Memo On European Sovereign Debt – 11/29/10

Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine

European Sovereign Debt

The 2008 global recession exposed weak underlying macro-fundamentals in several periphery
countries of the euro zone, most notably Greece, and more recently Ireland, catalyzing the 2010
European sovereign debt crisis. The situations in Greece and Ireland have not only pushed their
domestic economies further into recession, but have questioned the feasibility of a common
European currency. This memo progresses in four parts: 1) a discussion on Greek sovereign debt;
2) a discussion on Irish sovereign debt; 3) an analysis of how these crises have affected the euro
zone as a whole; 4) a look at the ways the European sovereign debt crisis may evolve and what
lessons should be learned. Taken together, this memo is intended to highlight the root causes of
the crisis, analyze the euro zone’s reactions, and evaluate the implications.

1) Greek Sovereign Debt Crisis

Overview:

Throughout the 1980s and 1990s Greece was viewed as a credit risk and was consequently forced
to pay borrowing rates up to 10% higher than Germany. i Greece saw the Euro as an opportunity
to receive lower interest rates since they would be backed by other credible European economies
and have a stable currency. Before being allowed to join the euro zone though, Greece had to
prove that they would be responsible by having a budget deficit of less than 3% and stabilizing
inflation.ii Rather than actually meeting these criteria, government officials manipulated the
figures to make it seem like Greece was responsible.

After Greece successfully joined the euro zone in 2001, they became eligible for low interest rate
loans. The Greek government relied heavily on these foreign loans and increased capital flows to
finance their excessive government spending and current account deficits. Moreover, Greece’s
primary budget deficit continued to grow as expenditure soared and tax evasion continued to be
rampant.

The financial crisis of 2008 caused a “sudden stop” of capital inflows and, without the ability to
depreciate its currency, Greece has been forced to bear the painful and slow process of decreases
in wages and prices.iii These pressures pushed the economy further into recession and exacerbated
the government’s debt problems. When the new government was elected in 2009, the estimated
budget deficit of 6.7% of GDP was revealed to be nearly double that at 13.6% of GDP. In
response to this news, Greek credit was downgraded and the euro zone was attacked by
widespread speculation.

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 Memo On European Sovereign Debt – 11/29/10
Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine

Response: Bailout and Austerity

As a result of Greece’s financial situation, the Greek government found itself unable to finance
itself on the markets like it had since joining the euro zone in 2001. With no other source of
capital and with fears of contagion in Europe if Greece defaulted, the European Union and the
International Monetary Fund intervened. The agreement between the EU-IMF and Greece
appropriated a total of €110bn ($146.5bn) to the Greek government in exchange for a multi-year
austerity plan. The contributions from the Euro member states were proportioned according to
their respective holdings in the European Central Bank's capital.

The euro zone loan promises were conditional on Greek reform and austerity measures; and
despite significant social unrest in Athens, the government passed legislation targeting
expenditure cuts, pension reform, tax reform, and labor market reform. Expenditure cuts mainly
took the form of wage freezes for all public sector workers, a cap on bonuses, as well as a
reduction in government employment. Pension reform was addressed through an increase in the
minimum retirement age, a tightening of the requirements for a full pension, and a determination
of the value of the pension by average salary rather than final salary. In addition to these reforms,
the value-added tax was increased and the labor market was made more flexible and
competitive.iv

When taken together, these measures were intended to cut the fiscal deficit from the estimated
13.6% of GDP to less than 3% of GDP by 2014. Such a reduction would move Greece into
compliance with the Euro Zone Stability and Growth Pact, hopefully calm the markets, and
position the country to secure much-needed funds in the future.

