European Crisis 1

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EUROPEAN CRISIS

Since the fall of 2009, the European Union has been struggling with a slow-moving but unshakable

crisis over the enormous debts faced by its weakest economies, such as Greece and Portugal, or

those most battered by the global recession, like Ireland. A series of negotiations, bailouts and

austerity packages have failed to stop the slide of investor confidence or to restore the growth

needed to give struggling countries a way out of their debt traps. By August 2011 European leadersfound themselves scrambling once again to intervene in the markets, this time to protect Italy and

Spain, two countries seen as too big to bail out. It has posed great risks to many of the continents

banks, which invested heavily in government bonds, and forced deep and painful cuts in

government spending that drove up unemployment and put several countries back into deep

recessions, leading a growing number of economists to call the austerity policies self-defeating.

The economic crisis gradually became a political one as well, leading to the ouster of governmentsin Ireland, Portugal, Greece and Italy. Protests by traditional interest groups like public sector

unions were joined by crowds of young people who camped out in Madrid and Athens in imitationof the Arab Spring demonstrations.

In the fall of 2011, even as European leaders struggled to come up with a new bailout plan forGreece, much larger fears loomed. Interest rates soared for Italy, the continents third largesteconomy, and rose for France, whose banks hold large amounts of Italian government bonds, andwhere government finances are strained. The continents economy was teetering on the brink of asecond recession.

The European sovereign debt crisis has been created by a combination of complex factors such as:

1) The globalization of finance;2) Easy credit conditions during the 2002-2008 period that encouraged high-risk lending

and borrowing practices;

3) International trade imbalances;4) Real-estate bubbles that have since burst;5) Slow growth economic conditions 2008 and after;6) Fiscal policy choices related to government revenues and expenses; and7) Approaches used by nations to bailout troubled banking industries and private

bondholders, assuming private debt burdens or socializing losses.

One narrative describing the causes of the crisis begins with the significant increase insavings available for investment during the 2000-2007 period. During this time, the global pool offixed income securities increased from approximately $36 trillion in 2000 to $70 trillion by 2007.This "Giant Pool of Money" increased as savings from high-growth developing nations enteredglobal capital markets. Investors searching for higher yields than those offered by U.S. Treasurybonds sought alternatives globally. The temptation offered by this readily available savingsoverwhelmed the policy and regulatory control mechanisms in country after country as global fixedincome investors searched for yield, generating bubble after bubble across the globe. While these

bubbles have burst causing asset prices (e.g., housing and commercial property) to decline, theliabilities owed to global investors remain at full price, generating questions regarding the solvencyof governments and their banking systems.
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How each European country involved in this crisis borrowed and invested the money varies. Forexample, Ireland's banks lent the money to property developers, generating a massive propertybubble. When the bubble burst, Ireland's government and taxpayers assumed private debts. InGreece, the government increased its commitments to public workers in the form of extremelygenerous pay and pension benefits. Iceland's banking system grew enormously, creating debts toglobal investors ("external debts") several times larger than its national GDP. The interconnection inthe global financial system means that if one nation defaults on its sovereign debt or enters into

recession that places some of the external private debt at risk as well, the banking systems ofcreditor nations face losses. For example, in October 2011 Italian borrowers owed French banks$366 billion (net). Should Italy be unable to finance itself, the French banking system and economycould come under significant pressure, which in turn would affect France's creditors and so on. Thisis referred to as financial contagion.[19][20]Further creating interconnection is the concept of debtprotection. Financial institutions enter into contracts called credit default swaps (CDS) that result inpayment or receipt of funds should default occur on a particular debt instrument or security, such asa government bond. Since multiple CDS can be purchased on the same security, the value of moneychanging hands can be many times larger than the amount of debt itself. It is unclear what exposureeach country's banking system has to CDS, which creates another type of uncertainty.

An Escalating Spiral of Debt?

As difficult as the last two years have been for Europe, 2012 could be even tougher. Each week,countries will need to sell billions of dollars of bondsa staggering $1 trillion in totaltoreplace existing debt and cover their current budget deficits.

At any point, should banks, pensions and other big investors balk, anxiety could course through themarkets, making government officials feel like they are stuck in a scary financial remake ofGroundhog Day.

Even if governments attract investors at reasonable interest rates one month, they will have to repeatthe process again the next monthand signs of skittish buyers could make each sale harder tomanage than the previous one.

The challenge for Europe is to keep Italy and Spain from ending up like Greece and Portugal, whoseborrowing costs rose so high in 2011 that it signaled real likelihood of default, making it impossiblefor the governments to find buyers for their debt. Since then, Greece and Portugal have been relianton the financial backing of the European Union and the International Monetary Fund.

The intense focus on the sovereign debt auctionsand their importance to the broader economystarkly underscores the difference between European and American responses to their crises.

Since 2008, there has been almost no private sector interest to buy new United States residentialmortgage loans, the financial asset at the root of the countrys crisis. To make up for that lack ofinvestor demand, the federal government has bought and guaranteed hundreds of billions of dollarsof new mortgages.

But the crisis response in the United States did not depend solely on government-backed entitieslike the Federal Reserve to buy housing loans. Banks and investors also took large losses on existing

housing debt. While painful, the mortgage debt proved less of a drag on the financial system.

So far, Europe has been averse to taking permanent losses on government bonds. Except in the caseof Greek debt, European policy makers have shied away from any plan that could mean privateholders of government debt get hurt.
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Such haircuts might seem like the recipe for more instability. But if Europe struggles to find buyersfor its debt, more radical options are likely to be considered. Europes debt problem is huge, and theexperience in the United States suggests dealing with it may take several, more drastic approaches.

Documents

European Crisis 1