subprime mortgage crisis and eurozone crisis

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Subprime mortgage crisisand eurozone crisis

ContentsArticles

European sovereign-debt crisis 1Subprime mortgage crisis 55

ReferencesArticle Sources and Contributors 100Image Sources, Licenses and Contributors 101

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European sovereign-debt crisis 1

European sovereign-debt crisis

Long-term interest rates (secondary market yields of governmentbonds with maturities of close to ten years) of all eurozone

countries except Estonia[1] A yield of 6% or more indicates thatfinancial markets have serious doubts about credit-worthiness.[2]

The European sovereign debt crisis (often referred toas the Eurozone crisis) is an ongoing financial crisis thathas made it difficult or impossible for some countries inthe euro area to repay or re-finance their governmentdebt without the assistance of third parties.[3]

From late 2009, fears of a sovereign debt crisisdeveloped among investors as a result of the risingprivate and government debt levels around the worldtogether with a wave of downgrading of governmentdebt in some European states. Causes of the crisis variedby country. In several countries, private debts arisingfrom a property bubble were transferred to sovereigndebt as a result of banking system bailouts andgovernment responses to slowing economiespost-bubble. In Greece, unsustainable public sector wageand pension commitments drove the debt increase.[4] Thestructure of the Eurozone as a monetary union (i.e., onecurrency) without fiscal union (e.g., different tax andpublic pension rules) contributed to the crisis and harmedthe ability of European leaders to respond.[5][6] Europeanbanks own a significant amount of sovereign debt, suchthat concerns regarding the solvency of banking systemsor sovereigns are negatively reinforcing.[7]

Concerns intensified in early 2010 and thereafter,[8][9] leading European nations to implement a series of financialsupport measures such as the European Financial Stability Facility (EFSF) and European Stability Mechanism.

Beside of all the political measures and bailout programmes being implemented to combat the European sovereigndebt crisis, the European Central Bank (ECB) has also done its part by lowering interest rates and providing cheaploans of more than one trillion Euros to maintain money flows between European banks. On 6 September 2012, theECB also calmed financial markets by announcing free unlimited support for all eurozone countries involved in asovereign state bailout/precautionary programme from EFSF/ESM, through some yield lowering Outright MonetaryTransactions (OMT).[10]

The crisis did not only introduce adverse economic effects for the worst hit countries, but also had a major politicalimpact on the ruling governments in 8 out of 17 eurozone countries, leading to power shifts in Greece, Ireland, Italy,Portugal, Spain, Slovenia, Slovakia, and the Netherlands.


Causes

Public debt $ and %GDP (2010) for selected European countries

Government debt of Eurozone, Germany and crisis countriescompared to Eurozone GDP

The European sovereign debt crisis resulted from acombination of complex factors, including theglobalization of finance; easy credit conditions duringthe 20022008 period that encouraged high-risk lendingand borrowing practices; the 20072012 global financialcrisis; international trade imbalances; real-estate bubblesthat have since burst; the 20082012 global recession;fiscal policy choices related to government revenues andexpenses; and approaches used by nations to bail outtroubled banking industries and private bondholders,assuming private debt burdens or socializing losses.[4][11]

One narrative describing the causes of the crisis beginswith the significant increase in savings available forinvestment during the 20002007 period when the globalpool of fixed-income securities increased fromapproximately $36 trillion in 2000 to $70 trillion by2007. This "Giant Pool of Money" increased as savingsfrom high-growth developing nations entered globalcapital markets. Investors searching for higher yieldsthan those offered by U.S. Treasury bonds soughtalternatives globally.[12]

The temptation offered by such readily available savingsoverwhelmed the policy and regulatory controlmechanisms in country after country, as lenders andborrowers put these savings to use, generating bubbleafter bubble across the globe. While these bubbles have burst, causing asset prices (e.g., housing and commercialproperty) to decline, the liabilities owed to global investors remain at full price, generating questions regarding thesolvency of governments and their banking systems.[4]

How each European country involved in this crisis borrowed and invested the money varies. For example, Ireland'sbanks lent the money to property developers, generating a massive property bubble. When the bubble burst, Ireland'sgovernment and taxpayers assumed private debts. In Greece, the government increased its commitments to publicworkers in the form of extremely generous wage and pension benefits, with the former doubling in real terms over10 years.[5] Iceland's banking system grew enormously, creating debts to global investors (external debts) severaltimes GDP.[4][13]

The interconnection in the global financial system means that if one nation defaults on its sovereign debt or entersinto recession putting some of the external private debt at risk, the banking systems of creditor nations face losses.For example, in October 2011, Italian borrowers owed French banks $366 billion (net). Should Italy be unable tofinance itself, the French banking system and economy could come under significant pressure, which in turn wouldaffect France's creditors and so on. This is referred to as financial contagion.[7][14] Another factor contributing tointerconnection is the concept of debt protection. Institutions entered into contracts called credit default swaps (CDS)that result in payment should default occur on a particular debt instrument (including government issued bonds). But,since multiple CDSs can be purchased on the same security, it is unclear what exposure each country's bankingsystem now has to CDS.[15]


Greece hid its growing debt and deceived EU officials with the help of derivatives designed by majorbanks.[16][17][18][19][20][21] Although some financial institutions clearly profited from the growing Greek governmentdebt in the short run,[16] there was a long lead-up to the crisis.

Rising household and government debt levels

Public debt as a percent of GDP (2010)

In 1992, members of the European Union signed theMaastricht Treaty, under which they pledged to limittheir deficit spending and debt levels. However, anumber of EU member states, including Greece andItaly, were able to circumvent these rules, failing to abideby their own internal guidelines, sidestepping bestpractice and ignoring internationally agreedstandards.[22] This allowed the sovereigns to mask theirdeficit and debt levels through a combination oftechniques, including inconsistent accounting,off-balance-sheet transactions [22] as well as the use of complex currency and credit derivatives structures.[23][24] Thecomplex structures were designed by prominent U.S. investment banks, who received substantial fees in return fortheir services.[16]

Convergence of interest rates in Eurozone countries

The adoption of the euro led to many Eurozone countriesof different credit worthiness receiving similar and verylow interest rates for their bonds and private creditsduring years preceding the crisis, which author MichaelLewis referred to as "a sort of implicit Germanyguarantee."[5] As a result, creditors in countries withoriginally weak currencies (and higher interest rates)suddenly enjoyed much more favorable credit terms,which spurred private and government spending and ledto an economic boom. In some countries such as Irelandand Spain low interest rates also led to a housing bubble, which burst at the height of the financial crisis.[25][26]

A number of economists have dismissed the popular belief that the debt crisis was caused by excessive socialwelfare spending. According to their analysis, increased debt levels were mostly due to the large bailout packagesprovided to the financial sector during the late-2000s financial crisis, and the global economic slowdown thereafter.The average fiscal deficit in the euro area in 2007 was only 0.6% before it grew to 7% during the financial crisis. Inthe same period, the average government debt rose from 66% to 84% of GDP. The authors also stressed that fiscaldeficits in the euro area were stable or even shrinking since the early 1990s.[27] US economist Paul Krugman namedGreece as the only country where fiscal irresponsibility is at the heart of the crisis.[28] British economic historianRobert Skidelsky added that it was indeed excessive lending by banks, not deficit spending that created this crisis.Government's mounting debts are a response to the economic downturn as spending rises and tax revenues fall, notits cause.[29]


Government deficit of Eurozone compared to USA and UK

Either way, high debt levels alone may not explain thecrisis. According to The Economist Intelligence Unit, theposition of the euro area looked "no worse and in somerespects, rather better than that of the US or theUK."[30][31] The budget deficit for the euro area as awhole (see graph) is much lower and the euro area'sgovernment debt/GDP ratio of 86% in 2010 was aboutthe same level as that of the US. Moreover,private-sector indebtedness across the euro area ismarkedly lower than in the highly leveragedAnglo-Saxon economies.[30]

Trade imbalances

Current account balances relative to GDP (2010)

Commentator and Financial Times journalist MartinWolf has asserted that the root of the crisis was growingtrade imbalances. He notes in the run-up to the crisis,from 1999 to 2007, Germany had a considerably betterpublic debt and fiscal deficit relative to GDP than themost affected eurozone members. In the same period,these countries (Portugal, Ireland, Italy and Spain) hadfar worse balance of payments positions.[32][33] WhereasGerman trade surpluses increased as a percentage ofGDP after 1999, the deficits of Italy, France and Spainall worsened.

