Money Matters - Simplified

Euro Debt Crisis: What Led to It?

The U.S. economy has barely recovered from tough times that here is the fear of relapsing into recession again, all thanks to the euro-debt crisis.

Had the countries not formed European Union and euro, chances are that crisis might have never occurred.

Back in 1999, 17 countries of Europe came together for better economic growth and trade prospects.

Eventually, euro, the single currency to give a tough competition to dollar, was introduced.

These countries benefited immensely from the free flow of labor and capital across European nations, in effect forming a free trade zone. The monetary union brought weak and strong countries together in a common marketplace.
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The weaker countries got access to cheap capital which global banks and investors were willing to lend, as they treated these nations at par with strong ones like Germany and France.

The reckless lending practices were encouraged by so called Basel rules that permitted these banks to treat sovereign debt as risk-free. Even though the banks in core countries followed sound lending practices at home, they traded with weaker peripheral countries.

The easy flow of credit to the PIIGS [Portugal,Ireland, Italy, Greece, Spain] countries spawned a wage and real estate bubble.

But the joy ride took a dangerous turn. All the member countries were supposed to behave like responsible spenders in return for euro membership. They were mandated to keep the fiscal deficit [the difference between a nation’s income and spending] to a maximum of 3 percent.

But these countries failed to follow fiscal discipline, which resulted in large fiscal deficits. As if this was not enough, they even tried to hide deficits by manipulating statistics to their benefit.

Eventually the markets got a whiff of this, and soon they raised borrowing costs for these countries.

The situation became grim for Greece in May 2009, as its bonds were dumped indiscriminately. This prompted European Union and IMF to hurriedly put together a bailout fund.

The markets did ease for some time but fell again, as rescue fund was found to be too small to tackle full problem.

Amid fear of contagion remains, these countries are trying hard to recover from crisis.

Italy has already been downgraded by S&P.

Further, the fear factor has again reached a high with money flowing out of European banks into the United States.

The first victim of a European sovereign default will be the European banking sector which in turn will affect American financial sector through global interlinkages. The situation could be worse than the Lehman Brothers crisis in 2008.

And as Europe’s economic growth collapses, it will adversely affect United States which is already very fragile. Currently, Europe consumes 20 percent of of U.S. exports.