Europe's Debt Haircut

27/10/2011 23:25 BST | Updated 27/12/2011 10:12 GMT

Wednesday night's deal by the EU leaders came about as a result of the increasing Government pressure on the banks to reduce the bill run up by the Greek government. The banks accepted a "voluntary haircut" of 50% on their holdings of Greek government debt (i.e they technically agreed to forgo 50% of the loan that they lent to Greece)

It was made clear that unless they accepted this proposal, EU leaders would move to a nuclear option of the total insolvency of Greece. This would essentially mean the country would go bankrupt, which would have wiped a lot of banks out. This "voluntary" restructuring can be compared to using diplomacy with a gun to the heads of the banks to arrive at the desired outcome.

Whether it is enough, only time will tell - but in any event, it is hoped that this voluntary write off of Greek debt will get the country's outstanding balance down to 120% of GDP by 2020 from 160% of GDP now.

However, it is worth noting that this would take Greece to the same relative debt level as a country such as Italy, which as it happens, is still considered in a poor economic state.

So what does this mean for Greece? The best way to illustrate it is by using an analogy of an ordinary house purchase, and the total mortgage payments on it.

Imagine the total value of the house or the Greek economy/GDP is €100k and the total debt owed on it is €160k. Unfortunately, to add to this, the value of that house is also falling, while the debt and interest on it still needs to be paid.

So, what does the EU deal mean to Greece (or the house value)? It means that instead of owing €160k on an economy that is only worth €100k, they will eventually only owe €120K, by 2020.

However that assumes that the value of their economy (or the house) won't shrink any further, and this is the big unknown.

Greece still needs to generate income to service the debt it still has to the IMF (International Monetary Fund) and other sovereign institutions. However, unfortunately its economy is still shrinking (or the value of the house is still falling) so the gap between the value of the house and the size of the debt continues to rise.

The public spending cuts in Greece, while necessary, are impacting on the ability of Greek businesses and the Greek people to grow their way out of the debt problems afflicting the country.

A change needs to take place to ensure taxes are collected from everyone as historically taxes have never been collected in an efficient manner.

The balance between income and expenditure for Greek government spending needs to be balanced in the same way household finances are balanced, and for years and years this had never been the case in the Greek economy. The bill has finally arrived and Greece can't pay, hence the problems now.

At the same time, the rest of Europe's consumers are also retrenching in the face of higher costs. This is in the form of rising inflation and fears about rising unemployment, which in turn is slowing down economic growth in Europe.

If consumers stop spending money then economies slow down. In turn, manufacturers stop producing as many goods and services, because they can't sell the ones they've already produced and stockpiles build up. Ultimately, economic growth slows down which means the ability of individual countries to generate income to pay down debt is diminished.

Greece is therefore a miniature version of the debt crisis in Europe affecting all countries.

Unless measures are taken to address the structural issues in Europe with respect to low growth and high debt levels, then last night's action by EU leaders merely serves to delay further debt "haircuts" further down the line.

This is why investors are so worried about Italy - it's the third largest European economy which has large banking exposure to France and Germany.

The Italians have €1.9trn worth of debts, or a debt to GDP ratio of 120%, with a stagnant economy. A loss of confidence in Italy therefore could well precipitate a full scale crisis in Europe.