Paul Krugman wrote in 2009 that a trade deficit bydefinition requires a corresponding inflow of capital tofund it, which can drive down interest rates and stimulate the creation of bubbles: "For a while, the inrush of capitalcreated the illusion of wealth in these countries, just as it did for American homeowners: asset prices were rising,currencies were strong, and everything looked fine. But bubbles always burst sooner or later, and yesterdays miracleeconomies have become todays basket cases, nations whose assets have evaporated but whose debts remain all tooreal."[34]

A trade deficit can also be affected by changes in relative labor costs, which made southern nations less competitiveand increased trade imbalances. Since 2001, Italy's unit labor costs rose 32% relative to Germany's.[35][36] Greek unitlabor costs rose much faster than Germany's during the last decade.[37] However, most EU nations had increases inlabor costs greater than Germany's.[38] Those nations that allowed "wages to grow faster than productivity" lostcompetitiveness.[33] Germany's restrained labor costs, while a debatable factor in trade imbalances,[38] are animportant factor for its low unemployment rate.[39] More recently, Greece's trading position has improved;[40] in theperiod 2011 to 2012, imports dropped 20.9% while exports grew 16.9%, reducing the trade deficit by 42.8%.[40]

Simon Johnson explains the hope for convergence in the Euro-zone and what went wrong. The euro locks countries into an exchange rate amounting to very big bet that their economies would converge in productivity. If not, workers would move to countries with greater productivity. Instead the opposite happened: the gap between German


and Greek productivity increased resulting in a large current account surplus financed by capital flows. The capitalflows could have been invested to increase productivity in the peripheral nations. Instead capital flows weresquandered in consumption and consumptive investments.[41]

Further, Eurozone countries with sustained trade surpluses (i.e., Germany) do not see their currency appreciaterelative to the other Eurozone nations due to a common currency, keeping their exports artificially cheap. Germany'strade surplus within the Eurozone declined in 2011 as its trading partners were less able to find financing necessaryto fund their trade deficits, but Germany's trade surplus outside the Eurozone has soared as the euro declined in valuerelative to the dollar and other currencies.[42]

Structural problem of Eurozone systemThere is a structural contradiction within the euro system, namely that there is a monetary union (common currency)without a fiscal union (e.g., common taxation, pension, and treasury functions).[43] In the Eurozone system, thecountries are required to follow a similar fiscal path, but they do not have common treasury to enforce it. That is,countries with the same monetary system have freedom in fiscal policies in taxation and expenditure. So, eventhough there are some agreements on monetary policy and through European Central Bank, countries may not beable to or would simply choose not to follow it. This feature brought fiscal free riding of peripheral economies,especially represented by Greece, as it is hard to control and regulate national financial institutions. Furthermore,there is also a problem that the euro zone system has a difficult structure for quick response. Eurozone, having 17nations as its members, require unanimous agreement for a decision making process. This would lead to failure incomplete prevention of contagion of other areas, as it would be hard for the Eurozone to respond quickly to theproblem.[44]

In addition, as of June 2012 there was no "banking union" meaning that there was no Europe-wide approach to bankdeposit insurance, bank oversight, or a joint means of recapitalization or resolution (wind-down) of failing banks.[45]

Bank deposit insurance helps avoid bank runs. Recapitalization refers to injecting money into banks so that they canmeet their immediate obligations and resume lending, as was done in 2008 in the U.S. via the Troubled Asset ReliefProgram.[46]

Columnist Thomas L. Friedman wrote in June 2012: "In Europe, hyperconnectedness both exposed just howuncompetitive some of their economies were, but also how interdependent they had become. It was a deadlycombination. When countries with such different cultures become this interconnected and interdependent whenthey share the same currency but not the same work ethics, retirement ages or budget discipline you end up withGerman savers seething at Greek workers, and vice versa."[47]

Monetary policy inflexibilityMembership in the Eurozone established a single monetary policy, preventing individual member states from actingindependently. In particular they cannot create Euros in order to pay creditors and eliminate their risk of default.Since they share the same currency as their (eurozone) trading partners, they cannot devalue their currency to maketheir exports cheaper, which in principle would lead to an improved balance of trade, increased GDP and higher taxrevenues in nominal terms.[48]

In the reverse direction moreover, assets held in a currency which has devalued suffer losses on the part of thoseholding them. For example, by the end of 2011, following a 25 percent fall in the rate of exchange and 5 percent risein inflation, eurozone investors in Pound Sterling, locked in to euro exchange rates, had suffered an approximate 30percent cut in the repayment value of this debt.[49]


Loss of confidence

Sovereign CDS prices of selected European countries(20102012). The left axis is in basis points; a level of 1,000means it costs $1million to protect $10million of debt for

five years.

Prior to development of the crisis it was assumed by bothregulators and banks that sovereign debt from the eurozonewas safe. Banks had substantial holdings of bonds fromweaker economies such as Greece which offered a smallpremium and seemingly were equally sound. As the crisisdeveloped it became obvious that Greek, and possibly othercountries', bonds offered substantially more risk.Contributing to lack of information about the risk ofEuropean sovereign debt was conflict of interest by banksthat were earning substantial sums underwriting thebonds.[50] The loss of confidence is marked by risingsovereign CDS prices, indicating market expectations aboutcountries' creditworthiness (see graph).

Furthermore, investors have doubts about the possibilities ofpolicy makers to quickly contain the crisis. Since countriesthat use the euro as their currency have fewer monetarypolicy choices (e.g., they cannot print money in their owncurrencies to pay debt holders), certain solutions requiremulti-national cooperation. Further, the European CentralBank has an inflation control mandate but not an employmentmandate, as opposed to the U.S. Federal Reserve, which has adual mandate.

According to The Economist, the crisis "is as much politicalas economic" and the result of the fact that the euro area isnot supported by the institutional paraphernalia (and mutualbonds of solidarity) of a state.[30] Heavy bank withdrawalshave occurred in weaker Eurozone states such as Greece and Spain.[51] Bank deposits in the Eurozone are insured,but by agencies of each member government. If banks fail, it is unlikely the government will be able to fully andpromptly honor their commitment, at least not in euros, and there is the possibility that they might abandon the euroand revert to a national currency; thus, euro deposits are safer in Dutch, German, or Austrian banks than they are inGreece or Spain.[52]

As of June, 2012, many European banking systems were under significant stress, particularly Spain. A series of"capital calls" or notices that banks required capital contributed to a freeze in funding markets and interbank lending,as investors worried that banks might be hiding losses or were losing trust in one another.[53][54]

In June 2012, as the euro hit new lows, there were reports that the wealthy were moving assets out of theEurozone[55] and within the Eurozone from the South to the North. Between June 2011 and June 2012 Spain andItaly alone have lost 286 bn and 235 bn euros. Altogether Mediterranean countries have lost assets worth ten percentof GDP since capital flight started in end of 2010.[56] Mario Draghi, president of the European Central Bank, hascalled for an integrated European system of deposit insurance which would require European political institutionscraft effective solutions for problems beyond the limits of the power of the European Central Bank.[57] As of June 6,2012, closer integration of European banking appeared to be under consideration by political leaders.[58]

Interest on long term sovereign debtIn June, 2012, following negotiation of the Spanish bailout line of credit interest on long-term Spanish and Italian debt continued to rise rapidly, casting doubt on the efficacy of bailout packages as anything more than a stopgap


measure. The Spanish rate, over 6% before the line of credit was approved, approached 7%, a rough rule of thumbindicator of serious trouble.[59]

Rating agency viewsOn 5 December 2011, S&P placed its long-term sovereign ratings on 15 members of the eurozone on "CreditWatch"with negative implications; S&P wrote this was due to "systemic stresses from five interrelated factors: 1)Tightening credit conditions across the eurozone; 2) Markedly higher risk premiums on a growing number ofeurozone sovereigns including some that are currently rated 'AAA'; 3) Continuing disagreements among Europeanpolicy makers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greatereconomic, financial, and fiscal convergence among eurozone members; 4) High levels of government and householdindebtedness across a large area of the eurozone; and 5) The rising risk of economic recession in the eurozone as awhole in 2012. Currently, we expect output to decline next year in countries such as Spain, Portugal and Greece, butwe now assign a 40% probability of a fall in output for the eurozone as a whole."[60]

Evolution of the crisis

The 2009 annual budget deficit and public debt both relative toGDP, for selected European countries. In the eurozone, the

following number of countries were: SGP-limit compliant (3),Unhealthy (1), Critical (12), and Unsustainable (1).

In the first few weeks of 2010, there was renewedanxiety about excessive national debt, with lendersdemanding ever higher interest rates from severalcountries with higher debt levels, deficits and currentaccount deficits. This in turn made it difficult for somegovernments to finance further budget deficits andservice existing debt, particularly when economic growthrates were low, and when a high percentage of debt wasin the hands of foreign creditors, as in the case of Greeceand Portugal.[61]

To fight the crisis some governments have focused onausterity measures (e.g., higher taxes and lowerexpenses) which has contributed to social unrest andsignificant debate among economists, many of whomadvocate greater deficits when economies are struggling.Especially in countries where budget deficits and

sovereign debts have increased sharply, a crisis of confidence has emerged with the widening of bond yield spreadsand risk insurance on CDS between these countries and other EU member states, most importantly Germany.[62] Bythe end of 2011, Germany was estimated to have made more than 9 billion out of the crisis as investors flocked tosafer but near zero interest rate German federal government bonds (bunds).[63] By July 2012 also the Netherlands,Austria and Finland benefited from zero or negative interest rates. Looking at short-term government bonds with amaturity of less than one year the list of beneficiaries also includes Belgium and France.[64] While Switzerland (andDenmark)[64] equally benefited from lower interest rates, the crisis also


The 2012 annual budget deficit and public debt both relative toGDP, for all eurozone countries and UK. In the eurozone, thefollowing number of countries were: SGP-limit compliant (3),

Unhealthy (5), Critical (8), and Unsustainable (1).

