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The Euro and the Sovereign Debt Crisis

As can be seen from the US/Euro foreign exchange rate, the lowering by Alan Greenspan of the US Federal Funds Rate, which was inflationary to the US dollar (devaluation) created an increase in value for the euro. From 2003 to mid 2008, the euro appreciated at a 12.2% compounded rate (FRED Economic Data n.d.).

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With the onset of the financial crisis in 2008, there was a run to the dollar as it was the largest and most liquid currency, the reserve currency of the world. Also, the European banking system held significant dollar denominated assets, for which credit became non-existent virtually overnight, losing 21.9% into 2009 (FRED Economic Data n.d.).

In 2009 the Euro staged a significant rally, regaining lost value. This correlates to the initiation of the Federal Reserve under Ben Bernanke, of the first Quantitative Easing Program (QE1). The QE program was simply a massive inflation, to provide liquidity to the banking system directly, and the financial system indirectly. This took place in late March 2009 (FRED Economic Data n.d.).

The first QE program lasted approximately one year. With the inflation of the US dollar ended, the euro again lost value. Two more rallies and declines correlate closely with the two further QE programs initiated by the Federal Reserve: QE2 and Operation Twist (FRED Economic data n.d.).

These currency exchange valuations are quite rational as the exchange value represents the purchasing power of the currency for produced goods and services. An increase in dollars will allow increased purchases of European produced goods and services, which, will paid for in Euro’s, purchased by US dollars, pushing the price of the euro higher, and the value of the dollar lower.

With the onset last weekend of the change in the governments of Europe, the financial markets became nervous of the increased uncertainty in Europe. With Operation Twist scheduled to culminate at the end of June, the sell-off in the euro reflects both the political risk and the slowing of US inflation, although, with the current fiscal deficits and approaching US Presidential election, I would expect a further QE program to be announced sooner rather than later (FRED Economic Data n.d).

The financial crisis in Europe and America is at root cause, an excess of debt over the ability to service that debt. The origins lie initially with the Federal Reserve Bank and Alan Greenspan. With the tremendous stock market bubble in America that ran from 1982 to 2000, best exemplified by the dot.coms, which entered a bear market in April 2000, Alan Greenspan, then Chairman of the Federal Reserve, enacted monetary policy designed to prevent or shorten the recession that engulfed America. He lowered the Federal Funds rate to 1%. The result of this easy money policy was to encourage the expansion of house purchases (Hartcher 2006, pg.205).

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Much has been made of the regulatory changes made by the US Congress and Senate in the lead-up to the crisis that has engulfed Western governments today.

While there is certainly some validity to these arguments, they miss the essential point. In the US and Europe, commercial banks are legally allowed to undertake fractional reserve lending. Fractional reserve lending is the use of a demand deposit, which is a contract that does not transfer ownership of the fungible deposit consisting of money, from the depositor, to the bank, to create new loans (De Soto 2006 pg.7).

The bank, must reserve a fraction of the deposit for liquidity purposes. This will vary based on reserve requirements set by the individual countries Central Bank. The remainder, can be loaned to a new customer. The new loan created, will be deposited into a bank account as a demand deposit.

The customer will at some point draw down on that loan, for the purpose that it was incurred. The new demand deposit that was created, can however be used as the basis for making a new loan to another customer. Once again, a reserve is made for liquidity purposes, and the remainder can create a new loan. The result is an expansion of the money supply through the expansion of credit in the commercial banking system. The expansion multiple is regulated via the reserve requirement mandated by the Central Bank.

The second change that spread this growth of debt worldwide was the sanctioning of mortgage debt to be pooled into securities, or, securitization. Thus a bank that made housing loans to customers, could, once a specific dollar figure of mortgage loans, sell those mortgages to investment banks who would package them into mortgage backed securities (MBS). These MBS were then sold to investors all over the world. This removed the mortgage loans from the commercial banks’ Balance Sheet, allowing the bank to start the whole process again.

So lucrative was this business to both the commercial banks and the investment banks in the layers of fees that they were able to charge at each stage of the process, that of course, the banks pursued this business, and declared increasing earnings from 2001 through 2007. As most of the banks are publicly traded common stocks, their share prices eventually responded to the increase in earnings.

