The 2008-09 U.S. financial crisis was huge, but it’s aftermath – still vibrant. While most countries struggled their way out of the global fall, a continent to specify, didn’t have an easy escape. The Eurozone or European Sovereign debt crisis, a multi-year debt crisis has been haunting the fates of European Union since 2009, leaving Eurozone members incapable of bailing out over-indebted financial institutions under national direction, minus intervention from major external monetary rescues. Needless to quote Sir Mervyn King it has been “the most serious financial crisis at least since the 1930s, if not ever.”

What went wrong?

Post the financial blow from U.S. in 2008-09, most global economies could no longer conceal their unsustainable fiscal policies, especially European nations. Greece and Germany amongst the PIIGS (Spain, Ireland, Italy, Portugal, and Greece) had enjoyed maritime for a long period, investing in R&D and productive purposes but unbothered to initiate fiscal reforms. Excessive use of available credit did increase the consumption but built up a large balance of payment deficit. And hence these countries were amongst the first to feel the onset of a fractured growth. This also meant a weaker growth of tax revenues, making high budget deficits even worse. Soon Greece’s debt account exceeded the size of its entire economy.

By default, investors analyzed the high risk and pinned their demand of higher yields on the country’s bonds which further added to the burden of debt it was already under. As a result, the situation called for mass bailouts by the European Union and the European Central Bank. The markets too responded in a similar fashion, redirecting yields of bonds into other heavily indebted nations and announcing the same problem. This built a vicious cycle – more the demand for higher yield, more will be the borrowing cost and more into debt crisis which intern meant more prompt for higher yields.

This also paved way for the “contagion” effect, whereby loss of confidence of investors meant not only the country to bear the consequences, but also countries with similar weak financial structure.

How did the Govt. respond?

Due to the restriction of initiating action only after consent of all nations in the union, the primary response has been slow yet massive bailouts for the troubled economies.

The European Union collectively with IMF disbursed $163 billion first, and $157 billion second to Greece alone, with more such funding for Ireland and Portugal. The European Financial Stability Facility (EFSF) was also created by Eurozone members for cover emergencies in troubled nations. The ECB agreed to purchase government bonds if needed at all to prevent surge in yields, which at this point seemed unaffordable by Italy and Spain. Under Long Term Refinancing Operation (LTRO) program, the ECB made credit equal to $639 billion available at low rates to the banks along with a second round.

In 2012, most financial institutions were running the dues of debt, which necessitated them to hold their scarce reserves instead of extending loans. Foreseeing how a low loan growth could worsen the crisis, the ECB helped banks boost their balance sheets to curb the potential threat.

But the larger issue still persisted. While tiny nations like Greece could be saved from the wrath of the crisis, larger nations like Spain and Italy were too big a system to be rescued. The countries’ ill financial health thus continued to be the cause of glitch at the markets for them.

In 2012, a positive turning point awaited the economies, when ECB President announced that ECB was hands down on doing whatever it takes to keep the Eurozone compact. As the news spread across global markets, the yields fell sharply later that year. It was definitely not a solution, but it did buy time for troubled countries to move their ways out as investors felt at comfort in buying the bonds of the tiny countries.

What was the problem with Default?

Put simply, why couldn’t a country start afresh by walking away from all its debts?

Unfortunately, it isn’t a cake walk for one big reason – although banks decreased their positions, they still held the government’s debt in the largest proportion.
As per norms, banks are required to maintain a certain amount of assets on their balance sheets against the debt they hold. Now if a country defaults on this debt, its bonds are bound to drown, which in turn results in reduction of assets or even possibly move towards insolvency. Thanks to the global economies coming closer than ever, a bank’s failure can never occur in complete vacuum. Instead it might create a spiral where series of banks fail and conclude with the domino effect or a more disastrous contagion.

What about the financial markets?

The possible stronger contagion made the crisis further more unstable. Investors had just survived the crash of 2008-09 and their default reaction to any bad news was quick – sell the risky and make purchases in countries most sound financially.
European market being the riskiest was the last choice for any potential investor and so European bank stocks and markets ill performed, especially at the crucial peak time of its crisis. The bond markets recorded a similar performance where increasing yields equated to falling prices. As a counter-reaction or a search for safety of the investors, the yields on U.S. Treasuries witnessed its historic low.
If something came as a little relief, it was the ECB’s plan to conserve the Eurozone. It gave an opportunity to the bond and equity market to reclaim their footing, conditioned a sustained growth.

What is the current outlook?
Today, the yields on debt have stooped extremely low. The high yields that followed up long ago appealed investors into the markets of Spain and Italy, resulting in increased prices and decreased yields. While this ensures greater comfort than risk in the bond markets for the investors, it is imperative to but translate it as slow economic growth and high chances of deflation. Following the path as carved by U.S. Federal Reserve, the ECB decided to slash the interest rates while working on a quantitative easing program. The risk of running a default has lowered but the problem of high government debt remains intact, making it difficult to allocate funds among the nations’ self-interest and the common good. The need to maintain austerity while not limiting national growth is still a vital challenge to address.
The European debt crisis has surely anticipated further economic shocks, and not just restricted to European region but the globe as a whole, and will likely make its presence felt for several years to come.

References –

Eurozone https://www.investopedia.com/terms/e/eurozone.asp#:~:text=The%20eurozone%2C%20officially%20known%20as,euro%20as%20their%20national%20currency.

U.S. Crisis
https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp

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