The Sovereign Debt Crisis hit the European economy in 2009. Though IMF and EU have acted swiftly to tackle the crisis, this on-going Euro zone Debt Crisis still continued to shake financial market both within and outside the Euro Zone. This paper aims to summarize the causes of the current crisis and proposes feasible short term and long term solution .
Causes of the Crisis
The Euro zone debt crisis has resulted from a combination of several interrelated factors, including the easy credit conditions during the 2002-2008 period, introduction of euro and euro zone , peripheral euro zone countries’ (Greek , Italy ,Ireland , Portugal, Spain ) domestic imbalance and fiscal profligacy, credit crunch caused by US financial crisis and outside contagion due to the globalization of financial market.
Easy credit conditions during the 2002-2008
During the 2002-2008 period, savings available for investment from both developed and developing countries increase significantly. For example, the total nominal amount of fixed income securities increased from approximately $36 trillion in 2000 to $70 trillion by 2008. This “Giant Pool of hot Money” entered the global financial system and sought for higher yield investment.
The benefit of readily available capitals inflow easily overrides the policy and regulatory control mechanism and nurtures high risk leading and borrowing practices. Large sudden capital inflow with short term investment horizon will inevitably cause asset prices rally, local commodity prices boom. Since purchase can be financed by relative cheap external money, this price movements will trigger more aggressive domestic lending and borrowing to push up price further. In turn, it generates bubble and exacerbates structural weakness of the domestic bank sector and whole domestic financial system.
Because of the nature of “hot money”: pursuing highest return possible, these speculative capital flows moved very quickly in and out of countries. When the hot money left the country, asset prices gave back their gains, however liabilities owned to external investors remained at the peak price. Considering the magnitude of this price change, it may endanger the solvency of domestic banking system or even the government itself.
Role of Euro and Eurozone
In 1992, the euro was established by the provision of Maastricht Treaty. Introducing the common currency does lead to gains in economic efficiency from the elimination of transaction cost and risk which comes from uncertain fluctuation of the exchange rates. However, it also planted the seeds of future crisis.
Under Maastricht treaty, all member states pledged to limit their deficit spending (no more than 3% of GDP) and debt levels (no more than 60% of GDP) to participate in the currency. However, this treaty was breached at the beginning. As the example, Greece and Italy were able to walk around these rules and mask their deficit and debt level by using cross currency swaps, designed by Investment bank Goldman Sachs. More important, this treaty doesn’t have provision to hold the individual member country accountable for their fiscal policy.
Before the Euro, different EU countries issue bond at different bond yield according to their own creditworthiness. For example, because Greece had a history of debt default, high inflation and banking crisis. The spread between Greek and German bonds was always high. However, once the euro was introduced, this bond yield spread started decreasing, because investors believed that under Maastricht treaty and common currency, inflation and default will not be a problem of Greek bond anymore. Therefore, Greek bond was perceived as safe as German bonds. Actually, after introduction of Euro, every peripheral Euro zone bond yield decreases. Therefore these countries could borrow at cheaper rate than before. Clearly introduction of Euro without further Euro country fiscal integration destroyed market pricing mechanism. Borrowing at lower rate may not necessary be a good thing. Peripheral euro zone countries, especially Greek, were borrowing cheap and misused this money to live beyond their means and gradually became dependent on credit from abroad. Once this credit flow stops, the stage was set for crisis.
Common currency also generated trade imbalance within the euro zone. Because lack of domestic demand and low return from domestic investment, Euro zone core countries (such as German, France) increasingly investing abroad. The peripheral euro zone became more attractive to invest, because that euro was backed by all the Euro zone countries; the risk of default was diminished. In addition, in order to create demand, with global easy credit condition, the Euro zone core countries have incentive to keep lending money to peripheral euro zone countries which use this money to continuously import and consume goods or service from core countries, even when these peripheral economy may not afford this level of consumption. As the result, core countries constantly run current account surplus. On the other side, peripheral euro zone countries run current account deficits. Furthermore, as the result of constantly lending to peripheral euro zone countries, core countries held large sum of peripheral euro zone countries government bonds. This heavy exposure explains why Euro zone debt crisis spreads across the area.
Peripheral euro zone countries’ domestic imbalance and fiscal profligacy
Though crisis strikes the whole euro zone and rattles global financial system, it has risen substantially in only a few euro zone countries – Peripheral euro zone countries. Examining countries specific imbalances is a crucial step to help identifying the cause of crisis and finding the solution.
