European Debt Crisis

Executive Summary

Background

In 2007, European economies were at their strongest in decades due to the favourable economic conditions at the time. The onset of the global financial crisis brought heavy and long lasting impacts on these economies. The main reasons for this down turn were connectivity and contagion of the financial systems, a drop in trade activities on a global scale and the effects of confidence and wealth on demand. Most of the losses initially originated from the American subprime crisis on mortgage. The global nature of most of Europe’s biggest insurance and banking corporations made them vulnerable to the American crisis. Year 2009 projections from the UK audit firm Ernst &Young showed that 51% of banks and 70% of insurance firms in 10 of Europe’s biggest economies had lost significant value with some institutions experiencing a deep of up to 96% in market capitalization.

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Introduction of the Euro currency had sparked economic growth in most of Europe’s less stable economies in an ‘economic boom’. Portugal, Greece and Ireland found their interest rates level with that of Germany and could now attract foreign investments and increase domestic demand whereas Germany had difficulties in matching domestic demand. The Euro enabled Germany to increase exports to countries like Greece. The economic boom had eroded external competitiveness as per capita labor costs rose. The stiffening of lending standards reduced wealth as asset prices fell and savings increased. Real GDP shrunk in 2009 by over 4% in the Eurozone resulting in recession.

Trade volumes in 2009 collapsed as trade intensive consumer and capital goods were critically affected. Deteriorations in government balances and public finance ensued as governments attempted to support the financial sector and improve aggregate demand. The resulting GDP deficits were 0.7% in 2007 and 6.2% in 2010; there was relief as the figures dropped to 5.5% in 2011.

Solutions

A Greek rescue package of 110 billion Euros was drafted in 2010 by the European Commission and IMF. It was later increased by 109 billion in 2011 in order to deal with the Greek debt crisis. After the Greek bailout, spreads against the German bond benchmark by Portuguese and Irish bonds had increased dramatically as costs of insurance against defaults also rose. Trade in Greek bonds in Wall Street had dropped sharply with only German bonds trading normally. Banks declined southern EU member bonds and markets were on the verge of freezing with imminent losses for financial institutions. The EU responded with a 750 billion Euro safety net to guarantee public debt. Another strategy was for the European systems of central banks to purchase struggling government bonds through the “securities market programme.” The ECB by October had invested 118 billion, with 42 billion Euros alone on Spanish and Italian bonds.

A treaty on 11th July 2011 established the ESM which was to be a permanent solution unlike the EFSF and ESFM which were temporary solutions. The ESM will be launched in 2013 and headquartered in Luxemburg and led by a Board of Governors. It will have an initial maximum of 500 billion Euros for lending and will only make interventions to ensure the stability of the entire Eurozone via adjustment programs and analysis on sustainability of public debt by a joint IMF and ECB panel before any involvement.

European Debt Crisis Background

In the year 2007, way before the beginning of the global financial crisis in 2008, European economies’ public finances throughout the Eurozone and the EU were at their strongest in decades due to the favourable conditions of the economy at the time (Nelson, Belkin & Mix, 2011). With the 2008/2009 proper onset of the global crisis, heavy and long lasting impacts to economic activities were experienced in EU member countries. The main reasons for this particular susceptibility of member economies occurred through a number of transmission channels. Three of the main ones were connectivity and contagion of the financial systems, a fall in trade activities on a global scale, and the effects of confidence and wealth on demand.

Most of the losses initially originated from the American sub-prime crisis on mortgages (Sesric Reports, 2011). Due to the global nature of most of Europe’s biggest insurance and banking corporations, most of these corporations ended up with very huge write-downs. In 2009 projections from financial firms such as UK’s audit firm Ernst &Young revealed that in 10 of Europe’s biggest economies, 51% of banks and 70% of insurance firms had eroded market confidence after they had lost significant value. The crisis was cutting so deep such that other financial institutions experienced a deep in market capitalization of up to 96% (Dadush, 2010).

It was the introduction of the Euro that startled the economic growth of most of Europe’s less stable economies in what was labeled as an ‘economic boom’. Countries such as Portugal, Italy, Greece and Ireland suddenly found their interest rates more or less level with those of the more stable economies such as those of Germany and Netherlands (Sesric Reports, 2011).

