Eurozone crisis

Supplements to this article include links to contemporary reports of the main events of the crisis; and notes on the the financial status of the PIIGS, their notionally required sustainability adjustments and their GDP growth rates

The financial assistance that was provided to the governments of Greece and Ireland in 2010 did not restore the confidence of the markets in their continued ability to service their debt, and bond market investors became reluctant to buy the bonds being issued by some other eurozone governments. The eurozone crisis that started in 2010 arose from doubts about the willingness of major eurozone governments to provide the further assistance that may be needed, and fears that there may be a breakup of the eurozone if they do not.

Overview

During 2010, prospective investors became increasingly reluctant to buy the bonds isued by five eurozone governments (Portugal, Ireland, Italy, Greece and Spain) at the offered interest rates, and the governments concerned had to make a succession of increases in those rates. Two of those governments - Greece and Ireland - eventually decided that, without help, they would not be able to continue to finance their budget deficits, and they sought - and received - loans from other European governments. Those loans failed to reassure potential investors, and in November they demanded further increases in the interest rates on the government bonds of all five governments (including those of Portugal, Spain and Italy, because of fears of contagion from Greece and Ireland).

By December 2010, there was widespread uncertainty about future prospects for the eurozone and beyond. There were doubts about the willingness of European governments to provide further financial support to the five "PIIGS" governments, and speculation that financing difficulties might spread to affect other governments. Some commentators considered it inevitable that one or other of the PIIGS governments would default on its loans, and other commentators forecast departures from the eurozone by governments wishing to escape its restraints. There were even those who envisaged wholesale departures, leading to a collapse of the common currency - an outcome that would impose substantial losses upon countries with investments in euro-denominated securities, and could threaten the stability of the international financial system.

Causes of the crisis

Departures from optimum currency area criteria

Currency area theory is concerned with extent to which efficiency gains from currency area membership are offset by losses due to increased vulnerability to external economic shocks, and the term "optimum currency area" (OCA) denotes an area in which such offsets are absent. Although an idealistic concept, it has practical implications because the increased costs of recessions, brought about by increased vulnerability to shocks, can be large compared with the benefits of the efficiency gains. For that reason it is generally accepted that a currency area may not succeed unless it goes a substantial way toward meeting OCA criteria. A currency area fully meets OCA criteria if there is complete price flexibility, or complete cross-boarder mobility of labour and capital. An alternative requirement arises from the fact that increased vulnerability to shocks need not occur if every shock has the same impact on all the economies of the member states. The term "convergence" is sometimes used to denote a condition in which the economies of members states are so similar as to eliminate asymmetric shocks - or to denote an approach to that condition.

The eurozone has not satisfied the OCA labour migration or price flexibility conditions. Labour mobility is low and there is only limited wage and price flexibility. Nor has it satisfied the convergence condition. There has been less price convergence among eurozone countries than among European Union countries as a whole,, and there have been large divergences of productivity, unit labour costs, and current account balances. The progress toward convergence as a result of membership, that was expected by the early proponents of monetary union, has not occurred.

The debt trap

If the annual interest payable on a government's debt were to continue to rise faster than the national income, it would eventually exceed the feasible revenue from taxation. The process is normally hastened by the fact that government debt is traded in a well-informed market. Operators in that market would be aware of the approach of the point at which the government would be forced to default on its debt, and they would be increasingly reluctant to allow that government to continue to roll over its debt. The government concerned could seek to overcome that reluctance by offering them higher interest on future loans, but an increase in the interest to be paid would hasten the process and increase the reluctance of further potential investors. That is what is known as the debt trap, the price formulation of which is the the debt trap identity.

The debt trap could be escaped:

- (i) by repudiation of the debt;

- (ii) (temporarily) by a negotiation with creditors to ease the terms of repayment (termed restructuring);

- (iii) (temporarily) by getting the country's central bank to purchase the debt; or,

- (iv) by a programme of reductions in public expenditure and/or increases in rates of taxation.

Options (i) and (ii) have the drawback of making future investors reluctant to buy the government's bonds. Option (iii) can also have that effect if it causes an inflation that reduces the value of the currency in which the debt is to be repaid. Option (iv) is free from that drawback, but is effective only if it avoids creating a recession that increases the deficit (by the operation of the country's automatic stabilisers).

Fewer options are available to members of a currency union, however. Option (iii) may be excluded by the fact that monetary policy is no longer under the control of the borrowing government. That fact also prevents the use of monetary policy to counter the recessionary consequences of (iv), (without which that option may be ineffective); and the rules of the currency union prevent the exchange rate deprecation that might otherwise counter them. To make (iii) possible and (iv) easier, a further option would be (v) - to leave the currency union.

