House of Lords - The euro area crisis - European Union Committee

The euro area crisis - European Union Committee Contents

CHAPTER 2: THE UNFOLDING CRISIS

11. The events of the past year have given ample demonstration of the complexity of the unfolding crisis. Professor Buiter described it as "a syndrome of multiple interdependent crises", explaining:

"It is a sovereign insolvency crisis for a number of countries in the so-called euro area periphery, most notably Greece, Portugal and Ireland. It is a sovereign liquidity crisis to other countries in what may be called the broader periphery—countries that one hopes and assumes are most likely solvent, as far as the sovereign is concerned, but at risk of being frozen out of the funding markets by markets panicking and refusing access to the sovereign. That is Italy and Spain. We also have a banking crisis throughout the EU, not just the euro area ... So we have this triple crisis: sovereign insolvency, sovereign illiquidity and bank undercapitalisation, which is significant enough among the three of them to pose a global challenge. What is being threatened here is not just the euro area banking system or even EU financial stability; there is no doubt ... [that it] could take down the European banking system and much of the world's banking system with it."[5]

12. In order to understand the crisis it is useful briefly to describe how it has evolved over the past year. By setting out the developments in terms of each of the main affected states, this chapter helps to identify the different elements of the crisis, before briefly outlining the series of policy initiatives which have thus far been put forward, both in the euro area itself and in the wider international community.

Greece

13. During 2011 the sovereign insolvency crisis in Greece emerged ever more clearly as the eye of the storm. As the Committee's March 2011 report pointed out, the underlying problem was that the Greek public finances were in a far worse state than had previously been thought.[6] In July 2011 the Greek Parliament narrowly voted in favour of further austerity measures; and the EU released a €12 billion tranche of a loan package agreed in May 2010 and agreed a new rescue package worth €109 billion, which also lowered the interest rate at which financial support was being provided. However, it was soon recognised that even this new package was unlikely to prove sufficient.

14. At the euro area summit on 26 October 2011 it was announced that, as part of a deal involving enhanced monitoring of Greece by the "Troika" (the European Commission, the ECB and the International Monetary Fund (IMF)), private sector banks holding Greek debt would consider a 50 per cent ''haircut'',[7] with the aim of reducing the Greek debt burden to 120 per cent of Gross Domestic Product (GDP) by 2020.

15. The surprise announcement on 1 November 2011 by Greek Prime Minister George Papandreou that the new rescue deal would be put to a national referendum sent shockwaves through the whole of Europe and beyond. Under intense political pressure both inside and outside Greece, including a statement by Chancellor Merkel and President Sarkozy that Greece needed to decide whether it wished to remain in the euro, Mr Papandreou was forced within days to withdraw his proposal for a referendum and to step down as Prime Minister. On 11 November a government of national unity (including ministers from three political parties) was appointed under the leadership of the former Governor of the Bank of Greece, Lucas Papademos. Mr Papademos sought to reassure European leaders and markets by stressing Greece's commitment to the October agreement and to the implementation of structural reforms, as well as its determination to remain within the euro area.

16. At the start of 2012, Prime Minister Papademos and the Greek government warned bluntly that there was a real danger that the country might default on its debt and have to leave the euro.[8] As we completed consideration of this report on 7 February the situation in Greece remained grave and unresolved. Negotiations involving the Greek government and major political parties, the Troika, and key EU Member States such as Germany and France, had not yet produced agreement on further Greek austerity and structural reform measures, the finalisation of a new €130 billion rescue package, and the extent of a haircut for private sector holders of Greek debt.

