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What Is the Eurozone Debt Crisis?
By Kimberly Amadeo, About.com Guide
The OECD [Organization for Economic Cooperation and Development – made up of 34 countries from
Europe and North America + Chile, Japan, S. Korea, Israel, Australia, and New Zealand] announced
the eurozone debt crisis was the world's greatest economic threat in 2011, and things have only
worsened in 2012. The crisis has festered since 2009, when the world first realized Greece could
default on its debt. In three years, it's 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 with bailouts
from the ECB (European Central Bank) and IMF (International Monetary Fund). These measures
haven't been enough, allowing the crisis to threaten the existence of the euro itself.
How the Eurozone Crisis Affects You:
The worst case scenario would be if Greece, Spain or other eurozone countries defaulted on their debt.
This would be much worse than the 2008 financial crisis for several reasons. Banks, the primary
holders of sovereign debt, would face huge losses with smaller banks collapsing. In a panic, they'd cut
back on lending to each other, and the LIBOR rate would skyrocket like it did in 2008.
Even worse, the European Central Bank (ECB) holds a lot of sovereign debt, so its future would be at
risk. Without a central bank to bail its members out, the EU itself might not survive. Left unchecked,
the rippling effect of uncontrolled sovereign debt defaults could create a recession, if not a global
depression.
It would also be worse than the 1998 sovereign debt crisis. When Russia defaulted, other emerging
market countries did too. However, the IMF stepped in, backed by the power of European countries
and the U.S. 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 U.S. -- are themselves highly
indebted. There would be little political appetite to add to that debt to fund the massive bailouts
needed. If sovereign debt defaults were left unchecked, the resulting panic could cause a shutdown of
credit, in which even the United States might have trouble funding its debt.
What's the Proposed Solution?:
In May 2012, German Chancellor Angela Merkel developed a six-point plan to rebut newly-elected
French President Francois Hollande's proposal to create eurobonds, cut back on austerity measures,
and create more economic stimulus. Merkel's plan would:
1.
2.
3.
4.
5.
6.
7.
Launch quick-start programs to facilitate business start-ups.
Relax protections against wrongful dismissal.
Introduce "mini-jobs" with lower taxes.
Combine apprenticeship with vocational education targeted toward youth unemployment.
Create special funds and tax benefits to privatize state-owned businesses.
Establish special economic zones, like those in China.
Invest in renewable energy.
Merkel found this worked to integrate East Germany, and it should work in southern Europe. She is
committed to these portions of the austerity measures because they will boost the competitiveness of
the entire eurozone.
The six-point plant follows an intergovernmental treaty approved December 8, 2011. The EU leaders
agreed to create a fiscal unity parallel to the monetary union that already exists. It's in the process of
being approved by all EU members. The treaty was designed to enforce the budget restrictions of the
Maastricht Treaty, reassure lenders that the EU would stand behind its members' sovereign debt, and
allow the EU to act as a more integrated unit. Specifically, the treaty would create five changes:
1. Eurozone member countries would legally give some power over their budgets 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) is replaced by a permanent bailout fund, the
European Stability Mechanism (ESM), effective July 2012. The permanent fund assures lenders
that the EU would fully stand behind its members, substantially lowering 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.
What Are the Consequences?:
Initially, the UK and several other EU countries that aren't part of the eurozone balked at the treaty. If
the treaty is ratified by only eurozone countries, it could lead to a "two-tier" EU. Eurozone countries
may then create preferential treaties for their members only, excluding 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 U.S. (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 want the ECB to step up and guarantee all
eurozone members' debts. But EU leader Germany opposes 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 additional taxes to fund the bailout. Germany is also paranoid about potential
inflation, remembering 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)
How Did the Eurozone Get Into This Crisis?:
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 has been cut in half. However, these measures have
also slowed the Greek economy by raising unemployment, cutting back consumer spending, and
reducing capital needed for lending. Greek voters are getting fed up with the recession. They
effectively 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 is working to continue with austerity, rather than leave the eurozone. (Article updated
July 19, 2012)
Source: http://useconomy.about.com/od/Europe/p/Eurozone-Crisis.htm