What is the cause of the European financial crisis?

My impression is they have been living beyond their means for a long time and the governments have been spending more than they take in and borrowing the difference. The people that have been lending them money are now getting a little reluctant to continue doing so and interest rates to do it are going up. And the citizens don’t want to make the sacrifices to ease the situation. So they’re stuck. I think the last Italian debt had a high interest rate on it and few takers. Same with Greece and Spain I think. If they can’t borrow money they can’t roll over the debt that’s coming due and they may default on some of it. If they default the game is up.

Greece has, as you may not be surprised to find out, a particularly expansive nanny state. The government is the largest employer and people feel like government jobs are no-show jobs. It has been thus for decades. Because of this, they have been living beyond their means. They spend more than they produce and now that they are part of the EU, they have borrowed more than their economy can produce.

Unfortunately, Italy, Spain, and others are in a similar mess. Worse, so is France and the Netherlands. Indeed, perhaps even Germany is in trouble. As a result of all this, these countries (except perhaps Germany) are seeing the cost of borrowing go up to unsustainable levels (7%). Their S&P ratings have gone to junk status.

Now, the integrity of the EU is threatened. The ministers are meeting and frantically working to fix things, but they seem to be as able to meet agreement as our special deficit reduction committee is. If they can’t solve this, the EU faces a high likelihood of dissolving and then we’d see the ramifications of that spreading out over the entire world. No one would buy shit anymore and even China and Brazil would be affected.

The Europeans, it seems, need a Union bank, similar to the Federal Reserve, that can set monetary policy for the entire EU. In this way they can start to control the borrowing and interest rates and make the interdependence of EU states more manageable. As with the political situation in the US, the solid countries don’t want to pay the debts of the poor countries. Unfortunately, if they don’t do it, the economy will crash. Countries really are too big to fail.

There are lessons here for the US, but I won’t go on to those. I’ll leave it here, for now.

Excellent answer, @wundayatta. Thanks for distilling it so succinctly. Now I get why the Fed and other large central banks have taken the action they did this morning. Of course, it has touched off concerns of future hyperinflation in some.

I didn’t know several nations had their bonds reduced to junk status. That’s pretty severe indeed.

Maybe the Congress can learn lessons from how the EU proceeds. But the global economy seems poised in a very precarious situation at the moment.

@cockswain Thanks. If you want a more detailed explanation of what the fed did today, check out this article.

Thanks for that article. I wonder what “the bazooka” would be. Too little action, while it may reduce current strain, might be wasted money longer term.

This situation isn’t getting nearly the US press that the 2008 recession did, but I wonder if it is a worse situation overall. I wonder this because the US hasn’t gotten back on its feet yet, and the EU problems will cripple us. If Greece and Japan alone can cause significant problems in the global economy, what the hell will happen if the EU’s economic system tanks?

European countries borrowed huge sums of money on the understanding that as their economies grew repayment would be easy. In fact their economies slowed and the ‘markets’ became worried they would be unable to repay their debts. This perception led to an increase in the costs of borrowing and threw their economies into crisis. The more difficult things are for them economically the more they have to pay. It is a vicious cycle that can only be broken with the help of stronger economies but they are reluctant to help to the extent required as it may bring down their economies in turn. Robert Peston has written some good articles on it.

This idea of nations living beyond their means really doesn’t seem too dissimilar from what is happening in the US, as evidenced by our national debt problems.

So is the US lending money to the foreign central banks at a lower rate than the Federal rate? I’m not sure if I’m asking this correctly. US banks borrow money at the Fed rate. Do global banks already have the ability to borrow from the Fed at this rate? I’m guessing not, but I don’t actually know. What is this new interest rate for foreign central banks?

Hmm, on further reading it looks like I may be confusing the Federal Funds Rate with the Federal Discount Rate with regard to my last post. I’m also not certain what a “dollar swap” is yet either. Looks like I’ve got more reading to do…

EDIT: Ah, here’s a good Reuters article for those like me.

Sunspots. (I realize that some folks might thing this answer is less than insightful but, seriously, is it any less realistic than any other junk science that passes for economic theory?).

I don’t really think economics is junk science. I think it’s largely sociological in nature, our theories are incomplete, and our economy is an on-going research experiment guided by educated guesses, but not junk science. Politicians can make it seem like junk science by the way they ignore economic theory, but I don’t think sunspots and Keynesian economic theory are equitable.

Most of the modern world adopted Keynesian economic as its economic system, yet everyone who adopted the system is crumbling economically, so what does that tell you about Keynesian economics? Those who adopted more or less free market capitalism is growing economically (hong kong – singapore).

Anyway, might as well answer your question while I’m at it, or better yet quote another perspective.

“Before the financial crisis, several governments of the eurozone, most notably those of Portugal, Italy, Ireland, Greece, and Spain (sometimes called ‘PIIGS’), had been able to finance their deficits at artificially low interest rates. Some had accumulated unsustainable levels of public debts.”

“Such reckless fiscal behavior was only possible because markets assumed that if the national situations got worse, these governments would be bailed out by other countries of the eurozone in order to forestall a breakup of the euro. In other words, the euro came with an implicit bailout guarantee permitting governments to overindulge in debt.”

“Equipped with this implicit guarantee, many governments did not address structural problems such as uncompetitive labor markets or unsustainable welfare systems. They papered over these problems with government deficits. As the financial crisis hit, government deficits increased sharply due to increasing public spending and falling revenues. Deficits soared, not only in the PIIGS countries (the bailout candidates), but also in the countries that were supposed to pay the costs of bailing out (most prominently Germany).”s(2010%E2%80%93present)