The Outbreak of Eurozone Sovereign Debt Crisis - Literature review Example

? CHAPTER 2: LITERATURE REVIEW Since the outbreak of Euro zone sovereign debt crisis, many scholars write papers about cause, influence and related economic theory of the crisis and sovereign debt crisis in history. The most relevant with dissertation are as follows (Portes, 1986): 2.1 Cause of the Crisis The general characteristics of sovereign debt crisis either are debt-servicing difficulties in a country by defaults or by over critical threshold of its bond spread (Pescatori et al. 2007). Minescu (2011) thinks similar with the Asian financial turmoil and the Nordic countries crisis; the main reason lied in rapid growth of long-term new loans and assets price. Although there are many special characteristics in the current sovereign debt crisis, the European Commission (2009) thought that the causes are similar to that for previous crises in Asia in late 1990s or the Nordic countries in the early 1990s. Caprio and Klingebiel (2003), McKinsey (2010), Mihalakas (2012) find that common problems existing in crisis countries are financial imbalances, government debt over the country's debt paying ability, huge public spending, which eventually lead to the occurrence of crisis. Calvo (1998), Eichengreen et al. (2005) and De Grauwe (2011) and Wolf (2011) all think that monetary union is one of the important factors. Detlef (2012) argues that large-scale sovereign debt is due to the endogenous structural problems. Leigh (2010) through the statistical methods to find low growth is another incentive to crisis. The financial crisis accompanied by the enormous public debt in the Euro zone particularly the Greece that occurred in 2009 resulted in a great confusion in the vast world financial market, this even became of in the year 2010 (Buckley & Arner, 2011). Despite this the International Monetary Fund (IMF) and the European Union (EU) have acted so fast to handle the crisis and restore the confidence of the market participants :( Portes, 1986). It did this through restoring the fiscal economies such as Greece, Ireland, and Portugal among others. However, the Euro zone crisis extended even in the first half of the 2011 through vigorously shaking the financial markets both internally and externally of the monetary union. This extended the thought that other countries would be rescued from the crisis later on. Although the countries mentioned so far are small economically, there was an exposure of through financial contagion and therefore the possibility of the scourge spreading to other countries of the EU like Spain and Italy, this has made handling of the crisis more complicated and serious. On the other hand, a variety of questions has been raised over whether the institutions conferred with the obligations of handling the issues will be up to the task (Buckley & Arner, 2011). The proponents of the advocacy that the monetary unions escaped national monetary and economic sovereignty are right though they lacked central fiscal authority :( Portes, 1986). It is quite evident that without such conferred authority; the organizations are toothless hence preventing the monetary union from effective action by the constituents. This therefore has made the recovery of the mentioned countries out of the debt crisis hence more muted than it would have been expected (Canuto & Giugale, 2010). For decades, the financial positions of the countries in the euro zone exhibited the strengths that have never been witnessed in the year 2007 (Canuto & Giugale, 2010). This had largely been attributed majorly due to the economic environments that facilitated the strongest view. The onset of the 2008-2009 financial crunches witnessed a longer and lasting impact in the economic environments of the countries in the EU (Buckley & Arner, 2011). This penetrated the economic environment in three major transmission channels, which entail: - the nature that the financial system is highly contagious and connected, the effects and impacts that demand had on wealth and confidence and lastly, the global trade activities generated and resulted into financial crisis (Canuto & Giugale, 2010). Form research findings, it is in records that the initial losses that resulted from sub-prime lending both originated from the united states though the majority of the write downs witnessed with the financial institutions covered the larger Europe, specifically the United Kingdom and the euro zone at large. This has made the financial institutions surviving in these regions losing so much in terms of financial value. According to Ernst & Young (2009), there were estimates that 51% of the total market capitalization of the 10-largest banks in Europe and 70% of top 10 insurance firms was greatly swept by the financial crisis and this lead to deterioration in the market confidence of the market participants. As indicated by the data from research, a market capitalization decreases of between 30%-96% of the top ten largest financial institutions (Canuto & Giugale, 2010). The factors behind the large spread in the percentages ranged from the stiffened lending standards accompanied by a decline in the wealth by the households :( Portes, 1986). Secondly, there was a rapid fall in the asset prices accompanied by an increase in savings with escalating demand for consumer durables and residential property. There was a rapid cut down in production of goods and services, which fuelled the demand further by building stock involuntarily; in addition, there was an amplified vicious inventory cycle (Canuto & Giugale, 2010). With a cut in real GDP by more than 4% in both the Euro zone and the EU, in general in the year 2009, the recession proved much deeper than any other was since that which occurred in the World War II. When recovery set in, apart from Germany, the recovery was sluggish in the whole of the euro zone as shown by the records of yearly quarterly growth performance data of the EU and Euro zone. While a growth rate was detected in the EU and Euro zone in the first quarter of 2010, the moderate growth figures until the