The European Union, led by Germany and France, struggled to support these members with bailouts from the ECB (European Central Bank) and IMF (International Monetary Fund). However, before it was all over the crisis threatened the concept and existence of the euro itself.
How the Eurozone Crisis Would Affect You:
Even worse, the European Central Bank (ECB) holds a lot of sovereign debt, so its future would be at risk. Without a central bank to bail its members out, the EU itself might not survive. Left unchecked, the rippling effect of uncontrolled sovereign debt defaults could create a recession, if not a global depression.
It would also be worse than the 1998 sovereign debt crisis. When Russia defaulted, other emerging market countries did too. However, the IMF stepped in, backed by the power of European countries and the U.S. This time, it's not the emerging markets, but the developed markets that are in danger of default. The major backers of the IMF -- Germany, France and the U.S. -- are themselves highly indebted. There would be little political appetite to add to that debt to fund the massive bailouts needed. If sovereign debt defaults were left unchecked, the resulting panic could cause a shutdown of credit, in which even the United States might have trouble funding its debt.
What Was the Proposed Solution?:
- Eurozone member countries would legally give some power over their budgets to centralized EU control.
- Members that exceeded the 3% deficit-to-GDP ratio would face financial sanctions. Any plans to issue sovereign debt must be reported in advance.
- The European Financial Stability Facility (EFSF) would be replaced by a permanent bailout fund, the European Stability Mechanism (ESM). The phaseout would begin in 2012 and take about a year. The permanent fund assures lenders that the EU would fully stand behind its members, substantially lowering the risk of default.
- Voting rules in the ESM would allow emergency decisions to be passed with an 85% qualified majority. This would allow the EU to act more quickly.
- Eurozone countries would lend another €200 billion to the IMF from their central banks.
What Are the Consequences?:
Second, eurozone countries must agree to cutbacks in spending. This could slow their economic growth, as it has in Greece. These austerity measures would be politically unpopular. Voter could bring in new leaders, who might leave the eurozone or the EU itself.
Third, a new form of financing -- the eurobond -- becomes available. The ESM would be funded by €700 billion in euro bonds, fully guaranteed by the eurozone countries. Like U.S. Treasuries, these bonds could be bought and sold on a secondary market. By competing with Treasuries, the eurobonds could lead to higher interest rates in the U.S. (Source: CNN, Will new deal solve Europe's problems?, December 9, 2011)
Why the Deal Wasn't Enough:
In addition, investors worry that austerity measures, needed in the long run, will only slow the economic rebound debtor countries need to repay their debts. (Source: CNBC, "S&P Says Eurozone May Need Another Shock",Euro Crisis Pits Germany and U.S. in Tactical Fight, December 12, 2011)
How Did the Eurozone Get Into This Crisis?:
Second, eurozone countries initially benefited from the low interest rates and increased investment capital made possible by the euro's power. Most of this flow of capital was from Germany and France to the southern nations. This increased liquidity raised wages and prices, making their exports less competitive. Because they were on the euro, they couldn't do what most countries do to cool inflation -- raise interest rates or print less currency. Public spending rose, while tax revenues fell, during the recession to pay for unemployment and other benefits. (Source: Financial Times, Paul Krugman, Is Austerity Killing the Euro?)
Third, although there are good arguments for austerity measures, they might only slow economic growth by being too restrictive. For example, the OECD said austerity measures would make Greece more competitive by improving its public finance management and reporting, cutbacks on public employee pensions and wages, and lowering its trade barriers. In fact, exports have risen. More important, the OECD said Greece needed to crack down on tax dodgers, and sell off state-owned businesses, to raise funds. (Source: OECD, Economic Survey of Greece 2011)
In return for austerity measures, Greece's debt has been cut in half. However, these measures have also slowed the Greek economy by raising unemployment, cutting back consumer spending, and reducing capital needed for lending. Greece may never grow its way out of its debt.
