EUROPEAN SOVEREIGN DEBT CRISIS

European Sovereign Debt Crisis



European Sovereign Debt Crisis

Introduction

In 2010, the financial crisis has driven up public debt in Europe's common currency zone to such heights that many economists fear the euro could collapse. The countries in trouble included Greece, Portugal, Spain, Ireland and Italy. The bond yield spreads between these countries and other EU members, most importantly Germany, have dramatically widened. On 2 May 2010, the Euro zone countries and the International Monetary Fund agreed to a €110 billion loan for Greece. In return Greece agreed to harsh austerity measures (Larry & Phillip, 2012). On 9 May 2010, Europe's Finance Ministers approved a comprehensive rescue package worth 750 billion euros ($975 billion). In July, 2011, Greece was hoping for another bailout and problems threatened to spill over into Spain and Italy. In August of the same year, the European Central Bank signalled it is ready to start buying Italian and Spanish securities to counter the sovereign debt crisis.

Part A: Commencement and Main Causes of European Sovereign Debt Crisis

Before the financial crisis, several governments of the Euro zone, most notably those of Portugal, Italy, Ireland, Greece, and Spain (sometimes called 'PIIGS'), had been able to finance their deficits at artificially low interest rates. Some had accumulated unsustainable levels of public debts. Such reckless fiscal behaviour was only possible because markets assumed that if the national situations got worse, these governments would be bailed out by other countries of the Euro zone in order to forestall a break-up of the Euro. In other words, the euro came with an implicit bailout guarantee permitting governments to overindulge in debt (Larry & Phillip, 2012).

Equipped with this implicit guarantee, many governments did not address structural problems such as uncompetitive labor markets or unsustainable welfare systems. They papered over these problems with government deficits. As the financial crisis hit, government deficits increased sharply due to increasing public spending and falling revenues (Nicolas, 2012). Deficits soared, not only in the PIIGS countries (the bailout candidates), but also in the countries that were supposed to pay the costs of bailing out (most prominently Germany).

It was at this point that market participants wanted to see something more than implicit promises. They started to doubt that Germany and others would be capable of bailing out the PIIGS governments, or willing to do so. Interest rates for bonds of PIIGS governments soared (Eaton & Gersovitz, 1981: 289). Finally, in May 2010, Euro zone governments had to make the implicit bailout guarantee into an explicit one. They installed a €750 billion rescue fund. The rescue fund has a limited term of three years. At the end of October, 2010, German chancellor Angela Merkel made it clear that the term would be extended only if there was reforms making private holders of government debt participate in the costs of future sovereign bailouts.

In other words, Germany threatened to take away part of the explicit bailout guarantee it gave to private investors in government ...