The Eurozone Crisis For Dummies

eurozone crisis for dummies third addition

Photo: Simone Foxman for Business Insider

Worries about an economic catastrophe in Europe are heating up again, and dramatic forecasts about doom are popping up everywhere.What’s important? And how did we get here?

Let’s put this all in 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 Greek, Portuguese, and Irish government bonds on the secondary market in order to keep borrowing costs low.
  • Ultimately, however, Greece needed even more money to prevent an economic collapse. EU leaders agreed in July 2011 that a “selective default” was the only option for Greece. Under this situation, euro area nations guaranteed payouts on Greek sovereign debt, and the country’s private sector lenders agreed to take a loss — a “haircut” — on their debt holdings.
  • The July agreement also expanded the EFSF to €440 billion and allowed the ECB to purchase Spanish and Italian government bonds.
  • In August 2011, the ECB also started buying Italian and Spanish bonds, as investor fears escalated about Italy’s 120 per cent debt-to-GDP ratio and the fragile solvency of Spain’s banks in the wake of a housing bubble.
  • However, pressures on both European banks and European sovereigns continued to escalate, and all faced more difficulty accessing funding.
  • By the time all 17 euro-member countries had approved the Greek plan and agreed to boost funding to the European bailout fund, pressures on European banks had dramatically increased. Concerns that banks would not be able to access enough cash to finance their activities threatened to render them insolvent.
Greece on fire

By late last year, problems that had begun with the small economies of Greece, Ireland, and Portugal now threatened to jeopardize the entire European banking system, let alone inflict another global recession. Investors who had pooh-poohed the initial impact of these concerns were now boggled by the extent of the crisis.

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 partly 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.

Continued: The ECB takes action…

The ECB takes action

By November 2011, funding stress on banks and sovereigns threatened to spiral out of control. With Italian Mario Draghi replacing the staid French Jean-Claude Trichet at the helm of the ECB, investors had high hopes that the bank might now take a more proactive role in addressing the crisis. Their hopes in the bank–though perhaps not the influence of Draghi–were soon vindicated.

The bank soon made two rate cuts despite high inflation numbers to encourage freer exchange of money in the banking sector. In late November, the ECB agreed to new dollar-swap agreements with the Federal Reserve, the Bank of England, the Bank of Canada, Bank of Japan, and Swiss National Bank that would allow commercial banks easier access to dollars.

Most importantly, it followed up just weeks later with unprecedented new actions to add liquidity to the banking system–two three-year long-term refinancing operations that would give banks two chances to access an unlimited amount of money without paying much interest or setting aside much collateral.

These actions immediately flooded the banking sector with cash, papering over funding concerns that had so recently threatened to drive banks under.

Optimists speculated that the ECB’s newest non-standard measures to support liquidity in the banking system would effectively “save” Europe by inducing banks to buy Italian and Spanish government bonds with cheap cash from the ECB. Those actions made a huge impact on Italian and Spanish borrowing costs, particularly in the short term.


italy spain 2 year govt bond 1 yearYields on Italian (greed) and Spanish (red) 2-year bonds fell sharply after the two LTROs in December and late February, however they have started rebounding since. (Percentages are shown.)

Photo: Bloomberg

However, after the second LTRO on February 28, the reprieve drew to an end. While Spain and Italy were paying far less to borrow than they were just a few months before, it was clear that the extra money in the system had not permanently satisfied investor fears, and that concerns about the solvency and sustainability of Europe’s banks and government remained paramount.

These fears swiftly became a reality amid new concerns about Greece.

Greece is in a Great Depression:

More than four years of recession have wreaked havoc on the Greek economy, throwing more than 20 per cent of the population–and half of young people–out of work. Even so, the Greek government has been coerced into passing more and more austerity programs, cutting pensions, wages, and workers in order to comply with the reform program demanded by the country’s international lenders–the ECB, EU countries, and the IMF.

While reforms that decrease the size of government, enforce taxes, eliminate corruption, and more may ultimately be required to return the Greek economy to competitiveness, but the short term consequences of austerity policies have been hard to bear. 

Local PapademosFormer Greek PM Lucas Papademos saw Greece through a new round of austerity measures and its selective default.

Photo: AP

Distaste for austerity–as well as pressure from other European powers–brought an end to Socialist (PA SOK) Prime Minister George Papandreou’s political career last November, when he called for Greeks to take part in a referendum on a new round of austerity measures stipulated in the terms of the second Greek bailout.EU and opposing Greek leaders put an end to these referendum hopes, agreeing that a national unity government led by technocrat Lucas Papademos could control the government until such reforms could be passed and new elections called. Papademos and his new coalition voted through those austerity measures in March, generating violent protests in which nearly 50 buildings were burned.

But resistance to taking orders from Northern Europe has since transformed the Greek political scene. The formerly empowered Socialist PASOK Party and the rival centre-right New Democracy Party have completely dominated Greek politics for the last 38 years, but a new round of elections on May 6 compromised their popular support.

Instead, parties that have advocated for renegotiating the terms of the EU treaty won an enormous portion of the vote. While New Democracy received the highest percentage of the vote, with 18.8 per cent of votes–and with even worse performance from PASOK–it was not in a position to form a coalition. The far-left SYRIZA, led by Alexis Tsipras, won more votes that PASOK but failed to form a government.

