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The Eurozone: Tough Talk and a 110 Billion-Euro Bailout [Teaser:] No eurozone country's fiscal situation is quite as dire as that of Greece, but the economic fundamentals are not as important as investors’ perceptions of those fundamentals. Summary The “culprit” of the dire economic circumstances in Europe is Greece, and the fear is that the country’s economic collapse will spread throughout Europe’s fragile banking system and from there to the rest of the world. Austerity measures imposed by the International Monetary Fund (IMF) and European Union are likely to collapse Greece, but Germany and the rest of the eurozone hope that a 110 billion-euro bailout will hold Greece together just long enough that it will no longer present a systemic risk to the rest of Europe. Analysis The sovereign debt crisis in Greece has stoked pessimism in the eurozone as a whole, which in turn has engendered a global investor panic, with fears that the situation in Europe could somehow spread to the United States and other regions. On May 6, the United States got its first taste of the panic, which sapped market confidence and resulted in a 3.24 percent drop in the S&P 500 -- a bellwether of U.S. economic performance. The “culprit” of the dire economic circumstances in Europe is Greece. Roots of the economic crisis -- rarely mentioned in the current debates -- lie in Athens’ gradual descent into irrelevance as the Cold War ended. Leveraging its role in stopping the Soviet penetration into the Mediterranean had allowed Athens to live beyond its economic means by tapping U.S. and EU allies for payouts. Once the Berlin Wall fell, Greece was supposed to learn to live within its means, but as far are successive Greek governments were concerned, taking advantage of the low interest rates brought on by the euro was much more desirable than enacting painful structural reforms. Years of extreme deficit spending -- kept under the radar by accounting shenanigans -left Greece with a government-debt to gross-domestic-product (GDP) ratio of 124.9 percent in 2010 (the second highest in the world after Japan’s) and a budget deficit of 13.6 percent of GDP in 2009. A number of prominent European banks are holding Greek government bonds, and the fear is that a collapse in Greece will spread throughout Europe’s fragile banking system and from there to the rest of the world. <link nid="161330">Austerity measures</link> imposed by the International Monetary Fund (IMF) and European Union are very likely to collapse Greece, but Germany and the rest of the eurozone hope that a 110 billion-euro bailout will hold Greece together just long enough that it will <link nid="161762">no longer present a systemic risk</link> to the rest of Europe. Portugal and Spain The situation in Greece is usually extrapolated to the rest of its Mediterranean neighbors, particularly to <link nid="156487">Portugal</link> and <link nid="136936">Spain</link>, both of which posted large budget deficits in 2009 and thus came under pressure from markets as the Greek sovereign-debt crisis flared. Both Portugal and Spain are set to run large budget deficits in 2010, 8.5 percent of GDP and 9.8 percent of GDP respectively, compared with the projected Greek 2010 budget deficit of 9.3 percent. However, there are a number of differences between Portugal and Spain on the one hand and Greece on the other. First, the Iberian countries are entering the crisis with about half the debt level -- relative to the size of their economies -- which provides Lisbon and Madrid with more room for fiscal maneuvering. Furthermore, both countries have more comfortable debt-redemption schedules -- they have less debt (as a percent of GDP) coming due in the next five years and are not under the same pressure as Greece. Debtservice payments (as a percentage of GDP) are also far smaller for Portugal and Spain, reflecting their lower costs of debt financing. However, both Portugal and Spain have considerable private-sector indebtedness, and there is fear that the troubled Iberian banks -- trying to recover from a <link nid="126839">dizzying housing boom</link> -- will crack long before their governments do. If such an event were to hamstring economic growth, Iberia could find its government balance sheet coming under pressure as the public sector tries to mitigate the fallout. Spain is the key to watch because its $1.6 trillion economy is too big to bail out. If Greek problems migrate through investor panic to Portugal and into Spain, then the eurozone's solutions become fairly limited, with only the possibility of a European Central Bank (ECB) direct intervention into government bonds -- expressly prohibited by eurozone rules -- to save the monetary bloc. Italy <link nid="126111">Italy</link> is not the focus for the moment, but it is part of the infamous “Club Med” that includes the three Mediterranean countries mentioned above. Italy’s government debt is teetering at about 118 percent of GDP (forecast for 2010), just a few percentage points below Greece's level. However, Italy has a long tradition of dealing with enormous government debt and has learned to manage it well. Only a quarter of the debt is short-term, which means the repayment schedule is favorable. Because the debt is dispersed over longer maturity periods, any increase in the cost of the debt will take about five years to average into Italy’s finances. Since the starting debt level was so high, the government's ability to "spend its way out of crisis" has been restricted, although falling tax revenues helped to widen the budget deficit to 5.3 percent of GDP in 2009. Ireland <link nid="137123">Ireland</link> is still feeling market pressure, despite its being relatively proactive about cutting its budget deficit. Unlike the Greek deficit, which is structural and therefore impossible to fix without painful austerity measures, the Irish debt came about from its decision to very early in the crisis safeguard its banking system. Irish banks are reeling from their over-extension of credit and are trying to limit the fallout from the bursting of its <link nid="129013">domestic housing bubble</link>. If Greek problems migrate to Europe’s financial system, Irish banks could be some of the first to crack. While Ireland may have initially made a good impression on markets with its ostensibly credible stability plan, Ireland may find itself under pressure until it delivers on those plans. Although no eurozone country's fiscal situation is quite as dire as that of Greece's -- yet -the economic fundamentals are not really as important as investors’ perceptions of those fundamentals. Although we don't consider Portugal’s and Spain’s problems to be the same as those of Greece, in the end, if markets construe reality to be different, it will not matter. It is for this reason that the eurozone has -- despite all its tough talk to the contrary -- finally come out in support of Greece (to the tune of about 110 billion euro). If Greece were to default right now -- at a time when the eurozone economy has not nearly recovered from the <link nid="137471">last crisis</link> -- the write-downs on holdings of Greek bonds and the blow to confidence in the region’s ability to see its way through the crisis could greatly complicate any economic recovery, if not hamstring it altogether.