Eurozone Debt Crisis

Causes, Cures, and Consequences

German chancellor Angela Merkel
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Steve Holland/G20 Australia/Getty Images

According to the Organization for Economic Cooperation and Development, the eurozone debt crisis was the world's greatest threat in 2011, and in 2012, things only got worse. The crisis started in 2009 when the world first realized that 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 European Central Bank (ECB) and the International Monetary Fund, but these measures didn't keep many from questioning the viability of the euro itself.

After President Trump threatened to double tariffs on aluminum and steel imports from Turkey in August 2018, the value of the Turkish lira lowered to a record low against the U.S. dollar—renewing fears that the poor health of the Turkish economy could trigger another crisis in the eurozone. Many European banks own stakes in Turkish lenders or made loans to Turkish companies. As the lira plummets, it becomes less likely these borrowers can afford to pay back these loans. The defaults could severely impact the European economy. As a result, Germany is considering lending Turkey enough to prevent a crisis.

Causes

First, there were no penalties for countries that violated the debt-to-GDP ratios set by the EU's founding Maastricht Criteria. This is because France and Germany also were spending above the limit, and it would 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, a harsh penalty which would weaken the power of the euro itself. The EU wanted to strengthen the euro's power.

Second, eurozone countries benefited from the euro's power. They enjoyed the low-interest rates and increased investment capital. Most of this flow of capital was from Germany and France to the southern nations, and this increased liquidity raised wages and prices—making their exports less competitive. Countries using the euro couldn't do what most countries do to cool inflation: raise interest rates or print less currency. During the recession, tax revenues fell, but public spending rose to pay for unemployment and other benefits.

Third, austerity measures slowed economic growth by being too restrictive. They increased unemployment, cut back consumer spending, and reduced the capital needed for lending. Greek voters were fed up with the recession and shut down the Greek government by giving an equal number of votes to the "no austerity" Syriza party. Rather than leave the eurozone, though, the new government worked to continue with austerity. In the long-term, austerity measures will alleviate the Greek debt crisis.

The Solution

In May 2012, German Chancellor Angela Merkel developed a 7-point plan, which 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 help business startups
  2. Relax protections against wrongful dismissal
  3. Introduce "mini-jobs" with lower taxes
  4. Combine apprenticeships 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, and saw how austerity measures could boost the competitiveness of the entire eurozone. The 7-point plan followed an intergovernmental treaty approved on December 8, 2011, where EU leaders agreed to create a fiscal unity parallel to the monetary union that already exists.

Affects of the Treaty

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, and any plans to issue sovereign debt must be reported in advance.
  3. The European Financial Stability Facility was replaced by a permanent bailout fund. The European Stability Mechanism became effective in July 2012, and the permanent fund assured lenders that the EU would stand behind its members—lowering the risk of default.
  4. Voting rules in the ESM would allow emergency decisions to be passed with an 85% qualified majority, allowing the EU to act faster.
  5. Eurozone countries would lend another 200 billion euros to the IMF from their central banks.

This followed a bailout in May 2010, where EU leaders pledged 720 billion euros ($928 billion) to prevent the debt crisis 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 U.S. and China intervened after the ECB said it would not rescue Greece, and the Libor rose as banks started to panic like in 2008. Only this time, banks were avoiding each other’s toxic Greek debt instead of mortgage-backed securities.

Consequences

First, the United Kingdom 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 and exclude EU countries that don't have the euro.

Second, eurozone countries must agree to cutbacks in spending, which 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, has become available. The ESM is funded by 700 billion euros in eurobonds, and these are fully guaranteed by the eurozone countries. Like U.S. Treasurys, these bonds could be bought and sold on a secondary market. By competing with Treasurys, the Eurobonds could lead to- higher interest rates in the U.S.

How the Crisis Could've Turned Out

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, and smaller ones would have collapsed. In a panic, they'd cut back on lending to each other, and the Libor rate would skyrocket like it did in 2008.

The ECB held a lot of sovereign debt; default would have jeopardized its future, and threatened the survival of the EU itself, as uncontrolled sovereign debt could result in a recession or global depression. It could have been worse than the 1998 sovereign debt crisis. When Russia defaulted, other emerging market countries did too, but not developed markets. This time, it's wasn't the emerging markets but the developed markets that were in danger of default. Germany, France, and the U.S., the major backers of the IMF, are themselves highly indebted. There would be little political appetite to add to that debt to fund the massive bailouts needed.

What Was at Stake

Debt rating agencies like Standard & Poor's and Moody's wanted the ECB to step up and guarantee all eurozone members' debts, but Germany, the EU leader, opposed such a move without assurances. It required debtor countries to install the austerity measures needed to put their fiscal houses in order. Investors worried that austerity measures would only slow any economic rebound, and debtor countries need that growth to repay their debts. The austerity measures are needed in the long run but are harmful in the short-term.