European debt crisis

Long-term interest rates of all eurozone countries except Estonia (secondary market yields of government bonds with maturities of close to ten years) A yield of 6 % or more indicates that financial markets have serious doubts about credit-worthiness.

S&P's ratings of European countries

The European sovereign debt crisis is an ongoing financial crisis that has made it difficult or impossible for some countries in the euro area to re-finance their government debt without the assistance of third parties.

From late 2009, fears of a sovereign debt crisis developed among investors as a result of the rising government debt levels around the world together with a wave of downgrading of government debt in some European states. Concerns intensified in early 2010 and thereafter, leading Europe's finance ministers on 9 May 2010 to approve a rescue package worth €750 billion aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF). In October 2011 and February 2012, the eurozone leaders agreed on more measures designed to prevent the collapse of member economies. This included an agreement whereby banks would accept a 53.5% write-off of Greek debt owed to private creditors, increasing the EFSF to about €1 trillion, and requiring European banks to achieve 9% capitalisation. To restore confidence in Europe, EU leaders also agreed to create a common fiscal union including the commitment of each participating country to introduce a balanced budget amendment.

While sovereign debt has risen substantially in only a few eurozone countries, it has become a perceived problem for the area as a whole. Nevertheless, the European currency has remained stable. As of mid-November 2011, the euro was even trading slightly higher against the bloc's major trading partners than at the beginning of the crisis. The three countries most affected, Greece, Ireland and Portugal, collectively account for six percent of the eurozone's gross domestic product (GDP).

Causes

Public debt $ and %GDP (2010) for selected European countries

The European sovereign debt crisis has resulted from a combination of complex factors, including the globalization of finance; easy credit conditions during the 2002–2008 period that encouraged high-risk lending and borrowing practices; international trade imbalances; real-estate bubbles that have since burst; slow economic growth in 2008 and thereafter; fiscal policy choices related to government revenues and expenses, particularly high entitlement spending, see welfare state; and approaches used by nations to bailout troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

One narrative describing the causes of the crisis begins with the significant increase in savings available for investment during the 2000–2007 period when the global pool of fixed income securities increased from approximately $36 trillion in 2000 to $70 trillion by 2007. This "Giant Pool of Money" increased as savings from high-growth developing nations entered global capital markets. Investors searching for higher yields than those offered by U.S. Treasury bonds sought alternatives globally. The temptation offered by such readily available savings overwhelmed the policy and regulatory control mechanisms in country after country as global fixed income investors searched for yield, generating bubble after bubble across the globe. While these bubbles have burst causing asset prices (e.g., housing and commercial property) to decline, the liabilities owed to global investors remain at full price, generating questions regarding the solvency of governments and their banking systems.

How each European country involved in this crisis borrowed and invested the money varies. For example, Ireland's banks lent the money to property developers, generating a massive property bubble. When the bubble burst, Ireland's government and taxpayers assumed private debts. In Greece, the government increased its commitments to public workers in the form of extremely generous pay and pension benefits. Iceland's banking system grew enormously, creating debts to global investors ("external debts") several times GDP.

The interconnection in the global financial system means that if one nation defaults on its sovereign debt or enters into recession putting some of the external private debt at risk, the banking systems of creditor nations face losses. For example, in October 2011 Italian borrowers owed French banks $366 billion (net). Should Italy be unable to finance itself, the French banking system and economy could come under significant pressure, which in turn would affect France's creditors and so on. This is referred to as financial contagion. Another factor contributing to interconnection is the concept of debt protection. Institutions entered into contracts called credit default swaps (CDS) that result in payment should default occur on a particular debt instrument (including government issued bonds). But, since multiple CDS's can be purchased on the same security, it is unclear what exposure each country's banking system now has to CDS.

Some politicians, notably Angela Merkel, have sought to attribute some of the blame for the crisis to hedge funds and other speculators stating that "institutions bailed out with public funds are exploiting the budget crisis in Greece and elsewhere". Although some financial institutions clearly profited from the growing Greek government debt in the short run, there was a long lead up to the crisis.

Rising government debt levels

Government debt of Eurozone, Germany and crisis countries compared to Eurozone GDP

Government deficit of Eurozone compared to USA and UK

In 1992, members of the European Union signed the Maastricht Treaty, under which they pledged to limit their deficit spending and debt levels. However, a number of EU member states, including Greece and Italy, were able to circumvent these rules and mask their deficit and debt levels through the use of complex currency and credit derivatives structures. The structures were designed by prominent U.S. investment banks, who received substantial fees in return for their services and who took on little credit risk themselves thanks to special legal protection for derivatives counterparties.

Public debt as a percent of GDP (2010)

A number of "appalled economists" have condemned the popular notion in the media that rising debt levels of European countries were caused by excess government spending. According to their analysis, increased debt levels are due to the large bailout packages provided to the financial sector during the late-2000s financial crisis, and the global economic slowdown thereafter. The average fiscal deficit in the euro area in 2007 was only 0.6% before it grew to 7% during the financial crisis. In the same period the average government debt rose from 66% to 84% of GDP. The authors also stressed that fiscal deficits in the euro area were stable or even shrinking since the early 1990s. US economist Paul Krugman named Greece as the only country where fiscal irresponsibility is at the heart of the crisis.

Either way, high debt levels alone may not explain the crisis. According to The Economist Intelligence Unit, the position of the euro area looked "no worse and in some respects, rather better than that of the US or the UK." The budget deficit for the euro area as a whole (see graph) is much lower and the euro area's government debt/GDP ratio of 86% in 2010 was about the same level as that of the US. Moreover, private-sector indebtedness across the euro area is markedly lower than in the highly leveraged Anglo-Saxon economies.

Trade imbalances

Current account balances relative to GDP (2010)

Commentators such as Financial Times journalist Martin Wolf have asserted that the root of the crisis was growing trade imbalances. He notes in the run-up to the crisis, from 1999 to 2007, Germany had a considerably better public debt and fiscal deficit relative to GDP than the most affected eurozone members. In the same period, these countries (Portugal, Ireland, Italy and Spain) had far worse balance of payments positions. Whereas German trade surpluses increased as a percentage of GDP after 1999, the deficits of Italy, France and Spain all worsened.

More recently, Greece's trading position has improved; in the period November 2010 to October 2011 imports dropped 12% while exports grew 15% (40% to non-EU countries in comparison to October 2010).

Monetary policy inflexibility

Since membership of the eurozone establishes a single monetary policy, individual member states can no longer act independently. Paradoxically, this situation creates a higher default risk than faced by smaller non-eurozone economies, like the United Kingdom, which are able to "print money" in order to pay creditors and ease their risk of default. (Such an option is not available to a state such as France.) By "printing money" a country's currency is devalued relative to its (eurozone) trading partners, making its exports cheaper, in principle leading to an improving balance of trade, increased GDP and higher tax revenues in nominal terms. In the reverse direction moreover, assets held in a currency which has devalued suffer losses on the part of those holding them. For example by the end of 2011, following a 25 percent fall in the rate of exchange and 5 percent rise in inflation, eurozone investors in Sterling, locked in to euro exchanges rates, had suffered an approximate 30 percent cut in the repayment value of this debt.

Loss of confidence

Sovereign CDS prices of selected European countries (2010–2011). The left axis is in basis points; a level of 1,000 means it costs $1 million to protect $10 million of debt for five years.

Prior to development of the crisis it was assumed by both regulators and banks that sovereign debt from the eurozone was safe. Banks had substantial holdings of bonds from weaker economies such as Greece which offered a small premium and seemingly were equally sound.

As the crisis developed it became obvious that Greek, and possibly other countries', bonds offered substantially more risk. Contributing to lack of information about the risk of European sovereign debt was conflict of interest by banks that were earning substantial sums underwriting the bonds. The loss of confidence is marked by rising sovereign CDS prices, indicating market expectations about countries' creditworthiness (see graph).

Furthermore, investors have doubts about the possibilities of policy makers to quickly contain the crisis. Since countries that use the euro as their currency have fewer monetary policy choices (e.g., they cannot print money in their own currencies to pay debt holders), certain solutions require multi-national cooperation. Further, the European Central Bank has an inflation control mandate but not an employment mandate, as opposed to the U.S. Federal Reserve, which has a dual mandate. According to the Economist, the crisis "is as much political as economic" and the result of the fact that the euro area is not supported by the institutional paraphernalia (and mutual bonds of solidarity) of a state.

