections then — Europe doesn't trust the Syriza-led government to actually implement austerity — and, after that, negotiations would probably continue along the same lines as before.
Although it's worth keeping in mind that a week is a long time when people can't get their money. What seems probable on Tuesday can become impossible by Friday.
Okay, back up a minute. Why would Greece's financial meltdown make it exit the euro?
If the ECB won't give Greece's banks the money they need, then there are only two ways for them to get it. That's to either take it from depositors or to print it. The first option, what's known as a bank bail-in, is what Cyprus did when the ECB stopped propping its banks up two years ago. But the second option is only one if Greece actually has a currency it can print. It doesn't right now. It has the euro. So Greece would have to ditch it and bring back the drachma if it wanted to recapitalize its banks via the printing press. Both of these are painful, of course, but default and devaluation should be less so for the economy.
Hold on. Greece might be better off without the euro? I thought the euro was a good thing.
As the culmination of Europe's 60-year project toward greater and greater integration, the euro is a political masterstroke. It's also an economic albatross. And it's one that wasn't hard to see coming. Plenty of economists, including Nobel Prize winner Milton Friedman, warned that it wouldn't work for countries with different economic needs to share a single monetary policy but not a fiscal policy. At any given time, money would be either be too tight or too loose for some members, and there wouldn't be anything — like unemployment insurance — to balance it out. The euro, in other words, is a paper monument to peace and prosperity that's made the latter impossible for some countries.
None more so than Greece. Its big bubble in the early 2000s was the result of interest rates that were too low for it, and its big bust since is, in large part, the result of a currency that's been too strong. Instead of being able to devalue its way back to competitiveness, Greece has been forced to deflate. That is, it's had to cut wages — which makes unemployment worse — rather than cut its currency. It's the same problem that the gold standard created during the 1930s. The difference, though, is that Europeans are even more attached to the euro than they were to the gold standard, which is saying something, since, at the time, they equated it with Western civilization itself. That's because the euro is the gold standard with moral authority.
Nobody wants to get rid of the real problem, and so the other ones continue.
But why does everyone care so much about Greece? Its economy is tiny, isn't it?
It is. Greece's economy is only about 2 percent of the euro zone's total. But the best way to think about why something so small still matters so much is to think about how we got here in the first place. Now whenever a country borrows too much, the IMF usually recommends that it write down its debts, balance its budget, and devalue its currency. The idea is that it's pointless to try to pay back more than you can — it can actually be self-defeating — but you also need to become fiscally self-reliant so you don't have to go back for one bailout after another.
The tricky thing, though, is that at the same time you're raising taxes and cutting spending, which hurts the economy, you need to get it growing again. Otherwise, shrinking national income might make it harder for you to pay back your debts even though you have fewer of them. And that's why the IMF prescribes a big dose of monetary stimulus — that is, a cheaper currency — to offset the economic pain from fiscal austerity. That, by the way, is how Iceland managed to recover so quickly despite the fact that it cut its budget more than any country not named Greece.
But this isn't what happened in Greece. Well, aside from the austerity. It did get more than enough of that. What it didn't get, though, was a cheaper currency or enough debt relief. This last part is the original sin of Europe's bailouts. See, back in 2010, policymakers were petrified that the euro zone was like a line of dominoes just waiting to get knocked over by the weakest link. If Greece defaulted on its debt, the French and German banks that had lent it money might go bust, and the banks that had lent them money might too, and, well, you get the idea. Not only that, but default also might force Greece out of the euro, at which point markets would begin to bet against whatever they thought was the next weakest link. That would push up borrowing costs for, say, Portugal and make it more likely that it would in fact default, which would then push up borrowing costs for Spain, and, well, you get the idea. In other words, Greece wasn't allowed to default, even though it needed to, because doing so threatened to set off a series of self-fulfilling prophecies that could have ripped the common currency apart.
So Greece got bailed out to the extent that it was given money to then give to the people it owed money to. That was good news for the aforementioned French and German banks that got their money back, but it wasn't for Greece. It still had as much debt as before, only now it owed official creditors like the IMF instead of private ones like the banks. Now, it's true that two years later, its official sector debts were given lower interest rates and longer maturities at the same time that its private sector debts were actually written down. But it wasn't nearly enough, especially given that it was getting harder for them to pay anything back with their economy collapsing under the combined weight of budget cuts and a too-strong currency. Indeed, since 2008, Greece's debt burden has shot up mostly because of its economy getting smaller rather than its debts getting bigger.
It only took five years, but Europe finally might be ready for a Greek default. Emphasis, though, on the word "might." Even though the ECB has created a firewall that should keep any kind of panic from spreading, it hasn't been tested yet. It should be enough, but who wants to find out? Europe doesn't if it can help it. But Europe also doesn't want to not find out so much that it's willing to give Greece whatever it wants to keep it from happening. This game of chicken, in other words, might end differently than the last.
So what does this mean for the global economy?
Maybe not as much as we think. Europe's firewall seems to be working so far. Sure, markets had a bad day on Monday, selling off 2 to 4 percent around the world, but it wasn't the Lehman moment it might have been if this had happened five years ago. It's hard to say what would happen in the worst case of Greece leaving the euro zone, but it's probably something like this:
- Greece. The new drachma would plummet, inflation would soar into the double digits, imports like food and oil might need to be rationed, companies that borrowed in euros might go bankrupt, and the government would have to balance its budget overnight. In other words, things would get a good deal worse than they already are, which is saying something when you're talking about a country with 25 percent unemployment. But after a year or two, this pain would pass and Greece would be left with a cheaper currency that would make its exports more competitive and its tourism more attractive. It would probably start to recover a lot faster than it would if it stayed in the euro.
- Europe. First off, they'd lose real money here, as in the hundreds of billions. Greece's government hasn't just gotten 240 billion euros, but its banks have also received 89 billion euros in loans from the ECB that all might be defaulted on in the case of euro exit. Second, there'd be some contagion. Borrowing costs would creep up for Italy, Spain and Portugal, but the fact that the ECB is already buying their bonds and has promised to buy as many as it takes to keep their interest rates low means they shouldn't rise that much. Third, all this uncertainty should make the euro fall even further, boosting their exports in the process. And finally, though this might sound cruel, the worst thing that could happen to Europe is if Greece does well after it leaves. That would embolden anti-austerity parties in the rest of the continent by showing that they have nothing to lose but their fiscal chains by challenging the continent's budget-cutting orthodoxy.
- The U.S. and everybody else. Our banks should be fine. Some hedge funds might fail. And the stronger dollar (the flip side of the weaker euro) should make our exports a little less competitive overseas. And that's it. There really shouldn't be too much damage from the failure of a country whose GDP is the size of Connecticut's. The fact that there ever would have been — and there would have — tells you how lacking the euro zone used to be, and how it's slightly less lacking now.