Tuesday, April 17, 2012

Eurozone Debt Crisis Exlpained

By Sarfaraz A.K. (2012)

2011 has been the year of Arab Spring, Japanese Tsunami, Osama Bin Ladin and Eurozone Crisis. Greece had hit all the major headlines in 2011. In 2012, we had other European nations waiting (not so anxiously) for their chance to shine, with Spain and Italy being at the forefront. So what exactly happened in Europe? Hadn't all the European nations claimed that they were out of the global financial crisis / global recession? Now they all seem to be talking about “expenditure cuts”. So what happened?
Recommended Reading (Amazon Link) 

We will need to go a little back in time in 1997 when the Euro was being created. Back then, all the EU leaders came on one platform and agreed to set a borrowing limit to 3% of their respective economies’ output. They set up a barrier for themselves; do not borrow more than 3% of the total economic output. This rule was meant to bring stability and growth to the Eurozone. It was supposed to be followed in letter and spirit to avoid any ‘debt crisis’. Countries were, however, allowed to cross the 3% limit under exceptional circumstances, (e.g. during recession).

The 3% rule was insisted on by German finance minister Theo Waigel and it was ironic that Germany (along with Italy) was the first country to break this rule. France saw what Italy and Germany were doing and it was not to be left behind, it broke the rule thrice in nine years, still not as bad as Germany (four times between 1999 – 2007) and Italy (six times between 1999 – 2007). 

Greece on the other hand was in a league of its own. Not even did it break all the rules, it manipulated the economic statistics to join the Eurozone in the first place. Surprisingly Spain was the only big Eurozone economy that did not break the rule and never borrowed more than 3% of its economic output between 1997-2007.

So if Spain remained within limits then why is it facing the debt crisis? Well, the total national debt is made up of government debt and private debt (companies and mortgage borrowers). If we focus on only on government debt  then Spain’s economic condition looks very strong, better than France, Germany or Italy.

If you look at their private debts, only then the picture changes entirely. Spain emerges as a nation deep in debt. 

So Spain, as it turns out, followed the 3% rule in letter but definitely not in spirit. This actually explains why markets have been unwilling to lend money to Spain while capital was readily available for Germany and France whenever they required. In fact Italy attracted more FDI, particularly in Solar energy sector during 2010-11, than Spain.
Recommended Reading (Amazon Link):
Despite breaking the 3% rule five out of 9 times, the Germans have done pretty well for themselves. Their overall national debt is much lower as compared to France, Italy and Spain. Out of all the European countries, Germany is the only one whose private sector debt has fallen during 2000-10 and is the only country whose overall debt increase was due to increase in government borrowing.  

So what did these countries do with all the money they borrowed?  With all that borrowed money flowing into the economy; Italy, Spain and France went on a shopping spree. Their imports soared and wages rose.  Their quality of life significantly improved, with all the imported products and increased wages.

The Germans followed a different strategy altogether. While their neighbors were out shopping, the Germans were out selling. Germany’s exports increased dramatically in this period. Furthermore, they kept their general wage levels fairly constant for ten years (2000-2010). It was (partially) due to the steady wage levels that Germans were able to offer most competitive export prices to their buyers. Eventually Germany has now surplus funds available when other European economies are facing recession and debt crisis.