Whereas the less stable economies had a field day attracting foreign investments and substantially increasing domestic demand, the stable countries within the Eurozone had difficulties in matching up their domestic demand levels. On the upside, the common currency enabled the likes of Germany to increase their exports to countries such as Greece whose output in the production sector had plummeted as the Greek economy saw increases in the service sector. The economic boom eroded external competitiveness as per capita labor costs continually kept rising thus the solitary currency proved to be rather loose to the rapid growing economies of the likes of Greece and became very tight for Netherlands and Germany who had continued to struggle in their efforts to spur domestic demand.

The stiffening of lending standards that followed resulted in household wealth declines as asset prices fell dramatically and savings increased. The worst affected was the residential and real estate investments which caused a vicious cycle in inventory as a build up in involuntary stock gave way to further cuts on economic production. Real GDP shrunk in 2009 by over 4 percentage points throughout the EU and Eurozone. This in essence was the worst recession to be experienced in Europe, except Germany which still exhibited quarterly growth since the 2nd World War (Dadush, 2010). These GDP shrinkages continued to persist until 2010 when most economies started showing recovery. However, none of the economies reached their previous pre-crisis levels. There were countries that were so deep in the crisis such as Greece such that output contractions from the preceding year were still at over 7% while the Italian and Spanish growth levels were barely at positive levels, with Italy’s in fact showing shrinkages at about 1%.

The volume of trade in 2009, especially in the last quarter, in the Eurozone collapsed as investments in business and consumer products’ demand, which are both strongly trade intensive and credit dependent, dropped dramatically. What made this trade shrinkage much more intensive was the kind of products that were affected; it was the trade intensive consumer and capital goods whose demand and availability was critically affected. Sharp deteriorations in government balances and public finance ensured as the various European governments stepped in with a bid to support the financial sector and improve the aggregate demand for goods and services. The resulting GDP deficit figures were 0.7% in 2007 and they rose to an all time high of 6.2% in 2010. There was relief as the figure dropped to 5.5% during the first two quarters of 2011 (Dadush, 2010).

Greece

Of all European Union countries, Greece faces the greatest challenge as it faces the challenges of a very huge loss in competitiveness and continually rising massive debts which it continually struggles to get itself out of (Nelson, Belkin & Mix, 2011). Greece needs an orderly restructuring of its debt so that its creditors will be in a better position to deal with massive short falls. The major challenge facing the Greek’s attempts to recover from the downfalls is their tiny tax net, coupled with the inefficiencies of its informal economic sector. Before the solitary monetary unit within the European Union, Greece had an economy that was probably the worst in the Eurozone. The slowest GDP growth which was further compounded with the highest rates of inflation resulted in the Greek government accessing debt at the highest premiums within Europe. Adoption of the common currency appeared to solve these economic problems as within the period of 2000-2007 inflation stood at 3% from an all time high of over 18% between 1980 and 1995. Government long-term bonds dropped to about 40 basis points from a high of 1100. With the eventual stabilization of the economy, the country quickly became a very attractive hub for foreign investment capital. The net position of their foreign assets plummeted from a GDP figure of -5% in 1995 to about -100% GDP value in 2007. The influx of cheap foreign capital in the economy resulted in surges in domestic demand with account balances deteriorating in 1997 from -3.7% of GDP to a 2008 figure of -14.4% (Dadush, 2010).

Prices were driven up due to the growth in domestic demand relative to other European Union members which also resulted to a weakening of the countries competitiveness as unit labor costs in the domestic market soared. A closer look at the rest of Europe shows that the Greek consumer prices had since 1997 risen by 47% as opposed to the European average of 27% in the same period. This erosion in the country’s competitiveness led the IMF to give dire figures of the Greek effective currency exchange rate as being overvalued by between 20-30% (Dadush, 2010). The shift in economic dynamics from manufacturing to service sector resulted in the contribution of the manufacturing sector contribution to GDP falling to 2.5% between 1997 and 2007 while the service sector of construction in the same period experienced a growth of 2%. This growth in the service sector resulted in the price change rate of 1.3% in favor of services over goods while the average in the EU zone was at 0.6%.

