By Shivranjani Singh

Edited by Maria Liz Kuriakose, Associate Editor, The Indian Economist

Over the past year the Eurozone crisis has been in the news extensively but can be quite difficult to understand what is going on exactly. Taking help from Jacob Goldstein writing for npr.org (The Crisis In Europe, Explained) here is what the Eurozone crisis is basically about.

  • Prior to the introduction of the Euro as a currency across the European continent, different governments had to borrow at different rates. With the Euro being used across all EU countries, all countries could borrow at the same rate. Also, policy regulators allowed banks to buy unlimited amounts of govt. bonds without having the govt. to set aside any equity capital. So, commercial banks accumulated bonds of weaker countries.
  • These weaker countries continued to rest on the borrowed money that they acquired and continued on a spending spree (welfare projects in these countries were quite good). Other countries such as Germany went on to become competitive and focused on selling their products. Because of the Euro, Germany could sell to countries surrounding Europe at cheaper rates and borrowing money was easier for the people of these countries to buy this stuff.
  • This model could have worked but in the early 2000s some EU member states started to fail to stay within the confines of the Maastricht Treaty of 1992 under which they pledged to limit their deficit spending and debt levels. In order to reduce their debts and deficits they started to securitize future government revenues. Simplistically, this means that a govt. sells contractual debts (loans owed, etc.) as bonds or securities, essentially creating a system where potential, yet for the moment fictional, money is promised at secondary and even tertiary levels.
  • Eventually, financial markets realised that the govt.s will not be able to pay back the debts they owe, triggering a panic and leading the banks to demand higher interest rates. Also, the banks that had already lent money to these countries were in trouble now.

Hence, the problem is:

  • Borrowing costs have risen for weaker countries.
  • Banks who have lent them money may not be able to recover it.

In 2010, with the coming of a new Greek govt., the extent of the govt.’s debt was revealed. With an increasing fear of the nation defaulting on their excessive debt, fuelled by international media, more and more nations were realised to have large amounts of debts and deficits. The insolvency of govt. debts also lead to bank customers, the common citizen, to withdraw their deposits causing a banking run which brought banks to fear bankruptcy.

It has been said that while the whole debacle could have been contained to a govt. debt crisis, it is now a banking crisis, a much more severe issue. While, the European Central Bank has tried to pump money into the countries, this may only result in inflation. This is because when the money supply is expanded without a corresponding increase in productivity the supply of money to purchase goods increases leading to greater competition for goods which drives the price of goods up. It would also lead to ‘moral hazard’ risk as it would allow banks to take on more risks, preparing the road to the next crisis. An article by Paul De Grauwe, a professor at the LSE Europe Institute, talks about how the response of the ECB at the time should have been to provide support in the secondary markets of the govt. bonds, so as to put a floor on the prices of the bonds. This would have helped keep larger structure afloat and could have been a long term solution as opposed to pumping money into the economy directly and creating a short term solution that is flawed.

http://www.npr.org/blogs/money/2012/06/04/154282337/the-crisis-in-europe-explained

Shivranjani frequently uses one word to describe herself: Potterhead. But other than that can often provide very legitimate arguments to support movies, music, literature and sentiments that are always labelled “mainstream”. For the more banal aspects of her identity, she is a English Lit student at Hansraj College, Delhi and claims to have heard every possible short joke in the universe.

Posted by The Indian Economist | For the Curious Mind