European sovereign-debt crisis

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European sovereign-debt crisis

The European sovereign debt crisis is an ongoing financial crisis that has made it difficult or impossible for some countries in the euro area to re-finance their government debt without the assistance of third parties.

The European debt crisis is the shorthand term for Europe’s struggle to pay the debts it has built up in recent decades. Five of the region’s countries – Greece, Portugal, Ireland, Italy, and Spain – have, to varying degrees, failed to generate enough economic growth to make their ability to pay back bondholders the guarantee it was intended to be. Although these five were seen as being the countries in immediate danger of a possible default, the crisis has far-reaching consequences that extend beyond their borders to the world as a whole. In fact, the head of the Bank of England referred to it as “the most serious financial crisis at least since the 1930s, if not ever,” in October 2011.

This is one of most important problems facing the world economy, but it is also one of the hardest to understand. Below is a Q&A to help familiarize you with the basics of this critical issue.

From late 2009, fears of a sovereign debt crisis developed among investors as a result of the rising private and government debt levels around the world together with a wave of downgrading of government debt in some European states. Causes of the crisis varied by country. In several countries, private debts arising from a property bubble were transferred to sovereign debt as a result of banking system bailouts and government responses to slowing economies post-bubble. In Greece, unsustainable public sector wage and pension commitments drove the debt increase. The structure of the Euro zone as a monetary union (i.e., one currency) without fiscal union (e.g., different tax and public pension rules) contributed to the crisis and impacted the ability of European leaders to respond. European banks own a significant amount of sovereign debt, such that concerns regarding the solvency of banking systems or sovereigns are negatively reinforcing.

Concerns intensified in early 2010 and thereafter, leading Europe's finance ministers on 9 May 2010 to approve a rescue package worth €750 billion aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF).

In October 2011 and February 2012, the euro zone leaders agreed on more measures designed to prevent the collapse of member economies. This included an agreement whereby banks would accept a 53.5% write-off of Greek debt owed to private creditors, increasing the EFSF to about €1 trillion, and requiring European banks to achieve 9% capitalisation. To restore confidence in Europe, EU leaders also agreed to create a European Fiscal Compact including the commitment of each participating country to introduce a balanced budget amendment.

While sovereign debt has risen substantially in only a few euro zone countries, it has become a perceived problem for the area as a whole.  Prior to May, 2012, the European currency remained stable. As of mid-November 2011, the euro was even trading slightly higher against the bloc's major trading partners than at the beginning of the crisis. Three countries significantly affected, Greece, Ireland and Portugal, collectively accounted for 6% of the euro zone's gross domestic product (GDP).

During June 2012, the Spanish debt crisis became a prime concern for the Euro-zone. Interest rates on Spain’s debt rose significantly and its ability to access capital markets was affected, leading to a bailout of its banks and other measures.

 

The Problem

Greece	2010	2011 (forecast in June 2011)	2012 (forecast in June 2011)
GDP (billion euros)	236
Growth of GDP (%)	-4,5	-3,5	1,1
Budget deficit (% of GDP)	-10,5	-9,5	-9,3
Interest on public debt (% of GDP)	5,6	6,7	7,4
Budget deficit w/o interest on debt (% of GDP)	-4,9	-2,8	-1,8
Public debt (% of GDP)	143	158	166
Current account deficit (% of GDP)	-10	n.a.	n.a.
Unemployment rate (% of working population)	12,6	15,2	15,3

sources: European Commission, Euro stat, Bank of Greece

Adoption of a common currency in Europe

In the 1990's the major European countries decided to have a common currency. They carried out their plan in two steps, first for business transactions in 1999, and then for all citizens, beginning January 1st, 2002. In broad outline, countries set aside the currencies they each were using previously and instead dealt themselves euros. From then on the so-called Euro zone had a single currency, a "unique money". In the 2000's Greece and other countries joined the group. Greece undertook the same operation. It relinquished its drachmas and received an equivalent amount of euros. We explain below technically the issuance of a new currency, but for the time being what's important is the result. Henceforth Greek firms and Greek citizens could buy goods and services anywhere in the Euro zone with their euros. Let's see how this lead to the present monetary crisis, and what is likely to happen next.