2) Irish Sovereign Debt Crisis

Overview:

Ireland became one of the fastest growing economies in Europe after it cut its corporate tax rates
and other taxes in the 1990’s, leading to large capital inflows and foreign direct investment.
However, during this time, a large housing bubble developed, which was heavily financed by
domestic banks. Meanwhile, the government increased public spending, raising domestic prices
and wages, and reducing Ireland’s competiveness abroad. v In 2008 when interest rates rose
throughout Europe, Ireland’s housing bubble burst, devastating their banks’ balance sheets and
the country’s external wealth. The government stepped in to bail out its banks, but this move put
the government further in debt.

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 Memo On European Sovereign Debt – 11/29/10
Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine

To mitigate the increases in debt, spending cuts and tax increases were implemented, but this
fiscal tightening sunk the economy further into recession, leading to a 7.1% drop in GDP in 2009
and 13% unemploymentvi. The negative shocks of the housing bubble burst and the subsequent
fiscal tightening sent Ireland into a downward spiral of recession and increased government debt.
This trend scared investors, resulting in the government’s debt being downgraded in quality by
the S&P.vii

Response: Bailout and Austerity

To combat this growing pessimism among investors, the EU and the IMF responded similarly as
they did in Greece, providing Ireland with an €85bn bailout. €50bn is aimed at helping Ireland’s
public finances, while the government implements a €15bn austerity package over the next four
years. The remaining €35bn will go towards recapitalizing Ireland’s banks, with €10bn to be used
in the short term recapitalization, and the rest set up as a contingency fund that can be drawn
upon if needed.viii

There is a lack of a consensus as to whether the bailout and austerity measures taken will be
enough to restore market confidence and prevent default. Ireland has taken a very tough stance on
keeping the Euro and not defaulting, implementing costly austerity measures to do so, which in
theory should help fend off some speculative attacks. However, some call for a more complete
restructuring of the Irish banks and their loans. ix

3) Crisis’s Affects to the Euro Zone

Implications for the Euro Zone:

The debt crises in Greece and Ireland have tested the sixteen-member euro zone’s commitment to
a common currency. Since the euro zone shares a common currency, their economies are
naturally very interdependent, despite asymmetric shocks to some periphery countries. Banks in
countries throughout the euro zone, especially in France, and Germany to a lesser extent, were
large holders of sovereign Greek debt. x A default by either Greece or Ireland would have sent
negative shockwaves throughout the financial system and the broader economy of the euro zone;
consequently, as an attempt to prevent this fear from materializing, the EU agreed to the bailouts.
Although Germany was initially, and still is, reluctant to partake in bailouts, it has helped their
economy, with the EU projecting robust 3.7% growth for Germany in 2010, lifting EU growth to
1.8%.xi

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 Memo On European Sovereign Debt – 11/29/10
Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine

Effects to the Value of the Euro:

Throughout the debt crisis, two major factors have influenced the value of the Euro. The first was
fear, which greatly depreciated the value of the Euro. When the debt crisis struck, the potential
risk of default on euro zone assets led to a sharp depreciation of the Euro as investors sold Euros
in search of safer returns in other currencies. This fear of potential default was enhanced by
Germany’s initial unwillingness to agree to terms on a rescue package. Even after the Greek
rescue package was announced, the Euro depreciated farther as fears of contagion circulated and
investors continued to sell Euros. Once this fear gradually subsided, the second factor, monetary
policy, led to an appreciation of the Euro. Because the ECB has pursued tighter monetary policy
than the Fed and other central banks, the Euro has erased most of the initial losses stemming from
a lack of faith.xii With that said, these fears have reappeared recently due to the crisis in Ireland.

