Explainer: How Europe got itself into such a financial mess, what might happen next and what it might mean for New Zealanders

By Bernard Hickey

Europe is in a financial mess that it can't seem to dig itself out of, despite a couple of years of trying.

It seems to be getting worse by the day. Now it's affecting growth in Europe and driving financial markets in America and elsewhere.

This rolling series of crises in Europe's bond markets and banking systems begs 10 questions for New Zealanders that I'll try to answer.

1. How did Europe's financial system get into such a mess?

It's been brewing for a while.

The eurozone was launched with much fanfare in 1999 as a way to improve trade and strengthen the economies of the European Union. It started off with the core countries of Germany, France, Italy, Spain, Austria, Belgium, The Netherlands, Portugal, Ireland, Luxembourg and Ireland. Greece joined in 2001, Slovenia joined in 2001, Cyprus and Malta joined in 2008, Slovakia joined in 2009 and Estonia joined this year. Interestingly, Sweden, Britain and Denmark have not joined the Eurozone, but are still members of the European Union with their own currencies.

The Eurozone economies all dropped their own monetary policies and currencies and adopted a single currency (the euro) and central bank (the European Central Bank ECB) ). For many economies, including Portugal, Ireland, Greece and Spain (PIGS), this meant their interest rates fell towards lower German and French levels and their banks could borrow money much more cheaply and easily from elsewhere in Europe, and in the United States. See more on the Eurozone here at the ECB site.

For a long time everyone was happy. After 1999 they partied like it was...well... 1999.

The Southern European countries were (mostly) thrilled because they could borrow much more cheaply than before and it was (slightly) easier to trade with other countries in Europe because they had the same currencies. The Northern European countries were happy (mostly) because they could export their surpluses to Southern Europe and make some nice money on the side lending to the Southern Europeans to buy these exports.

In many ways Germany took on the Chinese role of providing the vendor finance for Greek, Irish, Portugese and Spanish consumers to buy the BMWs, VWs and Audis they thought they deserved. Germany was able to run current account surpluses and export its products and savings to Southern Europe. Germany's currency was weaker than it would have been if it had kept the Deutschemark.

Germany's role inside the European monetary zone has been very similar to the Chinese role inside the interconnected China-US monetary zone. Germany and China lent the money to Greek and American consumers to buy German and Chinese exports.

This is all fine of course until the debt builds up to a level where people begin to wonder of the borrower can keep servicing all these debts they are building up. Essentially, the Global Financial Crisis has been the moment when these current account imbalances and debt mountains have built up to such large mountains that they have collapsed on themselves.

The whole idea of the euro zone was that the various countries inside Europe would use measures other than their currencies and interest rates to adjust their economies to imbalances within the euro zone. The idea was that Greeks and Spaniards and Portugese would change its labour laws or their wages or productivity to become more competitive, rather than let currencies and interest rates do the work.

The trouble is these internal changes never happened and this was reflected in massive government deficits in many of these Southern European economies (often near 10% of GDP). Europe realised this was a risk early on and set non-binding targets for budget deficits (no more than 3% of GDP), which everyone promptly ignored or cheated on. Initially governments were treated very similarly by bond market investors until they realised the laggards such as Greece were either failing to meet the targets or outright fudging their figures. This created the risks of defaults.

This surge in borrowing costs for the PIGS (Portugal, Ireland, Greece and Spain) relative to the core Eurozone economies (Germany and France) has been the outward sign of problems in the Eurozone and the mechanism by which investors can 'vote with their feet' about the laggards inside Europe. This week Greece's one year government bond yield hit 89% (!).

2. So what did the European governments do about it?

Initially, they sat on their hands and hoped it would go away. Then they told the Greeks and Portugese and Irish to get their budgets in order. This didn't work, partly because all this was happening as the Global Financial Crisis was happening, which slowed economic growth and worsened the problem.

Then, when the Greek situation got especially painful, they had a whip-around in mid 2010 and pledged some money to help the Greeks get back towards surplus. They had hoped this would be enough to stop a 'contagion' of concerns about sovereign debt spreading to Ireland, Portugal and, ultimately Spain.

Needless to say, this didn't work. It turned out the Greeks are a bunch of massive tax avoiders and the Greek economy has failed dismally to even try to catch up with the improvement in competitiveness that Germany had achieved through the 1990s. The Germans suppressed their wage growth and invested in machines and infrastructure through the 1990s and 2000s to make themselves more competitive. They were a bit like the Chinese. The Germans saved and invested, rather than borrowed and consumed. Sound familiar? (By the way, this is exactly what New Zealand didn't do...)

