Causes of Euro debt crisis

1. Profligacy of the European Government & Unsustainable Fiscal Policy

Countries including Greece, Portugal, Ireland, Spain and Italy in Europe are now paying a heavy price on their profligate way of spending, as reflected by the Euro debt crisis starting from late 2009. Fiscal policy is the use of government expenses and taxation income so as to influence the economy, while the average fiscal deficits had grown from 0.6% in 2007 to 7% at the beginning of the debt crisis across the Europe (Économistes Atterrés, 2010). Therefore, more and more debts were being issued by the above governments so as to support their national expenses, leading to an excessive rise in government debt levels. For instance, the average government debts per GDP had raised from 66% to 84% in the same period (Krugman, 2012).Basically, government debt is the money owed by the central government to the debt holders. As a result, with a high level of the debt-to-GDP ratio may imply that the country is less likely to repay the debt holders but higher chance to default on its debt obligations.

Greece, contributing about 3.3% of the annual GDP towards the European Union (Central Intelligence Agency, 2012), with a 165.3 % of debt-to GDP ratio in 2011, was responsible for the outbreak of the Euro debt crisis. Historically, Greece Government’s Debt to GDP ratio was already at a relatively high level across Europe (McAuley, 2011)(Graph 1). Following by the adoption of the single currency “EURO”, the difference between the public spending and the income of Greece started to rise eventually (BBC Business NEWS, 2012a). Owing to the poor planning of the fiscal policies, Greek has been suffering from budget deficit since 1995(Graph 2), thus, more debt was issued so as to sustain the government expenditures. The Greece Government Debt level was about 99.2% of the national GDP since 1995 and had risen exponentially throughout the past to 165.3% in 2012 (Graph 3). Yet, the Greece Government was running out of money and had to default their debts eventually, reaching the highest amount of debts in modern history on 2009 with 300 billion euros (BBC Business NEWS, 2012b). Greece debt holders, mainly governments from the euro zone have to write off the debts then, leading to a loss of capital and affecting their ability to repay their own government debts. As a result, domino effect has raised, where it is a chain reaction that the government in Europe were unable to get pay from the debts they hold and thus have to default their issued debts ultimately.

Figure 1 Government Debt to GDP ratio from countries across Europe Source: http://www.tradingeconomics.com/greece/government-budget

Figure 2 Greece Government Budget (1995 – current) Source: http://www.tradingeconomics.com/greece/government-debt-to-gdp

Figure 3Greece Government Debt to GDP (1995-current)

Source: http://www.tradingeconomics.com/government-debt-to-gdp-list-by-country?c=euro+area

2.1 Monetary policy inflexibility

Monetary policies are rulings by the government authorities so as to achieve a target interest rate and keeping inflation under control by controlling the supply of money (Friedman, 2002). However, there is only one single monetary policy being established within the Euro zone. And thus, none of the individual member is able to implement any independent monetary policy that is suitable for their own countries during debt crisis (Cox, 2012). Throughout the outbreak of Euro debt crisis, loosing monetary policy such as increasing the money supply would be helpful to alleviate the crisis. Printing money from the respective reserve bank could devalue a country’s currency and thus being able to repay debt holders and easing the risk of default. On top of that, increase in money supply could be beneficial in terms of making its exports more attractive to foreigners at a cheaper price. An increase on tax revenue based on an increased GDP can then be expected. Hence, this may help to relieve the fiscal deficit by regaining competitiveness even there is a need to pursue deflationary policies (Pettinger, 2011). Yet, it is prohibited for the countries within the euro union to do so.

2.2 Prohibition of devaluating EURO currency

Euro was officially comes into existence on 1 January 1999(BBC News, 2012). While the European Union consists of 27 sovereign member states, and all of these countries used the same currency, “EURO” except Britain. Thus none of its member could adjust EURO based on its own economic conditions. For most countries, the government would devaluate its currency when they face financial downturn. As the lower exchange rate for its currency would attract more exports and foreign business for the lower cost of operations, which then would assist the growth of local economy If Greece could devaluate EURO freely at an early stage during the outbreak of the crisis, it would be possible for Greece to have more sources of funds being collected and tried to pay out its government debt as much as it could. This could then mitigate the impacts of the spread of its crisis.

3. Overconfidence of investors and government

One potential cause of the debt crisis is the overconfidence by investors and European government in the sovereign bond market in the first stage.

As it has been all known, the government bonds are the most stable and safe financial instruments for investors with lower return than corporation bonds. Government debts are always seemed as an AAA+ credit rating. Thus investors would not worry about the default risk of these bonds. Thus, investors were happy to invest in the European sovereign bonds for a lower but safe return.
With a total of $402 billion Greek debt (Reuter, 2009), it reflected the confidence level on the government bonds of investors.

Figure 4 Monetary aggregate M3

Source: http://sdw.ecb.europa.eu/servlet/quickviewChart?SERIES_KEY=117.BSI.M.U2.Y.V.M30.X.I.U2.2300.Z01.A
And because the interest rate had an increase trend from 2004 with 5% to 2008 with over 12%, investors had an optimistic prospect on its return, as shown in the above figure. The major debt holders such as Greek bonds are euro system and EU loans with €45 billions, and Greek public funds with €75 billion (Barclays capital, 2011). This highlighted the response to the increase of interest rate, and also the bond’s yields. The investors assumed that all European sovereign debts and bank debt were risk-free and they would not default until 2008 (Boone & Johnson, 2011), which in deep would be seen as an overconfident behavior. But after Germany had signaled the possibility of default, investors may bear the lots for the euro-zone debts.

Moreover, the first stress test held by European central bank omitted the chances of default of the debts. And the north European leader claimed that they believed Europe was sufficiently prepared for the likelihood of default (Atwater, 2012), but actually this was not the case.

Owing to a lack of assessments and cautious planning on their current national financial situation, the Euro government debt, especially the Greece government had been accumulated exponentially. On top of that, the Global Financial Crisis in 2008 had also lead to a serious economic downturn, causing an increase on government Debt to GDP ratio and serious fiscal deficit across Europe, triggering the outbreak of the euro debt crisis.