The appreciation of the Euro has made it difficult for Germany’s export-oriented economy to
compete – hence their reluctance to run to the aid of Greece and Ireland. The appreciation caused
their exports to fall for consecutive months in July and August of this year. Unless the ECB
begins to loosen monetary policy at the rate of other central banks, this will continue to be a
problem for Germany, a country that relies on a large current accounts surplus, and is being relied
on to prop up weaker European economies such as Greece and Ireland. xiii

4) Appraisal of the European Sovereign Debt Crisis

Beyond Greece and Ireland

The sovereign debt problems that we have discussed so far focus around Greece and Ireland, two
countries with particularly acute fiscal problems. Greece, for example, has run persistently high
fiscal deficits for years and has failed to reform its economy such that the private sector can be
competitive and drive economic growth. xiv The crisis, however, has not been constrained to just
those two countries and has had significant impact on government policies and bond markets
across the euro zone. Bond rating agencies have downgraded the debt of a number of Euro
countries, including Spain and Portugal, and the yields that the market has demanded on the
weaker European countries’ debt has increased markedly. xv Despite the efforts of European
officials to use the example of Ireland to restore confidence to the markets, many investors worry
that Spain and Portugal are the next to face a debt crisis.

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 Memo On European Sovereign Debt – 11/29/10
Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine

Rather than reassuring the markets, the Irish bailout has caused bond yields to increase in
Portugal, Spain, and Greece. This is partially due to the recent German rumblings that
accompanied the bailout suggesting that, in the future, bond holders may have to pay a portion of
the cost.xvi Further, markets may be concerned that the appetite within Germany and other
sponsoring Euro countries for future, potentially costly bailouts, may be waning—and that if they
occur, they will result in harsher terms for bond holders. xvii

Across Europe, policymakers and governments have to reckon with uneasy bond markets as they
decide their fiscal policies. This has resulted in a reluctance to engage in expansionary fiscal
policy—and in the United Kingdom has prompted fiscal tightening despite the economic
recession and the fact that British bonds have not seen an increase in risk premium. In the event
of future weaknesses in the financial system, some euro zone members may have to weigh the
costs of not supporting their banks against the cost of losing bond market confidence, and thus
potentially a sovereign debt crisis. This problem is exacerbated by the fact that many euro zone
countries have large debt-to-GDP ratios: Italy at 116%; Greece at 113%; Belgium at 101%;
France at 78%; Portugal at 77%; and Germany at 73%. xviii Further, euro zone countries issue
short-term debt meaning that they are required to rollover their debt more frequently-- $1.3
trillion worth over the next year.xix At these levels, an increase in bond yields can result in a major
increase in government borrowing costs, decrease private sector investment, and lower overall
GDP growth, potentially putting the economy into recession.

Future Dangers and Impact:

When the euro zone first came into being, critics suggested that it would face serious problems
primarily due to the fact that it was attempting to establish a monetary union without a political
union. According to these critics, conditions could vary significantly across countries and with a
common currency, each country would lose the shock absorber of its own floating exchange rate.
With the euro zone’s initial successes, many European economists confidently viewed these
concerns as overblown.xx However, these potential problems have surfaced in the recent financial
crisis and have only become worse as euro zone members experience different recoveries and
government responses to the crisis and recession. In the third quarter of 2010, Germany’s GDP
growth was 0.7%, whereas Greece’s growth was -4.7% and Portugal’s growth was -0.1% for the
quarter.xxi

These numbers are indicative of dramatically different economic outlooks that will likely only
become divergent in the future. Greece and the other euro zone countries facing difficult bond

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 Memo On European Sovereign Debt – 11/29/10
Justin Ciambella, Gardner Davis, Sean Donovan, Kunal Malkani, and Nicholas Paine

markets will have to continue austerity measures for years, which will constrain GDP growth and
prolong their recession. On the other hand, Germany, France, and the other stronger European
economies have already emerged from the recession and will likely see continued and possibly
accelerating growth. In this environment, the European Central Bank will have to set a monetary
policy that attempts to balance between the requirements of the two groups—and will not be able
to fully meet either.

