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The European Sovereign Debt Crisis

- - - - The policy measures the EU, the ECB and the IMF implemented in recent years, , have focused on:
        • preventing a disorderly debt default of several EU members, most notably Greece but also Ireland and Portugal, and creating a framework that allows these countries to manage their debt levels down to sustainable levels;
        • preventing the spread of the crisis from affecting other EU members’ cost and availability of funding; and
        • broader policy measures aimed at preventing a similar crisis recurring in the future.
      - To avert complete disaster, the International Monetary Fund (IMF), the European Central Bank (ECB) and the European Commission (EC) issued the first of two international bailouts for Greece, which would eventually total more than EUR 240 billion. The bailouts came with conditions, widely referred to as ‘austerity measures’, which included requirements for the Greek government to implement deep budget cuts and steep tax increases. .
        
        The measures also sought to overhaul the country’s finances by streamlining the government, ending tax evasion and making Greece an easier place to do business (New York Times 2015)
    - - • the frustration of EU members with stronger economies, such as Germany, having to provide financial assistance to other EU members, which according to the stronger economies, faced financial pressures due to financial mismanagement;
        • setting a precedent for bailouts of members in financial distress;
        • a dilemma between wishing to prevent a disorderly default of EU members experiencing financial pressures and creating a ‘moral hazard’ (i.e. creating an effective incentive for a country to run a budget deficit on the expectation that other EU members will provide support); and
        • IMF’s limited funds, which are normally deployed in assisting developing countries, being deployed to assist developed countries. Also, the size of each recommended assistance package was quite large.
  - - - Regarding the banking union, the EU has made progress towards having a common banking supervision structure, with the ECB preparing to take on its new banking supervision tasks as part of a single supervisor mechanism (SSM). The SSM will create a new system of financial supervision comprising the ECB and the national competent authorities of participating EU countries.
        The participating countries include euro currency countries and other members of the EU that have decided to enter into close cooperation with the SSM. The ECB assumed its new banking supervision responsibilities in November 2014, which involve the direct supervision of about 130 significant banks and supervisory oversight of all remaining banks in the EU (ECB 2014).
      - The other transformation policy function required to fix the flaws in the current structure of the EU is a fiscal union. However, this would require a significant shift of sovereignty from the individual European states to the EU level, which appears unlikely in the near term.
- - - - Crisis trigger
        When the Greek government announced a revision of its budget deficit in November 2009, from 6 per cent to 12.7 per cent of GDP, the three major global credit rating agencies responded soon after by downgrading Greece’s credit rating
        
        A number of EU members became very vulnerable to financial shocks. The high debt levels and high budget deficits meant that a sudden increase in interest costs would place significant additional burden on those countries, and loss of access to reasonably priced debt would expose governments to bankruptcy risk (i.e. an inability to meet their payment obligations). This is what happened to Greece and a number of other countries in the eurozone.
        
        In Spain and Ireland, the financial problems of the government were compounded by a property market crash, causing large defaults of property loans and large losses for banks.
        
        contagin
        
        Contagion is defined as some or all of the following effects that a country may experience as a result of a financial crisis in another country:
        • increase in the perceived likelihood of a financial crisis
        • correlated increase in asset-price volatility
        • correlations in asset-price movements not driven by fundamentals, but rather by perception of risk and changes in risk.
        
        Missio and Watzka (2011) found that Portugal, Spain, Italy and Belgium have been particularly affected by the contagious effects of the Greek sovereign debt crisis, as evidenced by movements in bond yields
        
        The European banking system is highly integrated
        
        The exposure was concentrated in countries with larger banking systems—the total exposure of banks in Germany, the UK and France to other European countries was EUR 5 trillion (Yulek & Randazzo 2012, p. 74). Due to this high level of exposure, increased risk of default of several European countries threatened to destabilise the European banking system.
        
        Many European banks were large investors in government securities, and suffered losses from the falls in bond prices. They have also been required to increase their capital, to comply with the requirements of Basel III and their national regulators.
        
        The build-up of high debt levels was caused by consistent budget deficits (the difference between a government’s tax receipts and its spending). This meant that should a government lose access to cheap debt, it would need to take drastic measures to cut its expenditure, or increase taxes, to be able to balance its budget.