Then the Irish banking system and government accounts blew up, mostly because Ireland's banks borrowed madly from German, French and British banks during the naughty oughties, and then the government stupidly guaranteed the deposits and bonds held by those banks.

Many New Zealanders might remember that first week of October 2008 when then Prime Minister Helen Clark launched her re-election campgain with an announcement that New Zealand would guarantee the deposits in finance companies and banks. This followed a similar pledge by Australia, which followed similar guarantees in Europe triggered by the Irish government's bank guarantee. The Irish have an awful lot to answer for. (Read Fintan O'Toole's excellent book 'Ship of Fools' if you want to see the technicolour version of Ireland's corruption, greed and stupidity over this period).

People thought things had settled down in late 2010, but it turned out it was the calm before the storm.  A series of sovereign debt crises have cascaded back and forth across Southern Europe and Ireland this year. The Irish are on their second bailout. Greece has had two bailouts and Portugal has had one. Or is it two. I forget.

Things started to get really serious when it became clear the contagion had spread to Spain and then Italy. The Italian government debt, which is the third biggest in the world behind Japan's and America's, is the big Kahuna. In the increasingly stressed world of European sovereign debt, Italy really is too big to fail. That's why there's so much concern about Silvio Berlusconi spending too much time doing bunga bunga and not enough time fixing Italy's slow-growing economy.

A few weeks ago there were serious worries about France's banks when rumours surfaced of a sovereign credit rating downgrade and one big French bank tried to raise a big chunk of money from a US hedge fund. Dumb idea. It just made everyone very nervous.

3. So why is this a problem for the European banks?

The Northern European banks had a ball between 1999 and 2008 lending money to each other, the Southern European banks and the Southern European governments. For a long time they thought this was just as safe as lending to the German or French governments. Also a dumb idea.

Now these bonds from the PIGS are trading at yields much higher than German and French bond yields, which means they are worth much less on a bank's books. Remember, when bond yields rise that means their prices fall because they are fixed interest securities. The outgoing CEO of Deutsche Bank said this week if these bonds were 'marked to market' then many European banks would be wiped out.

This is the problem. Over the last two years this slump in bond prices has weakened many of these European banks. This has made them increasingly nervous about lending to each other. They're not quite sure about how many of these toxic bonds are held in the other banks they are lending to.

And they've also realised just how interconnected they have become. This graphic below (courtesy of the New York Times) explains it well. The great thing about the Eurozone is that it made it very easy for banks to lend across borders to each other. The appalling thing about the Eurozone is that trying to pull this spaghetti of funding lines apart is a messy exercise.

This has also made American banks and money market funds nervous about lending to European banks. Essentially, US money markets have stopped lending to European banks. This has stressed everyone out in recent weeks and forced them to take drastic action, including borrowing from the European Central Bank.

This graphic shows how the various countries in Europe have lent to each other. Have a good look at it to get an idea of how this set of dominos could fall. Your mind will boggle and your head will hurt.

4. So what is the European Central Bank doing about it?

Initially the ECB didn't do much and hoped it would go away. They left it to the European politicians to fix it. The ECB helped organise some pretty useless stress tests (which assumed there would be no European government bond defaults) and sat on the sidelines.

The ECB seemed so relaxed it actually started putting rates up in April and July to control inflationary pressures. This made the situation in Southern Europe worse.

In the last couple of months the ECB has been dragged kicking and screaming into the centre of things because it is one of the few coherent institutions in Europe able to do things quickly. When Europe's banks stopped lending to each other and the US money market funds stopped lending to the European banks a few weeks ago the ECB stepped in as the lender of last resort.

Many believe the ECB is basically single-handedly holding up the European banking system with its balance sheet. See more here at the NYTimes on that.

The ECB's role expanded dramatically last month when it jumped in to buy Italian and Spanish bonds holus bolus to try to drive their prices back up and their yields down. It felt it had to act because Europe's governments were either pfaffing around on holiday or too busy bickering to do anything about it.

5. So why don't the Northern European governments just come up with a big honking bailout fund to save everyone?

The first attempt at building such a fund was pretty meagre and was the least they could get away with at the time.  Earlier this year they had to increase the size of the fund known as the European Financial Stability Fund (EFSF), but it's now seen as too small to save the Italians and the Spanish. It's currently worth around 750 billion euros, but most people think it needs to be 3 trillion euros or more to be credible. See more detail here at the EFSF site.

The various European governments, which means mainly the Germans and the French, were able to cobble together the first versions of the fund relatively easily.

