Understanding the European Debt Crisis

Listening to the steady drumbeat of daily negative news about the European debt crisis during the past few months along with the complicated solutions that Europe’s leaders offer can be a little overwhelming to digest.

The media coverage of the debt crisis has done a good job in terms of covering the day to day economic and political developments from Europe. But few media reports have actually focused on the historical root causes which led to the European debt crisis.

On December 15th I posted on this blog, A Closer Look at the Debt Crisis, which briefly listed some of the contributing causes of the debt crisis besides the most obvious debt cause: excessive government spending by countries in Southern Europe.

Today I want to go into a little more detail explaining the causes of the euro zone debt crisis. A recent December 16th article from the Wall St. Journal,  Ties That Bound Europe Now Fraying, written by Stephen Fidler and David Enrich provides good insight and analysis about the root causes that led to the Euro zone debt crisis.

I want to use some quotes from this WSJ article and provide some brief commentary.  I believe that the article helps to explain the euro zone crisis in a clear and historical fashion.

Quote from WSJ article:

” The first decade of the euro intertwined the continent’s financial systems as never before. Banks and investments funds in one euro using country gorged on the bonds of others, freed of worry about devaluation prone currencies like the drachma, lira, peseta, and escudo. But as the devaluation danger waned, another risk grew, almost unseen by investors: the chance that governments, no longer backed by national central banks, could default.”

The devaluation in the above WSJ quote refers to currency devaluation which normally occurs when a sovereign nation is experiencing economic problems. In the past, especially during tough economic periods, it was common practice for central bankers throughout European countries to devalue their own currencies, allowing their own products (exports) to be cheaper on the international market, thereby greasing the wheels of their economy.

But now with 17 Euro countries all carrying one common currency (Euro), it has become impossible for sovereign countries in the euro zone to devalue their own currencies to help drive up demand in their own country. With the adoption of the Euro in 1999, the devaluation danger went away, only to be replaced by the default risk.

More WSJ quotes from article:

” Investors- their devaluation worries banished- viewed the bonds of the Mediterranean economies as a close susbstitute for those of Germany and other solid economies and they were drawn to them by the slightly higher yields.”

Regulatory incentives gave a push too.

“The ECB lets any bank in the euro area deposit government bonds in return for short term loans, under so called re-purchase, or repo agreements.”

“The ECB monetary operations helped make it easy for weaker nations to borrow at rock bottom rates and the operations fostered the view that a euro zone borrower would never be allowed to fail” says Simon Johnson, a former IMF Chief Economist and Peter Boone in a paper they wrote for the Peterson Institute for International Economics.

“Because default risk was seen as zero, EU banks didn’t have to hold capital in reserve against euro zone government bonds they owned. That gave a further motive to buy them, especially after the 2008 financial crisis ate into banks capital buffers.”

“In Greece, where the preponderance of its bonds were once Greek-owned, foreign holdings of them reached 55% by 2003. By the third quarter of 2009, it was 76%.”

“That was just weeks before a new government in Athens disclosed the country’s budget deficit was far worse than believed. The assumption that euro-zone government bonds were almost interchangeable and none could default steadily
began to crumble.”

“First, Greece was forced to go hat in hand to the International Monetary Fund and other euro-zone nations. Then, Germany made plain it didn’t intend to foot the bill indefinitely for the debts of what it saw as profligate governments.”

“German concerns were crystallized into euro-zone policy.”

“The share of Greek bonds in the hands of investors outside Greece has since fallen steeply to well below 50%.”

“Figures from Fitch Ratings show how foreigners have retreated from weaker euro-zone sovereign-bond markets across the board, leaving the bonds in the hands of domestic investors.”

“It isn’t only in sovereign debt that Europe’s financial integration has gone into reverse. Euro-zone banks’ holdings of assets of all types, including corporate loans, in Cyprus, Greece, Ireland, Italy, Portugal and Spain hit $1.9 trillion in 2007, up sixfold from 2001, but then declined 44% as of June 30, according to Barclays Capital. Barclays based its calculations on data from the Bank for International Settlements, or BIS.”

“A turning point for euro-zone investment came in July. European leaders, in negotiating an expanded Greek bailout, confirmed that investors in its bonds would take losses.”

“It was a wake-up call for the industry,” said a top French bank executive, who soon started dumping his Italian government bonds. Deutsche Bank AG said it substantially reduced its “net exposure” to Italy, both by selling bonds and buying default protection.”

 

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