Europe Debt Crisis the Maastricht

Europe Debt Crisis

The Maastricht Treaty produced a set of criteria which were to be met by countries seeking to join the Eurozone and adopt the euro as their currency. During the initial evaluation, Greece failed to meet the criteria, but later gained entry by way of fraud. The current economic crisis has exposed Greece and created a sovereign debt crisis in that country. Other economies have also suffered, in particular Ireland and Spain, which both face deflation and sky-high unemployment.

The situation in Greece is the worst of the three, with its debt achieving junk status as the interest rate on the 10-year note breaking the 10% barrier. The result is that each of these countries will be forced to face potentially years of debilitating deflation and unemployment in order to bring costs into line and restore those countries to international competitiveness. Stronger Eurozone countries will also suffer, as they will be forced to make transfers to weaker nations in order to maintain the stability of the currency union.

Introduction

In December 2009, Fitch downgraded the rating on Greece's long-term debt from A- to BBB+, marking the beginning of the Euro debt crisis. Greece has become the poster child for the problems in the Eurozone as a result of this crisis, but it was not alone in having difficulties. The Greek government, faced with an increased cost of borrowing, was forced to respond with austerity measures to get its deficit under control in order to demonstrate to bond markets that it could meet its obligations. These measures brought significant protest from the Greek people. More austerity measures were introduced, but even these could not stave off the need for a bailout, funded primarily by Germany (Wearden, 2010). The crisis in Greece is the most intense in Europe, but other Euro countries -- most notably Span and Ireland -- have also come under threat of similar crisis. Unlike Greece, however, those other two have not required bailouts, though they have seen their borrowing costs increase over the course of 2010 (Krugman, 2010). This paper will study the Eurozone debt crisis, with particular attention to the cases of Greece, Spain and Ireland. An attempt will be made to explain the nature of the crisis, and what the ramifications are of the increase in sovereign risk in these three countries.

Joining the Eurozone

The first distinction that needs to be made is between the European Union and the Eurozone. The European Union is a political body that attempts to streamline trade between its members and provides a consistent environment with respect to the governance of trade outside of the bloc. Within the European Union, sixteen of the twenty-seven constituent states have adopted a single currency, known as the Euro. These countries form the Eurozone. This distinction is critical because the nature of the common currency is one of the reasons why economic commentators are most concerned about the debt situations in Greece, Spain and Ireland.

The first of the three countries to join the European Union was Ireland, in 1973. Greece joined in 1981 and Spain followed in 1986. When the Euro was created, Ireland and Spain were among the founding members of that currency zone. Their currencies were pegged to the Euro in 1998 and when the Euro came into existence in 2002, Ireland and Spain adopted the common currency. Greece's ascension into the Eurozone came later. The drachma was first pegged to the Euro in 2000, and Greece was able to adopt the Euro upon its inception in January 2002.

The steps that Greece undertook to enable it to join the Eurozone were dramatic, and included steep cuts in inflation and interest rates. While the Greek government hailed this achievement at the time, there were problems, particularly concerns with the ability of Greece to maintain the strength of its economy (Wearden, 2010). Greece had been left out of the Eurozone initially in 1999 because it had failed to meet the strict economic criteria for inclusion. At the time, investors worried that Greece's inflation rates were still too high, as was its level of public debt (BBC, 2001). These criteria are known as the Maastricht Criteria, a reference to the Maastricht Treaty that in 1992 signaled the intention to create a common European currency.

The Maastricht Criteria

The Maastricht Criteria were the set of economic conditions that countries had to meet in order to join the Eurozone. The criteria are, as defined in Article 121(1) of the European Community Treaty, as follows:

1. "The achievement of a high degree of price stability; this will be apparent from a rate of inflation which is close to that of, at most, the three best-performing Member States in terms of price stability." This was defined as being a rate of inflation that does not exceed by more than 1.5 percentage points of the three best-performing member states."

2. "The sustainability of the government financial position; this will be apparent from having achieved a government budgetary position without a deficit that is excessive, as determined in accordance with Article 104 (6)." This was defined as a deficit to GDP ratio no greater than 3%.

3. "The observance of the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System, for at least two years, without devaluing against the currency of any other Member State."

4. "The durability of convergence achieved by the Member State and of its participation in the exchange-rate mechanism of the European Monetary System being reflected in the long-term interest-rate levels." This was defined as the country having an interest rate that does not exceed by more than 2 percentage points that of the three best-performing members. (European Central Bank, 2010).

Greece met the third condition by virtue of having tied its currency to the Euro on January 1, 2000, allowing it to adopt the Euro when the first European notes and coins were released on January 1, 2002. Greece initiated an austerity program in order to cut inflation and interest rates in time for 1999, when those numbers would be examined for consideration of entry into the Eurozone. In 1998, when Greece was not admitted for entry into the Eurozone, it had an inflation rate of 5.2%, a deficit to GDP ratio of 4% and long-term interest rates of 9.8%. These figures were significantly above those of other nations being admitted into the Eurozone and as a consequence Greece was rejected (Antweiler, 2001).