The eurozone dilemmas

Two dilemmas face Eiurozone policymakers. The first and more immediate dilemma is whether a debt-trap-threatened member should be:

- (a) rescued by their loans or guarantees, or

- (b) left to tackle its problem without their assistance.

Option (a) sets a precedent that reduces incentive upon individual members' to abide by the collectively-agreed rules of fiscal conduct, and thereby increases the long-term danger that the dilemma will recur (the moral hazard consideration).
Option (b) involves the more immediate danger of a default by the member concerned that might put other members in a similar situation (the contagion consideration), or of its departure from the eurozone in order to escape from its policy restraints.

The second dilemma concerns the means of preventing the creation of national debt traps. The options are:

- (a) the creation of regulations to deter the adoption of unsustainable fiscal policies, or

- (b) the transfer of control over fiscal policy from national government to a central authority

An intermediate possibility is the creation of a "transfer union" involving the automatic transfer of resources from surplus countries to deficit countries.

The effectiveness of avoidance by regulation is limited by a version of time inconsistency in which the government of a member country agrees at the outset to submit to a prudential regulation, such as a limit on deficits, but subsequently changes its mind under the pressure of unforeseen developments. The transfer of the power to control fiscal policy involves a loss of national sovereignty that would be almost equivalent amalgamation into a political union. A transfer union is a less radical option, but it does not solve the moral hazard problem.

The problem of the PIIGS

Since the inception of the eurozone, five of its members - Portugal, Italy, Ireland, Greece and Spain - had suffered increases in the interest rates payable on their bond issues, reflecting investors' fears that they might default. Those fears were mainly attributable to recession-induced increases in their budget deficits or in their public debt that raised doubts about their fiscal sustainability. Two of them - Greece and Ireland - have been given financial support, conditional upon their adoption of deficit-reduction programmes. In neither case has that been followed by an improvement in their credit ratings, suggesting that doubts remained concerning their ability to implement those programmes. Their current financial status remained a matter of concern, on their own account and because of the possibility that the bond market's loss of confidence might spread and affect the fiscal stability of Belgium and other EU countries. It was suggested that the future of the eurozone was at stake (even in 2009, before the eurozone crisis had gathered strength, the Managing Director of the International Monetary Fund was warning that "most advanced economies will not accept any more [bailouts]...the political reaction will be very strong, putting some democracies at risk"). If the euro were allowed to collapse, however, it has been estimated that reversion to national currencies would be followed by devaluations that would cost British, French and German banks about €360 billion creating a supply shock comparable to the collapse of the Lehmans Brothers bank that had triggered the Great Recession.

Background to the crisis

The eurozone

Membership

In 1991, the 15 members of 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 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.

The bail-out clauses

Article 104 of the Maastricht treaty appears to forbid any financial bail-out of member governments, but article 103 of the treaty appears to envisage circumstances under which a bail-out is permitted,

Bond purchase programme

In July 2009 the European Central Bank launched a "covered bond purchase programme", under which national central banks and the European Central Bank would buy eligible covered bonds . The aim of the programme was to support those financial market institutions that supply funds to banks that had been particularly affected by the financial crisis. The purchases under the programme were for a nominal value of EUR 60 billion. Its completion was announced on 30th June 2010, but there were reports of continued small-scale purchases in subsequent months. On 10th May 2010 the European Central Bank renewed purchases with its Securities Markets Programme . All purchases are sterilised in order not to affect the money supply

The Financial Stability Facility

In May 2010, the European Council adopted a regulation establishing a European financial stabilisation mechanism. A volume of up to EUR 60 billion is foreseen and activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF. The mechanism will operate without prejudice to the existing facility providing medium term financial assistance for non-euro area Member States' balance of payments. In addition, the representatives of the governments of the euro area member states adopted a decision to commit to provide assistance through a Special Purpose Vehicle that is guaranteed on a pro rata basis by participating member states in a coordinated manner and that will expire after three years, up to EUR 440 billion, in accordance with their share in the paid-up capital of the European Central Bank and pursuant to their national constitutional requirements

The growth of debt

Debt is a means of transferring resources from those who own them. but do not wish to use them, to those who wish to use them, but do not own them. It is also a means of "consumption smoothing", that enables a household to forego consumption when its income is relatively high, in order to enjoy an acceptable standard of living when the wage earner retires or if he is unemployed. However, debt may also contribute to economic instability. According to Hyman Minsky's financial instability hypothesis, borrowers accumulate debt in prosperous times, and allow it rise to a point at which it cannot be repaid out of current income. Debt reduction (or "deleveraging" nearly always follows a financial crisis, and inevitably creates reductions of consumption and thus of economic activity .