Rating agency views

On December 5, 2011 S&P placed its long-term sovereign ratings on 15 members of the eurozone on "CreditWatch" with negative implications; S&P wrote this was due to "systemic stresses from five interrelated factors: 1) Tightening credit conditions across the eurozone; 2) Markedly higher risk premiums on a growing number of eurozone sovereigns including some that are currently rated 'AAA'; 3) Continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial, and fiscal convergence among eurozone members; 4) High levels of government and household indebtedness across a large area of the eurozone; and 5) The rising risk of economic recession in the eurozone as a whole in 2012. Currently, we expect output to decline next year in countries such as Spain, Portugal and Greece, but we now assign a 40% probability of a fall in output for the eurozone as a whole."

Evolution of the crisis

See also: 2000s European sovereign debt crisis timeline

In the first few weeks of 2010, there was renewed anxiety about excessive national debt. Frightened investors demanded ever higher interest rates from several governments with higher debt levels, deficits and current account deficits. This in turn made it difficult for some governments to finance further budget deficits and service existing debt, particularly when economic growth rates were low, and when a high percentage of debt was in the hands of foreign creditors, as in the case of Greece and Portugal. Elected officials have focused on austerity measures (e.g., higher taxes and lower expenses) contributing to social unrest and significant debate among economists, many of whom advocate greater deficits when economies are struggling. Especially in countries where government budget deficits and sovereign debts have increased sharply, a crisis of confidence has emerged with the widening of bond yield spreads and risk insurance on CDS between these countries and other EU member states, most importantly Germany. By the end of 2011, Germany was estimated to have made more than €9 billion out of the crisis as investors flocked to safer but near zero interest rate German federal government bonds (bunds). While Switzerland equally benefited from lower interest rates, the crisis also harmed its export sector due to a substantial influx of foreign capital and the resulting rise of the Swiss franc. In September 2011 the Swiss National Bank surprised currency traders by pledging that "it will no longer tolerate a euro-franc exchange rate below the minimum rate of 1.20 francs", effectively weakening the Swiss franc. This is the biggest Swiss intervention since 1978.

Greece

Main article: Greek government debt crisis

Greece's debt percentage since 1999 compared to the average of the eurozone

In the early mid 2000s, Greece's economy was one of the fastest growing in the eurozone and the government took advantage of it by running a large structural deficit, partly due to high defense spending amid historic enmity to Turkey. As the world economy cooled in the late 2000s, Greece was hit especially hard because its main industries — shipping and tourism — were especially sensitive to changes in the business cycle. As a result, the country's debt began to increase rapidly.

100,000 people protest against the harsh austerity measures in front of parliament building in Athens (29 May 2011)

On 23 April 2010, the Greek government requested an initial loan of €45 billion from the EU and International Monetary Fund (IMF), to cover its financial needs for the remaining part of 2010. A few days later Standard & Poor's slashed Greece's sovereign debt rating to BB+ or "junk" status amid fears of default, in which case investors were liable to lose 30–50% of their money. Stock markets worldwide and the Euro currency declined in response to this announcement. On 1 May 2010, the Greek government announced a series of austerity measures to secure a three year €110 billion loan. This was met with great anger by the Greek public, leading to massive protests, riots and social unrest throughout Greece. The Troika (EU, ECB and IMF), offered Greece a second bailout loan worth €130 billion in October 2011, but with the activation being conditional on implementation of further austerity measures and a debt restructure agreement. A bit surprisingly, the Greek prime minister George Papandreou first answered that call, by announcing a December 2011 referendum on the new bailout plan, but had to back down amidst strong pressure from EU partners, who threatened to withhold an overdue €6 billion loan payment that Greece needed by mid-December. On 10 November 2011 Papandreou instead opted to resign, following an agreement with the New Democracy party and the Popular Orthodox Rally, to appoint non-MP technocrat Lucas Papademos as new prime minister of an interim national union government, with responsibility for implementing the needed austerity measures to pave the way for the second bailout loan.

All the implemented austerity measures, have so far helped Greece bring down its primary deficit before interest payments, from €24.7bn (10.6% of GDP) in 2009 to just €5.2bn (2.4% of GDP) in 2011, but as a side-effect they also contributed to a worsening of the Greek recession, which began in October 2008 and only became worse in 2010 and 2011. Overall the Greek GDP had its worst decline in 2011 with -6.8%, a year where the seasonal adjusted industrial output ended 28.4% lower than in 2005, and with 111,000 Greek companies going bankrupt (27% higher than in 2010). As a result, the seasonal adjusted unemployment rate also grew from 7.5% in September 2008 to a record high of 19.9% in November 2011, while the Youth unemployment rate during the same time rose from 22.0% to as high as 48.1%. Overall the share of the population living at "risk of poverty or social exclusion" did not increase noteworthy during the first 2 year of the crisis. The figure was measured to 27.6% in 2009 and 27.7% in 2010 (only being slightly worse than the EU27-average at 23.4%), but for 2011 the figure was now estimated to have risen sharply above 33%. In February 2012, an IMF official negotiating Greek austerity measures admitted that excessive spending cuts were harming Greece.

Some economic experts argue that the best option for Greece and the rest of the EU, would be to engineer an “orderly default”, allowing Athens to withdraw simultaneously from the eurozone and reintroduce its national currency the drachma at a debased rate. However, if Greece were to leave the euro, the economic and political impact would be devastating. According to Japanese financial company Nomura an exit would lead to a 60 percent devaluation of the new drachma. UBS warned of "hyperinflation, military coups and possible civil war that could afflict a departing country".

To prevent this from happening, the troika (EU, IMF and ECB) eventually agreed in February 2012 to provide a second bailout package worth €130 billion, conditional on the implementation of another harsh austerity package (reducing the Greek spendings with €3.3bn in 2012 and another €10bn in 2013 and 2014). For the first time, the bailout deal also included a debt restructure agreement with the private holders of Greek government bonds (banks, insurers and investment funds), to "voluntarily" accept a bond swap with a 53.5% nominal write-off along with lower interest rates and the maturity prolonged to 11-30 years (depending on the previous maturity). It is the world's biggest debt restructuring deal ever done, affecting some €206 billion of Greek government bonds. The debt write-off had a seize of €107 billion, and caused the Greek debt level to fall from roughly €350bn to €240bn in March 2012, with the predicted debt burden now showing a sustainable size equal to 120.5% of GDP by 2020.

Ireland

Main article: 2008–2012 Irish financial crisis

Irish government deficit compared to other European countries and the United States (2001–2011)

The Irish sovereign debt crisis was not based on government over-spending, but from the state guaranteeing the six main Irish-based banks who had financed a property bubble. On 29 September 2008, Finance Minister Brian Lenihan, Jnr issued a one-year guarantee to the banks' depositors and bond-holders. He renewed it for another year in September 2009 soon after the launch of the National Asset Management Agency (NAMA), a body designed to remove bad loans from the six banks.

Irish banks had lost an estimated 100 billion euros, much of it related to defaulted loans to property developers and homeowners made in the midst of the property bubble, which burst around 2007. The economy collapsed during 2008. Unemployment rose from 4% in 2006 to 14% by 2010, while the federal budget went from a surplus in 2007 to a deficit of 32% GDP in 2010, the highest in the history of the eurozone, despite draconian austerity measures. Ireland could have guaranteed bank deposits and let private bondholders who had invested in the banks face losses, but instead borrowed money from the ECB to pay these bondholders, shifting the losses and debt to its taxpayers, with severe negative impact on Ireland's creditworthiness. As a result, the government started negotiations with the EU, the IMF and three nations: the United Kingdom, Denmark and Sweden, resulting in a €67.5 billion "bailout" agreement of 29 November 2010 Together with additional €17.5 billion coming from Ireland's own reserves and pensions, the government received €85 billion, of which €34 billion were used to support the country's ailing financial sector. In return the government agreed to reduce its budget deficit to below three percent by 2015. In April 2011, despite all the measures taken, Moody's downgraded the banks' debt to junk status. In July 2011 European leaders agreed to cut the interest rate that Ireland was paying on its EU/IMF bailout loan from around 6% to between 3.5% and 4% and to double the loan time to 15 years. The move was expected to save the country between 600–700 million euros per year. On 14 September 2011, in a move to further ease Ireland's difficult financial situation, the European Commission announced it would cut the interest rate on its €22.5 billion loan coming from the European Financial Stability Mechanism, down to 2.59 per cent – which is the interest rate the EU itself pays to borrow from financial markets.

