SSgA CAPITAL INSIGHTS
Part of State Street’s Vision thought leadership series
The European
Sovereign Debt Crisis
by
John Nugée
Senior Managing Director
Head of SSgA Official Institutions
Group
The European sovereign debt crisis has become the dominant
issue not just in European markets, but in global finance. The
world is watching in fascination and with considerable concern
as European governments struggle to bring stability back to their
national finances. Much hangs on their efforts, including possibly
the fate of the euro itself.
The challenge in analyzing Europe’s crisis and predicting its future
path is not so much in understanding the economic issues, which
in themselves are fairly straightforward, as in interpreting them
against the wider political backdrop.
Economically, it is clear that several EU countries – most notably
Greece, Portugal, Spain, Ireland and Italy within the Eurozone but
also Hungary, Latvia and even the UK – have been running very
large deficits for some time, and are reaching or have already
reached levels of debt-to-GDP that are above 100% of GDP.
The exact reasons for the deficits and the large debt levels differ
between countries: in Greece’s case, it is mainly the result of
poor tax collection; in Ireland’s, it is a consequence of having
to support their banking system and in most of them, there has
been a consumption and property boom made possible by the
single European market and fuelled by the low interest rates that
came with euro membership.
VIEWPOINTS
But whatever the causes, in each country government debt has
reached excessive levels and markets are expressing doubt that
the situation is sustainable. Indeed, many commentators have
suggested that Greece has already reached the point where debt
rescheduling is inevitable, and some of the other states are not
far behind.
What if Greece Defaults?
It is here however that the situation in Europe begins to differ
from a “normal” sovereign default, such as Argentina’s 8 years
ago, because a default by Greece or any of the other southern
states would be a default in Europe’s single currency. And if
Greece for example were to default, the main losers, after the
Greek people themselves, would be the banking systems of
France, Germany and Belgium, all of which have lent substantial
amounts of money to Greek borrowers.
In effect, the competitive economies of northern Europe have
been engaged in a sustained exercise of vendor finance: in other
words, for about 10 years now, German and other banks have
been lending Greek and other consumers the money to buy
German exports.
The resulting web of loans and exposures is of an order of magni-
tude larger than normal cross-border banking (See Chart 1), and
is a direct consequence of monetary union, as intra-eurozone
loans across national boundaries are far in excess of what any
regulator or supervisor would have allowed absent the single
currency.1
The banking exposures are in fact large enough to threaten the
banking systems of the creditor states, with the result that the
effect of a Greek default would be felt in the finance ministries
of the creditors as well, as they were forced into rescuing their
banks. It is this fact above any other that is driving the politicians’
determination to avoid formal defaults.
SSGA CAPITAL INSIGHTS | THE EUROPEAN SOVEREIGN DEBT CRISIS

The rest of Europe is therefore prepared to go to almost any How Politics and History Come into Play
lengths to avoid declaring Greece formally in default. This This much is fairly straightforward, and most commentators
explains both the size of the rescue package, and also the fact have drawn the same conclusions, viz firstly, that the Greeks
that it has been put together as a loan – this is more usually the will struggle to deliver, and secondly, that even if they fail, the
solution for an illiquid borrower and is almost never the right solu- attempt to do so will cause a serious recession in the meantime.
tion for one which is insolvent. Indeed, for insolvent borrowers, What is interesting is what comes next, i.e. if the Greeks look as
lending more money merely threatens to increase the size of the though they are not keeping to the austerity plan, then politics
eventual rescheduling. and indeed history start to dominate the analysis.

Germany is well aware of this and is therefore determined that Broadly speaking Europe has twice in the past faced debt crises
alongside the new loans and guarantees for Greece, there are of this magnitude, after both World Wars. Nor was it only the
very strict deficit reduction requirements and the strongest vanquished who faced huge debts and in Germany’s case in the
possible measures to make sure Greece sticks to the repayment 1920s official reparations. Even the victors faced debt-to-GDP
schedules. These are extremely onerous, to the point that there levels well above 200%. But the response to the two crises could
are legitimate doubts that the Greek government, or indeed any not have been more different.
democratic government, has the ability to impose them on their
people, and the markets are openly speculating that they will fail.2 • In the 1920s and 1930s, Europe joined with most of the rest of
the world in believing in fixed exchange rates tied to the gold

Chart 1: Europe’s Web of Debt

FRANCE $75

GERMANY $45
BRITAIN $15

9GDQH&GDV
Banks and governments in these five
shaky economies owe each other
many billions of euros — converted
here to dollars — and have even
larger debts to Britain, France and )TGGEG
90
Germany. Arrow widths are 616#.&'$6 Y $1
MAN
proportional to debt amounts.  GER
.5 $+..+10 $0
$8 .7
D
OW
E LAN
$18 D GER IRE .8
4 MA NY: ES $0 NCE
CE FRA 11
$0.1

OW $5
$0.4

E EE
EE
C GR
GR ES
OW $6
.9
A ND
EL
IR
$46
+TGNCPF +VCN[
BRIT
AIN $+..+10 64+..+10
$18 $18
8

$5 Amount owed
FRA .4 AIN
NCE
$60
between countries BRIT
as of Dec. 31, in $77
billions of dollars.
1
$3
$30

Italy owes France $511 billion,

$6.7

or nearly 20 percent of the

$1.3

French gross domestic product.