Ireland

17. In the early days of the crisis Ireland was seen, alongside Greece, as the most vulnerable country within the euro area. As our last report pointed out, Ireland's current debt crisis is a result of its government's decision to offer a blanket guarantee to depositors caught out after the collapse of the Irish property bubble.[9] In November 2010 this led to Ireland becoming the second country, after Greece, to accept financial support from the EU via the two funds established in May 2010, the European Financial Stabilisation Mechanism (EFSM) and the larger European Financial Stability Facility (EFSF), as well as from the International Monetary Fund (IMF). The overall support package (including a bilateral loan from the UK) totalled €85 billion, and aimed to support the banking system as well as to help fund Government expenditure. Soon after, Dáil Éireann passed what was widely described as the toughest budget in the history of the state, before Taoiseach Brian Cowen's Fianna Fáil-led Government were heavily defeated at a general election in February 2011.

18. The story since then has been a rare brighter spot in the crisis. Ireland has seen a measure of economic recovery, the Minister for Europe arguing in November 2011 that Ireland is "an example of how tough reforms can have a beneficial impact".[10] On 19 January 2012 Ireland received a positive assessment from the Troika. Yet for all the progress that has been made, Ireland remains vulnerable. A further round of austerity measures was announced in the December 2011 budget, whilst GDP figures for the third quarter of 2011 suggested that the economy had begun to contract once more. As Professor Buiter told us: "Ireland, while doing heroically well in its attempts to honour its sovereign obligations, is still deep in the hole, especially with the global economy now slowing down".[11]

Portugal

19. The third ''peripheral'' nation seen to be at risk is Portugal. Portugal was under financial pressure even before the crisis erupted, as its appeal as a low-cost producer diminished in the face of competition from emerging markets in Asia and eastern Europe.[12] In May 2011 an assistance package of €78 billion was agreed, consisting of €26 billion each from the EFSM, the EFSF and the IMF. The resulting political crisis led to the defeat of Prime Minister Sócrates' Socialist Government in an election in June 2011. Professor Buiter told us in October 2011 that "in all likelihood Portugal will follow" Greece in requiring a restructuring of its debt, because it is "most likely insolvent".[13]

20. In November 2011 the newly elected centre-right Portuguese government put through a stringent austerity budget in order to meet the terms of the rescue deal, which was met by widespread public protest.[14] By late January 2012, Portugal's ten-year borrowing costs had soared, reflecting in part the forecast of a marked contraction in the Portuguese economy during 2012,[15] and the downgrading of Portuguese debt, and leading to increased speculation that Portugal may be forced to default.[16]

Spain

21. The Spanish economy suffered badly in the financial crisis, as the inflated property market collapsed and the country struggled to emerge from a long recession. In common with other governments across the EU, Socialist Prime Minister José Luis Rodríguez Zapatero's administration was forced into deep austerity budgetary measures. In August 2011 the European Central Bank (ECB) made the decision to begin purchasing Spanish sovereign bonds in the secondary markets, in an attempt to shore up Spain's position. In September, the Spanish Parliament voted to add a "golden rule" to the Spanish constitution, to keep future budget deficits to a strict limit. In November a rise in Spain's 10-year bond yield rates, close to the 7 per cent level widely considered as unsustainable in the long term, prompted the ECB to engage in further purchase of Spanish bonds, and the announcement of an even deeper austerity programme by the new government of People's Party leader Mariano Rajoy.

22. Our witnesses highlighted the fundamental causes of Spain's difficulties. Professor Begg told us that Spain has the "latent debt ... of the property boom and the possibility that that will deflate in a way that causes trouble for banks. Trouble for banks translates into problems for the sovereign." He asserted that one of Spain's problems was, in common with much of southern Europe, a lack of competitiveness.[17] Professor Buiter stressed that the Spanish case was distinct from the situation affecting Greece and Portugal, in that it was not a question of solvency, but rather of liquidity.[18] This meant that the most urgent funding need was for Spain's position to be ring-fenced in order to protect it from contagion.[19]

23. Spain's position continues to look vulnerable. Concerns remain about its low growth prospects (with unemployment rising to over 5 million by the end of 2011[20]) and high levels of debt, and although by January 2012 Spain's 10-year bond yields had fallen back to around 5.5 per cent, it remains to be seen whether enough has been done to protect Spain from contagion. In the light of the economic situation, at the end of January Prime Minister Rajoy called on the European Union to ease Spain's deficit reduction targets.[21]

