The Sovereign Debt Crisis In Europe

Published Date: 02 Nov 2017

Drue Verzosa

There is a sovereign debt crisis that is unfolding in the Eurozone economies that has began in Greece and the weak economies of Portugal, Ireland and Spain are "conspicuously vulnerable" (Moses, 2010). Portugal’s government deficit of 9.4% of GDP is highly at risk. The same can be said of Spain whose government deficit is 11.2% of GDP, close to that of Greece which is 13.6%. The most at risk to date is Ireland whose government deficit is 14.3% of GDP. The shortfalls as a share of gross domestic product were more than three times the European Union limit of 3 percent (Moses, 2010). "Greece is not the only potential problem," Svante Oeberg, First Deputy Governor of Swedish Central Bank, said in a speech posted on the Web site of the Stockholm-based Riksbank. According to "Other countries also have major problems and in a worst-case scenario, this could develop into a debt crisis in several countries, which also affects the bank system." (n.a, 2010) "On the face of it, a restructuring, a rescheduling or an external prop for the debt looks unavoidable" for Greece, Mark Schofield, head of interest-rate strategy at Citigroup Inc. in London, wrote in an investor note. That "could trigger rapid contagion that would cause a much graver problem should Spain, Portugal and Ireland be impacted," (Mnyanda & Jenkins, 2010)

Greece is the country that has lately been the main subject of speculation and discussion with regards to the sustainability of its public finances. Other countries are also experiencing serious problems. Among the euro countries, apart from Greece, these are mainly Portugal, Italy, Ireland and Spain.

Critical conditions for assessing how these countries shall attain a sustainable development of their public finances in the future are the current size of the public sector debt in relation to GDP, the credibility of their future fiscal policy and the conditions for growth in domestic and external demand. The larger a country’s debt in relation to its GDP, the greater its interest expenditure and the closer it is to an untenable situation which could lead to sovereign default.

Greece Dilemma

Greece economy grew at annual rate of 4.2% from year 2000 to 2007, one of the fastest growing economies in the Eurozone. This is mainly because of the influx of foreign capital. (grpresspoland, 2009)"A strong economy and falling bond yields allowed the government of Greece to run large structural deficits" (n.a, European sovereign debt crisis, 2011).

Decades of substantial public-finance deficits have meant that Greece entered this recession with a gross public debt of over 100 per cent of GDP. The growth of the Greek economy has so far been less affected by the global economic downturn than the OECD average. This is partly explained by Greece's relatively limited exposure to the world market but also by a considerable increase in public expenditure. This increase in expenditure, together with a slight fall in revenues, means that public sector indebtedness in Greece has increased to 115 per cent of GDP, and according to OECD forecasts from November it is expected to reach 130 per cent of GDP in 2011. (Öberg, 2010)

"Greece has been the notable example of an industrialized country that has faced difficulties in the markets because of rising debt levels" (n.a, European sovereign debt crisis, 2011).

The development of the central government debt in Greece, together with uncertainty about the country's ability to actually carry out the far-reaching consolidation of its public finances, has caused Greek government bond rates to rocket. The market participants have seen an imminent risk that Greece will not be able to overcome its debt crisis without outside assistance.

The 10-year Greek bond yield jumped 78 basis points to 9.58 percent on April 26, 2010 in London. The 6.25 percent security due in June 2020 slid 4.34, or 43.40 euros per 1,000-euro ($1,333) face amount, to 78.86. The two-year yield jumped 300 basis points to 13.96 percent, after soaring the most on record to 14.66 percent. (Kennedy & Krause-Jackson, 2010)

Greece’s fiscal crisis requires as much as 45 billion Euros of financial support from its European neighbors and the International Monetary Fund. Dominique Strauss-Kahn, the IMF’s managing director, said talks will end "in time to meet Greece’s needs." Finance Minister George Papaconstantinou said money will be available "rather soon" and warned investors they will "lose their shirts" if they bet the cash-strapped nation will default. (Kennedy & Krause-Jackson, 2010)

With 8.5 billion Euros of Greece’s bonds maturing May 19, 2010 Papaconstantinou said bridge loans may be possible should countries be unable to secure an accord in time. Left unsaid were what assistance Greece may receive beyond 2010 and what further austerity measures it will have to sign up to in return for aid.