first quarter of 2012 depicted that the pre-crisis performance is still much far from being reached (Chui & Gai, 2005). It is in record that Greece still suffers a pre-crisis contraction of about 7% basing on the output realised annually. It is much worse in both Spain and Italy where the output growth is barely at positive range with the economy of Italy commencing contraction at 1%. As aresult of the euro debt crisis, the trade volumes of the Euro zone shrunk in the last quarter of the year 2009 (Chui & Gai, 2005). This was due to business investment and rising demand for consumer goods, which was insufficient due to a cut in production. Again, the economy showed a strong dependent on credits and a high volume of trade activities and skyrocketed prices. The demand for credit and locally depleted sources of funds facilitated borrowings from countries abroad like the US increasing the government burden to repayment in terms of increased interest rates, which in addition worsened the economy amidst the crisis (Chui & Gai, 2005). Based on historical associations, the contraction in trade went deeper than it had been expected majorly originating from the composition of the shock in demand mostly affecting the highly intensive capital goods and consumable durables. These were fuelled further by the capital unavailability most so from local borrowing and the high speed with which the trade took place majorly because of globalization of both production and technology (Canuto & Giugale, 2010). Another impact originated from the action by the government, the swift government actions to aid both the financial sector and the aggregate demand resulted into the sharp deterioration of the Euro zone fiscal stance in both the general government balances and public money. The most ready influences of the factors listed alongside the automatic forces of stabilization (Chui & Gai, 2005). The GDP due to the human and the automatic forces above rose from 0.7% at the end of the year 2007 to a wide deficit of 6.2% at year 2010 end. During the first half of the year 2011, an increase of 5.5% in the euro zone deficit, which is a slight improvement as per the data showing the second quarter? Consequently, Euro zone countries such as Portugal, Spain, Greece went ahead to run very large budget deficit due to large external borrowing despite the records that showed significant improvements during the same period. This impact is experienced with great impact in Greece with a salvage only emanating from the strict austerity measures by the government to keep the deficit at about 10% which though higher that the current pre-crisis levels is healthy considering the current nature of the economy (Chui & Gai, 2005). The slit impacts are still felt in Ireland exhibited with an endearingly high budgetary gap ranging from 24% at the end of the year 2010 and 31% in the second quarter of the year 2011. The gap is likely to remain in the same state for a prolonged period given the sluggish recovery of the economy. As it can be realized, the size of the fiscal stimulus in the Euro zone is comparatively smaller as compared to that of the single currency run Chinese economies with the impact of the economic situation on the government in the EU and Euro zone more persistent than in the Chinese economy (Canuto & Giugale, 2010). 2.2 Influence of the Crisis The implications of the sovereign debt crisis can be numerous, but they are generally referring to the financial sector, the real economy, regulations among many other sectors of the society operations.Cogman & Dobbs (2008) and Reinhart and Rogoff (2008) argue that the impact of the crisis to economic entity and recovery time are also quite different. (Dooley 2000) analyzes the influence of Latin America on the world financial system. Adamu (2008) studies the influence of world economic crisis to Nigeria economy as a representation of the developing and African states. Karshenas (2009) points out that the degree of influence caused by world financial crisis to least-developed countries depends on its trade specialization degree. According to the studies of the world countries above, the sovereign debt crisis is found to impact on both the macroeconomic units as well as the micro units (Chui & Gai, 2005). In the broad sense of the macro-economy, it touched on the real investment sector and the employment and production of goods and services, which in turn affect demand trickling down to prices. Due to the increase of the government budgets deficits and sovereign debts, there has been a realization of the crisis of the confidence most so due to the widening of the secondary markets for the bond yield by the government issued securities. This is shown by a yield of about 6% which is a strong indicator of a serious doubt in the financial markets of a country throwing a questions as to whether the country in question is able to pay up for its debts hence a rating in the credit worthiness. The long-term impact of low credit worthiness because of the crisis is the unwillingness of sovereign government to lend money as long term financing to countries affected hence negative development. From the evidence adduced, it is clear that Greece, Portugal, and Ireland, which stood at rating of 7% stands as the reference mark below, which such country is in dire danger hence, should seek for a bailout. In addition, the yield of the bonds by both Italy and Spain stood at 6% though they have shown prospects of future growth so that in the very near future they are likely to surpass that level (External debt crisis and development: report of the Secretary-General.. (152003). As sovereign debt continues to harm most of the economies negatively, most of the countries in the EU and the entire Euro zone have witnessed the rate of unemployment in their respective countries drastically go up majorly due to the cuts in the government spending and the increase in the layoffs. Specifically, the three countries that have needed bailouts have witnessed majority of the unemployment cases with rates at 17.1%, 14.4% and 12.5% for Greece, Ireland and Portugal