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; ,      - tabulations of the fiscal characteristics of the PIIGS countries and their GDP growth rates; and,     - tabulations concerning the major member countries' attitudes to the crisis. It was last updated on 27 November 2012.

The eurozone crisis was triggered in 2010 by doubts about the Greek government's ability to service its debt. Investor reluctance to buy its bonds spread to affect the bond issues of several other eurozone members, including Ireland and Portugal; and by late 2011, it was having some effect upon the bonds of many of its members, even including Germany. Eurozone loans to Greece, Ireland, and Portugal had failed to restore investor confidence, and the austerity conditions attached to those loans were hampering their recovery from the Great Recession. Some other member governments were finding it difficult to roll-over maturing debt, and it came to be realised that the resources that would be needed to rescue larger members such as Spain or Italy could be greater than their eurozone partners could raise. What had been uncertainty about the fiscal sustainability of a few peripheral members had grown into uncertainty about the sustainability of the eurozone system itself. Confidence was partially restored in the course of 2012, despite the partial default of the Greek government, by the European Central Bank's willingness to buy bonds that had been issued by distressed member governments, but there was awareness of the need for further measures. As a long-term measure, 25 European Union governments agreed to a set of balanced-budget undertakings termed the "Fiscal Compact", and there was agreement in principle to a "Compact for Growth and Jobs" but the only early action under consideration was the creation of a banking union to relieve the pressure on member governments to recapitalise their banks. Proposals for debt mutualisation, for example by the creation of "eurobonds", were firmly rejected.

Background to the crisis

The eurozone

(A more comprehensive account of the rationale and constitution of the eurozone is available in the eurozone article.)

Overview

The eurozone was launched in 1991 as an economic and monetary union that was intended to increase economic efficiency while preserving financial stability. Financial vulnerability to asymmetric shocks as a result of disparities among member economies was intended to be countered in the medium term by limits on public debt and budget deficits, and in the long term, by progressive economic convergence. By the early years of the 21st century, however, it had became apparent that the fiscal limits could not be enforced, and that membership had enabled the governments of some countries - notably Greece - to borrow on more favourable terms than had previously been available. It had also become evident that membership had reduced the international competitiveness of low-productivity countries - such as Greece -, and that it had raised the competitiveness of high-productivity countries - such as Germany. For those and other reasons, it now appears that there had been divergence rather than convergence among the economies of the eurozone, and that their vulnerability to external shocks had beem increased rather diminished.

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 European Central Bank

The European Central Bank is the core of the "Eurosystem" that consists also of all the national central banks of the member countries of the Union (whether or not they are members of the eurozone). Its governing body consists of the six members of its Executive Board, and the governors of the national central banks of the 17 eurozone countries. It is responsible for the execution of the Union's monetary policy. Its statutory remit requires that, "without prejudice to the objective of price stability", it is to "support the general economic policies in the Community" including a "high level of employment" and "sustainable and non-inflationary growth". The bank's governing board sets the eurozone's discount rates and has been responsible for the introduction and management of refinancing operations . Article 101 of the European Treaty expressly forbids the ECB from lending to governments and Article 103 prohibits the euro zone from becoming liable for the debts of member states.

The Bank is an independent decision-making body, being protected from political control by article 107 of the Maastricht Treaty: " ”…, neither the ECB, nor a national central bank, nor any member of their decisionmaking bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body". It takes decisions by majority voting, which therefore cannot be vetoed by individual member-states.

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 announced as 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 22 of the 27 European Union countries in 2010.

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. Loans are subject to conditions negotiated with European Commission and the IMF, and accepted by the eurozone Finance Ministers.

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), which is to be a supranational institution, established by international treaty, with an independent decision-making power. (A comprehensive explanation of the EFSF and the ESM is available in question-and-answer form.)