The Euro Plus Monitor report from November 2011 attests to Ireland's vast progress in dealing with its financial crisis, expecting the country to stand on its own feet again and finance itself without any external support from the second half of 2012 onwards. According to the Centre for Economics and Business Research Ireland's export-led recovery "will gradually pull its economy out of its trough". As a result of the improved economic outlook, the cost of 10-year government bonds, which has already fallen substantially since mid July 2011 (see the graph "Long-term Interest Rates"), is expected to fall further to 4 per cent by 2015.

Portugal

A report released in January 2011 by the Diário de Notícias and published in Portugal by Gradiva, demonstrated that in the period between the Carnation Revolution in 1974 and 2010, the democratic Portuguese Republic governments have encouraged over-expenditure and investment bubbles through unclear public-private partnerships and funding of numerous ineffective and unnecessary external consultancy and advisory of committees and firms. This allowed considerable slippage in state-managed public works and inflated top management and head officer bonuses and wages. Persistent and lasting recruitment policies boosted the number of redundant public servants. Risky credit, public debt creation, and European structural and cohesion funds were mismanaged across almost four decades. Prime Minister Sócrates's cabinet was not able to forecast or prevent this in 2005, and later it was incapable of doing anything to improve the situation when the country was on the verge of bankruptcy by 2011.

Robert Fishman, in the New York Times article "Portugal's Unnecessary Bailout", points out that Portugal fell victim to successive waves of speculation by pressure from bond traders, rating agencies and speculators. In the first quarter of 2010, before pressure from the markets, Portugal had one of the best rates of economic recovery in the EU. From the perspective of Portugal's industrial orders, exports, entrepreneurial innovation and high-school achievement, the country matched or even surpassed its neighbors in Western Europe.

On 16 May 2011, the eurozone leaders officially approved a €78 billion bailout package for Portugal, which became the third eurozone country, after Ireland and Greece, to receive emergency funds. The bailout loan was equally split between the European Financial Stabilisation Mechanism, the European Financial Stability Facility, and the International Monetary Fund. According to the Portuguese finance minister, the average interest rate on the bailout loan is expected to be 5.1 percent. As part of the deal, the country agreed to cut its budget deficit from 9.8 percent of GDP in 2010 to 5.9 percent in 2011, 4.5 percent in 2012 and 3 percent in 2013. The Portuguese government also agreed to eliminate its golden share in Portugal Telecom to pave the way for privatization. In 2012, all public servants had already seen an average wage cut of 20% relative to their 2010 baseline, with cuts reaching 25% for those earning more than 1,500 euro. This led to a flood of specialized technicians and top officials leaving the public service, many looking for better positions in the private sector or in other European countries.

On 6 July 2011, the ratings agency Moody's had cut Portugal's credit rating to junk status, Moody's also launched speculation that Portugal could follow Greece in requesting a second bailout.

In December 2011, it was reported that Portugal's estimated budget deficit of 4.5 percent in 2011 would be substantially lower than expected, due to a one-off transfer of pension funds. The country would therefore meet its 2012 target a year earlier than expected. Despite the fact that the economy is expected to contract by 3 percent in 2011 the IMF expects the country to be able to return to medium and long-term debt sovereign markets by late 2013.

Possible spread to other countries

Total financing needs of selected countries in % of GDP (2011–2013)

Economic data from Portugal, Italy, Ireland, Greece, United Kingdom, Spain, Germany, the EU and the eurozone for 2009

The 2010 annual budget deficit and public debt, both relative to GDP for selected European countries

Long-term interest rates of selected European countries. Note that weak non-eurozone countries (Hungary, Romania) lack the sharp rise in interest rates characteristic of weak eurozone countries.

One of the central concerns prior to the bailout was that the crisis could spread to several other countries after reducing confidence in other European economies. According to the UK Financial Policy Committee "Market concerns remain over fiscal positions in a number of euro area countries and the potential for contagion to banking systems." Besides Ireland, with a government deficit in 2010 of 32.4% of GDP, and Portugal at 9.1%, other countries such as Spain with 9.2% are also at risk.

For 2010, the OECD forecast $16 trillion would be raised in government bonds among its 30 member countries. Financing needs for the eurozone come to a total of €1.6 trillion, while the U.S. is expected to issue US$1.7 trillion more Treasury securities in this period, and Japan has ¥213 trillion of government bonds to roll over. Greece has been the notable example of an industrialised country that has faced difficulties in the markets because of rising debt levels but even countries such as the U.S., Germany and the UK, have had fraught moments as investors shunned bond auctions due to concerns about public finances and the economy.

Italy

Italy's deficit of 4.6 percent of GDP in 2010 was similar to Germany’s at 4.3 percent and less than that of the U.K. and France. Italy even has a surplus in its primary budget, which excludes debt interest payments. However, its debt has increased to almost 120 percent of GDP (U.S. $2.4 trillion in 2010) and economic growth was lower than the EU average for over a decade. This has led investors to view Italian bonds more and more as a risky asset. On the other hand, the public debt of Italy has a longer maturity and a substantial share of it is held domestically. Overall this makes the country more resilient to financial shocks, ranking better than France and Belgium. About 300 billion euros of Italy's 1.9 trillion euro debt matures in 2012. It will therefore have to go to the capital markets for significant refinancing in the near-term.

On 15 July and 14 September 2011, Italy's government passed austerity measures meant to save €124 billion. Nonetheless, by 8 November 2011 the Italian bond yield was 6.74 percent for 10-year bonds, climbing above the 7 percent level where the country is thought to lose access to financial markets. On 11 November 2011, Italian 10-year borrowing costs fell sharply from 7.5 to 6.7 percent after Italian legislature approved further austerity measures and the formation of an emergency government to replace that of Prime Minister Silvio Berlusconi. The measures include a pledge to raise €15 billion from real-estate sales over the next three years, a two-year increase in the retirement age to 67 by 2026, opening up closed professions within 12 months and a gradual reduction in government ownership of local services. The interim government expected to put the new laws into practice is led by former European Union Competition Commissioner Mario Monti.

Spain

See also: 2008–2011 Spanish financial crisis

Spain has a comparatively low debt among advanced economies. The country's public debt relative to GDP in 2010 was only 60%, more than 20 points less than Germany, France or the US, and more than 60 points less than Italy, Ireland or Greece. Like Italy, Spain has most of its debt controlled internally, and both countries are in a better fiscal situation than Greece and Portugal, making a default unlikely unless the situation gets far more severe. As one of the largest eurozone economies the condition of Spain's economy is of particular concern to international observers, and has faced pressure from the United States, the IMF, other European countries and the European Commission to cut its deficit more aggressively. Spain's public debt was approximately U.S. $820 billion in 2010, roughly the level of Greece, Portugal, and Ireland combined.

Rumors raised by speculators about a Spanish bail-out were dismissed by then Spanish Prime Minister José Luis Rodríguez Zapatero as "complete insanity" and "intolerable". Nevertheless, shortly after the announcement of the EU's new "emergency fund" for eurozone countries in early May 2010, Spain had to announce new austerity measures designed to further reduce the country's budget deficit, in order to signal financial markets that it was safe to invest in the country. The Spanish government had hoped to avoid such deep cuts, but weak economic growth as well as domestic and international pressure forced the government to expand on cuts already announced in January.

Spain succeeded in trimming its deficit from 11.2% of GDP in 2009 to 9.2% in 2010 and 8.5% in 2011. Due to the European crisis and over spending by regional governments the latest figure is higher than the original target of 6%. To build up additional trust in the financial markets, the government amended the Spanish Constitution in 2011 to require a balanced budget at both the national and regional level by 2020. The amendment states that public debt can not exceed 60% of GDP, though exceptions would be made in case of a natural catastrophe, economic recession or other emergencies. The new conservative Spanish government led by Mariano Rajoy aims to cut the deficit further to 4.4 percent in 2012 and 3 percent in 2013.

