Why the Greek Meltdown Became a Euro-Zone Crisis

By Fischer, Hartmut; Neaman, Elliot et al. | Seton Hall Journal of Diplomacy and International Relations, Summer 2011 | Go to article overview

Why the Greek Meltdown Became a Euro-Zone Crisis


Fischer, Hartmut, Neaman, Elliot, Sharma, Shalendra D., Seton Hall Journal of Diplomacy and International Relations


In late April 2010, the spread between Greek and German 10-year bonds skyrocketed to 650 basis points. By the first week of May 2010, the interest rate on Greek bonds jumped to an unimaginable 38 percent, and default seemed imminent. In desperation, on May 10, after weeks of indecision, the European Union unveiled a "plan" to deal with Greece's growing sovereign debt crisis. As the Economist apdy noted, the euro-zone leaders were forced into action when faced with their own "Lehman moment," the frightening prospect of fiscal contagion as Greece defaulted; thus forcing the sovereign-debt crisis to spiral out of control, engulfing not only Portugal and Ireland, but also much larger economies such as Spain and Italy.1 Euro-zone negotiators put in long hours over the weekend of May 8 and 9 2010 to produce an unprecedented package of euro750 billion (US$950 billion) in hopes of restoring confidence in the embatded euro and mitigate the financial panic gripping the continent.2 The European Commission's president, José Manuel Barroso proudly announced that the package confirmed that the euro zone members would take action to defend the European Union. The International Monetary Fund (IMF) committed an additional $321 billion, and the world's leading central bank, the United States Federal Reserve, announced a joint intervention to make more dollars available for interbank lending, further underscoring the commitment of the key players in the global community to ensure the euro-zone's financial health. United States President Barack Obama, German Chancellor Angela Merkel, and French President Nicolas Sarkozy made it abundantly clear that they would restore investor confidence in the euro-zone.

The audacious $1 trillion plan worked - or in Merkel's evocative phrase, the euro passed its "existential test." The markets, seemingly desperate for a bold plan, finally got what they wanted.3 Just hours after the deal was announced, the European Central Bank (ECB) reversed its position and began to buy euro-zone government and corporate debt.4 In doing so, the ECB suspended its collateral standards to ensure that Greek debt remained eligible in its repurchase operations. This was a dramatic move as the cautious ECB bond purchase plan would now transfer Greece's risk from the private banks in Europe to the ECB.5 ECB President Jean-Claude Trichet attempted to put the best spin on the situation by rejecting suggestions that the plan was the start of an expansive monetary policy, and instead argued that the decision confirmed the flexibility of the ECB to deal with contingencies, and promised that the ECB bond purchases were a short-term measure designed to prevent a possible debt crisis from spreading to the EU banking system.6 As the central banks began buying euro zone government bonds, the EU financial system got a much-needed liquidity boost. In response, the risk premium on Greek and other government bonds plunged and Greece's 10-year borrowing costs declined by almost half. The beleaguered Euro rallied against the dollar, climbing above the $1 .30 mark for the first time in a week.

The respite was short-lived. Even Germany's bold but unworkable decision to place a ban on the short selling of euro zone government bonds and on the buying of sovereign credit-default swaps by investors who did not also buy the underlying bonds failed to have the desired effect. To the contrary, the ability to sell government bonds became even more difficult. On May 17, despite the ECB's formidable $1 trillion bailout guarantee, the euro/dollar rate fell to $1.22 - its lowest level since April 2006. Which factors explain the markets' abrupt volte-face? Why did the eurozone's unprecedented $1 trillion war-chest fail to placate the markets? Why did the problems in Greece, a relatively small economy, so quickly metastasize into a broader crisis, casting an ominous shadow over the 16 country7 euro-zone, and the EU? Which lessons does this crisis provide for the euro-zone and the EU, and what might be solutions to a crisis that placed into question the very existence of the European integration project? …

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