by Deepthi Sai
The Euro crisis has been talked about a lot lately. Before understanding the current scenario and how it is affecting the global economy let us back up a bit and understand what has happened and how it ballooned into a full blown crisis in the first place. The Euro came into existence in 1992 and was established as a part of the Maastricht treaty by the European Union (EU). Member states were evaluated based on certain economic parameters to qualify to join the currency. In the 1990s, a number of European countries decided to keep aside their respective currencies and were given an equal amount of Euros instead.
In 2001, Greece joined the Euro zone. Greece, just like all these countries set aside its original currency, the Drachma to adopt the Euro. Today, Greece owes different banks and financial institutions a lot of money. Year after year the government had been spending a lot more than they were earning. The Greek government spent heavily to subsidize education, health care and provision of retirement pensions etc. Before the adoption of the Euro, this difference was financed by printing more currency, a process called deficit financing. Thus, earlier Greece used to print drachmas to make its payments. After they joined the Euro zone, the difference began to be financed by borrowing money from banks and other foreign investors. It’s important to note at this point that since a number of countries used the same currency, it was no longer in the hands of the Greek government to make decisions regarding money supply which deprived them of the option of printing money to pay off debt. Foreign investors stood ready to lend money because the interest rates Greece promised to pay on the money they borrowed was high and even if Greece does fail to repay their money, they knew they had the EU to fall back on.
Now that Greece was able to borrow so easily, they did so and started spending lavishly, importing baskets of goods that they had not when they used the Drachma. As a result, their import spending increased significantly. Part of this spending was funded by their export earnings while a majority was funded through borrowings. Thus Greece started incurring huge amounts of debt, not only in terms of the amount they owed but also in terms of the interest payments they had to make. In 2012, Greece owes 166% of their total annual earnings while the Euro zone debt limit stands at 60% of GDP. What brought the problem to the surface was the slower growth in the world economy which came about as a result of the sub-prime crisis in the USA in 2008. As growth slackened, so did people’s incomes and consecutively tax revenue for the Greek governments. This impaired their ability to pay off debts.
The crisis that started in Greece spread to Portugal, Italy, Ireland and Spain. These countries are also called the PIIGS countries. After joining the Euro zone, Ireland was able to borrow money at interest rates almost 4% less than it could previously. Taking advantage of this, banks in Ireland borrowed heavy sums from German and French banks with plans to loan the money to people at much higher rates of interest and make profits. The biggest borrowers from Irish banks were property developers who borrowed in order to build lots of houses and banks were very happy to lend. But what was actually happening was that people were borrowing money and spending it on property they knew they could never afford and felt that they would manage to pay the sum back over a long period of time. After the 2008 crisis, a fall out in the world economy led to a steep fall in Irish property prices. This was when the property bubble, which was building over a period of time burst.
By this time, the banks had given away all of its money, the property developer was finding it difficult to return the money he had borrowed and the properties were not worth too much. Many projects undertaken were closed down and the property developers found it difficult to sell and thus began defaulting on loan payments. Potential businessmen and property investors were denied loans by Irish banks that lacked money themselves. The government stepped in at this point. The government borrowed money from Europe and gave it to the banks. They promised to pay the money back by raising taxes on the people. The rationale was that if the banks were given money and businessmen could borrow once again, it might stimulate economic activity, increase jobs and incomes and thus ability to pay off previous debt. Banks such as British Banks which were lending money to the Irish government were skeptical of this plan though. Thus they started lending money at higher and higher interest rates. This increase in interest rates started retarding the economy further because corporations too had to pay these rates to borrow money. The result was a deep recession in Ireland.
Spain and Portugal also have continuously been spending more than they should and are facing trouble since interest rates have continuously been increasing. Though Greece and Ireland constitute small parts of the Euro zone, a fall out in either country can potentially impact the entire world. This is mainly because the economic scenario in these countries impacts the strength and the position of the Euro in the market. Since the Euro is a common currency between so many nations, it affects their economy too. Also, the global economy is highly integrated and thus any contagion in any part of the world goes on to affect practically every other nation.
The Euro crisis has been talked about a lot lately. Before understanding the current scenario and how it is affecting the global economy let us back up a bit and understand what has happened and how it ballooned into a full blown crisis in the first place. The Euro came into existence in 1992 and was established as a part of the Maastricht treaty by the European Union (EU). Member states were evaluated based on certain economic parameters to qualify to join the currency. In the 1990s, a number of European countries decided to keep aside their respective currencies and were given an equal amount of Euros instead.