The wording of the criteria allows for some flexibility, however. Admittance to the Eurozone need not be based on strict meeting of the entry criteria, but rather on a demonstration of fiscal stability. If a nation falls outside the Maastricht Criteria, but can demonstrate that these figures are moving in the right direction strongly, it can be admitted. It has been intimated that both France and Germany had temporary deficits above the 3% criteria, but that this was forgiven in order to ensure the strength of the new currency (BBC, 2004). Indeed, if the deficit criteria are not met, then a debt criterion must be met, set at 60% of GDP. While France and Germany sat around that level, many countries that were admitted to the Eurozone were well above that level, including Belgium (122.2%), Italy (121.6%) and the Netherlands (72.1%) (Antweiler, 2001). The debt criteria, then, was largely overlooked as a means by which to judge the public finances of the countries applying for membership to the Eurozone. Greece, however, had a very high level of public debt in 1997 of 108.7%, the third-highest of all candidates.

In 2004, Greece revealed that it had fudged some of the numbers that were used to allow it to become admitted into the Eurozone. In particular, its level of deficit in 1999 -- the year being measured -- was 3.38%, well above the 3% threshold. This represented an improvement, however, and the European Central Bank decided not to take action against Greece at the time, even though its deficit had ballooned in the interim as a result of the cost of hosting the 2004 Summer Olympic Games (BBC, 2004). By 2004, the Greek deficit had hit 5.3% of GDP and the total debt had hit 112% of GDP. Among the causes were that military spending was not included in the budget and some debt -- including that used to fund public services -- was hidden from the budget as well (BBC, 2004, 2).

For their part, Ireland and Spain met the Maastricht Criteria in 1998 and were allowed to join the Eurozone immediately. Ireland had inflation of 1.2%, a budget surplus, and long-term interest rates at 6.2%, well below the target of 7.8%. Spain had an inflation rate of 1.8%, a deficit of 2.6% of GDP and long-term interest rates of 6.3% (Antweiler, 2001). At the time, these countries looked as stable as any other in the Eurozone. Although each had government debt over 60% of GDP, their figures were not out of line with those of other states in the Eurozone, save for the outliers at the high (Belgium, Italy and Greece) and low (Luxembourg) ends.

2004-2010: The Building of a Crisis

Greece's admittance into the Eurozone had its skeptics at the time it happened, and the controversy increased with the admission in 2004 that the deficit figure was fudged in order to allow Greece to join the exchange rate mechanism on January 1, 2000, which was key to the country being allowed to use the Euro when the currency was first introduced on January 1, 2002.

Between 1999 and 2007, the three Eurozone countries with the highest rates of inflation were Ireland, Greece and Spain respectively, each topping 3% per year (de Grauwe, 2009). This inflation was the first sign of the bubble that would eventually become a significant contributor to the debt crisis. Those economies each expanded rapidly in the middle part of the last decade. The following table illustrates the real GDP growth rate of the study countries in the years 2004-2010, the latter figure being an estimate (Eurostat, 2010).

Real GDP growth

2004

2005

2006

2007

2008

2009

2010*

Greece

4.6

2.2

4.5

4.5

2.0

-2.0

-3.0

Ireland

4.6

6.2

5.4

6.0

-3.0

-7.1

-0.9

Spain

3.3

3.6

4.0

3.6

0.9

-3.6

-0.4

Germany

1.2

0.8

3.4

2.7

1.0

-4.7

1.2

This table shows the size of the bubble in Greece, Ireland and Spain relative to the relatively minor bubble in Germany. The country with the most intense bubble, Ireland, saw the biggest contraction. Spain saw a steadier, more modest bubble and its decline has also been slower, steadier. Greece saw a modest bubble during the latter part of the decade, but its current debt crisis has precipitated estimates of a stronger contraction of GDP than is currently being experienced by either Spain or Ireland, which have not been forced into austerity measures as drastic as those imposed on Greece. Germany, by contrast, had a soft bubble and after one year of strong contraction has seen growth renew, a function of lower interest rates, a sound banking system and a strong export economy.

The following table illustrates the rates on the 10-year bond for Greece, Ireland, Spain and Germany (benchmark) from 2004 to 2007 (Eurostat, 2010):