Belgium

In 2010, Belgium's public debt was 100% of its GDP—the third highest in the eurozone after Greece and Italy and there were doubts about the financial stability of the banks, following the country's major financial crisis in 2008–2009. After inconclusive elections in June 2010, by November 2011e country still had only a caretaker government as parties from the two main language groups in the country (Flemish and Walloon) were unable to reach agreement on how to form a majority government. In November 2010 financial analysts forecast that Belgium would be the next country to be hit by the financial crisis as Belgium's borrowing costs rose.

However the government deficit of 5% was relatively modest and Belgian government 10-year bond yields in November 2010 of 3.7% were still below those of Ireland (9.2%), Portugal (7%) and Spain (5.2%). Furthermore, thanks to Belgium's high personal savings rate, the Belgian Government financed the deficit from mainly domestic savings, making it less prone to fluctuations of international credit markets. Nevertheless on 25 November 2011, Belgium's long-term sovereign credit rating was downgraded from AA+ to AA by Standard and Poorand 10-year bond yields reached 5.66%. Shortly after, Belgian negotiating parties reached an agreement to form a new government. The deal includes spending cuts and tax rises worth about €11 billion, which should bring the budget deficit down to 2.8% of GDP by 2012, and to balance the books in 2015. Following the announcement Belgium 10-year bond yields fell sharply to 4.6%.

France

France's public debt in 2010 was approximately U.S. $2.1 trillion and 83% GDP, with a 2010 budget deficit of 7% GDP. By 16 November 2011, France's bond yield spreads vs. Germany had widened 450% since July, 2011. France's C.D.S. contract value rose 300% in the same period. On 1 December 2011, France's bond yield had retreated and the country successfully auctioned €4.3 billion worth of 10 year bonds at an average yield of 3.18%, well below the perceived critical level of 7%. By early February 2012, yields on French 10 year bonds had fallen to 2.84%.

United Kingdom

According to the Financial Policy Committee "Any associated disruption to bank funding markets could spill over to UK banks." Bank of England governor Mervyn King declared that the UK is very much at risk from a domino-fall of defaults and called on banks to build up more capital when financial conditions allowed. This is because the UK has the highest gross foreign debt of any European country (€7.3 trillion; €117,580 per person) due in large part to its highly leveraged financial industry, which is closely connected with both the United States and the eurozone.

Solutions

EU emergency measures

European Financial Stability Facility (EFSF)

Main article: European Financial Stability Facility

On 9 May 2010, the 27 EU member states agreed to create the European Financial Stability Facility, a legal instrument aiming at preserving financial stability in Europe by providing financial assistance to eurozone states in difficulty. The EFSF can issue bonds or other debt instruments on the market with the support of the German Debt Management Office to raise the funds needed to provide loans to eurozone countries in financial troubles, recapitalize banks or buy sovereign debt. Emissions of bonds are backed by guarantees given by the euro area member states in proportion to their share in the paid-up capital of the European Central Bank. The €440 billion lending capacity of the facility is jointly and severally guaranteed by the eurozone countries' governments and may be combined with loans up to €60 billion from the European Financial Stabilisation Mechanism (reliant on funds raised by the European Commission using the EU budget as collateral) and up to €250 billion from the International Monetary Fund (IMF) to obtain a financial safety net up to €750 billion.

On 29 November 2011, the member state finance ministers agreed to expand the EFSF by creating certificates that could guarantee up to 30% of new issues from troubled euro-area governments, and to create investment vehicles that would boost the EFSF’s firepower to intervene in primary and secondary bond markets.

Reception by financial markets

Stocks surged worldwide after the EU announced the EFSF's creation. The facility eased fears that the Greek debt crisis would spread, and this led to some stocks rising to the highest level 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. Shortly after the euro rose again as hedge funds and other short-term traders unwound short positions and carry trades in the currency. 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. The agreement is interpreted as allowing the ECB to start buying government debt from the secondary market which is expected to reduce bond yields. As a result Greek bond yields fell sharply from over 10% to just over 5%. Asian bonds yields also fell with the EU bailout.)

Usage of EFSF funds

Debt profile of Eurozone countries

The EFSF only raises funds after an aid request is made by a country. As of the end of December 2011, it has been activated two times. In November 2010, it financed €17.7 billion of the total €67.5 billion rescue package for Ireland (the rest was loaned from individual European countries, the European Commission and the IMF). In May 2011 it contributed one third of the €78 billion package for Portugal. In the future, it is also planned that the loan for Greece should be shifted to the EFSF, which according to EU diplomats would amount to about €80 billion. This leaves the EFSF with €250 billion or an equivalent of €750 billion in leveraged firepower. According to German newspaper Sueddeutsche, this is more than enough to finance the debt rollovers of all flagging European countries until end of 2012, in case necessary.

The EFSF is set to expire in 2013, running one year parallel to the permanent €500 billion rescue funding program called the European Stability Mechanism (ESM), which will start operating as soon as member states representing 90% of the capital commitments have ratified it. This is expected to be in July 2012.

On 13 January 2012, Standard & Poor’s downgraded France and Austria from AAA rating, lowered Spain, Italy (and five other) euro members further, and maintained the top credit rating for Finland, Germany, Luxembourg, and the Netherlands; shortly after, S&P also downgraded the EFSF from AAA to AA+.

European Financial Stabilisation Mechanism (EFSM)

Main article: European Financial Stabilisation Mechanism

On 5 January 2011, the European Union created the European Financial Stabilisation Mechanism (EFSM), an emergency funding programme reliant upon funds raised on the financial markets and guaranteed by the European Commission using the budget of the European Union as collateral. It runs under the supervision of the Commission and aims at preserving financial stability in Europe by providing financial assistance to EU member states in economic difficulty. The Commission fund, backed by all 27 European Union members, has the authority to raise up to €60 billion and is rated AAA by Fitch, Moody's and Standard & Poor's.

Under the EFSM, the EU successfully placed in the capital markets a €5 billion issue of bonds as part of the financial support package agreed for Ireland, at a borrowing cost for the EFSM of 2.59%.

Like the EFSF, the EFSM will also be replaced by the permanent rescue funding programme ESM, which is due to be launched in July 2012.

Brussels agreement and aftermath

On 26 October 2011, leaders of the 17 eurozone countries met in Brussels and agreed on a 50% write-off of Greek sovereign debt held by banks, a fourfold increase (to about €1 trillion) in bail-out funds held under the European Financial Stability Facility, an increased mandatory level of 9% for bank capitalisation within the EU and a set of commitments from Italy to take measures to reduce its national debt. Also pledged was €35 billion in "credit enhancement" to mitigate losses likely to be suffered by European banks. José Manuel Barroso characterised the package as a set of "exceptional measures for exceptional times".

The package's acceptance was put into doubt on 31 October when Greek Prime Minister George Papandreou announced that a referendum would be held so that the Greek people would have the final say on the bailout, upsetting financial markets. On 3 November 2011 the promised Greek referendum on the bailout package was withdrawn by Prime Minister Papandreou.

In late 2011, Landon Thomas in the New York Times noted that some, at least, European banks were maintaining high dividend payout rates and none were getting capital injections from their governments even while being required to improve capital ratios. Thomas quoted Richard Koo, an economist based in Japan, an expert on that country's banking crisis, and specialist in balance sheet recessions, as saying:

I do not think Europeans understand the implications of a systemic banking crisis.... When all banks are forced to raise capital at the same time, the result is going to be even weaker banks and an even longer recession — if not depression.... Government intervention should be the first resort, not the last resort.

Beyond equity issuance and debt-to-equity conversion, then, one analyst "said that as banks find it more difficult to raise funds, they will move faster to cut down on loans and unload lagging assets" as they work to improve capital ratios. This latter contraction of balance sheets "could lead to a depression”, the analyst said. Reduced lending was a circumstance already at the time being seen in a "deepen[ing] crisis" in commodities trade finance in western Europe.

