European Debt Crisis

What is European debt crisis? It is the failure of Euro, the currency that unites together 17 European countries in an intimate but flawed manner.

Over the past 3 years, Greece, Portugal, Ireland, Italy and Spain have all fallen down to the brink of collapse, threatening to bring down the entire continent and the rest of the world. How did it happen?

For most of Europe's history, it's been in a war within itself. Countries at war with each other tend to do less business with each other. Europe was always a continent of trade barriers, tariffs and different currencies. Doing business across borders was difficult. You needed to pay a fee to exchange currencies, and you needed to pay tariff fee to buy and sell to the companies in other countries. That tendered to stifle economic growth.

Then came World War 2, which devastated Europe. Because the situation was so worse, the fastest way to rebuild Europe was to begin to remove these barriers. Steel and coal tariffs came down, so that the steel mill in one country could sell to a builder in another. This gave the survivors an idea - "A unified Europe". A union across the continent that would end all future wars. Countries began to bend towards this goal, bringing down trade barriers, lowering the cost of doing business. One of the last barriers to fall was the Berlin Wall. With a united Germany, Europe was ready.

27 countries signed the Maastricht Treaty and created the European Union. This made doing business across borders easier. But there was still one major obstacle - different currencies. A decade later they had won. The Euro launched on January 1st, 1999. The countries adopting the Euro, called the Euro area, discontinued their own currencies. They also discontinued their own monetary policies, giving control to the newly formed European Central Bank, commonly referred to as the ECB. The Euro area had one unified monetary policy, but it still had many different fiscal policies, a key reason for the debt crisis.

Monetary policy controls the money supply, literally how much money there is in the economy and what the interest rates are for borrowing money. Fiscal money controls how much money a government collects in taxes and how much it spends. A government can only spend as much it collects in taxes. Anything above that amount it has to borrow. This is called deficit spending.

Before the Euro, countries like Greece not only had to pay high interest rates to borrow, but they can only borrow so much. Lenders weren't comfortable lending them too much money. But now as they were part of the Euro area, the amount they could borrow sky-rocketed. Smaller countries had access to credit like never before. Greece and other countries which previously could only borrow at rates around 18% could now borrow at the same rate as Germany.

Joining the Euro area is lot more like sharing a credit card, Germany's credit card. Lenders now believed that if Greece was unable to repay its loans, Germany and other big economies of Europe would step in and repay them because they were now bound by common currency. With a new abundance of cheap credit, Greece and other European countries were able to adjust their fiscal policies and increase spending to previously impossible levels. 

Some countries embarked on huge deficit spending programs, primarily for politicians to get elected. They made promises such as more jobs and generous pensions, all of it paid for by the new money they could now borrow. The governments of Greece, Portugal and Italy accumulated huge debts. However, they were able to repay these debts with more borrowed money. As long as the borrowing continued, so did the spending and the unbalanced fiscal policies. In Ireland and Spain, cheap credit fueled enormous housing bubbles, just as they did in United States.

Credit flowed, debt accumulated and the economies of Europe became tightly intertwined. Companies began opening factories and offices across Europe. German banks lending to French companies, French banks lending to Spanish companies, and so on and so forth. This made doing business incredibly efficient, but at the same time tying together the collective fate of the Euro area. Things continued this way as long as credit was available, and credit was available until 2008.

Spread by a collapse in US housing market, a credit crisis swept the globe, bringing borrowing to a halt everywhere. Suddenly, the Greek economy couldn't function. It couldn't borrow money for all the new jobs and benefits it created. It couldn't borrow new money to pay its old debts. This was the problem for Greece, but because of the unified monetary policy, it was also the problem for all of the Europe. Much of the Europe had been on a spending spree and borrowed more money it could ever repay. But the problem is somebody has to step in or else every country in the Euro area will suffer. Since the countries that ran up the bill couldn't repay, everyone looked at Germany.

As the biggest and the strongest economy in Europe, Germany reluctantly agreed to help bail out the debtor countries. In other words, Germany agreed to repay the bills, but only if the debtor countries agreed to implement strict austerity measures to insure that will never happen again. Austerity measures meant sucking it up, cutting the spending, borrowing less and paying back more debt. This sounds like a simple solution. It's not! 

First of all, nobody wants austerity. Austerity means cutting government spending and since the government is, by far, the biggest spendor in any economy. When government cuts spending, it cuts the earnings of many of its citizens. People lose jobs, they get angry, they riot in the streets and austerity doesn't automatically balance the country's budget. The government collects taxes based on people's earnings. So when earnings are reduced, the government collects less in taxes, they still can't pay down their debts. On top of this, there are huge cultural differences within the Europe.

Germany is very financially responsible. Ever since the terrible hyper inflation the country experienced after World War 1, it has been extremely inflation averse and incredibly careful about spending and borrowing. In general, Germans work hard. They expect little state benefits, and meticulously pay all of their taxes. Many Greeks, on the other hand, enjoy generous state benefits and don't pay taxes. Greece has a terrible problem, it has never collected majority of the taxes it imposes on its citizens and it has always been this way. Joining the Euro just amplified it. The German view is, that doesn't work. If you want our money, you need our morals.

As the debtor countries headed towards the fall, the whole continent of Europe was in danger. Even though the economies of the debtor countries are relatively small, they posed a huge threat because the European financial system is so interconnected, precisely, because of the Euro. The debtor countries borrowed money from banks, investors and other countries throughout Europe. As the debtor countries get closer to default, everyone who lent them money becomes weaker, and everyone who lent those lenders money also becomes weaker, and so on and so forth. A problem in country could reverberate across the whole continent, triggering a chain reaction of default. If Greece defaults, then Spain will default, Italy, Portugal, Ireland, then France, then Germany. Pretty soon, it could spread not just across Europe, but across the world.

The problem is even if the debtor nations adopt austerity measures and even if the bail out from Germany and the stronger countries helps them pay down their debts and avoid the immediate crisis, there is no system in place to prevent it from happening again. This brings us back to the fundamental division of monetary policy and fiscal policy. Ultimately, the Euro area requires a fiscal union to match its monetary union, or neither. That is, there must be a political organization with authority to set fiscal policy within every Euro area country. It must have the power to cut spending, raise taxes and set laws. A fiscal union like this could actually prevent excessive borrowing and spending. 

However, this is an enormously complicated and unpopular notion. It means surrendering sovereignty to a higher power. In essence, a United States of Europe. Yet without a centralized fiscal union, countries will continue to run deficits, accumulate debt, degrade the value of the Euro, and threaten the stability of Europe. Can Europe take the necessary steps and create a fiscal union alongside the monetary union, or will the monetary union break up and may Euro disappear?