The positive turn for these economic changes for Greece was that the rate of economic growth rose from a meager 1.1% per annum throughout 1980 to 1997 to an average rate of 4.1% between 1997 and 2007. These economic growth rates were among the fastest in the EU with GDP per capita rising from a 1995 figure of 39% to 71% in 2008. The increase in tax revenues saw the government increase expenditure in wages in the public sector and social transfer. Per capita government expenditure between 1997 and 2008 rose by 140% compared to an average Eurozone value of 40%. Spending on social transfer rose to 18.9% of the GDP in the same period, up from 13.9% while that on average for Europe dropped from 17.1% to 16.1%. The highest difference to EU numbers was however in employee per capita expenditure compensation where the 38% European average was eclipsed by a Greek value of a massive 112% (Dadush, 2010).

The onset of the global financial crisis revealed the Greeks soft underbelly. An economy that was averaging a 5% GDP growth between 2000 and 2007 was quickly exposed when growth dropped to 2% in 2008 and shrunk by a further 2% more in 2009. Drops in revenue from taxes drove the deficit to 13.6% in 2009 from a 7.7% rate in 2008. Based on the trend of the debt ballooning in 2007 from 96% of GDP to a rise of 115% in 2009, the IMF made projections that by 2012 the debt could stand at 150% under what it termed as “draconian fiscal measures” (Dadush, 2010). The fear that the Greek could not repay their debts quickly spread fears that other EU member nations who had vulnerable economies like Greece would soon follow suit and so IMF and EU leaders stepped in to attempt and reassure markets by giving pledges of support. Support of $145 billion was extended to the Greek government to ease the pressures on the economy by covering the government’s requirements for two years.

Italy

After the economic troubles experienced by Greece, the next question on the mind of many economic observers was whether Italy, a country with a public debt over six times that of Greece, would soon follow suit. Although the Italians dealt with their financial matters in a better way than Greece at the time of the crisis, they still had a very large percentage debt with competitiveness that had equally plummeted like the Greek ever since it took up the Euro (Economic and Financial Affairs, 2009). The Italian economy continued to be vulnerable in the continually uncertain economic times.

After the adoption of the Euro currency by Italy in 1999, its interest rates fell to within German levels which were the lowest rates in Europe at the time. House prices and consumer spending were to increase tremendously. The result of the lower interest rates was that Italy could now access credit at more competitive rates such that they were able to effectively reduce their debt and deficits (Dadush, 2010). The Italian debt fell by 10% of GDP during the period of 1999 to 2007, which represented a forward approach to the country dealing with debt. Despite the fact that between 2008 and 2009 Greece soured its deficits to twice that of Italy and saw its debt double per GDP share, Italy’s load of debt still remains similar to that of Greece.

Since the debt of Italy is of short maturity compared to other European countries, it needs to cut down on its 115% of GDP public debt and interest rates of nearly 4%. Italy is left with the daunting task of spending 4.5% of its GDP per annum just to cover the interest its public debt attracts (Economic and Financial Affairs, 2009). There is a fear that public revenues may not be able to pay for all the interest rates and government expenditure. Therefore, the country’s debt will only continue to rise in the future relative to the economy which experts have predicted will for seven years grow at a rate of 3%. For there to be a change in these debt levels, Italy’s primary balance must change and become surplus.

Italy managed to remain relatively safe during the 1990s through pension reform and moderating expenditure by increasing revenue via the implementation of temporary measures on tax thus avoiding a debt explosion (Dadush, 2010). These measures also helped the conservatively managed Italian financial institutions go through the financial crisis without needing to be bailed out by the government. The country as a whole also survived without needing fiscal stimulus enactments. Italy, unlike Greece did not attract a lot of foreign investment during its boom in the period between 1993 and 1999. As a result, it maintained an average deficit on current accounts of 1.6% of the GDP up until 2000 where as Greece saw averages of 9.1% between 2000 and 2009; the result of these figures is that the Italians ended up with a healthy net foreign debt compared to other countries in the Eurozone. The foreign markets rewarded Italy for their better management on their fiscal policy as spreads on government tenyear bonds rose higher in Greece compared to Italy with the difference becoming more visible with the continual of the Greek crisis.

