Eurozone crisis

In addition to the following text, this article comprises:      - a country-by-country summary of the development of the crisis;      - links to contemporary reports of the main events of the crisis;      - notes on the debt trap, the eurozone's departures from optimum currency area criteria, and on the eurobond proposal; and,      - tabulations of the fiscal characteristics of the PIIGS countries , and their GDP growth rates

The eurozone crisis that started in 2010 arose from doubts about the ability of some eurozone governments to service their debts. . The financial assistance given to those governments has failed restore the confidence of the markets, and bond market investors have become reluctant to buy the bonds being issued by some other eurozone governments. There are uncertainties about the willingness of the major eurozone governments to provide the further assistance that may be needed, and fears that there may be a breakup of the eurozone and a global financial crisis if they do not.

Overview

The crisis started early in 2010 with the revelation that, without external assistance, the Greek government would be forced to default on its debt. The assistance that was provided by other eurozone governments enabled the Greek government to continue to roll-over maturing debts until, in the latter half of 20ll, it became evident that a default could no longer be avoided. In the meantime, investors' fears of default had increased the cost of borrowing to other eurozone governments, making it necessary to provide financial assistance to the governments of both Ireland and Portugal. By September 2011, the international community had become aware of the danger that a Greek government default, and that its repercussions could administer a shock to the world economy comparable to the shock that triggered the Great Recession. Plans were initiated to provide the financial support needed to avoid a comparable malfunction of the global financial system. Substantial political obstacles would have to be overcome before such plans could be put into effect.

Background to the crisis

The eurozone

Membership

In 1991, leaders of the 15 countries that then made up the European Union, meeting in the Dutch town of Maastricht, agreed to set up a monetary union with a single currency. They agreed upon strict criteria for joining, including targets for inflation, interest rates and budget deficits, and they subsequently agreed upon rules of conduct that were intended to preserve its members' fiscal sustainability. No provision was made for the expulsion of countries that did not comply with its rules, nor for the voluntary departure of those who no longer wished to, but the intention was announced of imposing financial penalties for breaches.

Greece joined, what by then was known as the eurozone in 2001, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009. The current membership comprises Belgium, Germany¸ Ireland, Greece, Spain, France, Italy, Cyprus, Luxembourg, Malta, The Netherlands, Austria, Portugal, Slovenia, Slovakia, and Finland. Bulgaria, Czech Republic, Denmark, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, Sweden and the United Kingdom are EU Member States but are not members of the eurozone.

The Stability and Growth Pact

The Stability and Growth Pact that was introduced as part of the Maastricht Treaty in 1992, set arbitrary limits upon member countries' budget deficits and levels of national debt at 3 per cent and 60 per cent of gdp respectively.

Following multiple breaches of those limits by France and Germany, the pact has since been renegotiated to introduce the flexibility necessary to take account of changing economic conditions. Revisions introduced in 2005 relaxed the pact's enforcement procedures by introducing "medium-term budgetary objectives" that are differentiated across countries and can be revised when a major structural reform is implemented; and by providing for abrogation of the procedures during periods of low or negative economic growth . A clarification of the concepts and methods of calculation involved was issued by the European Union's The Economic and Financial Affairs Council in November 2009 which includes an explanation of its excessive deficit procedure. According to the Commission services 2011 Spring forecasts, the government deficit exceeded 3% of GDP in twenty-two Member States in 2010.

It is not certain what was envisaged concerning the treatment of governments that could not meet their financial obligations. Article 104 of the Maastricht treaty appeared to forbid any financial bail-out of member governments, but article 103 of the treaty appeared to envisage circumstances under which a bail-out would be permitted.

The Financial Stability Facility

In May 2010, the European Council established a Financial Stability Facility(EFSF} that was intended to provide financial assistance to eurozone governments who experience "difficulties caused by exceptional circumstances beyond [their] control", on terms similar to those adopted by the International Monetary Fund. The EFSF was empowered to issue bonds guaranteed by member states for up to €440 billion subject to conditions negotiated with the European Commission in liaison with the European Central Bank and the International Monetary Fund, and approved by the Eurogroup. Assistance was intended to be in addition to loans by the European Financial Stabilisation Mechanism (EFSM)(which are raised by the European Commission and guaranteed by the EU budget), and to loans by the International Monetary Fund. Proposals to leverage the €440 billion by using it as collateral for loans from the European Central Bank have not been authorised. It is intended to replace the EFSF and the EFSM with a permanent crisis resolution regime that is to be called the European Stability Mechanism (ESM)

