European sovereign debt crisis (2010–present)

In 2010, the financial crisis has driven up public debt in Europe's common currency zone to such heights that many economists fear the euro could collapse. The countries in trouble included Greece, Portugal, Spain, Ireland and Italy. The bond yield spreads between these countries and other EU members, most importantly Germany, have dramatically widened.

On 2 May 2010, the Eurozone countries and the International Monetary Fund agreed to a €110 billion loan for Greece. In return Greece agreed to harsh austerity measures. On 9 May 2010, Europe's Finance Ministers approved a comprehensive rescue package worth 750 billion euros ($975 billion).

In July, 2011, Greece was hoping for another bailout and problems threatened to spill over into Spain and Italy. In August of the same year, the European Central Bank signaled it is ready to start buying Italian and Spanish securities to counter the sovereign debt crisis. However, the ECB will potentially have to buy up to half of the Italian and Spanish traded debt, the biggest risk-pulling effort ever engineered in Europe.

By 2012, there were public protests and election losses against austerity measures. However, European nations have not pursued classic austerity policies, relying instead on tax increases to cut deficits. Following years of large spending expansion, Spain, the United Kingdom, France, and Greece—countries widely cited for adopting austerity measures—haven’t significantly reduced spending since "austerity" supposedly started in 2008. France and the U.K. have not cut spending. When spending was actually reduced—between 2009-2011 in Greece, Italy, and Spain—the cuts were relatively small compared to the size of their budgets. While Italy reduced spending between 2009-2010, it also increased spending in the following year by an amount larger than the previous reduction. Most importantly, meaningful structural reforms were seldom implemented. Whenever cuts took place, they were always overwhelmed with large counterproductive tax increases.

Background and Causes
Before the financial crisis, several governments of the eurozone, most notably those of Portugal, Italy, Ireland, Greece, and Spain (sometimes called 'PIIGS'), had been able to finance their deficits at artificially low interest rates. Some had accumulated unsustainable levels of public debts.

Such reckless fiscal behavior was only possible because markets assumed that if the national situations got worse, these governments would be bailed out by other countries of the eurozone in order to forestall a breakup of the euro. In other words, the euro came with an implicit bailout guarantee permitting governments to overindulge in debt.

Equipped with this implicit guarantee, many governments did not address structural problems such as uncompetitive labor markets or unsustainable welfare systems. They papered over these problems with government deficits. As the financial crisis hit, government deficits increased sharply due to increasing public spending and falling revenues. Deficits soared, not only in the PIIGS countries (the bailout candidates), but also in the countries that were supposed to pay the costs of bailing out (most prominently Germany).

It was at this point that market participants wanted to see something more than implicit promises. They started to doubt that Germany and others would be capable of bailing out the PIIGS governments, or willing to do so. Interest rates for bonds of PIIGS governments soared. Finally, in May 2010, eurozone governments had to make the implicit bailout guarantee into an explicit one. They installed a €750 billion rescue fund.

The rescue fund has a limited term of three years. At the end of October, 2010, German chancellor Angela Merkel made it clear that the term would be extended only if there was a reform making private holders of government debt participate in the costs of future sovereign bailouts.

In other words, Germany threatened to take away part of the explicit bailout guarantee it gave to private investors in government debts. Investors could suffer losses in bailouts after 2013. As a consequence of this move, investors started selling government bonds of PIIGS countries and yields increased. The market's attention focused on Ireland. The Irish government had an estimated deficit of 32.5 percent of GDP for 2010 and its total government debt stood at 80 percent of GDP after repeated spending to prop up its insolvent banking system.

While banking profits during the boom were private, its losses were socialized on September 30, 2008, when the Irish government guaranteed all Irish bank liabilities. As of late 2010, Ireland has injected about €50 billion into its banking system. The Irish problems were created, not by an excessive welfare system, but by the socialization of the losses of a privileged banking system.

The threat of contagion
Mohamed A. El-Erian, CEO of PIMCO, the world’s largest bond investment management group, made a plea for "urgent EU action" to stop a contagious financial crisis from sweeping the Eurozone. However, a contagion, if the term is used accurately, occurs only in circumstances in which other countries are free of the problems of the country that first experienced trouble and yet suffered unwarranted investor disaffection. Not a single country in the Eurozone seemed to fit this description – not even the most prudent (Germany) or the most diminutive (Malta).

