2 European financial crisis
When does the narrative of the European financial crisis start? Is it with the first bailout loan granted to Greece in May 2010, the introduction of the European Stimulus Plan in November 2008 or the bankruptcy of Lehman Brothers, announced on 15 September 2008? A subsequent question concerns the nature of the European financial crisis. In particular, has it been a financial crisis, a banking crisis, a sovereign debt crisis, a crisis of trade imbalances or a mortgage crisis? Moreover, can we consider the European crisis an extension of the global financial crisis or as an entirely different phenomenon? None of these views are wrong. The European crisis is a multi-faceted phenomenon produced by a combination of factors: the financial meltdown of 2007, the weaknesses of the banking system, governments’ budgetary politics, but also, or even foremost, the institutional weakness of the Economic and Monetary Union (EMU) (Dyson, 2000).
The common currency was introduced in the European Union even though many economists and political scientists argued that the EU is not yet an optimum currency area (Enderlein and Verdun, 2009; Krugman, 2012). In particular, it has been observed that the eurozone meets only two out of three necessary conditions for establishing a common currency zone. While it is true that (1) labour mobility is guaranteed in the Treaties1 (Article 45 of the Treaty) and (2) the member states of the eurozone conduct most of their trade with each other, there is no fiscal integration. In particular, the eurozone is a monetary, but not a transfer, union, meaning that redistribution and taxation remain within the competence of particular member states.
However, European decision-makers were convinced that the peer pressure alone would be sufficient to maintain fiscal disciple along the lines laid down in the Stability and Growth Pact (Enderlein and Verdun, 2009) (Dyson, 2000), (Heipertz and Verdun 2005). Hence, a fully-fledged fiscal union was not considered necessary. First of all, a common currency was economically attractive: given the fact that the member states conduct most of their trade with each other, the introduction of the euro was supposed to make cross-border business less expensive and less complicated. Uncertainties related to fluctuating exchange rates were simply eliminated. However, there are also disadvantages due to membership in the common currency; in particular, governments can no longer devalue their currency in order to foster domestic competitiveness. The only option available is so-called ‘internal devaluation’, which entails direct cuts in wages.
Finally, the eurozone was not conceived as an exclusively economic but also as a political project (Dyson and Featherstone, 1999; McNamara, 1999). The expectation was that the euro would strengthen the perception of the European Union as an entity and deepen European citizens’ attachment to it (Risse, 2014). The political incentives have, therefore, played an important role in the process.
The global financial crisis erupted in the United States and later spilled over to Europe, affecting first of all its banking system. Accounting for the causes of the global financial crisis in 2007, Campbell (2010: 85) observed,
Many of these reforms were rooted in the rising prominence of neoliberalism as the guiding light for US regulatory policy. The rise of neoliberalism was driven in large part by the financial services industry, especially on Wall Street, and their powerful allies in Washington.
Probably the most direct cause of the financial crisis was the trend towards deregulation in the housing market and risky lending practices. The policy of cheap credit increased the availability of sub-prime mortgages – that is, mortgages granted to people with a poor debt-to-income ratio. After the bursting of the housing bubble in the United States, defaults on sub-prime mortgages became very frequent. For instance, by September 2008 the average price of houses in the United States had decreased by 20 percent, meaning that borrowers who defaulted on their loans could not repay the whole sum owed by selling the property.
The development of the shadow banking system has been recognized as another major cause of the global financial crisis (Campbell, 2010). Shadow banking entities are financial companies that operate in market segments previously dominated by ‘standard’ banks. However, shadow banking entities are not subject to the same regulatory practices concerning, for instance, the level of deposits, as standard banks. Due to that difference, shadow banking proliferated and boosted the proportion of risky operations. For instance, the Lehman Brothers investment bank, which declared bankruptcy on 15 September 2008, has been criticized for pursuing particularly risky operations in the sub-prime market. The federal government decided not to bail out the bank in order to manifest its condemnation of its prior risky practices.
