Monday, 24 September 2012

The Euro Crisis Explained, I. - What's With All The Debt?

Welcome back to Euro Crisis Explained! In our first post on the origins of the European financial crisis,  we have argued that Eurozone governments, like  Greece, Ireland and Portugal, Spain and Italy - the GIPSI countries, known without Ireland as the PIGS - had troubles financing their debts due to high interest rates forced upon them by the markets. However, that is just one side of the story. Countries like Spain, Italy, Greece, Ireland and Portugal have accumulated substantial government deficits on their own - and if your read below, we will explain how. 

Government debt in Greece, Spain, Italy, Ireland and Portugal is one of the biggest problems of the Great Recession.
Source: Gaijinpot.com

Reasons of debt


The most common theory about the reasons of the PIGS deficit is that following up to the outbreak of the crisis in 2008, these countries, away on the Eurozone's periphery, far from the watching eyes of Brussels, engaged massively in fiscal irresponsibility, running excessive budget deficits, caused by overblown safety nets (straight cash payments by the government to poorer classes, which do not increase aggregate demand) and inefficient taxation (taxes are not paid generally due to corruption or non-enforceability).
This theory - while it's individual components are for say, Greece and Portugal - is simply not true. According to Paul Krugman, one of the most famous contemporary economists argued in his book 'End This Depression, Now!' that surging government deficits represent only one side of the story of surging debts.

Real reasons of debt


This 'fiscal irresponsibility' theory has a major flaw - why did these countries' economies collapsed and government bond yields risen all at once, if their safety net policies and corruption levels are not related to each other? The answer is that the government yields rose due to a different cause - the lack of guarantee that they could pay back their debts. For years before the crisis, eg. Britain actually had higher deficit levels than Spain - Spain ran a budget surplus, and low debt. The major difference between the two countries is that the UK uses an independent currency, the pound, while Spain uses the euro. But why is that such a problem?

A quick guide to debt theory


Traditionally, governments finance their budget expenditures by issuing all sorts of government bonds - ranging from ten year, the scale usually goes down through five-,three-,two- year bonds down to month-long ones. The yields governments offer are set by the markets - a higher yield means a premium for accepting additional risks on the investors' part. Hence when a government  issues a bond at 10%, and later they manage to issue bonds at 7%, then they will be able to pay back the 10% bonds with the money from the 7% sales, hence decreasing their debts - in a special form or constant debt restructuring.
If for some reasons the investors don't buy these new bonds, then the government is in trouble - they will be forced to declare bankruptcy, at least theoretically.  In reality, a country's independent central bank then intervenes, and prints money to finance the debt - hence inflating the currency, but decreasing state debts.
And what happens when a country's bonds are not bought, and it doesn't have an independent central bank to step in?
Trouble.

The problems of the common currency


When the Euro was implemented in 2002, in central banking terms it meant an effective peg of the then-existing currencies to the Euro. This also meant giving up their independent central banks, with the local banks only setting domestic base rates from that point, without the ability to issue money. The power to issue euros fell to the ECB, the European Central Bank.
And when certain Eurozone economies - the PIGS - were devastated by the burst of the 2000-2008 housing bubble -, their governments got into trouble, since they promised domestic banks to act as a lender of last resort, not knowing that the need for government money would start emerging all at once.

Conclusion


So to sum it up how was the current, abysmal PIGS debt situation caused, check out the list below:
1) The housing bubble bursts, domestic banks, investors and home contractors are in huge trouble in South Europe.
2) Governments start to bail out their banks and companies in order to save the economy, gaining a huge government deficit in the process.
3) Suddenly, the deficit-running countries with their newly volatile economies can't sell government bonds to finance their deficit.
4) Due to the lack of a central bank, inflating the currency in order to finance the debts is not an option.
5) As a result, these countries' debt levels increase substantially, further scaring foreign bond investors and generating a vicious circle.

With the debt situation explained, two questions remain - Why didn't the ECB do something? And why was there a housing bubble in the first place? Continue reading Schoolonomic and this series to get the answers to these questions.

Other posts of the series:


No comments:

Post a Comment