Debt profile of Eurozone countries

harmed its export sector due to a substantial influx offoreign capital and the resulting rise of the Swiss franc.In September 2011 the Swiss National Bank surprisedcurrency traders by pledging that "it will no longertolerate a euro-franc exchange rate below the minimumrate of 1.20 francs", effectively weakening the Swissfranc. This is the biggest Swiss intervention since1978.[65]

Despite of sovereign debt only having rose substantiallyin a few eurozone countries, with the three most affectedcountries Greece, Ireland and Portugal collectively onlyaccounting for 6% of the eurozone's gross domesticproduct (GDP),[66] it has become a perceived problemfor the area as a whole,[67] leading to speculation offurther contagion of other European countries and apossible breakup of the Eurozone.

However, in Mid 2012, due to successful fiscalconsolidation and implementation of structural reformsin the countries being most at risk and various policymeasures taken by EU leaders and the ECB (see below),financial stability in the Eurozone has improvedsignificantly and interest rates have steadily fallen. Thishas also greatly diminished contagion risk for othereurozone countries. As of October 2012 only 3 out of 17eurozone countries, namely Greece, Portugal and Cyprusstill battled with long term interest rates above 6%.[68]

By the end of 2012, the debt crisis forced five out 17Eurozone countries to seek help from other nations.[3]


Greece

Greece's debt percentage since 1999 compared to the average ofthe eurozone.

100,000 people protest against the harsh austerity measures in frontof parliament building in Athens, 29 May 2011

In the early mid-2000s, Greece's economy was one of thefastest growing in the eurozone and was associated witha large structural deficit.[69] As the world economy washit by the global financial crisis in the late 2000s, Greecewas hit especially hard because its main industries shipping and tourism were especially sensitive tochanges in the business cycle. The government spentheavily to keep the economy functioning and thecountry's debt increased accordingly.

On 23 April 2010, the Greek government requested aninitial loan of 45 billion from the EU and InternationalMonetary Fund (IMF), to cover its financial needs for theremaining part of 2010.[70][71] A few days later Standard& Poor's slashed Greece's sovereign debt rating to BB+or "junk" status amid fears of default,[72] in which caseinvestors were liable to lose 3050% of their money.[72]

Stock markets worldwide and the euro currency declinedin response to the downgrade.[73]

On 1 May 2010, the Greek government announced aseries of austerity measures[74] to secure a three year110 billion loan.[75] This was met with great anger bythe Greek public, leading to massive protests, riots andsocial unrest throughout Greece.[76] The Troika (EC,ECB and IMF), offered Greece a second bailout loanworth 130 billion in October 2011, but with theactivation being conditional on implementation of furtherausterity measures and a debt restructure agreement. Abit surprisingly, the Greek prime minister GeorgePapandreou first answered that call, by announcing aDecember 2011 referendum on the new bailoutplan,[77][78] but had to back down amidst strong pressurefrom EU partners, who threatened to withhold an overdue 6 billion loan payment that Greece needed bymid-December.[77][79] On 10 November 2011 Papandreou instead opted to resign, following an agreement with theNew Democracy party and the Popular Orthodox Rally, to appoint non-MP technocrat Lucas Papademos as newprime minister of an interim national union government, with responsibility for implementing the needed austeritymeasures to pave the way for the second bailout loan.[80][81]

All the implemented austerity measures, have so far helped Greece bring down its primary deficit - i.e. fiscal deficit before interest payments - from 24.7bn (10.6% of GDP) in 2009 to just 5.2bn (2.4% of GDP) in 2011,[82][83] but as a side-effect they also contributed to a worsening of the Greek recession, which began in October 2008 and only became worse in 2010 and 2011.[84] The austerity relies primarily on tax increases which harms the private sector and economy.[85] Overall the Greek GDP had its worst decline in 2011 with 6.9%,[86] a year where the seasonal adjusted industrial output ended 28.4% lower than in 2005,[87][88] and with 111,000 Greek companies going bankrupt (27% higher than in 2010).[89][90] As a result, the seasonal adjusted unemployment rate also grew from 7.5% in September 2008 to a record high of 19.9% in November 2011, while the Youth unemployment rate during


the same time rose from 22.0% to as high as 48.1%.[91][92] Youth unemployment ratio hit 13 percent in 2011.[93][94]

Overall the share of the population living at "risk of poverty or social exclusion" did not increase noteworthily duringthe first 2 years of the crisis. The figure was measured to 27.6% in 2009 and 27.7% in 2010 (only being slightlyworse than the EU27-average at 23.4%),[95] but for 2011 the figure was now estimated to have risen sharply above33%.[96] In February 2012, an IMF official negotiating Greek austerity measures admitted that excessive spendingcuts were harming Greece.[82]

Some economic experts argue that the best option for Greece and the rest of the EU, would be to engineer anorderly default, allowing Athens to withdraw simultaneously from the eurozone and reintroduce its nationalcurrency the drachma at a debased rate.[97][98] However, if Greece were to leave the euro, the economic and politicalconsequences would be devastating. According to Japanese financial company Nomura an exit would lead to a 60%devaluation of the new drachma. Analysts at French bank BNP Paribas added that the fallout from a Greek exitwould wipe 20% off Greece's GDP, increase Greece's debt-to-GDP ratio to over 200%, and send inflation soaring to40%-50%.[99] Also UBS warned of hyperinflation, a bank run and even "military coups and possible civil war thatcould afflict a departing country".[100][101] Eurozone National Central Banks (NCBs) may lose up to 100bn in debtclaims against the Greek national bank through the ECB's TARGET2 system. The Deutsche Bundesbank alone mayhave to write off 27bn.[102]

To prevent all this from happening, the troika (EC, IMF and ECB) eventually agreed in February 2012 to provide asecond bailout package worth 130 billion,[103] conditional on the implementation of another harsh austeritypackage, reducing the Greek spendings with 3.3bn in 2012 and another 10bn in 2013 and 2014.[83] For the firsttime, the bailout deal also included a debt restructure agreement with the private holders of Greek government bonds(banks, insurers and investment funds), to "voluntarily" accept a bond swap with a 53.5% nominal write-off, partlyin short-term EFSF notes, partly in new Greek bonds with lower interest rates and the maturity prolonged to 1130years (independently of the previous maturity).[104] The deal implies that previous Greek bond holders are beinggiven, for 1000 of previous notional, 150 in PSI payment notes issued by the EFSF and 315 in New GreekBonds issued by the Hellenic Republic, including a GDP-linked security. The latter represents a marginal couponenhancement in case the Greek growth meets certain conditions. While the market price of the portfolio proposed inthe exchange is of the order of 21% of the original face value (15% for the two EFSF PSI notes 1 and 2 years and 6% for the New Greek Bonds 11 to 30 years), the duration of the set of New Greek Bonds is slightly below 10years.[105]

On 9 March 2012 the International Swaps and Derivatives Association (ISDA) issued a communiqu calling the debtrestructuring deal with its private sector involvement (PSI) a "Restructuring Credit Event" which will triggerpayment of credit default swaps. According to Forbes magazine Greeces restructuring represents a default.[106][107]

It is the world's biggest debt restructuring deal ever done, affecting some 206 billion of Greek governmentbonds.[108] The debt write-off had a size of 107 billion, and caused the Greek debt level to fall from roughly350bn to 240bn in March 2012, with the predicted debt burden now showing a more sustainable size equal to117% of GDP by 2020,[109] somewhat lower than the target of 120.5% initially outlined in the signed Memorandumwith the Troika.[83][110][111]

Critics such as the director of LSE's Hellenic Observatory [112] argue that the billions of taxpayer euros are notsaving Greece but financial institutions,[113] as "more than 80 percent of the rescue package is going tocreditorsthat is to say, to banks outside of Greece and to the ECB."[114] The shift in liabilities from Europeanbanks to European taxpayers has been staggering. One study found that the public debt of Greece to foreigngovernments, including debt to the EU/IMF loan facility and debt through the eurosystem, increased from 47.8bnto 180.5bn (+132,7bn) between January 2010 and September 2011,[115] while the combined exposure of foreignbanks to (public and private) Greek entities was reduced from well over 200bn in 2009 to around 80bn (-120bn)by mid-February 2012.[116]


Mid May 2012 the crisis and impossibility to form a new government after elections led to strong speculationsGreece would have to leave the Eurozone shortly due.[117][118][119][120] This phenomenon became known as "Grexit"and started to govern international market behaviour.[121][122] The center-right's narrow victory in the June 17thelection gives hope that a coalition will enable Greece to stay in the Euro-zone.[123] A victory by the anti-austerityaxis could have been "an excuse to cut Greece out of the euro zone" according to the Wall Street Journal.[124]

Ireland

Ireland's debt percentage compared to Eurozone average since1995

The Irish sovereign debt crisis was not based ongovernment over-spending, but from the stateguaranteeing the six main Irish-based banks who hadfinanced a property bubble. On 29 September 2008,Finance Minister Brian Lenihan, Jnr issued a two-yearguarantee to the banks' depositors and bond-holders.[126]

The guarantees were subsequently renewed for newdeposits and bonds in a slightly different manner. In2009, an National Asset Management Agency (NAMA),was created to acquire large property-related loans fromthe six banks at a market-related "long-term economicvalue".[127]