Continued Greek budget and trade deficits, borrowing euros

To understand the problem of Greece, we ought to distinguish monetary flows within the country from those across borders. They entail different accounting records, liabilities and problems. And within the country, let's focus on one very special economic agent, the government, the revenues of which normally come from taxes.

• Within the country: the Greek government kept its economic policy which consisted in spending more than it received from taxes and minor state entrepreneurial activities, and, in the past, printing drachmas to make up for its budget deficits. It amounts to a fiscal and monetary policy where tax revenues are produced with the printing press (producing bank notes or bonds). Some countries prefer this system to price stability, which has other advantages and drawbacks.
• Across Greek borders (1): The Greek government began to borrow euros mostly from foreign investors. Big European lenders (Société Générale, Deutsche Bank, etc.) were happy to lend to Greece, because the interest rate was high, to take into account the risk, and at the same time they knew that Europe would refund them should Greece fail. These were euros flowing into the country and corresponding promises to pay back later including some interests (= bonds) flowing out. Private Greek agents too borrowed within the country as well as abroad.
• Across Greek borders (2): in parallel to its budget deficits, Greece trade went into deep imbalance. Somehow the country indulged in a spending spree with its new money buying goods and services all over the world much more easily than with its previous drachma. Greece paid its imports in part with exports (tourism, textile, ore, food products, etc.), in part with promises, and in part with euros, which left the country.

Threat of default

The Greek State is nearing defaulting on its foreign liabilities, and it is running out of euros for domestic expenses. The Euro zone, feeling concerned, hesitates on what to do. Should we abide by the liberal credo. Let Greece go under - what does that mean about a sovereign State? -, let's buy the Parthenon like China all but did with the Piraeus. Or should the Euro zone act as a community, taking temporary control of the government of Greece? Angela Merkel opposes extending Greece further loans from the ECB and prefers to reschedule current payments due. Nicolas Sarkozy favors new loans in euros from the ECB, IMF, private banks or funds, because France and its own alarming twin deficits is not far from the situation of Greece. Jean-Claude Trichet, the head of the ECB and de facto of the Euro zone, opposes rescheduling payments to private banks because it would amount to defaulting and trigger the same process all over Europe. He prefers a formal solution from the IMF (which means not much more than SDR movement entries in books kept in Washington) or, in opposition to his staunch stance until may 2010, that the ECB print yet more euros recorded as a credit in the liabilities of its balance sheet, or open new accounts in credit, to exchange with sovereign debt from a member of the Euro zone, whose bonds would go as a debit in the assets of the ECB. Trichet buckled under the pressure of Euro zone debtors. Notice that a bond purchase by the ECB, despite some medias sensational presentation, requires no particular effort from anyone in the euro zone. Yet it contributes to corrupting its money and prepares the ground for a monetary tsunami in Europe in not so distant a future.

Monetary straitjacket

Meanwhile, the Greek government began to reduce the salaries of civil servants, pensions of retirees and public spending. A growing number of Greeks don't have enough money for their everyday expenditures, and therefore shops and local producers suffer as well. The whole country is simply running out of the official money and its GDP has been decreasing for the last three years.

Beginning of crisis

The global economy has experienced slow growth since the U.S. financial crisis of 2008-2009, which has exposed the unsustainable fiscal policies of countries in Europe and around the globe. Greece, which spent heartily for years and failed to undertake fiscal reforms, was one of the first to feel the pinch of weaker growth. When growth slows, so do tax revenues – making high budget deficits unsustainable. The result was that the new Prime Minister George Papandreou, in late 2009, was forced to announce that previous governments had failed to reveal the size of the nation’s deficits. In truth, Greece’s debts were so large that they actually exceed the size of the nation’s entire economy, and the country could no longer hide the problem.

Investors responded by demanding higher yields on Greece’s bonds, which raised the cost of the country’s debt burden and necessitated a series of bailouts by the European Union and European Central Bank (ECB). The markets also began driving up bond yields in the other heavily indebted countries in the region, anticipating problems similar to what occurred in Greece.