Eurozone crisis

The eurozone crisis  started in 2010 when  doubts about the ability of the Greek government to service its debt made bond market investors reluctant to buy its bonds, and those of several other eurozone governments. The series of rescue packages that were provided in the course of 2010 and 2011 failed to reassure investors, and in October 2011 an agreement was reached which excused the Greek government of half of its debt and increased the eurozone's capacity to provide financial assistance to its member governments.

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. The assistance that was provided by other eurozone governments enabled the Greek government to continue to roll-over maturing debts until, in the latter half of 20ll, it became evident that a default could no longer be avoided. In the meantime, investors' fears of default had increased the cost of borrowing to other eurozone governments, making it necessary to provide financial assistance to the governments of both Ireland and Portugal. By September 2011, the international community had become aware of the danger that a Greek government default, and that its repercussions could administer a shock to the world economy comparable to the shock that triggered the Great Recession. On October 26 a rescue plan was agreed, involving a 50 per cent write-off of the Greek government's debt; the recapitalisation of eurozone banks; and, an increase in the effective size of the European Financial Stability Facility.

The eurozone
(For a fuller account see the Eurozone article)

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 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 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 twenty-two Member States in 2010.

It is not certain what was envisaged concerning the treatment of governments that could not meet their financial obligations. Article 104 of the Maastricht treaty appeared to forbid any financial "bail-out" of member governments, but article 103 of the treaty appeared to envisage circumstances under which a bail-out would be permitted.

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. 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)

The PIIGS
The economies of five of the eurozone countries (Portugal, Italy, Ireland, Greece and Spain) 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 competiveness 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.

The development of the crisis
In April 2010, the Greek goverment faced the prospect of being unable to fund its maturing debts, and later that year, the Irish government found itself in a similar position. Their problems arose from large increases in their sovereign spreads reflecting the bond market's fears that they might default - fears that were based upon both  their large budget deficits, and  their limited economic prospects. In May 2010, the Greek government was granted a  €110 billion rescue package, and in November 2010 the Irish government was granted an €85 billion rescue package, both financed jointly by the eurozone governments and the IMF. Further increases in spreads showed that those rescue packages had failed to reassure the markets. Further support packages also failed to solve the problem, and signs began to appear of the contagion of the bond market fears from Greece to other eurozone 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  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.

During September and October 2011 there were negotiations involving eurozone governments,  the European Central Bank and the Institute for International Finance  representing the world's major banks. Agreement was sought to bring about a  reduction in the Greek government's debt, the recapitalisation of some  European banks  and an increase in the funds available to the European Financial Stability Facility. Objections were raised by the German, and the Dutch governments, and others, but an agreement in general terms was finally reached on 26th October 2011.

The October 26 rescue package
The package was intended to reduce the Greek government's debt to GDP ratio to 120% by 2020. There would be a "nominal discount" of 50% on "notional Greek debt" held by private investors. In order to provide the resources for further financial assistance, member states would make a private sector contribution of up to €30 billion, and there would be a new European Union-IMF contribution of up to €100 billion. Also, the European Financial Stability Facility would be permitted to leverage its financial capacity by 4 or 5 times to around €1 trillion (by issuing bonds for use as collateral for loans from the European Central Bank)

Possible international repercussions
One consequence of a default by the Greek government would be a loss of capital by those banks that have holdings in Greek bonds. The Bank for International Settlements puts French banks' total liabilities in Greece at $56 billion and Germany's at $24 billion. That loss might reduce their capital adequacy ratios to below the minimum considered prudent, in which case, the banks may be expected to restrict lending, raising the prospect of a widespread credit crunch. (It is even possible that both those consequences could result from the anticipation of a default). The eurozone's failure to rescue Greece might  also reduce the market's confidence in the bond issues of other eurozone governments. That might trigger an iterative process which could lead to a default by the government of a larger eurozone country, and result in an economic shock  large enough to generate another global financial crisis