Eurozone Debt Crisis: Causes, Cures and Consequences

How the Eurozone Crisis Affects You

eurozone crisis
Germany's Chancellor Angela Merkel waves as she arrives in Germany at the G20 terminal on November 14, 2014 in Brisbane, Australia. Photo by Steve Holland/G20 Australia via Getty Images

The eurozone debt crisis was the world's greatest threat in 2011, according to the OECD. Things only got worse in 2012. The crisis started in 2009, when the world first realized Greece could default on its debt. In three years, it escalated into the potential for sovereign debt defaults from Portugal, Italy, Ireland, and Spain. The European Union, led by Germany and France, struggled to support these members.

They initiated bailouts from the ECB (European Central Bank) and IMF (International Monetary Fund). These measures didn't keep many from questioning the viability of the euro itself.

How the Eurozone Crisis Affects You

If those countries had defaulted, it would have been worse than the 2008 financial crisis.Banks, the primary holders of sovereign debt, would face huge losses. Smaller banks would have collapsed. In a panic, they'd cut back on lending to each other. The LIBOR rate would skyrocket like it did in 2008.

The European Central Bank (ECB) held a lot of sovereign debt. Default would have jeopardized its future. It threatened the survival of the EU itself. Uncontrolled sovereign debt defaults could create a recession, if not a global depression.

It could have been worse than the 1998 sovereign debt crisis. When Russia defaulted, other emerging market countries did too. The IMF stepped in, backed by the power of European countries and the United States.

This time, it's not the emerging markets, but the developed markets that are in danger of default. The major backers of the IMF -- Germany, France and the United States -- are themselves highly indebted. There would be little political appetite to add to that debt to fund the massive bailouts needed.

What Was the Solution?

In May 2012, German Chancellor Angela Merkel developed a six-point plan. It went against newly-elected French President Francois Hollande's proposal to create Eurobonds. He also wanted to cut back on austerity measures, and create more economic stimulus. Merkel's plan would:

  1. Launch quick-start programs to facilitate business start-ups.
  2. Relax protections against wrongful dismissal.
  3. Introduce "mini-jobs" with lower taxes.
  4. Combine apprenticeship with vocational education targeted toward youth unemployment.
  5. Create special funds and tax benefits to privatize state-owned businesses.
  6. Establish special economic zones, like those in China.
  7. Invest in renewable energy.

Merkel found this worked to integrate East Germany. She saw how austerity measures could boost the competitiveness of the entire eurozone.

The six-point plant followed an intergovernmental treaty approved December 8, 2011. The EU leaders agreed to create a fiscal unity parallel to the monetary union that already exists. The treaty did three things. First, it enforced the budget restrictions of the Maastricht Treaty. Second, it reassured lenders that the EU would stand behind its members' sovereign debt. Third, it allowed the EU to act as a more integrated unit.

  Specifically, the treaty would create five changes:

  1. Eurozone member countries would legally give some budgetary power to centralized EU control.
  2. Members that exceeded the 3% deficit-to-GDP ratio would face financial sanctions. Any plans to issue sovereign debt must be reported in advance.
  3. The European Financial Stability Facility (EFSF) was replaced by a permanent bailout fund. The European Stability Mechanism (ESM) became effective in July 2012. The permanent fund assured lenders that the EU would stand behind its members. That  lowered the risk of default.
  4. Voting rules in the ESM would allow emergency decisions to be passed with an 85% qualified majority. This allows the EU to act more quickly.
  5. Eurozone countries would lend another €200 billion to the IMF from their central banks.

This followed a bailout in May 2010.

 EU leaders pledged 720 billion euros ($928 billion) to prevent the from triggering another Wall Street flash crash. The bailout restored faith in the euro, which slid to a 14-month low against the dollar.

The United States and China intervened after the ECB said it would not rescue Greece. LIBOR rose as banks started to panic, just like in 2008, Only this time banks were avoiding each others' toxic Greece debt, instead of mortgage-backed securities.

What Are the Consequences?

The UK and several other EU countries that aren't part of the eurozone balked at Merkel's treaty. They worried the treaty would lead to a "two-tier" EU. Eurozone countries could create preferential treaties for their members only. They would exclude EU countries that don't have the euro.

Second, eurozone countries must agree to cutbacks in spending. This could slow their economic growth, as it has in Greece. These austerity measures have been politically unpopular. Voters could bring in new leaders, who might leave the eurozone or the EU itself.

Third, a new form of financing -- the Eurobond -- becomes available. The ESM would be funded by €700 billion in euro bonds, fully guaranteed by the eurozone countries. Like U.S. Treasuries, these bonds could be bought and sold on a secondary market. By competing with Treasuries, the Eurobonds could lead to higher interest rates in the United States. (Source: CNN, Will new deal solve Europe's problems?, December 9, 2011)

What's at Stake?

Debt ratings agencies like Standard & Poor's and Moody's wanted the ECB to step up and guarantee all euro zone members' debts. But EU leader Germany opposed such a move without assurances that debtor countries will install the austerity measures needed to put their fiscal houses in order. Germany does not want to write a blank euro check just to reassure investors. German voters wouldn't be too happy about paying higher taxes to fund the bailout. Germany is also paranoid about potential inflation. Its people remember only too well the hyperinflation of the 1920s.

In addition, investors worry that austerity measures, needed in the long run, will only slow the economic rebound debtor countries need to repay their debts. (Source: CNBC, "S&P Says Eurozone May Need Another Shock", Euro Crisis Pits Germany and U.S. in Tactical Fight, December 12, 2011)

Causes

First, there were no penalties for countries that violated the debt-to-GDP ratios set by the EU's founding Maastricht Criteria. Why not? France and Germany also were spending above the limit. They'd be hypocritical to sanction others until they got their own houses in order. There were no teeth in any sanctions except expulsion from the eurozone, which would weaken the power of the euro itself. The EU wanted to strengthen the euro's power, putting pressure on non-eurozone EU members, like the UK, Denmark and Sweden, to adopt it. (Source: BBC News, Greece Joins Eurozone, January 1, 2001; Greece to Join Euro, June 1, 2000).

Second, eurozone countries initially benefited from the low interest rates and increased investment capital made possible by the euro's power. Most of this flow of capital was from Germany and France to the southern nations. This increased liquidity raised wages and prices, making their exports less competitive. Because they were on the euro, they couldn't do what most countries do to cool inflation -- raise interest rates or print less currency. Public spending rose, while tax revenues fell, during the recession to pay for unemployment and other benefits. (Source: New York Times, Paul Krugman, Killing the Euro. December 1, 2011)

Third, although there are good arguments for austerity measures, they might only slow economic growth by being too restrictive. For example, the OECD said austerity measures would make Greece more competitive by improving its public finance management and reporting, cutbacks on public employee pensions and wages, and lowering its trade barriers. In fact, exports have risen. More important, the OECD said Greece needed to crack down on tax dodgers, and sell off state-owned businesses, to raise funds. (Source: OECD, Economic Survey of Greece 2011)

In return for austerity measures, Greece's debt was cut in half. However, these measures also slowed the Greek economy. They increased unemployment, cut back consumer spending, and reduced capital needed for lending. Greek voters were fed up with the recession. They shut down the Greek government by giving an equal number of votes to the "no austerity" Syriza party. Another election was held on June 17 that narrowly defeated Syriza. The new government worked to continue with austerity, rather than leave the eurozone. For more, see Greece Debt Crisis.