The Tipping Point
The EU has run into financial difficulties from which it is unlikely to recover. The states of the EU have different taxation and debt policies that are maintained under each individual state. The political structure of the EU doesn’t have the authority to tax individual states for their debt burden or even the right to tax the entire EU to assist one struggling state. Those burdens are left to the individual states themselves by selling bonds to the general market, which usually involves banks of other members of the EU.
For instance, let’s take a look at the favourite whipping boy of the EU right now: Greece. Historically, Greece has had a bit of a left-leaning, socialist populace. When the country reverted back to a democratic government in 1974, many social welfare-like government programs were enacted to appease its citizens. Greek citizens embraced and became accustomed to the idea of “Big Government,” where the government spends a lot of money in all aspects of daily life.
While a healthy dose of government spending sounds like a panacea that can help everyone, there is a certain amount of social morality and responsibility that has to go along with it. Namely, citizens who are receiving the great benefits of that government spending have to pay their taxes. Taxes in nations with high government participation are usually higher than those with small government spending. Unfortunately, a higher tax usually leads to people looking for ways to avoid them, and in Greek society, this has become a national pastime.
In 2011, former Greek Prime Minister George Papandreou declared that Greece was losing approximately €30 billion in tax revenues due to tax evasion. That accounts for approximately 14.6% of Greece’s GDP!
Considering that the current revenues on taxes amount to around €82 billion, the Greek government is failing to receive a little more than a quarter of what they should be getting. Spending meanwhile, has not gone down accordingly. In fact, it has actually increased. So the Greek government started to borrow money to pay for their obligations. They sold bonds (IOUs) to anyone who wanted to purchase them, promising that the purchaser would get their money back, with interest, at the date printed on that note.
Overwhelmingly, banks are the purchasers of those bonds. What better way can a bank invest money safely than buying bonds of a sovereign nation? It seemed like a no-brainer investment. But just like the credit card abuser, the money runs out eventually, and the banks began to realise this. In turn, they were demanding to be paid more interest to buy those bonds.
How did it get to this point? When it comes down to it, politicians really like being politicians, and they will usually do whatever they can to keep that political post. No politician wants to rock the boat or be the “bad guy” and tell the populace that they need to reign in their spending. Besides, if people continue to loan them money, then they will continue to take it. Kicking the can down the road instead of picking it up and putting it in the trash is much easier and much more politically popular.
The tipping point came when Greece could no longer afford to pay back the money that it owed. This is the equivalent of defaulting on your home’s mortgage. Ideally, the bank would go in, take possession of the asset, sell it off, and write off their losses. However, banks that lent money to Greece couldn’t just send a letter of eviction to a sovereign nation and take all of their stuff. They would just have to take the losses, allow Greece to default, and deal with the consequences of their actions.
Letting Greece default, however, would be catastrophic for the EU because the majority of the banks that were purchasing those bonds are from either France or Germany. If Greece doesn’t pay their obligation to the banks, the banks won’t have money coming in. They could then decide that it’s better to not loan to anyone because they are losing money on their Greek deal. Or worse yet, the banks could just go bankrupt. Suddenly, businesses in export-driven France and Germany can’t borrow money from the banks to make the products that they are trying to export. As they can’t make those products, they begin to lay people off, unemployment goes up, the health of the economy goes down, and we fall in to another worldwide recession, if not depression.
This is why some have suggested that any bailout of Greece is actually a bailout for French and German banks in order to keep the European machine running. As the crisis has come to a head in recent months, many people, including FX360 analysts, have suggested that Europe must consider collectivising a portion of the debts of its member states by authorising the central bank to issue bonds backed by the credit of the EU as a whole.
But France and Germany have both ruled out such a step, for fear of putting their citizens on the hook for financial troubles of weaker member states.
If Greece were the only EU nation going through this issue, there wouldn’t be that much fanfare. In fact, Greece accounts for only about 2% of the total Eurozone economy. The recent bailout of Greece via the European Financial Stability Facility (EFSF) was supposed to fix all of the problems by forgiving some debt and implementing austerity measures (less government spending) to fill the gaps. Unfortunately, Greece is not alone; Portugal (1.5% of Eurozone economy), Ireland (1.3%), Italy (12.7%), and Spain (8.7%) are having the same type of issues.
Using the example of a home loan again, imagine that your neighbour defaults on his home’s mortgage. You might expect the bank to come in and tell him that he must vacate the home and the bank will take possession. But instead of kicking him out, let’s assume that they let him stay and that he doesn’t have to worry about paying back the old mortgage. The bank will give him a new mortgage at 50% of the old one and he can continue to live in the same house. What do you think you are going to do? Defaulting on your mortgage would seem like a great idea at that point. This is a classic exercise in game theory, where one’s success is based upon the choices of others. The rest of the PIIGS nations are looking at Greece and would logically want the same treatment. The EFSF was supposed to solve the problem, but it appears it may have just opened a gigantic can of worms.