The PIIGS

The economies of five of the eurozone countries (Portugal, Italy, Ireland, Greece and Spain) differed in several respects from those of the others. Unlike most of the others, they had developed deficits on their balance of payments current accounts (largely attributable to the effect of the euro's exchange rate upon the competiveness of their exports). Deleveraging of corporate and household debt had amplified the effects of the recession to a greater extent - especially in those with larger-than-average financial sectors, and those that had experienced debt-financed housing booms. In common with the others, they had developed cyclical deficits under the action of their economies' automatic stabilisers and of their governments' discretionary fiscal stimuli, and increases in existing structural deficits as a result of losses of revenue-generating productive capacity. In some cases, their budget deficits had been further increased by subventions and guarantees to distressed banks.

The development of the crisis

A chronology of the crisis, with links to contemporary reports, is available on the and timelines subpage, and a country-by-country account of the crisis, together with tabulations of supporting data are available on the addendum subpage.

We are experiencing an episode in the history of the world which is very very special. It is the gravest financial crisis, economic crisis, since World War II, so it is something which is big. It is big in Europe, it is big in the US, big in Japan, big in the rest of the world. European Central Bank President Jean-Claude Trichet 30th August 2011[1]

“The issue is no longer if Greece will default — leaders want to ensure there is the financial firepower to deal with a default and ensure contagion does not spread throughout the eurozone when it happens Gerard Lyons, reporting to the Sunday Times on a meeting of G20 Finance Ministers, 24 September 2011[2].

In April 2010, the Greek goverment faced the prospect of being unable to fund its maturing debts, and later that year, the Irish government found itself in a similar position. Their problems arose from large increases in their sovereign spreads reflecting the bond market's fears that they might default - fears that were based upon both their large budget deficits, and their limited economic prospects. In May 2010, the Greek government was granted a €110 billion rescue package, and in November 2010 the Irish government was granted an €85 billion rescue package, both financed jointly by the eurozone governments and the IMF. Further increases in spreads showed that those rescue packages had failed to reassure the markets. Further support packages also failed to solve the problem, and signs began to appear of the contagion of the bond market fears from Greece to other eurozone countries, particularly Portugal and Spain. Portugal received an EU/IMF rescue package in May 2011, and Greece was assigned a second package in July, neither of which restored the bond market's confidence in eurozone sovereign debt. There was a dramatic increase in measures of the market assessment of default risk, implying a 98 per cent probability of a Greek government default. Also in 2011, there was a major decline in confidence in eurozone banks, following rumours that losses on Greek bonds had left them undercapitalised.

What had started as a Greek crisis was developing into a eurozone crisis because the rescue packages that could be needed for the much bigger economies of Spain or Italy were expected be larger than the eurozone could afford. It was also acquiring the potential to trigger a second international financial crisis because the default of a European government might be expected to create a shock comparable to the failure of the Lehman Brothers bank that had triggered the crash of 2008. The falls in world stock market prices that occurred in August and September of 2011 were widely attributed to fears of a eurozone-generated financial crisis.

In late September 2011, work started on a rescue plan, said to include a reduction in the Greek government's debt, the recapitalisation of some European banks and an increase in the funds available to the Financial Stability Facility . However, German Finance Minister Wolfgang Schaeuble is reported to have said that eurozone governments have no intention of raising the European Financial Stability Facility’s volume above the agreed €440 billion, and a similar denial was reported to have been issued by the Dutch Prime Minister.

Policy options

Conditional loans

The EU/IMF loans had been primarily intended to restore the confidence of the bond markets in their recipients' ability to meet their financial obligations. They were subject to conditions that were to be expected to cause substantial reductions in economic growth and increases in unemployment. (The conditions attached to the loans to the Greece government were designed to reduce its budget deficit to 3 per cent of its GDP by 2014, from its 2009 level of 11.6 per cent, by means that included a tax increase of 4 per cent of GDP and public spending reductions of 5 per cent of GDP). When the first loan failed to restore confidence, it was decide to add a second loan and to reduce the interest rate charged on all loans from 5.5 to 3.5 percent, in addition to which EU financial institutions agreed to make a financial contribution and to agree to the restructuring of some of the Greek government's debt.

As rescue measures, they were a dramatic failure.