$16

7
$4
With unemployment at
$5.2
$9.7

20 percent, Spain has

an economy among
the weakest in Europe. $2
2
$86
5RCKP 2QTVWICN
64+..+10 $+..+10

$28
BR

Nearly one-third of Portugal’s

ITA

debt is held by Spain, and

FR

IN
GE
20

AN

both countries’ credit ratings

$2
$2

RM

4
CE

have been dropping.

CE

AN

$4
AN

5
$4
FR

7
14
38

$1
$2

IN
Y
AN

ITA
RM

BR
GE

Source: Bank for International Settlements.

©2010 New York Times Graphics.Source: Bank for International Settlements BILL MARSH/THE NEW YORK TIMES 2
SSGA CAPITAL INSIGHTS | THE EUROPEAN SOVEREIGN DEBT CRISIS
standard and a general orthodoxy that government budgets
should be broadly balanced. In this environment, the natural
course for a nation facing fiscal stresses – viz devaluation – is
officially resisted, and the only other course of action is fiscal
retrenchment, austerity and a deflationary depression. The
idea was that debts would be paid off “the hard way”, i.e. in
real terms, and this was largely achieved, albeit at the cost of
much social unrest and hardship.
• In the 1950s and 1960s, on the other hand, Europe had
become overtly Keynesian, and the policy recipe contained
devaluations, demand management through fiscal actions,
and unconvertible currencies protected by exchange controls.
Not very surprisingly, the result was multi-decade inflation
that remains unmatched in peace-time history, and the many
national debts were in effect paid off “the easy way” by being
inflated away, with much less social unrest and hardship –
except to creditors.
It is important to realize that the choice that European policy-
makers made to allow inflation as the way of eliminating their
debts post World War II was a conscious policy decision. The
experiences of the 1930s were still extremely fresh in policy-
makers’ minds, and no one wanted to recreate the vicious
cycle which so many countries had experienced then of (i)
Bank failures, leading to (ii) Government bailouts, leading to
(iii) Fiscal strains, requiring (iv) Austerity measures, producing
(v) Deep recessions, leading back to (i) Further bank failures.
This cycle was only broken in many countries when the working
classes were unable to be squeezed any further and rioted,
and the middle classes brought in the military to restore order.
The greatest casualty of the crisis in far too many countries was
Democracy itself.3
Turning Back to the Present Crisis: Look to Berlin
Turning now to the present crisis, it is clear that in almost
every way – viz the fixed currency backdrop, the preference for
balanced fiscal budgets and the proposed austerity regimes – the
outlook for those highly indebted countries in the eurozone is
much closer to the 1930s than the 1950s. Given the analysis
4 is reopening wounds and feelings that Europe had hoped were
above, and the extreme social consequences of the 1930s, it
may seem strange, but the key to understanding what is driving
this is in Berlin.
In the previous two debt work-outs in Europe, the winners and
losers were very clear. In the 1930s, with austerity and deflation,
there was a transfer of real wealth from debtors to creditors. In
the 1950s, the general inflation transferred real wealth from cred-
itors to debtors. Today Germany, the largest and most powerful
country in Europe, is also the largest creditor, and naturally seeks
to protect and preserve the real value of its assets. When this is
coupled with the legendary German aversion to inflation as a
result of their experiences in the early 1920s, the stance from
Berlin that “the debts must be paid and the debtors must pay” is
both understandable and inevitable.
The challenge for Europe is to make the austerity programmes
demanded by the creditors stick. Here Europe’s political failings
loom large: the political underpinnings of the EU are incomplete
and weak, and the Union remains a federation of sovereign
states with most relationships between them still very largely at
bottom based on international treaties. This has the result that
the “federal” authorities (to use the US parlance) perpetually
have to struggle to impose their will on the member states, with
the most egregious failure being the Stability and Growth pact,
which set annual limits on budget deficits and national debt as
a percent of GDP and was widely ignored even before it was
unceremoniously abandoned in all but name when it suited the
larger states to do so.
The Solution: An “Ever Closer Union”
The solution, for those who believe in the concept of Europe and
the EU – and for the moment, no serious European politician
can afford to be seen not to believe – is an “ever closer union”,
a phrase which is almost as old as the EU itself but which in
the current crisis, is being interpreted as “ever closer control of
national finances from the centre”. And, with Germany as the
main creditor, paymaster and driver of events, this is becoming
more and more synonymous, for the debtor countries, with
having a German veto over their actions.
This is where matters currently stand. If we ask what may
happen next, however, it is much less easy to be sure. The crisis
buried and consigned to history, and at the extreme, threatens
to undo the whole of the post-war consensus. This can make –
indeed has made – politicians act in unexpected ways and almost
nothing can be ruled out as totally impossible, including one or
more countries leaving the euro.
3
SSGA CAPITAL INSIGHTS | THE EUROPEAN SOVEREIGN DEBT CRISIS
Defenders of the euro, when challenged about the potential for
an EMU break-up, are quick to observe that “there is no way
to leave the euro, and no nation would dare try because of the
chaos that would ensue”. The first part of this statement is true
but irrelevant – no, there is no plan for an exit, but if a state
either chooses to leave a monetary union or has to, a way will be
found. And the second part is not even true – yes, if Greece were
to leave and reinstate the drachma, presumably with the inten-
tion of devaluing it, there would be chaos and the only certain
outcome is that the Greek banking system, with its drachma
assets and euro liabilities, would be insolvent.5 But the position
is very different for a country choosing to leave to re-introduce a
strong currency, and while Germany would face a logistical chal-
lenge in re-issuing the deutschmark, it would not result in either
chaos or the bankruptcy of the German banking system.
The probability is that Europe will recoil from the edge of the
abyss and that sensible voices will prevail, but no-one can say
with confidence that this is inevitable or guaranteed. The night-
mare is that the debtor nations do not stick to the austerity plans,
that the ECB is forced further and further to compromise its “no
bail-out” policy and that eventually, even so, one or more of the
debtor nations defaults. That will cause a major banking crisis,
not least at the ECB itself,6 and may push Germany over the edge
and encourage them to “wash their hands completely” of the
feckless southerners.
For Investors: A Challenge
For investors, this poses a challenge. While equity investors
will note the much lower euro and may conclude that efficient
companies in Germany and elsewhere stand to benefit from
their increased competitiveness, fixed-income investors face an
outlook in which the most likely scenario is for fiscal austerity
and low growth in a deflationary environment (in other words,
like in the 1930s), but where there is a possibility of much more
significant volatility, including state and banking system defaults.
In such markets, investors should consider their liabilities: those
who have a natural exposure to European markets and the euro
will wish to stay fully invested but may wish to reallocate assets
towards the more creditworthy sovereigns; while those for whom
any exposure to the euro represents voluntary risk may wish to
consider whether the risk-return characteristics merit a more
limited position until the outlook becomes clearer.
4
SSGA CAPITAL INSIGHTS | THE EUROPEAN SOVEREIGN DEBT CRISIS