In the United States and Europe decision-makers responded to the crisis with a fiscal stimulus. In Europe, in November 2008 the European Commission proposed the European Economic Recovery Plan,2 aimed at alleviating the effects of the global financial crisis. The plan, envisaged for two years, was financed from national budgets, the EU budget and the European Investment Bank. The recommendation was to implement a fiscal stimulus amounting to 1.5 percent of GDP. Furthermore, the Commission allowed EU member states to violate the criteria of the Stability and Growth Pack, for instance, by running higher deficits. The European Central Bank lowered its interest rates in order to stimulate the demand for credit. Most member states lowered taxes and introduced measures supporting green technologies or green initiatives such as scrappage programmes, which offered rebates for taxpayers willing to scrap their old, non-environmentally friendly vehicles in order to purchase modern ones. In practice, the amounts of fiscal stimulus introduced in the EU member states varied substantially. Few states opted for more substantial packages exceeding 2 percent of GDP; for instance, the sum of two packages introduced in Germany represented around 3 percent of GDP, in the United Kingdom the fiscal stimulus amounted to 2.2 percent of GDP, while in Spain it reached around 8 percent of GDP.
The European financial crisis manifested itself in 2009 with a rapid increase in interest rates on certain governments’ bonds. This increase was caused by investors’ concerns about debt sustainability in particular member states of the eurozone. Although by the end of 2009 the financial crisis still remained limited to Greece, a few months later it extended to other countries, namely, Ireland, Portugal, Spain and eventually Cyprus.
Over time it has become apparent that, in terms of the causes of the financial crisis, Greece constitutes a special, not a representative, case (Featherstone, 2011). Whereas in Greece the economic deterioration can be partly attributed to successive governments’ fiscal mismanagement3 or the large underground economy (Dell’Anno et al., 2007; Buehn and Schneider, 2011), Spain had a comparatively low level of debt at the beginning of the crisis (2010), at only 53 percent of GDP. However, in the first two years of the crisis the focus was often put on governments’ irresponsibility, which ignores structural factors responsible for the European crisis. The dominant discourse of that time is well illustrated in the speech of a Belgian MP, who observed that ‘It is difficult to maintain solidarity with those who have not adhered to the rules of financial transparency and made the figures look much better than they are.’4
In the initial period of the crisis, decision-makers recognized skyrocketing interest rates on government bonds as the most disturbing symptom. The main efforts, therefore, concentrated on winning back market confidence and helping states in crisis to maintain liquidity. While the key trigger of the crisis was declared to be overspending, the major remedy was austerity policies. By the same token, the member states of the eurozone initiated a change in the dominant paradigm from Keynesian policy-making to neoliberalism.
It has been observed that the Greek government-debt crisis was triggered indirectly by the global financial crisis of 2007, the structural weaknesses of the Greek economy, as evident in its low competitiveness and demand-led growth model, risky practices by French and German banks as well as the fiscal irresponsibility of Greek governments. The leading sectors of the Greek economy, namely, tourism and shipping, were severely affected by the global crisis. Imports and exports have decreased worldwide, which affected Greek companies involved in commerce (predominantly companies transporting goods with container vessels). Furthermore, the global economic downturn had a negative effect on tourism revenues, which fell by 15 percent in 2009. Although Greece recorded growth after the introduction of the euro (around 4 percent each year), the country continued to run high deficits, above 3 percent of GDP. It has been observed that the following factors were likely to contribute to deficits; persistently high public expenditure, imports of military equipment amounting to 8 percent of GDP,5 as well as inability of the state bureaucracy to collect tax revenues (Buehn et al., 2011).
In February 2010 the newly elected government of George Papandreou realized that the Greek debt was higher than previously reported. The government admitted that flawed statistical practices were in place before it was elected. As a result, it was reported that the deficit did not amount to around 6 percent of GDP, as previously estimated, but rather 12 percent. Only two months later, the deficit calculated according to Eurostat’s standardized method was already reported as 15.7 percent of GDP. The credit rating agencies severely downgraded Greek bonds, which made it impossible for Greece to finance itself on the open market. On 23 April 2010, Prime Minister Papandreou, in a speech from the island of Kastelorizo, acknowledged the need for external help:
I have asked our partners to contribute decisively in order to give Greece a safe harbor. At the same time, we are sending a strong message to the markets that the EU is serious about protecting its common interest and common currency.6
The call for European solidarity was not widely acknowledged as legitimate; there were even voices suggesting that Greece sell its islands, but these suggestions were immediately rejected by the Prime Minister, who said that ‘There are more imaginative and effective ways of dealing with the deficit than selling off Greek islands.’7 Eventually, in May 2010 representatives of the European Commission, European Central Bank and the International Monetary Fund launched a bailout loan of 110 billion euros in order to prevent a Greek default. The loan was made conditional on fulfilment of the Memorandum of Understanding (MoE) specifying the reforms that had to be undertaken in Greece. With the worsening economic situation at the end of 2011 it became necessary to support Greece with another bailout loan of 130 billion euros. Bondholders also accepted an extended maturity on bonds as well as lower interest rates.
