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From Special Report:

The anatomy of a crisis

Billions have been spent in bailouts and action from central banks, but Europe remains on the brink

By Richard Dunbar | Published Sep 24, 2012 | comments

Perhaps the euro was always going to be an act of folly. Its aims, like most acts of folly, were undoubtedly laudable: never again would Europe be torn apart by its differences.

A common currency, it was thought, would bring nations together. A convergence of economic interest would, ultimately, lead to closer fiscal and political bonds. But those hopes are fading. Far from aligning Europe, the single currency project has served to further expose the continent’s entrenched social and cultural differences.

The causes of the eurozone debt crisis are well documented. Historically low interest rates allowed governments and consumers to borrow cheaply – and they did so with gusto. German banks, lest we forget, were at the forefront of this lending. The prerequisite fiscal adjustments and tough economic reforms set out by the Maastricht Treaty were roundly ignored, masked by extravagant spending binges. Then Lehman Brothers collapsed, the inflow of foreign capital stopped and the woeful state of many periphery nations’ finances was laid bare.

The result? Billions of euros in bailouts, massive policy action from central banks and lashings of austerity. And yet we remain at the precipice. Politicians have been found wanting, often moving only as quickly as their electorates will allow. That is as much a consequence of ineffectual communication than genuine voter revolt. But there is still time.

If the crisis is to be solved, however, the diagnosis must first be right. For too long policy has been either too small or aimed at the wrong problem. Only once we understand the genesis of the crisis can we fully expect to resolve it. This is not merely a debt crisis: it is a political crisis, a currency crisis, a banking crisis, a social crisis, a property crisis and a tax crisis.


If the euro is to fail, the blame will, rightly or wrongly, be laid at Greece’s door. The Hellenic Republic has certainly become a model for profligacy, inefficiency and, some would say, corruption. No better place is this illustrated than Greece’s approach to tax.

It has been estimated that, prior to the eruption of the debt crisis, Greece lost roughly €19bn (£15.2bn) a year in uncollected tax, some 27 per cent of total revenues. For years, legal loopholes have made tax evasion a national pastime. One oft-quoted fact, courtesy of the former head of the government’s economic department, is that there are more Porsche Cayennes registered in Greece than there are taxpayers declaring income of more than €50,000.

Even now, with the world’s spotlight trained on Athens, little has been done to close these loopholes. To exacerbate matters, since the start of 2012 revenues have fallen by a third. Funding for schools, hospitals and other vital institutions is in danger of drying up. During the days of debt-fuelled extravagance, this wouldn’t have mattered. But that tap has been turned off. A new government may have been sworn in, but its task remains colossal. Even now, a Greek exit from the euro looks a real possibility.

Maybe, though, the Greeks deserve a modicum of sympathy. After all, its eurozone peers – including Germany – knew at the dawn of the euro that Greece did not meet the strict entry criteria as set out by the Maastricht Treaty. It was hoped that, given enough time and sufficient financial incentives, Greece would ultimately get its house in order. No such thing happened. The government went on a spending spree, while international investment banks deftly finessed the figures. But, as has been said before: if you invite an alcoholic to your party, you can’t blame them for drinking all your booze.


Spain’s troubles stem not from government extravagance – in 2007 debt-to-GDP was only 36 per cent, compared with Germany’s 65 per cent – but from a massive US-like property bubble, fuelled by reckless lending from regional savings banks (or cajas).

Unencumbered by regulation or central oversight, banks lent vast sums to property developers and home buyers. Properties sprung up across the country, and the construction industry flourished, employing tens of thousands of workers from across the age spectrum. House prices, meanwhile, tripled between 1996 and 2007. And then the credit crunch hit, inflows of foreign capital ceased and the property bubble burst. Builders went bankrupt, while developments lay unfinished. Overindebted homeowners, meanwhile, faced financial ruin. The economy, as a result, nose-dived into recession. Worse, unemployment soared: one in four Spaniards are now out of work. Those that are in employment remain grossly uncompetitive: unit labour costs in Spain have risen by 40 per cent compared with Germany in the past 10 years. This is a shocking statistic – and one that will take years to remedy.

Banks are groaning under the weight of toxic loan books. Billions of euros have yet to be written off. One study by leading Spanish economists estimated that the value of the property overhang (excess properties as a result of the bubble) is in the region of €380bn, or 37 per cent of GDP. This will have to be absorbed by the economy before the property bubble can said to be over.

The Spanish government, as a result, has had to tap its eurozone partners – via the European Stability Mechanism (ESM) – for nearly €100bn to prop up its financial sector. That the rescue came shortly after the banks had passed ‘far-reaching’ stress tests is alarming. The ‘big four’ are now pouring over the cajas’ books – the final cost, as a result, could swell even further. But it is only once Spanish banks admit to, and then write down, their entire property-based liabilities can confidence in the sector be restored.

