The European Economic Crisis Explained.

So for the last year or so we have been reading and hearing about the economic crisis in Europe and many people have no clue about what is going on. So I will break it down in the simplest way possible so that all my readers can understand. Here goes ....

What caused the crisis ?

There was a big build-up of debts in Spain and Italy before 2008, but it had nothing to do with governments. Instead it was the private sector companies and mortgage borrowers who were taking out loans. Interest rates had fallen to unprecedented lows in southern European countries when they joined the euro. And that encouraged a debt-fuelled boom.

1. The Convergence

Before the euro was introduced, governments in Greece, Spain and Ireland, among others, had to pay a lot more to borrow money than governments such as France and Germany. But after the euro was introduced, there was this amazing convergence. Suddenly, all the countries could borrow at the same rate.

Caroline explains the convergence:

When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge.

Translation: European officials essentially told banks: Bonds from all euro zone countries are identical. It doesn't matter whether they're sold by Greece or Germany or whoever. They're all the same. So banks rushed to lend money to the weaker euro zone countries, and their borrowing costs plummeted.

2. The False Dream

For roughly a decade, it seemed that the dream of the euro was coming true. Borrowing costs were almost identical for all of the countries in Europe. But under the surface, Europe was actually growing apart.

Caroline explains :

Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries enjoyed housing and consumption booms on the back of cheap credit, making them less competitive.

Translation: Germany got better at selling stuff to the rest of the world over the past decade. Other countries in Europe had a false sense of prosperity. They borrowed lots of money to buy stuff and build houses, and they got worse at selling stuff to the rest of the world.

 The euro made it easier for Germany to sell stuff to countries on the periphery of Europe, both by making German goods cheaper for people in those countries, and by making it easier for people in those countries to borrow money to buy stuff from Germany.

3. The Crisis

After the financial crisis, it eventually dawned on everybody that the countries that shared the euro are, in fact, a bunch of different countries, with vastly different economies and that, despite what the officials said, not all eurozone government bonds are identical.

Caroline explains :

It took some time for the financial markets to discover that government bonds which had been considered riskless are subject to speculative attack and may actually default; but when they did, risk premiums rose dramatically. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent. And that constituted the two main components of the problem confronting us today: a sovereign debt crisis and a banking crisis which are closely interlinked.

Translation: Once everybody realized that some eurozone countries might not be able to pay back their debts, they started demanding higher interest rates to lend to weaker countries. That, in turn, hammered the banks that had loaned all that money to those weaker countries. Those two, related problems rising borrowing costs for weaker countries, and trouble for banks that have loaned money to those countries are at the core of the European crisis.

Why a euro zone breakup would be bad for Germany

Caroline argues that, in the end, Germany will try to save the euro in order to protect its own interests. I explain :

The likelihood is that the euro will survive because a breakup would be devastating not only for the periphery but also for Germany. It would leave Germany with large unenforceable claims against the periphery countries. The Bundesbank alone will have over a trillion euros of claims arising out of target by the end of this year, in addition to all the intergovernmental obligations. And a return to the Deutschemark would likely price Germany out of its export markets...

Translation: The end of the euro would hurt Germany in two main ways. First, it would mean Germany's central bank would never be able to recover a huge amount of money its owed as part of Europe's current system. Second, the end of the euro would make German exports much more expensive in the rest of Europe. That would be a big blow for a key part of Germany's economy. But the version of the euro that survives may be ugly, Caroline writes:

Germany is likely to do what is necessary to preserve the euro but nothing more. That would result in a eurozone dominated by Germany in which the divergence between the creditor and debtor countries would continue to widen and the periphery would turn into permanently depressed areas in need of constant transfer of payments.

Translation: The deep problem facing the euro zone isn't just debt. It's the vast gap between the economies in the struggling countries and the economies in the stronger countries. If Germany does the bare minimum to keep the euro afloat, those differences will persist and the struggling countries will continue to struggle indefinitely. I argue that Germany should do more than the bare minimum, to try to change the broader economic picture in Europe. But  in my opinion that's not likely to happen.