In January 2015 left-wing party Syriza won the national elections in Greece. Greek voters placed their trust in the party that promised to bring an end to austerity. However, the national governments of euro states and the Commission were not willing to accept a reduction of the Greek debt. The political conflict escalated in summer 2015, with Prime Minister Alexis Tsipras announcing a referendum in which the Greek people were asked to decide whether their state should accept the bailout conditions laid down on 25 June by the Commission. On 5 July 2015, the Greek people rejected the conditions, with 61 percent voting against. The no-vote has not helped the Greek government to renegotiate better financial conditions. On the contrary, the bailout package accepted on 13 July by the Greek government contained more severe cuts in pensions and tax increases than the initial package rejected in the referendum.
In Ireland the 1990s were the period of the ‘Celtic Tiger’, when the country experienced an extraordinary economic growth fuelled predominantly by investment in high technology and the pharmaceutical sector. Although in the late 1990s and early 2000s the Irish economy experienced a slowdown, growth was maintained due to policies oriented towards attracting foreign companies, predominantly from the financial sector. In particular, during that period the government attracted foreign companies by very low corporation tax, deregulation and weak surveillance of the banking sector, low interest rates and a credit-friendly environment. These policies fuelled growth through high tax revenues: investment, particularly in the real estate sector, generated many new jobs. As a consequence, unemployment decreased and the Irish labour market accommodated many new workers, who also contributed to growth with their taxes. In the years preceding the global financial crisis Ireland had the lowest ratio of national debt to GDP in the whole eurozone.
However, the global financial crisis profoundly affected the Irish banking system. It has been estimated that in the years preceding the banking crisis the liabilities of Irish banks represented over 300 percent of GDP (Mair, 2011). Banks were extravagant in their lending to property developers and individual consumers; as a result, in the late 2000s the level of private debt in Ireland became very high. With the global financial crisis, the property bubble burst. The major Irish banks – the Anglo Irish Bank, the Bank of Ireland and Allied Irish Bank – which were involved in extensive lending, started losing deposits and were threatened by a loss of liquidity. When the Anglo Irish Bank announced a cash shortfall of 12 billion euros in September 2008, it found itself on the verge of bankruptcy. Faced with growing speculation, the Irish government announced a guarantee of all liabilities of the troubled banks. At that time, the total size of banks’ liabilities has been estimated at around 334 billion euros, while Irish GDP was estimated at around 160 billion euros. When the private debt was transformed into public debt, the credit rating of Irish bonds fell and the government had to ask for a bailout loan. The loan was for 85 billion euros and consisted of loans from the bailout fund, the National Pension Reserve Fund and bilateral loans. In return, the Irish government agreed to introduce measures designed to reduce the national debt.
In Spain the major factor contributing to the crisis was the housing bubble. In the years preceding the crisis Spain had low debt, at only 53 percent of GDP. However, the demand-led growth model, combined with easy access to credit for individual consumers, contributed to a deterioration of the economic situation in 2009. As in the United States, the housing bubble was generated by a combination of rapidly growing house prices, banks’ extravagance in granting credits to individual clients and government incentives, such as tax deductions on mortgages. It is estimated that real estate prices in Spain increased by 200 percent between 1996 and 2007. Spanish banks also invested in sub-prime mortgages and the level of Spanish household mortgage debt became one of the highest in the European Union. As a result of the global financial crisis of 2007 Spain fell into prolonged recession, which brought about a rapid increase in unemployment. This unemployment triggered a wave of defaults on sub-prime mortgages, which destabilized the banking system in Spain. In May 2012 the largest mortgage bank, Bankia, experienced severe losses from unpaid mortgages and, in order to avoid bankruptcy, it was nationalized. However, as other banks were also seriously affected by individual clients’ defaults, the Spanish government obtained a 100 billion euro recapitalization package for Spanish banks from the European Financial Stability Facility (EFSF) in June 2012.