But each time they had to go back to their parliaments and voters to top it up the political heat has grown. The Germans, in particular, are becoming very grumpy about having to keep bailing out those 'lazy' Greeks and Portugese. If the Germans thought about it for a moment they'd realise that all they're doing is helping a creditor work through a tough time so they can keep borrowing from the bank (ie the German and French banks). It's the old saying that a small debt is the borrower's problem. A really big debt is the bank's problem. The PIGS have really big debts and they are now the German and French banks' problem.

However, the politics of all these bailouts is turning very toxic. The Germans were always nervous about giving up their strong Deutsche Mark for the Euro and exchanging their inflation-fighting Bundesbank for the ECB. Conservative Chancellor Angela Merkel is also instinctively against such bailouts and lately she has been losing lots of local elections to anti-bailout politicians. She suffered more local election defeats over the weekend. There have been similar revolts in Finland and France.

6. So why don't the Eurozone governments agree on a common fiscal policy?

This is the problem at the heart of the Eurozone. It has a common monetary policy with the same short term interest rates and the same currency. But it has a plethora of governments with all sorts of different taxes, welfare systems, labour laws and budget deficit outlooks.

Many believe the ultimate solution is for the Eurozone governments to issue a common Eurozone government bond. This would mean governments would have to agree on taxation policies and spending policies. Can you imagine it? It would be like the Australian Prime Minister Julia Gillard flying into Wellington and telling New Zealand it needed to agree to a carbon tax and a much higher income tax rate. That's several cups of cold sick going down a few gullets right there.

The common European fiscal policy is not going to happen easily. Already there are major protests in Greece and Italy about how the 'Germans' are forcing them to raise taxes (Italy is currently debating whether to put its GST up to 21% (!) ), sell off assets, slash state sector jobs and slice pay rates (Irish civil servant pay has been cut by more than 15%).

If the Eurozone is to work, it must have a common monetary policy, a common fiscal policy and, ultimately, the same labour laws and social policies. Some believe, secretly and not so secretly, that this was the plan all along: a United States of Europe (USE). (Mwah, hah, hah, hah...) The architects of the Eurozone actually called for just such a thing last week. See more here from Reuters on former German Chancellor Gerhard Shroeder's call for a USE on Sunday.

7. So how might this all end for the Europeans?

It's not looking good for a happy ending. Many, many people are now seriously talking about some form of Eurozone break-up. The speculation about the exact form of a break-up is endless.

The Greeks could opt out of the Euro and go back to the Drachma, but this is a lot easier to say than to do. Such an exit would immediately destroy Greece's banks and trigger a massive devaluation. There would be bank runs. There would not be orderly queues at the ATMS. (Some are quietly saying that bank runs have already started in Greece. Greeks are regularly arrested at the borders lugging out suitcases of cash. Deposit boxes are out of stock in Athens....)

This financial mayhem would cascade through the rest of Europe's banking system. UBS has estimated any country that leaves the Eurozone would see their GDP fall as much as 50% in the immediate year or two afterwards. See more on that here at FTAlphaville.

Another suggestion is that either (or both) Germany and France would pull out of the Eurozone to avoid having to bail out the rest. The whole thing would implode if this happened. UBS reminded everyone in the note mentioned above that wars and massive social upheavals have followed such currency dissolutions in Europe in the past. Hmmm.

There is the possibility that Europe's leaders could pull it all out of the fire at the last minute. This would require some sort of vast bailout fund created by the French and Germans. There are some doubts about whether the French in particular could afford  it, and it would also require the Germans to keep growing their economy reasonably strongly. That requires China and the United States to also be growing and buying German exports at the same time. Neither is a sure thing. In recent weeks the prospects for such non-Eurozone growth have worsened too.

Meanwhile, the ECB will have to keep buying the PIIGS bonds hand over fist while keeping interest rates near 0% and potentially printing a lot more money. It will have to do it over the dead bodies of the inflation fighting Germans at the Bundesbank and a bunch of very grumpy central bankers elsewhere. This week the Swiss National Bank pledged to print money for Africa and buy euros to try to force the franc down to some reasonable level so its export sector might live for a while longer. It worked for one day.

Panicked investors and depositers in Europe are fleeing across the border into Switzerland and buying francs as a safe haven currency. The Swiss National Bank's actions indicate just how stressed the system has become. See more here in this NYTimes graphic to see how ugly European money markets are.

The unintended consequences of all those 'solutions' referred to above boggle the mind.

8. So why should New Zealanders care about European financial mayhem?

Some might say this is all irrelevant for New Zealand.

Our economy is now firmly tied to Australia and Asia. Countries in the EU bought just 11% or NZ$5.2 billion of our total merchandise exports of NZ$46.2 billion in the year to July. Exports to Australia, China, the USA, Japan and Korea totalled NZ$25 billion or 54% of our exports over the same period.