The PIIGS countries differed from most of the other eurozone countries by deficits on their balance of payments current accounts and, (some of them) by above-average levels of household and business sector debt. The effects on them of the Great Recession were amplified by deleveraging of the corporate and household debt, especially in countries with larger-than-average financial sectors, and those that had experienced debt-financed housing booms. Its effects upon their governments' fiscal stance were to create cyclical deficits because of the action of their automatic stabilisers and of discretionary fiscal stimuli, and to increase the previous structural deficits as a result of the loss of revenue-generating productive capacity. In some of the PIIGS countries, budget deficits were further increased by subventions and guarantees to distressed banks.

Fiscal policies

The dept trap identity establishes the condition for fiscal sustainability as the requirement that interest rate on the public debt does not exceed the growth rate of nominal GDP. To avoid an increase in public debt in the course of any year, the budget balance during that year must not be greater than the opening level of debt multiplied by the difference between the interest rate on the debt and the nominal GDP growth rate in that year (and that means a budget surplus if the interest rate is greater than the growth rate). If, for example, the interest rate were 5% and the growth rate were 2% then a debt of 50% of gdp would require a surplus of 1.5% of GDP, a debt of 100% of GDP would require a surplus of 3% of gdp, and so forth.

The bond market

Government bonds are traded in the world's stock markets and their prices are quoted daily in the financial press. The stock market price of a bond determines its yield, and competition normally ensures that government bonds of similar maturity have similar yields. If, however, traders perceive there to be a finite probability of default by the issuer of a bond, that probability is reflected by the addition of a risk premium to the yield of that bond. The term spread is applied to the difference between the market yield of such a bond and the market yield of those deemed to be completely safe. The spread on a government's bonds is often determined by trading in the market for credit default swaps (CDS) - which are undertakings to provide their purchasers with full compensation if there is a default. The market price of a CDS for a bond is another measure of its spread.

It is reasonable to suppose that, in assigning speads to goverment bonds, the markets would be influenced by the factors determining fiscal sustainability, including a government's debt, its budget deficit, the country's expected growth rate, and the existing spread on its bonds. Among other factors that would seem relevant are the proportion of debt held by foreigners - who might be expected to have less influence than domestic bond-holders on the issuing government's conduct - and the proportion of debt that is due for redemption. Some researchers have used the term debt intolerance to encompass the other, more judgemental, factors that appear relevant. Their findings about the influence of past defaults among developing countries have no bearing on the eurozone crisis because there has been no post-war default of a goverment of a country with a fully-developed market economy. It is evident, nevertheless, that judgements on matters other than fiscal sustainability play a part - for example, there has been no adverse bond market reaction to Japan's public debt, which has been proportionately larger than those of the PIIGS.

Grades awarded by the credit rating agencies are associated with market spreads, but it is not clear whether they contribute information to the market or merely reflect the information that it already uses. Some researchers have suggested that they have a destabilising influence by understating risks in good times and overstating them in bad times.

History of the crisis

Greece

The crisis in Greece was the result of the impact of the recession upon the already inflated public debt of a heavily indebted economy that had already suffered a loss in international competitiveness.

Greece joined the eurozone in 2001, and membership enabled it to use borrowing from abroad to finance an economic boom. Labour costs rose more rapidly than productivity over the next seven years, as a result of which there was a fall in export competitiveness, and the deficit on its balance of payments rose to over 14 per cent of GDP. Much of the government's public expenditure during those years was also financed by borrowing, and the country's public debt rose to several times the European average, at around 100 per cent of GDP. By 2010 it had further increased to 130 per cent of GDP as a result of the increases in borrowing brought about by the Great Recession. Concern about the sustainability of the goverment's fiscal policy led the a succession of credit rating downgrades in the first quarter of 2010. By May the yields on 10-year government bonds had reached 10 per cent, the CDS spread on 5-year bonds was over 9 per cent, and there was doubt about the government's ability to finance that year's budget deficit. A loan was sought from other eurozone governments and a €110 billion European Union/International Monetary Fund rescue was mounted. In addition, a "European Financial Stability Facility", was created to provide support, if required, to other applicants, including a loan facility of up to €500 billion from member governments and the European Commission. The loan failed to reassure investors, and the CDS spread on Greek bonds rose from 4.8 per cent in April to 10 pre cent in November.

Ireland

Ireland's financial crisis resulted from a recession-induced bursting of an asset price bubble, not from an above-average level of its pre-recession public debt. It was greatly aggravated, however, by a government decision to guarantee its banks' deposits.

