How did Europe get into its debt mess?

Reuters
11:35 AM EST September 20, 2011

The 17 nations sharing the euro are in deep crisis, saddled with massive debts and dangerously weakened by political division over how to find a way out, just as the world economy flirts with another downturn.

Growing alarm that Greece may default or even leave the euro, potentially triggering contagion in the much larger economies of Italy and Spain, puts the debt crisis at the heart of IMF, World Bank and G20 meetings in Washington this week.

Investors and top officials, including U.S. Treasury Secretary Timothy Geithner, are urging European politicians to act and say a failure to do so could provoke a crippling recession and even the break-up of the European Union itself.

Following is a look at how the euro zone got into debt, possible scenarios and how it might end the crisis.

Heavy borrowing
With the euro's introduction in 1999, unified interest rates allowed members to borrow heavily. Bonds issued by southern European nations were taken to be as safe as German ones. Money flowed into Greece. Spain and Ireland had real estate booms.

The bursting of the housing bubble in the United States and Europe in late 2007 dealt the first blow to the euro zone's aura of invincibility. Then in late 2009, when a new Greek government found that its predecessor lied about its borrowings and had run up huge debts, the revelation provoked a drastic loss in investor confidence that spread across the currency bloc.

In a recurring theme of the debt crisis, euro zone politicians were slow to react, calling for an investigation into Greece's financial dishonesty rather than trying to reassure nervous investors who began pulling their money out of the country and demanding punitive interest rates on its debt.

Larger euro zone economies and the International Monetary Fund extended Athens an emergency credit line in May 2010, but by then Greece's finances had destroyed the illusion that all euro zone members were equal. Investors quickly turned on the weaker economies of Portugal and Spain, driving up their borrowing costs.


Massive losses at Irish banks stemming from the housing bubble forced Ireland to take a bailout six months after Greece; uncompetitive Portugal then followed in May this year.

Still, euro zone leaders missed another chance to reassure markets. Reluctance in Germany, the region's biggest economy, to fully commit to helping wayward member states meant the rescues did not constitute an effective firewall -- markets continue to be difficult for Spain and Italy, which have a combined debt of about 2.5 trillion euros.

Meanwhile, the strict austerity measures imposed on Greece in return for its financial aid have led to a deep contraction in growth, and debilitating spending cuts and tax increases, further undermining confidence.

Adding to the difficulty, Athens is dragging its feet over privatisations and reforms it promised in return for help, putting its next aid disbursement at risk and possibly leaving the government without money for salaries and pensions next month. The liquidity of the sovereign is now in question.

Worst-case scenarios of Greek default
Hyperinflation, a run on Greek banks, violence, economic depression, international isolation and investor panic spreading to Italy and Spain make up the worst-case scenario if Greece were to default on its 370 billion euro debts.

European banks that lent to Greece at the height of the borrowing binge would certainly be hit; French banks have been particularly under pressure in recent days for their Greek exposure.

A Greek default would also likely set off a domino effect. Since investors would no longer believe the euro zone protects its own members, they would sell off Spanish and Italian paper, possibly sparking more defaults. Banks and governments around the world holding euro assets would take major losses.

Given those costs, euro zone leaders are adamant that Greece will not default. Some privately like to talk of an "orderly" Greek default: bank deposits would be protected, bankrupt banks would be kept functioning to keep the economy running and other euro zone governments' bonds would be protected from contagion.

A default could allow Greece to restructure its debt and force creditors to take a 60- to 80-percent loss on their bonds, perhaps providing a chance to return more quickly to economic growth, although some reforms would probably still be necessary.

But if Argentina's default a decade ago is anything to go by, Greece would likely be forced to devalue by leaving the euro and taking back the old drachma, making imports prohibitive. Credit would dry up, demand would shrivel and the country would be plunged into a prolonged depression.

If Spain and Italy were subsequently forced to leave the euro, some economists estimate it could cost them anywhere between 25 and 50 percent of their annual output, while the break-up of the currency bloc could cost trillions of euros.

What is to be done?
Some European politicians and economists say euro zone states should consider issuing bonds jointly underwritten by all countries in the bloc -- euro zone bonds.

The bonds would create a common interest rate for the bloc and allow weaker states to access markets at reasonable rates.

But the implementation of such an idea could take years and currently there is fierce opposition to the idea in Germany.

Washington has suggested the euro zone should leverage its rescue fund to increase its lending capacity beyond its current 440 billion euros, giving it ammunition to help Spain and Italy, if needed.

More immediate solutions include sorting out weak banks and helping economies where growth has been hit by budget-cutting measures, weakening government finances.

The ECB could also increase its programme of buying Italian debt to contain the widening spreads over German benchmark bonds, but the bank is divided and the scheme has already prompted ECB chief economist Juergen Stark to resign in protest.

Ultimately, Europe's politicians must convince markets that they stand completely behind the sovereign debt of euro zone members to avoid any further investor panic.

Can governments agree?
The risk of a collapse of the euro or even of the European Union itself could eventually force Germany, the EU's paymaster, to do whatever it takes to back weaker euro zone nations, whether it be with the ECB intervening in markets to buy riskier debt or providing more funding to recapitalise European banks.

But for now, European politicians seem more divided than ever, particularly on issues such as budget sovereignty. Even countries central to the European project, such as the Netherlands, are increasingly wary.

That division was underscored by last week's meeting of finance ministers in Poland, who agreed no new action, despite the critical hour.

Swedish Finance Minister Anders Borg, whose country stands within the European Union but outside the single currency, put it politely: "There are different voices in the debate."