Pre-crisis performance

Neither a 1999-2008 growth rate comparison, nor a 2008-2011 growth rate comparison shows a significant difference between the performance of the eurozone as a whole and of the European Union as a whole, However, there is clear evidence that the Great Recession had imposed an asymmetric shock on the eurozone, causing downturns of above average severity in the economies of the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain), that are attributable to departures from currency area criteria, including large differences in member country trade balances, limited labour mobility and price flexibility.

The PIIGS

The economies of the PIIGS countries 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.

Overview of the crisis

It became evident early in 2010 that, without external assistance, the Greek government would be forced to default on its debt. Eurozone governments, in conjunction with the International Monetary Fund, responded with conditional loans to enable the Greek government to continue to roll-over its maturing debts. Investors' fears of sovereign default by other eurozone governments developed in the course of 2010 and conditional loans had to be provided to the governments of Ireland and Portugal. The crisis deepened when, in the latter half of 2011, it became evident that a default by the Greek government could no longer be avoided. On October 26 2011 there was provisional agreement for a further EU/IMF loan and a partial write-off of private sector holdings of Greek government debt, but it was not until the following February that the conditions required of the Greek government were deemed to have been met. In the meantime there was substantial sovereign spread contagion by Spain, Italy and modest contagion by other eurozone countries including France. By early 2012, however, there had been substantial falls in sovereign spreads as a result of bond purchases by eurozone banks using loans from the European Central Bank, and by late February, confidence had been further restored by reduced expectations of a Greek default.

The PIIGS crisis (March 2010 to October 2011)

The blue country links in this section are to country reports on the addendum subpage.

Overview

The Great Recession brought about large increases in the indebtedness of the eurozone governments and by 2009, twelve member states had public debt/GDP ratios of over 60% of GDP. Concern developed in early 2010 concerning the fiscal sustainability of the economies of the "PIIGS" countries (Portugal, Ireland, Italy, Greece and Spain) and a eurozone fund was set up to assist members in difficilty. Bond markets were eventually reassured by the conditional loans provided to Ireland, but despite a eurozone loan to Greece, they demanded increasing risk premiums for lending to its government. In late 2010 there were signs of contagion of market fears by the governments of other eurozone countries, and it appeared that that the integrity of the eurozone was being put in question.

The Greek problem

In April 2010, the Greek government faced the prospect of being unable to fund its maturing debts. Its problems arose from large increases in its sovereign spreads reflecting the bond market's fears that it might default - fears that were based upon both its large budget deficits, and its limited economic prospects. In May 2010, the Greek government was granted a €110 billion rescue package, financed jointly by the eurozone governments and the IMF. Further increases in spreads showed that those rescue packages had failed to reassure the markets.

The Irish problem

Between 2009 and 2010 Ireland's budget deficit increased from 14.2 per cent to 32.4 per cent of GDP, as a result mainly of one-off measures in support of the banking sector. November 2010 the government applied for financial assistance from the EU and the IMF. By the Autumn of 2011 the government's programmes of tax increases had brought about a major improvement in fiscal sustainability, bringing down its budget deficit from 32.4 percent to an expected 10.6 percent of GDP and enabling the government to return to the bond market.

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[3]

"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

Contagion among the PIIGS

Signs began to appear of the contagion of the bond market fears from Greece to other PIIGS 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. Bond market concern about the sustainability of Italy's public debt was reflected in a progressive rise in the yield on its 10-year government bonds during 2011, and by October it had risen to over 5 percent.

Policy responses

Overview

On the 26th of October, a meeting of eurozone leaders was held, the declared purpose of which was to restore confidence by adopting a "comprehensive set of additional measures reflecting our strong determination to do whatever is required to overcome the present difficulties". One set of measures that was adopted for that purpose, acknowledged the Greek government's inability to repay its debt in full, and provided for the restructuring of that debt, and for the financial support necessary for the government's survival. A second set was intended to provide an insurance against the contagion by other eurozone countries of the Greek government's difficulties and to assure the markets that sufficient eurozone funds would be available to cope with contagion should it occur. Thirdly, and in view of the market's awareness that a rescue of the Italian government would impose a major drain on those funds, the leaders sought to strengthen that government's defences against default. The measures that were agreed are recorded in a communiqué and in a list of "main results".

