European debt crisis: Explained in SIMPLE terms

By - Shonalee Biswas

"So where were you?" asked my roommate as I came back home very late in the night. "Oh. You know na, Sheena broke up and she just kept crying. So I was trying to pacify her," I replied. " Yeah. But that happened a month back, na?" "Yeah it did." "So? "Arrey, the teddy bear which he had given her on her last birthday fell out of the loft. And this reminded her of all the good times they had spent together and it made her cry." "Yeah. As a line in the song Hotel California goes, ". . . you can check out anytime you like, but you can never leave," she remarked rather philosophically. "Hmmm. You know her situation reminds me of what is happening in Europe." "That is quiet an analogy. Kindly explain!" she said. "In 1958, an organisation called European Coal and Steel Community was formed. This evolved into the European Union (EU) which was established by the Maastricht Treaty in 1993. The European Union introduced the euro on January 1, 1999. On this day, 11 member countries of the EU started using euro as their currency. It benefited countries such as Portugal, Italy, Ireland, Greece and Spain (together now known as the PIIGS)," I said. "So how did it benefit them?" she ased. "Before these countries started to use the euro as a currency, they had to borrow money at interest rates much higher than the rates at which a country like Germany borrowed. When these countries started to use the euro they could borrow money at interest rates close to that of Germany, which was economically the best managed country in the EU," I explained. "As the famous American writer Michael Lewis says in a recent piece, 'The rest of Europe, in effect, used Germany's credit rating to indulge its material desires. They borrowed as cheaply as Germans could to buy stuff they couldn't afford,'" I added. "Ah, sounds like our neighbours. They keep buying stuff they cannot really afford," my roommate said.

'As this is also the moment when the state begins to shovel out generous pensions. and it means more and more borrowing by the government. musicians ' write Mauldin and Tepper in Endgame.The End of the Debt Supercycle and How it Changes Everything. "But that's just one country you have talked about.'" "Now that's hilarious. when they already have so much debt. pays 70. Spain had the biggest housing bubble in the world. "Yeah. that means that if the borrowing rate is 3 per cent while inflation is 4 per cent you're effectively borrowing for 1 per cent less than inflation. the governments also started to borrow. So. even though the US is six times bigger. "Take the case of Spain. You're being paid to borrow." I said.' Take the case of Greece. "But what's the connection you are trying to make?" she asked." I added. 'To get around pay restraints in the calendar year the Greek government simply paid employees a 13th and even 14th monthly salary -. outright.000 euros in Greece. my dear. "To put things in perspective. radio announcers. now quite interested in what I was holding forth on." I went on.' I said. "'And borrow they did. The Greek government categorises certain jobs as arduous. Most of these new homes were financed with capital from abroad. And the European peripheral countries (PIIGS) racked up enormous amount of debt in euros.000 euros in Germany. 'In plain English. why aren't countries defaulting?" "Oh. "Take the case of Greece." I explained. helps out with a bailout. "Have some patience. more than 600 Greek professions somehow managed to get themselves classified as arduous: hairdressers. What about others?" asked my roommate. Spain's real estate debt comes to around 50 per cent of its GDP. every time there are default threats."Also other than the low interest rates. A job which now pays 55. "There is more to come. 'Since the start of the financial crisis it (the ECB) has bought." exclaimed my roommate. the European Central Bank (ECB). even with the fact that Germany is a more productive nation. As Lewis writes. These jobs have a retirement age of 55 for men and 50 for women. their debt currently amounts to around 160 per cent of their GDP. other than the citizens. "So with so much debt going around." she frowned.months that didn't exist." "That's some fraud going on." write Mauldin and Tepper. As Lewis writes. As John Mauldin and Jonathan Tepper write in Endgame -. This helped politicians keep their constituency of voters happy. the inflation in the PIIGS countries was higher than the rate of interest. Spain now has as many unsold homes as the United States. .

In case of Greece. and lent another $450 billion or so to various European governments and European banks. interest rates in Hungary were at 12.'" "Of course. instead of taking this long and convoluted route?" she asked. which keeps contributing the ECB rescue fund. Greece now ranked 126th: the Greeks were officially regarded as the least likely people on the planet to repay their debts. In 2004. Why would Austrians borrow at 2 per cent when they could just as easily borrow at 0." "That's some connection. In neighbouring Austria. a lot of German and French banks which have lent money will be in trouble if Greece defaults.'" I said. So the Austrian banks. Of the 126 countries with rated debt. Take the case of Germany.something like $80 billion of Greek and Irish and Portuguese government bonds." I said. "So basically they keep paying the governments so that they don't default?" she asked. you have a point there." I added. countries which aspire to have Euro as their currency some day. they were even lower at around 0." "But can't countries get out of the Euro and go back to their own currencies and then print money to repay their creditors?" she asked. many of which also had branches in Hungary began to engage in the same business there. "Similarly. may have been lower than in Hungary. Take the case of Hungary. the banks had started to offer loans and mortgages to their customers in Swiss francs. There are more such cases. if there was a blow up. Rates in Austria." I said. accepting virtually any collateral." I quoted. This meant borrowing money was extremely expensive. the Austrian government wouldn't be able to save the banks and ECB might have to step in.' writes Lewis.5 per cent. including Greek government bonds.5% per cent?' write Mauldin and Tepper. it is. "The situation is pretty messy because it is interlinked. except that the difference was much bigger. I went on quoting Mauldin and Tepper: 'The same question applied to Hungarians. lending to Hungarian borrowers. but in Switzerland. "Yeah. Swedish banks have also lent a lot of money to Estonia. . Even though Hungary has put in austerity measures and is trying to repay. now Austrian banks have lent 140 per cent of their GDP to countries like Hungary. "So it's all connected to one another?" she said.5 per cent. 'The German government gives money to the rescue fund so that it can give money to the Irish government so that the Irish government can give money to Irish banks so the Irish banks can repay their loans to the German banks. "Yeah. at 2 per cent. But wouldn't it be easier for the German government to just pay the German banks separately. Lithuania and Latvia.

which would then lose value against the euro. When countries go back to their own currencies to print it and repay debt. but very difficult to get out of. . "Oh. 'Households and firms. "Why will they be concerned?" she asked."The thing is that the mechanics of leaving the euro are very messy. that makes some sense. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments. Relationships are easy to get into. citizens will be concerned. with all the people queuing up at banks at the same time demanding their money back. "Simply because when a country prints currency in huge quantities. "This will lead to bank runs.' write the authors. would shift their deposits to other euro-area banks. that's simple. "Mauldin and Tepper elaborate on this using the example of Italy. ." I said. Also going back to your own currency might lead to other problems for a country. "Yeah. of course." I explained. this would be the mother of all financial crises. will lead to a lot of banks collapsing." she nodded. anticipating that domestic deposits would be redenominated into the lira (Italy's currency before it started using the euro)." I explained. the currency will not remain of any real value. leading to a bond market crisis. or will continue using the euro. So the citizens of the country will try and move their money to either other assets like gold. "So what's the moral of the story?" she asked." I told her." was my quick response. . This. A system-wide bank run would follow.

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