A short summary of the sovereign debt crisis

How the EU entered one of the most challenging times in its history, and why ‘solidarity’ and ‘discipline’ will be the buzzwords of this generation

January 8th, 2012 7:40 am| by admin
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With Europe’s ministers calling meeting after meeting and making complicated proposals while the media warns there’s only weeks to save the euro, it’s hard not to notice Europe’s in a state of crisis. But what exactly is going on? Whose crisis is it and how are we going to fix it?

In a nutshell, the crisis in Europe has to do with the fear that some countries may be unable to pay back their debt. But debt in itself is not always considered a problem and European governments often use more money than they earn. Governments were able to borrow so cheaply in the past decade that running a deficit was often used to stimulate economic growth.

One of the ways governments can raise money is through selling bonds, which are bought back after a number of years with interest added. Interest on government bonds has been low for most European countries because bonds were considered secure investments. The market worked on the assumption that governments would always be able to afford buying them back.

But what if a country can’t pay back their loans? If a business or individual is in this position, they default and are found bankrupt. But countries can also default on their loans. Argentina defaulted on almost $100 billion of debt owed to the World Bank in 2002. Unemployment soared to 25 percent, GDP dropped by over 10 percent and the Argentine peso lost half its value overnight.

This is the scenario that European leaders wanted to avoid when in 2009 concern started to mount over Greece’s ability to pay off its debt. Should Greece default, it would probably be forced to pull out of the euro with unknown but potentially grave consequences for the global economy.

The bad apple

Greece never had a good grip on its finances and many feared what might happen when it was allowed to adopt the euro when it was introduced in 2001. Since its move to democracy in 1974 the country had run a high government deficit to pay for a large public sector that offered high wages and generous pensions. But despite maintaining a debt level close to 100 percent of its GDP (its debts were worth as much as the value of its entire economy), Greece witnessed healthy economic growth.

According to Zsolt Darvas from Bruegel, a Brussels-based think tank, Greece’s problems started when they decided to hide their actual level of debt in order to be allowed entry into the Eurozone.

“Not only before the crisis but during the crisis the management of the public finances was horrible,” Darvas said. “Greece was just fiscally irresponsible. They lied about their numbers, they lied to get inside the Eurozone and they didn’t use the good times to prepare for an economic downturn.”

Greece followed a global trend when its economy shrank in 2008 as a result of the financial crisis. But unlike some countries that tightened their belts to cope, Greece was unprepared, and as its income shrank, its debt rose relatively. By 2010 its debt had risen from 100 to 145 percent of its GDP and this is forecast to increase to over 170 percent by 2012.

Greece’s rising debt troubled the markets from whom it borrowed. Raising more money became difficult and expensive and despite pledges to cut public spending it was eventually forced to start accepting bail-outs in 2010. Despite accepting over €110 billion in loans to balance its books, European leaders took the drastic decision this October to forgive half of Greece’s debt.

Effects of a Greek default

Many economists have argued that Greek should default and pull out of the euro. But according to a study released this September by UBS bank, Greece would suffer a painful economic contraction if it were to do so. According to its figures, a weak euro country such as Greece pulling out of the Euro would face a drop in GDP of between 40 and 50 percent, or a per person cost of between €9,500 and €10,500.

And it wouldn’t stop there. According to Diego Valiante from the Centre for European Policy Studies, the effects on global financial system could be more severe than we could imagine.

“We have discovered that the financial system is enormous and is just too big and interconnected to fail. We have to save the financial system from a collapse which would have repercussions on the economies and competitiveness of countries.”

Valiante argued that if Greece went down, it would inevitably affect the rest of the global economy due to intertwined the relationships of global banks. If Greece defaults, then banks across Europe who bought billions of euros of Greek debt – because it was considered safe – would suddenly be left with worthless assets.

This is where contagion kicks in. Other banks, unsure of who has bought Greek debt, will then start calling in debts out of fear that they cannot reclaim their loans. This then trickles down to businesses who would then be unable to raise the capital they need and Europe’s economies would inevitably experience another recession.

Sigurd Næss-Schmidt, from the think tank Copenhagen Economics, believes this process has already started. “Banks are losing trust in each other again. They don’t know who has enough assets and credit markets are freezing up,” he said at a recent lecture in Brussels.

Solutions

The European sovereign debt crisis has many other actors all contributing in their small way to create this frenzied fight to save the euro. But while Italy, Portugal and Ireland all face similar debt problems, the problem with Greece best illustrates the primary issues – European governments borrowed too much money while times were good, and as the global economy shrank in 2008, those unable to adjust their public finances were left scrambling to pay back their debts.

So the problem lies in two places, first with countries such as Greece who need to control their debt, and secondly with the banks for allowing such cheap and risky borrowing in the first place. Tackling the problem with banks is already well underway. Under the package introduced in October that halved Greece’s debt, Europe’s banks were instructed to hold more of their assets as capital to create greater buffers when their investments go sour.

Banks also need investment, but if the markets don’t know if a bank is holding bad assets, they aren’t going to invest. According to Næss-Schmidt, European countries need to continually press their banks to see if they are holding risky assets.

“We need the stress tests to make sure that banks lend to one another but also so that financial markets put capital back into them. There’s no shortage of private capital in European pension and saving funds and lots of them would be happy to put money into the banks if they knew how solid they are.”

But how do we make sure countries are able to pay their debts? Countries with central banks, such as the US and its Federal Reserve, can buy back bad debt from banks if such a crisis approaches. This approach, effectively printing money, leads  to increased inflation.

The European Central Bank has been proposed as such a ‘lender of last resort’ though this option now seems off the table as Howard Wheeldon, senior strategist at BGC Partners explained to CNN this November.

“Once you’ve put that ‘lender of last resort’ thing out there, the perception will be (that cash-strapped countries will) be automatically bailed out,” said Wheeldon. “But financial stability can only occur if countries have discipline.”

Discipline and solidarity

This December, European leaders decided to create a tighter fiscal union. While the details have yet to be fleshed out, it seems likely that budgets of member states will come under increased scrutiny from Brussels with penalties for countries who don’t uphold budgetary discipline.

With fears mounting that the decision will lead to a ‘two-speed’ Europe it will be Denmark’s job while it hold the presidency to make sure that countries stick to their agreements while also keeping non-euro countries involved in the negotiations.

“The primary objective of the Danish presidency is that decisions which have been made are acted upon,” the economy minster, Margrethe Vestager, told journalists in Brussels in November. “Implementation is the new black – it’s the most important thing to do, to make sure that people and markets and businesses experience that we do what say we’re going to.”

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