Irish banks had lost an estimated 100 billion euros, muchof it related to defaulted loans to property developers andhomeowners made in the midst of the property bubble,which burst around 2007. The economy collapsed during2008. Unemployment rose from 4% in 2006 to 14% by2010, while the national budget went from a surplus in2007 to a deficit of 32% GDP in 2010, the highest in the history of the eurozone, despite austerity measures.[4][128]

With Ireland's credit rating falling rapidly in the face of mounting estimates of the banking losses, guaranteeddepositors and bondholders cashed in during 2009-10, and especially after August 2010. (The necessary funds wereborrowed from the central bank.) With yields on Irish Government debt rising rapidly it was clear that theGovernment would have to seek assistance from the EU and IMF, resulting in a 67.5 billion "bailout" agreement of29 November 2010[129][130] Together with additional 17.5 billion coming from Ireland's own reserves andpensions, the government received 85 billion,[131] of which up to 34 billion was to be used to support thecountry's ailing financial sector (only about half of this was used in that way following stress tests conducted in2011).[132] In return the government agreed to reduce its budget deficit to below three percent by 2015.[132] In


Irish government deficit compared to other European countries andthe United States (20002013)[125]

April 2011, despite all the measures taken, Moody'sdowngraded the banks' debt to junk status.[133]

In July 2011 European leaders agreed to cut the interestrate that Ireland was paying on its EU/IMF bailout loanfrom around 6% to between 3.5% and 4% and to doublethe loan time to 15 years. The move was expected tosave the country between 600700 million euros peryear.[134] On 14 September 2011, in a move to furtherease Ireland's difficult financial situation, the EuropeanCommission announced it would cut the interest rate onits 22.5 billion loan coming from the EuropeanFinancial Stability Mechanism, down to 2.59 per cent which is the interest rate the EU itself pays to borrowfrom financial markets.[135]

The Euro Plus Monitor report from November 2011 attests to Ireland's vast progress in dealing with its financialcrisis, expecting the country to stand on its own feet again and finance itself without any external support from thesecond half of 2012 onwards.[136] According to the Centre for Economics and Business Research Ireland's export-ledrecovery "will gradually pull its economy out of its trough". As a result of the improved economic outlook, the costof 10-year government bonds, has already fallen substantially since its record high at 12% in mid July 2011 (see thegraph "Long-term Interest Rates"). At 24 July 2012 it was down at a sustainable 6.3%,[137] and it is expected to falleven further to a level of only 4% by 2015.[138]

On 26 July 2012, for the first time since September 2010, Ireland was able to return to the financial markets sellingover 5 billion in long-term government debt, with an interest rate of 5.9% for the 5-year bonds and 6.1% for the8-year bonds at sale.[139]


Portugal

Portugal's debt percentage compared to Eurozone average since1999

According to a report by the Dirio de Notcias[140]

Portugal had allowed considerable slippage instate-managed public works and inflated topmanagement and head officer bonuses and wages in theperiod between the Carnation Revolution in 1974 and2010. Persistent and lasting recruitment policies boostedthe number of redundant public servants. Risky credit,public debt creation, and European structural andcohesion funds were mismanaged across almost fourdecades.[141] When the global crisis disrupted themarkets and the world economy, together with the UScredit crunch and the European sovereign debt crisis,Portugal was one of the first and most affectedeconomies to succumb.

In the summer of 2010, Moody's Investors Service cutPortugal's sovereign bond rating,[3][142] which led toincreased pressure on Portuguese government bonds.[143]

In the first half of 2011, Portugal requested a 78 billionIMF-EU bailout package in a bid to stabilise its public finances.[144] These measures were put in place as a directresult of decades-long governmental overspending and an over bureaucratised civil service. After the bailout wasannounced, the Portuguese government headed by Pedro Passos Coelho managed to implement measures to improvethe State's financial situation and the country started to be seen as moving on the right track. However, this also leadto a strong increase of the unemployment rate to over 15 percent in the second quarter 2012 and it is expected to riseeven further in the near future.[145]

Portugals debt was in September 2012 forecast by the Troika to peak at around 124% of GDP in 2014, followed bya firm downward trajectory after 2014. Previously the Troika had predicted it would peak at 118.5% of GDP in2013, so the developments proved to be a bit worse than first anticipated, but the situation was described as fullysustainable and progressing well. As a result from the slightly worse economic circumstances, the country has beengiven one more year to reduce the budget deficit to a level below 3% of GDP, moving the target year from 2013 to2014. The budget deficit for 2012 has been forecast to end at 5%. The recession in the economy is now alsoprojected to last until 2013, with GDP declining 3% in 2012 and 1% in 2013; followed by a return to positive realgrowth in 2014.[146]

As part of the bailout programme, Portugal is required to regain complete access to financial markets starting fromSeptember 2013. The first step has been successfully completed on 3 October 2012, when the country managed toregain partly market access. Once Portugal regains complete access it is expected to benefit from interventions bythe ECB, which announced support in the form of some yield-lowering bond purchases (OMTs),[146] to bringgovernmental interest rates down to sustainable levels. A peak for the Portuguese 10-year governmental interest rateshappened on 30 January 2012, where it reached 17.3% after the rating agencies had cut the governments credit ratingto "non-investment grade" (also referred to as "junk").[147] As of 24 November 2012, it has been more than halved toonly 7.9%.[148]


Spain

Spain's debt percentage compared to Eurozone average since 1999

Spain had a comparatively low debt level amongadvanced economies prior to the crisis.[149] It's publicdebt relative to GDP in 2010 was only 60%, more than20 points less than Germany, France or the US, and morethan 60 points less than Italy, Ireland or Greece.[150][151]

Debt was largely avoided by the ballooning tax revenuefrom the housing bubble, which helped accommodate adecade of increased government spending without debtaccumulation.[152] When the bubble burst, Spain spentlarge amounts of money on bank bailouts. In May 2012,Bankia received a 19 billion euro bailout,[153] on top ofthe previous 4.5 billion euros to prop up Bankia.[154]

Questionable accounting methods disguised banklosses.[155] During September 2012, regulators indicatedthat Spanish banks required 59 billion (USD $77billion) in additional capital to offset losses from realestate investments.[156]

The bank bailouts and the economic downturn increased the country's deficit and debt levels and led to a substantialdowngrading of its credit rating. To build up trust in the financial markets, the government began to introduceausterity measures and it amended the Spanish Constitution in 2011 to require a balanced budget at both the nationaland regional level by 2020. The amendment states that public debt can not exceed 60% of GDP, though exceptionswould be made in case of a natural catastrophe, economic recession or other emergencies.[157][158] As one of thelargest eurozone economies (larger than Greece, Portugal and Ireland combined[159]) the condition of Spain'seconomy is of particular concern to international observers. Under pressure from the United States, the IMF, otherEuropean countries and the European Commission[160][161] the Spanish governments eventually succeeded intrimming the deficit from 11.2% of GDP in 2009 to an expected 5.4% in 2012.[159]

Nevertheless, in June 2012, Spain became a prime concern for the Euro-zone[162] when interest on Spains 10-yearbonds reached the 7% level and it faced difficulty in accessing bond markets. This led the Eurogroup on 9 June 2012to grant Spain a financial support package of up to 100 billion.[163] The funds will not go directly to Spanish banks,but be transferred to a governmently owned Spanish fund responsible to conduct the needed bank recapitalisations(FROB), and thus it will be counted for as additional sovereign debt in Spain's national account.[164][165][166] Aneconomic forecast in June 2012highlighted the need for the arranged bank recapitalisation support package, as theoutlook promised a negative growth rate of 1.7%, unemployment rising to 25%, and a continued declining trend forhousing prices.[159] In September 2012 the ECB removed some of the pressure from Spain on financial markets,when it announced its "unlimited bond-buying plan", to be initiated if Spain would sign a new sovereign bailoutpackage with EFSF/ESM.[167][168]

As of October 2012, the Troika (EC, ECB and IMF) is indeed in negotiations with Spain to establish an economic recovery program, which is required if the country should request a bailout package for the sovereign state from ESM. Reportedly Spain, in addition to the 100bn "bank recapitalisation" package arranged for in June 2012,[169]

now also seeks sovereign financial support from a "Precautionary Conditioned Credit Line" (PCCL) package.[170] If Spain receives a PCCL package, irrespective to what extent it subsequently decides to draw on this established credit line, Spain would immediately qualify to receive "free" additional financial support from ECB, in the form of some unlimited yield-lowering bond purchases (OMT).[171][172] According to recent statements by the Prime Minister, the country as of December 2012 still consider perhaps to request a PCCL sovereign bailout package in 2013, but only if


developments at financial markets will promise Spain a significant financial advantage of doing so. As of 7December 2012, the yield of 10-year government bonds had declined to 5.4%.[173]

According to the latest debt sustainability analysis published by the European Commission in October 2012, thefiscal outlook for Spain, if assuming the country will stick to the fiscal consolidation path and targets outlined by thecountry's current EDP programme, will result in a debt-to-GDP ratio reaching its maximum at 110% in 2018 -followed by a declining trend in subsequent years. In regards of the structural deficit the same outlook has promised,that it will gradually decline to comply with the maximum 0.5% level required by the Fiscal Compact in2022/2027.[174]

Policy reactions

EU emergency measuresThe table below provides an overview of the financial composition of all bailout programs being initiated for EUmember states, since the financial crisis erupted in September 2008. Member states outside the eurozone (markedwith yellow in the table) have no access to the funds provided by EFSF/ESM, but can be covered with rescue loansfrom EU's Balance of Payments programme (BoP), IMF and other funds.

