Eurozone crisis

In addition to the following text, this article comprises:      - a country-by-country summary of the development of the crisis;      - links to contemporary reports of the main events of the crisis;      - brief profiles of the principal actors;      - notes on the debt trap, the eurozone's departures from optimum currency area criteria, on the eurozone's policy options; and,      - tabulations of the fiscal characteristics of the PIIGS countries and their GDP growth rates It was last updated on 06 November 2011

The eurozone crisis started in 2010 when doubts about the ability of the Greek government to service its debt made bond market investors reluctant to buy its bonds, and those of several other eurozone governments. The series of rescue packages that were provided in the course of 2010 and 2011 failed to reassure investors, and in October 2011 an agreement was reached which excused the Greek government of half of its debt and increased the eurozone's capacity to provide financial assistance to its member governments.

Overview

The crisis started early in 2010 with the revelation that, without external assistance, the Greek government would be forced to default on its debt. The rescue measures that were initially adopted by the other eurozone governments took the form of conditional loans that enabled the Greek government to continue to roll-over its maturing debts. In the course of 2010, however, investors' fears of sovereign default by other eurozone governments increased their cost of borrowing, and further conditional loans had to be provided to the governments of Ireland and Portugal. The crisis deepened when, in the latter half of 20ll, it became evident that a default by the Greek government could no longer be avoided. Awareness that such a default could threaten the existence of the eurozone, and administer a shock to the world economy, prompted the urgent consideration of other policy options. On October 26 2011, after prolonged negotiations, a rescue plan was agreed, involving a 50 per cent write-off of the Greek government's debt; the recapitalisation of eurozone banks; and an increase in the effective size of the European Financial Stability Facility.

Background to the crisis

The eurozone

Membership

In 1991, leaders of the 15 countries that then made up the European Union, set up a monetary union with a single currency. There were strict criteria for joining (including targets for inflation, interest rates and budget deficits), and other rules that were intended to preserve its members' fiscal sustainability were added later. No provision was made for the expulsion of countries that did not comply with its rules, nor for the voluntary departure of those who no longer wished to remain, but it was intended to impose financial penalties for breaches.

Greece joined, what by then was known as the eurozone, in 2001, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009. The current membership comprises Belgium, Germany¸ Ireland, Greece, Spain, France, Italy, Cyprus, Luxembourg, Malta, The Netherlands, Austria, Portugal, Slovenia, Slovakia, and Finland. Bulgaria, Czech Republic.

The non-members of the eurozone among members of the European Union are Denmark, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, Sweden and the United Kingdom.

The Stability and Growth Pact

The Stability and Growth Pact that was introduced as part of the Maastricht Treaty in 1992, set arbitrary limits upon member countries' budget deficits and levels of public debt at 3 per cent and 60 per cent of gdp respectively.

Following multiple breaches of those limits by France and Germany, the pact has since been renegotiated to introduce the flexibility necessary to take account of changing economic conditions. Revisions introduced in 2005 relaxed the pact's enforcement procedures by introducing "medium-term budgetary objectives" that are differentiated across countries and can be revised when a major structural reform is implemented; and by providing for abrogation of the procedures during periods of low or negative economic growth . A clarification of the concepts and methods of calculation involved was issued by the European Union's The Economic and Financial Affairs Council in November 2009 which includes an explanation of its excessive deficit procedure. According to the Commission services 2011 Spring forecasts, the government deficit exceeded 3% of GDP in twenty-two Member States in 2010.

It is not certain what was envisaged concerning the treatment of governments that could not meet their financial obligations. Article 104 of the Maastricht treaty appeared to forbid any financial "bail-out" of member governments, but article 103 of the treaty appeared to envisage circumstances under which a bail-out would be permitted.

The European Financial Stability Facility

In May 2010, the Council of Ministers established a Financial Stability Facility (EFSF) to assist eurozone governments in difficulties "caused by exceptional circumstances beyond their control". It was empowered to raise up €440 billion by issuing bonds guaranteed by member states . It was to supplement an existing provision for loans of up to €60 billion by the European Financial Stability Mechanism (EFSM), and loans by the International Monetary Fund. Proposals to leverage the €440 billion by loans from the European Central Bank were not authorised until October 2011. The EFSF and the EFSM are to be replaced in 2013 by a permanent crisis resolution regime, to be called the European Stability Mechanism (ESM)

The PIIGS

The economies of five of the eurozone countries (Portugal, Italy, Ireland, Greece and Spain) differed in several respects from those of the others. Unlike most of the others, they had developed deficits on their balance of payments current accounts (largely attributable to the effect of the euro's exchange rate upon the competitiveness of their exports). Deleveraging of corporate and household debt had amplified the effects of the recession to a greater extent - especially in those with larger-than-average financial sectors, and those that had experienced debt-financed housing booms. In common with the others, they had developed cyclical deficits under the action of their economies' automatic stabilisers and of their governments' discretionary fiscal stimuli, and increases in existing structural deficits as a result of losses of revenue-generating productive capacity. In some cases, their budget deficits had been further increased by subventions and guarantees to distressed banks.