Having joined the eurozone, the Irish government offered tax incentives to promote inward investment by financial companies and there was a large inflow of capital. Between 2001 and 2008 the country's total debt (pubic and private) doubled to reach over 700 per cent of GDP - of which 421 per cent went to the financial sector and much of the rest was used to finance a housing boom. In 2008, however, a downturn in the output of the construction industry that had started in 2007, developed into a full-blown economic recession, and construction and property companies began to default on loans from the banks. Bank losses amounted to as much as 20 per cent of GDP by 2009, and foreign banks and investors, that had been the banks' principal source of short-term finance, became reluctant to risk further commitments. A banking crisis developed, consumer confidence fell and there was a very sharp increase in unemployment. In an attempt to restore confidence, the Irish government undertook to guarantee loans to the banks. The government also introduced fiscal stimulus measures amounting to 4.4 per cent of GDP spread over the three years 2008-10 which, combined with the effects of its automatic stabilisers was expected to raise the national debt to over 80 per cent of GDP from its 2007 level of 28 per cent. Foreign investors became wary of the possibility a sovereign default, and the government's ability to finance the deficit was threatened by a general loss of confidence. In March 2009 the Standard and Poor credit rating agency downgraded its rating for Ireland from AAA to AA+, and April, the government decided that the only way to restore confidence was to take steps to reduce its deficit - and took the extraordinary step of increasing taxation in the midst of a recession . Additional steps taken included direct purchase of stock in some banks and the establishment of the "National Asset Management Agency" - essentially a government-owned bank that will buy toxic debt from six financial institutions - both steps aimed at improving their balance sheets and freeing up capital. On August 24, 2010 the Standard and Poor's credit rating agency downgraded Ireland's debt for the 3rd time to AA- (following 3 downgrades by the Fitch agency and 2 by Moody's).

Ireland's economy suffered a second downturn in the second quarter of 2010 and the Government's financial position continued to deteriorate. In September 2010, its CDS spread reached a record 5 per cent. On the 22nd of November 2010 the government applied for financial assistance from the EU and the IMF. The package that was agreed included €35 billion to restructure the banking sector, €50 billion to assist the state budget. Of that sum, Ireland agreed to provide €17.5 billion from its own reserves and €67.5 billion, was to be divided equally among the International Monetary Fund, the European Commission and the European Financial Stability Fund ((a special-purpose fund created by eurozone countries in May, augmented by extra contributions from Britain, Sweden and Denmark). The interest rate on the loans was to average about 5.8%.

Portugal

Portugal is expected to be the next applicant for financial assistance. Although its fiscal position is stronger than Ireland's (see table), and its government has already succeeded in reducing its budget deficit, the country's growth prospects are so poor that its debt levels may begin to rise again.

Since joining the eurozone, Portuguese labour costs have risen faster than its productivity, leading to a fall in international competitiveness, and to a growing balance of payments deficit - financed by borrowing from abroad. Its principal sources of income were agricultural exports, tourism, and income from its nationals working abroad . All three were hit by the recession, and its economy suffered a downturn earlier than other eurozone economies. In response to the downturn (and to fiscal stimulus of about 1¼ per cent of GDP) the 2009 budget deficit rose to 9.3 per cent of GDP. There was a return to GDP growth early in 2010, but output fell again in the 4th quarter of the year, and despite reductions in public expenditure the deficit for the year remained above 9 per cent of GDP, and expectations of a further fallin output in 2011 cast doubt upon the prospect of further deficit reductions and the level of public debt is expected to rise from its 2010 level of 83 per cent of GDP to 93 per cent by 2012. On 5th May 2011 the EU and the IMF provided Portugal with a conditinal €26 Billion Extended Fund Facility Arrangement. Under the agreement, Portugal is required to reduce its budget deficit to 3 percent of GDP by 2013.

Spain

The recession in Spain was shallower but more protracted than the European average, and the recovery, which started in the first quarter of 2010, has been described as "weak and fragile". Spain's unemployment rate was among the highest in Europe, reaching 20 per cent by mid 2010. A major contributory factor was the bursting of a vigorous housing bubble, as a result of which the construction sector crashed, and the banking sector suffered a downturn despite the fact that it had avoided the acquisition of toxic debt. Another major factor was deleveraging of a deeply indebted household sector. The Government responded with a major fiscal stimulus that, together with the effects of the country's automatic stabilisers resulted in the largest budget deficit in the European Union - although its public debt as a percentage of GDP was among the smallest. In 2010, the bond market developed a debt aversion against Spain following the Greek crisis, the Standard and Poor credit rating agency downgraded its credit rating from AA+ to AA on 28 April 2010, and the sovereign spread over Germany's 10-year bonds rose to 164 basis points in early May 2010.

Policy implications

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