Italy

24. Professor Begg told us in November 2011 that the "underlying arithmetic for Italy is not that bad. Their debt is high, yes, at 120% of GDP, but the deficit is only just over 4% of GDP".[22] However, this level of public debt in an economy as large as Italy's adds up to a substantial amount: nearly €2 trillion. Furthermore, the Italian economy has specific structural weaknesses, such as an unreformed labour market, as the repeated calls from other EU leaders for reform to Italy's pension arrangements demonstrate.

25. In November 2011, as bond yields began to soar and market confidence in Italy collapsed, Prime Minister Berlusconi's government was defeated in a vote of confidence. He resigned on 12 November, after the Italian Parliament had agreed a new package of austerity measures. Former European Commissioner Mario Monti was appointed in his place as head of a non-party-political government, committed to reducing sovereign debt and restoring economic growth. Despite strong opposition, Mr Monti has quickly brought forward a package of economic liberalisation measures. As the third largest economy within the euro area, the future of the entire euro project could hinge on Italy's fate.

The wider euro area and beyond

26. As this chapter has illustrated, any solution to the crisis needs to address several distinct problems at once. The five nations described have long been seen as the most vulnerable to the effects of the crisis. Yet the rest of the euro area, and the broader EU including the United Kingdom, are far from immune from their problems. It has become more apparent than ever how, within the euro area and beyond, the fates of national economies are intertwined.

27. In this context, EU leaders have over the past year made repeated attempts to resolve, or at the very least contain, the crisis. Our previous report considered the proposal to establish a permanent replacement, the European Stability Mechanism (ESM), for the two temporary financial support packages, the EFSM and the larger EFSF.[23] The ESM was due to be launched in 2013, and aimed to make a total of €500 billion of financial support available to sovereigns in need.[24]

28. In July 2011, euro area leaders agreed a new package, including €109 billion in new loans to Greece and the renegotiation of repayment terms—including voluntary private sector participation in a 21 per cent writedown, or haircut, on Greek debts. There was an extension of repayment terms of loans to Ireland and Portugal; additional powers were granted to the EFSF to buy bonds and make credit available to countries not at immediate risk of insolvency, such as Spain and Italy; and the EFSF's lending capacity was increased to €440 billion.[25]

29. The political process of approval of this package was not smooth. Long before the final state ratified the proposed additional powers for the EFSF on 11 October (which caused the fall of the Slovakian government), it was clear that the July package would not prove sufficient to deal with the crisis. A further EU summit was twice delayed, on the second occasion to allow Chancellor Merkel to seek a revised mandate to negotiate from the German Bundestag. When the summit finally took place in Brussels on 26 October, a three-pillared deal was agreed. First, private sector banks holding Greek debt agreed to explore a 50 per cent haircut. Second, a plan was announced that sought to boost the funding available through the EFSF to €1 trillion. Third, the finances of European banks were to be protected from contagion by being required to raise €106 billion in new capital by June 2012.[26] We explore this agreement in more detail in chapter 3.

30. The package of legislative proposals on economic governance first set out in September 2010, the so-called "six pack", was agreed in October 2011. These proposals were based on provisions of the EU Treaties.

31. After the October summit events in Greece and Italy marked a dramatic escalation in the crisis. Pressure mounted for a more fundamental response. In particular, calls grew for action in three spheres: the possibility of joint 'eurobonds'; a stronger role for the ECB; and enhanced fiscal integration including through treaty change. In November the Commission published a Green Paper on 'eurobonds', or 'stability bonds' (loans which would be in some way mutually guaranteed by the euro area states), but these were promptly dismissed by the German government. Since December the ECB has complemented its programme of purchasing sovereign debt in the secondary markets with a major operation to provide long-term loans to European banks. 'Eurobonds', and the role of the ECB, are assessed in chapter 4.

