Q&A: Eurozone debt crisis

Merkel and Sarkozy have recently been dubbed ‘Merkozy’ for their joint efforts to restore the eurozone’s financial health [Reuters]

2011 has been a troubled year for the 17 countries that use the euro as their currency. Now, ratings agency Standard & Poor’s has placed 15 eurozone countries on a “negative credit watch” amid concerns that the countries’ debt problems will spread and worsen.

Meanwhile, French President Nicolas Sarkozy and German Chancellor Angela Merkel have called for changes to the European Union’s governing treaty that would compel countries to rein in government spending. However, it remains unclear how politically feasible this would be.

Al Jazeera looks at the origins of the debt crisis, what is happening in the eurozone right now, and why the crisis matters.

What is happening in the eurozone right now?

For two years, several European countries have faced difficulties in repaying debts to their creditors and bondholders. These countries include Greece, Ireland, Portugal, and Italy. The debt crisis was triggered by the worldwide financial collapse that began in 2008 – and exacerbated by poor financial management.

Many European countries were living beyond their means in recent years, and the level of debt has placed a strain on countries that have been spending more than their income. The problem is not just confined to these countries: Failure to find a workable solution to the crisis could damage economies around the world.

In November, fallout from the crisis led to changes in government in three eurozone countries. The governments of both Greece and Italy fell in November; both countries’ leaders were replaced by so-called “technocrats” – economic experts who had not previously worked as politicians. In the same month, Spain voted out the incumbent Socialists in a landslide and elected the centre-right Popular Party to power instead.

Non-eurozone countries including Japan, Canada, Switzerland, the US, and the United Kingdom are wary of the ripple effects that could result from the debt crisis. Accordingly, these countries’ central banks have decided to reduce the amount of interest they charge on loans to other banks by half a percentage point. This will make it easier for troubled European banks to borrow money.

What role do bonds play in the eurozone debt crisis?

Bonds are essentially loans. Bondholders – which can be private individuals, banks, pension funds, foreign governments, or other institutions – make an up-front payment to a company or government (known as an “issuer”) that needs money in the short-term. Over the lifespan of the bond, which can be as long as 30 years, the issuer regularly pays interest to its bondholders. At the end of the bond’s lifespan, the issuer has to repay the bondholder for the amount of money it paid up-front.

If a company or government cannot make good on its interest payments, this is known as “default”. Governments rarely fully default on their bonds; instead, they often force bondholders to accept a “haircut”, or a partial reduction in what they are owed.

What happens when a government defaults?

When a country’s government is unable – or refuses to – pay its bondholders what they had been promised, investors can become wary of lending money to that government in the future. As a result, they will often demand higher interest rates in exchange for investing in that country’s bonds. If capital inflows suddenly stop, this can have disastrous effects for the country’s economy.

In 2008, the collapse of the housing bubble ravaged Icelandic banks, which had taken on huge risks during the years before the crash. Iceland’s government took control of the troubled banks, which owed huge amounts of money to its bondholders. Instead of paying these bondholders in full, Iceland defaulted by paying them only a percentage of what they were owed.

Although Iceland was shunned by investors for a few years thereafter, the country was able to issue bonds this year at a five per cent yield, which is a relatively low rate.

Why does the eurozone debt crisis matter?

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The debt crisis is not confined to especially troubled countries such as Greece. It has since spread and affected other countries, such as Portugal, Spain, and Italy. Other countries could succumb to the crisis if bondholders lose faith in their ability to repay debt.

If Standard and Poor’s cuts its ratings of eurozone countries’ bonds, as it has warned it might do, investors will likely be less willing to lend to these countries. And investors are already wary: Even Germany – regarded as the eurozone’s strongest economy – has had difficulty selling government bonds in recent weeks.

If a country fails to repay bondholders, banks that hold that country’s debt would have to take losses, possibly causing those banks to become undercapitalised.

This could then spur governments to bail out these affected banks, so that they are able to cover their loans. These bailouts could, in turn, cause these governments to run huge deficits, causing the debt crisis to spread.

Credit is the lifeblood of modern economies, and if banks are unable to lend because they are insolvent, economies are at risk of sinking into recession.

How did the debt crisis originate?

Greece’s crisis began in 2009; however, the roots of the problem can be traced to the global economic crisis that began in 2008, which was fuelled by the collapse of the US housing bubble and the subprime mortgage market.

For a long time, the Greek government spent more money than it took in. Because of this, the government had to borrow money to cover the difference.

When a new government, led by George Papandreou, was elected in Greece in 2009, it revealed that the previous government had fudged its financial data. The world had thought that Greece’s deficit was about six per cent of its GDP. In fact, the new government announced, Greece’s deficit was over twice as high: 12.7 per cent.

