Before going into the crisis let us look at the background of the European Union (EU). European Union is a group of 27 European countries. 17 members of the EU and 5 other countries not from EU adopted a single currency Euro in the year 1992 to further integrate their economies.
Some countries(like UK,Denmark etc) did not adopt
Euro because it would mean giving up the right to independent monetary policy. This was because adoption of a single currency meant that the exchange rate of Euro would not be devalued to suit an individual country’s need. Also, the interest rate of all the Euro-zone countries was to be fixed by the European Commercial Bank(ECB). It could not be changed to manage inflation
Now lets talk about the build-up to the crisis. All the countries had different reasons for accumulation of huge amount of debt. For instance in Greece,the wages and pension commitments were very high. The cause common to all the countries was the Global Recession of 2008. Shipping and tourism which were a fundamental source of capital inflows in Greece took a huge hit. In countries like Spain, the government had to give huge ‘bail-out’ packages to the banks after the sub-prime crisis. Its affect was that the banking sector’s debt was transferred to the balance sheet of these countries.
In 2009, the rating agencies downgraded the government debt of eurozone countries. It led to further fears of default. As the perceived risk of lending to these countries increased, their cost of borrowing increased and the countries could not refinance their debt(ie take new debt to pay off the existing one)because of high interest rates.
So, the IMF stepped in and along with ECB gave bail-out funds to the crisis-hit countries on condition of strict austerity (decreased govt. spending). It was criticised on the grounds that decreased spending during recession further deepens the recession in the economy because of low levels of economic activity.
The crisis has made the EU realise the fundamental flaw in Euro. If the debt crisis had taken place in India we could have devalued our currency to correct the fiscal imbalance (along with other measures). The other main flaw is that the eurozone is a monetary union without a fiscal union. In the treaty signed before the adoption of Euro, all countries had agreed to keep debt levels within 3% of their GDP. But, Greece had run high fiscal deficit for years and manipulated its balance sheet to give an impression of compliance. It could afford to be fiscally irresponsible because there was no fiscal union.
In 2012, the ECB announced free unlimited support for all eurozone countries involved in the crisis. It led to decrease in interest rates of bonds issued by these countries.
Though the financial markets have calmed down after his assurance, eurozone is still not out of the crisis. The debt levels of the countries are still above sustainable levels and the economic growth rate has not picked up.