Bond purchases

At an early stage, the failure of conditional loans to avert the growing crisis prompted the exploration of possible alternatives. Some of them have since been adopted, and all of them are the subject of continuing debate. Among those that were adopted was the idea of sovereign bond purchases. Before May 2010, the European Central Bank had used bond purchases only for the purpose of monetary policy, but in May 2010, in a major policy change, it decided to buy European government bonds in order to assist governments who were experiencing funding difficulties - a policy change that was opposed by Axel Weber, the then President of the German central bank. Purchases are reported to have included the bonds of all of the PIIGS countries, including Spain and Italy, but they achieved only temporary stabilisations of the affected markets.

Eurobonds

The Greek government's funding problems would be solved if it were permitted to issue bonds that were guaranteed by the other eurozone governments, and several such "eurobond" proposals have been put forward at an academic level. The idea was advanced at a ministerial level in December 2010 by Jean-Claude Juncker, the Luxembourg prime minister and Giulio Tremonti, the Italian finance minister,, but rejected as unconstitutional by German Chancellor Angela Merkel. In August 2011, the financier George Soros argued that such a "eurobond" would have to be an essential feature of any effective Greek rescue package, an assessment that was endorsed by the eminent economist, Joseph Siglitz . The proposal was again rejected by Angela Merkel, but in September 2011 the European Commission President, Jose Manuel Barroso, announced that the Commission would soon present options for the introduction of eurozone joint bonds .

Fiscal union

It has been argued by the economist Wolfgang Münchau, and others, that the eurozone embodies a logical inconsistency that will continue to make it vulnerable to economic shocks unless it is resolved by the introduction of some form of fiscal union. It is generally acknowledged, however, that the political obstacles that would have to be overcome are such as to put such a solution beyond reach for several years. (For example, the German constitutional court has ruled that political control over fiscal policy is a part of national sovereignty that cannot be transferred to the European Union).

Debt restructuring

It is generally accepted that the costs of sovereign default to all concerned are such as to make its avoidance a high priority objective. However it is being argued that, when default becomes unavoidable, some of those costs can be avoided by a timely "restructuring" agreement with the country's creditors. In May 2011, European Finance Ministers discussed the possibility of a rescheduling of the Greek government's debt (also referred to as "soft restructuring" or "reprofiling").

Guntram Wolff, the deputy director of the Bruegel think tank believes that Greece's debt ratio needs to be reduced by around 50 percentage points if Athens is to approach long-term debt sustainability, and Greece's Finance Minister is reported to consider an "orderly default with a 50 percent haircut for bondholders" to be one of his government's options.

Bank Recapitalisation

European banks have suffered reductions in their assets as a result of falls in the value of their holdings of Greek bonds, estimate by the IMF to amount to about €200 billion and the resulting reductions in their capital adequacy ratios are reported by the European Banking Authority to be in need of recapitalisation. It is evident that, without large-scale recapitalisation, the proposed restructuring of the Greek government's debts would result in multiple bank failures.

Exit from the eurozone

Departure from the eurozone would enable a country to monetise its debt, and would offer the prospect of an increase in competetiveness resulting from a currency devaluation. However, according to a study by UBS economists, the benefits to a country like Greece would be overwhelmingly outweighed by costs. It would also result in mass sovereign and corporate default, a major increase in the cost of capital, and the collapse of its banking system (the first-year cost of its departure was later estimated to be 40 to 50 per cent of GDP. ). The economic commentator, Anotole Kaletsky, has argued that the "seemingly impossible" solution of a German exit might become inevitable, and would be much less disruptive than a Greek expulsion because it would not trigger bank runs in countries, but would enable a devalued euro to be managed on less austere principles. But the UBS economists estimate that departure of Germany would lead to a first-year loss to its economy of 20 to 25 per cent of GDP.

Possible international repercussions

One consequence of a default by the Greek government would be a loss of capital by those banks that have holdings in Greek bonds. The Bank for International Settlements puts French banks' total liabilities in Greece at $56 billion and Germany's at $24 billion. That loss might reduce their capital adequacy ratios to below the minimum considered prudent, in which case, the banks may be expected to restrict lending, raising the prospect of a widespread credit crunch. (It is even possible that both those consequences could result from the anticipation of a default). The eurozone's failure to rescue Greece might also reduce the market's confidence in the bond issues of other eurozone governments. That might trigger an iterative process which could lead to a default by the government of a larger eurozone country, and result in an economic shock large enough to generate another global financial crisis