Worse, the crisis has also tied the Spanish government ever closer to its struggling banks, who themselves carry huge swathes of government debt on their balance sheets. Markets are worried that both could topple were this symbiotic relationship to sour further.


Like Spain, Ireland’s prosperity was built on an unsustainable property boom. Relationships between politicians, bankers and property developers were as deep as they were mutually beneficial. A mixture of easy money, lax regulatory supervision, generous tax incentives and hubris meant that between 1995 and 1997 some 700,000 new homes were built. A modern-day gold rush was born. Rents, meanwhile, continued to climb: house prices rose by an astonishing 344 per cent between 1994 and 2007. This bore no relation to annual incomes, meaning buyers had to borrow extensively from banks in order to purchase their homes. Luckily – or unluckily, as it turned out – bankers were only too willing to lend the cash. Household debt, as a result, rose from €57bn in 2003 to €157bn in 2008.

Meanwhile, mass rezoning of farmland for development, courtesy of local councillors, opened up additional tracks of real estate for new property projects – so much so that by 2006 more than 200,000 properties lay unoccupied. Then came the global financial crisis. Credit evaporated and the value of assets slumped. The property boom was over and the fallout was seismic. It soon became apparent that Ireland’s banks would have to be rescued.

What happened next shocked the financial world. The Irish government guaranteed all bank deposits and senior bondholders, putting the taxpayer on the hook for over €70bn (Ireland’s total GDP was €155bn in 2011). This was a calculated gamble at the time – one that failed to pay off. It was then that the banking crisis became a sovereign crisis. Confidence in the economy crashed, and a bailout followed.

And yet there is a glimmer of hope emanating from the emerald isle. The government may have been, with the benefit of hindsight, rash in guaranteeing all banking deposits, but decisive political action in other areas is starting to pay dividends. For example, even before IMF/EU bailout conditions were imposed, Ireland had started a painful but necessary consolidation programme. Spending was cut, while taxes were raised. Steps were put in place to slim down the nation’s bloated banking sector. This included moving some €70bn of bad loans onto the books of the National Asset Management Agency, to be realised in the next decade. The three largest domestic banks are also deleveraging on a large scale.

As a result, after three years of recession the economy is once again growing – albeit slowly. Exports are up, while house prices have almost halved since their 2007 peak. More importantly, property prices relative to household incomes are starting to come back in line. Bond yields, meanwhile, have started to fall as confidence in Ireland’s economy grows.

The government is now hoping it can return to the market in late 2012. Progress, then, has been made – but much work needs to be done. Unemployment remains high, while domestic demand continues to stagnant. Nonetheless, the Irish example shows that with forthright and bold action, a country can eventually emerge from the depths of a sovereign debt crisis.


As for Portugal, it was the mishandling of its finances and poor political management that led to its ruin. Like Greece, tax collection was pitiful, while debt-fuelled spending was rampant. Cheap borrowing created investment bubbles; public sector wages rocketed, while productivity slipped; state-sponsored boondoggles littered the countryside; government spending on healthcare, education and other social entitlements soared. Competitiveness dissolved: it is estimated that 40 per cent of Portugal’s exports have now lost market share. Economic growth, meanwhile, stagnated – GDP grew by only 1.1 per cent during 2001-2007, the slowest in the eurozone.

Add to this the country’s rigid labour market and the result has been rising government deficits and unmanageable sovereign leverage.


It is deep-seated structural problems that have hobbled Italy’s economy for years – namely, huge debt, chronically low growth, inflexible labour laws and an ageing population. Its political class has become an object of scorn and ridicule, none more so than former prime minister Silvio Berlusconi.

Even now, with a technocrat at the helm, Italy’s borrowing costs are alarmingly high. Its economy remains moribund. But like Greece, Italy should never have been allowed to join the euro in the first place. You don’t have to be Milton Friedman to see the country was ill-equipped to meet the exacting requirements laid out by the Maastricht Treaty.

Solving the country’s problems, meanwhile, will take fortitude and resolve. Unions exert considerable influence throughout Italy’s industries and service sectors; business and political relationships border on the incestuous, while tax collection is woeful. But perhaps leaders in Berlin, in their rush to condemn, should remember that it was they who drafted the guest list for the eurozone party – it’s somewhat hypocritical to now blame Italy and Greece for accepting the invite.

The solution

On the one hand we have a banking crisis (Ireland and Spain), and on the other a debt crisis (Portugal, Greece and Italy). These are different problems that require different remedies. The common theme running through each country, however, is stagnant economic growth, spiralling debt and political mismanagement. A chronic lack of competitiveness is also a theme, as is high unemployment.

Solving the banks’ problems should be, at least on paper, fairly straightforward, albeit extremely painful. Banks must be recapitalised, their debts written down and balance sheets rebuilt.But governments can’t afford such measures alone.

The eurozone’s structural problems, on the other hand, are harder to solve. Austerity – as prescribed by Germany – hasn’t worked. Periphery economies remain mired in recession and unemployment has soared. Living standards have plummeted while domestic demand has slumped. Tax receipts, as a result, have fallen. As for restoring competitiveness, in the past countries like Italy could devalue their national currency, thereby making their workers and goods cheaper, and the country more competitive on the international stage.

