With everyone going crazy about all the eurozone rumours circulating right now, it’s easy to lose track of what’s important.So let’s bring this back into perspective.
A little background:
– Since joining the euro back in 1999, the governments of Greece and Portugal (among other offenders) have gotten used to spending a LOT of money. When times were good, it wasn’t a problem — banks and other investors were willing to lend them money on the cheap and their public sectors became bloated.
– When the financial crisis hit, however, problems came to a head. Debt levels in Portugal, Italy, and Greece became unsustainable, and taxes in a contracting economy are no longer enough to pay the bills.
– Greece, Portugal, and Ireland are still struggling to bring their public debt under control, after receiving billions of euros in bailout aid from the European Commission, the International Monetary Fund, and the European Central Bank (the so-called troika). Some of this aid was provided through a temporary Special Purpose Vehicle called the European Financial Stability Facility (EFSF).
– These governments needed this money because it became too expensive for them to borrow cash on the open markets, with speculators demanding high rates for lending and traders even betting on a disorderly sovereign default.
– The initial round of aid money helped these governments prop up their banks and pay their bills.
– The ECB also started buying government bonds in order to keep borrowing costs low.
– But now Greece needs more dough to stay solvent. EU leaders agreed back in July that a “selective default” was the only option for Greece. Under this situation, euro area nations will guarantee payouts on Greek sovereign debt, but the private sector will bear take a loss — a “haircut” — on their debt holdings, reducing the face value of those holdings.
When the 17 leaders of eurozone countries agreed to a second bailout for Greece back in July:
– The economic situation in Europe wasn’t quite as bad as it is now:
– There wasn’t as much scepticism about Greece’s ability to actually make good on the deficit-reduction and privatization goals that were terms of its first bailout.
– And — perhaps most importantly — there were not as many signs that banks across Europe were having trouble getting access to cash.
All this changed in the nearly three months needed to get approval for the July 21 agreement. Suddenly market attention is focused on the eurozone crisis, and the signs are worsening that core European banks not in troubled countries are at risk. That fear came to a head with the fall of the Belgian bank Dexia earlier this month.
Greece looks ever closer to a disorderly default, its government having underperformed on measures to stop public sector debt from ballooning and still unable to collect a lot of its taxes. And the euro area is just getting more and more angry — but the consequences are too big to actually let Greece default in an uncontrolled manner. Here’s what could happen in the event of a disorderly Greek default >
At the same time, the banking sector is hurting badly. Sovereign bonds in the PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain) — which just a few years ago were highly rated — have lost their high ratings, forcing banks to fear big write downs that cripple lending. Investors wary about the consequences of a Greek default (and other economic problems) are unwilling to loan out cash, producing a liquidity crisis. This is creating a vicious cycle and funding conditions are getting ever tighter.
This hurts economic growth not only in the euro area periphery but in core countries like Germany and France, which have kept their spending under control. While they are to blame for letting the PIIGS spend freely during the good years, now they’re angry. They don’t want to print more money to allow the PIIGS to get off scot free because it would deflate the value of their own assets. Taxpayers don’t want more of their money siphoned off.
But they also would suffer horribly if Greece defaulted and the banking system collapsed.
The immediate context:
With the EFSF finally approved by all 17 member states, EU leaders are meeting this weekend to discuss and potentially amend the way in which those funds will be used.
It’s clear that the plan needs more cash. The EFSF doesn’t have enough money to buy enough sovereign bonds in Italy and Spain to keep speculators from raising their borrowing costs. And it probably needs to help recapitalize banks so that they’ll lend money again. Chatter has been circulating about leveraging the fund with cash from the private sector, euro area national banks, the ECB, and even the G20 (the latter two possibilities are unlikely right now).
Getting that cash is going to be tricky. If EU leaders increase the hit private sector bondholders (like banks and investment firms) have to take on their holdings of Greek bonds like they’ve been talking about, then the banks will suffer and contagion will spread throughout the system.
But they also don’t want to risk another long, drawn out approval process by the parliaments of EU states. Not only is raising more money from national governments going to take time, approval would be a lot more contentious this time around.
At the moment:
EU leaders are heading to Brussels this weekend. The powerful German Chancellor Angela Merkel and French President Nicolas Sarkozy have both promised a solution to the crisis by the end of the month, but even they seem to be in disagreement about how to fix things.
Divisions among EU leaders have been so strong, in fact, that they’ve been forced to schedule a second EU summit by October 26. This time, they’ve promised to produce an “ambitious” comprehensive solution to the eurozone crisis.
This could be huge. But then again, we’ve heard this rhetoric before. Whether they will find a way to solve things permanently this time around is anyone’s guess.
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