Role of External Debts in the Euro Area Crisis - Literature review Example

Role of External Debts In The Euro Area Crisis Introduction. In reference to Soros , the Euro area is a group of countries in the European continent that use a common currency referred to as the Euro. As a currency union, the European Central Bank has the mandate to make monetary rules and control the money in circulation. In 2011, the Euro area was in the midst of a crisis also referred to as the Euro zone sovereign crisis. The financial mayhem was as a result of some countries in the zone such as Greece that spent most of its revenue compared to others in the zone. The excessive expenditure resulted in the governments of these countries borrowing heavily to maintain their economic status. However, it reached a point where the countries could not manage their financial situation. Due to the inability to repay the debts in full, the lender countries demanded more interest rates for their loans resulting in a sovereign debt crisis. According to Lane and Pels (2012), a current account imbalance occurs when there exists a gap between the expenditure and savings of a country. A positive current account balance is used to determine the revenue a country generates from investments it has made outside its boundaries. A negative current account balance simply shows the amount of domestic expenditure that is being financed by other countries in the shape of a loan. The balance is calculated in the domestic currency where the imports and net abroad investment returns are combined minus the total sum of exports. The Euro crisis has been linked to several factors that are believed to be behind the situation. These range from fiscal policies to current account imbalances. However, current account imbalances are the prime cause of the scenario. Key Facts about the Euro area crisis In the rules and regulations that were aired by the Maastricht Treaty, stability, and regional growth were the key points of reference. The treaty emphasised on fiscal sustainability of member states’ governments activities. The expenses incurred by the private sector together with the value of exports were at the center stage as markers of growth. The Euro area has two type of members that have varying rights and abilities. Core countries such as Germany and Austria were given the mandate to pursue devaluation of the Euro currency during times of economic hardships. Non-core countries include Portugal, Spain, Ireland and Greece. The labor costs in the peripheral countries were relatively higher compared to the labor costs in the core member states. On a more specific tone, the labor costs in the core member states constantly increased by 7 percent from 2000 to 2007. On the other hand, the unit labor costs increased by 24 percent. Countries such a Greece that are not in the core membership were not allowed to devaluate their currency even in a move to ensure foreign exchange generation from exports. The Euro, adopted currency for all Euro area members, precludes nominal depreciations in order to compensate the gap created by the increase in wages in the core countries in relation to those in the periphery countries (Cesaratto S. and Stirati A, 2010). In reference to Grauwe (2003), the ability of all the Euro area member states to adapt to a negative change in the economy was already an issue that was in doubt. From the beginning of the Euro area, many argued that the switching to a new regional currency and doing away with national currencies was a wrong idea. To begin with, the newly introduced currency gave only a few countries, referred to as core members, the ability to devalue the currency in order to boost their current accounts in case of a financial crisis. According to Wyplosz (2006), thetraditional mechanisms that previously existed in the member countries were all scrapped off in a move to maintain proper distribution of the resources. The move was not valid since there existed countries such as Germany that were better off compared to fellow member states such as Greece. This simply meant the core countries would not welcome the idea of being at the same level and sharing similar policies with member states who had worse economies. In reference to Lane (2006), the Euro area allowed member states to borrow loans from their neighbouring countries in the economic union that were better off in terms of economic establishment and stability. In reference to Marzinotto, Andre and Wolff (2011), countries in the same economic union where a similar currency is adopted should not borrow from each other due to the problem of free-riding where the union often bails out the country that undergoes excessive borrowing. According to Wyplosz (1999), the indigenous Euro area was aimed at addressing the problem of excessive debts amongst its member states. The growth and stability pact set a problem to the countries that had fewer developments where it banned bailing out of countries burdened with external debts. Role of external versus internal debt in euro area crisis: An external debt is the total debt that a country owes foreign governments or non-residents. The debt includes both government (public debt) and private debt. External debt is paid back in the form of an internationally accepted currency. The debt can also be paid back in terms of goods and services that are produced by the country. The category of internal debt refers to the amount of money that a government borrows from lenders within its boundaries(Calvo, 1988). Such lenders include banks, companies or even individuals. The overall internal debt ought to be at a state of equilibrium with the level of debt owed to lenders outside a countrys boundaries. The importance of making sure that there is a state of balance between external and internal debt is to ensure that the economy is stabilised. The urge to borrow from external parties is also to ensure that the currency of a country is protected hence preventing inflation or avoiding a period of recession. The ability of a country to manage its external and internal debts is key to avoiding a major economic crisis. These debts need to be serviced in accordance with a good plan. When working on a way on how to settle the external or internal debt, the government has to formulate a few strategies in the best way possible. The repayment should occur in such a manner that a crisis is not created for the population in a country. A crisis could arise where the citizens are left with little to save as a result of high taxation. Also, uncouth practices such as printing more currency and releasing it to circulation increase the purchasing power of the population hence resulting in inflation. However, there exists a high level of interdependence between countries in an economic union. In reference to Bortis (1997), all the Euro area countries use a single currency and the simplest misuse of these finances greatly affects the financial stability of fellow member countries through a ripple effect. In Greece, a country well embroiled in a sovereign debt crisis, the banking system of the nation crumbled thus the lack of