As a result, all nations can do is devalue internally, which means swingeing pay-cuts and slashing pensions. To make up the short-fall – and to keep their economies from collapsing – governments are forced to borrow more. With confidence in the market fragile, the cost of borrowing on the open market spirals. Yields on bonds climb until, eventually, the situation becomes untenable. The evidence is there – debt-to-GDP ratios have risen since the start of the crisis, not fallen. Far from restoring growth, then, austerity has merely compounded matters. Only when this debt spiral is arrested can economies grow.

But the tide may be turning. Governments across the eurozone have been swept from power by a wave of anti-austerity sentiment. France’s leader François Hollande has vowed to lobby Germany to implement a “growth pact”. Bond traders and ratings agencies have also softened the tone of the austerity-at-all-cost narrative.

This may give the green light for a loosening of short-term fiscal targets, giving periphery nations the wiggle room to appease their electorates. These measures, of course, will have to be accompanied by strict longer-term budgetary commitments. Any such changes will also have to be clearly articulated to the market, and receive unequivocal support from Germany.

The latest EU summit – held at the end of June – offered some indication that Europe’s leaders were finally starting to move in one direction. As for concrete proposals, three key initiatives emerged. First, the announcement of a eurozone banking union. This represents a genuinely significant expansion of euro-wide coordination into bank regulation and supervision. It also means struggling lenders can be recapitalised quickly and directly, while floundering institutions can be wound down efficiently and without the impediments of local politics and bureaucracy.

The second concrete proposal was the commitment to give the eurozone’s bailout funds – the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) – more flexibility. This allows the rescue funds to directly recapitalise banks (much to Spain’s relief) or buy government debt with less “conditionality” (a victory for Italy).

Lastly, a “growth pact” was finalised. The sums involved are not huge – roughly €130bn – but the deal is a significant move away from the austerity-at-all-costs narrative that has been all-pervading in the past year. It also represent a shift in the Franco-German alliance in the wake of Mr Hollande taking up the French presidency in May.

Are we out of the woods? Not by a long way. The mandate to inject capital into Spain’s banks while bypassing Madrid will require more detailed political agreement on joint banking supervision before it can be enacted. This could take time – time that bond markets may not extend to Spain, especially in light of its deteriorating economy.

Furthermore, while the European bailout funds were afforded wider remits, they were not provided any additional ammunition. This matters because the ESM currently stands at €500bn and given the prospective calls on its resources – not only from the €100bn Spanish bank rescue, but also from the bailout of Cyprus and potential Italian debt purchases – its potency as a firewall could quickly diminish.

Already doubt has started to colour proceedings, with many fearing the latest proposals will be diluted by the horse-trading and championing of national self-interests that characterise politics in Brussels. Spain’s borrowing costs are back on an upward trajectory.

One feature of the crisis has been the growing divergence between the borrowing costs of member states. Germany, for example, can borrow at historically low levels (yields on its 10-year bonds are currently less than 2 per cent), while periphery nations have to pay increasingly punitive rates – in excess of 7 per cent in some cases this year. A pooled borrowing instrument for the eurozone – eurobonds – would level the playing field, allowing all member states to borrow at the same rate. But Germans remain staunchly apposed to the idea, for numerous reasons.

First, and most simply, they view eurobonds as fundamentally unfair – why should frugal, hard-working German taxpayers support their improvident neighbours to the south?

Second, German politicians are concerned that such a move would encourage struggling eurozone members to borrow even more, inflating their debts and creating further instability.

Third, leaders in Berlin also think it would discourage countries from implementing vital economic reforms. In addition, they worry it would increase Germany’s borrowing costs, since markets would view the entire eurozone as a more risky investment than a unencumbered and financially strong Germany. Finally, the creation of such an instrument would require an adjustment to the Maastricht Treaty, something that the German Federal Constitutional Court would surely block.

There are, though, many more unanswered questions. What would happen, for example, if one country was unable to pay its portion of the bond payments? Assuming the remaining 16 countries step in to foot the bill, what penalty would be applied to the tardy nation? And who decides how the money raised by eurobonds is spent? How much should each country be allowed to borrow? The list goes on. But such measures would only calm the situation. The long-term imbalances that exist in the eurozone will have to be addressed if the single currency is to survive.

The onus will, ultimately, fall on Germany. It must decide – once and for all – whether it wants to pay for the eurozone project. Closer fiscal, banking and political ties will be necessary. Tough choices await. These issues should have been resolved some 20 years ago when the euro was first mooted. Alas, the passage of time has only made the political choices more difficult and the economic choices more costly. But they will have to be made – no matter how unpalatable they are to Europe’s leaders and its voters.

Richard Dunbar is global equity investment director at Scottish Widows Investment Partnership (Swip)

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