In 2001, Greece joined the Euro zone. Greece, just like all these countries set aside its original currency, the Drachma to adopt the Euro. Today, Greece owes different banks and financial institutions a lot of money. Year after year the government had been spending a lot more than they were earning. The Greek government spent heavily to subsidize education, health care and provision of retirement pensions etc. Before the adoption of the Euro, this difference was financed by printing more currency, a process called deficit financing. Thus, earlier Greece used to print drachmas to make its payments. After they joined the Euro zone, the difference began to be financed by borrowing money from banks and other foreign investors. It’s important to note at this point that since a number of countries used the same currency, it was no longer in the hands of the Greek government to make decisions regarding money supply which deprived them of the option of printing money to pay off debt. Foreign investors stood ready to lend money because the interest rates Greece promised to pay on the money they borrowed was high and even if Greece does fail to repay their money, they knew they had the EU to fall back on.
Now that Greece was able to borrow so easily, they did so and started spending lavishly, importing baskets of goods that they had not when they used the Drachma. As a result, their import spending increased significantly. Part of this spending was funded by their export earnings while a majority was funded through borrowings. Thus Greece started incurring huge amounts of debt, not only in terms of the amount they owed but also in terms of the interest payments they had to make. In 2012, Greece owes 166% of their total annual earnings while the Euro zone debt limit stands at 60% of GDP. What brought the problem to the surface was the slower growth in the world economy which came about as a result of the sub-prime crisis in the USA in 2008. As growth slackened, so did people’s incomes and consecutively tax revenue for the Greek governments. This impaired their ability to pay off debts.
The crisis that started in Greece spread to Portugal, Italy, Ireland and Spain. These countries are also called the PIIGS countries. After joining the Euro zone, Ireland was able to borrow money at interest rates almost 4% less than it could previously. Taking advantage of this, banks in Ireland borrowed heavy sums from German and French banks with plans to loan the money to people at much higher rates of interest and make profits. The biggest borrowers from Irish banks were property developers who borrowed in order to build lots of houses and banks were very happy to lend. But what was actually happening was that people were borrowing money and spending it on property they knew they could never afford and felt that they would manage to pay the sum back over a long period of time. After the 2008 crisis, a fall out in the world economy led to a steep fall in Irish property prices. This was when the property bubble, which was building over a period of time burst.
By this time, the banks had given away all of its money, the property developer was finding it difficult to return the money he had borrowed and the properties were not worth too much. Many projects undertaken were closed down and the property developers found it difficult to sell and thus began defaulting on loan payments. Potential businessmen and property investors were denied loans by Irish banks that lacked money themselves. The government stepped in at this point. The government borrowed money from Europe and gave it to the banks. They promised to pay the money back by raising taxes on the people. The rationale was that if the banks were given money and businessmen could borrow once again, it might stimulate economic activity, increase jobs and incomes and thus ability to pay off previous debt. Banks such as British Banks which were lending money to the Irish government were skeptical of this plan though. Thus they started lending money at higher and higher interest rates. This increase in interest rates started retarding the economy further because corporations too had to pay these rates to borrow money. The result was a deep recession in Ireland.
Spain and Portugal also have continuously been spending more than they should and are facing trouble since interest rates have continuously been increasing. Though Greece and Ireland constitute small parts of the Euro zone, a fall out in either country can potentially impact the entire world. This is mainly because the economic scenario in these countries impacts the strength and the position of the Euro in the market. Since the Euro is a common currency between so many nations, it affects their economy too. Also, the global economy is highly integrated and thus any contagion in any part of the world goes on to affect practically every other nation.
References
"Eurozone Crisis Explained." BBC News. BBC, 19 June 2012. Web. 21 Sept. 2012. <http://www.bbc.co.uk/news/business-16290598>.
Kenny, Thomas. "What Is the European Debt Crisis?" About.com Bonds. N.p., n.d. Web. 21 Sept. 2012. <http://bonds.about.com/od/advancedbonds/a/What-Is-The-European-Debt-Crisis.htm>.
"Timeline: The Unfolding Eurozone Crisis." BBC News. BBC, 13 June 2012. Web. 21 Sept. 2012. <http://www.bbc.co.uk/news/business-13856580>.
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