The trouble is that economies, financial markets and banking systems in Europe, Asia and America are now broadly interconnected. When banks fall over in Europe, the Americans get worried. When the American economy slows down the Chinese get worried. It's impossible to ignore what's happening in Europe. It will all wash up on our shores eventually, either through our financial markets, our banking systems, or through our ports and airports.

Rinse and repeat.

9. But how exactly will it wash up on our shores and when?

There's a couple of different mechanisms. Our banks rely on hot international money markets (funding for less than 90 days through 'Commercial Paper' issuance) for about a third of their funding, either from non-resident banks or in foreign currency form. See more detail here in the RBNZ stats. That's better than it was before the Global Financial Crisis, but it's still a lot and leaves us vulnerable to ructions on global markets.

The IMF, the OECD and the ratings agencies have warned us repeatedly about this vulnerability to 'hot' money markets freezing up in periods of stress. The Reserve Bank helped tide our banks over and cope during late 2008 and early 2009 by creating a special lending facility. Since then the Reserve Bank has encouraged the banks to find more stable and more local forms of funding. But there's still a signficant vulnerability.

The more unstable these international money markets become, the more expensive it becomes for our banks to roll over these foreign debts. See the interactive chart below for a one measure of this financial market nevousness and cost. The chart shows the Credit Default Swap spreads for Australasian corporates, which is mostly the Australian banks. The 'extra' costs to roll over foreign bank debt rose to over 150 basis points (1.5%) in the crisis that followed the collapse of Lehman Bros. These costs dropped down well below 1% early this year, but they've been rising quite sharply in recent months.

Those extra costs are eventually reflected in more expensive mortgage rates (relative to the Official Cash Rate) and business lending rates in New Zealand.

At the same time a slowdown in Europe's economy will depress demand for New Zealand's exports and for long-haul tourism. Companies such as Tourism Holdings, which rents out camper vans to British and European tourists, has really struggled in the last couple of years. It will also eventually flow through into slower growth for China (and therefore Australia) as Europe is a major export market for China.

Luckily for us, our banks aren't closely connected at all to the European banks stuck in the middle of this mess. The one European bank that does operate in a substantial way here, Rabobank, has a AAA credit rating and much, much stronger capital than other European banks. It is seen as one of the top 10 safest banks in the world. See more here in Gareth Vaughan's article last week.

But a collapse of any sort of the European banking system would have indirect consequences here. We've already seen it through the various receiverships of finance companies (Strategic Finance, Hanover Finance) that were linked to the withdrawal of support or funding by Bank of Scotland (now part of the UK government controlled Lloyds HBOS), which had lent heavily in property finance in New Zealand before the Global Financial crisis.

10. So what are the trigger points and events New Zealanders should look for?

In the end the European crisis is all about politics.

If German voters were happy then Germany would keep bailing everybody out. But they're not and they keep telling Merkel every time they get a chance. The next German Federal elections are not until September or October 2013.

Before then the key moments will be political decisions by Merkel and her governing coalition. Most believe any more German bailouts, ECB money printing, a move to fiscal union, any sort of German-backed eurozone bond or any sort of United States of Europe talk are seen as political poison. There will be endless summits and crisis meetings. There's already been plenty.

French voters could also revolt against bailouts or a move towards a United States of Europe. The far right leader Marine Le Pen (daughter of Jean Marie) has said the Euro should die a natural death. She is currently leading in the opinion polls ahead of next year's French Presidential election. See more here at Business Insider.

Far right and far left anti-euro movements are growing heads of steam all across Europe, fueled by high unemployment, budget austerity and all sorts of stresses around migration and multi-culturalism. Many are now rightly saying European voters should not have to pay to bail out a bunch of privately held banks (and their bonused-up bankers). It's a toxic brew.

The next set of elections to watch is in Denmark on September 15 where a left-leaning coalition is expected to win and impose a financial transactions tax. France and Germany have already indicated they they want one of these 'Robin Hood' taxes. EU leader Barroso is was campaigning in Australia for Julia Gillard's support for such a tax. If Australia adopts one we'll have little choice but to follow.

Then there's the riots, strikes and the fall of governments outside of elections. Riots in Greece are commonplace. There is a general strike happening in Italy this week.

Even this week the German Constitutional Court was watched closely because it could have blocked the already woefully inadequate bailout fund. In the end it didn't block it, although it said the German parliament (rather than just the government) must approve any changes. See more here at Blooomberg.

Then there's the Finnish side deal with Greece over its bailout package...and talk that Ireland is downgrading its growth forecast...and a fresh vote of (no) confidence in the Italian senate over Silvio Berlusconi's latest austerity plan....

You get the picture.

Watch this space.