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RussianWith Europe these past few years, the financial markets are seeing the crisis of too much government debt and poor government balance sheets as well as a weak banking sector unfolding. The crisis originated with Greece, moved to Ireland and Portugal, and struck Italy in the second half of 2011. This article will try and present the historical reasons why, as well as the key issues facing Europe in early 2012. At the root here, this story is about competitiveness, interest rates, and the imbalances that grew out of the introduction of the euro.
Failure of the Growth and Stability Pact
In the 1990's the European nations that wanted to pursue a currency union, laid out the "European Stability and Growth Pact" which attempted to limit countries' budget deficits to 3% of GDP with a secondary goal of keeping total debt load below 60% of GDP.
Who was able to keep to these rules during the 9 years prior to the 2008 financial crisis and who wasn't?
- Germany was the first country to break the rules, running a deficit above 3% in 2001, and the 4 years after that. That's 5 out of 9 years it did not meet the targets.
- France ran a deficit above 3% from 2002 to 2004, missing the target 3 out of the 9 years.
- Italy was the worst offender, breaking the rules 6 years out of 9.
- Spain, a country now being targeted during the sovereign debt crisis, was actually the best performer here, keeping to the target of the Growth & Stability pact all 9 years.
Therefore it wasn't who followed the rules here that eventually got into trouble, which means we had another key factor that was at the root of the current crisis.
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Converging Interest Rates & Growth in Debt Levels
Well, there are 2 key factors. The first one to consider was the narrowing in borrowing costs charged the various governments within the Euro-zone.
The chart to the right shows the 10-year yields for the various Euro-zone countries as they approached the introduction of monetary and currency union in 1999 and shows that these rates converged during that period. Prior to this convergence, in 1995 for instance, interest rates varied widely, with those countries on the periphery - Greece (19%), Portugal (11%), Spain (11%) and Italy (12%) - paying much higher borrowing costs.
As Europe got closer to the introduction of the Euro, all of these spreads tightened to such a degree that a country like Italy or Spain, which historically had more generous social benefits and were less competitive than those in northern European were able to borrow at the exact same prices. A country like Greece, just a few years later, held the same privilege.
This convergence laid the seeds for the current crisis as it created big imbalances in sovereign bond markets, as countries like Greece, Ireland, Portugal, Spain, and Italy (and their banking systems) were all able to borrow much more than they would have been able to if they were not a part of the euro.
After the collapse of Lehman Brothers these spreads started to widen out as investors become concerned about defaults, counterparty risk, and the solvency of these "periphery" European nations.
Now, it wasn't even necessarily government debt that exploded as a result of these lower borrowing costs, but private debt loads. In the chart above we see the difference in government and private debt from 2000 to 2010.
- In Germany, government debt grew from 61% of GDP to 77%, while private debts remained the same around 165% of GDP.
- In France, government debt grew from 73% to 97% of GDP, while private debt rose from 170% to 224%, bringing the total debt load from 243% of GDP to 321%.
- In Italy, gov't debt remained relatively constant, while private debts grew by 55%.
- In Spain, gov't debt growth was also tame, but fueled by a housing boom, its private debt load jumped by 100% of GDP, bringing its total debt to 355% of GDP.