Greece and Italy share similar domestic precondition – irresponsible politicians and fiscal profligacy. As we discussed before, during 2002-2008 period, abundant hot money are available on the global financial market and peripheral euro zone countries were able to borrow at cheaper rate. As the result, almost all peripheral euro zone countries ran current account deficit and there were constant capital inflows into these countries. Gradual capital inflow normally is good for the recipient country. For example, it can be used as the investment to finance the manufacturing project to increase the productivity, to subside education system to raise the human capital and enhance country’s competitiveness or support any other wealth creating activity. In the long run or even medium term, country should see domestic output increase, in turn; it will lead to sustainable growth and gradually minimize the current account deficit. More important, the country will have better position in the global competition and be able to weather all kinds of external financial shock.
However, Greece and Italy didn’t follow this optimal path. Instead, irresponsible politicians used external capital to finance consumption and fund expensive populist policies by increasing pensions and wage, hiring more public sector workers, offering lavishing social benefits. All these fiscal profligacy practices lead to short term higher employment rate , better country welfare level , and of course politicians’ election victory. However, all these practices cannot last without further net external capital inflow.
Ireland and Spain financed domestic excessive consumption through another channel: property bubble. For example, in Spain, house price more than doubled during the period from 200 to 2006. The construction industry boomed and created extra employment. More and more external money were injected into the overheated real estate market by banks through loans and mortgages. The whole local economy boomed to the unsustainable level. When the bubble busted, the banking industry was bailed out by the government.
All in all, Peripheral euro zone countries were borrowing cheap external money and injected these short term money into the domestic economy from different channel (irresponsible fiscal spending or excessive loan mortgage lending). Through these practices, Peripheral euro zone countries were able to live above their means .Even worse; domestic economy structure adjusted accordingly and became addict to the cheap external money inflow.
Last straw – Credit crunch caused by US financial crisis and outside contagion
The last straw that broke the camel’s back was the credit crunch caused by US financial crisis. This financial crisis started in US and quickly spread across world. Due to the panic caused by crisis and loss of investor confidence, credit crunch became the inevitable result: a significant reduction of available loan and tighten conditions required to obtain a loan.
Due to peripheral euro zone countries’ domestic imbalance, their financial conditions worsen very fast. First, during the crisis period almost all hot money flee to the safe haven, such as US Treasury bond, German government bond. Riskier assets became less attractive even with higher return. In addition, the creditors suddenly found peripheral euro zone countries’ bonds were not as safe as they assumed before and demanded very higher risk premium for peripheral euro zone sovereign debit. Secondly, US financial crisis also impaired the global economy and international trade; both peripheral euro zone countries’ domestic output and export decreased. Last but not least, peripheral euro zone countries still have to finance the lavishing social program and serviced the pre-existing debt. Therefore these countries’ pre crisis public debt may not significant compare to GDP, but it accumulated to large sum in a very short time period. More important, because of credit crunch, Peripheral euro zone countries’ bond yield increased to unsustainable level, it became hard to service the debt in the bond market. Soon these countries became insolvent.
At this stage only three countries were under water, Greece, Ireland and Portugal, which only account for 6% of the euro zone GDP. However, many external banks and creditors held large sum of peripheral euro zone countries’ bonds. If peripheral euro zone countries went under, this event may threaten external banks and creditors’ solvency. As the result, Euro zone debt crisis spread across the global financial system.
After the Sovereign Debt Crisis hit in 2009, EU have acted swiftly to tackle the crisis. On May 9 2010, EU approved a rescue package: European Financial Stability Facility (EFSF ) worth €750 billion to insure financial stability across Europe. When the crisis intensified, in Oct 2011 and Feb 2012, European leaders agreed on that banks and private investors would accept a 53.5% write off of Greek debt. In addition, EFSF will be increased to €1 trillion and European banks have to achieved 9% capitalization to weather the future financial shock. However, after all these measurements, Euro zone debt crisis is still an ongoing financial crisis; global financial market still experienced very high level volatility.
In order to find feasible solution to calm the market and restore the confident, “Which party should hold accountable for this crisis” may be the ultimate question to ask.