respectively. Spain has witnessed the highest unemployment rate of 21.3% since the second quarter of the year 2008 and this ran up to the second quarter of the year 2011(External debt crisis and development: report of the Secretary-General.. (152003). This has opened up the countries avenues and enabled it realize the need of shifting from overdependence on specific sectors like construction industry which is in record to have supported the economy until the onset of the crisis. Furthermore, it is suggested by the figures of unemployment rate that countries which uses the euro as their currencies and are within the EU and euro zone to an extent suffer higher unemployment rates as compared to those countries which depend on floating national currencies. A reference point in this is china, which lays its emphasis on the Yuan (Howden, 2011). The impact of the sovereign debt crisis was not felt just locally but outside the EU and to a large extent the Euro zone, this is due to the level in which both the public and the private enterprises within the prescribed region is exposed and hence resulting into serious financial contagion effects (Howden, 2011). In fact, some countries outside the EU and Euro zone are cushioned from the crisis largely; this is majorly due to how the economies are being run and due to the trade in merchandise and development assistance inflow. This is shown from the research figures that indicate that the sum total value of the exports and imports to countries external to the affected EU regions and largely to Africa and China in the east. These indicates that enabled the countries not experience the shock and had fully recovered by the year 2010 as compared to the countries in the Euro zone which had only shown half way recovery by the same time (Kolb, 2011). The euro zone sovereign debt crisis has also affected the less developed countries majorly from Africa and the Scandinavian countries like Nigeria and Kosovo (Kolb, 2011). This is due to the sole reason that countries from such areas mostly depend on foreign aid which when invoked makes such countries experience a great shock. The decline in the trend of donations from donor countries over the past five years is largely been traced to have taken effect from the EU and Euro zone and this has been due to the impact of the debt crisis (Howden, 2011). While the amount of aid inflows from donors have remained around the same level since the onset of the financials and debt crisis, a sharp decline has been witnessed of $11.6 billion $6.7 billion in 2008 and 2010 respectively hence a decline of more than half since the year 2005. 2.3 Sovereign Debt Crisis in History Defaults of government debts repeated in a series of similar episodes stretching back over a period of centuries. Most notably in the 1840s, 1930s and 1980s. Rothbard (2002) and Walsh (2011) analysis the 1840s’ sovereignty default. These are the major indicators of a collapsing economy since after a while the governments find it hard to repay the debts. Eichengreen and Portes (1989) study the 1930s’ sovereign default by three stages, which in turn happened in the Latin American countries, southern Europe and eastern European countries. Diaz - Alejandro (1983), Fishlow (1985) and Eichengreen and Portes (1986) through the study find low development is the decision factors to default and summarize the characteristics of the sovereign debt default. Walsh (2011), Cardenas (2012) and Hornbeck (2004) analyze the 1980-1990’s sovereignty debt crisis and solutions. On 9 of august 2007; 15 September 2008; 2 April 2009; 9 May 2010 and 5th August 2011 became the most critical stages of which the most severe crisis hit the world economy (Kolb, 2011). This is from the alluded facts that the greatest depression can be found within these dates hence sub-prime to the downgrades. The first phase of 9 August 2007 began with a serious attack of the banking system with the announcement of the BNP paribus that it was terminating its operations in three most critical hedge funds in the United States mortgage market (Chui & Gai, 2005). The bankers’ had underestimated the amount involved in this pullout until it came to the surface that there were trillions of dollars swilling around, this is the point when the depth of the losses and the extent of the risks that the banks were facing to an extent that no bank could continue doing business with the other. Another hit came one year later when the US government did not intervene to salvage the Lehman Brothers from going bankrupt, as is the case of the role by government in such situations (Kolb, 2011). Fear raged through every one individual on the surface of the earth, as the notion that big banks could never crumble could not hold waters anymore hence all the banks became risky on the face of everyone. The western government through a domino effect came to the rescue of banks though this could not prevent the world economy from crunching, as it was quite late (Chui & Gai, 2005). Therefore, business operations went to a standstill as the consumer credit flows was choked. The winter of September 2008 came with another boost as the G20 a group of 20 developed countries came together in an attempt to bring out recession from becoming a permanent fall (Kolb, 2011). The ever-high interest rates were cut down, stimulus packages like the Obama’s $787 billion package put in place and technologically, the electronic money through economic easing was created. In the London G20 summit of the 2 April 2009 saw the world leaders commit to a $5tn fiscal expansion and an extra $1.1tn to help boost growth and reforms in the banking sector. These support lead to the onset of the facelift of the banking sector as the international corporations split and individual nations went into engaging in their own agenda. Engagements drastically shifted from the private sector to public sector and the crisis went deep into governments when the EU and IMF announced assistance for Greece (Krugman, 2000). The cause was because of escalated budget deficits given that the receipt of taxes became low and partly it