The demand from the banks for new deposits, from which to leverage the creation of new mortgages, was driven by the high profitability that these fees provided. The money markets became a source of new capital, with which to create new mortgages from. The commercial banks knew that due to securitization, the new mortgages that they created, would in a short period of time, be removed from their Balance Sheets. In this case the banks undertook a risky strategy: they borrowed short and lent long.

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This created a maturity mismatch. The money that they borrowed short, would fall due for repayment before the loan principal. The banks had two solutions to this problem: first, the mortgages on the bank’s Balance Sheet had to be sold to the Investment banks for MBS packaging, and second, they simply rolled over the short-term loans. The second solution was the best, provided one critical provision: that the money markets were able and willing to rollover the short-term loans.

In economics the law of supply and demand rules. The commercial banks had secured a supply of money, with which to continuously expand credit, and thus the money supply. They required a demand for this credit expansion. The flood of new credit that was flowing into the housing market had its usual effect, nominal prices started to rise due to the demand of new customers who had now qualified for a mortgage (FRED Economic Data n.d.).

The early applicants had reasonable credit scores, the banks undertook due diligence. The early mortgages that were packaged into MBS have had relatively lower default rates than later ones. This is because to satisfy a demand for their seemingly limitless supply of new money, the commercial banks lowered their credit scores required to qualify an applicant for a mortgage. In the end, there were no requirements at all. Anyone could, and did, qualify for a mortgage.

The quality of the mortgages granted declined precipitously. These mortgages became known as the sub-prime mortgages. These were also packaged as MBS and sold to investors all over the world.

There existed into 2006 a demand for housing, due to the massive creation of credit by the commercial banks, that could not be met by new supply quickly. It takes time for a new house to be built. Land has to be sourced, planning permission from local governments obtained for building permission of the type of building to be erected, labour and materials sourced, and finally if all the various requirements are fulfilled, building of new housing stock can be undertaken and completed (FRED Economic Data n.d.).

In 2006 the top of the housing bubble was reached in the US, as supply finally exceeded demand. The initial result was simply a pause, as prices stopped rising. As 2006 turned into 2008, and the interest rates under pressure from a rising Federal Funds rate, which under Chairman Bernanke, had been rising, the sub-prime area of the market started to default (FRED Economic Data n.d.).

The supply of MBS was for the Commercial banks and Investment banks, who between them created the supply of MBS, was so lucrative because of the demand for their supply. Pension Funds, Banks, Insurance companies, and Hedge Funds from all over the globe, purchased these securities. Why? Simply because many of them, Pension Funds and Insurance companies in particular, held long dated liabilities. MBS products provided them with a long dated maturity, that they could then match to the liability. Being that these were mortgages, they carried, relative to other fixed income, higher yields. Don’t higher yields usually mean higher risk?

Higher yields are understood to carry higher risk. However the three ratings agencies: Standard and Poor, Moody’s and Fitch, all rated the MBS securities with their highest AAA ratings.

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The reason that they provided in the aftermath, was that the securities were diversified geographically, and that the US had up to that point, never suffered a national property recession. There had been numerous examples of regional property busts, California, Texas and Florida had at various time had property booms followed by busts, but never a national boom and bust concurrently. They reasoned therefore that due to that fact, and that due to the geographic diversification of the MBS products, that an AAA rating was fair.

The creators of the MBS products knew that there was a large demand for higher yielding fixed income investments. MBS products were therefore created with differing tranches of risk. The higher the yield provided by the MBS, the higher the concentration of lower credit quality mortgages constituted the tranches, pushing the yield higher. Now MBS securities had geographic diversification and credit diversification, which, the ratings agencies again awarded AAA ratings to.

When in late 2008 the defaults started in earnest, it escalated rapidly. The average write-off at US commercial banks averaged 0.20 or less since the 1980’s with a couple of exceptions. From Q1 2004 – Q3 2006 default write-offs were 0.10 or lower. In Q4 2006 they jumped to 0.15. They remained elevated, and started to rise. In Q1 2008 they rose to 0.85. By Q4 2008 they had risen to 1.63. In Q4 2009 they hit their current cycle peak of 2.85 (Board Of Governors of the Federal Reserve System n.d.).