In an effort to recap on the lost competitiveness that it has experienced, Italy who had a 32% unit labor cost figure between 2000 and 2009 attempted to keep its labor costs per unit flat during the previous decade to similar levels of Germany, where wages were at pace with the productivity. Italy however continued to struggle in the worldwide context as its competitive levels continued to drop against the world’s other heavy trading countries like Japan, China and USA. The problem with Italian trade in this aspect was the low growth precipitated by drops in ‘total factor productivity’ (Cembalest, 2011) which between 1996 up to 2004 had an average drop of close to 1% while that of Germany increased in the same ratio.

For the Italians to remain competitive in the Eurozone, they ought to take up a three-year plan in order to raise their primary balance to a minimum of 4% of GDP and adopt a real devaluation that will result to an eventual rise to 6% via structural reforms and wage cuts. Even though these actions may not be sufficient, they will still go a long way to maintain expansionary policies that will target the weaker Euro (Dadush, 2010). The country will need to eliminate the structural issues that have continued to hit the economy over the years in order to be more competitive worldwide. Issues such as inadequacies in the public sector, excessive and defective regulations, dual labor and market rigidity in labor, and the challenges of governance in Southern Italy have only been making things hard for Italy.

Germany

Germany being Europe’s biggest economy is without the best placed country that can be able to dig the entire continent out of the crisis that it finds itself in (Dadush, 2010). In order to understand German’s role in the European Union, it is very imperative to note how it came into being in a unified European currency federation in terms of the European Union. It is a fact that Germany’s competitiveness in global commerce has been on a downward trend ever since the adoption of the Euro as its currency. The journey towards Germany’s reemergence as a major political and economic power began with the reunification of the country. The challenge for the new nation was to unite its industrial superior west to the great potentials that lay in the east (Dullien & Schwarzer, 2011). This positive unification gave rise to huge structural reforms that contributed to exceptional moderations in wages. The culmination of these wage advantages put Germany in sole position to have the best consolidated labor cost per unit to all its new partners in the European Union. In East Germany, wages started to converge to those in the west despite there not being a similar convergence in overall productivity (Dadush, 2010). It was on this backdrop that between 1990 and 1995 there was a 17.6% hike in labor costs per unit as compared to an average European rise of just 11.5%. In an effort to boost the living standards throughout the nation, the services sector took more emphasis over exports. Thus between 1990 and 1995, there was a nearly 7% GDP rise in domestic demand while the share of exports in the GDP fell between 1991 and 1993.

The downside to this superiority is that growth in domestic demand and exports surged behind those of other major European economies such as Italy, France and Spain as its surplus bilateral trade with these countries widened. Unemployment levels in the East rose after the reunification from 4.2% to 8.2% in 1991 and 1994 respectively, with the export industry being the hardest hit (Economic and Financial Affairs, 2009). The government was forced to look into wage moderation via employee compensation which between 1993 and 2003 resulted to a 1% fall in GDP demands. Private sector started looking into other countries where costs of labor were cheaper. These forced labor demands down and collective bargaining with labor costs falling by 3.4% between 1995 and 2000. The fall in labor costs resulted in a rise in export quantities as between 1993 and 2000, contributions of exports value to the GDP rose from 22% to 33% despite a 3.4% worldwide drop in overall share.

The use of the Euro has over time increased Germany’s position as a major world economy by being cheaper compared to the Deutschmark, with conservative estimates by the European commission giving an undervalued 10-12% figure for the euro in 2009. This undervaluation resulted in increased demand for German products externally. Over the period of 1993 to 2008, a 14% rise in GDP figures reached an astounding 25% overall contribution by exports to GDP, larger than any country within the Eurozone. It did all this while other European countries focused inwardly in economies that were domestically driven and thus Germany effectively evolved to being the largest exporter in the world (Economic and Financial Affairs, 2009).

Portugal

The boom that Portugal experienced after adopting the euro currency, unlike other equally vulnerable economies in the Eurozone, was quick to fade (Economic and Financial Affairs, 2009). Before the inception of the Euro, the Portuguese GDP was growing at average annual rates of nearly 4%, which was among the highest rates in the entire EU, at over 1% the European average. Due to the fact that the Portuguese demand boom was not coupled by corresponding increases in supply potential but rather declines in rates of interests and fueled by fiscal policy expansion, the country soon ended up losing its competitiveness much earlier than most member states. Between 2001 and 2005 alone, the tremendous growth rates had dropped from the 4% highs to a meager average of 1% per annum (Cembalest, 2011).

