European Debt Crisis

Hannelore Foerster/Bloomberg News

Updated: Jan. 9, 2012

Recent Developments Jan. 9 Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France called for Greece to move forward with promised economic changes or risk losing the next installment of badly needed bailout funds. Investors bought German debt at a negative yield, meaning they are paying Germany to hold their money, in another sign of mounting market concerns. Jan. 5 In Europes first major tests of market confidence this year, France paid slightly more to sell its bonds and the euro zones bailout fund raised funds to help Ireland and Portugal, while problems in Italy and Hungary grabbed the attention of investors. Dec. 30 Spains new prime minister, Mariano Rajoy, announced an austerity package consisting of $7.8 billion in tax hikes and $11.5 billion in spending cuts, in an effort to close a budget deficit expected to reach 8 percent of gross domestic product this year 2 percentage points above the governments target. Dec. 29 An auction of 10-year Italian bonds gave a gloomier picture; interest rates fell, but remained just a fraction below 7 percent, a level seen as unsustainable. Dec. 28 Italys short-term borrowing costs were halved at an auction of government bills, easing the immediate pressure on the countrys economy. The lower borrowing costs appeared to reflect the adoption of a new austerity package in Italy, as well as a huge infusion of low-cost, long-term liquidity into euro zone banks by the European Central Bank. Dec. 21 Banks lined up for almost half a trillion euros in cheap three-year loans from the European Central Bank as part of its unprecedented effort to keep credit flowing. Dec. 19 The European Central Bank warned of a perilous year ahead as the sovereign debt crisis collides with slower economic growth and a dearth of market financing for banks. Meanwhile, E.U. governments fell short of their target to expand their backup plan for the euro by channeling more resources through the International Monetary Fund, raising only 150 billion euros, short of the 200 billion euro goal. Overview Since the fall of 2009, the European Union has been struggling with a slow-moving but unshakable crisis over the enormous debts faced by its weakest economies, such as Greece and Portugal, or those most battered by the global recession, like Ireland. A series of negotiations, bailouts and austerity packages have failed to stop the slide of investor confidence or to restore the growth needed to give struggling countries a way out of

their debt traps. By August 2011 European leaders found themselves scrambling once again to intervene in the markets, this time to protect Italy and Spain, two countries seen as too big to bail out. The crisis has produced the deepest tensions within the union in memory, as Germany in particular has resisted aid to countries it sees as profligate, and has raised questions about whether the euro can survive as a multinational currency, since countries like Greece have been unable to boost their exports by devaluing their own currency.

It has posed great risks to many of the continents banks, which invested heavily in government bonds, and forced deep and painful cuts in government spending that drove up unemployment and put several countries back into deep recessions, leading a growing number of economists to call the austerity policies self-defeating. The economic crisis gradually became a political one as well, leading to the ouster of governments in Ireland, Portugal, Greece and Italy. Protests by traditional interest groups like public sector unions were joined by crowds of young people who camped out in Madrid and Athens in imitation of the Arab Spring demonstrations. In the fall of 2011, even as European leaders struggled to come up with a new bailout plan for Greece, much larger fears loomed. Interest rates soared for Italy, the continents third largest economy, and rose for France, whose banks hold large amounts of Italian government bonds, and where government finances are strained. The continents economy was teetering on the brink of a second recession. A growing number of economists called for the European Central Bank to step forward as a lender of last resort, as the Federal Reserve has done, to stop the contagion. But the bank, whose mandate is focused solely on preventing inflation, has resisted, saying a political solution is required. As the crisis deepened, banks in Europe began to hoard capital, straining the finances of their counterparts and hurting companies across the globe that depend on them for loans. In December, leaders of the countries that use the euro agreed to an intergovernmental pact adopting tighter fiscal controls. All 17 of the countries that use the euro agreed to join, as did six others. But Britain refused, raising questions about its future in which it has become increasingly isolated. The agreement, which can be adopted more quickly than a change to the European Union treaty and without Britains consent would reassert rules limiting deficits to 3 percent of gross domestic product and total debt to 60 percent. Violators would be hit with sanctions unless a majority of other countries agreed. After the summit, the familiar pattern of market relief followed by new market worries was repeated. But on Dec. 21, banks borrowed more than $600 billion from the European Central Bank at the extraordinarily easy terms of 1 percent interest for a three-year loan. Analysts suggested that the Bank had hit upon an indirect method of stopping the market spiral threatening Italy, Spain and other governments, by flooding banks with money they could use to lock in guaranteed profits by buying sovereign debt. The next week, Italys short-term borrowing costs fell by half, in the most concrete indication of market confidence yet.

