Understanding what the Euro Debt Crisis is all about

You’ve heard it all over the news; the Euro Debt Crisis.  We know it is serious and it could affect millions of people in Europe, here in Canada, and throughout the world.  But, have you ever sat back and asked yourself, “What is the Euro Debt Crisis really all about?”  If you are unfamiliar with the Euro Debt Crisis, keep reading as I spell it out in this post.  I’m going to try and explain the Euro from when it was just a dream to the impacts it has caused in Greece, Germany, and many other European countries today.

A large portion of my information is from the show “Continental Breakup” on the podcast “This American Life”.  I highly recommend listening to this podcast.  It will give you even more information of the crisis and give you some names of the key individuals involved in its development.

Click here to visit the “This American Life” web page and listen to the podcast “Continental Breakup”.

So here we go!  Grab a coffee; this might be one of my much longer posts.

The Idea of a United Currency

The idea of a united currency is not a new concept.  It has been a dream for well over 150 years.  The reason why a united Europe was such a big dream was because if Europe was united, there would be less war and more peace among the nations.  The nations would be tied to each other’s markets and currency.  If you were going to go to war with a country with the same currency, you were putting your own economic health at risk.  The idea was centered on peace.

It remained a dream until shortly after WWII.  Germany was defeated and they wanted to be embraced again; they did not want to dominate Europe or be perceived as wanting to.  They wanted to change the image the world had of them and truly wanted to be a team player with the rest of Europe.  This was in line with France as well; France did not want Germany to dominate Europe for obvious reasons.  Their common goal was to share the same currency.  France wanted the stability and progress that the German currency could offer and Germany wanted to be part of a united Europe.  But still France wanted their independence; they did not want to be Germany.  And Germany wanted to remain Germany.

Germans were, and still are, afraid of inflation.  In the 1920’s Germany went through horrible hyper- inflation period.  The economy greatly suffered, but most of all the people suffered and this has stuck in the German DNA ever since.  Inflation was to always be watched and never messed with.  This was a big concern for Germany, a fear that could be faced if there was a united currency.

The two countries discussed and debated over the united currency issue for what seemed like forever.  In fact it took about 30 odd years for the two to finally agree.  It all came in 1989 as the Berlin Wall that divided East and West Germany came down.  It was decided that a similar currency would work, but countries would keep their state; there would be no central government.

The French were happy; they would have a strong currency and would be able to remain French.  The Germans were happy; they were now united.  But, Germany strictly said that countries who join the currency must abide by their rules.  These rules included: borrowing responsibly, watching the government deficit, and most importantly, keeping a thumb on inflation.

This seemed great.  Europe was headed towards being more like Germany, which was a very economically strong country.  Other countries in Europe were eager to agree with the rules set by Germany.  Having your currency tied to Germany was beneficial because it meant stability and progress.  But for some, these rules were very unrealistic.

In the 90s it was ludicrous to think that Greece or Italy would join the union.  Greece had inflation as high as 20% and Italy had a deficit that did not follow the rules.  But soon that changed.

 

Hello.  My Name is Greece and I would like to join your Club.

Greece started producing country data that would allow them to join the European Union.  The data they were showing suggested that Greece was becoming more like Germany.  Inflation was in check and the deficit was being handled.  But there was a problem.

Germany and France did not believe Greece’s data.  They strongly felt that the numbers were wrong and that Greece was being more like Greece, not Germany.  But here is where the story gets weird.  Nobody said anything; no one.  Not France or Germany.  But why?  Why would no one point out or challenge Greece’s numbers when it was fairly obvious that they were fudged?  Well my friends, it’s always for the same reason: money.

You have two sides.  The first are the poor countries.  These countries want the stability and progress the Euro provided.  The second are the rich countries like Germany.  With millions of new people using the same currency as Germany, the German marketplace would get a lot bigger, and the people in that market would became relatively wealthier.  This meant big money for Germany.  So in 2002 the Euro was born.

 

It’s a new baby boy!  What are you going to name it?  The Euro.

Europe now had a united currency.  Trade became simple and companies no longer had to worry about exchange risk while selling their products within the Euro zone; life was good.  But with this new currency came some new changes.

One change that happened in Greece was the banking system.  It was simple before. Banking was borrowing at one rate and lending at a higher rate.  But banking soon became more like a grocery store.  The bank would offer products to sell to customers.  Customers could buy a product that fit their certain situation.  Derivatives were used, loans were grouped, and things became more complicated.  The term “Retail Banking” now became the norm.

Another change that Greek banks were able to make was significantly lowering loan rates.  Bankers would see the rates drop every week; 20%, then 18%, 16%, 10%, and down to 4%.  This meant that money became cheap.  Had a mortgage that cost you $2000?  Well now that same mortgage is around $1200.  There were significant changes that happened for no real reason.  Companies started investing in projects that would never have started before and individuals starting buying cars, vacations, and new houses they would never have bought before.