"On 2 May 2010, a loan agreement was reached between Greece, the other Eurozone countries, and the International Monetary Fund. The deal consisted of an immediate €45 billion in loans to be provided in 2010, with more funds available later. (n.a, European sovereign debt crisis, 2011)

"A total of €110 billion has been agreed". (Thesing & Krause-Jackson, 2010) "The interest for the Eurozone loans is 5%, considered to be a rather high level for any bailout loan". (Hope, 2010) "The government of Greece agreed to impose a fourth and final round of austerity measures." (n.a, European sovereign debt crisis, 2011)

These include: (n.a, Knife in the 13th and 14th salary to the government, is preserved in the private sector, 2010)

"Public sector limit of €1,000 introduced to bi-annual bonus, abolished entirely for those earning over €3,000 a month." (n.a, European sovereign debt crisis, 2011)

"An 8% cut on public sector allowances and a 3% pay cut for DEKO (public sector utilities) employees". (n.a, European sovereign debt crisis, 2011)

"Limit of €800 per month to 13th and 14th month pension installments; abolished for pensioners receiving over €2,500 a month." (n.a, European sovereign debt crisis, 2011)

"Return of a special tax on high pensions." (n.a, European sovereign debt crisis, 2011)

"Changes were planned to the laws governing lay-offs and overtime pay." (n.a, European sovereign debt crisis, 2011)

"Extraordinary taxes imposed on company profits." (n.a, European sovereign debt crisis, 2011)

"Increases in VAT to 23%, 11% and 5.5%." (n.a, European sovereign debt crisis, 2011)

"10% rise in luxury taxes and taxes on alcohol, cigarettes, and fuel." (n.a, European sovereign debt crisis, 2011)

"Equalization of men's and women's pension age limits." (n.a, European sovereign debt crisis, 2011)

"General pension age has not changed, but a mechanism has been introduced to scale them to life expectancy changes." (n.a, European sovereign debt crisis, 2011)

"A financial stability fund has been created." (n.a, European sovereign debt crisis, 2011)

"Average retirement age for public sector workers has increased from 61 to 65." (Freidman, 2010)

"Public-owned companies to be reduced from 6,000 to 2,000." (Freidman, 2010)

Portugal Next?

"A report published in January 2011 by the Diário de Notícias, a leading Portuguese newspaper, demonstrated that in the period between the Carnation Revolution in 1974 and 2010, the democratic Portuguese Republic governments have encouraged over expenditure and investment bubbles through unclear public-private partnerships, funding numerous ineffective and unnecessary external consultancy and advising committees and firms, allowing considerable slippage in state-managed public works, inflating top management and head officers’ bonuses and wages, persistent and lasting recruitment policy that boosts the number of redundant public servants, along with the help of risky credit, public debt creation, and mismanaged European structural and cohesion funds across almost four decades, that the Prime Minister Socrates’ cabinet was not able to forecast or prevent at first hand in 2005, and later was incapable of doing anything to remediate the situation when the country was on the verge of bankruptcy by 2011". (n.a, Meet the real weight of the state, 2011)

The deficits are currently large in all of the vulnerable countries, but while Ireland and Spain have been able to show a balance or surplus during the years prior to the crisis, Italy and Portugal have shown a deficit throughout.

The strong growth in domestic demand in recent years and the weaker competitiveness have resulted in a current account deficit and thus rising foreign debts. In the case of countries with their own currencies one would expect a depreciation of the currency to restore competitiveness. This opportunity is not available to the countries in the euro area. Here, it is instead necessary for wages and prices to fall in relation to other countries. One difficulty in this context is that both public and private debts and the interest payable grow in real terms – that is, a larger part of production goes to meeting the costs of the debts. (Öberg, 2010)

What is the Solution

The importance of public finances for stable economic development in the slightly longer term should be emphasized. The situation with regard to general government net lending, that is the relationship between public-sector revenue and expenditure, has therefore deteriorated. This has in turn led to a substantial increase in public-sector indebtedness. The gross debt of the public sector in the OECD area has increased from 73 per cent of GDP in 2007 to 90 per cent of GDP in 2009 and will continue to grow rapidly as long as the large deficit remains.

