Europe's Debt Crisis Five Threats to the Common Currency

First it was Greece. Then came Portugal and Spain, with Ireland and Italy not far behind. 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. SPIEGEL ONLINE takes a look at the five greatest risks to the future of the euro zone.
An anti-capitalist piece of graffiti in Athens: Greece's debt crisis is just one of the euro zone's many problems.

An anti-capitalist piece of graffiti in Athens: Greece's debt crisis is just one of the euro zone's many problems.

Foto: Orestis Panagiotou/ dpa

European Union leaders are gathered in Brussels on Thursday for a summit which will focus primarily on how to address Greece's significant financial difficulties. Already, a number of EU leaders have voiced approval for an aid package for Athens.  Financial assistance is on the way, it seems.

"We are talking about lines of credit," said Austrian Chancellor Werner Faymann shortly before Thursday's meeting. He said the money could be made available with the help of the International Monetary Fund. Spanish Prime Minister Jose Luis Rodriguez Zapatero, who currently holds the EU's rotating presidency, also pledged EU solidarity in a meeting with his Greek counterpart. "We need a unified solution," he said. "The EU must prove that it is able to come to grips with the problem."

Graphic: Euro-dollar exchange rate

Graphic: Euro-dollar exchange rate

Foto: DER SPIEGEL

"If we only look at bilateral solutions, Greece threatens to become the victim or renewed market speculation," said Poul Nyrup Rasmussen, president of the Social Democratic group in the European Parliament. He called for "a unified solution from the countries belonging to the euro zone."

Such demonstrations of solidarity are good news for the euro. On Thursday morning, one euro cost $1.3780, about one cent more than on the previous evening.

The jump is a sign of confidence. For now, most investors seem to no longer believe that the worst-case scenario will come to pass: a Greek bankruptcy which could spread to other EU countries and trigger a market collapse like the one which followed the disintegration of the US investment bank Lehman Brothers in September 2008.

For now, at least.

Greece isn't the only problem facing the euro zone this spring. Public debt has skyrocketed across the Continent as a result of the financial crisis. Plunging tax revenues combined with expensive economic stimulus programs have severely stretched budgets.

In addition to Greece, Portugal is also facing serious difficulties. Spain, too, is under close observation. Of particular concern is the fact that, since the introduction of the euro, both countries have become less and less competitive. Instead of introducing necessary reforms, low euro-zone interest rates in recent years led them to rely heavily on borrowing. The financial crisis and concurrent economic stimulus packages magnified the problem. Greek's budget deficit ballooned last year to 12.7 percent of its gross domestic product. Spain also has a double-digit deficit -- both far away from the 3 percent mandated by the Maastricht criteria of the euro zone stability pact. Strict savings measures and deep cuts in public spending seem the only way out.

Graphic: Budget deficits in the euro zone

Graphic: Budget deficits in the euro zone

Foto: DER SPIEGEL

The same holds partially true in Ireland. The country likewise faces a large public deficit. The government, though, took drastic action in December, thus easing fears of a national bankruptcy.

Italy, too, has experts worried. The situation is, to be sure, not as bad as in Greece, but state debt has been well over 100 percent of GDP for years -- and the government has shown little interest in dealing with the problem.

That makes five of 16 euro zone states where public finances are in a shambles -- enough to make the entire Continent uneasy. Investors fear that stable countries like Germany, Finland or the Netherlands could ultimately be affected; that they may be forced to pay for the financial errors of Greece and the others; that the euro will continue to drop against the dollar; and that the common currency will become a millstone around Europe's neck.

The threat to the euro is in no way merely a short-term one. Even if Italy and Spain avoid bankruptcy for the time being, what happens if the governments of those countries are too weak to push through the necessary reforms? Both Greece and Portugal have already been hit by serious protests as a result of budget cuts. But without much-needed reform, the gap between the strong and weak members of the euro zone threatens to get ever wider.

Star economist Nouriel Roubini, a professor at the Stern School of Business in New York, voiced fears at the Davos World Economic Forum that the common currency zone could even break apart. Not necessarily this year, or even next. But if the Continent is unable to get its deficits under control, the threat remains.

Greece: The Euro Zone's Problem Child

Heavily indebted Greece is Europe's biggest problem. The country's debt is already well over 100 percent of GDP and is still rising. According to euro zone rules, total government debt should not exceed 60 percent of GDP. The country's budget deficit in 2009 was almost 13 percent of GDP, more than four times the 3 percent limit allowed in the euro zone.