When a loan is created through fractional reserve lending, creating an expansion of credit and the money supply, it creates a multiplier that is proportional to the reserve requirement. When a loan, created through credit expansion defaults, it creates a multiplier in a contraction of credit and the money supply. The default of a loan creates a deflation, or liquidity crisis, where there is not enough physical money to supply the demand to hold physical money.

Because MBS had been sold all over the world, to all manner of financial institutions, the contraction in the money supply shut off credit across all markets. The extent of the crisis can be seen directly in the LIBOR data. At the height of the banking crisis, banks essentially stopped lending to each other. Credit simply did not exist at this point, and this contagion spread all over the world. Probably for the first time since the 1930’s bank runs were seen all over the world as depositors rushed to withdraw cash, as no-one was sure whether their bank could survive (FRED EConomic Data n.d.).

It was into this maelstrom that the Central bankers and governments acted, creating massive injections of new credit and money, which was supplied not just to the banking system, but eventually the entire financial system worldwide. The Federal Reserve before the crisis, held on its Balance Sheet less than $200 billion in reserves, expanded at the peak to $1.7 trillion in reserves. MBS held by the Federal Reserve on their Balance sheet was just below $1.2 trillion in 2009 (FRED Economic Data n.d.).

In addition to the Federal Reserve supplying as much liquidity to the banking system as required, the US government created the Troubled Asset Relief Program (TARP). This was signed into effect by President Bush in October 2008 and authorized $700 billion to purchase troubled assets, predominantly sub-prime MBS products from financial institutions. It was a further liquidity creating measure, required to counteract the deflationary forces unleashed through the rising default rate.

Europe was embroiled in this crisis in part because their financial institutions purchased US created MBS products, and second because they fueled their property bubbles through the same borrow short, lend long maturity mis-matches through the financial money markets, but the European banking system added a further layer of risk: they borrowed in US dollars.

When dollar credit froze, the European banks were at the point of collapse as they could no longer rollover the short-term maturities to refinance in dollars. The European Central Bank started a credit expansion, creating an expansion of euros, which were sold, purchasing dollars. In addition, the Federal Reserve initiated a Swaps and Repurchase program that supplied dollars to the European banking system (FRED Economic Data n.d.).

The result worldwide of the banking crisis, has been to create an employment crisis. With the significant expansion of employment within the building industry to satisfy the demand for residential and commercial property, when that demand evaporated almost overnight, employment in the building industry collapsed worldwide. When an industry expands to the degree that the building industry had, and then collapses, other areas of the economy suffer the loss of demand, and also have to reduce employment and their demand. The rise in unemployment worldwide and specific Euro areas has been a tragedy.

In Europe, the welfare state is more generous than that in the US. Automatic stabilizers take effect as unemployment levels rise, reconfiguring welfare entitlements and provision. This is not free. Government taxation provides the revenues required to pay for welfare programs. With fast rising unemployment, government revenues also fell rapidly. At the same time that government revenues were falling, their expenditures were rising, creating deficits.

In the Euro block the union was monetary, not fiscal. This meant that unlike countries that tied monetary policy to fiscal policy, allowing the massive printing of money (inflation), the European countries could not print money and devalue their currencies, but provide the money required to pay for their welfare programs. Their only option was to borrow. To increase the ratio of sovereign debt to Gross Domestic Product (GDP). This is exactly what they did.

The problem is that with the entire world in recession, and all that can, devaluing their currencies to promote exports, and by implication employment in those export industries, Europe could not individually devalue to promote exports. Exports became relative to Chinese, American and Japanese exports, expensive. This has maintained the unemployment levels, and increased them, putting even further strain on individual members with debt to GDP ratios.

The ECB, largely controlled by Germany, one of the few European nations that have weathered the storm, advocate severe expenditure cuts if that member requires additional loans. To date Ireland, Greece, Portugal, Italy and Spain are all in various stages of trying to implement austerity measures. The elections over the weekend, signaled the electorates dissatisfaction with the austerity measures imposed by the ECB. France elected an outright Socialist. Greece looks to need to stage further elections, and there is a real risk of Greece leaving the Euro area.

European banks hold significant values of sovereign debt. Why do they hold so much? This goes back to one of the great fallacies or myths: sovereign nations or governments do not default on their debt. You would think that this myth would have been long dead after Russia defaulted in 1998 on their Rouble debt, and the numerous Latin American defaults through the decades.

