The Story Behind Greece's Woes and Bailout

As of Wednesday, German legislators are in talks to coordinate an effort with other European Union members to offer loan guarantees for Greece even as investors also signal concerns about the economies of Portugal and Spain.

The Deteriorating Conditions

In the past week, the spread of credit default swaps on the sovereign debt of Greece, Portugal and Spain, and Greece has widened to record levels.

A Deutsche Bank analyst called the woes of peripheral Europe a dress-rehearsal for the U.S. and U.K. down the road as both nations face ballooning budget deficits.

Last week, Europeans repeatedly rejected talk of an International Monetary Fund bailout and planned to rely on Greece's tax raising and budget cutting measures to fix the problem.  Many critics doubted feasibility of the plans.   

Soon after the measures were announced, Greek government employees staged strikes and powerful Greek unions threatened to stage more in the future.

The Greek government is not the only one facing funding issues; if conditions of sovereign debt deteriorate further, Greek banks could be in serious trouble.

Banks belonging to European Union nations receive funding from the European Central Bank by posting sovereign debt as collateral.  However, the sovereign debt must be above certain threshold ratings.

Should the ratings of Greek sovereign debt fall below the threshold, Greek banks may face serious funding concerns.

Tensions could also arise as a cashed strapped Greece tries to implement its austerity plans and the European Central Bank faces its eventual need to withdrawal its extraordinary level of liquidity.

On Tuesday, Goldman Sachs cut its rating for the National Bank of Greece. 

The Rumors

Investors had been anticipating a bailout since Friday and Saturday last week, when the finance ministers of the Group of 7 met in Canada.  Investors were disappointed when European members of G7 gave no such indication. 

On Tuesday of this week, the U.S. stock market largely rose on rumors of a bailout.

In the morning, the stock market rallied when various publications claimed that ECB President Jean-Claude Trichet cut short his trip to Australia in order to attend Thursday's European Union Economic Summit and discuss bailout options.

Stocks then pared gains as an official statement refuted such claims; Trichet rescheduled his flight because he feared missing a connecting flight back to Europe and had intended to attend the EU Economic Summit since mid January.

Stocks then soared as reports surfaced that Germany was in talks to plan a Greek bailout.  However a German official then said the rumors were unfounded, according to Reuters.

The S&P 500 Index dipped nearly 7 points in 10 minutes.  However, the official merely meant to refute the claim that a decision to bailout Greece had been reached.

Germany was only discussing various options to bail out Greece; a final decision, however, had not been reached yet.

When the situation became clear to market participants, the S&P 500 held on to its gains to close up 13.78 points, or 1.30 percent, at 1,070.52 on Tuesday.

The Economics

Like the 1997 Asian Financial Crisis and the subprime mortgage crisis, the Greek debt woes stem from underlying economic frictions and imbalances.

Greece is plagued by a woeful tax collecting system.  It also has been living beyond its means, triggering alarm after its budget deficit grew to 12.7 percent of its gross domestic product, more than triple the amount permitted by EU regulators.

But perhaps that alone cannot be blamed for the financial difficulties facing peripheral European Union nations. 

Scott Redler, Chief Strategic Officer of T3 Capital Management, names the European common currency as one of the frictions. 

In many respects, the inevitability of the Greece bailout stems from the challenges of a monetary union.  When countries with very different economies share a currency, they lose control over their monetary policy, said Redler.

Having sacrificed monetary policy freedom when they joined they joined the European common currency system, member states must resort to fiscal measures to address their economic issues.

To get the same effect of lowering interest rates, member states can increase government spending or reduce taxes. Unrestrained, such moves could lead to a high budget deficit.

Last week, the European Union accepted Greece's plans to reduce government spending and increase taxes.

The Consequences

German banks would be hit hard if conditions in Greece were allowed to further deteriorate, says Redler, who sees Germany's plans as a back-door bailout for its banks, an analogous situation to the benefits Goldman Sachs derived from the bailout of American International Group.

A Greek default may also also trigger a flight to safety within the Euro Zone and bring about a larger deflationary spiral, he said.

A Greek bailout, however, may set the stage for subsequent bailouts in other economically troubled nations, creating a risk of moral hazard.

Redler cautioned that once you get started, there's really no way to stop.

Before public talks about the bailout possibility, the Greek government made reluctant concessions on spending.  With a loan guarantee, however, the Greek government may not be so incentivized to reduce its budget deficit.