(Article) European Debt Crisis: A New Fear of Collapse

European Debt Crisis: A New Fear of Collapse

Fears of a sovereign debt crisis developed In early 2010 concerning some countries in Europe including: Greece, Ireland, Spain, and Portugal. This led to a crisis of confidence as well as the widening of bond yield spreads and risk insurance on credit default swaps between these countries and other EU members, most importantly Germany.

Concern about rising government deficits and debt levels across the globe together with a wave of down grading of European Government debt has created alarm on financial markets. The debt crisis has been  mostly centred on recent events in Greece, where there is concern about the rising cost of financing  government debt. On 2 May 2010, the Euro zone countries and the International Monetary Fund agreed to a €110 billion loan for Greece, conditional on the implementation of harsh Greek austerity measures. On 9 May 2010, Europe's Finance Ministers approved a comprehensive rescue package worth almost a trillion dollars aimed at ensuring financial stability across Europe.


The Greek economy was one of the fastest growing in the euro zone during the 2000s; from 2000 to 2007 it grew at an annual rate of 4.2% as foreign capital flooded the country. A strong economy and falling bond yields allowed the government of Greece to run large structural deficits. According to an editorial published by the Greek newspaper Kathimerini, large public deficits are one of the features that have marked the Greek social model since the restoration of democracy in 1974.

After the removal of the right leaning military junta, the government wanted to bring disenfrachised left leaning portions of the population into the economic mainstream. In order to do so, successive Greek governments have, among other things, run large deficits to finance public sector jobs, pensions, and other social benefits. Initially currency devaluation helped finance the borrowing. After the introduction of the euro Greece was initially able to borrow due the lower interest rates government bonds could command. Since the introduction of the Euro, debt to GDP has remained above 100%. The global financial crisis that began in 2008 had a particularly large effect on Greece. Two of the country's largest industries are tourism and shipping, and both were badly affected by the downturn with revenues falling 15% in 2009.

To keep with in the monetary union guidelines, the government of Greece has been found to have consistently and deliberately misreported the country's official economic statistics. In the beginning of 2010, it was discovered that Greece had paid Goldman Sachs and other banks hundreds of millions of dollars in fees since 2001 for arranging transactions that hid the actual level of borrowing. The purpose of these deals made by several subsequent Greek governments was to enable them to spend beyond their means, while hiding the actual deficit from the EU overseers.

In 2009, the government of George Papandreou revised its deficit from an estimated 6% (or 8% if a special tax for building irregularities were not to be applied) to 12.7%. In May 2010, the Greek government deficit was estimated to be 13.6% which is one of the highest in the world relative to GDP. Greek government debt was estimated at €216 billion in January 2010. Accumulated government debt is forecast, according to some estimates, to hit 120% of GDP in 2010. The Greek government bond market is reliant on foreign investors, with some estimates suggesting that up to 70% of Greek government bonds are held externally. Estimated tax evasion costs the Greek government over $20 billion per year.

Despite the crisis, Greek government bond auctions have all been over-subscribed in 2010 (as of 26 January). According to the Financial Times on 25 January 2010, "Investors placed about €20bn ($28bn, £17bn) in orders for the five-year, fixed rate bond, four times more than the (Greek) government had reckoned on." In March, again according to the Financial Times, "Athens sold €5bn (£4.5bn) in 10-year bonds and received orders for three times that amount."

Downgrading of Debt

On 27 April 2010, the Greek debt rating was decreased to 'junk' status by Standard& Poor's amidst fears of default by the Greek government. Yields on Greek government two-year bonds rose to 15.3% following the downgrading. Some analysts question Greece's ability to refinance its debt. Standard & Poor's estimates that in the event of default investors would lose 30–50% of their money. Stock markets worldwide declined in response to this announcement.

Following down gradings by Fitch, Moody's and S&P, Greek bond yields rose in 2010, both in absolute terms and relative to German government  bonds. Yields have risen, particularly in the wake of successive ratings downgrading. According to the Wall Street Journal "with only a handful of bonds changing hands, the meaning of the bond move isn't so clear." As of 6 May 2010, Greek 10- year bonds were trading at an effective yield of 11.31%.