"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

The rescue package for Greece included a 50 percent write-off of the Greek government's debt (as had been agreed with the Insitute of International Finance representing the world's banks), and a €130 billion conditional loan. The Greek government responded to the conditions for the loan by calling a referendum to enable the Greek people to decide whether to accept the package. At an emergency summit on 2nd November, however, 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 the acceptability of the rescue package. He was also told that the €8 billion tranche of the EU/IMF loan that (needed to avoid a default in December) would be withheld until after the referendum. Acknowledging the prospect that the referendum could result in the departure of Greece from the eurozone,Jean-Claude Juncker, the Chairman of the Eurogroup of eurozone Finance Ministers announced that preparations for that outcome were in hand. The next day Prime Minister Papandreou announced his willingness to cancel the referendum, and that he had obtained agreement of opposition leaders to do so. On the 6th of November party leaders agreed to form a coalition government under a new Prime Minister. A new government was formed with Lucas Papademos as Prime Minister of Greece, and the terms of the EU rescue were agreed.

Strengthening Italy's policies

A programme of reform proposed by the Italian Government was itemised in the summit communiqué, and Prime Minister Berlusconi was called upon to submit "an ambitious timetable" for its implementation. The reforms that were promised in response in his "letter of intent" are reported to include also a reduction in the size of the civil service, a €15 billion privatisation of state assets and the promotion of private sector investment in the infrastructure. . It was approved on the 12th of November by the Italian parliament as the Financial Stability Law, and Berlusconi was replaced as Prime Minister by the eminent economist, Mario Monti.

Strengthening the firewall

The "firewall measures" that were proposed in order to limit contagion by European governments and their banks included a 4- to 5-fold increase in the size of the European Financial Stability Facility and the recapitalisation of selected eurozone banks.

Strengthening the banks

On 8 December the European Banking Authority published a bank recapitalisation plan as part of co-ordinated measures to restore confidence in the banking sector. Also on 8 December 2011, the European Central Bank offered to lend unlimited amounts to eurozone banks for a period of three years at an interest rate of 1 per cent . A second round of cheap three-year loans was issued on 29 February 2012, raising the total to almost €1 trillion. On 12 September 2012 the European Commission submitted a "roadmap toward a banking union" to the European Parliament and the Council of Ministers, and floated the idea of a European Union deposit guarantee which would enable depositors to claim compensation from a central fund instead of drawing upon national resources.

ECB bond purchases

On 7 August 2011 it was announced that the European Central Bank intended to use its Securities Markets Programme to purchase bonds issued by the Spanish and Italian Governments . On 3 November 2011 a new covered bond purchase programme was announced. In July 2012, the bank's President annouced that "the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough". On 6th September 2012, the European Central Bank announced a programme of "Outright Monetary Transactions" involving unlimited (but sterilised) purchases on the secondary market of the bonds of those governments that seek "bail-out" assistance from the EU's European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programmes,

The eurozone crisis (November 2011 to present)

Overview

Bond market investors were not immediately reassured by the decisions of October 2011 and there was a loss of confidence that extended briefly beyond the PIIGS group. Despite the new Italian government's acceptance of the measures had been agreed, the yields on its bonds rose to over 7 per cent. However, the December offer by the European Central Bank's to lend unlimited amounts to eurozone banks at an interest rate of 1 per cent, was followed by a marked reduction in the yields on Italian and Spanish government bonds and, following the Bank's subsequent bond purchases, there was a general recovery of investor confidence(see CDS spreads table). In other respects the crisis deepened, with falling growth (see the GDP growth table) and deteriorating economic sentiment (see the Economic sentiment indicator table) in Portugal, Italy, Greece and Spain, and in the eurozone as a whole. Also, there is continuing uncertainty concerning the fiscal sustainability of Greece and Spain.

