Economic Forecasts November 2011 – A history of the European debt crisis

Financial markets continue to be battered amid the unresolved European sovereign debt crisis.   The risks and uncertainty surrounding this situation have greatly influenced our outlook for both the global and domestic economies.   This article outlines how Europe got to where it is today.

A brief history of the Euro-zone

In order to understand why the sovereign debt problems of a few nations have become a European-wide crisis it is essential to understand little bit of the history of the Euro-zone.

The euro was introduced to facilitate trade within a bloc of participating European nations.   It was hoped that the removal of exchange rate risk between these nations and reduction in cross-border transaction costs would stimulate trade volumes.   However, in joining a currency union, not only do nations give up their old currency, but also autonomy over their monetary policy.   Therefore, the implementation of the euro was accompanied by the creation of the European Central Bank (ECB).   The Bank is charged with promoting European-wide price stability by setting a common interest rate target.

Fears regarding fiscal sustainability were first raised during the design of the euro.   Germany, in particular, feared that certain member nations may be tempted to borrow more than they should.   This excess borrowing could stem from such nations taking advantage of lower interest rates than they would otherwise have had courtesy of the stability of stronger nations in the currency bloc.   Excessive deficits could lead to an unsustainable debt build-up, which may have external implications on other European Monetary Union states via upward pressure on European interest rates.

To counteract debt sustainability concerns, the Maastricht Treaty was introduced, which identifies specific numerical targets for government finances.   These targets state that a nation must keep deficits to within 3% of GDP and public debt below 60% of GDP.   The aim was to persuade members to balance their budgets over the medium-term, while allowing governments the ability to help their local economy out of crises.

Adherence to these criteria is monitored by way of annual updates, which are submitted by each nation to a European-level council.   If nation’s budget is not complying with debt and deficit criteria then adjustment will be recommended, and in certain circumstances a sanction could be imposed.

The storm brewed

In practice, nations have been able to break the Maastricht Treaty’s debt and deficit targets without major consequences.  Culprits have even included Germany, one of the primary advocates for fixed targets during the creation of the euro.   This undermining of deficit targets has occurred because of a design fault in the monitoring and dissuasion system.   All EU states may vote on the decision to take action against an offending nation.   However, as each state may anticipate being in a similar position in future, voting is biased towards not imposing sanctions.

Scant regard for the debt and deficit targets was particularly apparent in Portugal, Greece, and Italy throughout the middle of last decade.   This trend was able to continue without any immediate problems thanks to strong economic growth, but conditions worsened as the global financial crisis (GFC) got underway in 2008.

Graph 5.1

Two nations which bucked the pre-crisis deficit trend, and largely ran surpluses, were Ireland and Spain.   However, with the ECB setting interest rates "too low" for their economies, private debt climbed.   As a result, when the GFC took hold, their government deficits and public debt burdens have exploded.     Ireland was forced to bail out its banking sector, which had crashed following an implosion of the Irish real estate market.  Spain too faced a real estate collapse, as well as soaring unemployment that has now reached more than 21%.

Graph 5.2

Following a ratings downgrade in late 2009, markets began to worry about Greek public debt.   Interest rates on Greek debt began to climb.   Faced with increasing liquidity problems the Greek government was forced to accept international assistance, and in May 2010 it received its first payment from a rescue package agreed upon with the IMF and EU.   However, concerns lingered regarding whether the size of the bail-out was sufficient and whether the Greeks would implement austerity measures that satisfied the terms of the bail-out.

Nervous markets began looking at other euro nations with shaky public finances.     Soon these concerns were reflected in the interest rates demanded on both Portuguese and Irish government debt.   These governments, too, were forced to take assistance from the IMF and EU.

Graph 5.3

Recently, interest rates for both Spanish and Italian government debt have also been elevated.   However, the magnitudes of these spikes have been softened by ECB intervention into bond markets to shore up liquidity.

The bottom line

The manner in which the crisis has quickly spilled over into other nations highlights the role of financial markets in shifting domestic troubles into the international sphere.   Furthermore, it raises the issue of liquidity problems versus solvency.  

Of the nations to have sought assistance only Greece is likely to be truly insolvent – lending it more merely allows its Ponzi scheme to continue.   Greece is unlikely to have the ability to pay back all of its debt in the long-term, so a default of some sort is inevitable.   In contrast, the other troubled European nations are showing signs of turning around their fiscal positions.   They simply need plenty of short-run funding (liquidity)while they implement fiscal discipline and return to growth.

For Europe, the crisis in Greece is not so much about Greece itself, but rather the potential for its problems to spill over into the rest of Europe.   Even after ensuring other troubled European nations have plenty of liquidity, making banks realise losses will have an impact across the continent.   A Greek default would burn banks holding Greek debt and lead to more cautious behaviour by banks.

This scenario has similarities to the Lehman Brothers crisis because at the moment no one knows who will ultimately bear the burden.  As a result, banks are reluctant to lend.   The onus is on European authorities to begin making clear decisions so that market players can begin operating with more certainty.

If a major European bank does fail, then the global consequences could be similar to the fall-out from the collapse of Lehman Brothers.   However, in our view this outcome is unlikely, due to three factors.

Firstly, rather than involving a complicated and tangled web of sophisticated securities, much of the Greek debt is relatively simple in structure.   So once the default has happened, we know who has lost out and people will lend again.

Secondly, slightly more than 50% of Greek debt is held by public institutions.   Of this tally, some debt is of little concern internationally as it is held within public institutions in Greece itself.   The rest of the burden is shared between the IMF, central banks, and European bail-out loans.  Although European taxpayers ultimately stand behind European-level bail-outs, any losses to these loans will be distributed across various nations.

Finally, the exposure of private banks is relatively easy to calculate and, if necessary, capital could be extended to shore up their balance sheets.   Furthermore, private bank exposure to Greek debt only represents a small fraction of each nation’s GDP.   In other words, there seems to be little risk that recapitalising banks would overwhelm these nations.

Graph 5.4

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