Final agreement on the second bailout package

In a marathon meeting on 20/21 February 2012 the Eurogroup agreed with the IMF and the Institute of International Finance on the final conditions of the second bailout package worth €130 billion. The lenders agreed to increase the nominal haircut from 50% to 53.5%. EU Member States agreed to an additional retroactive lowering of the interest rates of the Greek Loan Facility to a level of just 150 basis points above the Euribor. Furthermore, governments of Member States where central banks currently hold Greek government bonds in their investment portfolio commit to pass on to Greece an amount equal to any future income until 2020. Altogether this should bring down Greece's debt to 120.5% by 2020.

ECB interventions

ECB Securities Markets Program (SMP) covering bond purchases from May 2010 till February 2012

The European Central Bank (ECB) has taken a series of measures aimed at reducing volatility in the financial markets and at improving liquidity. In May 2010 it took the following actions:

• It began open market operations buying government and private debt securities, reaching €219.5 billion by February of 2012, though it simultaneously absorbed the same amount of liquidity to prevent a rise in inflation. According to Rabobank economist Elwin de Groot, there is a “natural limit” of €300 billion the ECB can sterilize.
• It announced two 3-month and one 6-month full allotment of Long Term Refinancing Operations (LTROs).
• It reactivated the dollar swap lines with Federal Reserve support.
• It changed its policy regarding the necessary credit rating for loan deposits, accepting as collateral all outstanding and new debt instruments issued or guaranteed by the Greek government, regardless of the nation's credit rating.

The move took some pressure off Greek government bonds, which had just been downgraded to junk status, making it difficult for the government to raise money on capital markets.

On 30 November 2011, the European Central Bank, the U.S. Federal Reserve Federal Reserve, the central banks of Canada, Japan, Britain and the Swiss National Bank provided global financial markets with additional liquidity to ward off the debt crisis and to support the real economy. The central banks agreed to lower the cost of dollar currency swaps by 50 basis points to come into effect on 5 December 2011. They also agreed to provide each other with abundant liquidity to make sure that commercial banks stay liquid in other currencies.

Long Term Refinancing Operation (LTRO)

On 22 December 2011, the ECB started the biggest infusion of credit into the European banking system in the euro's 13 year history. Under its Long Term Refinancing Operation (LTRO) it loaned €489 billion to 523 banks for an exceptionally long period of three years at a rate of just one percent. The by far biggest amount of €325 billion was tapped by banks in Greece, Ireland, Italy and Spain. This way the ECB tried to make sure that banks have enough cash to pay off €200 billion of their own maturing debts in the first three months of 2012, and at the same time keep operating and loaning to businesses so that a credit crunch does not choke off economic growth. It also hoped that banks would use some of the money to buy government bonds, effectively easing the debt crisis.

On 29 February 2012, the ECB held a second auction, providing 800 Eurozone banks with further €529.5 billion in cheap loans.

Resignations

In September 2011, Jürgen Stark became the second German after Axel A. Weber to resign from the ECB Governing Council in 2011. Weber, the former Deutsche Bundesbank president, was once thought to be a likely successor to Jean-Claude Trichet as bank president. He and Stark were both thought to have resigned due to "unhappiness with the ECB’s bond purchases, which critics say erode the bank’s independence". Stark was "probably the most hawkish" member of the council when he resigned. Weber was replaced by his Bundesbank successor Jens Weidmann, while Belgium's Peter Praet took Stark's original position, heading the ECB's economics department.

Economic reforms and recovery

Increase competitiveness

See also: Euro Plus Pact

Change in unit labour costs (2000-2010)

Eurozone economic health and adjustment progress 2011 (Source: Euro Plus Monitor)

Slow GDP growth rates correspond to slower growth in tax revenues and higher safety net spending, increasing deficits and debt levels. Fareed Zakaria described the factors slowing growth in the eurozone, writing in November 2011: "Europe's core problem [is] a lack of growth... Italy's economy has not grown for an entire decade. No debt restructuring will work if it stays stagnant for another decade... The fact is that Western economies - with high wages, generous middle-class subsidies and complex regulations and taxes - have become sclerotic. Now they face pressures from three fronts: demography (an aging population), technology (which has allowed companies to do much more with fewer people) and globalization (which has allowed manufacturing and services to locate across the world)." He advocated lower wages and steps to bring in more foreign capital investment. British economic historian Robert Skidelsky disagreed saying it was excessive lending by banks, not deficit spending that created this crisis. Government's mounting debts are a response to the economic downturn as spending rises and tax revenues fall, not its cause.

To improve the situation, crisis countries must significantly increase their international competitiveness. Typically this is done by depreciating the currency, as in the case of Iceland, which suffered the largest financial crisis in 2008-2011 in economic history but has since vastly improved its position. Since eurozone countries cannot devalue their currency, policy makers try to to restore competitiveness through internal devaluation, a painful economic adjustment process, where a country aims to reduce its unit labour costs. German economist Hans-Werner Sinn noted in 2012 that Ireland was the only country that had implemented relative wage moderation in the last five year, which helped decrease its relative price/wage levels by 16%. Greece would need to bring this figure down by 31%, effectively reaching the level of Turkey.

Other economists argue that no matter how much Greece and Portugal drive down their wages, they could never compete with with low-cost developing countries such as China or India. Instead weak European countries must shift their economies to higher quality products and services, though this is a long-term process and may not bring immediate relief.

Progress

On 15 November 2011, the Lisbon Council published the Euro Plus Monitor 2011. According to the report most critical eurozone member countries are in the process of rapid reforms. The authors note that "Many of those countries most in need to adjust [...] are now making the greatest progress towards restoring their fiscal balance and external competitiveness". Greece, Ireland and Spain are among the top five reformers and Portugal is ranked seventh among 17 countries included in the report (see graph).

Increase investment

There has been substantial criticism over the austerity measures implemented by most European nations to counter this debt crisis. Some argue that an abrupt return to "non-Keynesian" financial policies is not a viable solution and predict that deflationary policies now being imposed on countries such as Greece and Spain might prolong and deepen their recessions. In a 2003 study that analyzed 133 IMF austerity programmes, the IMF's independent evaluation office found that policy makers consistently underestimated the disastrous effects of rigid spending cuts on economic growth. In early 2012 an IMF official, who negotiated Greek austerity measures, admitted that spending cuts were harming Greece. Nouriel Roubini adds that 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."

According to Keynesian economists "growth-friendly austerity" relies on the false argument that public cuts would be compensated for by more spending from consumers and businesses, a theoretical claim that has not materialized. The case of Greece shows that excessive levels of private indebtedness and a collapse of public confidence (over 90% of Greeks fear unemployment, poverty and the closure of businesses) led the private sector to decrease spending in an attempt to save up for rainy days ahead. This led to even lower demand for both products and labor, which further deepened the recession and made it ever more difficult to generate tax revenues and fight public indebtedness.

Instead of austerity, Keynes suggested increasing investment and cutting income tax for low earners to kick-start the economy and boost growth and employment. Since struggling European countries lack the funds to engage in deficit spending, German economist and member of the German Council of Economic Experts Peter Bofinger and Sony Kapoor from global think tank "re-define" suggest financing additional public investments by growth-friendly taxes on "property, land, wealth, carbon emissions and the under-taxed financial sector". They also called on EU countries to renegotiate the EU savings tax directive and to sign an agreement to help each other crack down on tax evasion and avoidance. Currently authorities capture less than 1% in annual tax revenue on untaxed wealth transferred to other EU members. Furthermore they suggest providing €40 billion in additional funds to the European Investment Bank, which could then lend ten times that amount to the employment-intensive smaller business sector.

Apart from arguments over whether or not austerity, rather than increased or frozen spending, is a macroeconomic solution, union leaders have also argued that the working population is being unjustly held responsible for the economic mismanagement errors of economists, investors, and bankers. Over 23 million EU workers have become unemployed as a consequence of the global economic crisis of 2007–2010, while thousands of bankers across the EU have become millionaires despite collapse or nationalization (ultimately paid for by taxpayers) of institutions they worked for during the crisis, a fact that has led many to call for additional regulation of the banking sector across not only Europe, but the entire world.