This revelation shocked bondholders. Because investors became less confident about Greece’s ability to repay them, they demanded Greece pay higher interest rates on their bonds. This had a spiral effect: The more Greece had to pay bondholders in interest, the more it had to borrow, which in turn drove up interest rates even more.

Greece’s debt problems led investors who owned bonds issued by other peripheral Eurozone countries to lose confidence, especially because banks in France, Germany and the UK owned over $56bn worth of Greek government bonds.

What does the euro have to do with the debt crisis?

In 1999, 11 European countries adopted a common currency, the euro. Two years later, Greece adopted the euro as well, and there are now 17 eurozone member countries. Because investors viewed the euro as a strong, stable currency, they weren’t very worried about inflation when they bought eurozone countries’ bonds. As a result, Greece was able to issue bonds at lower interest rates than it would have been able to before adopting the euro.

In part because it could borrow money more cheaply, Greece went on a spending spree due to the lower interest rates – and financed this spending by issuing bonds.

What are eurozone countries doing about the debt crisis?

Right now, Greece does not have enough money to repay its bondholders in full. To become solvent, other eurozone countries – especially Germany, have lent Greece money at low interest rates to repay its bondholders.

These bailout loans were made under the condition that Greece also implements so-called “austerity” measures. The conditions would require Greece to raise taxes and reduce public sector spending, so that it could eventually have a budget surplus to pay back its debt. On December 6, the Greek parliament will vote on whether to adopt austerity measures for the country’s 2012 budget.

Unlike Greece, Ireland did not run big spending deficits before 2008. Instead, Ireland’s problems largely were the result of the housing bubble collapse. Its government had agreed to bail out Irish banks that had lost money in the collapse. But the size of the bailout was much larger than initially expected, causing the government to run huge deficits. In order to avoid defaulting on its debt, Ireland cut spending, raised taxes, and received an $121bn rescue package from the International Monetary Fund and EU.

The country most recently announced $2.94bn in spending cuts, and $2.15bn in new taxes. Prime Minister Enda Kenny admitted that the situation in Ireland would get worse before it gets better.

Spain and Portugal also faced big budget deficits following the 2008 financial collapse and subsequent recession. Portugal received a bailout package in May 2011, while Spain is attempting to remain solvent by balancing its budget and introducing severe austerity measures.

Recently, there have been growing concerns that Italy might be unable to pay the $2.5tn of debt that it owes. Italy’s new government, led by Prime Minister Mario Monti, is pushing for a $32bn package that would reduce Italy’s debt by cutting pensions and raising the retirement age.

However, trade unions – a powerful political force in Italy – are fiercely opposed to the deal. Politicians are hesitant, too: Al Jazeera’s Jacky Rowland reported that Italy’s welfare minister broke down in tears when acknowledging the financial hardships that austerity measures would impose on Italians.

European leaders are particularly concerned about Italy’s debt problem, because the country has the third-largest economy in the eurozone (the size of Greece’s economy, by contrast, is much smaller).

What is the European Union trying to do to solve the problem?

Eurozone leaders are trying to create a long-term fix for the debt crisis. The leaders of Germany and France, the countries with the two largest economies in the eurozone, have suggested that European Union members should sign on to a new treaty that would set limits on how much countries can spend.

Nicolas Sarkozy added that he and German Chancellor Angela Merkel “want automatic sanctions if countries violate the rule imposing deficits of less than three per cent”.

Merkel proposed that eurozone countries should permit a central authority to control their budgets, citing the need to improve confidence in the markets. “We are in a difficult situation, and we need to regain confidence,” she said. “The belief that we can be taken at our word has suffered.”

European Union leaders will meet on December 9 in Brussels to discuss the Sarkozy-Merkel plan. As yet, it is unclear whether all 27 EU member states would have to ratify the plan – or whether only the 17 countries that use the euro would have to approve.

Why is the eurozone crisis political?

How indebted countries deal with their burden is by its very nature political. Cutting social services and raising taxes to repay bondholders – many of which are foreign institutions – often stokes resentment, especially among the younger generation, many of whom are directly affected by high unemployment rates. Spain, for instance, has an unemployment rate of about 20 per cent, the highest in Europe. But among 15 to 24-year-olds, according to The Economist, the unemployment rate in Spain was 46.2 per cent in September.

Greece’s economy is already contracting, and tax hikes and spending cuts will likely cause the economy to contract even further, leading to a rise in unemployment. Already, attempts to balance Greece’s bloated budget have led to mass protests and general strikes.

There is disagreement within Europe as to how much sovereignty eurozone countries should have over their budgets, given that these countries share a common currency. Even countries that were central to the Union’s European project, like the Netherlands, are increasingly sceptical of the eurozone.

Many taxpayers in richer eurozone countries, like Germany, are already tiring of bailing out other eurozone countries; however, public opinion in these countries is divided.