It started to get a little out of hand.  One example is a small town in Greece that decided they wanted an international airport.  There was no need for the airport and it was definitely not going to be profitable, but money was cheap and the town wanted it.  So, up went an airport.  This happened across Europe in Spain, Ireland, Italy, and Portugal to name a few.

Government didn’t stay out of the fun either.  With all this new money, the Greek government decided to address their high unemployment problem.  They made more government jobs.  This is risky because a government job does not increase GDP, there is no real profit investing in government jobs.  Now this is fine if you have a strong GDP and can afford to pay for these positions from revenue (taxes), but when you are paying for these jobs through debt… well that’s a problem.  And some of the jobs were ridiculous.  There was one committee formed to overlook the drying of a lake.  That alone sounds crazy, but what’s even crazier is that the lake had been dry for over 30 years!  But, employees kept getting paid.

People started to ask themselves, “Where is all this money coming from?”  Good question.  Well it turns out a good chunk came from a company in the states called Pimco.  Pimco is a bond trading company.  What this company does is manage money for institutional clients.  They manage money for pensions, universities, governments, life insurance companies… really big institutions.  The total amount of funds managed under the company was around $1 Trillion.  The policy is to invest in very safe (low risk) investments for their clients, usually investment grade bonds of reputable companies and countries.

What happened over night was that countries like Greece, Spain, Italy, Ireland, and Portugal (all countries that would normally be considered unsafe) became safe.  How does this happen?  Well, they were now under the Euro, these countries were in a way under the umbrella of Germany, France and other strong European countries.  Now that these countries’ bonds became “safe” to invest in, Pimco started buying them up by the truck load and these countries now saw a flood of money pour in.  But the golden goose couldn’t last forever.

 

It looks like we may have made a mistake.

In 2009 Greece had an election.  A new party came into power and a new truth came to light.  It seems as though that the Greece Statistics Department “sort of” reported incorrect numbers.  The reported deficit-to-GDP was currently at around 6%, but the new government said it was more like 13%.  That’s more than double what had originally been stated.  This is bad.

Pimco, that bond trading company who bought up all those Greece Bonds, based their acquisitions on the 6% number.  But now, with this new 13% number, the amount of risk more than doubled in their portfolio overnight.  So Pimco did what they were required to do; they liquidated their holdings of all Greece, Portugal, and Spanish bonds.  Portugal and Spain didn’t actually mess with their numbers, but there was fear in the market and investment companies began to question whether these countries were as safe as they thought.

That was just the tip of the problem for Greece.  Greece needed to raise more money (mostly to pay for the debt they already built up), so they went to Pimco and offered new bonds.  Pimco said no thank you.  Greece offered rates that were very enticing, but there was just no confidence in Greece politics or the country’s economy.

But that’s not the worst part.  Normally a country could print more money to pay off their debt.  This would lead to the value of their currency going down and inflation rising, but you wouldn’t default on your loans.  But, remember Greece was not independent; they were tied to the Euro.  Greece could not print money.  The Euro became a curse; it was the ECBs decision to print money, not theirs.  Enter crisis mode.

 

We shall force the rules.

The solution the ECB decided on was to strongly enforce the rules laid out when the Euro was created.  The deficit would be tracked, inflation would be watched, and the rules would be followed.  The ECB sent a technocrat to Greece to try and solve the riddle of the vastly different Deficit-to-GDP ratios.

When the technocrat began looking through the data, he soon realized the task was harder than he anticipated.  One task he had to complete before the real ratio could be calculated was to answer the question, “Who was government?”  Seems like an easy question right?  Government is well Government!  But the technocrat soon discovered that many private companies were actually parts of the government.    How many of these companies were there?  There were 17 in total, and none of them had been accounted for in the ratio.

With this new information, the technocrat was now able to compute the ratio.  The deficit-to-GDP ratio for Greece in 2009 ended up being 15.8%.  Even higher than what was sighted before as the “real” number.  The ECB said, “Okay, this is bad, but at least we have a number to work with now, let’s move on.” But it wasn’t that easy.

The old head of the Greece Statistics Department said that this number was bogus.  He demanded that the staff should be able to vote on what the correct number was.  The staff even protested and occupied the Statistical Office to push their view.  But this is where the story gets weird again.  The technocrat was asked to come to a meeting with the council.  He thought it was to discuss the number, but it turned out he was being accused of treason.  The official charge was “Breach of faith against the state.”  The old leader felt this was a plan devised by ECB leaders and the technocrat to make Greece look bad, which would then allow them to send in their own team to run things how they wanted.  So the technocrat now finds himself on trial and may possibly spend life in prison.  This is his reward for trying to restore confidence back in Greece.  Oh, and did I forget to mention he was originally from Greece?

 

Ah Mamma Mia!!!