Despite having better showings than Greece in public debt and budget deficit controls, Portugal’s Achilles heel comes from its poor growth prospects in the long-term, high private and public indebtedness. Its loss in competitiveness makes the Portuguese nation particularly susceptible. The country’s over reliance on Spain for its exports, nearly 25% of exports, also makes it vulnerable due to the Spanish nation also facing the same dire prospects (Dullien & Schwarzer, 2011). Portugal between 1991 and 1995 had interest rates at a high of 12.3%. However, these rates dramatically fell to nearly 6% between 1996 and 2000, thus effectively beginning the consumption boom in its markets. This boom gave observers optimism that the per capita GDP of Portugal, which was among the lowest in the Eurozone at nearly 0.6 that of Germany between 1985 and1995, would be able to rise and converge to the average EU levels at the time.

A 7% of GDP drop in private savings occurred during the period of 1995 and 2000 while the non-financial and household sector debt increased by nearly twice in GDP terms between the 1990s and 2002. These figures reflected the role that an external borrowing in the economy was financing investments and consumption. As a result the country’s deficit soared from almost 0% in 1995 to about 9% by the end of 2000 (Dadush, 2010). Despite the surge in tax revenues, a combination of pro-cyclical fiscal policies resulted to additions in expansionary conditions as primary balance dropped by nearly 3.5% of GDP during the 1995 to 2001 period. Unlike Spain, Greece and Ireland whom the adoption of European monetary policy resulted in housing booms in their economies, housing investments in GDP terms in Portugal declined as inflation dropped. The stalling of household spending, high debt levels and deteriorating prospects coupled with virtually little convergence in terms of per capita GDP saw to an end the consumption and investment boom.

The global recession did not affect Portugal as adversely as it did the other European economies that were equally vulnerable but still saw its GDP shrink by 2.7% in 2009. This slump in GDP saw unemployment rise to 10.7% in 2009 up from 8.7% in 2007 while at the same period public finances saw debt levels up to 86% from 66% (Sesric Reports, 2011). The cause for the Portuguese stagnation was all down to its export structure in the period before and immediately after the launching of the EU. The country was heavily reliant on slow growth sectors in which the comparative advantages were shifting to the Asian emerging economies. In low-tech manufacturing, production share dropped from a 1995 level of 80% to just about 73% in 2001, revealing the inflexibility of labor markets and the business climate in the country as a whole.

The tightening of labor markets and rapid increases in wages had served to catalyze the Portuguese Euro boom with an annual raise of nearly 6% in per capita wages between 1995 and 2002 twice that of the EU. The wage bill consequently increased between 1995 and 2002 by 2% of GDP as compared to those of Ireland and Spain which shrunk by over 1%. The government’s wage bill as of 2002 stood at 15% of GDP compared to the European average of 10% in 2002.

All these policies and wage increments resulted in the country’s “Real Effective Exchange Rate, REER” (Dadush, 2010), calculated from labor costs per capita, increasing by 12% between 1994 and 2002 while remaining the same in Ireland and Spain. This appreciation in REER favored local demand to exports leading to increases in macroeconomic imbalance that ended up being reflected in Portugal’s Foreign Direct Investments, FDI. Portugal continued to be a less attractive option for investments as it went on to loose 10% of its share in the export market between 1995 and 2000.

Solutions

110 billion Euro Greek rescue package

Before the peak of the Greek crisis, observers were of the opinion that the Eurozone should not help Greece as they thought that the payment difficulties would affect other member states such as Spain and Portugal (Nelson, Belkin & Mix, 2011). However, contagion effects like the turmoil experienced in the markets in late April to early May 2010 changed this thought process. The spikes in the bond yields in the financial markets had the potential to push other nations into defaulting on their own debts. Intervention by the IMF could not be sufficient due to its limited and constrained resources and IMF quotas could not stabilize the difficulties. Sovereign debt default in nations of southern Europe would exacerbate the situation for European banks that had already been badly exposed by the subprime crisis of America. Businesses in Greece no longer received any public sector payment from their government and were in a downward spiral. Other countries also faced a similar prospect in the near future; therefore, Eurozone leaders had to act quickly to avert the looming crisis (Dullien & Schwarzer, 2011). During the spring in 2010, they passed a package in unison with the European Commission and IMF to the tune of 110 billion which would later in 2011 be adjusted to a further 109 billion. Although the Greek economy did not really need the loan due to their turmoil being mostly a solvency problem and not a liquidity problem, the Eurozone leadership had to act fast to prevent the looming default. Though the package really did little in solving the problem, it bought time for strategic policy adjustments to be implemented as what Greece really needed was a debt restructuring program to dig it out of the recession that was brought about by the collapse in amounts of tax revenue.

