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.

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 rescue measures that were initially adopted by the other eurozone governments took the form of conditional loans that enabled 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 20ll, it became evident that a default by the Greek government could no longer be avoided. On October 26 2011, after prolonged negotiations, 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. There were increases in the sovereign spreads of Spain and Italy that were attributed to contagion from Greece, and eurozone leaders prevailed upon the Italian government to take determined action to reduce its debt. Bond market investors were not reassured. In mid November there were increases in the bond yields of other eurozone countries including France, and on 24 November 2011 there was a partial failure of a German government bond auction. Leaders of the eurozone differ about how its collapse is to be averted.

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".

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. 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).

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. Nevertheless, the eurozone leaders did not take decisive action until October 2011, when they sought to restore confidence in the governments of Greece and Ireland.

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.

Contagion beyond the PIIGS
The bond market was not immediately 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,  in the form of sharply rising sovereign spreads. On 23 November, contagion reached Germany. Its 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

It appeared that bond market investors had bacome reluctant to buy the sovereign bonds of any eurozone country because of fear of a breakdown of the entire eurozone system.

Overview
The principal alternatives that have been put forward to the current policy responses to the crisis have  been (a) the extension of the European Central Bank's limited practice of government bond purchases to the point of giving it the obligation to serve as member governments' lender of last resort, and (b) the issue by individual member government of eurobonds that would be jointly guaranteed by member states as a whole. The reason that has been put forward for their rejection by the eurozone's decision makers has been the fear that the moral hazard that is  associated with financial rescues, would lead to reckless conduct by member governments, of the sort that would increase the prospects of a recurrence of the crisis. There is evidence, however, of dissension among member states, some of whom consider that the avoidance of, what they fear to be, the imminent collapse of the eurozone should be given priority over the longer-term problem of avoiding moral hazard.

The European Central Bank
The European Central Bank would be able to make a decisive response to the crisis were it not for the constraint of its mandate, and were it not for the restrictive interpretation that it applies to its function. Article 123 of the Treaty on European Union prohibits it from buying bonds from member governments, so that an amendment to the treaty would, in principle, be necessary to enable it to act as their "lender of last resort". Statements by its governors make it clear, however, that they consider the function of a central bank to be the avoidance of inflation, and that they would be very reluctant to use its  powers for other purposes. Interpreted literally, the treaty does not forbid the purchase of government bonds on the secondary market, and there have been a number of such purchases. They have been too small to make a decisive difference, however and, even so, they have been opposed to the point of resignation by some of the Bank's governors.

The European Commission
The Commission has put forward its proposals for the introduction of eurobonds and for improved fiscal coordination  but, although fhe European Union's treaties authorise the Commission to take the initiative in proposing legislation, legislative decisions (except those concerning competition policy) can be taken only by the Council of Ministers and the European Parliament.

Germany
With the largest of the eurozone's economies, and the largest contributor to its rescue measures, Germany's attitudes have necessarily had a decisive influence on the eurozone's response to the crisis, and the European press is virtually unanimous in the belief that its Chancellor, Angela Merkel dictates her conditions on what should be done. .

The German Government is opposed to "any participation of the European Central Bank in the strategies to resolve the euro debt and banking crisis". It is also opposed to the European Commission's eurobond proposal. Chancellor Merkel described the proposal as "extremely regrettable and inappropriate", arguing that the case for it should be put at the end of the process of European integration, "if indeed it is put at all", but newspaper reports in Germany indicate that some within her Christian Democratic Union  Party  and the Christian Social Union  might be willing to give up their objections if it were made conditional on the introduction of an effective system of fiscal coordination (in light of a judgement by the German Constitutional Court , an amendment to the German constitution may be needed for that purpose).

According to a YouGov poll held in August 2011, most Germans disapprove of their government's handling of the crisis (75%), and they want no more bailouts (59%), but want Greece expelled from the eurozone (58%). But German opinion is dividide on the question of whether Germany should leave the eurozone (44% for/48% against). However, the results of a European Parliament "Eurobarometer" survey do not  show German attitudes to the crisis as differimg greatly from those of other eurozone countries,  except for their disapproval of eurobonds.

There have been signs that Angela Merkel's coalition government has been losing popular support , but federal elections are not due until 2013.

France
France's President Sarkozy is reported to favour both the eurobond proposal, and the proposal to use the the European Central Bank as lender of last resort, but to be willing to avoid public statements of disagreement with Chancellor Merkel.

Others
Qn a visit to Berlin on 28th November, the Polish Foreign Minister attacked the German Government's policy with the words " we ask that Germany admits that she is the biggest beneficiary of the current arrangements and therefore that she has the biggest obligation to make them sustainable'' and called for immediate action to strengthen fiscal coordination and to make the European Central Bank the eurozone's lender of last resort.

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