The development of the crisis

The Greek crisis

In April 2010, the Greek government faced the prospect of being unable to fund its maturing debts, and later that year, the Irish government found itself in a similar position. Their problems arose from large increases in their sovereign spreads reflecting the bond market's fears that they might default - fears that were based upon both their large budget deficits, and their limited economic prospects. In May 2010, the Greek government was granted a €110 billion rescue package, and in November 2010 the Irish government was granted an €85 billion rescue package, both financed jointly by the eurozone governments and the IMF. Further increases in spreads showed that those rescue packages had failed to reassure the markets. Further support packages also failed to solve the problem.

We are experiencing an episode in the history of the world which is very very special. It is the gravest financial crisis, economic crisis, since World War II, so it is something which is big. It is big in Europe, it is big in the US, big in Japan, big in the rest of the world. European Central Bank President Jean-Claude Trichet 30th August 2011[1]

"We are now facing the greatest challenge our Union has ever seen... This is a financial, economic and social crisis, but also a crisis of confidence with respect to our leaders in general, to Europe itself, and to our ability to find solutions." José Manuel Durão Barroso President of the European Commission State of the Union Address, 28 September 2011

The eurozone crisis

Signs began to appear of the contagion of the bond market fears from Greece to other eurozone countries, particularly Portugal and Spain. Portugal received an EU/IMF rescue package in May 2011, and Greece was assigned a second package in July, neither of which restored the bond market's confidence in eurozone sovereign debt. There was a dramatic increase in measures of the market assessment of default risk, implying a 98 per cent probability of a Greek government default. Also in 2011, there was a major decline in confidence in eurozone banks, following rumours that losses on Greek bonds had left them undercapitalised. What had started as a Greek crisis was developing into a eurozone crisis because the rescue packages that could be needed for the much bigger economies of Spain or Italy were expected to be larger than the eurozone could afford. It was also acquiring the potential to trigger a second international financial crisis because the default of a European government might be expected to create a shock comparable to the failure of the Lehman Brothers bank that had triggered the crash of 2008. The falls in world stock market prices that occurred in August and September of 2011 were widely attributed to fears of a eurozone-generated financial crisis. During September and October 2011 there were negotiations involving eurozone governments, the European Central Bank and the Institute for International Finance representing the world's major banks. Agreement was sought to bring about a reduction in the Greek government's debt, the recapitalisation of some European banks and an increase in the funds available to the European Financial Stability Facility . Objections were raised by the German , and the Dutch governments, and others, but an agreement in general terms was finally reached on 26th October 2011.

The policy response of October 2011

Overview

"We want Greece to remain in the Euro. At the same time, Greece must decide whether it is ready to take the commitments that come with Euro membership" José Manuel Durão Barroso President of the European Commission. Remarks following the G20 Summit Joint EU Press Conference Cannes, 4 November 2011

Restructuring the Greek debt

On the 26th of October 2011, at a European Union summit, a further rescue package was agreed, that included a 50 percent write-off of the Greek government's debt and a further €130 billion loan. (Provision was also agreed for the recapitalisation of eurozone banks and an increase in the capacity of the European Financial Stability Facility . The Greek government responded by calling a referendum to enable the Greek people to decide whether to accept the terms of the associated austerity package. At an emergency summit on 2nd November, Greek Prime Minister Papandreou was persuaded by French President Sarkozy and German Chancellor Merkel that the subject of the referendum should be whether Greece should remain within the eurozone, rather than his proposed question concerning the rescue package. It was decided that the €8 billion tranche of the EU/IMF loan that is needed to avoid a default in December would be withheld until after the referendum. Jean-Claude Juncker, the Chairman of the Eurogroup of eurozone Finance Ministers indicated that preparations for the exit of Greece from the eurozone were in hand. Prime Minister Papandreou is reported to have obtained the ageement of opposition leaders to the cancellation of the referendum, for which confirmation was obtained by a vote of confidence on 4th November.

International repercussions

One consequence of a default by the Greek government would be a loss of capital by those banks that have holdings in Greek bonds. The Bank for International Settlements puts French banks' total liabilities in Greece at $56 billion and Germany's at $24 billion. That loss might reduce their capital adequacy ratios to below the minimum considered prudent, in which case, the banks may be expected to restrict lending, raising the prospect of a widespread credit crunch. (It is even possible that both those consequences could result from the anticipation of a default). The eurozone's failure to rescue Greece might also reduce the market's confidence in the bond issues of other eurozone governments. That might trigger an iterative process which could lead to a default by the government of a larger eurozone country, and result in an economic shock large enough to generate another global financial crisis