Economics | The cause of the financial recession and the EU’s current position

By Pierre Heistein

This article originally appeared in the Business Report Opinion & Analysis pages on 10 November 2011. To interact with Pierre, visit www.facebook.com/understandingeconomics.

The financial recession started because of the belief that asset prices, such as property, shares and funds, would continue to increase. Companies, banks and households fell into this trap, taking on increasing levels of debt to finance these assets, but at some point the prices stopped increasing.

Realising that returns would not be made, mass selling began driving the value of assets even lower, while the value of the debt remained the same. Soon, many investors were in the position where the earnings from their assets were not enough to pay the interest on their debts and were forced to default on their loans, thus causing a loss for whoever had lent them money, usually the commercial banks.

But some companies, and the banks themselves, are considered too important to default and collapse and in this case that government steps in to “bail them out”. Government does this by paying their debts for them and in doing so transfers this debt to their own account. Now it is up to government to find the finance to pay off these debts, as well as their own, and if they cannot do so they themselves run the risk of defaulting and needing to be bailed out.

This is the problem currently facing the EU. Greece, Portugal and Ireland have already been bailed out once by the European Financial Stability Facility (EFSF), a fund paid into by other EU countries and used to provide financial assistance to countries in need. But this fund is running out of money and the more stable EU countries are refusing to contribute. They have agreed on a $179 billion bailout package for Greece, without which it is likely to default by mid-December, but Greece is just the first in the line, with Italy, Spain and possibly Portugal again requiring such assistance – or facing not being able to pay their creditors or wage bills.

Government-backed financial assets, mostly in the form of bonds, are considered to be the safest place to store money as they are a “risk-free” holding (meaning you are guaranteed to get your money back). But if any of the EU countries were to default, and bond holders to accept only some or none of their investment paid back to them, this perception would change completely.

As government bonds become more risky, the interest paid on these bonds (interest payment from the government to the person who bought the bond) increases to compensate investors for the risk. Already highly indebted governments will now need to pay more in order to service their loans, thereby increasing their spending and making them an even higher default risk.

While bailout packages and increased money may help to patch the immediate crisis, the only way out of this for the EU economies is to start reducing their debt and balancing their books. Money spent now is going to be used to pay for growth in the past rather than for encouraging future growth, and the EU economies are likely to stagnate for many years to come.

But South Africa is in a far luckier position – we can choose now whether to continue spending money we don’t yet have and end up in a similar position, or to follow more prudent policies and encourage saving and growth based on real earnings.  We do not have problems of defaulting banks and bailed out companies, but with some studies showing up to 95% correlation between South African growth and foreign economic success, and the Treasury promising to reduce spending to balance the budget, money is going to be scarce. What Europe has taught us is that the solution is sensible spending and innovative ideas, not borrowing.

This article is published under the Creative Commons Attribution license.