was because of the poor fiscal packages announced in the year 2008-2009. Governments therefore became insolvent lead by Greece, which unsorted problems with its public resources and its inability to collect taxes (Chui & Gai, 2005). Several countries across the world started to worry about their budget deficits prompting the mentioned states to go down into finding austerity measures (Krugman, 2000). These measures affected largely the decisions with regard to policies instituted in the EU and the euro zone. The US was also part of such policies with the US government being the longest country to stick to the expansionary fiscal policies. The day when the private sector was getting into a sovereign debt crisis, the rating agency waited the Wall Street to close down so that they do valuation of the stocks without an avail. The policy makers were though confronted with sluggishness in the economy and systemic crisis, this was due to stupidity in unison exhibited and blanket austerity, which instead of easing issues went further to worsen the situations. The biggest challenge for the policy makers was how to strike a balance between big creditors like China and Germany verses the big debtors like the US (Thunberg, 1986). Amidst the hard times, the only solace was optimism given that the markets were bound to remain in the worsened state for some time even though the bond yields had gone up (Krugman, 2000). Japans growth prospects remained poor as it had lost its S&P triple A rating with a national debt of over 200% of the GDP and yield from bonds remaining a record time low. The world economy remained threatened since the bond yield of the America remained low though dressed down to make the superpower retain the grip. China in the east exhibited a growth rate of 10% amidst this crisis threatening to overtake the US making the communist in the east to appear bold to lead the capitalists in the east a better way of managing the economy (Thunberg, 1986). The 5 August will remain in the calendar as the date when the American hegemony was hogwash, as the superpower could not deliver economic recovery. The America exhibited characteristics such as that of negative equity, a record time unemployment level leading to the tightening of the fiscal policy for quite a period due to the expiry of tax breaks and elapsed deadlines for government spending (Sun, Stewart & Pollard, 2011). Generally, what was witnessed was the fall of the west, which includes the US, EU and the euro zone in total as the east through communism rise to teach the west a lesson on economy management (Thunberg, 1986). The east got recognition and there is no G7 meeting that can be held today without China. The result of this game is zero as there is no successful conclusion to it, there was and still there is a trickle of the impacts of the sovereign debt crisis. Most countries still exhibit a high level of unemployment with slow economic growth, as the banks are still obligated to pay the debts accumulated, the world economy is still likely to go into a crisis as the world powers are likely to go back and the euro breaks apart (Sun, Stewart & Pollard, 2011). 2.4 Relative Economic Theories Surveys from the large national debts have it that after the government engages most of its revenues they are likely to crush into a state of financial or global crisis. This is due to the ability of the public debt to threaten and eventually lead a state into bankruptcy (Publishing, 2012). This theory is though still under tight scrutiny and intense research. According to study by Ricardian Equivalence Theorem, an economic theory exclaims that it does not matter the means, which the government employs in financing its budgets, as the consumers are able to internalize the government’s constraints (Sun, Stewart & Pollard, 2011). Therefore, whether it is through debt or taxation, the elicited level of demand is the same. The basic reasoning behind this is that the consumption pattern over time does not deviate much from this given that the initial conditions do not change the present value of wealth. The other theory is the financial accelerator theory, it postulates that the frictions in the financial markets makes louder the spending of borrowers and hence depicts automatic fluctuations in the aggregate economic operations as opposed to a world presumed not to exhibit frictions in its financial markets (Publishing, 2012). The amplifications because of the frictions in the financial markets result into the shocks that cause synergy during the global crunch. According to Robert Mundell(1961), Ronald McKinnon(1963) and Kenen(1969); the Optimal Currency Area theory is founded and explained. They argue that there are potential characteristics that the potential members of a monetary union ought to posses in order to make it feasible to surrender a policy that is nationally tailored; that is, a policy that reflects all the needs of the nation at the time of the crisis and even during stability. This as well entails the adjustments of the exchange rates of the national currency. This theory if well formulated and implemented leads to the financial stability of the financial sector of any given economy (Publishing, 2012). References Buckley, RP, & Arner, DW, 2011, from crisis to crisis: the global financial system and regulatory failure, Kluwer Law & Business: Alphen aan den Rijn. Canuto, O, & Giugale, M, 2010, the day after tomorrow: a handbook on the future of economic policy in the developing world, World Bank: Washington, D.C. Chui, M, & Gai, P, 2005, Private sector involvement and international financial crises: an analytical perspective, Oxford University Press: Oxford. External debt crisis and development: report of the Secretary-General, 152003, UN: New York. Howden, D, 2011, Institutions in Crisis European Perspectives on the Recession, Edward Elgar Pub: Cheltenham. Kolb, RW, 2011, financial contagion: the viral threat to the wealth of nations, Wiley: Hoboken, N.J. Krugman, PR, 2000, Currency crises, University of Chicago Press: Chicago. 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