The 750billion Euro safety net

After the first Greek bailout, spreads between Portuguese, Greek, Irish and Spanish bonds rose to new highs against the German benchmark bond thus costs of insurance against defaults for these vulnerable states rose dramatically (Nelson,Belkin & Mix, 2011). Wall Street trade in Greek bonds dropped sharply along with those of other southern Eurozone members. The state debt of France was also hit and by 7th May, only German bonds continued to trade normally. Banks started to decline bonds from southern EU member states and other affected countries. The money markets were on the verge of freezing up as interbank lending dropped and familiars seemed imminent as huge losses in stock markets ensued especially in financial institutions. The EU in response put together a package of 750 billion Euros as a safety net to loans and guarantees (Sesric Reports, 2011). The breakdown for the fund was such that 60billion was an emergency fund guaranteed in the budget of the EU, an upward of 250 billion from the IMF, 440 billion backed by member states for capital markets and loan grants for governments that run into debts, and lastly for the ECB to buy the bonds of member states in an effort to stabilize interest rates. However, at its inception the 440 billion was estimated to only cover the borrowings of Spain and Portugal. The main mechanism for this package is to encourage countries to prevent a self-fulfilling crisis and contagion.

ECB’s bond purchases

The European systems of central banks were to purchase struggling government bonds through the secondary market, through the so-called “securities market programme” (Cembalest, 2011). On commencement of the program on 8th August 2011, the ECB bought Spanish and Italian bonds to the tune of 42 billion out of the 118 billion it had invested by October. The principle of this move was to prevent excessive drops for the bond prices by stopping deteriorations due to price overshoots resulting from thin markets. The ECB and the member state with solvency rather than liquidity problems stand to gain in the country can successfully service its debts. The downside to this program is bonds from insolvent countries result in other member states implicitly paying for the defaulted debt.

European Stability Mechanism (ESM)

A treaty establishing the ESM was signed on 11th July 2011. It followed a decision by the European Council and the Treaty on the Functioning of the European Union (TFEU) of December 16th 2010. The uniqueness of the ESM is that it is a permanent mechanism unlike the European Financial Stability Facility (EFSF) and European Financial Stabilization Mechanism (ESFM) which were both temporary solutions. The ESM will be launched in 2013 and headquartered in Luxemburg and led by a board of governors with governors from each member state. Unlike other policies which look at conditions in specific nations, the ESM will only intervene if the intervention will ensure the stability of the entire Eurozone (Sesric Reports, 2011). Any state receiving its aid will have to implement adjustment programs and analysis on sustainability of public debt by a joint IMF and ECB panel. The ESM will have an initial maximum of 500 billion Euros for lending based on 700 billion capital stocks that will ensure safe lending levels. The capital stocks will consists of collectable shares of 620 billion and 80 billion paid-in shares.

Conclusion

Initial beliefs that high debt levels in southern Eurozone economies could not necessitate a catastrophic impact on the entire EU were disapproved when the Greek system failed and started a chain of event that affected other member states such as Italy and Portugal. Other member states continue to face challenges to their economies until this day as public debt continues to rise while their global competitiveness continues to shrink as unemployment soar to record highs. The initial 110 billion Euro package was an eye opener that served to show EU leaders that in order for a country to crawl out of financial turmoil, what needs to be done is implement policies that affect the solvency of the economy such that any future injection of liquidity can have a stable platform to cause the desired effect. No doubt the recent policies that have been adopted by the member states such as the EFSF, ESFM and ESM will go a long way in averting future troubles in the financial sectors by having more stringent and far reaching policies and measures, in addition to the larger reserves of capital.