Overview of Europe’s crisis

However, the real origins of the crisis can be traced to the very structures that govern Europe’s institutions.
The creation of the European Union as we know it today began with ratification of the Maastricht Treaty on 7 February, 1992. The Maastricht Treaty provisions imposed stringent economic requirements, known as “convergence criteria,” that member states are required to meet before they could gain admittance to the common currency zone that has come to be known as the eurozone.
Among these convergence criteria are:
l Price developments: These requirements are designed to ensure that member nations have low and stable inflation. Inflation in the year preceding potential admittance to the eurozone can only be 1,5 percent more than the average of the three best-performing member states. In practice, the rate of inflation used to determine if this criterion is met is the preceeding 12-month average of the Harmonised Index of Consumer Prices – the EU-wide inflation index.
l Fiscal developments: These requirements are designed to ensure a prospective member state has a strong fiscal condition. Among the requirements are budget deficits that cannot exceed 3 percent of GDP unless a nation finds itself in exceptional and temporary circumstances. Total sovereign debt amounts cannot exceed 60 percent of GDP. Both of these criteria are waived if there is evidence of substantial and continuous declines.
l Exchange-rate developments: These requirements are designed to ensure stability of a member state’s currency exchange rate before gaining admittance. Specifically, a prospective member cannot have devalued its currency relative to any other member state’s currency for the preceding two years.
The Maastricht Treaty failed, however, to provide enforcement mechanisms should a member state fail to meet the convergence criteria. Instead of enforcement mechanisms, the only provision is for the European Commission to prepare a report for the opinion of the Economic and Financial Committee, a body set up under the terms of the Treaty.
Admittance to the eurozone promised great economic rewards as nations whose sovereign credit ratings were lower than those of the strongest member states would be able to borrow money as if they too had the superior rating. In addition, the common currency held the promise of preventing trading partners from devaluing their currency, forcing all eurozone members to compete on a level playing field.
And with a European economy that featured a common currency, but that excluded centralised fiscal policy, it required individual nations to proactively manage their trade balance, lest such imbalances result in excess debt.
Thus, the coupling of tremendous economic rewards for admittance to the eurozone with no enforcement mechanism for nations failing to meet the convergence criteria created an incentive-rich environment for nations to overburden themselves with debt without much fear of reprisal.
In fact, as was later revealed, Greece was able to lie its way into the eurozone. This was disclosed by Eurostat in its 22 November 2004 report titled, “Report by Eurostat on the Revision of the Greek Government Deficit and Debt Figures.” Eurostat reported that Greece’s 2003 budget deficit had actually been 4,6 percent of GDP, rather than the previously reported 1,7 percent of GDP.
Additionally, the three Greek budget deficits of 2000-2002 were all revised upward by more than 2 percent. Meanwhile, total government debt figures were revised upward by more than 7 percent. As the authors of the report stated bluntly: “Data revisions of such a scale have given rise to questions about the reliability of the Greek statistics on public finances.”
Though it would be easy to exclusively blame Greece for the European sovereign debt crisis of 2009-2011, Greece’s debt problems are best viewed as a spark on a stack of kindling. The International Monetary Fund estimates that, from 2006 to projected year-end 2012, total debt in the eurozone will have increased from €5,870 billion to €8,714 billion, an increase of €2,844 billion. By comparison, GDP has grown from €8,568 billion in 2006 to an estimated €9,687 billion in 2012, an increase of €1,119 billion.
In other words, it is projected that absolute debt levels in the eurozone will have grown 2.5 times faster than GDP. Using the IMF”s projected figures for 2012 debt and GDP, here are the compound annual growth rates for debt and GDP for each member of the eurozone: Nearly all eurozone members – 13 of 17 countries – have debt levels exceeding the convergence criteria maximum of 60 percent.
Among this group are the large economies – Germany (81,9 percent), France (89,4 percent), Italy (121,4 percent), and Spain (70,2 percent). The projected 2012 debt of these four nations alone totals €6,732 billion, versus projected 2012 GDP of €7,410 – a debt-to-GDP ratio of 90,9 percent, a full 51,4 percent higher than the 60 percent maximum required by the convergence criteria. Thus the European sovereign debt crisis is truly a European crisis, and not just a crisis for the Greeks to resolve. – blogs.cfainstitute.org.

l Jason Voss, CFA, is a content director at CFA Institute, where he focuses on fixed income, behavioral finance, finance, and quantitative methods.