On 3 May 2010, the European Central Bank suspended its minimum threshold for Greek debt "until further notice", meaning the bonds will remain eligible as collateral even with junk status. The decision will guarantee Greek banks' access to cheap central bank funding, and analysts said its hould also help increase Greek bonds' attractiveness to investors. Following the introduction of these measures the yield on Greek 10-year bonds fell to 8.5%, 550 basis points above German yields, down from 800 basis points earlier.

Austerity and Loan Agreement

On 5 March 2010, the Greek parliament passed the Economy Protection Bill, expected to save €4.8 billion through a number of measures including public sector wage reductions. Passage of the bill occurred amid widespread protests against government austerity measures in the Greek capital, Athens. On 23 April 2010, the Greek government requested that the EU/IMF bailout package be activated. The IMF has said it was "prepared to move expeditiously on this request". Greece needs some of the money before 19 May, when it faces a debt roll over of $11.3bn. On 2 May 2010, a loan agreement was reached between Greece, the other euro zone countries, and the International Monetary Fund. The deal consists of an immediate €45 billion in low interest loans to be provided in 2010, with more funds available later. A total of €100 billion has been agreed. The interest for the Euro zone loans is 5%, considered to be a rather high level for any bailout loan. The government of Greece agreed to impose a fourth and final round of austerity measures.

These include:

  • Public Sector limit introduced of €1,000 to biannual bonus, abolished entirely for those earning over €3,000 a month.
  • Cuts of 8% on public sector allowances and 3% pay cut for DEKO (public sector utilities) pay cheques.
  • Freeze on increases in public sector wages for three years.
  • Limit of €800 to 13th and 14th month pension installment. Abolished for those pensioners receiving over €2,500 a month.
  • Return of special tax (LAFKA) on high pensions.
  • Changes planned to the laws governing layoffs and overtime pay.
  • Extraordinary taxes on company profits.
  • Increases in VAT to 23%, 11% and 5.5%.
  • 10% rise in taxes on alcohol, cigarettes, and fuels.
  • 10% increase in luxury taxes.
  • Equalisation of men's and women's pension age limits.
  • General pension age does not change but a mechanism is introduced to scale them to life expectations changes.
  • Creation of a financial stability fund.
  • Average retirement age for public sector workers increased from 61 to 65.
  • Public-owned companies to diminish from 6,000 to 2,000.

On 5 May 2010, a national strike was held in opposition to the planned spending cuts and tax increases. Protest on that date was widespread and turned violent in Athens, killing three people and injuring dozens.

According to research published on 5 May 2010, by Citibank, the EMU loans will be pari passu and not senior like those of the IMF. In fact the seniority of the IMF loans themselves has no legal basis but is respected nonetheless. The amount of the loans will cover Greece's funding needs for the next three years (estimated at 30bn for the rest of 2010 and 40bn each for 2011 and 2012). Citibank finds the fiscal tightening "unexpectedly tough". It will amount to a total of €30 billion (i.e. 12.5% of 2009 Greek GDP) and consist of 5 pp of GDP tightening in 2010 and a further 4 pp tightening in 2011.

Danger of Default

Without a bailout agreement, there was a possibility that Greece would have been forced to default on some of its debt. The premiums on Greek debt had risen to a level that reflected a high chance of a default or restructuring. One analyst gave a 80 to 90% chance of a default or restructuring. Martin Feldstein called a Greek default "inevitable." A default would most likely have taken the form of a restructuring where Greece would pay creditors only a portion of what they were owed, perhaps 50 or 25 percent. This would effectively remove Greece from the euro, as it would no longer have collateral with the European Central Bank. It would also destabilise the Euro Inter bank Offered Rate, which is backed by government securities. Since Greece is on the euro, it cannot print its own currency. This prevents it from inflating away a portion of its obligations or otherwise stimulating its economy with monetary policy.

For example, the U.S. Federal Reserve expanded its balance sheet by over $1.3 trillion since the global financial crisis began, essentially printing new money and injecting it into the system by purchasing outstanding debt.

The overall effect of Greece being forced off the euro, would itself have been small for the other European economies. Greece represents only 2% of the euro zone economy. The more severe danger is that a default by Greece will cause investors to lose faith in other Euro zone countries. This concern is focused on Portugal and Ireland, all of whom have high debt and deficit issues. Italy also has a high debt, but its budget position is better than the European average, and it is not considered amongst the countries most at risk.