The demand-led growth model which dominated the decade before the crisis was fuelled by low interest rates on government bonds and the inflow of capital from northern European countries. The capital was employed predominantly to finance investments in real estate. Therefore, although in the pre-crisis decade Spain already had high expenditure, the economy was growing thanks to high tax revenues, to which the booming construction sector contributed significantly. However, already in 2004 Spain experienced a significant trade deficit, meaning that the monetary value of imports was higher than the monetary value of exports.
Two factors contributed to generating a trade deficit in Spain: wage increases and demand-driven growth (Hall, 2014). After the introduction of the euro, Spain experienced a fall in unemployment and a rapid increase in wages. As a result, domestic consumption also increased significantly and helped to generate growth through increased tax revenues. However, high wages decreased the competitiveness of Spanish production, which became more expensive. This trend had far-reaching consequences. Namely, growing labour costs usually motivate investors to relocate production to cheaper regions. Furthermore, wage increases are also reflected in the cost of exported products, which become more expensive. If there are other producers on the market that offer the same product for a lower price, the producer in question is likely to lose that market.
At the same time, in the decade preceding the crisis, Germany oriented its economy towards an export-led model in which growth is generated through trade surpluses (Hall, 2014). The implementation of the strategy became possible due to two important conditions. First, Germany exports technologically advanced and innovative products. Second, in order to foster the competitiveness of its exported goods, German wages were suppressed in order to keep prices low. By comparison, after the introduction of the euro, Spanish wages increased more rapidly than German ones. The global financial crisis has also affected the German economy, but not to a similar extent as in southern Europe. In particular, German exports to southern Europe decreased, but the gap could be compensated through trade with Asia. Southern Europe, relying on a demand-led growth model, had no alternative options at its disposal but to pursue internal devaluation in order to regain competitiveness. Devaluation is the most common strategy for bringing a trade deficit under control. If the national currency loses value in relation to other currencies, the debt generated through trade deficit decreases and the competitiveness of the country can be boosted because its exports become cheaper. In the eurozone, devaluation is not available; governments of states running trade deficits have to pursue internal devaluation in order to re-establish the trade balance. Along these lines, the Spanish government decreased wages, liberalized the labour market and increased taxes.
In Portugal the financial crisis was triggered predominantly by bad banking practices. The two major banks – Banco Português de Negócios (BPN) and Banco Privado Português (BPP) – accumulated losses due to risky investments and fraud, which came to light in the turmoil of the financial crisis. The global financial crisis of 2007 also weakened the banking system. In 2008, Portugal, like other EU member states, introduced a fiscal stimulus. The expenditure was reflected in the deficit of 2009, which reached 9.4 percent of GDP. Like other states whose deficits increased either due to fiscal stimulus or purchases of banks’ share capital, investors downgraded the government’s bonds. When the 10-year government bond reached 7 percent, the Portuguese government decided to ask for a bailout loan. In September 2010 the austerity package for Portugal was announced, mainly comprising measures of internal devaluation, such as reduction of labour costs. Furthermore, the austerity plan also introduced measures oriented towards reducing the deficit, such as tax increases.
The Cypriot economy has been particularly affected by external developments, such as the global financial crisis of 2007 and the Greek financial crisis of 2010. Due to the global financial crisis Cyprus experienced losses in tourism and shipping, which contributed to the growth of unemployment. Furthermore, in that period the average value of properties decreased by 30 percent. In 2010 Cyprus’ major banks – Cyprus Popular Bank (also known as LAIKI), the Bank of Cyprus and the Hellenic Bank – found themselves on the verge of collapse due to exposure to the Greek financial crisis. In the decade preceding the European financial crisis, Cypriot banks invested considerably in Greek bonds and thus experienced losses when depositors had to accept lower interest and extended maturity on Greek bonds.
