The Greece debt crisis is much more than whether the tiny country of Greece will default on its debt or leave the eurozone. Like the 2008 collapse of a relatively small investment bank called Lehman Brothers. a Greek default could plunge the world into a financial crisis. Like the historical canary in a coal mine, the Greek debt crisis highlights the dilemma other heavily indebted countries face. As the European Union leaders struggle to agree on a resolution, this tiny country has triggered the Eurozone debt crisis. threatening the viability of the eurozone itself.

Greece Crisis Explained

Greece kicked off the crisis in 2009 by admitting its budget deficit would be 12.9% of GDP, more than four times the EU’s 3% limit. Fitch, Moody’s and Standard & Poor’s warned investors by lowering Greece’s credit ratings. Unfortunately, this also drove up the cost of future loans, making it more unlikely that Greece could find the funds to repay its debt.

In 2010, Greece announced an austerity package, designed to reassure the agencies it was fiscally responsible by lowering the deficit to 3% of GDP by 2012. Just four months later, Greece warned it might default. The EU and the the IMF have provided a total of €240 billion in emergency funding in return for austerity measures. Unfortunately, these measures further slowed the Greek economy, reducing the tax revenues needed to repay the debt. The funding only gave Greece enough money to pay interest on its debt and keep banks capitalized and barely running. Unemployment rose to 25%, riots erupted in the streets, and the political system was in an upheaval as voters turned to anyone who promised a painless way out.

By 2012, Greece’s debt-to-GDP ratio had risen to 175%, nearly three times the EU’s limit of 60%. Bondholders finally agreed to a haircut, exchanging $77 billion in bonds for debt worth 75% less. (Source: New York Times, Greece )

Why Were Austerity Measures Needed?

If austerity measures slowed the Greek economy and made it more difficult to repay the debt, why were they needed? First, ratings agencies wanted to make sure Greece wouldn’t just take on new debt to pay off the old. Second, Germany and other EU leaders had successfully used austerity measures to strengthen their own economies. Since they were paying for the bailouts, they wanted Greece to follow their examples.

Third, the OECD argued these measures would improve Greece’s competitiveness in the global marketplace. By following the austerity measures, Greece improved how it managed its public finances and its financial statistics and reporting. It also reformed its labor market and pension system, and lowered trade barriers. As a result, exports began to rise.

The OECD recommended Greece raise more revenue by strengthening tax collection, taking a hard line against tax evasion, and selling off state-owned businesses and assets. However, this is exactly what the Greeks did not want to do. Instead, they periodically threaten to default on their debt and leave the eurozone if the EU continues to impose austerity.(Source: OECD, Economic Survey of Greece )

Causes of the Greece Crisis

How did Greece and the EU get into this mess in the first place? The seeds were sown back in 2001, when Greece adopted the euro as its currency. Greece had been an EU member since 1981, but its annual budget deficit was never low enough to satisfy the eurozone’s Maastricht Criteria.

All went well for the first several years. Like other eurozone countries, Greece benefited from the power of the euro, which meant lower interest rates and an inflow of investment capital and loans.

However, in 2004, Greece announced it had lied to get around the Maastrict Criteria. Surprisingly, the EU imposed no sanctions! Why not? There were three reasons.

1. France and Germany were also spending above the limit at the time. They’d be hypocritical to sanction Greece until they imposed their own austerity measures first.
2. There was uncertainty on exactly what sanctions to apply. They could expel Greece, but that would be highly disruptive and possibly weaken the euro itself.
3. The EU wanted to strengthen, not weaken, the power of the euro in international currency markets. A strong euro would convince other EU countries, like the UK, Denmark, and Sweden, to adopt the euro. (Source:Bloomberg, Greece Cheated. May 26, 2011; BBC News, Greece Joins Eurozone. January 1, 2001; Greece to Join Euro. June 1, 2000).

As a result, Greek debt continued to rise until the crisis erupted. Now, the EU must stand behind its member or face the consequences of either Greece leaving the eurozone, or even worse, a Greek default.

What Happens If Greece Leaves the Eurozone?

Greece might decide it would be better off abandoning the euro, and reinstating the drachma. First, it could get rid of the hated austerity measures. Once it converted its euro-based debt to drachmas, it could then print more currency, lowering the exchange rate value of its debt.

That would initially be great for Greece, but the impact on investors would be similar to a default. Foreign owners of Greek debt would suffer debilitating losses, and some banks may even go bankrupt. Interest rates on other indebted countries, such as Italy or Ireland, might go even higher as ratings agencies become concerned they’d leave the euro also. The value of the euro itself would weaken, helping EU exports but creating higher prices for imports into the EU. Eventually, Greece would find itself back to where it is now—burdened under debt it can’t repay.

What Happens If Greece Defaults?

A Greek default would have a more immediate effect. First, Greek banks — already on the brink — would go bankrupt. Next, losses would threaten the solvency of other European banks, particularly in Germany and France. Even worse, the EU’s central bank (ECB) holds a lot of Greek and other sovereign debt. If Greece defaults, it could put the future of the ECB at risk. Other indebted countries might decide, or be forced, to default. Without a central bank to bail them out, the EU itself may not survive.

For these reasons, a Greek default could be worse than the 1998 debt crisis. Russia’s default led to a tidal wave of defaults in other emerging market countries. The IMF prevented many by providing needed capital until their economies improved.

The difference today is the scale of defaults, which are in the developed markets — the source of much of the IMF’s funds. The U.S. is a huge backer of IMF funding, but it’s now over-indebted itself. There would be little political appetite for a U.S.-backed bailout of European sovereign debt. Article updated February 6,2015.