Recent rumours raised by speculators about a Spanish bail-out were dismissed by Spanish President Mr. Zapatero as "complete insanity" and "intolerable". Spain has a comparatively low debt amongst advanced economies, at only 53% of GDP in 2010, more than 20 points less than Germany, France or the US, and more than 60 points less than Italy, Ireland or Greece, and it doesn't face a risk of default. Spain and Italy are far larger and more central economies than Greece, both countries have most of their debt controlled internally, and are in a better fiscal situation than Greece and Portugal, making a default unlikely unless the situation gets far more severe.

Objections to Proposed Policies

The crisis is seen as a justification for imposing fiscal austerity on Greece in exchange for European funding which would lower borrowing costs for the Greek government. The negative impact of tighter fiscal policy could offset the positive impact of lower borrowing costs and social disruption could have a significantly negative impact on investment and growth in the longer term. Joseph Stiglitz has also criticised the EU for being too slow
to help Greece, insufficiently supportive of the new government, lacking the will power to set up sufficient "solidarity and stabilisation framework" to support countries experiencing economic difficulty, and too deferential to bond rating agencies.

An alternative to the bailout agreement, would have been Greece leaving the Euro zone. Wilhelm Hankel, professor emeritus of economics at the University of Frankfurt am Main suggested in an article published in the Financial Times that the preferred solution to the Greek bond 'crisis' is a Greek exit from the euro followed by a devaluation of the currency. Fiscal austerity or a euro exit is the alternative to accepting differentiated government bond yields within the Euro Area. If Greece remains in the euro while accepting higher bond yields, reflecting its high government deficit, then high interest rates would dampen demand, raise savings and slow the economy. An improved trade performance and less reliance on foreign capital would result.

EU Emergency Measures

On 9 May 2010, Europe's Finance Ministers approved, in an emergency meeting, a rescue package that could provide 750 billion Euros for crisis aid aimed at ensuring financial stability across Europe.

The package announced has three components: The first part expands a €60 billion (US$70 billion) Euro group's stabilisation fund (European Financial Stabilization mechanism). Countries will be able to draw on that fund but activation will be subject to strict conditionalities. It is intended to help any member of the euro zone that is struggling to finance its debts because of high interest rates demanded by the financial markets. All EU countries contribute to this fund on a pro-rata basis, whether they are euro zone countries or not.

The second part worth €440 billion (US$570 billion) consists of government-backed loans to improve market confidence. The loans will be issued by a Special purpose vehicle (SPV) managed by the Commission and backed by the explicit guarantee of the EMU member states and the implicit guarantee of the European Central Bank. All euro zone economies will participate in funding this mechanism, while other EU members can choose whether to participate.

Sweden and Poland have agreed to participate, while the UK's refusal prompted strong criticism from the French government, along with a threat that euro zone countries would not support the pound in the case of speculative attacks. Denmark will not contribute despite its participation in the European Exchange Rate Mechanism.

Finally the third part consists of €250 billion (US$284 billion), half the size of the EU participation, with additional contribution from the International Monetary Fund.

The agreement also allowed the European Central Bank to start buying government debt which is expected to reduce bond yields. (Greek bond yields fell from over 10% to just over 5%; Asian bonds also fell with the EU bailout.)

The ECB has also announced a series measures aimed at reducing volatility in the financial markets and at improving liquidity:

First, it began open market operations buying government and private debt securities. Second, it announced two 3-month and one 6- month full allotment of Long Term Refinancing Operations (LTRO's).

Thirdly, it reactivated the dollar swap lines with Federal Reserve support.

Subsequently, the member banks of the European System of Central Banks started buying government debt.

Stocks worldwide surged after this announcement as fears that the Greek debt crisis would spread subsided, some rose the most in a year or more. The Euro made its biggest gain in 18 months, before falling to a new four-year low a week later. Commodity prices also rose following the announcement. The dollar Libor held at a nine-month high. Default swaps also fell. The VIX closed down a record almost 30%, after a record weekly rise the preceding week that prompted the bailout.

Despite the moves by the EU, the European Commissioner for Economic and Financial Affairs, Olli Rehn, called for "absolutely necessary" deficit cuts by the heavily indebted countries of Spain and Portugal. Private sector bankers and economists also warned that the threat from a double dip recession has not faded. Stephen Roach, chairman of Morgan Stanley Asia, warned about this threat saying "When you have a vulnerable post-crisis economic recovery and crises reverberating in the aftermath of that, you have some very serious risks to the global business cycle.

