Greek debt crisis eases, but drama is not over

DAVID McHUGH AP Business Writer Published:

More than two years after it came clean about its addiction to debt, Greece may finally have begun its long and painful road to recovery.

Greece's political leaders struck a historic deal Thursday to make deep cuts in government jobs and spending to help save the country from a default that could shock the world financial system.

The deal is one of two critical steps Greece must take to receive a euro130 billion ($170 billion) bailout from other countries in Europe and around the globe. It was announced by Greek Prime Minister Lucas Papademos' office and came ahead of talks in Brussels between finance ministers from the 17 countries that use the euro.

In addition to the fiscal austerity mandated by the European Union, the European Central Bank and the International Monetary Fund, Greece is close to an agreement with private investors who hold nearly two-thirds of its debt to sharply reduce the country's borrowing costs.

Greece needs the bailout by March 20 so it will have enough money to redeem euro14.5 billion worth of bonds coming due. If it doesn't make that payment, it will be in default. Financial analysts fear that could set off a chain reaction similar to the financial meltdown triggered by the collapse of investment bank Lehman Brothers in the fall of 2008.

The bailout will ease the turmoil that has rocked Europe and the world financial system for more than two years, but it will not bring down the curtain on Greece's debt drama.

Greece remains in a deep recession. Unemployment is near 21 percent after the economy's third straight year of decline. Its government finances and its economy are being dragged down by costly political patronage, tax evasion and special protections for some favored trades.

Greece will be struggling to pay its debts for years, says Domenico Lombardi, senior fellow at the Brookings Institution. "The scope of the problems that have to be tackled in Greece are so huge and so entrenched," he says.

Efforts to fix those fundamental problems, at the behest of Greece's increasingly exasperated creditors -- including prosperous Germany -- are moving slowly, if at all. If they are not solved, Greece may find itself back at the bailout trough.

Greece is also close to a vital debt-relief deal with banks, hedge funds, pension funds and other private investors. Under the deal, the private investors would exchange euro206 billion in Greek government bonds for euro30 billion in cash, plus euro70 billion in new bonds. The cash will come from the euro130 billion package from Europe and the IMF. The new bonds will have a lower average interest rate and a longer term of maturity.

The combination of less principal to repay when the bonds mature and less interest to pay every year until then means Greece will spend about 70 percent less than it would have without a deal.

The debt held by the European Central Bank and other public institutions accounts for one third of Greece's national debt and is not part of this deal.

If Greece had defaulted, investors would have become reluctant to lend to other heavily indebted European countries for fear they would not get their money back, pushing their borrowing costs even higher than they are now.

Those other countries include Italy, which has an economy six times the size of Greece's. Most analysts say Italy is too big to bail out.

The specter of default has hung over world financial markets for more than two years. Whenever there has been progress -- and, indeed, U.S. stock indexes have doubled from the lows they reached in March 2009 -- Greece has always stood in the way of more.

And while the immediate danger appears to have passed, it is far from clear whether Greece has won enough debt relief to fix its finances for good.

Its economy -- ultimately the key to handling debt -- remains in a deep recession. It shrank at an annual rate of 5 percent in the third quarter of 2011. Earlier in the year, it was shrinking at an 8.3 percent rate, about as fast as the United States economy was shrinking during the worst of the Great Recession. Thousands of shops and small businesses, vital to the Greek economy, have gone bankrupt. And protesters have taken to the streets of Athens regularly to denounce the government and its austerity measures.

Greece's troubles with debt go back to the 1980s, when successive governments began increasing the size of government and the number of public employees. By 2010, the total had reached 750,000 full-time employees -- including 10,000 Greek Orthodox priests and 81,000 military officers -- and 150,000 on part-time contracts. That was almost one in five people in Greece able to work.

Government jobs became a way of rewarding supporters of Greece's two main political parties. The parties made matters worse by raising the wages of government employees to unsustainable levels. At the same time, the government was so lax about enforcing tax collections that it had to issue ever more debt to cover its spiraling wage bills.