EUmember

Time span IMF[169][175][176][177]

(billion )World

Bank[177]

(billion )

EIB / EBRD(billion )

Bilateralloans

[169]

(billion )

BoP[177]

(billion)

GLF[175]

(billion )EFSM

[169]

(billion )EFSF

[169]

(billion )ESM

[169]

(billion )

Bailout intotal

(billion )

Cyprus Jan.2013-Dec.2015 (negotiates)1 - - - - - - - (negotiates)1 (negotiates)1

Greece May 2010-Mar.2016 48.1 (20.1+19.8+8.2) - - - - 52.9 - 144.6 - 245.62

Hungary Nov.2008-Oct.2010 9.1 out of 12.5[178][179] 1.0 - - 5.5 out of6.5

- - - - 15.6 out of20.03

Ireland Nov.2010-Dec.2013 22.5 - - 4.8 - - 22.5 17.7 - 67.54

Latvia Dec.2008-Dec.2011 1.1 out of 1.7[180][181] 0.4[180][181] 0.1[180][181] 0.0 out of2.2[180][181]

2.9 out of3.1

- - - - 4.5 out of7.55

Portugal May 2011-May2014

26 - - - - - 26 26 - 78

RomaniaI

May 2009-June2011

12.6 out of 13.6[182][183] 1.0 1.0 - 5.0 - - - - 19.6 out of20.66

RomaniaII

Mar 2011-Mar 2013 0.0 out of 3.7[184][185] - - - 0.0 out of1.4

- - - - 0.0 out of5.17

Spain I July 2012-Dec.2013 - - - - - - - - 60 out of100[174]

60 out of1008

Spain II Perhaps in 2013 (negotiates) - - - - - - - (negotiates) (negotiates)9

Totalpayment

Nov.2008-Mar.2016 119.4 2.4 1.1 4.8 13.4 52.9 48.5 188.3 60 490.8

1 Negotiations between the Troika and Cyprus is ongoing.[186] PIMCO will submit the final evaluation report of Cypriot banks in January2013.[187] It is currently estimated the overall bailout package will have a size of 17.5bn, comprising 10bn for bank recapitalisation and6.0bn for refinancing maturing debt plus 1.5bn to cover budget deficits in 2013+2014+2015. If the entire bank recapitalisation is paid throughthe state to the banks (as required by current rules), this entire bailout package is expected to increase the Cypriot debt-to-GDP ratio to around

140%.[188]


2 Many sources list the first bailout was 110bn followed by the second on 130bn. When you deduct 2.7bn due to Ireland+Portugal+Slovakiaopting out as creditors for the first bailout, and add the extra 8.2bn IMF has promised to pay Greece for the years in 2015-16, the total amount ofbailout funds sums up to 245.6bn.[175]

3 Hungary recovered faster than expected, and thus did not receive the remaining 4.4bn bailout support scheduled for October 2009-October2010.[177][189] IMF paid in total 7.6 out of 10.5 billion SDR,[178] equal to 9.1bn out of 12.5bn at current exchange rates.[179]

4 In Ireland the National Treasury Management Agency also paid 17.5bn for the program on behalf of the Irish government, increasing thebailout total to 85bn.[169]

5 Latvia recovered faster than expected, and thus did not receive the remaining 3.0bn bailout support originally scheduled for 2011.[180][181]

6 Romania recovered faster than expected, and thus did not receive the remaining 1.0bn bailout support originally scheduled for 2011.[182][183]

7 Romania had a precautionary credit line with 5.1bn available for two years (Mar 2011-Mar 2013) to draw money from if needed; but entirelyavoided to draw on it.[177]

8 Spain's first 100bn support package has been earmarked only for recapitalisation of the financial sector.[190] Initially an emergency accountwith 30bn was available, but nothing was drawed, and it was cancelled again in November.[191] The first recapitalisation tranch of 39.5bn wasapproved 28 November,[192][193] and transferred to the bank recapitalisation fund of the Spanish government (FROB) on 12 December

2012.[191] Approvement of a second tranch for "category 2" banks has been scheduled for the end of December 2012, while "category 3" banks

will be subject for a possible third tranch in June 2013. All in all, it has been estimated maximum 60bn will be needed for the threetranches.[174] The support package's remaining 40bn will most likely not be needed, but will stay available as precautionary reserve until 31December 2013.[190]

9 Spain currently negotiates and consider to accept signing a MoU to get a Precautionary Conditioned Credit Line or an Enhanced Conditioned

Credit Line. If the line is created, Spain plan not to draw any money from it, and are only interested to get it for precautionary reasons (to calm

down markets; and to enable ECB to perform a yield lowering OMT).

European Financial Stability Facility (EFSF)

On 9 May 2010, the 27 EU member states agreed to create the European Financial Stability Facility, a legalinstrument[194] aiming at preserving financial stability in Europe by providing financial assistance to eurozone statesin difficulty. The EFSF can issue bonds or other debt instruments on the market with the support of the German DebtManagement Office to raise the funds needed to provide loans to eurozone countries in financial troubles,recapitalize banks or buy sovereign debt.[195]

Emissions of bonds are backed by guarantees given by the euro area member states in proportion to their share in thepaid-up capital of the European Central Bank. The 440 billion lending capacity of the facility is jointly andseverally guaranteed by the eurozone countries' governments and may be combined with loans up to 60 billionfrom the European Financial Stabilisation Mechanism (reliant on funds raised by the European Commission usingthe EU budget as collateral) and up to 250 billion from the International Monetary Fund (IMF) to obtain a financialsafety net up to 750 billion.[196]

The EFSF issued 5 billion of five-year bonds in its inaugural benchmark issue 25 January 2011, attracting an orderbook of 44.5 billion. This amount is a record for any sovereign bond in Europe, and 24.5 billion more than theEuropean Financial Stabilisation Mechanism (EFSM), a separate European Union funding vehicle, with a 5 billionissue in the first week of January 2011.[197]

On 29 November 2011, the member state finance ministers agreed to expand the EFSF by creating certificates thatcould guarantee up to 30% of new issues from troubled euro-area governments, and to create investment vehiclesthat would boost the EFSFs firepower to intervene in primary and secondary bond markets.[198]

Reception by financial marketsStocks surged worldwide after the EU announced the EFSF's creation. The facility eased fears that the Greek debt crisis would spread,[199] and this led to some stocks rising to the highest level in a year or more.[200] The euro made its biggest gain in 18 months,[201] before falling to a new four-year low a week later.[202] Shortly after the euro rose


again as hedge funds and other short-term traders unwound short positions and carry trades in the currency.[203]

Commodity prices also rose following the announcement.[204]

The dollar Libor held at a nine-month high.[205] Default swaps also fell.[206] The VIX closed down a record almost30%, after a record weekly rise the preceding week that prompted the bailout.[207] The agreement is interpreted asallowing the ECB to start buying government debt from the secondary market which is expected to reduce bondyields.[208] As a result Greek bond yields fell sharply from over 10% to just over 5%.[209] Asian bonds yields alsofell with the EU bailout.[210])Usage of EFSF fundsThe EFSF only raises funds after an aid request is made by a country.[211] As of the end of July 2012, it has beenactivated various times. In November 2010, it financed 17.7 billion of the total 67.5 billion rescue package forIreland (the rest was loaned from individual European countries, the European Commission and the IMF). In May2011 it contributed one third of the 78 billion package for Portugal. As part of the second bailout for Greece, theloan was shifted to the EFSF, amounting to 164 billion (130bn new package plus 34.4bn remaining from GreekLoan Facility) throughout 2014.[212] On 20 July 2012, European finance ministers sanctioned the first tranche of apartial bail-out worth up to 100 billion for Spanish banks.[213] This leaves the EFSF with 148 billion[213] or anequivalent of 444 billion in leveraged firepower.[214]

The EFSF is set to expire in 2013, running some months parallel to the permanent 500 billion rescue fundingprogram called the European Stability Mechanism (ESM), which will start operating as soon as member statesrepresenting 90% of the capital commitments have ratified it. (see section: ESM)On 13 January 2012, Standard & Poors downgraded France and Austria from AAA rating, lowered Spain, Italy (andfive other[215]) euro members further, and maintained the top credit rating for Finland, Germany, Luxembourg, andthe Netherlands; shortly after, S&P also downgraded the EFSF from AAA to AA+.[215][216]

European Financial Stabilisation Mechanism (EFSM)

On 5 January 2011, the European Union created the European Financial Stabilisation Mechanism (EFSM), anemergency funding programme reliant upon funds raised on the financial markets and guaranteed by the EuropeanCommission using the budget of the European Union as collateral.[217] It runs under the supervision of theCommission[218] and aims at preserving financial stability in Europe by providing financial assistance to EU memberstates in economic difficulty.[219] The Commission fund, backed by all 27 European Union members, has theauthority to raise up to 60 billion[220] and is rated AAA by Fitch, Moody's and Standard & Poor's.[221][222]

Under the EFSM, the EU successfully placed in the capital markets a 5 billion issue of bonds as part of thefinancial support package agreed for Ireland, at a borrowing cost for the EFSM of 2.59%.[223]

Like the EFSF, the EFSM will also be replaced by the permanent rescue funding programme ESM, which is due tobe launched in July 2012.[224]

Brussels agreement and aftermath

On 26 October 2011, leaders of the 17 eurozone countries met in Brussels and agreed on a 50% write-off of Greeksovereign debt held by banks, a fourfold increase (to about 1 trillion) in bail-out funds held under the EuropeanFinancial Stability Facility, an increased mandatory level of 9% for bank capitalisation within the EU and a set ofcommitments from Italy to take measures to reduce its national debt. Also pledged was 35 billion in "creditenhancement" to mitigate losses likely to be suffered by European banks. Jos Manuel Barroso characterised thepackage as a set of "exceptional measures for exceptional times".[225][226]

The package's acceptance was put into doubt on 31 October when Greek Prime Minister George Papandreouannounced that a referendum would be held so that the Greek people would have the final say on the bailout,upsetting financial markets.[227] On 3 November 2011 the promised Greek referendum on the bailout package waswithdrawn by Prime Minister Papandreou.


