What is the European Debt Crisis ?

It's the failure of the Euro,

the currency that ties together 17 European countries in an intimate but flawed manner.

Over the past three years, Greece, Portugal, Ireland, Italy and Spain,

a ball teetered on the brink of financial collapse

threatening to bring down the entire continent and the rest of the world.

How did it happened?

Uniting Europe

For most of Europe's history, it's been a war with itself.

And countries at war with each other tend to do less business together.

Europe is always a continent of trade barriers, tariffs and different currencies.

Doing business across borders was difficult.

You needed to pay a fee to exchange currencies.

And you needed to pay a tariff fee to buy and sell to companies in other countries.

That tended to stifle economic growth.

Then came World War II, which devastated Europe.

Because the situation was so dire, the fastest way to rebuild Europe was to begin to remove these barriers.

Steel and coal tariffs came down so that a steel mill in one country could sell to a builder in another.

This gave the survivors an idea.

A unified Europe, a union across the continent that will end all future wars.

Countries began to band together toward this goal, bringing down trade barriers, lowering the cost of doing business.

One of the last barriers to fall was the Berlin Wall.

With the united Germany, Europe was ready.

27 countries signed the Maastricht Treaty and created the European Union.

This made doing business across borders easier, but there was still one major obstacle: the different currencies.

A decade later, they had one.

The Euro, launched on January 1,1999.

Countries adopting the euro, called the euro area, discontinued their own currencies.

They also discontinued their own monetary policies, giving control to newly formed European Central Bank, commonly referred to as the ECB.

The euro area now have one unified monetary policy, but it still have many different fiscal policies,

a key reason for the current debt crisis.

Monetary policy versus Fiscal policy

You see it's important to understand the difference between monetary policy and fiscal policy.

Monetary policy controls the money supply, literally how much money there is in the economy, and what the interest rates are for borrowing money.

Fiscal policy controls how much money a government collects in taxes, and how much it spends.

A government can only spend as much as it collects in taxes.

Anything above that amount it has to borrow. This is called "Deficit Spending".

Before the euro, countries like Greece, not only had to pay high interest rates to borrow, but they can only borrow so much.

Lenders weren't comfortable lending them to much money.

But now that they were part of the euro area's new united monetary policy, the amount they could borrow skyrocketed.

Smaller countries suddenly have access to credit like never before.

Greece and other countries which previously could only borrowed at rates around 18%, could now borrow for the same low rate as Germany.

How?

Germany's credit card

You see, joining the euro area is a lot like sharing a credit card, Germany's credit card.

Lenders now believe that if Greece was unable to repay its loans, Germany and the other bigger economies of Europe will stepped in and repay them,

because they were now bond by a common currency.

With the new abundance of cheap credit, Greece and other European countries were able to adjust their fiscal policies,

and increase spending to previously impossible levels.

Some countries embarked on huge deficit spending programs, primarily for politicians to get elected.

They made promises such as more jobs and generous pensions, all that paid for with the new money they could now borrow.

The governments of Greece, Portugal, and Italy accumulated huge debts,

however, they were able to repay these debts with more borrowed money.

As long as the borrowing continued, so did the spending, and the unbalanced fiscal policies.

In Ireland and Spain, cheap credit fueled enormous housing bubbles just as it did in the United States.

Credit flowed, debt accumulated, and the economies of Europe became tightly intertwined.

Companies began opening factories and offices across Europe.

German banks lending to French companies, French banks lending to Spanish companies and so on and so forth.

This made doing business incredibly efficient, while at the same time tying together the collective fate of the Euro area.

Things continue this way as long as credit was available and credit was available until 2008.

Spurred by a collapse in the US housing market, a credit crisis swept the globe bringing borrowing to a halt. Everywhere.

Suddenly the Greek economy couldn't function.

It couldn't borrow money to pay for all the new jobs and benefits it created.

It couldn't borrow the new money it needed to pay its all debts.

This was a problem for Greece, but because of the unified monetary policy, it was also a problem for all of Europe.

Much of Europe have been on a spending spree and borrowed more money than it could ever repay.

But the problem is somebody has to pick up the tab or else every country in the euro area will suffer.

Since the countries that ran up the bill couldn't repay, everyone looked to Germany.

Austerity Measures

As the biggest and strongest economy in Europe Germany reluctantly agreed to help bail out the debtor countries.

In other words, Germany agreed to repay the bill but only if the debtor countries agreed to implement strict austerity measures to ensure that it would never happen again.

Austerity measures meant sucking it up, cutting spending, borrowing less and paying back more debt.

This sounds like a simple solution, right? It's not.

First of all, nobody wants austerity.

Austerity means cutting government spending, and since the government is by far the biggest spender in the economy,

when the government cut spending, it cuts the earnings of many of its citizens.

People lose jobs, they get angry, they riot in the streets.

And austerity also doesn't automatically balance a country's budget.

You see, the government collects taxes based on people's earnings.

So when earnings are reduced, the government collects lesser taxes.

They still can't pay down their debts.

The pain is so bad that it's almost politically impossible to accomplish.

On top of that there are huge cultural differences within the Euro area.

Extreme Cultural Differences

(More grappa! To the Beach!)

(Pay back my money!)

Germany is very financially responsible.

Ever since the terrible hyper-inflation the country experienced after World War I,

it's been extremely inflation averse and incredibly careful about spending and borrowing.

In general, Germans work hard, expect little in the line of state benefits and meticulously pay all of their taxes.

Many Greeks, on the other hand, enjoy generous state benefits and don't pay taxes.

Greece has a terrible problem, it has never collected the majority of the taxes it imposes on its citizens and its always been this way.

Joining the Euro just amplified it.

The German view is that doesn't work.

If you want our money, you need our morals.

As the debtor countries headed towards default the whole continent of Europe was in danger.

Even though the economies of the debtor countries are relatively small,

they posed a huge threat because the European financial system is so interconnected precisely because of the Euro.

Remember, the debtor countries borrowed money from banks, investors, and other governments throughout Europe,

as the debtor countries get closer to default everyone who lent them money becomes weaker,

and everyone who lent those lenders money also becomes weaker, and so on and so forth.

A problem in one country could reverberate across the whole continent, triggering a chain-reaction of default.

If Greece defaults then Spain could default, Italy, Portugal, and Ireland would be next, then France, then Germany.

Pretty soon it could spread not just across Europe but across the world.

Fiscal Union or Breakup

The problem is even if the debtor nations adopt austerity measures

and even if the bailout from Germany and the stronger countries helps them pay down their debts and avoid the immediate crisis,

there's no system in place to prevent this from happening again.

This brings us back to that fundamental division of monetary policy and fiscal policy.

Ultimately, the euro area requires a fiscal union to match its monetary union, or neither.

That is, there must be a political organization with authority to set fiscal policy within every Euro area country.

It must have the power to cut spending, raise taxes and set laws.

A fiscal union like this could actually prevent excessive borrowing and spending.

However, this is an enormously complicated and unpopular notion.

It means surrendering sovereignty to a higher power, in essence, a United States of Europe.

Yet without a centralized fiscal union countries will continue to run deficits, accumulate debt,

degrade the value of the euro and threatens stability in Europe.

Can Europe take the necessary steps and create a fiscal union alongside the monetary union?

Or will the monetary union breakup and the Euro disappear