International Financial Markets, European Sovereign Debt Crisis - Essay Example

INTERNATIONAL FINANCIAL MARKETS al Affiliation European sovereign debt crisis From the beginning of the euro crisis, the capacity of the Euro- member states to survive the negative financial and macroeconomic alarm has been identified as the main challenge for the Euro currency’s success. Switching from a national option of currency devaluation was eliminated; the currency devaluation was used as the traditional adjustment mechanism between the national economies of the countries. The Euro could not match the design of the American dollar union used in the United States because the money value was not accompanied by a considerable degree of the European banking union system. The nations found it feasible to retain it as a national responsibility for their financial regulations and monetary policy. The ability for national governments to borrow excessively using a common currency is one major risk towards the economic collapse of the Euro. Initially, the European Union gave its most ambitious attempt in history for having a supranational organization; pooling sovereignty rather than going to war seemed the best option for the rivaling nations (The Economist, 2010c, p. 1). It became apparent to the states participating that political unity should be considered so as to attain both economic and political stability. Many commercial European banks lost an enormous amount of their money due to the exposure of bad debts in the United States, also known as subprime mortgage debt bundles. In America, financial institutions have become favored by securitization in the sense that these banks grant loans and their interest rates are variable with regards to the poor households; the banks could sell the loans they granted to others rather than keep the granted loans on their balance sheets. Based on this the monetary institution in charge of this increased the interest rates for the year 2005 and 2006 so as to reduce inflation (Lane, 2012 p. 49). The drastic diminishing trust among banks is as a result of difficulties to obtain short term financings like process of securitization and loan losses. Banks were scared of lending out financial assistance to others and in the end there was a fall of liquidity in majority of banks since they had no access to short term financing. Interbank short term investment was a major deal for most banks in the US. Based on this the euro crisis turned from a financial crisis and became an economic crisis because there was a reduction in terms of credit supply by the banks (Lane, 2012 p. 50). The difficulties and losses in obtaining short-term refinancing contributed to the reduction in the ability for the banks to grant loans, the consequence of this were diminishing of the investment and consumption rates. The Euro crisis became worse from 2008 until 2013; countries such as Greece and Ireland became the first nations to receive financial bailout from the European Union and international monetary fund. The two countries face difficulties with regards to and the European economic and monetary union. Initially, the Euro aimed at addressing the problem of over borrowing especially by the smaller economies such as Ireland and Greece. The Euro initially sought to address the issue of over borrowing from banks in two ways; stability and growth pact set limits on the size of the annual budgetary deficit at 3% of the gross domestic product and the public stock debt of 60 % of the gross domestic product (Lane, 2012 p. 49). Another way was through sovereign default taking precedence over the national government failed to meet its debt obligation; in the Euro rules, there was a no-bail out clause (Lane, 2012 p. 50). Using a single currency to unite the European nations helps take advantage of the economies of scale in order to compete more aggressively with respect to the world markets (Castleberry and Subramaniam, 2014 P. 104). Poor private investments that later escalated when governments secured bad private debt contributed to the euro crisis. The European public debt was building up even as the parties were busy ensuring the individual losses in the financial system (Castleberry and Subramaniam, 2014 P. 104). The recession resulted in a steep decline in government finances; the government receives less tax when there is a negative growth and has to spend more money on unemployment benefits. The public guarantee of commercial bank loans, which was not a direct payment rather than debt liability resulted in an economic downturn (Castleberry and Subramaniam, 2014 P. 104). In case of a private default; the risk premium increases and becomes attributed to the liabilities. Here the rise in debt to the Gross Domestic Product ratio plays a huge role; when there is a fall in the GDP, there is a resultant increase in shares and consequently an increase in the increase in debt to GDP ratio that is evident with Ireland when it became a member of the European Community during the early 1970’s energy crisis and global recession (Taylor, 2011 p. 9). Becoming a member was economically attractive for Ireland; the Irish government was pushing for a national project of modernization and as such would benefit greatly from a large market for the sale of Irish goods (Taylor, 2011 p. 9). Ireland also opted to join the community so as to relinquish itself from the United Kingdom, which they had become fully dependent. Ireland was a less developed country as compared to other European economies including France and Britain and was an agricultural country before joining the European Community. After joining the community, Ireland improved in its economic structure and became more industrialized and urbanized; this helped open up the country’s economy to the larger European market (Taylor, 2011 p. 9). With the political independence from United Kingdom came several pressures towards Ireland’s governance structure. During transition of becoming a European community member state, Irish policymakers and politicians introduced multi governance; a small state enhanced freedom of action and