Greece

In early 2012 there were growing doubts about the ability of the Greek government to repay the holders of the €14.4bn of debt that was due to mature in late March. It had been expected that it would be getting a further €130bn tranche of EU/IMF funds before that date, but negotiations concerning the terms of the loan had run into difficulties.
The conditions attached to the loan by the EU/IMF team included: (a) a further austerity drive, and (b) the conclusion of the private sector debt swap deal ( involving a 50% nominal reduction of Greece’s sovereign bonds in private investors’ hands and up to €100 billion of debt forgiveness) that had been part of the decisions of 12th October 2011. An agreement, conditional upon an intensified austerity programme was finally reached on 20th February. A general election in May resulted in the defeat of the parties that had formed the government, without generating a coalition to replace it, and a second election was called for June,as a result of which. Antonis Samaras became prime minister, heading a coalition of the conservative New Democracy and socialist PASOK parties. Negotiations with the IMF/EU/ECB team concerning the release of the next €31bn bailout tranche were concluded in November 2012' The December tranche would comprise €23.8 billion for banks and €10.6 billion in budget assistance, after which Greece is to receive up to €43.7 billion in stages as it fulfils the required deficit-reducing conditions. The agreed package also included a cut the interest rate on official loans, an extension of their maturity by 15 years to 30 years, and a 10-year interest repayment deferral, and the possibility of an eventual er debt write-off was recognised.

The larger PIIGS

There was concern about the short-term fiscal stability of Italy and Spain in view of the large sums that would be required to roll-over debts that are due to mature in 2012 - amounts that are much larger than those needed to rescue Greece (approximately €300 billion for Italy and €150 billion for Spain). Market concern arose from doubts about the willingness of the eurozone leaders to commit themselves to the continuing support of Italy and Spain, and about their ability to raise the necessary funds. In December 2011, with sovereign bond yields at around 7 per cent for Italy and 6 per cent for Spain, it appeared questionable whether those countries would be able to raise the funds required by further bond issues. On 12th January, however, Spain and Italy sold about €22bn of government debt at sharply lower costs than at previous auctions. In June 2012 the Spanish government requested, and was granted, a €100bn loan from the European Union to recapitalise its banks. In October 2012 there was concern that Spain may need a bailout.

Contagion beyond the PIIGS

The decisions of October 2011 were followed in November by sharply rising sovereign spreads, on the bond issues of Austria and France, and on 23 November, the German government failed to sell more than two-thirds of its 10-year bonds at auction, after which its bond yields rose above the yields on US treasuries and UK gilts. On 5th December the Standard & Poor's credit rating agency placed its long-term sovereign ratings on 15 members of the eurozone on "CreditWatch review with negative implications", and in January the Standard and Poor's credit rating agency, downgraded the bonds of 16 eurozone governments, including those of France and Austria.

The policy debate

"Where should we see action? Certainly, in Europe and more specifically in the Eurozone, which is still at this point the epicenter of the crisis and where most urgent action is needed. Action has already occurred ….but more needs to happen and faster." IMF Director Christine Lagarde press conference 10 October 2012[4]

Overview

France's Finance Minister,Pierre Moscovici has argued that the eurozone will only succeed if austerity is not the only perspective that ministers can offer and he advocated stronger measures to support economic growth, an effective banking union, real political and budgetary coordination among Member States, enhanced fiscal coordination in the eurozone, and an ambitious social union to encourage workers’ mobility.

A July 2012 statement by the 17 economists of the INET Council on the eurozone crisis expressed their view that the eurozone leadership had not presented a convincing plan to stop the downward economic spiral in the deficit countries.