10-Year Rate

2004

2005

2006

2007

2008

2009

2010

Greece

4.25

3.58

4.07

4.29

4.40

5.57

6.05

Ireland

4.08

3.33

3.74

4.04

4.25

5.01

4.80

Spain

4.10

3.39

3.78

4.07

4.22

4.11

4.01

Germany

4.04

3.35

3.76

4.02

4.04

3.09

3.29

What this chart indicates is that for the most part, spreads against the benchmark (Germany) did not increase significantly during this period for any of the study countries. Spain maintained a slight risk premium. At the height of Ireland's economic boom, it had lower rates than Germany. Greece maintained a risk premium ranging between 21 points and 31 points. In the last three years, while rates in Germany have fallen, rates in these three countries have taken a different trajectory. Spain's performance has been the best, with rates remaining relatively stable. While this has increased the risk premium over German bonds, it is not cause for crisis. While the 10-year Spanish rate spike somewhat in June and July of 2010, it has since fallen back down to 4.13% today (TradingEconomics.com, 2010). The Irish rate has increased recently, causing a widening in the spread against Germany, and the current rate of 5.31% represents a high level for Irish debt. Greece, however, shows the truest signs of crisis. The 10-year rate increased steadily into the beginning of 2010 as debt fears mounted. The Fitch downgrade was followed by an S&P downgrade to junk status and this along with concerns that even the German stimulus may be insufficient to rescue Greece has caused rates to spike to 10.26% (TradingEconomics.com, 2010). This brings the spread against the German bond to 773 points, orders of magnitude higher than the previous 21 to 31 point range from 2004 to 2007.

Inflation rates in each of these countries can be found in the following table, a measure of HICP (

harmonized index of consumer prices) annual average rate of change (Eurostat, 2010).

HICP

2004

2005

2006

2007

2008

2009

2010

Greece

3.0

3.5

3.3

3.0

4.2

1.3

Ireland

2.3

2.2

2.7

2.9

3.1

-1.7

Spain

3.1

3.4

3.6

2.8

4.1

-0.6

Germany

1.8

1.9

1.8

2.3

2.8

0.2

Each of the three troubled economies faced strong bubbles. If the same "best three-performing economies" criterion was used as per the Maastricht Treaty, that figure would have been the mean of the HICP for Germany, the Netherlands and Portugal, which comes to 2.56. Despite the consistently higher rates of inflation in Ireland, Greece and Spain only the latter two in 2008 would have failed to meet the Maastricht Criteria on the basis of inflation rates. However, the consistently high rates of inflation produced the bubble in prices that has lead not only to the debt crisis but to the claims of economists and observers that these countries will have significant difficulty recovering quickly from the crisis.

Another key economic measure is unemployment, as measured in the following table, again with data from Eurostat (2010).

Unemployment Rate

2004

2005

2006

2007

2008

2009

2010

Greece

10.5

9.9

8.9

8.3

7.7

9.5

Ireland

4.5

4.4

4.5

4.6

6.3

11.9

Spain

10.6

9.2

8.5

8.3

11.3

18.0

Germany

9.8

10.7

9.8

8.4

7.3

7.5

Whereas Germany has seen its unemployment rate fall in the second half of the decade, the other countries saw their rates spike. The rates in Ireland and Spain in particular have shot high as the result of the global economic slowdown. The importance of unemployment is that it not only creates a social ill that must be remedied, but it also provides a systemic barrier to economic recovery, in particular if that unemployment becomes structural in nature itself.

The final key economic variable is the level of public debt as a percentage of GDP. These figures, again compiled from Eurostat (2010) are as follows:

Borrowings as % of GDP

2004

2005

2006

2007

2008

2009

2010

Greece

-7.5

-5.2

-3.6

-5.1

-7.7

-13.6

Ireland

1.4

1.6

3.0

0.1

-7.3

-14.3

Spain

-0.3

1.0

2.0

1.9

-4.1

-11.2

Germany

-3.8

-3.3

-1.6

-0.2

0.0

-3.3

Again, these figures show the depth of the crisis in Greece, Ireland and Spain. While the former two were able to show strong financial performance at the height the bubble, a collapse in inflows has resulted in significant increases to the national deficits in the past couple of years. By contrast, Greece never saw strong financial performance during its bubble, and has continually increased the amount of federal borrowing since 2004, which combined with Olympic-related borrowing means that Greece has increased its borrowing ever since being admitted into the Eurozone.

Causes and Consequences Associated with the Increase in Sovereign Risk

The economic analysis above indicates that each of the three countries faces a crisis that is slightly different. The situation in Greece is by far the worst in terms of debt and deficit. Greece has never been able to meet the Maastricht criteria. Indeed, while it showed improvements in 1999 sufficient to convince the European Central Bank to allow it into the Eurozone, its performance began to deteriorate almost immediately. Greece is currently facing a GDP that continues to decline, even as other nations show signs of recovery. More importantly, its sovereign risk has increased significantly, such that long-term rates on its bonds are in line with junk status.

For Greece, addressing the problem will be difficult. Financial markets have demanded austerity measures to indicate that Greece is finally going to live up to its debt and deficit obligations. Only by working towards these obligations will the high cost of borrowing come down. These measures, however, will only serve to increase unemployment, making the recovery more difficult by adding to the level of structural unemployment. Part of the problem for Greece is the fact that it is in the Eurozone. Typically, a country facing such a crisis could devalue its currency in order to make the country more competitive in export markets, spurring recovery (Krugman, 2010). Instead, it has no power to improve its international competitiveness through monetary measures. Instead, Greece is likely going to require further bailouts, Eurozone inflation or both in order to spur some sort of recovery amid strict public sector austerity measures (Ibid). Some measure of deflation in Greek prices will also be required, and as of January 1, 2010 Greece still had positive inflation (Eurostat, 2010).