Background The debt crisis first surfaced in Greece in October 2009, when the newly elected Socialist government of Prime Minister George A. Papandreou announced that his predecessor had disguised the size of the countrys ballooning deficit. But its roots of the crisis go back further, beginning with a strong euro and the rock-bottom interest rates that prevailed for much of the previous decade. Greece took advantage of this easy money to drive up borrowing by the countrys consumers and its government, which built up $400 billion in debt. In Spain and Ireland, government spending was kept under control, but easy money helped turn real-estate booms there into bubbles a process helped in Irelands case by the aggressive deregulation of its banks that helped draw investment from around the world. After the bubble burst, the Irish government made the banks problems its own by guaranteeing all their liabilities. After the extent of Greek debt was revealed, markets reacted by sending interest rates up not only for its debt, but also for borrowing by Spain, Portugal and Ireland. In early 2010, the European Union and the International Monetary Fund put together a series of bailout packages for Greece that totalled 110 billion euros ($163 billion) in a process that critics said ended up costing more because European leaders failed to get ahead of the curve. In May, leaders approved a contingency fund of 500 billions euro (about $680 billion) for the union at large. The hope was that the fund would never have to be tapped, as its existence would calm investors. But in the fall of 2010 interest rates began creeping up again, as countries that reduced spending to meet tough deficit targets found themselves falling farther behind, as their economies slowed and revenues declined. In November, European officials arranged a bailout of 85 billion euros (roughly $112 billion) for Ireland, after overcoming the resistance of Irish officials to the move, which they saw an attack on sovereignty. (In fact, news of the deal led Prime Minister Brian Cowen to announce that he would step down after passing a new round of budget cuts, and his party was ousted at the next election). In the spring of 2010, after much hesitation, the European Union and the International Monetary Fund combined first to offer Greece a bailout package of 110 billion euros ($163 billion), followed by a broader contingency fund of 500 billions euro (about $680 billion). The hope was that this show of financial force would reassure markets about the solvency of euro countries. But the new loans, combined with the effect of the austerity measures demanded of Greece, Ireland and Portugal, drove them into recession and did little to ease their debt burden Greeces debt load even increased. As the debt crisis renewed over the winter of 2010 and spring of 2011 it led to the fall of governments in Ireland and Portugal, and saw unrest rise in Spain, where unemployment remained close to 20 percent. Contagion Fears Return By the summer of 2011, it was clear that Greece would need a second big bailout package, and worries rose again about contagion, as Italy and Spain saw the interest rates charged on its borrowing rise steeply. The European Central Bank responded by buying large amounts of Italian and Spanish bonds, as leaders put together a plan that would increase the powers of

the European Financial Stability Facility to head off a run' on governments seen as in danger of default. By September, with growth slowing, stalled or in reverse across the continent, European leaders were increasingly discussing the creation of a central financial authority with powers in areas like taxation, bond issuance and budget approval that could eventually turn the euro zone into something resembling a United States of Europe. But talk of long-term solutions did little to calm markets worried about the weakness of banks in France and elsewhere that held large amounts of debt from Greece and other shaky governments. And the resignation of Jrgen Stark, a top German official at the European Central Bank, highlighted the depth of policy discord among senior policymakers. Mr. Stark, like many German officials, had opposed the banks large-scale purchases of government debt. Another potential crisis bubbled up in September, as European officials angrily warned Greece that the next installment of its bailout funding would be withheld in October a step that would lead to certain bankruptcy unless further radical cuts in government spending were pushed through. Earlier that summer, Greece, which had started the crisis, faced its more dire fiscal emergency, as it stood to run out of cash in August without a new installment of money from the first bailout. European leaders refused to release the funds until a second, more drastic round of austerity measures were adopted, including the sale of $72 billion in state assets. The government of Prime Minister George Papandreou teetered, but the measure was pushed through after days of giant street protests. The basic conflict over the shape of a new bailout plan was between Germanys chancellor, Angela Merkel, who insisted that private banks pay part of the cost by taking losses on Greek bonds, and the European Central Bank, who opposed even a voluntary haircut' for banks, saying it would be seen as a default. July Agreement Falls Behind the Curve The deal reached in late July included $157 billion in new funds for Greece and a modest reduction of its debt burden; private lenders saw their bonds rolled over into longer maturities but also had them guaranteed. And the European Financial Stability Facility, the eurozone rescue fund, saw its contingency fund grow to 440 billion euros, or $632 billion, and was given new, amplified powers and the ability to use the money to bail out Portugal and Ireland if necessary. The response to the package was not what leaders hoped: investors began driving up interest rates in Italy and Spain, economies too large to be bailed out by the new arrangements. At the same time, the fall in confidence threatened to undermine the big banks in those countries, whose large holdings of government bonds began to lose value. On Aug. 7, 2011, the European Central Bank said it would actively implement its bondbuying program to address dysfunctional market segments, a statement interpreted as a sign that it will intervene to prevent borrowing costs for Italy and Spain from becoming unsustainable. Vowing Closer Paths