At first, bond investors lent freely, at interest rates slightly higher than for economic powerhouse Germany. After all, Greece was one of the 17 countries that use the euro. All had promised to observe strict budget and deficit limits. And while on paper the treaty that created the 27-country European Union forbade bailouts, there was a vague sense that Europe could not let a country go bust.

Then came Oct. 21, 2009. A newly elected government in Athens told its European partners that its finances were far worse than the previous government had disclosed.

The national deficit, the difference between what the government took in and what it spent, was not 3.7 percent of annual economic output, as had been believed. It was 12.5 percent, and that was later revised higher to 15.4 percent. One condition of being in the eurozone was that countries were required to keep deficits to a manageable level of no more than 3 percent of economic output.

Investors around the world, still reeling from the collapse of Lehman Brothers and the worldwide financial crisis just a year earlier, began looking hard at risk. They demanded higher interest rates to loan Greece money by buying its bonds, and Greece's borrowing costs soared.

On April 27, 2010, ratings agency Standard & Poor's downgraded Greek bonds to junk status -- the first time a eurozone country was given a non-investment grade rating.

The next month, other euro countries and the IMF intervened. They promised euro110 billion in loans -- to be paid out in stages -- so that Greece could pay its debts as they came due.

The terms of the bailout were harsh: higher taxes and deep cuts in public spending and wages at least through 2020, a package of fiscal belt-tightening known as austerity. As it took hold, the Greek economy sagged further, and it's expected to remain weak for years.

The second euro130 billion bailout package will come in the form of loans plus euro30 billion in cash that will go to the private creditors who agree to swap their bonds. Greece will use an additional euro40 billion of the bailout money to invest in the country's banks. The banks will take massive losses as part of the debt-relief deal.

Even with the debt relief and the bailout money, it will be difficult for Greece to ensure that its new, lower level of debt is manageable, or that it will be able to sell bonds at favorable interest rates over the next decade. Greece will have to continue to borrowing money to repay holders of bonds that mature, as well as to finance budget deficits that will continue, even though they'll be smaller.

"I do not think the plan will work," says Uri Dadush, director of the international economics program at the Carnegie Endowment for International Peace. Dadush says Greece needs even more debt relief.

But a responsible budget and sound economic policies are supposed to convince investors that the country will be able to pay its debts, and thus should be able to borrow at affordable rates.

In recent weeks, other countries in the European Union have made some progress in doing just that. In the final months of last year, countries such as Italy and Spain watched helplessly as yields on their debt spiraled ever higher. Governments fell in Rome and Madrid.

The new governments moved swiftly to cut spending. The result has been an easier time raising money in the bond markets and much lower rates. On Nov. 25, the interest rate on Italy's two-year bonds was 7.40 percent. On Friday, it was 2.96 percent, the lowest since June 2010.

Much of the improvement, though, is credited to the European Central Bank, which announced a program in December designed to help stabilize shaky banks in the eurozone. The ECB said it would loan the banks unlimited amounts of money at 1 percent interest and for three years instead of the normal one. The banks responded by borrowing euro489 billion ($632.6 billion). They've used at least some of that money to buy government bonds -- extra demand that has helped bring down governments' borrowing costs.

But Greece's problems are so severe it has remained locked out of the bond market.

Greece's outstanding government debt is about euro350 billion, an amount equal to more than 160 percent of its annual economic output. The budget reforms and debt-relief deals aim to get that figure down to 120 percent by 2020. The United States has a debt-to-gross domestic product ratio of 100 percent. But because it is seen by investors as one of the safest countries to lend to, its borrowing costs have stayed low.

For Greece, the target of 120 percent is still a relatively high figure. According to the IMF, it is on the outside limit of what is manageable. And the figure assumes that Greece's economy will meet expectations for economic growth -- no sure thing after years of ever deeper recession.

Also in question is whether Greek voters, who will choose a new government in an election tentatively set for this spring, will put up with eight more years of austerity.

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AP Economics Writer Paul Wiseman in Washington contributed to this report.