Even the US under Nixon, when he closed the gold window in August 1971 created a de facto debt default. Why then is it any surprise that Euro nations, struggling under enormous debt burdens, run the increased risk of default? If that is accepted as a reasonable assumption, why would banks purchase said debt?

To understand why the banking system is again at risk from sovereign debt the creation of credit must be examined. The ECB creates reserves for the commercial bank in question, and the bank sells Euro denominated bonds to the ECB. The commercial bank now has cash. A government can now incur Euro denominated debt through selling debt to the bank in exchange for cash denominated in euros. The bank, then repeats the process.

This can only continue for as long as the ECB purchases the Euro debt supplied by the government in question. The bank can also act on its behalf, purchasing debt from individual governments to gain the interest payments. If the debt purchased has a higher yield than the cost of funds, the bank will earn the spread less costs. This means however that the risker governments, to fund themselves, are required to pay a higher interest rate. The government cannot set through monetary policy its own desired interest rate.

The consequences of this are plain to see. Countries whose economic growth has slowed, earn less in tax revenues with which to service their current expenditures, thus to finance the deficit, they require further borrowing, increasing again the interest burden. Any commercial bank that purchases debt issued from a sovereign that has a deteriorating debt/GDP ratio, while gaining increased yield, runs the risk of a sovereign default.

If a sovereign does default, there is once again a contraction in the money and credit supply. Depending on the size of the default, once again a deflationary spiral could be triggered, that would necessitate a liquidity injection by the ECB, or potentially allow financial institutions holding excessive sovereign debt of that nation on their Balance Sheets, to fail. To avoid that problem, a restructuring deal has been put into place.

To date, the ECB under pressure from the Germans, have forced a Greek restructuring of their debt. This entailed an enforced acceptance of a reduction in principal. From

“The deal under dispute asked bondholders to give up 53.5% of the principal of their bonds by swapping them for new ones carrying lower interest rates and longer maturities but also a higher credit rating. Investors also received two-year triple-A European Financial Stability Facility bonds as an incentive to participate in the deal. In exchange, Greece was promised new loans totaling Euros 130 billion” ( 2012, para.6).

Also from the Wall St. Journal,

“Greece said Wednesday it had completed the mammoth debt restructuring demanded by its international creditors in exchange for its new €130 billion ($172 billion) bailout, but it remains unclear what the country will do with the small group of dissenters who have refused to voluntarily sign up to the deal. Holders of this Greek debt have taken losses. The figure would have very carefully been calculated to spare any banking collapses when the principal was written down. In addition a mini-bailout also was part of the deal; with AAA European Financial Stability Facility Bonds providing I suspect, close to the lost principal write-down to the banks involved” (Wall St. Journal 2012, para.1).

Currently, the Euro area under the European Central bank is undertaking the same solution that is being applied in China, Japan and the US: inflation. The ECB has under the Long Term Refinancing Operation, has expanded its Balance Sheet to almost Euros 3 trillion. From the Wall St. Journal;

“LONDON—The European Central Bank handed out €529.5 billion ($712.81 billion) in cheap, three-year loans to 800 lenders, the central bank’s latest effort to arrest a financial crisis now entering its third year. Wednesday’s loans were on top of the €489.2 billion of similar loans the ECB dispensed to 523 banks in late December. The ECB’s goal is to help struggling banks pay off maturing debts and to coax them to lend to strained governments and customers. The takeup of this week’s loans was roughly consistent with what bankers, investors and analysts had expected. The December loans helped spur a large rally in Spanish and Italian debt, particularly among bonds that are maturing before the ECB loans must be repaid. This time, Spanish and Italian two-year bonds saw modest gains, pushing down yields. The price of Italian 10-year bond, a key indicator of investor confidence in the euro zone, also strengthened, pushing the yield to 5.19% compared with 5.31% before the ECB disclosed the size of its lending” (Wall St. Journal, 2012,para.1).

In the long term there are only two possible potential solutions: the first is a common fiscal policy, the second, a break-up of the Euro-zone. Both have advantages and disadvantages, but one is far more likely than another.