32. The question of fiscal union came to the fore at the summit in Brussels on 8-9 December. At the summit the euro area nations agreed to "a new fiscal compact" moving towards a "fiscal stability union", including the adoption by national governments of a "fiscal rule" to achieve a balanced budget, and stronger Brussels oversight of national budgets and surveillance of states not meeting their targets, including "automatic consequences" (unless a qualified majority were opposed) should a country's deficit exceed 3 per cent of GDP. The agreement also included measures on closer economic policy coordination. In addition, leaders agreed on an acceleration of the entry into force of the ESM to July 2012, to review in March 2012 the level of funding available under the EFSF/ESM, and for euro area and other Member States to consider the provision of additional resources for the IMF of up to €200 billion.[27] Some of the agreed measures would be decided as EU secondary legislation, but the leaders decided that some should be achieved through a treaty. Because the UK Government would not agree to amending the EU Treaties, a separate international agreement would be adopted. The proposed agreement is examined in chapter 5.

33. Since the summit took place, the euro area has remained under intense pressure. The January 2012 credit rating downgrade by one of the ratings companies of a number of euro area countries, most notably France, as well as of the EFSF mechanism, came as little surprise. As forecasters have predicted that the euro area will slip into recession, criticism of the perceived ''austerity agenda'' championed by Chancellor Merkel has grown. Influential leaders including Mario Monti and the head of the IMF, Christine Lagarde, have pushed for a new emphasis on growth.

34. At the summit on 30 January 2012 EU leaders sought to respond, proposing a range of measures to support job creation, especially for the young; economic growth through developing the single market; and boosting financing for small and medium enterprises. Most attention was, however, focused on the agreement of 25 of 27 EU Member States to a treaty[28] embodying the December "fiscal compact" and measures on economic policy coordination. The Czech Republic decided not to participate for the time being. It is intended that the treaty will be signed at the European Council on 1-2 March.

35. The euro area crisis has worldwide implications, and actors outside the EU are playing an ever more prominent role. The IMF has contributed to each of the loans made to Greece, Portugal and Ireland, and has formed part of the Troika, alongside the European Commission and the ECB, monitoring developments in these countries. Both the G20 (at the Cannes summit in November 2011) and the Euro area (at the December 2011 summit) agreed that the firepower of the IMF should be increased. (The role of the IMF is considered further along with the European rescue funds, in chapter 3.) Speaking in January 2012 Christine Lagarde, head of the IMF, warned that if the euro area crisis was not solved "we could easily slide into a 1930s moment. A moment where trust and co-operation break down and countries turn inward. A moment, ultimately, leading to a downward spiral that could engulf the entire world."[29]

5 Q 30 (Sub-Committee). See the Glossary for definitions of some these terms. See also The future of economic governance in the EU for further background information on the various affected states. Back

6 The future of economic governance in the EU, para 6. Back

7 A haircut occurs when a lender has to accept a reduction in the redemption value of a bond because of the inability of the borrower to pay it in full; for example, if only 90 cents is repaid per euro, the haircut would be ten cents (10 per cent). Back

8 "Greece warns of euro-exit as EU economies drift apart", EUObserver.com, 4 January 2012; and ''Greek PM says country faces risk of disorderly default in March'', Wall Street Journal, 4 January 2012. Back

9 The future of economic governance in the EU, para 26. Back

10 Q 14 (Select). Back

11 Q 37 (Sub-Committee). Back

12 See http://www.economist.com/node/15838029. Back

13 QQ 37, 46 (Sub-Committee). Back

14 ''Concern grows over Portugal's commitment to radical reform'', Financial Times, 25 November 2011. Back

15 "Portuguese debt looms over Europe", Financial Times, 31 January 2012; International Monetary Fund, World Economic Outlook (Update), 24 January 2012. Back

16 ''Portuguese debt looms over Europe'', Financial Times, 31 January 2012. Back