Proposed long-term solutions

European fiscal union and revision of the Lisbon Treaty

Main article: European Fiscal Union

In March 2011 a new reform of the Stability and Growth Pact was initiated, aiming at straightening the rules by adopting an automatic procedure for imposing of penalties in case of breaches of either the deficit or the debt rules. By the end of the year, Germany, France and some other smaller EU countries went a step further and vowed to create a fiscal union across the eurozone with strict and enforceable fiscal rules and automatic penalties embedded in the EU treaties. On 9 December 2011 at the European Council meeting, all 17 members of the eurozone and six countries that aspire to join agreed on a new intergovernmental treaty to put strict caps on government spending and borrowing, with penalties for those countries who violate the limits. All other non-eurozone countries apart from the UK are also prepared to join in, subject to parliamentary vote.

Originally EU leaders planned to change existing EU treaties but this was blocked by British prime minister David Cameron, who demanded that the City of London be excluded from future financial regulations, including the proposed EU financial transaction tax. By the end of the day, 26 countries had agreed to the plan, leaving the United Kingdom as the only country not willing to join. Cameron subsequently conceded that his action had failed to secure any safeguards for the UK. Britain's refusal to be part of the Franco-German fiscal compact to safeguard the eurozone constituted a de facto refusal (PM David Cameron vetoed the project) to engage in any radical revision of the Lisbon Treaty at the expense of British sovereignty: centrist analysts such as John Rentoul of The Independent (a generally Europhile newspaper) concluded that "Any Prime Minister would have done as Cameron did".

Eurobonds

Main article: Eurobonds

A growing number of investors and economists say Eurobonds would be the best way of solving a debt crisis, though their introduction matched by tight financial and budgetary coordination may well require changes in EU treaties. On 21 November 2011, the European Commission suggested that eurobonds issued jointly by the 17 euro nations would be an effective way to tackle the financial crisis. Using the term "stability bonds", Jose Manuel Barroso insisted that any such plan would have to be matched by tight fiscal surveillance and economic policy coordination as an essential counterpart so as to avoid moral hazard and ensure sustainable public finances.

However, Germany remains opposed (at least in the short term) to take over the debt and interest risk of states that have run excessive budget deficits and borrowed excessively over the past years, saying this could substantially raise the country's liabilities.

European Stability Mechanism (ESM)

Main article: European Stability Mechanism

The European Stability Mechanism (ESM) is a permanent rescue funding programme to succeed the temporary European Financial Stability Facility and European Financial Stabilisation Mechanism in July 2012.

On 16 December 2010 the European Council agreed a two line amendment to the EU Lisbon Treaty to allow for a permanent bail-out mechanism to be established including stronger sanctions. In March 2011, the European Parliament approved the treaty amendment after receiving assurances that the European Commission, rather than EU states, would play 'a central role' in running the ESM. According to this treaty, the ESM will be an intergovernmental organisation under public international law and will be located in Luxembourg.

Such a mechanism serves as a "financial firewall." Instead of a default by one country rippling through the entire interconnected financial system, the firewall mechanism can ensure that downstream nations and banking systems are protected by guaranteeing some or all of their obligations. Then the single default can be managed while limiting financial contagion.

Address current account imbalances

Current account imbalances (1997-2013)

Regardless of the corrective measures chosen to solve the current predicament, as long as cross border capital flows remain unregulated in the euro area, current account imbalances are likely to continue. A country that runs a large current account or trade deficit (i.e., importing more than it exports) must ultimately 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 either decrease its savings reserves or borrow to pay for those imports. Conversely, Germany's large trade surplus (net export position) means that it must either increase its savings reserves or be a net exporter of capital, lending money to other countries to allow them to buy German goods.

The 2009 trade deficits for Italy, Spain, Greece, and Portugal were estimated to be $42.96 billion, $75.31bn and $35.97bn, and $25.6bn respectively, while Germany's trade surplus was $188.6bn. 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 abroad. 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. Alternatively, trade imbalances can be reduced if a country encouraged domestic saving by restricting or penalizing the flow of capital across borders, or by raising interest rates, although this benefit is likely offset by slowing down the economy and increasing government interest payments.

Either way, many of the countries involved in the crisis are on the euro, so devaluation, individual interest rates and capital controls are not available. The only solution left to raise a country's level of saving is to reduce budget deficits and to change consumption and savings habits. For example, if a country's citizens saved more instead of consuming imports, this would reduce its trade deficit. It has therefore been suggested that countries with large trade deficits (e.g. Greece) consume less and improve their exporting industries. On the other hand, export driven countries with a large trade surplus, such as Germany, Austria and the Netherlands would need to shift their economies more towards domestic services and increase wages to support domestic consumption.

European Monetary Fund

On 20 October 2011, the Austrian Institute of Economic Research published an article that suggests transforming the EFSF into a European Monetary Fund (EMF), which could provide governments with fixed interest rate Eurobonds at a rate slightly below medium-term economic growth (in nominal terms). These bonds would not be tradable but could be held by investors with the EMF and liquidated at any time. Given the backing of all the eurozone countries and the ECB "the EMU would achieve a similarly strong position vis-a-vis financial investors as the US where the Fed backs government bonds to an unlimited extent." To ensure fiscal discipline despite the lack of market pressure, the EMF would operate according to strict rules, providing funds only to countries that meet fiscal and macroeconomic criteria. Governments lacking sound financial policies would be forced to rely on traditional (national) governmental bonds with less favorable market rates.

Since investors would finance governments directly, banks would no longer be able to unduly benefit from intermediary profits by borrowing from the ECB at low rates and investing in government bonds at high rates. Econometric analysis suggests that a stable long-term interest rate of three percent in all eurozone countries would lead to higher nominal GDP growth rates and substantially lower sovereign debt levels by 2015, compared to the baseline scenario with market based interest levels.

Drastic debt write-off financed by wealth tax

Overall debt levels in 2009 and write-offs necessary in the Eurozone, UK and U.S. to reach sustainable grounds

According to the Bank for International Settlements, the combined private and public debt of 18 OECD countries nearly quadrupled between 1980 and 2010, and will likely continue to grow, reaching between 250% (for Italy) and about 600% (for Japan) by 2040. The same authors also found in a previous study that increased financial burden imposed by aging populations and lower growth makes it unlikely that indebted economies can grow out of their debt problem if only one of the following three conditions is met:

• government debt is more than 80 to 100 percent of GDP;
• non-financial corporate debt is more than 90 percent;
• private household debt is more than 85 percent of GDP.

The Boston Consulting Group (BCG) adds that if the overall debt load continues to grow faster than the economy, then large scale debt restructuring becomes inevitable. To prevent a vicious upward debt spiral from gaining momentum the authors urge policy makers to "act quickly and decisively" and aim for an overall debt level well below 180 percent for the private and government sector. This number is based on the assumption that governments, nonfinancial corporations, and private households can each sustain a debt load of 60 percent of GDP, at an interest rate of 5 percent and a nominal economic growth rate of 3 percent per year. Lower interest rates and/or higher growth would help reduce the debt burden further.

To reach sustainable levels the Eurozone must reduce its overall debt level by €6.1 trillion. According to BCG this could be financed by a one-time wealth tax of between 11 and 30 percent for most countries, apart from the crisis countries (particularly Ireland) where a write-off would have to be substantially higher. The authors admit that such programs would be "drastic", "unpopular" and "require broad political coordination and leadership" but they maintain that the longer politicians and central bankers wait, the more necessary such a step will be.

Instead of a one-time write-off, German economist Harald Spehl has called for a 30 year debt-reduction plan, similar to the one Germany used after the Second World War to share the burden of reconstruction and development. Similar calls have been made by political parties in Germany including the Greens and The Left.

Speculation about the breakup of the eurozone

Economists, mostly from outside Europe and associated with Modern Monetary Theory and other post-Keynesian schools, condemned the design of the euro currency system from the beginning because it ceded national monetary and economic sovereignty but lacked a central fiscal authority. When faced with economic problems, they maintained, "Without such an institution, EMU would prevent effective action by individual countries and put nothing in its place." Some non-Keynesian economists, such as Luca A. Ricci of the IMF, contend the eurozone does not fulfill the necessary criteria for an optimum currency area, though it is moving in that direction.