1
Indeed it has been received wisdom in the EU that national current accounts and cross-border exposures were rendered irrelevant by Europe’s Economic and Monetary Union (EMU),
much as (for example) the UK does not compile balance of payments statistics for Wales or Northern Ireland: if they did, the latter would show a negative balance to the rest of the UK of
between 5 and 10% of GDP for every single one of the last 30 years. The difference is of course that within the UK this is countered with fiscal transfers from London to Belfast, whereas
no such balancing transfers have been made in the EU and the counter balance has therefore been in the form of private sector bank loans. The banking regulators overlooked this.
2
The austerity package being “recommended” to Greece by its EU partners includes a 4% tightening of fiscal policy in each of the next three years; but even if the Greeks stick to this
their debt–to-GDP level is expected to reach 145% by 2014.
3
The roll-call of developed European countries that surrendered their democratic governance systems in the 1930s is sombre indeed. By 1938, Greece, Bulgaria, Romania, Hungary,
Yugoslavia, Poland, Latvia, Lithuania, Estonia, Italy, Spain, Portugal, Austria and of course most notably Germany were all either partially or fully under military dictatorship. The memory
of this has dominated post-war European politics and, inter alia, created both the consensus in favour of the post-war inflation and the creation of the EU itself.
4
But not necessarily for those countries outside the eurozone. The UK for one looks as if it has chosen a half way house between the 1930s austerity and the 1950s route of devaluation
and inflation, and the US may well follow this route too.
5
Much as happened in Argentina when the convertibility of the peso at the fixed parity of 1-1 with the USD was abandoned in 2002.
6
The ECB’s decision to buy bonds outright, and therefore accept principal risk, was a major watershed. It was bitterly – and publicly – opposed by the Bundesbank, which is increasingly
clearly at odds with the ECB’s leadership. It also raises the spectre that the ECB may, if a state defaults, have losses of such magnitude that it needs recapitalisation. If this were to
happen, the ECB would need to go cap in hand to the 16 member states of the Eurozone and ask for more capital. And it is by no means guaranteed that Germany would agree; indeed
many in Germany would say that the ECB had behaved recklessly against German advice, had brought its plight on itself, had forfeited the right to look after the currency of German
citizens, and that in response Germany would prefer to wind the ECB up and reissue DM.

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