To address the growing debt crisis, Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France met on Aug. 16, 2011 at the lyse Palace in Paris. The leaders promised to take concrete steps toward a closer political and economic union of the 17 countries that use the euro. They called for each nation in the euro zone to enshrine a golden rule into their national constitutions to work toward balanced budgets and debt reduction, a level of discipline well beyond the current, oft-broken commitment. They also pledged to push for a new tax on financial transactions, and for regular summit meetings of the zones members. Both leaders ruled out issuing collective bonds, known as eurobonds, to share responsibility for government debt across member states, and they opposed a further increase in a bailout fund that will not be put into place until late September 2011 at the earliest. Mrs. Merkel said there was no magic wand to solve all the problems of the euro, arguing that they must be met over time with improved fiscal discipline, competitiveness and economic growth among weaker states. But a growing number of leaders in September began quietly discussing a broader plan for greater fiscal integration since the alternatives could include the collapse of the euro or increasing conflict over bailouts. Officials said a major overhaul of the way Europe conducts fiscal policy was likely to take a long time and require changes in the treaties governing the euro. But they pointed to the smaller changes that were already taking place as evidence that euro area financial ministries see that they have little choice but to move together if they want to avoid a catastrophic breakdown. Increasing Distress The talks took place against a background of increasing continent-wide distress. Official figures released in August 2011 showed that quarterly growth in the euro zone fell to its lowest rate in two years. Germany the Continents powerhouse slowed almost to a standstill. Most of Europes main stock indexes lost ground after the data suggested that the debt and economic problems in countries like Greece and Italy were infecting the rest of the 17-country euro zone. Meanwhile, leaders groped for a way to expand the effective firepower of the bailout fund, the European Financial Stability Facility, amid a general agreement that the boost agreed to in July was no longer adequate to calm the markets fears about big economies like Spain and Italy. One suggestion, pushed by the Obama administration, was to use the facilitys funds to guarantee loans from the European Central Bank rather than to make loans directly. Also in September, Greece pushed through a hugely unpopular property tax increase as part of a new austerity package needed to keep installments of the first bailout package flowing. And the eurozones members crept through the process of signing off on the July agreement, with crucial votes in favor coming from Germany and Finland, which had threatened to block it unless it got higher levels of collateral on its contribution. Under the fretful gaze of investors, the meandering approval process has revealed ever more fissures, layers of decision making and complexity in Europe that adds up to a worrisome inability to react quickly and decisively to upheaval in fast-moving financial markets. October Talks

In October, leaders agreed that the euro zones banks needed to add 100 billion euros in new capital to assure the markets of their solidity. Banks would first be asked to raise the funds themselves, and then individual governments would step in to make up any shortfalls. Two big issues remained unresolved when a meeting broke up on Oct. 23: whether to ask banks to take losses on their loans to Greece of up to 60 percent, rather thanthe 20 percent agreed upon in July, and how to increase the effective power of the bailout fund, the European Financial Stability Facility. Germany blocked the idea that the EFSF could function as a bank, and borrow funds from the European Central Bank as needed to stave off market panics a backdoor arrangement for making the central bank the kind of lender of last resort that the Fed has always been in the United States. Other ideas included asking the International Monetary Fund for more assistance; creating a separate fund linked to the stability fund that would be open to investors and sovereignwealth funds from outside Europe, like the Chinese, Indians and Brazilians, as well as noneuro countries like Sweden and Norway, with a goal of amassing resources of 750 billion to 1.25 trillion euros in all; and finding ways to use the stability fund as insurance against partial losses that might be suffered by holders of sovereign bonds, another way to get greater impact from the funds resources. On Oct. 27, European leaders announced a three-part plan: an effort to recapitalize weak euro-zone banks, an increase in the size and scope of Europes main rescue fund, and a proposal that banks take a 50 percent write-down on their Greek bonds. While the agreement by banks to write down 50 percent of Greek debt was welcomed, the deals success is conditioned on investors agreeing to take such a large loss. If a large number of investors refuse to accept such a loss, then the plan loses its voluntary status and would thus become a default creating more unease and panic in the markets. Moreover, private investors are not obliged to take the write-down, and two big holders of Greek debt, the International Monetary Fund and the European Central Bank, are not granting debt relief. So it is not clear how much of Greeces overall sovereign debt of 340 billion euros ($480 billion) is going to be forgiven. In contrast to bank rescue plans in the United States and Britain, European governments are not injecting funds directly into the banks. Instead they are asking that banks significantly raise their capital level, to 9 percent by 2012. But for banks that have been weakened from their exposure to dubious European debt, raising money from private investors will be difficult especially as many of the likely sovereign fund candidates are the ones that suffered deep losses from investing in troubled American banks in 2007 and 2008. And the latest idea for increasing the amount of bailout money available creating a new investment vehicle that would seek funds from China and other emerging nations, along with private investors raised the question of whether such a fund would be able to attract the level of money needed.