Eurozone crisis

The eurozone crisis started in 2010 when  doubts about  its  ability to service its debt made investors reluctant to buy  bonds issued by the Greek government. That reluctance spread to affect the bond issues of several other eurozone members, and by late November 2011, it was affecting  the bonds of all of its members, including Germany. Measures agreed by eurozone leaders in a series of summits in the course of 2011 were judged by the financial markets to have been insufficient to resolve the crisis.

Overview
The crisis started early in 2010 with the revelation that, without external assistance, the Greek government would be forced to default on its debt. Eurozone governments responded with conditional loans to enable the Greek government to continue to roll-over its maturing debts. In the course of 2010, however, investors' fears of sovereign default by other eurozone governments increased their cost of borrowing, and further conditional loans had to be  provided to the governments of  Ireland and Portugal. The crisis deepened when, in the latter half of 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 were sharp increases in the sovereign spreads of Spain and Italy, followed by modest increases in the bond yields of 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.

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
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 repeated loans 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 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.

The Greek crisis
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.

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. It was also acquiring the potential to trigger a second international financial crisis because the default of a European government might be expected to create a shock comparable to the failure of the Lehman Brothers bank that had triggered the crash of 2008. The falls in world stock market prices that occurred in August and September of 2011 were widely attributed to fears of a eurozone-generated financial crisis.

The Italian crisis
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.

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".

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.

Overview
The bond market was not reassured by the decisions of October 2011. Despite the new Italian government's acceptance of the measures had been agreed, the  yields on its bonds rose to over 7 per cent, and there was evidence of contagion of the crisis by other PIIGS and  non-PIIGS countries, including Austria and France, and even by Germany. As a result of the policy constraints affecting the European Central Bank and the German Government, the further summit decisions of 8 December 2011 contained nothing of immediate relevance to the crisis, and had no lasting effect upon the financial markets. The only decisive moves were the European Central Bank's offer to lend unlimited amounts to eurozone banks at an interest rate of 1 per cent, and the agreement of the Eurogroup to a second round of conditional financial support to Greece. The Bank's action was followed a marked reduction in the yields on Italian and Spanish government bonds.

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. 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.

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

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.

Policy responses
A European Union summit on 5-8 December proposed the adoption in March 2012 of a treaty change, including a new fiscal compact, the effect of which if adopted, would be a major strenghtening of the stability and growth pact. Its eventual adoption will depend upon the approval of the parliaments of the member countries. No action was taken to resolve the immediate crisis - an omission that was attributed to the attitudes of the German authorities (see lower box), and to their policy constraints.

On 8 December, 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 . It was suggested by President Sarkozy that "each state can turn to its banks, which will have liquidity at their disposal". Although the banks in Greece, Italy and Spain were reported to be in need of assistance , there were substantial reductions in sovereign spreads in the course of the following month. It has been reported that a second round of cheap three-year loans was to be issued on 29 February, raising the total to almost €1 trillion. The programme has so far been used mainly by Spanish and Italian banks to shore up funding gaps and buy government bonds.

The policy debate
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