As the debt crisis expanded beyond Greece, these economists continued to advocate, albeit more forcefully, the disbandment of the eurozone. If this was not immediately feasible, they recommended that Greece and the other debtor nations unilaterally leave the eurozone, default on their debts, regain their fiscal sovereignty, and re-adopt national currencies. Bloomberg suggested in June 2011 that, if the Greek and Irish bailouts should fail, an alternative would be for Germany to leave the eurozone in order to save the currency through depreciation instead of austerity. The likely substantial fall in the euro against a newly reconstituted Deutsche Mark would give a "huge boost" to its members' competitiveness. Also The Wall Street Journal conjectured that Germany could return to the Deutsche Mark, or create another currency union with the Netherlands, Austria, Finland, Luxembourg and other European countries such as Denmark, Norway, Sweden, Switzerland and the Baltics. A monetary union of these countries with current account surpluses would create the world's largest creditor bloc, bigger than China or Japan. The Wall Street Journal added that without the German-led bloc, a residual euro would have the flexibility to keep interest rates low and engage in quantitative easing or fiscal stimulus in support of a job-targeting economic policy instead of inflation targeting in the current configuration.

German Chancellor Angela Merkel and French President Nicolas Sarkozy have, however, on numerous occasions publicly said that they would not allow the eurozone to disintegrate, linking the survival of the euro with that of the entire European Union. In September 2011, EU commissioner Joaquín Almunia shared this view, saying that expelling weaker countries from the euro was not an option. Furthermore, former ECB president Jean-Claude Trichet also denounced the possibility of a return of the Deutsche Mark.

Controversies

EU treaty violations

No bail-out clause

The EU's Maastricht Treaty contains juridical language which appears to rule out intra-EU bailouts. First, the “no bail-out” clause (Article 125 TFEU) ensures that the responsibility for repaying public debt remains national and prevents risk premiums caused by unsound fiscal policies from spilling over to partner countries. The clause thus encourages prudent fiscal policies at the national level.

The European Central Bank's purchase of distressed country bonds can be viewed as violating the prohibition of monetary financing of budget deficits (Article 123 TFEU). The creation of further leverage in EFSF with access to ECB lending would also appear to violate the terms of this article.

Articles 125 and 123 were meant to create disincentives for EU member states to run excessive deficits and state debt, and prevent the moral hazard of over-spending and lending in good times. They were also meant to protect the taxpayers of the other more prudent member states. By issuing bail-out aid guaranteed by prudent eurozone taxpayers to rule-breaking eurozone countries such as Greece, the EU and eurozone countries also encourage moral hazard in the future. While the no bail-out clause remains in place, the "no bail-out doctrine" seems to be a thing of the past.

Convergence criteria

The EU treaties contain so called convergence criteria. Concerning government finance the states have agreed that the annual government budget deficit should not exceed 3% of the gross domestic product (GDP) and that the gross government debt to GDP should not exceed 60% of the GDP. For eurozone members there is the Stability and Growth Pact which contains the same requirements for budget deficit and debt limitation but with a much stricter regime. Nevertheless the main crisis states Greece and Italy (status November 2011) have substantially exceeded these criteria over a long period of time.

Actors fueling the crisis

Credit rating agencies

Standard & Poor's Headquarters in Lower Manhattan, New York City

The international U.S.-based credit rating agencies—Moody's, Standard & Poor's and Fitch—which have already been under fire during the housing bubble and the Icelandic crisis—have also played a central and controversial role in the current European bond market crisis. On the one hand, the agencies have been accused of giving overly generous ratings due to conflicts of interest. On the other hand, ratings agencies have a tendency to act conservatively, and to take some time to adjust when a firm or country is in trouble. In the case of Greece, the market responded to the crisis before the downgrades, with Greek bonds trading at junk levels several weeks before the ratings agencies began to describe them as such.

European policy makers have criticized ratings agencies for acting politically, accusing the Big Three of bias towards European assets and fueling speculation. Particularly Moody's decision to downgrade Portugal's foreign debt to the category Ba2 "junk" has infuriated officials from the EU and Portugal alike. State owned utility and infrastructure companies like ANA – Aeroportos de Portugal, Energias de Portugal, Redes Energéticas Nacionais, and Brisa – Auto-estradas de Portugal were also downgraded despite claims to having solid financial profiles and significant foreign revenue. France too has shown its anger at its downgrade. French central bank chief Christian Noyer criticized the decision of Standard & Poor's to lower the rating of France but not that of the United Kingdom, which "has more deficits, as much debt, more inflation, less growth than us". Similar comments were made by high ranking politicians in Germany. Michael Fuchs, deputy leader of the leading Christian Democrats, said: "Standard and Poor's must stop playing politics. Why doesn't it act on the highly indebted United States or highly indebted Britain?", adding that the latter's collective private and public sector debts are the largest in Europe. He further added: "If the agency downgrades France, it should also downgrade Britain in order to be consistent."

Credit rating agencies were also accused of bullying politicians by systematically downgrading eurozone countries just before important European Council meetings. As one EU source put it: "It is interesting to look at the downgradings and the timings of the downgradings ... It is strange that we have so many downgrades in the weeks of summits."

Regulatory reliance on credit ratings

Think-tanks such as the World Pensions Council have criticized European powers such as France and Germany for pushing for the adoption of the Basel II recommendations, adopted in 2005 and transposed in European Union law through the Capital Requirements Directive (CRD), effective since 2008. In essence, this forced European banks and more importantly the European Central Bank, e.g. when gauging the solvency of EU-based financial institutions, to rely heavily on the standardized assessments of credit risk marketed by only two private US agencies- Moody’s and S&P.

Counter measures

Due to the failures of the ratings agencies, European regulators obtained new powers to supervise ratings agencies. With the creation of the European Supervisory Authority in January 2011 the EU set up a whole range of new financial regulatory institutions, including the European Securities and Markets Authority (ESMA), which became the EU’s single credit-ratings firm regulator. Credit-ratings companies have to comply with the new standards or will be denied operation on EU territory, says ESMA Chief Steven Maijoor.

Germany's foreign minister Guido Westerwelle has called for an "independent" European ratings agency, which could avoid the conflicts of interest that he claimed US-based agencies faced. European leaders are reportedly studying the possibility of setting up a European ratings agency in order that the private U.S.-based ratings agencies have less influence on developments in European financial markets in the future. According to German consultant company Roland Berger, setting up a new ratings agency would cost €300 million. On 30 January 2012, the company said it was already collecting funds from financial institutions and business intelligence agencies to set up an independent non-profit ratings agency by mid 2012, which could provide its first country ratings by the end of the year.

But attempts to regulate more strictly credit rating agencies in the wake of the European sovereign debt crisis have been rather unsuccessful. Some European financial law and regulation experts have argued that the hastily drafted, unevenly transposed in national law, and poorly enforced EU rule on ratings agencies (Regulation EC N° 1060/2009) has had little effect on the way financial analysts and economists interpret data or on the potential for conflicts of interests created by the complex contractual arrangements between credit rating agencies and their clients"

Media

There has been considerable controversy about the role of the English-language press in regard to the bond market crisis.

Greek Prime Minister Papandreou is quoted as saying that there was no question of Greece leaving the euro and suggested that the ­crisis was politically as well as financially motivated. "This is an attack on the eurozone by certain other interests, political or financial". The Spanish Prime Minister José Luis Rodríguez Zapatero has also suggested that the recent financial market crisis in Europe is an attempt to undermine the euro. He ordered the Centro Nacional de Inteligencia intelligence service (National Intelligence Center, CNI in Spanish) to investigate the role of the "Anglo-Saxon media" in fomenting the crisis. So far no results have been reported from this investigation.

Other commentators believe that the euro is under attack so that countries, such as the U.K. and the U.S., can continue to fund their large external deficits and government deficits, and to avoid the collapse of the US dollar. The U.S. and U.K. do not have large domestic savings pools to draw on and therefore are dependent on external savings e.g. from China. This is not the case in the eurozone which is self funding.

Speculators

Both the Spanish and Greek Prime Ministers have accused financial speculators and hedge funds of worsening the crisis by short selling euros. German chancellor Merkel has stated that "institutions bailed out with public funds are exploiting the budget crisis in Greece and elsewhere."