While the ECB directed its key refinancing rate for all Eurozone borrowing from it, real interest rates of its member states diverged wildly. High inflation periphery countries saw real interest rates turn down sharply, even veering into negative territory during much of the boom. The fractional reserve structure of the monetary system allowed a huge amount of credit to be built upon a relatively small amount of actual deposits, savings and bank reserves.

With a reserve requirement set at 2 percent since 1999, the ECB permitted €50 to be loaned out as credit for every €1 a bank holds in its vaults. The Bank of England permitted even more extreme potential increases in credit. A voluntary reserve requirement (except for the cash ratio deposit of 0.15%, which cannot be drawn on) implied that banks can loan out an infinite amount of credit against zero deposits. Such policies allowed a credit induced boom to sweep the Euro area, the repercussions of which only later became fully known.

In July, 2011, Greece was hoping for another bailout and problems threatened to spill over into Spain and Italy.

Jens Weidmann, the Bundesbank's president, told the Bild Zeitung that "nothing would destroy the incentives for a solid budget policy more quickly and more permanently than joint liability for national debts. European and especially German taxpayers would have to answer for the entire state debt of Greece. That would be a step toward a transfer union."

Days earlier he shot down proposals for issuance of eurobonds or use of Europe's rescue fund to buy Spanish and Italian bonds on the open market, crucial steps to prevent Italy and Spain being drawn into the maelstrom. "It has a high cost, limited use, and dangerous secondary effects," he said.

The International Monetary Fund said there is a "serious risk" of eurozone contagion with "large" potential knock-on effects worldwide.

The yields on Spanish 10-year bonds reached post-EMU records of 6.34pc this week, and Italian yields topped 6pc. "We believe that Spain has entered the danger zone for yield levels," said Harvender Sian, credit strategist of the bank RBS, who fears the "point-of-no-return" may be 6.5pc. "Given that Spain [and likely soon Italy] has entered this territory, there is a growing risk that a large systemic risk event is plausible in the near term and if not then in a matter of weeks."

Greece
For years, the Greek government has demonstrated rather thriftless spending behavior. This was exacerbated when Greece started to pay lower interest rates on government bonds by virtue of having entered the European Economic and Monetary Union.

Greece's interest rates were subsidized due to an implicit guarantee from the strong members of the eurozone, who were expected to support weaker members in times of trouble. During the first years of the euro, interest rates on Greek bonds were thus reduced; they approached German bond yields. Greece spent wildly but paid interest rates like a much more conservative country. Meanwhile, the Greek economy and voting public adapted to government spending subsidized by low interest rates.

When the global financial crisis broke out, deficits of both strong and weak eurozone countries widened. Stronger countries had their own problems and people started to doubt that they would support the weaker countries in an emergency. Furthermore, the difference between the interest rate that Greece had to pay on its bonds and the rate Germany had to pay increased.

In October 2009, the Greek government deficit for 2008 was revised from 5.0% of GDP (the ratio reported by Greece, and published and validated by Eurostat in April 2009) to 7.7% of GDP. At the same time, the Greek authorities also revised the planned deficit ratio for 2009 from 3.7% of GDP (the figure reported in spring) to 12.5% of GDP, reflecting a number of factors (the impact of the economic crisis, budgetary slippages in an electoral year and accounting decisions). The deficit was later revised to 13.6%, with a possible revision of up to 14%.

By the beginning of 2010, a discussion about the bailout of Greece has begun. However, Greece was already being bailed out by the rest of the union. The European Central Bank (ECB) accepted Greek government bonds as collateral for their lending operations. Prices started to rise in Greece, and the money would flow to other countries, bidding up prices throughout the eurozone. The Greek government was being bailed out by a constant transfer of purchasing power from the rest of Europe.

In the Eurosystem, each government has an incentive to accumulate higher deficits than the rest of the eurozone, because its costs can be externalized. Consequently, there is an inbuilt tendency toward continual losses in purchasing power. This overexploitation may finally result in the collapse of the euro.

To avoid this, the European Monetary Union is regulated with the Stability and Growth Pact, and it requires that each country's annual budget deficit is below 3% and its gross public debt not higher than 60% of its GDP. Sanctions were defined to enforce these rules.

Yet the sanctions have never been enacted and the pact is generally ignored. For 2010, all but one member state was expected to have a budget deficit higher than 3%; the general European debt ratio was 88%. Germany, the main country that urged these requirements, was among the first to refuse to fulfill them.

European Central Bank President Jean-Claude Trichet pledged in January, 2010, that it would not loosen lending requirements "for the sake of any particular country." However, credit-rating downgrades threatened to render Greek government bonds ineligible as collateral and exacerbate the crisis.

Already in March 2010, ECB lowered its threshold for accepting debt as collateral. At the end of April, 2010, Standard & Poor’s cut Greece’s sovereign rating to junk status, below the minimum BBB- required by the ECB from at least one major rating company.

On May 3rd 2010, the European Central Bank has suspended the minimum credit rating threshold in the requirements for the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the Greek government. That was a day after euro-zone countries and the International Monetary Fund agreed to extend an unprecedented €110 billion ($147 billion) rescue package to the debt-laden country.

As of March, 2011, a debt default by Greece was considered a possibility according to Standard & Poor’s. This would have negative effect on banks across Europe and European Central Bank. The Frankfurt-based institution would be forced to write down a significant portion of its claims as irrecoverable. In addition to its exposure to the banks, the ECB also owns large amounts of Greek state bonds, the total estimated to be worth at least €40 billion ($58 billion) as of May 2011.

Together with the International Monetary Fund, the EU member states have already pledged €110 billion ($159.5 billion) in aid to Athens -- half of which has already been paid out. Should the country become insolvent, euro-zone countries would have to renounce a portion of their claims.

By January, 2012, Greece's government warned that the debt-crippled country will have to ditch the euro if it fails to finalize the details of its second, €130 billion ($169 billion) international bailout and that more austerity measures may need to be implemented. After the government failed in elections in May, 2012, Greece's exit from eurozone was considered even by EU officials. Even US private equity firm MidOcean Partners led by Ted Virtue focused on mid-market investments in the US because of Greece market's downfall during the crisis.

Ireland
In the Irish property bubble, around 2006 more than a fifth of the Irish workforce was employed building houses. The Irish construction industry had swollen to become nearly a quarter of the country’s G.D.P.—compared with less than 10 percent in a normal economy—and Ireland was building half as many new houses a year as the United Kingdom, which had almost 15 times as many people to house. Since 1994 the average price for a Dublin home had risen more than 500 percent. In parts of the city, rents had fallen to less than 1 percent of the purchase price—that is, you could rent a million-dollar home for less than $833 a month. The investment returns on Irish land were ridiculously low: it made no sense for capital to flow into Ireland to develop more of it. Irish home prices implied an economic growth rate that would leave Ireland, in 25 years, three times as rich as the United States. By 2007, Irish banks were lending 40 percent more to property developers than they had to the entire Irish population seven years earlier. Morgan Kelly, a professor of economics at University College Dublin, predicted the Irish real-estate prices could fell relative to income—by 40 to 50 per cent, and they did.

Many of housing developments are called "ghost estates" because they’re empty. According to the audit of Ireland’s Department of the Environment published in October, 2010, of the nearly 180,000 units that had been granted planning permission, only 78,195 were completed and occupied. Others are occupied but remain unfinished. Virtually all construction has ceased. There were never enough people in Ireland to fill the new houses.

Iceland
As in other countries, Icelandic banks enjoyed guarantees by the government to bail them out should their bets on the market turn erroneous. However, while this guarantee was merely implicit in most developed economies, the Central Bank of Iceland committed to it explicitly. The CBI effectively functioned as the "roller-over of last resort," providing fresh short-term debt as the market required it. Indeed, the three main Icelandic banks were so big that they could regard themselves as too big to fail. This led to moral hazard problems.

In the Icelandic case, the malinvestments were made mainly in the aluminum and construction industries. Both aluminum mines and residential and commercial housing represent long-term investment projects that were financed by short-term funds and not by savings of an equal term. Another consequence was that resources were drawn into the financial sector, which expanded enormously. Fishermen became investment bankers to meet the insatiable demands of the newly profitable financial sector and Iceland became an exporter of financial services and an importer of goods. This distorted structure of production threatened to "starve" the population during the currency breakdown when Iceland had problems obtaining foreign exchange to pay for the imports the country had become so reliant on consuming.

From 2001 to 2008, there was a 2,300 percent increase in foreign liabilities that occurred over the seven-year period. Domestic liabilities, in contrast, also saw a significant 600 percent increase — the result of low nominal interest rates, which hovered near zero when factored for inflation. An extremely accommodating monetary policy — both domestically and internationally — made ample quantities of liquidity available to be borrowed and invested. In Iceland’s specific case, broad-based monetary aggregates such as M1, grew at a rate of 20–30 percent per annum every year between 2002 and 2007. As long as the liquidity remained high, Icelandic banks faced no problem continually obtaining new short-term funding. However, as the interbank lending markets dried up last year after the collapse of Lehman Brothers, Icelandic banks found themselves unable to cover the shortfall.

By choosing the bankruptcy path rather than continued bailouts, the Icelandic economy fell into a deep immediate decline. Within months its stock market had fallen more than 95 percent from its 2007 highs. The krona depreciated by 60 percent against the euro. While such drastic adjustments were devastating for the short-run, they were necessary to provide entrepreneurs with the essential signals to aid economic recalculation, and to promote coordination.

The combination of a general unease to lend to the Icelandic government and a devalued exchange rate made it increasingly difficult for the Icelandic government to continue running budget deficits. Austerity measures that other countries have only discussed came into place. Real wages, started showing positive growth in Iceland in 2010. As inflation has stabilized in Iceland, the country is showing strong signs of recovery. A significantly devalued krona has allowed the country to return to competitiveness, with commensurate growth in its GDP.

Portugal
The troubles of Portugal were described as a chronically low savings rate that forces a reliance on foreign investors to finance persistent deficits. Portuguese exporters have been losing market share to competitors since entering the common currency in 2000. That, in turn, has pushed the government to borrow from abroad to finance the current account deficit, pushing debt to its current levels.

As of April, 2010, the Portuguese government has taken pre-emptive steps to cut spending and raise taxes. Portugal’s debt, at just under 90 percent of gross domestic product, was still lower than Greece’s 113 percent level. The savings rate was 7.5 percent of gross domestic product (compared to 6 percent for Greece). In contrast, Italy had a savings rate of 17.5 percent, Spain 20 percent, France 19 percent and Germany 23 percent.

In a burgeoning welfare state, citizens were granted a multitude of social and economic rights, including the right to work, housing, education, culture, health, and social security. Prior to the 1974 revolution, the government spent about 20% of GDP, mostly on the traditional functions of military defence, domestic administration, and infrastructure. Since then, driven by social expenditures, the weight of government has risen to 46% of GDP, higher than the European average. Over the same period, the number of public-sector workers quadrupled.

Since the revolution, Portugal has not even once avoided a fiscal deficit.

The country's adoption of the euro reduced debt-servicing costs. Figuring that giving up its own currency would force the government to implement market reforms, instead of resorting to the previous ways of depreciation, the bond market lowered the risk premium charged on Portuguese debt. But few reforms were made.

In January, 2011, Portugal’s prime minister Jose Socrates insisted his country doesn’t need a bailout and is cutting its debt faster than promised. He also said Portugal ‘won't ask for any financial help because it's not necessary.’ Commentators pointed out that that is precisely what Ireland said in the weeks before it accepted a €90 billion bailout and Greece said before it bowed to market pressure and accepted a €120 billion handout. Several analysts expressed worry that a bailout of Portugal could speed up the rate at which the euro zone’s sovereign debtors fall.

The interest rates, or yields, as well as the cost of insuring money lent to the Portuguese government have been rising on the government debt markets. That has prompted the European Central Bank to start buying Portuguese debt and has sparked reassurances from China and Japan that they too will buy the debt to try and prop up prices.

By February, 2011, the rising costs to service Portuguese debt led to speculations of an imminent bailout. Athanasios Orphanides, a member of the European Central Bank's governing council, said that Portugal's case is "particularly urgent." He warned that failure to come up with convincing changes to fiscal policy and competitiveness could destabilize the 17-country euro zone.

As of July, 2011, the nation's long-term government bond rating was cut by Moody's to Ba2, which is two levels into junk, and assigned a negative outlook, meaning further downgrades were possible.

The downgrade was driven by an increasing probability that Portugal will not be able to borrow at sustainable rates in the capital markets in the second half of 2013 and for some time thereafter. Moody's also expressed concerns about the country's ability to fully achieve the deficit reduction and debt stabilization targets Portugal set out in its loan agreement with the European Union and International Monetary Fund due to "formidable challenges the country is facing in reducing spending, increasing tax compliance, achieving economic growth and supporting the banking system." Private-sector owners of Portugal’s government bonds may be asked to participate in a bailout of the country.

In July, Portugal's new Prime Minister Pedro Passos Coelho has told the nation to brace for further austerity measures after his government discovered a "colossal" €2bn (£1.7bn) hole in the public accounts left by the outgoing Socialists. Portugal's government will have to cover the gap with another round of spending cuts, mostly in the civil service and state-owned industries.

Spain
Spain, the euro zone's fourth largest economy, has stagnated as other European economies begin to recover from the global economic downturn. The bleak outlook for Spain, which has debt obligations three times that of Greece, has raised the specter of a broader debt crisis.

Spain massively invested into production of renewable energy, creating a bubble. No other country has given such broad support to the construction and production of electricity through renewable sources. According to a study of March, 2009, for every renewable energy job that the State managed to finance, on average 2.2 jobs would be destroyed. The rising energy costs were complained about by large energy-intensive producers, some companies have frozen their expansion plans, scaled down their operations or considered leaving the country altogether. In 2010, Spain has started to cut subsidies to reduce energy prices.

In 2006, the height of the housing bubble, 760,000 houses were constructed; more than the 650,000 started that year in France and the United Kingdom, with a combined populations almost triple that of Spain. Between 2001 and 2008 around four million new houses have been built and the average number of housing units completed per year was 565,000, more than double the figure of 250,000 for the previous decade. This is equivalent to the construction of twelve dwellings per thousand inhabitants, far in excess of the European average of five per thousand.

In 2009, after the collapse of the construction sector caused by the bursting of the housing bubble and the effects of the global economic crisis, the number of housing units started to fall to 160,000, and there were almost 700,000 housing units in stock (that is, completed but unsold).

In second quarter of 2010, Spain's unemployment rate rose to 20.09 percent, up from 20.05 percent from the previous quarter. It is the highest level in 13 years, and it comes despite a rise in seasonal jobs for the summer. The figure means 4.6 million people are jobless in Spain. By 2009, unemployment among people ages 16 to 24 was 42.9 percent, the highest in Europe.

In June, 2012, Spain's Treasury minister Cristobal Montoro said Spain's high borrowing costs mean it is effectively shut out of the bond market. He said Spanish banks should be recapitalized through "European mechanisms", departing from the previous government line that Spain could raise the money on its own.

Prime Minister Rajoy has also voiced concern that Spain cannot continue to finance itself indefinitely on the market at such high borrowing costs. He has repeatedly called for urgent action, which is understood to be aimed at the European Central Bank to revive its bond-buying program or inject more liquidity into the financial system. Spain is pressing for a direct European rescue for its banks, without the government having to go through he humiliation of asking for help, but Germany has appeared to rule out such a "bailout lite" for the euro zone's fourth biggest economy.

Italy
According to International Monetary Fund projections, Italy's headline debt will reach 120 percent of national output in 2011, and then decline only slightly to 118 percent by the end of 2016. As of July, 2011, Italian bonds yielded about 4.9 percent, with the spread over German bonds widening to about two full percentage points (in contrast, the Greek-German spread is now about 13 percentage points). Further increases in interest rates could push the forecasts for Italy's debt toward Greek levels.

Bailing out makes sense for smaller countries like Greece. It has about 360 billion euros in debt outstanding and the potential credit losses in any restructuring are in the range of 100 billion to 200 billion euros. The amounts are small relative to the EU's 12 trillion-euro economy.

Italy, though, has close to 2 trillion euros in debt outstanding. It's inconceivable that Germany or the IMF could provide a rescue to protect its creditors. Such a package would have to involve loans and guarantees of at least 500 billion, and possibly 1 trillion, euros to impress the markets. This would be a significant fraction of Germany's gross domestic product of about 2.5 trillion euros. With a debt-to-GDP ratio of about 80 percent, Germany's ability to take on new debt is limited.

The Netherlands, Finland and Austria, combined with Germany, have a GDP of about 3.5 trillion euros. France adds 2 trillion more, but its debt, already 85 percent of output, is expected to grow over the next several years.

Europe does not have enough fiscal firepower to handle an Italian crisis -- at least in such a way as to protect creditors completely. Beyond the difficult numbers, why would Germany or other EU countries lend to Italy, particularly when its politicians show no sign of coming to grips with their new reality?

Italian banks will be able to draw on substantial credit from the European Central Bank, especially once Mario Draghi, former head of the Bank of Italy, becomes the ECB president in November, 2011. But the entire euro system -- the ECB plus the 17 central banks sharing the euro -- has a combined balance sheet of only about 1.9 trillion euros. It's unlikely that ECB credit can do more than postpone sovereign-debt problems on an Italian scale.

The price of insuring Italian sovereign bonds against default risk has soared 11% since the weekend, when the European Union finally gave Greece the cash to make its July debt payments. Standard & Poor's warned that Greece could technically be considered in default. Faced with such a scenario, traders have already turned a cold eye to the other fragile economies of the euro zone: Portugal, Spain, Italy. The cost of insuring Spanish and Portuguese bonds surged 3% as of July, 2011, and credit default swap spreads on Italian debt, which was previously seen as relatively insulated, soared a full 6.7%.

European banks have total claims and potential exposures of $998.7 billion to Italy, more than six times the $162.4 billion exposure they have to Greece, according to Barclays Capital. European banks have $774 billion of exposure to Spain and $532 billion of exposure to Ireland.

In the United States, banks are also more exposed to Italy than to any other euro zone country, to the tune of $269 billion, according to Barclays. American banks’ next biggest exposure is to Spain, with total claims estimated at $179 billion.

BELLs
Prominent Polish economist Leszek Balcerowicz, who has headed the Polish Finance Ministry and the Central Bank, has proposed a term BELL to collectively denote Bulgaria, Estonia, Latvia, and Lithuania, four countries that have launched rigid austerity measures in response to the crisis.

"Balcerowicz remains adamant that fixes are best implemented as quickly as possible. Europe's PIGS - Portugal, Italy, Greece, Spain - moved slowly. By contrast, Mr. Balcerowicz offers the BELLs: Bulgaria, Estonia, Latvia, and Lithuania," the American newspaper The Wall Street Journal writes.

According to the article, the latter EU countries went through a credit boom-bust after 2009, their economies tanked by over 10 percent and their governments adopted harsher measures to cut spending than Greece.

"The adjustment hurt but recovery came by 2010. The BELL GDP growth curves are V-shaped. The PIGS decline was less steep, but prolonged and worse over time," The Wall Street Journal said in the article about Balcerowicz.

Balcerowicz emphasized that radical changes in the BELL helped recover market confidence, which led to a decrease in borrowing costs.

In 2009, Lithuania's economy went down 14.8 percent. Growth recovered with a 1.4 percent rise in the gross domestic product (GDP) in 2010. Last year, Lithuania's economy went up 6 percent, with a 3.5 percent increase forecast by the Finance Ministry for this year.

Austerity measures
In many European countries governments "planned" to cut their spending and raise tax revenues. Of course, "planned" cuts are not actual cuts. Four years after the crash of 2008, the UK government had only implemented 6 percent of planned cuts in spending and only 12 percent of planned cuts in benefits. In almost all European countries, government spending was higher in 2013 than it was in 2008. A new study by Constantin Gurdgiev of Trinity College in Dublin examined government spending as a percentage of GDP in 2012 compared with the average level of pre-recession spending (2003–2007). Only Germany, Malta, and Sweden had actually cut spending.

Although several governments have raised tax rates, tax revenues have collapsed in response. The large and growing black markets in Greece, Italy, Spain, and even France are a testament to European tax policies.

Notably, this form of austerity has led to an increase, not a decrease, in the relative size of the public sector. For example, the Greek public sector, while getting smaller, has nonetheless been contracting at a slower rate than the private sector. Since the first bailout, Greece lost at least 500,000 private sector jobs but shed far fewer public sector jobs. For years, the Greek government has been pledging to cut 500,000 public sector jobs, and in 2013, the Greek government has finally pledged to begin laying off public sector workers over the next two years. A total of 12,500 civil servants, including teachers and police, face reassignment or the axe by the end of the year, with a further 15,000 facing the same options next year. This is also only a pledge.

Latvia cut government spending from 44 percent of GDP to 36 percent. It fired 30 percent of the civil servants, closed half the state agencies, and reduced the average public salary by 26 percent in one year. Government ministers took personal wage cuts of 35 percent, although pensions and social benefits were barely reduced and the flat tax on personal income was left untouched at 25 percent.

The Latvian economy dropped 24 percent in two years, but rebounded sharply in 2011 and 2012 with yearly real growth of over 5 percent. Unemployment hit 20.7 percent in 2010, but has steadily declined to a little over 12 percent today. Because the cuts prompted deregulation, Latvia enjoyed a boom in the creation of new enterprises in 2011. It was able to transition from a bloated construction sector to a vibrant economy of many small- and medium-sized enterprises. Latvia borrowed heavily from the IMF, and was criticized in 2009 for its overly aggressive economic strategy. Latvia recently repaid its loan to the IMF three years early, indirectly silencing its critics.

Monetary deflation
If one or more governments defaulted, northern European banks, which were large-scale investors in government debt, would have massive loan and capital losses. The result of these losses would be banks going out of business, calling in outstanding loans, or both, thereby reversing the money multiplier process and causing a decline in the money supply. The falling money supply — deflation — would make the euro more, not less, valuable.

However, a more realistic threat to the euro is that some governments might shed it and return to their own domestic currency. Fed up with the (prudent) restraint of money creation imposed upon them by the ECB, indebted governments might want to be able to print their way out of their trouble. But even if one or more countries walked away from the euro in favor of their own currencies, the euro could still be protected by the ECB.

This is because the ECB could exchange a particular country's old, previous currency for the euro, thereby adjusting the euro money supply so that the volume of euros in the remaining countries remained the same. This operation would not alter the quantity of money in the economy; it would simply swap one type of money for another, keeping the overall purchasing power constant.

Monetary inflation
The ECB has decided to take on the job, because European governments will not allow themselves to face the political consequences of a banking collapse and the subsequent economic problems that a debt deflation would bring about. Instead, they will, as all politicians do, delay the day of reckoning and let taxpayers and future politicians suffer larger problems down the road.

Printing money and increasing taxes and debt — to the tune of more than a trillion dollars — on the (northern) European taxpayer in order to prevent bank losses is called by some "saving the euro." But a question in case of would be, Why is the euro worth paying such a price?

With the higher prices and lower standards of living that "saving the euro" entails, all Europeans — except bankers and politicians — would be better off shedding the euro and returning to a "less expensive" currency. At the least, individual countries should decide if they want to force their own citizens to suffer the consequences of printing money and overborrowing. Under the current scenario, German and French citizens (mostly) will have to pay on behalf of the profligate Portuguese, Irish, Italians, Greeks, and Spanish.

Links

 * Financial Crisis and Recession by Jesus Huerta de Soto, October 2008
 * Growing Fallout from Eastern Europe's Busted Bubbles by Richard M. Ebeling, March 2009
 * Don't Bail Out Eastern Europe by Bogdan C. Enache, March 2009
 * The Global Debt Crisis by Marius Gustavson, March 2010
 * Have We Crossed the Point of No Return? by Philipp Bagus, May 2010
 * A Greek Tragedy in the Making by Ganesh Rathnam, May 2010
 * Global stock markets fall as Spain default fears grow by Emma Rowley, May 2011
 * In Europe, Rifts Widen Over Greece by Landon Thomas jr., May 2011
 * Eurozone woes are US woes by Robert Peston, June 2011
 * Why Italy’s Days in the Eurozone May Be Numbered by Nouriel Roubini, November 2011
 * Latitude by The Economist, November 2011, sums up economic indicators in the North and South
 * Asian powers spurn German debt on EMU chaos by Ambrose Evans-Pritchard, November 2011
 * Europe Fears a Credit Squeeze as Investors Sell Bond Holdings by Nelson D. Schwartz and Eric Dash, November 2011
 * UK alone as EU agrees fiscal deal, BBC, December 2011
 * Graphic: European debt crisis explained by Conrad Quilty-Harper, and Daniel Palmer, November 2011
 * Eurozone unemployment reaches new high by Andrews Walker, January 2013
 * European sovereign debt crisis of 2010–present on Wikipedia
 * How Greek Default May Still Unravel the EU by Frank Hollenbeck, January 2015
 * European sovereign debt crisis of 2010–present on Wikipedia
 * How Greek Default May Still Unravel the EU by Frank Hollenbeck, January 2015