Greece's main problem is that the huge debts must soon be refinanced. The rating agency Moody's calculates that the government will have to take on approximately €40 billion in new debt in the first half of 2010, just to service existing debt obligations and to finance new spending. The government itself states that it will need to refinance around 10 percent of its public debt in 2010, mostly in April and May.

That will be a difficult task for a country whose dire financial situation has been the subject of growing concern in recent weeks. The rating agencies and lenders on the capital markets are uneasy, while the so-called spread between Greece's 10-year government bonds and benchmark German bonds -- a measure of the perceived relative risk of the bonds -- temporarily reached a record high of four percentage points. Fears are growing that the state could soon go bankrupt, should it no longer be able to find buyers for its bonds.

The Greek government has now submitted its recovery plan to the EU, but they seem overly optimistic. According to the plan, the government intends to get its budget deficit under the 3 percent limit by 2012 -- a reduction of almost 10 percentage points within just three years. Out of the members of the Organization for Economic Cooperation and Development (OECD) in the period since the early 1990s, only Sweden has managed to accomplish a similar feat -- and it was helped along by the New Economy boom, which gave the global economy a helpful boost. Now, in contrast, the global economy is looking at a long period of stagnation, in the opinion of many economists.

The Greek government has now announced a program of far-ranging austerity measures in a bid to get its finances in order. It includes several measures affecting public sector workers, such as wage cuts, a hiring freeze and the cutting of supplemental wage allowances, as well as measures to fight tax evasion. But the austerity program does not explain how the public sector can be modernized and how corruption can be fought. Hence a large degree of uncertainty still reigns on the capital markets.

The Greek plan was also not enough to placate the EU. Speaking Tuesday, the EU's monetary affairs commissioner, Joaquin Almunia, said Thursday's summit should make it clear to Greece that any help would be in return for clear commitments. "You can't get support for free," he said. Greece can expect any bailout from other euro zone members to come with strict conditions.

Portugal: An Impotent Government

As well as Greece, concerns about Portugal have also triggered tremors on the markets in recent days. European Monetary Affairs Commissioner Joaquin Almunia is partly responsible for that. "Greece, Portugal, Spain (…) and others in the euro area share some features," he told a news conference last week. "In those countries we can observe a permanent loss of competitiveness since they (became) members of the Economic and Monetary Union."

The indirect comparison with Greece did not do Portugal any favors. The risk premiums for Portugal's 10-year government bonds soared, with the so-called spread over benchmark German bonds widening to as much as 1.5 percentage points at times.

Portugal is indeed facing enormous challenges. The budget deficit has skyrocketed, reaching 9.3 percent of GDP in 2009. And although the debt ratio at 77.4 percent of GDP is still around the European average, it threatens to rise to 85 percent in 2010. If the government does not take determined action soon, more and more investors may start doubting the creditworthiness of the country.

But whether the government can act with the necessary toughness remains an open question. Prime Minister Jose Socrates is the head of a minority government, meaning that the opposition can force laws through parliament against the will of the government. Recently, it managed to torpedo Socrates' planned austerity measures. In a parliamentary vote, both conservative and left-leaning parties approved a bill that provides additional financial transfers to the autonomous regions of the Azores and Madeira and which will create a €400 million hole in the budget over the next four years. Unsurprisingly, the move made investors nervous.

Socrates needs to get the country's budget deficit under the euro zone's limit of 3 percent of GDP by 2013. The government has announced it will cut civil service jobs and freeze salaries. However there is little prospect of far-reaching austerity measures or structural reforms. Portugal's agricultural sector is inefficient and outdated and the tourism sector is still being developed. The country has failed to increase its competitiveness against the northern EU members since it joined the euro zone.

In 2008 per capita income in Portugal was only 76 percent of the EU average. With a powerless government, it will be difficult to turn things around.

Spain: The Biggest Threat to the Euro?

Spain is well on its way to becoming the EU's next problem child. Indeed, experts fear that the country could become an even greater threat to the stability of the euro than Greece. "The biggest trouble spot isn't Greece, it's Spain," wrote Nobel prize-winning economist Paul Krugman in his blog recently. He also expressed concern about the burst real-estate bubble in the country. Economics professor Nouriel Roubini likewise sees Spain as being the biggest threat to the European common currency. The Financial Times has also pointed out that the next big problem for Europe is to be found in Madrid.