There are a number of causes behind the substantial deficits in public finances. (Öberg, 2010)

Firstly, many countries were in a weak initial position even before the crisis began, as their public finances were already in deficit. Many countries failed to save money for a rainy day when times were good. This is illustrated by the fact that in the decade prior to the crisis average general government net lending was -2 per cent of GDP in the OECD area, the USA and the euro area. In the case of the euro area this is remarkable given that the so-called growth and stability pact stipulates that the aim should be to achieve a balance or a surplus in public finances in the medium term.

Secondly, a downturn automatically leads to a weakening of public finances. Tax

Revenues fall and cyclical expenditure, for example on labor-market policy, increases. The OECD estimates that this effect has accounted for just under half of the total deterioration in public finances since 2007.

Thirdly, most countries have implemented extensive fiscal policy stimulus

Measures. The OECD estimates that these measures have accounted for just over half of the reduction in general government net lending in the OECD area. In the United States, where stimulus packages have been introduced on an unprecedented scale, the OECD estimates that these active stimulus measures have accounted for as much as three-quarters of the deterioration in public-sector finances. In the euro area it is instead the automatic effects on tax revenues and cyclical expenditures that have predominated.

Lessons from Other Countries

Developments in Germany show that such internal cost-cutting in relation to other countries is fully possible. The combination of a muted growth in nominal wages and productivity improvements has led to unit labor costs in Germany falling by 15 per cent since 2000, compared with the euro area as a whole. In the Baltic countries, which have not yet adopted the euro, but have retained fixed exchange rates throughout the crisis, one can even see falling wages.

In the United Kingdom, following several years of a deficit in the region of 3 per cent of GDP, the crisis entailed a rapid deterioration to a deficit of 13 per cent in 2009. According to the OECD's forecast, gross public debt in the United Kingdom will double between 2007 and 2011. Here, too, we can see an increase in unit labor costs compared to the euro area, but the crucial difference is that the weaker pound has made it possible to strengthen competitiveness.

Like the countries in the euro area whose public finances are in a poor state today, Sweden had also experienced problems with the development of costs. However, unlike these countries, it was possible for us to limit the loss of competitiveness by means of a depreciation of the currency, just as in the United Kingdom today.

Sweden had a long-established pattern of substantial surpluses in public finances in normal times, which probably increased the credibility of our consolidation measures and thus limited our costs for financing the central government debt. The strong public finances to start with have helped Sweden to pursue an expansionary fiscal policy during the crisis without putting the long-term sustainability of public finances at risk, and to keep interest rates down at German levels.

One of the reasons why public finances in Sweden are so strong is that after the crisis of the 1990s the government and parliament formulated a surplus target for the public sector. Public finances were to show a surplus of 2 per cent of GDP over an economic cycle. This was in line with the growth and stability pact in the EU, which among other things meant that public finances should be in balance in the medium term, or show a surplus.

A Point to Consider

Economic analyst has highlighted the importance of continually using a surplus target for public finances in the long term. Firstly, it will strengthen the country’s ability to manage crises and recessions. If there is a public-finance surplus when a crisis begins, there is little risk that the deficit will exceed the 3 per cent of GDP limit of the growth and stability pact when the crisis is most severe. Secondly, averaging a surplus over an economic cycle means that the indebtedness and interest expenditure of the public sector will decrease over time.

The debt crises in several areas of the world particularly in weak economies of the Eurozone illustrated the importance of sustainable public finances. Due to large deficits in public finances in the wake of the financial crisis, it lead to higher interest rates and will force tighter fiscal policy to be conducted, which will in turn subdue growth.