Eurozone crisis

The financial assistance that was provided to the governments of Greece and Ireland in  2010 failed restore the confidence of the markets in their continued ability to service their debt,  and bond market investors became reluctant to buy the bonds being issued by some other eurozone governments. The eurozone crisis that started in 2010 arose from doubts about the willingness of major eurozone governments to provide the further assistance that may be needed, and fears that there may be a breakup of the eurozone if they do not.

Overview
During 2010, prospective investors became increasingly reluctant to buy the bonds issued by five eurozone governments (Portugal, Ireland, Italy, Greece and Spain) at the offered interest rates,  and the governments concerned had to make a succession of increases in those rates. Two of those governments - Greece and Ireland - eventually decided that, without help, they  would not be able to continue to  finance their budget deficits,  and they sought - and received - loans from other European governments. Those loans failed to reassure potential investors, and in November  they  demanded further increases in the interest rates on   the  government bonds of all five governments (including  those of Portugal, Spain and Italy,  because of fears of contagion from Greece and Ireland).

By December 2010, there was widespread uncertainty about future prospects for the eurozone and beyond. There were doubts about the willingness of European governments to provide further financial support to the five "PIIGS" governments, and speculation that financing difficulties might spread to affect other governments. Some commentators considered it inevitable that one or other of the PIIGS governments would default on its loans, and other commentators forecast departures from the eurozone by governments wishing  to escape its  restraints. There were even those who envisaged wholesale departures, leading to a collapse of the common currency - an outcome that would impose substantial losses upon countries with investments in euro-denominated securities, and could threaten the stability of the international financial system.

Membership
In 1991, the 15 members of the European Union, meeting in the Dutch town of Maastricht, agreed to set up a monetary union with a single currency. They agreed upon strict criteria for joining, including targets for inflation, interest rates and budget deficits, and they subsequently agreed upon rules of conduct that were intended to preserve its members' fiscal sustainability. 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, but the intention was announced of imposing financial penalties for breaches.

Greece joined 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, Denmark, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, Sweden and the United Kingdom are EU Member States but are not members of the eurozone.

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 national 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 Financial Stability Facility
In May 2010, the European Council established a Financial Stability Facility(EFSF} that was intended to provide financial assistance to eurozone governments who experience  "difficulties caused by exceptional circumstances beyond [their] control",  on terms similar to those adopted by the IMF. Additional assistance  would be provided  by member states, guaranteed on a pro rata basis, and maturing after three years . Assistance  was intended to be in addition to loans by the European Financial Stabilisation Mechanism (EFSM) (which are raised by the European Commission and guaranteed by the EU budget), and to loans by  the International Monetary Fund.  It is intended to replace the EFSF and the EFSM with a permanent crisis resolution regime  that is 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 2010, the Greek goverment faced the prospect of being unable to fund its maturing debts, and in 2010 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 received 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.

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.

Conditional loans
The EU/IMF loans had been primarily intended to restore the confidence of the bond markets in their recipients' ability to meet their financial obligations. They were subject to conditions that were to be expected to cause substantial reductions in economic growth and increases in unemployment. (The conditions attached to the loans to the Greece government were designed to reduce its budget deficit to 3 per cent of its GDP by 2014, from its 2009 level of 11.6 per cent, by means that included a tax increase of 4 per cent of GDP and public spending reductions of 5 per cent of GDP). When the first loan failed to restore confidence, it was decide to add a second loan and to reduce the interest rate charged on all  loans from 5.5 to  3.5 percent, in addition to which  EU financial institutions  agreed to  make a financial contribution and  to agree to the restructuring of some of the Greek government's debt.

As rescue measures, they were a dramatic failure.

Bond purchases
At an early stage, the failure of conditional loans to avert the growing crisis prompted the exploration of possible alternatives. Some of them have since been adopted, and all of them are the subject of continuing debate. Among those that were adopted was the idea of sovereign bond purchases. Before May 2010, the European Central Bank had used bond purchases only for the purpose of monetary policy, but in May 2010, in a major policy change, it decided to buy European government bonds in order to assist governments who were experiencing funding difficulties - a policy change that was opposed by Axel Weber, the then President of the German central bank. Purchases are reported to have included the bonds of all of the PIIGS countries, including Spain and Italy, but they achieved only temporary stabilisations of the affected markets.

Eurobonds
The Greek government's funding problems would be solved if it were permitted to issue bonds that were guaranteed by the other eurozone governments, and several such "eurobond" proposals have been put forward at an academic level. The idea was advanced at a ministerial level in December 2010 by Jean-Claude Juncker, the Luxembourg prime minister and Giulio Tremonti, the Italian finance minister,, but rejected as unconstitutional by German Chancellor Angela Merkel. In August 2011, the financier George Soros argued that such a "eurobond" would have to be an essential feature of any effective Greek rescue package, an assessment that was endorsed by the eminent economist, Joseph Siglitz . The proposal was again rejected by Angela Merkel, but in September 2011 the European Commission President, Jose Manuel Barroso, announced that the Commission would soon present options for the introduction of eurozone joint bonds.

Fiscal union
It has been argued by the economist Wolfgang Münchau, and others, that the eurozone embodies a logical inconsistency that will continue to make it vulnerable to economic shocks unless it is resolved by the introduction of some form of fiscal union. It is generally acknowledged, however, that the political obstacles that would have to be overcome are such as to put such a solution beyond reach for several years. (For example, the German constitutional court has ruled that political control over fiscal policy is a part of national sovereignty that cannot be transferred to the European Union ).

Debt restructuring
It is generally accepted that the costs of sovereign default to all concerned are such as to make its avoidance a high priority objective. However it is being argued that, when default becomes unavoidable, some of those costs can be avoided by a timely "restructuring" agreement with the country's creditors. In May 2011, European Finance Ministers discussed the possibility of a rescheduling of the Greek government's debt (also referred to as "soft restructuring" or "reprofiling").

Guntram Wolff, the deputy director of the Bruegel think tank believes that Greece's debt ratio needs to be reduced by around 50 percentage points if Athens is to approach long-term debt sustainability, and Greece's Finance Minister is reported to consider an "orderly default with a 50 percent haircut for bondholders" to be one of his government's options.

Exit from the eurozone
Departure from the eurozone would enable a country to monetise its debt, and would offer the prospect of an increase in competetiveness resulting from a currency devaluation. However, according to a study by UBS economists, the benefits to a country like Greece would be overwhelmingly outweighed by costs. It would also result in mass sovereign and corporate default, a major increase in the cost of capital, and the collapse of its banking system (the first-year cost of its departure was later estimated to be 40 to 50 per cent of GDP. ). The economic commentator, Anotole Kaletsky, has argued that the "seemingly impossible" solution of   a German exit might become inevitable, and  would be much less disruptive than a Greek expulsion because  it would not trigger bank runs in countries, but would enable a devalued  euro to be managed on less austere principles. But the UBS economists estimate that departure of Germany would lead to a  first-year loss to its economy of 20 to 25 per cent of GDP.

International repercussions
The first-round 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. but estimates that exposure to Greek sovereign debt is less, at about 10 billion euro or less for each country. The loss might reduce their capital adequacy ratios to below the minimum considered prudent, in which case and, in order to restore that ratio, the banks would be expected to restrict lending, raising the prospect of a credit crunch as a second-round consequence. (It is even possible that both those consequences could result from the anticipation of a default)

If the euro were allowed to collapse, however, it has been estimated that reversion to national currencies would be followed by devaluations that would cost British, French and German banks about €360 billion creating a supply shock.