The country's public debt is relatively low, at 54.3 percent of gross domestic product. But the potential dangers for Europe are much greater than those emanating from Athens, because the Spanish economy is four times as large.

And there are fears that Madrid's debt could skyrocket in the next 12 months. The budget deficit spiked in 2009 to 11.2 percent of GDP. Furthermore, the country's economy has not followed the upward trend of most industrial states. According to IMF forecasts, Spain will be the only large EU state which will not experience economic growth in 2010.

Economists have little hope that the situation will improve in coming years. The motor that led the Spanish economy to flourish through the middle part of the 2000s, the real-estate sector, was demolished by the financial crisis. For years, the country benefited from an unprecedented construction boom, fuelled by rampant speculation. Now, half-finished settlements of new homes have become ghost towns and unemployment has grown dramatically. Fully 4 million Spaniards are without work, a jobless rate of more than 20 percent.

As a result, Spain needs to restructure its economy to a greater degree than most other countries in the common currency zone. At the same time, however, Madrid must follow a strict savings regime to pay down its debt.

To satisfy EU skeptics and begin the reform process, the government of Prime Minister Jose Luis Rodriguez Zapatero has presented an economic savings and reform plan. By 2013, the country wants to cut expenditures by €50 billion and shrink the budget deficit to 3 percent, as called for by euro zone rules. But the plan quickly became an embarrassment. Just hours after submitting the plan to EU bean counters in Brussels, Madrid had to make corrections. The paper called for deep cuts to pensions, which resulted in a storm of protest in Spain. The passage was cut. "We are dealing with an unbelievably botched plan," wrote the paper El Mundo the next day.

Investors, understandably, are concerned. The spread between Spanish state bonds and benchmark German bonds -- a measure of the perceived risk of the bonds -- is currently over one percentage point.

Ireland: Reforms Underway but Big Debts Remain

Ireland continues to battle the effects of the global downturn. Its budget deficit, standing at 12.5 percent of GDP, is almost as high as that of Greece. In 2009, the Irish economy was even worse hit than the German economy -- the European Commission estimated that the Republic's economy shrunk by 7.5 percent.

But leading economists, like Paul Krugman and Nouriel Roubini, have already struck Ireland from their list of countries in crisis. In early February, European Central Bank chief Jean-Claude Trichet labeled Ireland's example as "impressive."

The government in Dublin has already introduced the kinds of reforms that Greece, Portugal and Spain have only just begun addressing. It has slashed civil servant salaries and has embarked on a plan to cut spending by €4 billion. The government has also managed to stabilize Ireland's all-important banking sector, for now at least. Around €77 billion in bad loans have been taken off the books of the struggling banking sector.

But rating agency Standard & Poor's has correctly pointed out that this debt was only moved out of the official budgets -- meaning that it continues to provide a large element of uncertainty for the country.

Italy: Overlooking the Debt Mountain

The risk premium on Italian government bonds has increased significantly in recent weeks. Its 10-year bond stands a good one percentage point higher than its German equivalent -- and at first glance, that is not surprising. After all, Italy's total public debt is sky high: According to government estimates, it stands at more than 100 percent of GDP.

That, though, has been the case since 2006, long before the outbreak of the crisis. Economists are giving Italy the all-clear for now, saying it does not face the same short-term risk as Greece and others. Nor does Italy have the same crisis symptoms as the more economically fragile European countries.

Unlike Spain, Italy's economy has not been shaken to its foundations by the bursting of a housing bubble. Unlike Greece, its government does not tinker with its own budget deficit figures. Unlike Ireland, its financial sector has not been badly affected by the crisis: The Italian banking oversight system has long been relatively strict, even before the Lehman Brothers crash.

In addition, it is seen as unlikely that Italian public spending will significantly increase in the foreseeable future. On the contrary, the government pushed an austerity package through parliament in July 2008. Nevertheless, a national debt of more than 100 percent of GDP remains a huge risk factor. And Italy's current budget deficit of 5.3 percent of GDP may be well below that of other crisis-struck countries, but it still lies well above the stability pact limit of 3 percent. "Government spending continues to gallop," criticized the Milan economist Tito Boeri last week. And the Italian government shows no sign of trying to change the situation any time soon.

The rating agency Fitch recently criticized Italy, saying it has indefinitely postponed almost all its measures to slim down its debt. As a result, it is no big surprise that capital markets are lumping Italy together with high-risk euro zone countries such as Greece and Portugal.