" Nouriel Roubini said the new credit available to the heavily indebted countries did not equate to an immediate revival of economic fortunes: "While money is available now on the table, all this money is conditional on all these countries doing fiscal adjustment and structural reform."

After initially falling to a four-year low early in the week following the announcement of the EU guarantee packages, the euro rose as hedge funds and other short-term traders unwound short positions and carry trades in the currency.

Long-Term Solutions

European Union leaders have made two major proposals for ensuring fiscal stability in the long term. The first proposal is the creation of a common fund responsible for bailing out, with strict conditions,  an EU member country. This reactive tool is sometimes dubbed as the European Monetary Fund by the media. The second is a single authority responsible for tax policy oversight and government spending coordination of EU member countries. This preventive tool is dubbed the European Treasury. The monetary fund would be supported by EU member governments, and the treasury would be supported by the European Commission.

However, strong European Commission oversight in the fields of taxation and budgetary policy and the enforcement mechanisms that go with it have been described as infringements on the sovereignty of euro zone member states and are opposed by key EU nations such as France and Italy, which could jeopardise the establishment of a European Treasury.

Some think-tanks such as the CEE Council have argued that the predicament some EU countries find themselves in is the result of a decade of debt fueled Keynesian policies pursued by local policy makers and complacent EU central bankers, and have recommended the imposition of a battery of corrective policies to control public debt. Some senior German policy makers went as far as to say that emergency bailouts should bring harsh penalties to EU aid recipients such as Greece.

Others argue that an abrupt return to "non- Keynesian" financial policies is not a viable solution and predict the deflationary policies now being imposed on countries such as Greece and Spain might prolong and deepen their recessions. The Economist has suggested that ultimately the Greek "social contract," which involves "buying" social peace through public sector jobs, pensions, and other social benefits, will have to be changed to one predicated more on price stability and government restraint if the euro is to survive. As Greece can no longer devalue its way out of economic difficulties it will have to more tightly control spending than it has since the inception of the Third Hellenic Republic.

Regardless of the corrective measures chosen to solve the current predicament, as long as cross border capital flows remain unregulated in the Euro Area, asset bubbles and current account imbalances are likely to continue. For example, a country that runs a large current account or trade deficit (i.e., it imports more than it exports) must also be a net importer of capital; this is a mathematical identity called the balance of payments. In other words, a country that imports more than it exports must also borrow to pay for those imports. Conversely, Germany's large trade surplus (net export position) means that it must also be a net exporter of capital, lending money to other countries to allow them to buy German goods. The 2009 trade deficits for Spain, Greece, and Portugal were estimated to be $69.5 billion, $34.4B and $18.6B, respectively ($122.5B total), while Germany's trade surplus was $109.7B. A similar imbalance exists in the U.S., which runs a large trade deficit (net import position) and therefore is a net borrower of capital from  broad. Ben Bernanke warned of the risks of such imbalances in 2005, arguing that a "savings glut" in one country with a trade surplus can drive capital into other countries with trade deficits, artificially lowering interest rates and creating asset bubbles.

A country with a large trade surplus would generally see the value of its currency appreciate relative to other currencies, which would reduce the imbalance as the relative price of its exports increases. This currency appreciation occurs as the importing country sells its currency to buy the exporting country's currency used to purchase the  goods. However, many of the countries involved in the crisis are on the Euro, so this is not an available solution at present. Alternatively, trade imbalances might be addressed by changing consumption and savings habits. For example, if a country's citizens saved more instead of consuming imports, this would reduce its trade deficit.

Likewise, reducing budget deficits is another method of raising a country's level of saving. Capital controls that restrict or penalize the flow of capital across borders is another method that can reduce trade imbalances. Interest rates can also be raised to encourage domestic saving, although this  benefit is offset by slowing down an economy and increasing government interest payments.

The suggestion has been made that long term stability in the euro zone requires a common fiscal policy rather than controls on portfolio investment. In exchange for cheaper funding from the EU, Greece and other countries, in addition to having already lost control over monetary policy and foreign exchange policy since the euro came into being, would therefore also lose control over domestic fiscal policy.

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