The Re-emergence of Europe: The Fallout From Europe's Debt and Banking Crisis

01/16/2013 07:47 am ET | Updated Mar 18, 2013

How did the European debt and banking crises arise? And what are the consequences? One reason some European countries got themselves so heavily into debt was the robustly enforced anti-inflationary stance of the European Central Bank (ECB). Interest rates fell across the board as a consequence and it became so cheap to borrow; almost everyone did, in the public and private sectors alike.

From 2000 to 2008, government expenditure as a proportion of real gross domestic product (GDP) rose on average by 12 percentage points in Ireland and by 3.8 points in Greece, Italy, Portugal and Spain. It was, as historian Timothy Garton Ash put it, "the mother of all binges."

Now Ireland, Portugal, Italy and Greece find themselves saddled with gross government debt of above 100 percent of GDP, but the Eurozone as a whole (the 17 countries that adopted the euro currency in 1999) has a gross government debt figure of below 100%, lower, in fact, than that of the US and Japan.

The big, some might say catastrophic, mistake the debt markets made was assuming all Eurozone bonds were equally risky, no matter which country issued them. This was profoundly wrong. The underlying risk associated with southern European countries in particular, was not accurately reflected in the interest rates of their bonds.

Why? The markets had been lulled into a false sense of security by monetary union, despite the fact that the earlier Maastricht Treaty of 1992 specifically prohibited one member state bailing out another. The so-called union was, economically speaking, nothing of the sort, with a mismatch emerging between the reasonably healthy fiscal positions of countries in the North and the riskier, high-deficit positions of countries in the South.

The usual link between fiscal deficits and bond interest rates had been broken, leading to excessive lending and borrowing. Risk had not been assessed correctly. When the markets realized their mistake in late 2009, interest rates on the sovereign debts of Greece, Italy and Spain began to rise. This put into motion an "adverse feedback loop." Rising bond interest rates increased government borrowing costs to almost unsustainable levels. This led to downgrades by credit ratings agencies which only increased interest rates further, pushing some countries to the brink of insolvency.

This in turn, led to a banking crisis, as many large national banks, particularly in Italy and Spain, had huge exposure to government debt -- debt which increasingly looked like it might not be repaid. Seemingly safe bonds had revealed themselves to be risky, poor-quality bonds. What looked like valuable assets on bank balance sheets were now a lot less valuable.

The problem was exacerbated by the fact that regulators had allowed the banks to buy as many sovereign bonds as they liked, without putting aside any equity capital. Sovereign default had then seemed unthinkable. Excessive lending to the private sector, encouraged by low interest rates and the misreading of bond risk, led to a real estate bubble. When the bubble burst in 2008-2009, banks were faced with huge levels of toxic debt. Politicians could not countenance runs on banks or bank closures and decided, rightly or wrongly, to bail them out. This further increased public debt and further reduced the value of government bonds, resulting in another adverse feedback loop.

Banks were then forced to strengthen their balance sheets by taking fewer risks, lending less and selling off as many non-core assets as they could. Depositors, worried that banks could go bust, began withdrawing funds -- in effect, a slow-motion run.

So how can we restore stability to the European banking system? A banking union is the only solution, including bank deposit insurance to protect savers' assets and a central regulator, the European Central Bank.

And what about the economy? Bank of International Settlements economists concluded that when debt -- be it government, corporate or household -- exceeds about 85 percent of GDP, it becomes a drag on growth. And when countries stop growing, the only way to reduce debt is to cut spending, hence the unpopular austerity measures being imposed in many European countries.

We need growth and debt reduction.

This post is part of a series by Professor Klaus Schwab, Founder and Executive Chairman of the World Economic Forum, based on his book The Re-emergence of Europe.