However, the major trigger of the financial crisis in Cyprus was the over-sized banking industry and particularly the offshore banking sector. In the 2000s banks attracted many depositors by offering them very good conditions. As a consequence, Cyprus, a state with a small population and a small economy, grew a very large banking industry. As a consequence, in Cyprus bank assets are estimated at a multiple of eight times GDP, amounting to 19 billion euros in 2011 (Begg, 2013). Out of 41 banks operating in Cyprus on the verge of the crisis in 2012, only 6 were local. Offshore banks, constituting a substantial share of banks in Cyprus, were estimated to hold assets worth approximately 82 billion US dollars. Offshore banks are banks located outside the country of residence of the depositors, usually in low-tax areas or so-called tax havens. For instance, in Cyprus a large share of the foreign deposits belong to wealthy Russians. Offshore banks are attracted by exemption from the local regulatory environment and taxes. In return, they offer more secrecy to their clients and higher interest rates. However, because the states in which offshore banks are located usually do not insure the deposits, their holders risk losing their savings if a given offshore bank defaults.
After the Cyprus Popular Bank (LAIKI) – the largest bank in Cyprus – experienced severe losses, due predominantly to the ‘haircut’ on Greek deposits, it was downgraded by credit rating agencies and, as a result, lost liquidity. In order to prevent a default, the government covered the capital deficit of 1.8 billion euros and acquired 84 percent of its share capital. The bank was thus nationalized. The increase in debt caused by recapitalization of the Cyprus Popular Bank led to a downgrading of the government’s bonds in June 2012 to BB+ (for long-term assessments) and B (for short-term assessments). The Republic of Cyprus then asked for a bailout loan. The 10 billion euro loan was conditional on the implementation of a general haircut (cut in interest rates) on deposits. However, the national parliament rejected the measure in March 2013. Eventually, the haircut was approved only for uninsured deposits of more than 100,000 euros.
Anti-crisis measures had very different kinds of legal status, encompassing acts under international private law, intergovernmental agreements, a treaty amendment (Article 136.3 TFEU), regulations and directives, but also country-specific recommendations of a dubious legal nature. As a consequence, the procedures for their approval also differed. Furthermore, governments also influenced the approval procedures by merging two measures and submitting them in that form for parliamentary discussion and vote. The implication was that parliaments could have one vote in order to decide on two different measures simultaneously. In this section we briefly present the legal status, content and mode of approval of the measures analyzed.
The EFSF was established with the EFSF framework agreement as a private company based in Luxembourg, outside the EU legal framework. Member states did not foresee its incorporation into the Treaty, although they envisaged taking this step later with its successor, the European Stability Mechanism (ESM) (De Witte, 2011). The legality of the EFSF has been disputed. In particular, critics questioned the legal basis for the EFSF (private company established outside EU law). Furthermore, referring to both the European Financial Stabilization Mechanism (EFSM)8 and the EFSF, critics noted that Article 122(2) refers to cases of ‘natural disasters or exceptional occurrences beyond its control’ (Ruffert, 2011), whereas maintaining budgetary discipline cannot be recognized as being beyond governments’ control.
However, there were also legal experts who maintained that the EFSF does not breach the no-bailout clause (Haede, 2009; Louis, 2010; Seyad, 2010). First, the financial assistance offered to member states would only be temporary due to the extraordinary character of the situation, and second, Article 122 does not explicitly prohibit financial assistance, and the provision is relatively open regarding the means by which it could be provided.
The establishment of the European Financial Stability Facility (EFSF), as well as the increase of its budgetary capacity, required the unanimous approval of all eurozone member states. Although the EFSF constituted an intergovernmental agreement under private law (the EFSF was established as a private company owned by the governments of the eurozone states), the measure was approved by a ratification procedure, otherwise reserved for international agreements.
In contrast to the temporary EFSF, the European Stability Mechanism (ESM) has a less precarious legal basis (De Witte, 2011). In particular, it was established as an intergovernmental organization with the Treaty Establishing the European Stability Mechanism. The ESM became the permanent bailout fund and continues to fulfil the same goals as the temporary EFSF. The European Council of 25 March 2011, acting in unanimity, and following the procedure of Article 48(6), adapted Decision 2011/119/EU amending Article 136(3) TFEU by inserting the following text:
The member states whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality.