Since joining the euro back in 1999, the governments of Greece and Portugal (among other offenders) have gotten used to spending a lot of money. When times were good, it wasn’t a problem — banks and other investors were willing to lend them money on the cheap and their public sectors became bloated.
When the financial crisis hit, however, problems came to a head. Debt levels in Portugal, Italy, and Greece became unsustainable, and taxes in a contracting economy are no longer enough to pay the bills.
Greece, Portugal, and Ireland are still struggling to bring their public debt under control, after receiving billions of euros in bailout aid from the European Commission, the International Monetary Fund, and the European Central Bank (the so-called troika). Some of this aid was provided through a temporary Special Purpose Vehicle called the European Financial Stability Facility (EFSF).
These governments needed this money because it became too expensive for them to borrow cash on the open markets, with speculators demanding high rates for lending and traders even betting on a disorderly sovereign default.
The initial round of aid money helped these governments prop up their banks and pay their bills. The ECB also started buying government bonds on the secondary market in order to keep borrowing costs low.
But now Greece needs more dough to stay solvent. EU leaders agreed back in July that a “selective default” was the only option for Greece. Under this situation, euro area nations will guarantee payouts on Greek sovereign debt, but the private sector will bear take a loss — a “haircut” — on their debt holdings, reducing the face value of those holdings.
Italy and Spain are now crucial to the debate. The former has an incredible level of public debt (120 percent in 2010) and the latter has been crushed by a housing bubble and subsequent banking crisis. The July agreement also expanded the EFSF to €440 billion and allowed the ECB to purchase Spanish and Italian government bonds.
Banking Sector Affected
All these problems are now affecting the banking sector. Sovereign bonds in the PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain) — which just a few years ago were highly rated — have lost their high ratings, forcing banks to fear big write downs that cripple lending. Investors wary about the consequences of a Greek default (and other economic problems) are unwilling to loan out cash, producing a liquidity crisis. This is creating a vicious cycle and funding conditions are getting ever tighter.
This hurts economic growth not only in the euro area periphery but in core countries like Germany and France, which have kept their spending under control. While they are to blame for letting the PIIGS spend freely during the good years, now they’re angry. They don’t want to print more money to allow the PIIGS to get off scot-free because it would deflate the value of their own assets. Taxpayers don’t want more of their money siphoned off.
But they also would suffer horribly if Greece defaulted and the banking system collapsed.
The Past Six Months: An Overview
When the 17 leaders of eurozone countries agreed to a second bailout for Greece back in July:
The economic situation in Europe wasn’t quite as bad as it is now. There wasn’t as much skepticism about Greece's ability to actually make good on the deficit-reduction and privatization goals that were terms of its first bailout. And — perhaps most importantly — there were not as many signs that banks across Europe were having trouble getting access to cash.