At a glance - the European debt crisis

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It started back in 2008

We could go back further, but let's start with the severe downturn the economy began to take in 2008. The downturn was triggered by a severe financial crisis that affected banks around the world. This event, in and of itself, was quite complicated. In the end, though, it came down to banks having large amounts of assets that were worth much less than was thought. This was triggered by a rather dramatic drop in the value of housing in the U.S. leading to a sudden recognition that investments called "mortgage backed securities" or "asset backed securities" were worth far less than investment buyers had believed.

Asset values took a real hit

As an example, suppose you owned a house that you thought was worth $450,000. Then, after a severe change in the market, you find that it is worth only $300,000. You would have $150,000 less "on your books" in terms of the value of assets that you owned. And that is what happened to banks around the world. All of a sudden, they had dramatically less value on their books than they thought. To be able to keep doing business and cover their costs and the needs of their clients, they needed a capital infusion – that is, more money with which to do business and more value added to their books.

We came close to a collapse of the global financial system

The global financial system came close to collapse. Why? Because if a number of major banks had been forced into bankruptcy, this could have triggered other banks and financial institutions to fail. In today's global economy, markets – including financial markets – are greatly interconnected. If one bank fails, it can have a domino effect. It would then be hard to predict how bad things would get and how it might all end.

Governments stepped in to help

Since no responsible person wanted that to happen, governments and central banks stepped in to boost the banks' liquidity and the amount of capital they had on hand to continue to do business. Central banks can do this, for example, by transferring large amounts of money into the commercial banks as new deposits. That helps to stabilize them, which is what happened.

But the economy took a turn for the worse too – a big turn

This global financial crisis was largely responsible for a slowdown in the North American and European economies. However, at the same time as this financial crisis was unfolding, economies around the world were going into recession. Output was falling, companies were struggling, unemployment was rising, incomes were being lost. This added further to the negative outlook. As many know, major car companies, such as GM and Chrysler, already in a weakened state, came very close to bankruptcy.

To make matters worse, the fragile banks were being quite tight with lending since they didn't want to face further losses with an economic outlook that was very uncertain and filled with risk. In addition, in such uncertain times, they wanted to keep their balance sheets as healthy as possible. Therefore, they were less willing to take on risk and make loans.

Governments took on more debt

So to try to save the world's financial system from collapse, to boost economic activity and to spur investment governments stepped in. But by taking on new spending to help companies and financial institutions (note that Canada's financial institutions did not need any tax-payer bailouts), governments went into deficit. That is, in the course of the year governments spent more than they took in as revenue – in many cases, quite a bit more. Canada, for example, incurred a federal deficit of between $50 and $60 billion in 2009-2010– and, across the country, many provinces incurred large deficits as well.

Canada, and Canadian banks, were better positioned than most

This was a challenge for many countries around the world. Canada, though, was in much better shape than most. In fact, by many measurements, Canada was in the best position among the major G20 economies to handle the challenges. This, in large part, was due to past efforts by governments since the mid 1990s to get Canada's financial house in order. It was also due to the banks in Canada being more conservative – or, as one might put it, less aggressive – in their lending practices. The banks did not take on the same level of risk as some others around the world.

Financial regulations in Canada helped

This relatively positive position for Canada was also due to financial regulations in this country that require banks to have more capital on hand than banks, say, in the U.S. to support their activities. Therefore, both by practice and regulation, Canadian banks were less exposed and in a healthier financial position to face the turbulence that unfolded.

No housing bubble in Canada

Another factor in Canada's favour, partly due to our more conservative mortgage lending policies, was that we did not have the housing bubble that some other countries – such as Ireland and the U.S. – had. That is, house prices were not significantly over-valued and therefore did not face the sharp decline that happened in the countries where a bubble had built up.

Mortgages better reflected real value

As a result, the mortgages on the books of Canadian banks were much closer to representing actual value than was the case in a country such as the U.S. So Canadian banks had pretty solid assets on their books and a strong capital position to support their activities. In short, they were in a much healthier position than many banks around the world and faced significantly less risk. There was no need for the government to step in to rescue banks from potential failure. The Bank of Canada did transfer more money into the commercial banks to help support their liquidity position – to make sure they had enough money to conduct their business – but no taxpayer bailouts were needed in Canada.

Other countries, though, were not in good shape

Other countries were not so fortunate. This was particularly true of some European nations and it is important to understand the impact of the European countries coming together as the European Union and the adoption by many of them of a common currency – the Euro.

