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The roots of the European sovereign debt crisis go back thirty years

The Wall Street Journal is reporting that a plan to bail out Greece to the tune of $41 billion is now being formulated by Germany and France. It might seem as if a bailout is inevitable and that the terms of such a bailout are the only things now being negotiated between EU members. However, even within this account, German Chancellor spokesman Ulrich Wilhelm has denied that such a plan even exists. Clearly, then, there is still a lot of uncertainty about the situation in Greece – and whether they will receive a bailout and on what terms.

This post will update you on the latest events. But it should also give you a perspective on the historical reasons for the political posturing we are witnessing.

The Euro’s beginnings

The story began in March 1979, more than thirty years ago – before Greece was a member of the EU. This was when the ECU (European Currency Unit), the precursor to the Euro, came into being. The currency volatility which followed the break down in the Bretton Woods fixed exchange rate system in 1973 was a shock to policy makers and seen as a major source of economic instability during the 1970s. The goal in Europe was to create a European Exchange Rate Mechanism (ERM) which minimized currency volatility and set the stage for monetary union by fixing a maximum 2.25% range for currency fluctuation. But this also required a degree of economic harmonisation between countries on fiscal and monetary policy.

Unfortunately, the harmonisation was not forthcoming. Italy, in particular, was seen as politically unstable, with thirty different governments in the post-war First Republic from 1946-1994 and another eight since then. This meant that Italy often operated with a large fiscal deficit. It had high rates of inflation and a weak currency. Therefore, during the ERM days, its currency band was set at 6%.

Greece, Spain and Portugal ended dictatorships in 1974 and 1975 and 1976 respectively, paving their way for entry into the European Union in the 1980s. However, they too had fiscal, currency and inflation problems. So when the Euro’s terms were set in 1992 in the Maastricht Treaty, the Germans, in particular, were adamant about inserting the Stability and Growth Pact.

The Germans, who had seen their currency destroyed by Hyperinflation in the 1920s and the Nazis in the 1940s, were keen to ensure a strong currency.  The Deutsche Mark had been a strong currency and this strength was seen as a major source of the German economic miracle which brought the country back from collapse after World War II. So, at the time of the Maastricht Treaty, the Germans wanted more European integration to keep the tensions which had led to two devastating wars in the 20th century at bay. But they also wanted to prevent free riders (like Portugal, Italy, Greece and Spain) from watering down the Euro with an inflationary economic policy and making it a weak currency.

The mechanism eventually chosen to stop free riders was the Stability and Growth Pact (SGP). This provision set strict limits on fiscal policy, namely an annual budget deficit of no greater than 3% and a debt-to-GDP ratio either of no greater than 60% or declining toward that mark.

Shenanigans to dodge the SGP

In the lead-up to the Euro’s creation, Theo Waigel, then the German finance minister and a leading Bavarian CSU politician, pushed for the SGP. But, many felt it was too restrictive and that enforcement was unworkable. Former EU and Italian head Romano Prodi called it “stupid.”

In fact, from the word go, countries were ‘cheating’ to gain admission into the Eurozone. Italy certainly was – and now we know Greece was as well. I wouldn’t be surprised if similar stories surfaced in Spain, Belgium, or Portugal. And eventually even France and Germany breached the 3% hurdle.  When former German Chancellor Gerhard Schroeder’s government missed the 3% hurdle, he too called for scrapping the SGP. Hard money types like Otmar Issing, the chief economist at the ECB, dismissed these calls out of hand.

Hardliners vs. Pollyannas?

It is these same hard money types who want Greece to dangle in the wind. Issing, now retired from the ECB wrote the following in the Financial Times two weeks ago:

To bail out Greece or not? The question is grabbing headlines daily. Supporters of a bail-out argue that if Greece collapses, others would follow. Financial markets have already identified the next candidates. As such, European economic and monetary union is at risk. Only financial aid and “solidarity” with highly indebted members can rescue the euro.

It is certainly true that this is a decisive moment for Emu – but for the opposite reason. Greece will continue to receive support from several European Union funds. But financial aid from other EU countries or institutions that amounted, directly or indirectly, to a bail-out would violate EU treaties and undermine the foundations of Emu. Such principles do not allow for compromise. Once Greece was helped, the dam would be broken. A bail-out for the country that broke the rules would make it impossible to deny aid to others.

