Eurozone crisis

The crisis

The basic problem

As a matter of arithmetic, the public debt owed by a government that continued to run a budget deficit every year, would eventually become so large that the interest on it would be more than could be raised by taxation - and the larger the deficits, the sooner would that point be reached. In practice, that process is 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 debt trap could be escaped:

- (i) by repudiation of the debt;

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

- (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 of 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 dilemma

The eurozone members' collective 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).

The problem of the PIIGS

Since the inception of the Eurozone, five of its members - Portugal, Italy, Ireland, Greece and Spain - have suffered downgrades of their governments' credit ratings. The downgrades were prompted by above-average budget deficits accompanied, in some cases, by an adverse judgement of the likelihood of their default (known as debt intolerance). 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 remain concerning their ability to implement those programmes.
(The data of the current situation are summarised in the addendum)

History of the crisis

Greece

When Greece joined the Eurozone in 2001, it was less prosperous than the other members[56], but its GDP grew more rapidly over the next seven years and fell less rapidly in the course of 2009. By the end of 2009, its unemployment rate had nevertheless risen in line with the European average and it was still suffering higher levels of poverty [57], and its national debt had risen by about 25 per cent above its pre-crisis level of 100 per cent of GDP[3]. Concern about the sustainability of the goverment's fiscal policy had led the credit rating agencies to downgrade the government's debt in January 2010, [58], and several times after that; and by early 2010 the cost of insuring against default by the Greek government rose after Moody’s Investors Service said the country’s economy was facing a “slow death” from deteriorating finances[59]. The investor panic continued until, in April 2010, it was announced that members of the Eurozone were prepared to offer the government a conditional of €30 billion at lower interest rates than the current market rate (then over 7 per cent) [60] [61]. In return, the Government was required to carry out a programme of fiscal contraction that was expected to drive its economy into a deep recession. The statement did not have the expected stabilising effect, but was followed by increases in risk premiums and further credit rating downgrades with Standard and Poor estimating that investors would recover only 30 to 50 per cent of their investments if the Greek government defaults. A further agreement on May 2[62] to lend the Greek government €110 billion also failed to reassure investors[63]. Public spending cut-backs have sparked widespread demonstrations. An August 2010 review [64] applauded the government's measures, but investors continued to be unwilling to buy its bonds. Fiscal tightening in 2010 is expected to amount to 7.5 per cent of GDP.

Ireland

A downturn in the output of the formerly booming Irish construction industry that started in 2007, intensified and developed into a full-blown economic recession in the course of 2008 and construction and property companies began to default on loans from the banks. News of their defaults made foreign banks and investors, that had been the banks' principal source of short-term finance, reluctant to risk further commitments, and a banking crisis developed. Consumer confidence fell and there was a very sharp increase in unemployment[42][43]. In an attempt to restore confidence, the Irish government undertook to guarantee loans to the banks. GDP growth rates averaging about 6 percent over the period 1995-2007 were followed by year-on-year falls of 8 percent in the 4th quarter of 2008 and 9 per cent in the first quarter of 2009, and the inflation rate fell to -3 per cent in September 2009. The government 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 is expected to raise the national debt to over 80 per cent of GDP from its 2007 level of 28 per cent[3]. 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+[44], 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 [45]. 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.[46][47].

The report of an IMF consultation published in July 2010 concluded that the governments "aggressive measures" had helped gain policy credibility and stabilize the economy but that further long-haul efforts with active risk management would be need to preserve policy credibility[48]. 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[49].