According to The Wall Street Journal several hedge-fund managers launched "large bearish bets" against the euro in early 2010. On February 8, the boutique research and brokerage firm Monness, Crespi, Hardt & Co. hosted an exclusive "idea dinner" at a private townhouse in Manhattan, where a small group of hedge-fund managers from SAC Capital Advisors LP, Soros Fund Management LLC, Green Light Capital Inc., Brigade Capital Management LLC and others argued that the euro was likely to fall to parity with the US dollar and were of the opinion that Greek government bonds represented the weakest link of the euro and that Greek contagion could soon spread to infect all sovereign debt in the world. Three days later the euro was hit with a wave of selling, triggering a decline that brought the currency below $1.36. There was no suggestion by regulators that there was any collusion or other improper action. On 8 June, exactly four months after the dinner, the Euro hit a four year low at $1.19 before it started to rise again. Traders estimate that bets for and against the euro account for a huge part of the daily three trillion dollar global currency market.

The role of Goldman Sachs in Greek bond yield increases is also under scrutiny. It is not yet clear to what extent this bank has been involved in the unfolding of the crisis or if they have made a profit as a result of the sell-off on the Greek government debt market.

In response to accusations that speculators were worsening the problem, some markets banned naked short selling for a few months.

Odious debt

Main article: Odious debt

Some protesters, commentators such as Libération correspondent Jean Quatremer and the Liège based NGO Committee for the Abolition of the Third World Debt (CADTM) allege that the debt should be characterized as odious debt. The Greek documentary Debtocracy examines whether the recent Siemens scandal and uncommercial ECB loans which were conditional on the purchase of military aircraft and submarines are evidence that the loans amount to odious debt and that an audit would result in invalidation of a large amount of the debt.

National statistics

In 1992, members of the European Union signed an agreement known as the Maastricht Treaty, under which they pledged to limit their deficit spending and debt levels. However, a number of EU member states, including Greece and Italy, were able to circumvent these rules and mask their deficit and debt levels through the use of complex currency and credit derivatives structures. The structures were designed by prominent U.S. investment banks, who received substantial fees in return for their services and who took on little credit risk themselves thanks to special legal protections for derivatives counterparties. Financial reforms within the U.S. since the financial crisis have only served to reinforce special protections for derivatives—including greater access to government guarantees—while minimizing disclosure to broader financial markets.

The revision of Greece’s 2009 budget deficit from a forecast of "6–8% of GDP" to 12.7% by the new Pasok Government in late 2009 (a number which, after reclassification of expenses under IMF/EU supervision was further raised to 15.4% in 2010) has been cited as one of the issues that ignited the Greek debt crisis.

This added a new dimension in the world financial turmoil, as the issues of "creative accounting" and manipulation of statistics by several nations came into focus, potentially undermining investor confidence.

The focus has naturally remained on Greece due to its debt crisis. There has however been a growing number of reports about manipulated statistics by EU and other nations aiming, as was the case for Greece, to mask the sizes of public debts and deficits. These have included analyses of examples in several countries or have focused on Italy, the United Kingdom, Spain, the United States, and even Germany.

Collateral for Finland

On 18 August 2011, as requested by the Finnish parliament as a condition for any further bailouts, it became apparent that Finland would receive collateral from Greece, enabling it to participate in the potential new €109 billion support package for the Greek economy. Austria, the Netherlands, Slovenia, and Slovakia responded with irritation over this special guarantee for Finland and demanded equal treatment across the eurozone, or a similar deal with Greece, so as not to increase the risk level over their participation in the bailout. The main point of contention was that the collateral is aimed to be a cash deposit, a collateral the Greeks can only give by recycling part of the funds loaned by Finland for the bailout, which means Finland and the other eurozone countries guarantee the Finnish loans in the event of a Greek default.

After extensive negotiations to implement a collateral structure open to all eurozone countries, on 4 October 2011, a modified escrow collateral agreement was reached. The expectation is that only Finland will utilise it, due to i.a. requirement to contribute initial capital to European Stability Mechanism in one installment instead of five installments over time. Finland, as one of the strongest AAA countries, can raise the required capital with relative ease.

At the beginning of October, Slovakia and Netherlands were the last countries to vote on the EFSF expansion, which was the immediate issue behind the collateral discussion, with a mid-October vote. On 13 October 2011 Slovakia approved euro bailout expansion, but the government has been forced to call new elections in exchange.

In February 2012, the four largest Greek banks agreed to provide the €880 million in collateral to Finland in order to secure the second bailout program.

Political impact

Handling of the ongoing crisis has led to the premature end of a number of European national governments and impacted the outcome of many elections:

• Finland – April 2011 – The approach to the Portuguese bailout and the EFSF dominated the April 2011 election debate and formation of the subsequent government.
• Greece – November 2011 – Following widespread criticism of a referendum proposal on austerity and bailout measures, from within his party, the opposition and other EU governments, PM George Papandreou announced plans for his resignation in favour of a national unity government between three parties, of which only two remain in the coalition. Meanwhile the popularity of Papandreou's PASOK party dropped from 42.5% in 2010 to as low as 7% in some polls in 2012. Following protests from within their parties, Papandreou and Antonis Samaras removed a total of 44 MPs from their respective parliamentary groups, leading to PASOK losing its parliamentary majority. Early elections are likely to be held in 2012.
• Ireland – November 2010 – In return for its support for the IMF bailout and consequent austerity budget, the junior party in the coalition government, the Green Party set a time-limit on its support for the Cowen Government which set the path to early elections in Feb 2011.
• Italy – November 2011 – Following market pressure on government bond prices in response to concerns about levels of debt, the Government of Silvio Berlusconi lost its majority, resigned and was replaced by the Government of Mario Monti.
• Portugal – March 2011 – Following the failure of parliament to adopt the government austerity measures, PM José Sócrates and his government resigned, bringing about early elections in June 2011.
• Slovakia – October 2011 – In return for the approval of the EFSF by her coalition partners, PM Iveta Radičová had to concede early elections in March 2012.
• Slovenia – September 2011 – Following the failure of June referendums on measures to combat the economic crisis and the departure of coalition partners, the Borut Pahor government lost a motion of confidence and December 2011 early elections were set, following which Janez Janša became PM.
• Spain – July 2011 – Following the failure of the Spanish government to handle the economic situation, PM José Luis Rodríguez Zapatero announced early elections in November. "It is convenient to hold elections this fall so a new government can take charge of the economy in 2012, fresh from the balloting" he said. Following the elections, Mariano Rajoy became PM.

See also

• 2000s European sovereign debt crisis timeline
• 2000s commodities boom
• Crisis situations and protests in Europe since 2000
• FRED (Federal Reserve Economic Data)
• List of countries by credit rating
• List of acronyms
• Late-2000s recession in Europe
• 2008–2011 Icelandic financial crisis

External links

• 2011 Dahrendorf Symposium – Changing the Debate on Europe – Moving Beyond Conventional Wisdoms
• 2011 Dahrendorf Symposium Blog
• Eurostat – Statistics Explained: Structure of government debt (October 2011 data)
• Interactive Map of the Debt Crisis Economist Magazine, 9 February 2011
• European Debt Crisis New York Times topic page updated daily.
• Tracking Europe's Debt Crisis New York Times topic page, with latest headline by country (France, Germany, Greece, Italy, Portugal, Spain).
• Map of European Debts New York Times 20 December 2010
• Budget deficit from 2007 to 2015 Economist Intelligence Unit 30 March 2011
• Protests in Greece in Response to Severe Austerity Measures in EU, IMF Bailout – video report by Democracy Now!
• Diagram of Interlocking Debt Positions of European Countries New York Times 1 May 2010
• Argentina: Life After Default Sand and Colours 2 August 2010
• Google – public data: Government Debt in Europe
• Stefan Collignon: Democratic requirements for a European Economic Government Friedrich-Ebert-Stiftung, December 2010 (PDF 625 KB)
• Nick Malkoutzis: Greece – A Year in Crisis Friedrich-Ebert-Stiftung, Juni 2011
• Rainer Lenz: Crisis in the Eurozone Friedrich-Ebert-Stiftung, Juni 2011
• Wolf, Martin, "Creditors can huff but they need debtors", Financial Times, November 1, 2011 7:28 pm.
• More Pain, No Gain for Greece: Is the Euro Worth the Costs of Pro-Cyclical Fiscal Policy and Internal Devaluation? Center for Economic and Policy Research, February 2012