• Euro zone leaders have agreed to a tough set of rules – insisted on by Germany – that will limit their governments’ borrowing each year to just 3% of their economies’ output. This is to stop them accumulating too much debt, and make sure we avoid we another financial crisis.

But didn’t they already agree to this back in the ’90s?

• Hang on a minute. They agreed to exactly the same 3% borrowing limit back in 1997, when the euro was being set up.  It was the  German finance minister Theo Waigel who insisted on the “stability and growth pact”. What happened?

So who kept to the rules?

• Italy was the worst offender. It regularly broke the 3% annual borrowing limit.  But actually Germany – along with Italy – was the first big country to break the 3% rule. After that, France followed. Of the big economies, only Spain kept its nose clear until the 2008 financial crisis; the Madrid government stayed within the 3% limit every year from the euro’s creation in 1999 until 2007. Not only that – of the four, Spain’s government also has the smallest debts to the size of its economy. Greece, by the way, is in a class of its own. It never stuck to the 3% target, but manipulated its borrowing statistics to look good, which allowed it to get into the euro in the first place.  Its waywardness was uncovered two years ago.
• 3/9 Italy
  Worst offender
• 5/9 Germany
  First to break rules
• 6/9 France
  Offender
• 9/9 Spain
  Top of the Class

But the markets have other ideas

• So surely Germany, France and Italy should be in trouble with all that reckless borrowing, while Spain should be reaping the rewards of its virtue? Well, no.  Actually Germany is the “safe haven” – markets have been willing to lend to it at historically low interest rates since the crisis began.  Spain on the other hand is seen by markets as almost as risky as Italy.
• So what gives?

So what really caused the crisis?

• There was a big build-up of debts in Spain and Italy before 2008, but it had nothing to do with governments. Instead it was the private sector – companies and mortgage borrowers [@1  LAW #8] – who were taking out loans [@2 LAW #4] . Interest rates had fallen to unprecedented lows in southern European countries when they joined the euro. And that encouraged a debt-fuelled boom.
• Good news for Germany…
• All that debt helped finance more and more imports by Spain, Italy and even France. Meanwhile, Germany became an export power-house after the euro zone was set up in 1999, selling far more to the rest of the world (including southern Europeans) than it was buying as imports. That meant Germany was earning a lot of surplus cash on its exports. And guess what – most of that cash ended up being lent to southern Europe.
• …bad news for southern Europe
• But debts are only part of the problem in Italy and Spain. During the boom years, wages rose and rose in the south (and in France). But German unions agreed to hold their wages (and their personal spending) steady. So Italian and Spanish workers now face a huge competitive price disadvantage. Indeed, this loss of competitiveness  [@3 LAW #3]  is the main reason southern Europeans have found it so much harder to export than Germany.
• …and a nasty dilemma
• So to recap, government borrowing – which has ballooned since the 2008 global financial crisis – had very little to do with creating the current euro zone crisis in the first place, especially in Spain (Greece’s government is the big exception here). So even if governments don’t break the borrowing rules this time, that won’t necessarily stop a similar crisis from happening all over again.
• Spain and Italy are now facing nasty recessions, because no-one wants to spend. Companies and mortgage borrowers are too busy repaying their debts to spend more.  Exports are uncompetitive.  And now governments – whose borrowing has exploded since the 2008 financial crisis savaged their economies – have agreed to drastically cut their spending back as well [@4 What Law is that?].  But…

Cut spending…

• …and you are pretty sure to deepen the recession. That probably means even more unemployment (already over 20% in Spain), which may push wages down to more competitive levels – though history suggests this is very hard to do. Even so, lower wages will just make people’s debts even harder to repay, meaning they are likely to cut their own spending even more, or stop repaying their debts. And lower wages may not even lead to a quick rise in exports, if all of your European export markets are in recession too. In any case, you can probably expect more strikes and protests, and more nervousness in financial markets about whether you really will stay in the euro.

Don’t cut spending…

• …and you risk a financial collapse. The amount you borrow each year has exploded since 2008 due to economic stagnation and high unemployment. But your economy looks to be chronically uncompetitive within the euro. So markets are liable to lose confidence in you – they may fear your economy is simply too weak to support your ballooning debt load. Meanwhile, other European governments may not have enough money to bail you out, and the European Central Bank says its mandate doesn’t allow it to. And if they won’t lend to you, why would anyone else?