Continued: The debate over growth and austerity is intensifying…

merkel hollande eu summit may 2012German Chancellor Angela Merkel and French President Francois Hollande have not gotten off on the right foot.

Photo: The Council of the European Union

The debate over growth and austerity is intensifying:The typical thinking in dealing with the unsustainable, bailed out economies of Greece and Portugal (and, to an extent, Ireland) has been to impose harsh austerity measures aimed at cutting down the size of governments and making business policies more competitive. However, this has entailed steep cutbacks that have stretched throughout the economy, and the sharp drawdown in demand has cut into the revenues of the entire euro area.

In December, EU leaders agreed to a fiscal compact that would be part of a new EU Treaty. It would impose automatic sanctions on any country that failed to adhere to new restrictions on the amount of money governments can spend and those who refuse to cut their public debts to about 60 per cent of GDP.

But Greeks are not alone in growing more resistant towards austerity. Critics of current plans are concerned that they are more targeted at making sure Germany and other creditors are paid and less geared towards actually returning economies to long-term growth. Since Merkel and Germany have been the primary proponents of the current position, they have come under increasing fire from leaders and EU citizens outside Germany.

Opposition to German leadership manifested in the most recent round of French presidential elections. That vote not only brought an end to the leadership of conservative Nicholas Sarkozy but to his partnership with the German Merkel. Indeed, the credit for his loss can be attributed–at least in part–to French distaste for his willingness to bend to Merkel’s will.

The new Socialist French President, Francois Hollande, has since championed a much more activist response to the crisis, and even campaigned to rewrite the new Treaty to include a pro-growth component.

The current obstacles:

Unsurprisingly, the relationship between Merkel and Hollande has proved tenuous. His public support for eurobonds–which would force Germany to guarantee the debts of less creditworthy countries like Italy and Spain–has led Italian PM Mario Monti and Spanish PM Mariano Rajoy to speak out in favour of such measures as well.

Their disagreements dominated the latest EU Summit on May 23, and investors have begun betting that Italy and Spain might soon need help from international lenders to stay afloat.

Because the three leading Greek political parties each failed to form a coalition, Greeks will have to return to the polls and vote again. Tsipras and his anti-bailout cohorts insist that EU leaders will give in and revise demands for more austerity. EU leaders, on the other hand, insist that this vote is a referendum on Greece’s membership on the European Monetary Union, and that the terms of the bailout are nonnegotiable. While 75 per cent of the Greek population supports the country’s membership in the euro currency, about 65 per cent disagree with the austerity measures.

The game of chicken between EU and Greek leaders has led more and more economists to believe that Greece might be forced to exit the euro currency, perhaps in the short term. Should EU leaders make good on their promises, and should Tsipras and SYRIZA win enough support to form an anti-bailout government after a new round of elections on June 17, they argue, EU leaders will withhold the next round of bailout funding. Greece would not be able to pay off its debts, and thus default in a disorderly fashion.

Such a default would hit Greece’s international lenders most severely, and it is unlikely that the ECB would continue to interact with a government that had directly disobeyed euro rules. Thus Greece would be forced out of the euro area. Should Greece leave, investors fear, it would compromise the fundamental tenets of the union itself. Thus, people and companies would withdraw money en masse from banks in Portugal, Ireland, Spain, and Italy, fearing that they, too, would choose devaluation and an exit from the euro area rather than years of recession and austerity.

Many other economists point out that fears of an immediate euro exit are overblown. A disorderly Greek exit would cause panic and upset the entire European banking system, and force countries like Germany to make structural changes to the monetary union that they are not willing to do yet. Some strategists also argue that recent campaigns by EU leaders to convince Greeks that their next election decision is a referendum on the euro have been successful, and that voters are moving back towards PASOK and New Democracy.

mario draghi ecb presidentInvestors look to ECB President Mario Draghi to take strong action should the crisis spiral out of control.

Photo: AP/Riccardo De Luca

No matter what happens in the next round of Greek elections, it is clear that concerns about the viability of the euro are heating up once again. Germany and other Northern European countries are loathe to make concessions to support the South, and Italy, Spain, Greece, and Portugal are dipping into even deeper recessions.More and more, analysts appear convinced that only the ECB has the power to truly “save” Europe in time. In particular, they are hoping for some kind of blanket guarantee by the ECB to buy an unlimited quantity of Italian and Spanish bonds, regardless of the implications for inflation.

However, the ECB argues that this would amount to “monetizing sovereign debt,” something that is illegal under the EU treaty and not within the central bank’s mandate. It has also reiterated that its commitment remains to price stability (i.e. keeping inflation under control), not growth or employment.

Ultimately, the conclusion to the crisis will only be true fiscal union, where Germany, Finland, the Netherlands, France, and other big economies will be able to transfer their wealth and business to the South. Solutions like eurobonds and a stronger central governance are not yet politically viable, but it seems apparent that Europe will need to become a lot more like the United States in order to survive.

Looking ahead:

The next big day for Europe is clearly June 17, when Greece will return to the polls.

Meanwhile, investors are concerned that withdrawals from European banks will intensify. There are signs that money is moving out of Greece and other peripheral European countries–a veritable “jog” on the banks.

But for now, the markets–and the eurozone–remain in limbo.


We published our first edition of this post on October 21, a second edition on December 30, and will continue to re-publish this “users guide” with updates as the crisis develops.

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