Austerity programmes

The eurogroup's provision of loans that were conditional upon the adoption of debt-reducing "austerity" programmes met with opposition from two sides. There were those who advocated either the imposition of stricter debt-reduction conditions or the outright refusal to grant loans; and there were those who advocated the relaxation of debt-reduction conditions and the introduction of growth-promoting measures. In the former group was the influential German economist Hams-Werner Sinn who in 2010 put forward "a few rules for euro sustainability"and who has subsequently argued that Greece should leave the Eurozone on the grounds that continuation of the current bailout measures would risk an internal balance of payment crisis leading to the collapse of the eurozone. What Greece requires, he argues, is a "policy focused on hard budget constraints and simultaneous improvements in competitiveness" involving a 30 per cent reduction in domestic costs. In the latter group was Nobel laureate Joseph Stiglitz, who argued that the current austerity policy is a result of a misdiagnosis of the problem and is making matters worse. He pointed out that if each US state were totally responsible for its own budget, America, too, would be in fiscal crisis. and argued that if the European Central Bank were to borrow, and re-lend the proceeds, the costs of servicing Europe’s debt would fall, creating room for the kinds of expenditure that would promote growth and employment. Laura Tyson, a former chair of the US President's Council of Economic Advisors, agreed that the current austerity policy is self-defeating and argued that a shift toward policies to promote growth, supported by the easing of deficit targets and the issuance of Eurobonds, is essential to bring Europe back from the brink of sustained recession . Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University argued that the adjustment costs of a cessation in debt finance have been grossly underestimated, and that such costs are the reason for financial markets loss confidence in the government of Greece . The INET economists consider it necessary to stabilize output and employment in the deficit countries, and argue that it is impossible to do so without delaying some of the ongoing fiscal adjustment and channeling more support to the deficit countries.

Mutualisation of debt

"Euro bonds, euro bills, debt redemption funds are not only unconstitutional in Germany but also economically wrong and counterproductive" Angela Merkel: speech to the Reichstag 27 June 2012

In December 2010, finance ministers Jean-Claude Juncker and Giulio Tremonti put forward a proposal under which bonds issued by individual governments would be collectively guaranteed by the other eurozone governments, . In August 2011, the financier George Soros argued that eurobonds would have to be an essential feature of any effective Greek rescue package, an assessment that was endorsed by the eminent economist, Joseph Stiglitz . In November 2011, the European Commission published an analysis of the feasibility of introducing what they termed Stability Bonds. Arguments for and against the mutualisation of Europe's debt were set out in detail in the Economist debate of July 2012. Paul De Grauwe (John Paulson Chair in European Political Economy, London School of Economics) argued that debt mutualisation is an essential component of a fiscal union and that fiscal union is necessary for the success of a monetary union. Ansgar Belke {Professor of Macroeconomics, University of Duisburg-Essen) argued that the introduction of a banking union would make debt mutualisation unnecessary. Other contributors included Jean Pisani-Ferry who saw eurobonds as a gift that Germany could make to its partners in exchange for them locking in budgetary discipline and Daniel Gros who argued that eurobonds would be unlikely to lower financing costs for everybody in the euro zone because what debtor countries would gain in terms of lower financing costs would be offset by the losses for creditor countries, which would face higher borrowing costs.

Banking union

In July 2012, a group of 172 German economists led by Hans-Werner Sinn signed a letter of protest against proposals for a banking union.arguing that "Banks must be allowed to fail. If the debtor can not pay back, there is only one group that should bear the burden : the creditors themselves" . A group of over 100 German, Austrian, and Swiss economists led by Michael Burda posted a reply to Hans-Werner Sinn's petition, arguing that "deeper financial integration and a de-coupling of government and banking finance are essential elements for a more stable financial architecture in Europe" . Ansgar Belke argues that with a solid banking system in place, banking-sector losses would no longer threaten the solvency of solid sovereigns (such as Ireland and Spain), and the bail-out of less reliable sovereigns would no longer be necessary. There would be a lower chance that fundamentally sound sovereigns would suffer from a confidence crisis and rocketing risk premiums..

International repercussions

The eurozone crisis is thought to have 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.