The problem isn’t so much if Greece fails.  That would be bad.  Actually, it would be really bad.  But the real problem is the chain reaction that could, and probably would, happen if Greece failed.  We could see Spain, Portugal, Ireland, and eventually Italy all start to fail as well.  Now what’s so important about Italy?  Well my parents are from there, but that’s not the biggest factor.  Italy is the 7th biggest market in the world.  If Italy failed then we would be in real big trouble.

The recovery in North America from the 2008 recession would be even slower.  Jobs would slow down and unemployment would reach high levels again.  Companies would invest less and cut down their work force.  Confidence in the market and countries would be lost.

This is why the debt crisis is so important.  We are tied globally now.  Our markets are no longer independent.  If countries start failing in the East, we would feel the impacts in the West.  So what is the plan?

Well the ECB still has strong pressure from Germany and they want countries to stick by the rules.  If you remember from earlier in the post, the rules are: borrow responsibly, watch the government deficit, and most importantly, keep a thumb on inflation.  Forming a plan with the rules in mind would mean: a) cut spending.  This means cutting all those government jobs created in Greece.  Seems logical, but those are real people.  Cutting jobs means people will face hard times, even harder than it already is. B) Raise taxes.  This is to help reduce the deficit, but people who are already poor and in hard times may not be able to bear that extra tax.

This plan is a little scary because unemployment is already in the high teens/low twenties (that’s great depression levels) and the plan might not actually work out too well.  A lot of people in Greece are working but not getting paid.  There is an example in the podcast that talks about a doctor who works for a government lab.  This lab is producing research and products that are helping Greece’s GDP, but there is no money for funding.  So this doctor and many other employees are working for free.  She explains how she hasn’t been paid for months.  She keeps working because she feels that if she helps the lab make money, eventually she will get back those missed earnings.  So if your raise tax rates on revenues that are near zero will the plan really work?

 

Was the Euro a good idea?

This is a topic that is really hard to get your head around.  The Euro has been great for some countries.  Markets grew, exports increased, and costs went down for countries which had a strong market to begin with.  For the poor countries there was a period of bliss; money rolled in and people lived well.  And they were able to share in the stability and progress of stronger countries.  Now, the story has changed for many of those countries.  Times are harder than they have been in a long time and they have no control over their own monetary or fiscal policies to get them out.

A benefit of the Euro was unity.  It has helped unify the countries of Europe.  Trade became less complicated and currency risk became less of a problem for those companies exporting to other parts of Europe.  And most people still like the Euro, even in Greece, despite the chaos that arose from it.

What really needs to happen is that the Euro needs to devalue.  The ECB needs to print more money; that means bailouts.  Bailouts aren’t fun and they really aren’t great for other countries involved, but it is the less of two evils.  If Greece failed thousands of people would be greatly affected, possibly even millions. And as we discussed earlier, the probability is high that it would cause a domino effect on other markets.

Greece needs to be able to be competitive in their export markets once again.  The same goes for Spain, Portugal, Ireland, and Italy.  But, there is a problem; Germany hates inflation.  In fact, they are downright scared of inflation, which is logical considering their past experience with hyper-inflation.  As long as Germany has the most say in the Euro, bailouts will be smaller than they really need to be (to control inflation), and this debt crisis will keep going and going.

So if this is not the solution, what is?  Well, currently the rules state that countries using the Euro must act like Germany.  This is really an ideal.  If everyone was like Germany fiscally, it would probably be a good thing for markets.  But, the problem is not every country is like Germany.  The people are different, the cultures are different, the education is different, and the governments are different.  Everyone being like Germany is a plan that is just too far out and unreachable.  So what is more achievable?

Instead of everyone moving towards one end, it may make sense for everyone to move towards the middle.  This would mean everyone should try to be a bit more like Germany and Germany should be a bit more like everyone else.  This is the only path that I see having a chance of making the Euro work.

What else must happen is there must be a third party review of numbers submitted for tracking country performance and debt levels.  There cannot be another incident where a key statistic in bond valuation has three vastly different values.  There must also be accountability for fixing numbers and there should be a system in place that makes challenging statistics acceptable.

No matter what plan is chosen, there is going to be hardship.  Countries in the Euro Zone are going to have hard times for years to come.  Small bailouts will help, but they won’t cure anything; they will just prolong the pain.  Kicking Greece and other underperforming countries out of the Euro group may help, and would probably be good for them in the long run, but the short-term and the long-term would be extremely painful.  And kicking these groups out will have implications for the strong countries as well: their markets will shrink and growth will slow.

The truth is the answer is not easy.  Any plan will have dramatic effects on people and the economy, but delaying a plan is just turning the crisis into a bigger problem that will be harder to fix down the road.  There needs to be a serious plan with teeth, and it needs to happen soon.

 

Thanks for reading and good luck out there!

Remember to check out the “Continental Breakup” show on the podcast “This American Life”.  It will give you much more information about the crisis and some of the names of the people involved.

Click here to visit the “This American Life” web page and listen to the podcast “Continental Breakup”.

What do you think?  What are your views on the issue?  What do you think the solution is?  Leave a comment below to share your thoughts.

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