-Europe cannot afford to rescue Greece, Otmar Issing, FT.com

Translation: Don’t bail out Greece. It is forbidden and invites others to ask for the same unwarranted hand out.

All this despite Germany’s breaking the 3% hurdle yet again. But, Issing is not the only one saying this. The Dutch joined the Germans in rejecting bailout of Greece weeks ago. Dutch premier Bos was quoted in the Dutch finance daily NRC Handelsblad as wanting the IMF involved (Dutch-language article here). The Irish and Swedish have joined the chorus of countries seeking austerity for the Greeks, with the Swedish premier also mentioning the IMF.

What you have is the countries with former ‘hard’ currencies balking at a bailout and wanting draconian terms for Greece if one is forthcoming. They are met by the former ‘soft’ currency countries pushing for a bailout. The press from this morning shows you how political this debate is based on the slant of the headlines. In Ireland it’s: EU demands Greece acts on debt ahead of bailout package. But, in Spain, it’s “Zapatero proposes a joint rescue for Greece (Zapatero propone un rescate común para Grecia).”

Conflicting reports

Meanwhile in North America, the National Post says: “EU tells Greece to do more on budget, markets improve” which is a very different spin than the Wall Street Journal’s “Greece Bailout Plan Takes Shape.”

All of this is spin and speculation. The fact is no one knows where this is headed. Two weeks ago after the EU issued it’s first statement of support for Greece, I said:

…the approach seems to be long on psychological and political support and short on specifics or financial aid.  In theory, there will be loans in exchange for austerity. Details are to come. But the euro has sold off on the news.  Moreover, as this is a debt crisis, not just a crisis of confidence, I don’t think ”psychological and political support” is going to cut it.

And I think the politicians get this. Therefore, they are working to do something more concrete. My understanding is that they are looking to offer a support package i.e. a contingency plan under which a bailout via loan guarantees or Greek debt purchases kicks in only if necessary. This kind of ”psychological and political support” is more concrete and more credible. The EU is hoping that the pressure on Greece will subside if they commit categorically to a contingent bailout.

Other possibilities include an EU-led bailout with IMF ‘technical advisory assistance’ in exchange for fiscal austerity from the Greeks. This is what I have proposed. But, my proposal understands that fiscal tightening doesn’t happen in a vacuum. There are consequences for the trade and private sector because the financial sectors must balance. A lot of people, including the American President, don’t seem to understand this (see my post “Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip” The problem with fiscal austerity is that it reduces the government sector’s deficit which must be offset by an equivalent decrease in the combined private and trade sectors’ surplus. Given the fixed exchange rate, all of the burden falls on the private sector for this adjustment Translation: if the government cuts its deficit by 10% of GDP in a fixed exchange rate system as Greece must do to get into SGP compliance, it automatically means the private sector must spend 10% more of GDP.  This likely means piling on private sector debt in a country awash in debt.

However, in my view, it is wishful thinking to think more than that is coming given the resistance to a bailout in Germany, Sweden, the Netherlands, and Ireland I have detailed here and previously. But given the focus on the fiscal side of things without considering the context for the private and trade sectors, we are headed to a poor outcome. I hope that helps put this debate in context.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

4 Comments

  1. Martin, the Netherlands says:

    As a contributor to Wikipedia, I was very pleased to see all those links to Wikipedia articles! ;)

    • It’s a great place to get up to speed quickly on historical issues in a way
      that adds a lot of good context. Wikipedia is much maligned for accuracy,
      but on the whole you all do good work.

  2. I think we have to be pragmatic in the approach to this eurozone sovereign debt crisis. That suggests a more homogeneous “unicredit” type of bond market which means that the issuance of EU bonds is necessary. If the Euro is in trouble you need more Euro integration not less.
    It’s easy: if you just apply a financial transaction tax at EU level (US will come later on…) you get immediately some 100-200 billions Euro. With this money you can set up a European monetary Fund, arrange for Greece bailout and/or even fund the EU budget as its single own resource.
    Technically you could also start the common issuance of an EU bond without backing of a financial transaction tax as revenue. In this case we should arrange for cross-guarantees and appropriate sharing of interest rates to be paid among EU Member States. This would not only significantly reduce the cost of financing of PIGS debt (in the case of Greece the spread is more than 4% over German bond thus the savings from a common EU issuance are quite big and more than any fiscal measures), while creating a EU bond market, but it would replace any International Monetary Fund role and/or conditional loans.