The euro zone will also face further stress if the indebted countries have trouble in meeting their
strict targets for austerity, fiscal reductions, and economic reforms. Greece, for one, already has
said it will not be able to meet its 8.1% deficit target this year. xxii If this continues, Germany may
tire of its role as creditor for all of the euro zone’s debt. Struggling countries may find it attractive
to leave the Euro and devalue their currency to combat their fiscal position rather than to struggle
through fiscal austerity.xxiii We did not focus on the question of the Euro as a viable currency
union, so we cannot discuss its outlook in detail. However, our understanding suggest that while a
total collapse of the Euro is unlikely, it is possible that the euro zone gradually shrinks to just
those countries with workable fundamentals and growing economies.

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i
Lewis, MIchael. "Beware of Greeks Bearing Bonds." Vanity Fair. 01 Oct 2010.
ii
Ibid.
iii
Krugman, Paul. "The Euro Trap." The New York Times. N.p., 30 Apr 2010. Web. <http://www.nytimes.com/2010/04/30/opinion/30krugman.html>.
iv
"Greek Parliament Approves Crucial Austerity Package as Global Markets Reel." IHS Global Insight. Web.
<http://www.ihsglobalinsight.com/SDA/SDADetail18653.htm>.
v
FitzFerald, Garret. “Dublin is paying the price of three follies.” Financial Times. FT, 22 Nov. 2010.
vi
“Ireland.” The New York Times. NYT, 23 Nov. 2010.
vii
Brown, John Murray. “S&P Downgrades Ireland on Debt Worries.” Financial Times. 29 Nov. 2010.
viii
Tait, Nikki, Joshua Chaffin, Quentin Peel, and John Murray Brown. “EU Agrees 85bn Irish Bail-Out.” Financial Times. 29 Nov. 2010.
ix
“Europe has not yet rescued Ireland.” Financial Times. 22 Nov. 2010.
x
Kirkegaard, Jacob F. "The Biggest Losers: Who Gets Hurt from a Greek Default or Restructuring." Peter G. Peterson Institute for International
Economics. 27 Apr. 2010. Web. 25 Nov. 2010.
xi
Wishart, Ian. "EU Predicts Economic Growth." European Voice | An Independent Voice on EU News and Affairs. Web. 27 Nov. 2010.
xii
"How to Run the Euro: Fixing Europe's Single Currency." The Economist 23 Sept. 2010.
xiii
Junga, Katharina. "Germany: Export Prospects With a Strengthening Euro." Roubini Global Economics. 22 Oct. 2010. Web. 24 Nov. 2010.
xiv
Jerome Cukier, OECD, Deepening Debt, March 23, 2010. https://community.oecd.org/community/factblog/blog/2010/03/23/deepening-debt
OECD, Greece at a Glance: Policies for a Sustainable Recovery. http://www.oecd.org/dataoecd/6/39/44785912.pdf.
xv
Reuters, Key staging posts in spread of euro zone debt crisis, November 29, 2010. http://www.reuters.com/article/idUSTRE6AS34V20101129.
xvi
The Economist, A Contagious Irish Disease?, November 25, 2010.
xvii
Bild, First the Greeks, then the Irish, then…will we end up having to pay for everyone in Europe?, via The Economist (ibid).
xviii
CIA, World Factbook: Public Debt Country Comparison. https://www.cia.gov/library/publications/the-world-factbook/rankorder/2186rank.html.
xix
Sujata Rao and Sebastian Tong, Reuters, Emerging Markets Can Weather Global Rollover Risks, May 25, 2010.
http://uk.reuters.com/article/idUKLNE64O00520100525.
xx
Lars Jonung and Eoin Drea, It Can’t Happen, It’s a Bad Idea, It Won’t Last: U.S. Economists on the EMU and the Euro, 1989-2002, Economics in
Practice, January 2010. Via Paul Krugman.
xxi
Jana Randow and Jeff Black, Bloomberg BusinessWeek, Germany’s Economic Growth Slows from Record Pace, November 12, 2010.
xxii
Charles Forelle, Wall Street Journal, Greece, Germany Grapple Over Debt, November 16, 2010.
xxiii
A Portuguese Minister has already speculated that it may have to leave the Euro due to its acute crisis. Forelle, ibid.