In late 2011, Landon Thomas in the New York Times noted that some, at least, European banks were maintaininghigh dividend payout rates and none were getting capital injections from their governments even while beingrequired to improve capital ratios. Thomas quoted Richard Koo, an economist based in Japan, an expert on thatcountry's banking crisis, and specialist in balance sheet recessions, as saying:

I do not think Europeans understand the implications of a systemic banking crisis.... When all banks areforced to raise capital at the same time, the result is going to be even weaker banks and an even longerrecession if not depression.... Government intervention should be the first resort, not the last resort.

Beyond equity issuance and debt-to-equity conversion, then, one analyst "said that as banks find it more difficult toraise funds, they will move faster to cut down on loans and unload lagging assets" as they work to improve capitalratios. This latter contraction of balance sheets "could lead to a depression, the analyst said.[228] Reduced lendingwas a circumstance already at the time being seen in a "deepen[ing] crisis" in commodities trade finance in westernEurope.[229]

Final agreement on the second bailout packageIn a marathon meeting on 20/21 February 2012 the Eurogroup agreed with the IMF and the Institute of InternationalFinance on the final conditions of the second bailout package worth 130 billion. The lenders agreed to increase thenominal haircut from 50% to 53.5%. EU Member States agreed to an additional retroactive lowering of the interestrates of the Greek Loan Facility to a level of just 150 basis points above the Euribor. Furthermore, governments ofMember States where central banks currently hold Greek government bonds in their investment portfolio commit topass on to Greece an amount equal to any future income until 2020. Altogether this should bring down Greece's debtto between 117%[109] and 120.5% of GDP by 2020.[110]

European Central Bank

ECB Securities Markets Program (SMP) covering bond purchasesfrom May 2010 till October 2012.

The European Central Bank (ECB) has taken a series ofmeasures aimed at reducing volatility in the financialmarkets and at improving liquidity.[230]

In May 2010 it took the following actions: It began open market operations buying government

and private debt securities,[231] reaching 219.5billion in February 2012,[232] though it simultaneouslyabsorbed the same amount of liquidity to prevent arise in inflation.[233] According to Rabobankeconomist Elwin de Groot, there is a natural limit of300 billion the ECB can sterilize.[234]

It reactivated the dollar swap lines[235] with FederalReserve support.[236]

It changed its policy regarding the necessary creditrating for loan deposits, accepting as collateral alloutstanding and new debt instruments issued orguaranteed by the Greek government, regardless of the nation's credit rating.

The move took some pressure off Greek government bonds, which had just been downgraded to junk status, makingit difficult for the government to raise money on capital markets.[237]

On 30 November 2011, the ECB, the U.S. Federal Reserve, the central banks of Canada, Japan, Britain and the Swiss National Bank provided global financial markets with additional liquidity to ward off the debt crisis and to support the real economy. The central banks agreed to lower the cost of dollar currency swaps by 50 basis points to come into effect on 5 December 2011. They also agreed to provide each other with abundant liquidity to make sure


that commercial banks stay liquid in other currencies.[238]

Long Term Refinancing Operation (LTRO)Though the ECB's main refinancing operations (MRO) are from repo auctions with a (bi)weekly maturity andmonthly maturation, the ECB now conducts Long Term Refinancing Operations (LTROs), maturing after threemonths, six months, 12 months and 36 months. In 2003, refinancing via LTROs amounted to 45 bln euro which isabout 20% of overall liquidity provided by the ECB.[239]

The ECB's first supplementary longer-term refinancing operation (LTRO) with a six-month maturity was announcedMarch 2008.[240] Previously the longest tender offered was three months. It announced two 3-month and one6-month full allotment of Long Term Refinancing Operations (LTROs). The first tender was settled 3 April, and wasmore than four times oversubscribed. The 25 billion auction drew bids amounting to 103.1 billion, from 177banks. Another six-month tender was allotted on 9 July, again to the amount of 25 billion.[240] The first 12 monthLTRO in June 2009 had close to 1100 bidders.[241]

On 22 December 2011, the ECB[242] started the biggest infusion of credit into the European banking system in theeuro's 13 year history. Under its Long Term Refinancing Operations (LTROs) it loaned 489 billion to 523 banksfor an exceptionally long period of three years at a rate of just one percent.[243] Previous refinancing operationsmatured after three, six and twelve months.[241] The by far biggest amount of 325 billion was tapped by banks inGreece, Ireland, Italy and Spain.[244]

This way the ECB tried to make sure that banks have enough cash to pay off 200 billion of their own maturingdebts in the first three months of 2012, and at the same time keep operating and loaning to businesses so that a creditcrunch does not choke off economic growth. It also hoped that banks would use some of the money to buygovernment bonds, effectively easing the debt crisis.[245] On 29 February 2012, the ECB held a second auction,LTRO2, providing 800 Eurozone banks with further 529.5 billion in cheap loans.[246] Net new borrowing under the529.5 billion February auction was around 313 billion; out of a total of 256 billion existing ECB lending (MRO+ 3m&6m LTROs), 215 billion was rolled into LTRO2.[247]

ECB lending has largely replaced inter-bank lending. Spain has 365 billion and Italy has 281 billion ofborrowings from the ECB (June 2012 data). Germany has 275 billion on deposit.[248]

ResignationsIn September 2011, Jrgen Stark became the second German after Axel A. Weber to resign from the ECB GoverningCouncil in 2011. Weber, the former Deutsche Bundesbank president, was once thought to be a likely successor toJean-Claude Trichet as bank president. He and Stark were both thought to have resigned due to "unhappiness withthe ECBs bond purchases, which critics say erode the banks independence". Stark was "probably the most hawkish"member of the council when he resigned. Weber was replaced by his Bundesbank successor Jens Weidmann, whileBelgium's Peter Praet took Stark's original position, heading the ECB's economics department.[249]

Money supply growthIn April, 2012, statistics showed a growth trend in the M1 "core" money supply. Having fallen from an over 9%growth rate in mid-2008 to negative 1% +/- for several months in 2011, M1 core has built to a 2-3% range in early2012. "'It is still early days but a further recovery in peripheral real M1 would suggest an end to recessions by late2012,' said Simon Ward from Henderson Global Investors who collects the data." While attributing the moneysupply growth to ECB's LTRO policies, an analysis in The Telegraph said lending "continued to fall across theeurozone in March [and] ... [t]he jury is out on the ... three-year lending adventure (LTRO)".[250]

Reorganization of the European banking systemOn June 16, 2012 the European Central Bank together with other European leaders hammered out plans for the ECBto become a bank regulator and to form a deposit insurance program to augment national programs. Other economicreforms promoting European growth and employment were also proposed.[251]

Outright Monetary Transactions (OMTs)


On 6 September 2012, the ECB announced to offer additional financial support in the form of some yield-loweringbond purchases (OMT), for all eurozone countries involved in a sovereign state bailout program from EFSF/ESM (atthe point of time where the country regain/posses a complete market access).[10] A eurozone country can benefitfrom the program if -and for as long as- it is found to suffer from stressed bond yields at excessive levels; but only atthe point of time where the country posses/regain a complete market access -and only if the country still comply withall terms in the signed Memorandum of Understanding (MoU) agreement.[10][167] Countries receiving aprecautionary programme rather than a sovereign bailout, will per definition have complete market access and thusqualify for OMT support if also suffering from stressed interest rates on its government bonds. In regards ofcountries receiving a sovereign bailout (Ireland, Portugal and Greece), they will on the other hand not qualify forOMT support before they have regained complete market access, which will normally only happen after havingreceived the last scheduled bailout disbursement.[10][252] Despite none OMT programmes were ready to start inSeptember/October, the financial markets straight away took notice of the additionally planned OMT packages fromECB, and started slowly to price-in a decline of both short term and long term interest rates in all European countriespreviously suffering from stressed and elevated interest levels (as OMTs were regarded as an extra potentialback-stop to counter the frozen liquidity and highly stressed rates; and just the knowledge about their potentialexistence in the very near future helped to calm the markets).If Spain signs a negotiated Memorandum of Understanding with the Troika (EC, ECB and IMF) outlining ESM shalloffer a precautionary programme with credit lines for the Spanish government to potentially draw on if needed(beside of the bank recapitalisation package they already applied for), this would qualify Spain also to receive theOMT support from ECB, as the sovereign state would still continue to operate with a complete market access withthe precautionary conditioned credit line. In regards of Ireland, Portugal and Greece, they on the other hand have notyet regained complete market access, and thus do not yet qualify for OMT support.[252] Provided these 3 countriescontinue to comply with the programme conditions outlined in their signed Memorandum of Understanding, theywill however qualify to receive OMT at the moment they regain complete market access (until the point of timewhere they no longer suffer from elevated/stressed interest rates).[10]

