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THE EUROZONE CRISIS
The eurozone crisis began with Greece and threatened other nations as well, as the fear of overindebtedness grew. Greece had engaged in overspending before it joined the euro, and only increased spending afterward. Tax evasion prevented the government from obtaining much-needed funds to cover increases in spending. With the coming of the Great Recession, Greece experienced an external shock that exposed its high levels of indebtedness and made it impossible for the government to continue paying on its debts. The new Greek socialist government elected in October 2009 announced higher-than-reported debt levels.
The Greek crisis spread, as little to nothing was done to stop the decline in Greek debt. By May 2010, Greece was presented with a bailout package of €22 billion from the eurozone and IMF (BBC 2012a). The crisis spread to other countries that were in deficit, including Spain and Italy, and in response the European Financial Stabilization Fund of €750 billion was created. The fund did little to reassure markets, since conditions for fund distribution were dictated by Germany, which was unwilling to bail out deficit countries (Soros 2012). Germany fell back upon the Maastricht Treaty as a guideline for conducting emergency activity (stating that no bailouts shall be carried out) within the European Union, refusing to change the rules to meet the needs of debtor countries. Even so, due to the fear that Greece’s descent into crisis would sharply damage the eurozone through interconnectedness of the financial sectors, a second bailout package of €109 billion was agreed upon to prevent contagion to other economies.
The peripheral eurozone economies had remained relatively uncompetitive before the crisis struck. Wages increased more quickly than productivity, while education and other institutions lagged behind. These countries were therefore quite susceptible to the crisis. Portugal fell into crisis and was bailed out at €78 billion by the European Union and the IMF. The country received funds for bank recapitalization - BCP and BPI received €3.5 billion and €1.5 billion in return for convertible bonds - and committed to austerity measures that would reduce wages and pensions and even cut some national holidays (Evans-Pritchard 2012). Portugal, like Greece, had engaged in overspending, and had an increasingly large current account deficit. The global crisis acted as an impetus for Portugal’s debt crisis as investors withdrew funds from savings certificates and bonds, raising bond yields.
Spain was forced to bail out savings banks and municipalities. The country had also experienced a real estate boom, with housing prices rising 44 percent between 2004 and 2008, and a corresponding crash (BBC 2012b). By April 2012, the government had injected more than €34 billion into its banks. In addition, Bankia, the country’s fourth-1 argest bank, received €19 billion before it was nationalized. Spain was to borrow up to €100 billion from the European Financial Stability Facility and the European Stability Mechanism to continue to shore up its banking sector.
Smimou and Khallouli (2015) find that contagion of the global crisis was transmitted to eurozone countries through liquidity channels, as wealthy investors in one nation reduced investment in another nation in an atmosphere of increased risk, and overall liquidity declined. Negative shocks stemmed from financial linkages within European stock markets and from US financial channels.
Changes in financial flows occurred as the crisis played out. Acharya and Steffen (2015) characterize changes in financial flows within the eurozone as carry trade behavior. The carry trade is generated by positive loading on peripheral bonds and negative loading on German bonds. The authors explain this behavior through regulatory capital arbitrage and risk shifting by undercapitalized banks, home bias of banks in peripheral countries, and inducement by sovereign bodies and home countries to maintain bond holdings. Large banks and banks with high levels of short-term leverage, high-risk weighted assets, and low Tier 1 capital ratios held larger quantities of peripheral sovereign debt. In addition, peripheral banks that were bailed out held higher levels of peripheral bonds.
Fiscal tightening at both the center and the periphery of the European Union did not help matters. France, Spain, Ireland, and Greece were ordered to reduce their budget deficits starting in April 2009 (BBC 2012a). Greece’s austerity plan became a source of major unrest, as successive budget cuts were made to appease international lenders. Portuguese workers protested austerity measures as the government followed the measures closely. Spain passed a constitutional amendment that required limiting future budget deficits; while Italy passed a large austerity budget with an eye to balancing the budget by 2013.
In Europe, austerity measures bred anti-government protests, as social protection was in some cases decreased rather than increased even as workers lost their jobs. The decline in social protection was particularly worrisome in a region that already had a relatively high rate of unemployment, at 7 percent in 2007 and at 15.5 percent for younger workers, before the crisis took hold (Euzeby 2010).
Monetary policy measures carried out by the European Central Bank (ECB) were relatively cautious. Non-standard monetary policies included fixed-rate full-allotment for longer term refinancing operations (LTRO), the Covered Bond Purchase Program, Securities Markets Program, and Outright Monetary Transactions. The three-year LTRO carried out in December 2011 and February 2012 represented the biggest attempt to inject liquidity into the European banking system (Pronobis 2014). The ECB also purchased sovereign bonds in order to lower the borrowing costs of Greece, Italy, Portugal, and Spain.
As the crisis wore on, country debt was downgraded in the US and the eurozone. At the end of summer 2011, Standard & Poor’s downgraded US debt for the first time, from AAA to AA+, due to the country’s inability to curb deficits. In January 2012, Standard & Poor’s downgraded sovereign debt ratings of nine eurozone countries: France, Austria, Spain, Italy, Portugal, Malta, Cyprus, Slovenia, and Slovakia (Gauthier-Villars 2012). Greece’s sovereign debt rating slid far further down the ratings scale to “selective default” in February 2012. Sovereign downgrades, coupled with political uncertainty, played a key role in increasing Greek sovereign spreads (Gibson et al. 2014). To underscore this, Kazanas and Tzavalis (2014) find that credit ratings impacted Greece separately from economic fundamentals; these affected credit spreads independently from real indicators.
The EU approved a macroeconomic surveillance structure that consisted of a European Banking Authority, a European Securities and Markets Authority, a European Insurance and Occupational Pensions Authority, and a European Systemic Risk Board (ESRB) (European Commission 2010). These entities were set up to reduce systemic risk, ensure regional rule compliance, and regulate cross-border firms. However, it has become clear that there are structural flaws in the eurozone that must also be overcome if the eurozone is to survive long term. Eichengreen (2012) makes the case that these flaws in the eurozone are parallel to those in the global financial system. Specifically, the absence of a sufficient adjustment mechanism to account for imbalances, where devaluation of currency for one country is impossible given the zone-wide use of the currency, and the lack of bank regulation at the union level, which encourages neglect of crossborder impacts of policies, remain a problem. The European Banking Authority may ameliorate the latter problem, but implementation of policies is local. Similarly, currency and financial regulation policy imbalances remain problems at the global level.
Germany was strongly and negatively impacted by the global crisis through export channels, but rebounded rapidly. The cause of its resilience has been attributed to wage competitiveness as well as to technological prowess. Stockhammer (2015) states that German growth has been based on wage suppression. Storm and Naastepad (2015) make the case that Germany’s technological, or non-price competitiveness and high-tech productive capabilities, trump other reasons for its rapid post-crisis restoration of growth, based on Kaldor’s theory which states that the effects of relative costs on exports are relatively weak.