autonomy through pooling of sovereignty therefore there were certain reservations regarding their traditional doctrines of sovereignty (Laffan, 2003, p. 248). Ireland’s multi-level governance strategies saw opportunities for particular interests playing an important role for the state’s interests. Another reason for the European sovereign debt crisis is due to economic stabilization (Castleberry and Subramaniam, 2014 P. 105). The high unemployment rate lowers the tax collected by government and causes the government to pay out more in benefits to the unemployed citizens and the poor (Castleberry and Subramaniam, 2014 P. 105). Other nations like Greece got into heavy debts and were not allowed to join the Euro zone as they did not meet the four Maastricht indicators (Castleberry and Subramaniam, 2014 P. 105). The Greek credit default swaps together with the huge entitlements became large they even caused credit on debt to get substantial than the nation’s capacity to pay up, this caused the European Central Bank to quickly respond towards their urgency (Castleberry and Subramaniam, 2014 P. 105). Even though ways of preventing crisis like deflating the value of the Drachma and even reducing the interest rates was there, involvement in the Euro prevented such measures since the Euro currency was built without a central power for decision making. Greece was under many inquiries from the United States because of their wavering economy more so after Standard and Poor’s reduced Greece’s credit rating twice on 2010; these reduced Greece’s credit rating to lowest rank possible thus causing the interest rates to skyrocket as it is a major importer of goods from US (Castleberry and Subramaniam, 2014 P. 105). The financial collapse and credit crunch led to a fall in European house prices thus increasing the losses of many European banks (Eckhard, 2009 p.345). Iceland had a similar housing bubble like the one experienced in the United States that led to emergency debt crisis and banking systems. Borrowers in Iceland were being issued with creative real estate loans countering the inflation of its currency, the loans ranged from between 10% to 50% (Castleberry and Subramaniam, 2014 P. 107) and in turn ended up becoming the largest storm of disaster for banks in Iceland and the general public. When the real estate bubble opened its doors, almost all the citizens owned a sub-prime financial plan; this meant none of the owners could move even if they wanted to. In order to reduce their loss banks began investing in rent house market; this became impossible as a significant number of the population could not be able to pay their rent. As much as the citizens of Iceland knew the risks involved with such mortgages, they still accepted since the economy was good at the time and the society saw fit to invest in real estate market through their financial institutions. Monetary institutions froze making it hard for people to gain access to their funds (Eckhard, 2009 p.348). Spain also suffered the same housing collapse however the nation’s largest debt issue revolved around the economic stagnation through its slow growth (Castleberry and Subramaniam, 2014 P. 107). Austerity measures led to an increase in the number of workers in their 20’s from becoming unemployed by about 50%. Spain’s credit became downgraded from triple A to double A based on the doubling budget deficit projections in 2010; this brought about an increase in the interest rates. According to Codongo (2003), not only did the interest rates increase due to low liquidity level but also an additional premium for uncertainty existed. As a result of the recent financial crisis, Iceland and Greece are facing difficulties (Taylor, 2011 p.14); this is with reference to the terms of European economic and monetary union. The United States could have a direct effect towards the European debt crisis. The American housing model bubble was adopted by Iceland banking facilities; however American banks are much better than European nations in the sense that they have a better position with housing finances as compared to their counterparts who adopted their strategy since they have a lower scale of debt in relation to their GDP when compared to European Community. America can be able to bail out its financial institutions in case of such recession whereas the European community could not be able to (Castleberry and Subramaniam, 2014 P. 110). Lessons learnt from the European sovereign debt crisis is the importance of enacting austerity measures with immediate effect; the level of debt prior to the collapse of European countries and the subsequent bailout of the countries by IMF and the European Union is comparable to the amount of debt in United States. Ireland as a country should serve as a wakening call and adopt austerity measures soon. Since small economies are unable to devalue the currency, among other reasons, in order to regain economic competitiveness as members of a single user currency, it becomes possible to note that the Euro zone’s economic structure may be inadequate to address the national economic vulnerabilities in times of crisis. The other lesson learnt from the European debt crisis is not to allow the debts to go higher by means of allowing there to be deficit budgets each year (Castleberry and Subramaniam, 2014 P. 108). Greece is one example of an overburdened economy in crisis, the nation’s entitlement and social leaning government has created a lavish lifestyle for the citizens and as a result such entitlements have contributed to the country locking out basic provisions for its citizens (Castleberry and Subramaniam, 2014, P. 108). In conclusion, the European sovereign debt predicament can be attributed to the flaws in the original design of the euro. The absence of the banking union as well as other European cushion mechanisms led to an incomplete understanding of how fragile the conditions of monetary union are. Politically it is important for a country to emphasis the essence of social investments and protects them for the interest of the society. 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