Clearly banks should not be blamed for their huge holdings of peripheral euro zone sovereign debt. Just as Milton Friedman (1970 p.6) stated that “there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” Banks may hold peripheral euro zone sovereign debt as long as this is legal and compile with regulation. Capitalism will not succeed as a system, if banks or other businesses are bounded by vaguely defined “social responsibility”. In order to maximize the profit, banks will certainly pursue the asset with high return at low cost. Due to the perception that country is more financially sound than Corporation, the capital requirement for corporate loan was 8%, but for peripheral euro zone sovereign debt only 1.6%.Therefore it was huge advantage for bank to hold these debts and there was no regulatory requirement to limit the amount of this holding.
Corrupt peripheral euro zone politician may hold responsible for the crisis. But their greedy, selfish and financial irresponsible practices are also not the root cause of the crisis. It is hard to imagine that, during the period 2002-2008, any peripheral euro zone politician would challenge the populist policies and stop the whole nation lived beyond their means using external money. Even, by accident, any government suddenly wants to change the practice. Clearly this authority would not survive next election. Lesson learned by next government, who would certainly resume the course which leaded to current crisis.
Premature Euro Implementation
After joined the Euro zone, peripheral euro zone countries could borrow at cheaper rates from global financial market. Without tight fiscal integration, it is hard to prevent individual Euro zone country implementing fiscal irresponsible policy, which clearly caused current crisis and will lead to future ones, if leave it unchecked. Therefore, premature Euro implementation without further fiscal integration is the root cause of current crisis.
Short term solution and Long term complete solution
Creating a European Fiscal compact to hold each participating country responsible for balanced budget is the only complete solution for the crisis. However, this compact needs all Euro zone country parliament approval. No doubt this democratic process will take long time to complete. Even worse, this goal may not be achieved without urgency of imminent devastating crisis.
Considering that it may takes Euro zone countries years or even decades to negotiate, approve and finally implement this European Fiscal compact, this can only be the long term solution. EU and IMF need more credible short solution to deal with current on-going crisis.
As many economists and policy makers already agreed, “Orderly default” will be the best result for Greece, because the current austerity measures are impairing its economy and eliminating any possibility for future growth. In addition, Greek current or future government‘s ability to implement the austerity measurement is open to doubt. Greece may even consider return to its own currency. Greece may experience severe pain at the beginning: hyperinflation, high unemployment rate or devaluation of new currency. But it may be the only way for Greece to complete social restructuring, regain the competitive edge and restore growth.
The most challenging task for EU and IMF is to build the firewall to contain Greek shock from spreading and buy time for long term solution – implementing a comprehensive a European Fiscal compact.
1. Haidar, Jamal Ibrahim, 2012. “Sovereign Credit Risk in the Eurozone,” World Economics, World Economics, vol. 13(1), pages 123-136, March
2. George Matlock (16 February 2010). “Peripheral euro zone government bond spreads widen”. Reuters.
3. How the Euro Became Europe’s Greatest Threat”. Der Spiegel. 20 June 2011.
4. Nouriel Roubini (28 June 2010). “Greece’s best option is an orderly default”. Financial Times.
5. “Pondering a Dire Day: Leaving the Euro”. New York Times. 12 December 2011.
6. “Greece bailout: six key elements of the deal”. The Guardian. 21 February 2012.
7. “Eurozone crisis and Greek default –summary and suggestion”. Vuk Vukovic, 22 October 2011.
8. “The Eurozone debt crisis: a second wave of the global crisis?”.SESRIC ,January-June 2011
9. “Ireland set for strong recovery after bail-out”. 2 September 2011.
10. “Deconstructing Europe: How A €20 Billion Liquidity Crisis Is Set To Become A €1.6 Trillion Funding Crisis”. Zero Hedge. 9 February 2010.
11. “The golden amendment”, Economist.
12. “Eurozone debt web: Who owes what to whom?”. BBC News. 18 November 2011.
13. Wearden, Graeme; Kollewe, Julia (17 May 2010). “Euro hits four-year low on fears debt crisis will spread”. The Guardian (UK).
14. “ECB announces measures to support bank lending and money market activity”. 2011-12.
15. “Eurozone crisis live: ECB to launch massive cash injection”. The Guardian. 29 February 2012.
16. “The fiscal compact ready to be signed”. European Commission. 31 January 2012.
17. “Europe Agrees to Basics of Plan to Resolve Euro Crisis”. Associated Press. 21 November 2011.
18. “Back to Mesopotamia?: The Looming Threat of Debt Restructuring”. Boston Consulting Group. 23 September 2011.
19. “How the Euro Zone Ignored Its Own Rules”. Der Spiegel. 6 Oct 2011.