European Stability Mechanism (ESM)The European Stability Mechanism (ESM) is a permanent rescue funding programme to succeed the temporaryEuropean Financial Stability Facility and European Financial Stabilisation Mechanism in July 2012[224] but it had tobe postponed until after the Federal Constitutional Court of Germany had confirmed the legality of the measures on12 September 2012.[253][254] The permanent bailout fund is now expected to be up and running on 8 October2012.[255]

On 16 December 2010 the European Council agreed a two line amendment to the EU Lisbon Treaty to allow for apermanent bail-out mechanism to be established[256] including stronger sanctions. In March 2011, the EuropeanParliament approved the treaty amendment after receiving assurances that the European Commission, rather than EUstates, would play 'a central role' in running the ESM.[257][258] According to this treaty, the ESM will be anintergovernmental organisation under public international law and will be located in Luxembourg.[259][260]

Such a mechanism serves as a "financial firewall." Instead of a default by one country rippling through the entireinterconnected financial system, the firewall mechanism can ensure that downstream nations and banking systemsare protected by guaranteeing some or all of their obligations. Then the single default can be managed while limitingfinancial contagion.


European Fiscal Compact

Public debt to GDP ratio for selected Eurozone countries and theUK - 2008 to 2011. Source Data: Eurostat.

In March 2011 a new reform of the Stability and GrowthPact was initiated, aiming at straightening the rules byadopting an automatic procedure for imposing ofpenalties in case of breaches of either the 3% deficit orthe 60% debt rules.[261][262] By the end of the year,Germany, France and some other smaller EU countrieswent a step further and vowed to create a fiscal unionacross the eurozone with strict and enforceable fiscalrules and automatic penalties embedded in the EUtreaties.[263][264] On 9 December 2011 at the EuropeanCouncil meeting, all 17 members of the eurozone and sixcountries that aspire to join agreed on a newintergovernmental treaty to put strict caps on governmentspending and borrowing, with penalties for thosecountries who violate the limits.[265] All other non-eurozone countries apart from the UK are also prepared to join in,subject to parliamentary vote.[] The treaty will enter into force on 1 January 2013, if by that time 12 members of theeuro area have ratified it.[266]

Originally EU leaders planned to change existing EU treaties but this was blocked by British prime minister DavidCameron, who demanded that the City of London be excluded from future financial regulations, including theproposed EU financial transaction tax.[267][268] By the end of the day, 26 countries had agreed to the plan, leavingthe United Kingdom as the only country not willing to join.[269] Cameron subsequently conceded that his action hadfailed to secure any safeguards for the UK.[270] Britain's refusal to be part of the fiscal compact to safeguard theeurozone constituted a de facto refusal (PM David Cameron vetoed the project) to engage in any radical revision ofthe Lisbon Treaty. John Rentoul of The Independent concluded that "Any Prime Minister would have done asCameron did".[271]

Economic reforms and recovery proposals

Direct loans to banks and banking regulationOn June 28, 2012 Eurozone leaders agreed to permit loans by the European Stability Mechanism to be made directlyto stressed banks rather than through Eurozone states, to avoid adding to sovereign debt. The reform was linked toplans for banking regulation by the European Central Bank. The reform was immediately reflected by a reduction inyield of long-term bonds issued by member states such as Italy and Spain and a rise in value of theEuro.[272][273][274]

Less austerity, more investmentThere has been substantial criticism over the austerity measures implemented by most European nations to counter this debt crisis. US economist and Nobel laureate Paul Krugman argues that an abrupt return to "'non-Keynesian' financial policies" is not a viable solution[275] Pointing at historical evidence, he predicts that deflationary policies now being imposed on countries such as Greece and Spain will prolong and deepen their recessions.[276] Together with over 9,000 signatories of "A Manifesto for Economic Sense"[277] Krugman also dismissed the belief of austerity focusing policy makers such as EU economic commissioner Olli Rehn and most European finance ministers[278] that "budget consolidation" revives confidence in financial markets over the longer haul.[279][280] In a 2003 study that analyzed 133 IMF austerity programmes, the IMF's independent evaluation office found that policy makers


consistently underestimated the disastrous effects of rigid spending cuts on economic growth.[281][282] In early 2012an IMF official, who negotiated Greek austerity measures, admitted that spending cuts were harming Greece.[82][82]

In October 2012, the IMF said that its forecasts for countries which implemented austerity programs have beenconsistently overoptimistic, suggesting that tax hikes and spending cuts have been doing more damage thanexpected, and countries which implemented fiscal stimulus, such as Germany and Austria, did better thanexpected.[283]

Despite years of draconian austerity measures Greece has failed toreach a balanced budget as public revenues remain low.

According to Keynesian economists "growth-friendlyausterity" relies on the false argument that public cutswould be compensated for by more spending fromconsumers and businesses, a theoretical claim that hasnot materialized.[284] The case of Greece shows thatexcessive levels of private indebtedness and a collapse ofpublic confidence (over 90% of Greeks fearunemployment, poverty and the closure ofbusinesses)[285] led the private sector to decreasespending in an attempt to save up for rainy days ahead.This led to even lower demand for both products andlabor, which further deepened the recession and made it ever more difficult to generate tax revenues and fight publicindebtedness.[286] According to Financial Times chief economics commentator Martin Wolf, "structural tighteningdoes deliver actual tightening. But its impact is much less than one to one. A one percentage point reduction in thestructural deficit delivers a 0.67 percentage point improvement in the actual fiscal deficit." This means that Irelande.g. would require structural fiscal tightening of more than 12% to eliminate its 2012 actual fiscal deficit. A task thatis difficult to achieve without an exogenous eurozone-wide economic boom.[287] Austerity is bound to fail if it relieslargely on tax increases[288] instead of cuts in government expenditures coupled with encouraging "privateinvestment and risk-taking, labor mobility and flexibility, an end to price controls, tax rates that encouraged capitalformation ..." as Germany has done in the decade before the crisis.[289]

Instead of public austerity, a "growth compact" centering on tax increases[286] and deficit spending is proposed.Since struggling European countries lack the funds to engage in deficit spending, German economist and member ofthe German Council of Economic Experts Peter Bofinger and Sony Kapoor of the global think tank Re-Definesuggest providing 40 billion in additional funds to the European Investment Bank (EIB), which could then lend tentimes that amount to the employment-intensive smaller business sector.[286] The EU is currently planning a possible10 billion increase in the EIB's capital base. Furthermore the two suggest financing additional public investmentsby growth-friendly taxes on "property, land, wealth, carbon emissions and the under-taxed financial sector". Theyalso called on EU countries to renegotiate the EU savings tax directive and to sign an agreement to help each othercrack down on tax evasion and avoidance. Currently authorities capture less than 1% in annual tax revenue onuntaxed wealth transferred between EU members.[286] According to the Tax Justice Network, worldwide, a globalsuper-rich elite had between $21 and $32 trillion (up to 26,000bn Euros) hidden in secret tax havens by the end of2010, resulting in a tax deficit of up to $280bn.[290][291]

Apart from arguments over whether or not austerity, rather than increased or frozen spending, is a macroeconomicsolution,[292] union leaders have also argued that the working population is being unjustly held responsible for theeconomic mismanagement errors of economists, investors, and bankers. Over 23 million EU workers have becomeunemployed as a consequence of the global economic crisis of 20072010, and this has led many to call foradditional regulation of the banking sector across not only Europe, but the entire world.[293]

In the turmoil of the Global Financial Crisis, the focus across all EU member states has been gradually to implement austerity measures, with the purpose of lowering the budget deficits to levels below 3% of GDP, so that the debt level would either stay below -or start decline towards- the 60% limit defined by the Stability and Growth Pact. In


order to further restore the confidence in Europe, 23 out of 27 EU countries also agreed on adopting the Euro PlusPact, consisting of political reforms to improve fiscal strength and competitiveness; and 25 out of 27 EU countriesalso decided to implement the Fiscal Compact which include the commitment of each participating country tointroduce a balanced budget amendment as part of their national law/constitution. The Fiscal Compact is a directsuccessor of the previous Stability and Growth Pact, but it is more strict, not only because criteria compliance will besecured through its integration into national law/constitution, but also because it starting from 2014 will require allratifying countries not involved in ongoing bailout programmes, to comply with the new strict criteria of only havinga structural deficit of either maximum 0.5% or 1% (depending on the debt level).[263][264] Each of the eurozonecountries being involved in a bailout program (Greece, Portugal and Ireland) was asked both to follow a programwith fiscal consolidation/austerity, and to restore competitiveness through implementation of structural reforms andinternal devaluation, i.e. lowering their relative production costs.[294] The measures implemented to restorecompetitiveness in the weakest countries are needed, not only to build the foundation for GDP growth, but also inorder to decrease the current account imbalances among eurozone member states.[295][296]

