Will Europe step in to bail out Greece?

European Union leaders gathering for a crucial summit Thursday face tough choices: come to Greece’s rescue with the first ever bail out of a eurozone state or hold back and see if Greek spending cuts and reforms can avert a default.

By , Correspondent

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    Demonstrators take part in a protest outside the Greek Parliament in central Athens on Wednesday.
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In the darkest hour yet faced by Europe’s 11-year-old common currency, the sharks of international finance are suddenly circling the euro.

The crisis has come to head as a result of the public debt crisis faced by the Achilles heel of the 16-member eurozone, Greece. Currency speculators are now either betting on a fall in the value of the euro – or waiting for Greece's problems to spread to other states. Traders are already reported to have bet nearly $8 billion against the euro, according to the CME Group, the world's largest futures exchange.

European Union (EU) leaders gathering for a crucial summit Thursday in Brussels face some tough choices: come to Greece’s rescue with the first ever bailout of a eurozone member state or hold back and hope radical spending cuts and reforms unveiled by the Greek government will be enough to avert a default.

Amid rumor and counter rumor Wednesday, observers remained divided on whether the eurozone’s biggest economies would step in to prevent the monetary union from unravelling in the event of Greece having to leave the club.

“The bottom line is that this shows what happens when you put countries with such a variety of economies into one currency union,” says Nigel Hakwins, a senior fellow of the free-market Adam Smith Institute in London. “The likelihood is that the Germans, with assistance from the French, will be prevailed upon to get Greece out of this crisis so that it does not spread to eurozone members like Spain and Portugal,” he says.

Nevertheless, the euro fell against the dollar early Wednesday on expectations that the EU will probably not announce an aid package for debt- stricken Greece but will instead opt for new policy measures and words of solidarity.

Thousands of Greek civil servants also took to the streets Wednesday during a 24-hour strike over a planned wage freeze, testing their government's will to impose stringent spending cuts.

It goes beyond Greece

The crisis underlines the threat to the long-term health of the euro from its most troubled and indebted economies – the so-called PIIGS (Portugal, Italy, Ireland, Greece and Spain).

At 12.7 percent of GDP, the Greek budget deficit is more than four times higher than eurozone rules allow. Currently, it's total debt stands at around $419 billion.

To date, demand from investors for Greek bonds has been good – but serious doubts remain about the ability of Greece to borrow all of the $74 billion its government wants this year.

Of the other PIIGS, potentially the biggest worry in the immediate term is Spain, one of the eurozone’s largest economies. Last week, Spain raised its 2009 public deficit projection from 9.5 percent of gross domestic product to 11.4 percent.

In contrast, Ireland been able to “step out of the spotlight” and gain increased confidence from international markets after putting forward a program for reducing its debt as part of major cuts in public spending, according to Vanessa Rossi, an international economics analyst at Britain’s Chatham House think tank.

“Greece is clearly in the opposite camp, combined with the fact that there has been a problem of misreporting of statistics by the Greek authorities,” she adds, referring to how Greek debt and deficit figures were understated in order for it to originally become a member of the European Monetary Union (EMU).

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Similar cooking of the books in Athens is also suspected to have happened in 2008 and 2009 ahead of elections.

European Union options

In the place of an EU bail out, Ms. Rossi suggests that there could be leeway for the European Central Bank to opt to loosen some fiscal measures and for a program of specifically targeted regional aid from EU funds.

Robert Hancké, an expert on European affairs and the Germany economy at the London School of Economics, says the impact of a Greek default isn't clear.

“The European Central Bank is not really supposed to intervene, although the standard operational framework of the monetary union does not seem to operate at the moment – they are re-writing the rules as we speak,” he says.

“If this crisis is anything like previous currency crisis then it is a given that there will be a knock-on effect from one country to another. In that case, in the event of defaults they may have to think about their membership of the euro so that they can move to a position of being able to devalue.”

“What is the political impact of that? If the weaker economies are out [of the eurozone], then it may well be in the interests of the stronger [European economies], like Germany and France,” says Hancké.

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