The European Union largely adopted a common currency

As many European countries accepted the new common currency (Britain, for example, did not, although it is an E.U. member) they gave up their own currencies. With that, they gave up the opportunity to influence the value of their own currency. The value of the Euro would be determined in global financial markets and would not be influenced by monetary

policies in countries such as Greece, Spain and Italy, which had adopted the Euro. Countries had to accept the value of the Euro for what it was.

But they didn't put a common treasury in place

But although many of the countries accepted the same currency, they did not set up an overall treasury to help oversee the fiscal policies of the participating countries. Fiscal policies are those that affect government spending and taxation and ultimately determine whether a country runs a deficit or surplus. The European countries all set individual fiscal policies.

Some European countries, such as Germany, ran sound fiscal policies and, at the time the crisis hit, were in pretty good shape. But some other European countries had run up large amounts of government debt relative to the size of their economies (i.e. had large debt burdens). That meant that as these countries tried to weather the economic and financial crisis, their economies were already stressed and they faced the prospect of getting deeper and deeper into a financial hole.

How do governments take on debt?

It is important to note that governments are able to go into debt by selling bonds. They could just print more money, but all that does is cause inflation and make the country's currency worth less. And for the countries with the Euro as a common currency, this was not an option even if they had built up large mounts of debt before the crisis hit.

Interest costs have to be paid on the debt

Therefore, governments sell bonds to borrow money. When they do this, they pay interest to the bondholders. The debt the governments take on is called sovereign debt. As a country's debt burden increases, it becomes less able to increase spending and/or reduce taxes. The more debt a country takes on, the greater the risk there is that it might not be able to pay it back, or even pay the interest. That means that the more debt a country has, and the more bonds it needs to sell, the harder it can become to find buyers. And as potential buyers become more nervous and feel there is greater risk that they might not get all of their money back, they want a higher rate of return to cover the higher risk.

Some assumptions were made about the European Union

However, when the European Union came together to establish the Euro, those able and willing to lend money (buyers of government bonds) took this as an indication that the member countries would not let one among them default on their loan obligations. As a result, a country such as Greece was able to issue bonds and borrow money at the same interest rate as Germany even though the two countries were in much different economic positions.

Problems arise when governments commit to what they can't afford

A significant part of the problem for Greece was that, over many years, it had put in place policies related to work contracts, social benefits and social services that it could not really afford. But the citizens of Greece came to expect such benefits and this is what made it difficult for Greece, especially for its politicians, to make the changes necessary to confront the country's growing economic and financial difficulties.

Greece got into trouble

As a result of these years of excess, when the crisis hit Greece was in trouble and found it difficult to cover its debts. In addition, with the risk of default, and no clear indication that the other European countries were going to step in to head off a Greek default, it became harder and more expensive for Greece to find buyers for its bonds. The country faced hitting the wall and having to default on its debt.

All for one and one for all?

The European Union, facing the possibility of a snowballing financial contagion that might bring risk to the global financial system, had little choice but to get together and help. Why? Well, we come back to global interdependence again. Today, major North American, European, and Asian economies are linked by trade, investments, and finance – as well as by political and consumer confidence. If banks from other countries hold a lot of Greek debt (and many banks from other countries do), and if Greece can't make its debt payments, then those banks in other countries get hurt too. This in turn can hurt companies, depositors, lenders and consumers in those other countries.

Greece was at risk of defaulting on its debts

So if Greece were to default on its debts payments – that is, not be able to make them - it would not just be Greece that got hurt. Banks and countries throughout Europe and around the world could get hurt, some more than others. But, in the end, it means that there are many countries and financial institutions concerned about a possible Greek default.

The consequences of default would impact many others

So the European Union got together to put together a bailout fund – a fund to help countries like Greece that were at risk of going into default. This rescue didn't come together quickly, though. It took months and this created a great deal of uncertainty around the world. Businesses were nervous. Financial institutions were nervous. Investors were nervous. Governments were nervous.

Nervous investors and consumers hesitate to invest and spend

When companies, banks, consumers and investors are nervous, they are less likely to spend or invest. As a result, the recovery has been slowed down. This has made problems even worse since weaker economies mean less tax revenues as well as increased need for social program spending – especially unemployment insurance - and governments that are already struggling have to struggle even more.