It has been a long known belief that austerity measures will always reduce the GDP growth in the short term. Thereason why Europe nevertheless chose the path of austerity measures, is because they on the medium and long termhave been found to benefit and prosper GDP growth, as countries with healthy debt levels in return will be rewardedby the financial markets with higher confidence and lower interest rates. Some economists believing in Keynesianpolicies, however criticized the timing and amount of austerity measures being called for in the bailout programmes,as they argued such extensive measures should not be implemented during the crisis years with an ongoingrecession, but if possible delayed until the years after some positive real GDP growth had returned. In October 2012,a report published by International Monetary Fund (IMF) also found, that tax hikes and spending cuts during themost recent decade had indeed damaged the GDP growth more severely, compared to what had been expected andforecasted in advance (based on the "GDP damage ratios" previously recorded in earlier decades and under differenteconomic scenarios).[283] Already a half year earlier, several European countries as a response to the problem withsubdued GDP growth in the eurozone, likewise had called for the implementation of a new reinforced growthstrategy based on additional public investments, to be financed by growth-friendly taxes on property, land, wealth,and financial institutions. In June 2012, EU leaders agreed as a first step to moderately increase the funds of theEuropean Investment Bank, in order to kick-start infrastructure projects and increase loans to the private sector. Afew months later 11 out of 17 eurozone countries also agreed to introduce a new EU financial transaction tax to becollected from 1 January 2014.[297]

ProgressIn April, 2012, Olli Rehn, the European commissioner for economic and monetary affairs in Brussels,"enthusiastically announced to EU parliamentarians in mid-April that 'there was a breakthrough before Easter'. Hesaid the European heads of state had given the green light to pilot projects worth billions, such as building highwaysin Greece." Other growth initiatives include "project bonds" wherein the EIB would "provide guarantees thatsafeguard private investors. In the pilot phase until 2013, EU funds amounting to 230 million are expected tomobilize investments of up to 4.6 billion." Der Spiegel also said: "According to sources inside the Germangovernment, instead of funding new highways, Berlin is interested in supporting innovation and programs topromote small and medium-sized businesses. To ensure that this is done as professionally as possible, the Germanswould like to see the southern European countries receive their own state-owned development banks, modeled afterGermany's [Marshall Plan-era-origin] Kreditanstalt fr Wiederaufbau (KfW) banking group. It's hoped that this willget the economy moving in Greece and Portugal."[298]


Increase competitivenessCrisis countries must significantly increase their international competitiveness to generate economic growth andimprove their terms of trade. Indian-American journalist Fareed Zakaria notes in November 2011 that no debtrestructuring will work without growth, even more so as European countries "face pressures from three fronts:demography (an aging population), technology (which has allowed companies to do much more with fewer people)and globalization (which has allowed manufacturing and services to locate across the world)."[299]

In case of economic shocks, policy makers typically try to improve competitiveness by depreciating the currency, asin the case of Iceland, which suffered the largest financial crisis in 20082011 in economic history but has sincevastly improved its position. However, eurozone countries cannot devalue their currency.Internal devaluation

Relative change in unit labour costs, 20002011

As a workaround many policy makers try to restorecompetitiveness through internal devaluation, a painfuleconomic adjustment process, where a country aims toreduce its unit labour costs.[294][300] German economistHans-Werner Sinn noted in 2012 that Ireland was theonly country that had implemented relative wagemoderation in the last five years, which helped decreaseits relative price/wage levels by 16%. Greece would needto bring this figure down by 31%, effectively reachingthe level of Turkey.[301][302] By 2012, wages in Greecehave been cut to a level last seen in the late 1990s.Purchasing power dropped even more to the level of1986.[303]

Other economists argue that no matter how much Greeceand Portugal drive down their wages, they could nevercompete with low-cost developing countries such as China or India. Instead weak European countries must shift theireconomies to higher quality products and services, though this is a long-term process and may not bring immediaterelief.[304]

Fiscal devaluationAnother option would be to implement fiscal devaluation, based on an idea originally developed by John MaynardKeynes in 1931.[305][306] According to this neo-Keynesian logic, policy makers can increase the competitiveness ofan economy by lowering corporate tax burden such as employer's social security contributions, while offsetting theloss of government revenues through higher taxes on consumption (VAT) and pollution, i.e. by pursuing anecological tax reform.[307][308][309]

Germany has successfully pushed its economic competitiveness by increasing the value added tax (VAT) by threepercentage points in 2007, and using part of the additional revenues to lower employer's unemployment insurancecontribution. Portugal has taken a similar stance[309] and also France appears to follow this suit. In November 2012French president Franois Hollande announced plans to reduce tax burden of the corporate sector by 20 billionwithin three years, while increasing the standard VAT from 19.6% to 20% and introducing additional eco-taxes in2016. To minimize negative effects of such policies on purchasing power and economic activity the Frenchgovernment will partly offset the tax hikes by decreasing employees' social security contributions by 10 billion andby reducing the lower VAT for convenience goods (necessities) from 5.5% to 5%.[310]

Progress


Eurozone economic health and adjustment progress 2011 (Source:Euro Plus Monitor)[311]

On 15 November 2011, the Lisbon Council published theEuro Plus Monitor 2011. According to the report mostcritical eurozone member countries are in the process ofrapid reforms. The authors note that "Many of thosecountries most in need to adjust [...] are now making thegreatest progress towards restoring their fiscal balanceand external competitiveness". Greece, Ireland and Spainare among the top five reformers and Portugal is rankedseventh among 17 countries included in the report (seegraph).[311]

Address current account imbalances

Current account imbalances (19972013)

Regardless of the corrective measures chosen to solvethe current predicament, as long as cross border capitalflows remain unregulated in the euro area,[312] currentaccount imbalances are likely to continue. A country thatruns a large current account or trade deficit (i.e.,importing more than it exports) must ultimately be a netimporter of capital; this is a mathematical identity calledthe balance of payments. In other words, a country thatimports more than it exports must either decrease itssavings reserves or borrow to pay for those imports.Conversely, Germany's large trade surplus (net exportposition) means that it must either increase its savingsreserves or be a net exporter of capital, lending money toother countries to allow them to buy German goods.[313]

The 2009 trade deficits for Italy, Spain, Greece, andPortugal were estimated to be $42.96 billion, $75.31bnand $35.97bn, and $25.6bn respectively, whileGermany's trade surplus was $188.6bn.[314] A similarimbalance exists in the U.S., which runs a large tradedeficit (net import position) and therefore is a netborrower of capital from abroad. Ben Bernanke warnedof the risks of such imbalances in 2005, arguing that a"savings glut" in one country with a trade surplus can drive capital into other countries with trade deficits, artificiallylowering interest rates and creating asset bubbles.[315][316][317]

A country with a large trade surplus would generally see the value of its currency appreciate relative to other currencies, which would reduce the imbalance as the relative price of its exports increases. This currency appreciation occurs as the importing country sells its currency to buy the exporting country's currency used to purchase the goods. Alternatively, trade imbalances can be reduced if a country encouraged domestic saving by


restricting or penalizing the flow of capital across borders, or by raising interest rates, although this benefit is likelyoffset by slowing down the economy and increasing government interest payments.[318]

Either way, many of the countries involved in the crisis are on the euro, so devaluation, individual interest rates andcapital controls are not available. The only solution left to raise a country's level of saving is to reduce budgetdeficits and to change consumption and savings habits. For example, if a country's citizens saved more instead ofconsuming imports, this would reduce its trade deficit.[318] It has therefore been suggested that countries with largetrade deficits (e.g. Greece) consume less and improve their exporting industries. On the other hand, export drivencountries with a large trade surplus, such as Germany, Austria and the Netherlands would need to shift theireconomies more towards domestic services and increase wages to support domestic consumption.[32][319]

ProgressIn its spring 2012 economic forecast, the European Commission finds "some evidence that the current-accountrebalancing is underpinned by changes in relative prices and competitiveness positions as well as gains in exportmarket shares and expenditure switching in deficit countries."[320] In May 2012 German finance minister WolfgangSchuble has signaled support for a significant increase in German wages to help decrease current accountimbalances within the eurozone.[321]

Mobilization of creditA number of proposals were made in the summer of 2012 to purchase the debt of distressed European countries suchas Spain and Italy. Markus Brunnermeier,[322] the economist Graham Bishop, and Daniel Gros were among thoseadvancing proposals. Finding a formula which was not simply backed by Germany is central in crafting anacceptable and effective remedy.[323]

CommentaryU.S. President Barack Obama stated in June 2012: "Right now, [Europe's] focus has to be on strengthening theiroverall banking system...making a series of decisive actions that give people confidence that the banking system issolid...In addition, theyre going to have to look at how do they achieve growth at the same time as theyre carryingout structural reforms that may take two or three or five years to fully accomplish. So countries like Spain and Italy,for example, have embarked on some smart structural reforms that eve

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