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European debt crisisEuropean debt crisis

Shashikant Kulkarni

shashi1605@gmail.com

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In 1958, an

organization called

European Coal and

Steel Community was

formed. This evolved

into the European

Union (EU) which

was established by

the Maastricht Treaty

in 1993. The

European Union

introduced the euro

on January 1, 1999.

On this day, 11

member countries of 

the EU started using

euro as their

currency. It benefited

countries such as

Portugal, Italy,

Ireland, Greece and

Spain (together now

known as the PIIGS)

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Before these countries started to use the euro

as a currency, they had to borrow money at

interest rates much higher than the rates at

which a country like Germany borrowed. When

these countries started to use the euro they

could borrow money at interest rates close to

that of Germany, which was economically the

best managed country in the EU

The rest of 

Europe, in

effect, usedGermany's

credit rating

to indulge its

material

desires. They

borrowed ascheaply as

Germans

could to buy

stuff they

couldn't

afford

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Also other than the low interest rates, the

inflation in the PIIGS countries was higher

than the rate of interest.

It means that, if the

borrowing rate is 3 per

cent while inflation is 4

per cent you're

effectively borrowing

for 1 per cent less than

inflation. You're being

paid to borrow

And borrow they did. And the European peripheral countries (PIIGS) racked up enormous

amount of debt in euros.' The debt of Greece, currently amounts to around 160 per cent of its

GDP. So, other than the citizens, the governments also started to borrow. This helped

politicians keep their constituency of voters happy

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Take the case of Greece. A job which now pays 55,000 euros in Germany, pays70,000 euros in Greece, even with the fact that Germany is a more productivenation. To get around pay restraints in the calendar year the Greekgovernment simply paid employees a 13th and even 14th monthly salary --months that didn't exist.

There is more to come. The Greek government categorises certain jobs asarduous. These jobs have a retirement age of 55 for men and 50 for women.'As this is also the moment when the state begins to shovel out generouspensions, more than 600 Greek professions somehow managed to getthemselves classified as arduous: hairdressers, radio announcers,musicians

It means more and more borrowing by the government, when they alreadyhave so much debt

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Take the case of Spain. Spain had thebiggest housing bubble in the world."To put things in perspective, Spain

now has as many unsold homes as theUnited States, even though the US is sixtimes bigger. Most of these new homeswere financed with capital from abroad.Spain's real estate debt comes toaround 50 per cent of its GDP

Every time there are default threats, theEuropean Central Bank (ECB), helps outwith a bailout.

Since the start of the financial crisis it(the ECB) has bought, outright,something like $80 billion of Greek and

Irish and Portuguese governmentbonds, and lent another $450 billion or so to various European governmentsand European banks, accepting virtuallyany collateral, including Greekgovernment bonds

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'The German governmentgives money to therescue fund so that it cangive money to the Irish

government so that theIrish government cangive money to Irishbanks so the Irish bankscan repay their loans tothe German banks,µ

But wouldn't it be easier for the German government to just pay the Germseparately, instead of taking this long and convoluted route?

The situation is pretty messy because itis interlinked. Take the case of Germany, which keeps contributing theECB rescue fund.

In case of Greece, a lot of Ger French banks which have lentwill be in trouble if Greece def 

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In 2004, interest rates in Hungary were at 12.5per cent. This meant borrowing money was

extremely expensive, In neighbouring Austria,

the banks had started to offer loans and

mortgages to their customers in Swiss francs.

Rates in Austria, at 2 per cent, may have been

lower than in Hungary, but in Switzerland, they

were even lower at around 0.5 per cent. Whywould Austrians borrow at 2 per cent when they

could just as easily borrow at 0.5% per cent?µ .

The same question applied to Hungarians,

except that the difference was much bigger. So

the Austrian banks, many of which also had

branches in Hungary began to engage in the

same business there, lending to Hungarianborrowers.

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 Austrian banks have lent 140% of their GDP to countries like Hungary. Even though Hungary has

put in austerity measures and is trying to repay, if there was a blow up, the Austrian government

wouldn't be able to save the banks and ECB might have to step in

Swedish banks have also lent a lot of money to Estonia, Lithuania and Latvia, countries which

aspire to have Euro as their currency some day

When countries go back to their own currencies to print it and repay debt, citizens will beaffected.

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When a country prints

currency in huge

quantities, the

currency will notremain of any real

value. So the citizens

of the country will try

and move their money

to either other assets

like gold, or willcontinue using the

euro. This will lead to

bank runs, with all the

people queuing up at

banks at the same

time demanding their money back. This, of 

course, will lead to a

lot of banks collapsing

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Mauldin and Tepper  

elaborate on this using the

example of Italy.

'Households and firms,anticipating that domesticdeposits would beredenominated into the lira(Italy's currency before it

started using the euro),which would then losevalue against the euro,would shift their depositsto other euro-area banks. Asystem-wide bank runwould follow. Investors

anticipating that their claims on the Italiangovernment would beredenominated into lirawould shift into claims onother euro-areagovernments, leading to a

bond market crisis. . . thiswould be the mother of allfinancial crises,' write theauthors,"

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Reference Book:ENDGAME

ByJOHN MAULDIN

AndJONATHAN TEPPER

eBook Publisher:

John Wiley & Sons

Imprint: Wiley

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Thanks to

Shonalee Biswas

(European debt crisis: Explained in SIMPLE terms)

www.rediff.com(My favourite Portal for the last decade)

&

Many Web sites for the images used in this presentation

Shashikant Kulkarnishashi1605@gmail.com