A deal was struck

So recently a deal was worked out for Greece – at least it looks that way. As part of the deal, bondholders will not get all their money back, but they will get a significant chunk of it, so it is not a complete default for those who invested in Greek bonds. However, in return Greece has to commit to getting its economic house in order. What does that mean? Essentially it means putting the country on a path it can afford – cutting government spending, raising revenues and getting the country back to living within its means.

But the deal came with expectations – and the prospect of major changes

This is a challenge for Greece since it means big changes for its people. There have been riots in the streets as a result. It also means some loss of autonomy for Greece, at least for a while, since others who are part of the bailout are insisting that the country enact certain policies. Why is that? Well, again, consider the Germans. The German government is contributing a large amount to the bailout fund. That money comes from German taxpayers. German taxpayers question why they are bailing out a country that spent beyond its means. In the end, though, the actions of the German government were supported within Germany because people understood that, if Greece failed, there are consequences for all European countries and other countries around the world.

Greece proposed a public referendum

So Germans went along with the bailout – but only to a point. Now they want to see Greece get its house in order so that this doesn't happen again. That is why, when Greece said that it was going to put the bailout plan to the people in a referendum, there was uproar among the other European nations. That led to a reversal of the Greek referendum plan and the resignation of the Greek leader. An interim government is being put in place to help get the Greek economy on course.

The government of Greece fell

An interim government is likely the best solution because no traditional political party is likely to want to lead Greece through the period it is about to encounter. There will be considerable hardship for many in Greece as they deal with the necessary changes. The country may be in for very unstable times and there is talk of youth losing hope as they face dismal prospects for employment.

Will Greece be able to get its economic house in order?

Can Greece do it? That question continues to feed uncertainty around the world. Markets have so far reacted positively to the efforts to stabilize Greece, but they are still nervous as to whether Greece will have the commitment to follow through.

And then there was Italy

But no sooner did all of this occur than attention turned to Italy. Italy has a very large government debt -- about 1.3 trillion Euros. Those who hold Italian bonds, or who are considering buying Italian bonds, are nervous about Italy's ability to cover its debt payments. As a result, they are looking for ever-higher interest on the bonds. In the past, when lenders expect close to a 7% yield on bonds, that has been considered a crisis point – at which a country can get into trouble carrying the payments on its sovereign debt.

As well, bonds have an end date on them. When that is reached, the rates have to be renegotiated. Italy has quite a bit of debt coming due and bondholders are expecting ever-higher rates. That means the costs of carrying Italy's debt climbs. This makes a bad situation even worse.

Consequences of Italy defaulting greater than for Greece

Italy is a much bigger country than Greece in terms of its economy and its debt – about six times as large. The damage that could be done throughout Europe and around the world if Italy were to default would be significantly greater than if Greece were to default. Once again, people are looking to Italy to change course and get its economy and government policies heading in a sustainable direction. If that could be achieved, bondholders would become less nervous, interest rates on the Italian debt would decline and global markets would derive some comfort.

Could Italian leaders get the job done?

The question arose as to whether the leadership of Italy was able to do the necessary job to calm investors and global markets. As it happened, there was not confidence within Italy in the leadership and Prime Minister Berlusconi has resigned. And, as with Greece, efforts are being made to form an interim government that can assure nervous global markets and investors about Italy's ability to manage its debt.

Big questions remain

Will that happen? Will Greece take steps to gets its economic and financial house in order? Will Italy? Will bond markets be willing to accept a lower rate of return? Will the European Union have enough funds in their bailout program to cover the needs of any other EU country that gets into financial difficulty? Will any other country start to have difficulty – e.g., Spain?

Europe is already in recession – and uncertainty remains

These are the questions that continue to create uncertainty in global markets. These questions work to dampen spending, investing and growth in world economies. Many economists believe Europe is already in recession. That is why employment is slow to recover, why governments find it more difficult to reduce their deficits, and why stock markets around the world are so volatile.

Large amounts of money will likely continue to sit on the sidelines

It is likely that, around the world, there are billions if not trillions of dollars waiting to go back into markets, investments, spending etc. However, as long as uncertainty about what will unfold in Europe remains, that money will likely continue to sit on the sidelines. And the economic recovery will continue to be slow.

We can only hope

So that's what's been going on in Europe. That's the background on what is meant by a "sovereign debt crisis." And that's probably why you are finding life a little more challenging these days. We can only hope that things get on the right track, that confidence is restored by governments implementing credible tax and spending policies, and that the global economy can get back to more stable times.

Gary Rabbior is president of the Canadian Foundation for Economic Education