The second outcome, the dissolution of the Euro-zone, has history on its side. Europe historically has developed under distinct cultures and languages. Countless wars, both major and minor have scarred the individual nations and populations. Existing political divisions divide any potential consensus being found, even if a thousand years of history could be put aside.

For a fiscal union to take place, which in practical terms means a common tax policy and welfare system, the country to whom the largest proportion of the tax bill would fall, would have to agree that their taxes went to support not Germany unemployed, but rather Greek, Spanish and Italian unemployed, with the French soon to be adding to the total, as the new Socialist government policies will rapidly expand that total. Simply, after footing the bill to absorb Eastern Germany back into West Germany, after the bankruptcy of Soviet Communism, the Germans will not.

This leaves the dissolution of Europe as a monetary union. This is probably for the best. The much touted advantages have been nothing but propaganda and a politicians pipe dream. From the Cato Institute;

“The creation of the eurozone was presented as an unambiguous economic benefit to all the countries willing to give up their currencies that had been in existence for decades or centuries. Extensive, yet tendentious and, therefore, quasi-scientific studies were published before the launch of the single currency.

Those studies promised that the euro would help accelerate economic growth and reduce inflation and stressed, in particular, the expectation that the member states of the eurozone would be protected against all kinds of unfavorable economic disruptions or exogenous shocks. This is clear that nothing of that sort has happened. After the establishment of the eurozone, the economic growth of its member states slowed down compared to the previous decades, thus increasing the gap between the speed of economic growth in the eurozone countries and that in major economies such as the United States and China, smaller economies in Southeast Asia and parts of the developing world, as well as Central and Eastern European countries that are not members of the eurozone.

Since the 1960s, economic growth in the eurozone countries has been slowing down and the existence of the euro has not reversed that trend. According to European Central Bank data, average annual economic growth in the eurozone countries was 3.4 percent in the 1970s, 2.4 percent in the 1980s, 2.2 percent in the 1990s and only 1.1 percent from 2001 to 2009 (the decade of the euro) (see Figure 1).1 A similar slowdown has not occurred anywhere else in the world” (Cato Institute 2012, para.2).

In the event of a Euro-zone dissolution, the euro will cease to exist, with a return to national currencies that prevailed before the euro. This is not a solution to the underlying problem which is not purely a question of currency, but rather a question of economic growth and productivity. Germany is the dominant economy, because it is the dominant producer, thus any currency that Germany utilizes, will reflect this economic reality.

Whether Greece, Ireland, or Portugal leave the Euro-zone, they will be able through a reversion to a home government controlled currency, in the short-term, be able to resort to the inflation strategy. This will not however create the panacea to their economic problems: it simply allows the day of reckoning to be put off to another day. The answer, however is unpalatable, the debt that cannot be serviced or repaid, must be defaulted on. This will allow the debt burden to be relieved.

Further the money monopoly enjoyed by government has been grossly mismanaged. It needs to be revoked, and a free market money such as the classic gold standard, where physical gold circulated as money, needs to be reinstigated, along with the abolishment of fractional reserve lending. With gold as a money, Europe, and the whole world would again be on a single currency. Banks on a 100% reserve requirement could not inflate the money system for fear of a bank run and insolvency.

To create growth, the natural rate of interest needs to drive the market rates of interest. Market rates of interest reflect consumers time preferences, present consumption against future consumption. To create economic growth, present consumption must be curtailed with increased savings that are invested in more roundabout productive processes that produce a greater quantity of goods. This increased supply lowers their price, assuming a constant demand.

Will Europe follow such a course? It is highly unlikely that the governments will voluntarily cede power. Unless their Keynesian policies bear fruit, this outcome may be forced upon them.


Cato Institute 2012, When Will the Eurozone Collapse? Web. 2012, Greece completes exchange of EUR20.3 billion of foreign law bonds. Web.

Board Of Governors of the Federal Reserve System, n.d., Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks. Web.

De Soto, J. 2006, Money, Bank Credit, and Economic Cycles. Mises Institute, Auburn, Alabama.

FRED Economic Data n.d. Web.

Hartcher, P. 2006, Bubble Man. W.W. Norton Company Inc., New York.

Wall St. Journal 2012, Greek Debt Restructuring Leaves Dissent Question. Web.

Wall St. Journal 2012, ECB Gives Banks Big Dollop of Cash. Web.

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