proper investments. The currency collapse led to the weakening of the German and French economies. Inevitable employee lay-offs, reduced purchasing powers and economic hardships for citizens were some of the effects of the destabilisation that occurred as a result of the imbalance in current accounts. In reference to Rogoff, Reinhart and Kenneth (2010), an internal debt is different from an external debt in that, payment of an internal debt facilitates the proper distribution of resources. The principle behind this is that the money is borrowed from an internal source such as a bank. The value of resources required to pay back the loan in full also plays another role where it helps in the development of a country. In the case of development, the resources turn a country into a self-sufficient and effective system where the citizens also benefit from job provision by the internal lenders. The taxes obtained from the citizens do not cause any form of monetary burden. The reason behind it is that the taxpayer could be the bold holder hence no actual crisis results from the repayment. Causes of high external debt: According to Reinhart (2010), most external debts are as a result of a country trying to restructure in order to achieve economic growth. Since 2003, the gross external debts of major world economic unions have increased considerably. The increase resulted from the rising urge by governments in response to the global crisis in 2008. The existence of high bonds made the repayment of the loans extremely exhausting to the country. Embezzlement of the loans granted to a country by the leaders results to high debts due to lack of proper investment. Money borrowed from external sources should be used to finance projects that can generate income such as building the infrastructure so as to increase the productivity of a country.In the Euro crisis, the country that was at the epicenter of the whole tragedy is Greece. The country is known to have had spiraling cases of debt crises even before it was endorsed as a Euro area member. According to Wyplosz (2006), the adoption of a new currency simply compounded the problem in Greece. The embracement of a common currency hindered Greece from carrying out devaluation of its currency in order to cope with the 2008 global crisis.This meant that the risk of affecting the economies of other countries was going to go high than normal. In reference to Muellbauer (2011), the Euro area incorporates a large number of countries that suffered from similar problems prior to the adoption of the Euro. These include Italy, Ireland, Portugal and Spain. The economic area is a unique union where countries, each with a conspicuous economic status operate on the same currency. The level of economic development and financial stability varies from one country to another. The differences mean that the amount of loans required by every country is different. Debt crises are diverse and in the same breath, they can be triggered easily by a range of factors. These factors include political, violation of rules, banking systems and the reliability of rating agencies figures. Political factors have the capability of disrupting the ability of a country to sustain its projects without considering major external loans. The level of political policies in a country increases distress in the financial institutions such as banks. Political factors that influence a debt crisis include the formulation of policies that go against the will of most citizens. Political decisions that are made anywhere within the economic zone also affect other member states in an economic union. It is the basic knowledge that economics and politics make up the two sides of a coin. The role of politics in a debt crisis cannot be ignored since the conflicting interests of the various governments have the capability of raising the level of external debt in a country. In the Euro area, a good example can be deduced from the role of Germany in the progression of the Euro crisis. Germany and other more developed countries such as France opposed the suggestion to bail out euro area member states such as Ireland and Italy(Cesaratto S. and Stirati A, 2010). In reference to Marzinotto, Andre and Wolff (2011), the rules and regulations that govern the Euro area were clearly outlined in the Maastricht Treaty in 1992. However, the leadership breached the rules, a situation that resulted in countries such as Cyprus and Greece not presenting to the union truthful information on their real economic and financial situation. Following the harsh effects of the financial crisis that started in the United States, high risk decisions such as credit default swaps were made in response to speculations that the euro area countries would separate following the crisis and lack of trust in the single currency. The Euro area banking sector became vulnerable when they learnt that they would have left banks to spend their cash in bailing out their respective governments from the crisis instead of funding their customers. The rating agencies also played a huge part in encouraging external borrowing and lending to foreign governments. As a result of poor ratings, the yields on the bonds rose considerably which made it extremely difficult for governments to raise money to fund their projects. As a result, lack of trust by creditors who found it difficult to lend money, greatly affected the governments (Rogoff, Reinhart and Kenneth, 2010). The slow reaction from the Euro area officials to handle the crisis also propagated the progression of the debt crisis. The debt crisis that had its roots in Greece moved from one country to another due to the inability of the union to develop corrective measures fast enough to solve the ongoing challenge. In accordance with Wyplosz (2006), the existence of a single currency and a tight monetary policy also played a huge part in encouraging the rise in external debt. Most peripheral countries in the Euro area such as Spain and Portugal did not have the rights to devalue their currency in order to retain their competitiveness hence resulting in inflation. In reference to Burnside, Eichenbaum and Rebelo (2007), the level of the domestic credit boom is an important predictor of a financial crisis just like in the euro. In this particular economic union, countries were encouraged to borrow from outside their boundaries in similar currency. The disadvantage of this kind of borrowing means that countries could borrow uncontrollably without paying attention to the rising risk of development of a financial crisis. According to Lane and Pels(2012), the countries making up the periphery in the Euro area enjoyed this strong credit boom. According to Lane and Milesi-Ferretti (2004), the Euro area member states suffered from an increasedpersistent case of current account imbalances where the level of external debts exceeded the internal debts. For the countries in the union that operated on large and sustained external deficits, they were exposed to several risk factors. To begin with, Reinhart (2010) noted that a deficit in the current account is totally unhealthy. The challenge is as a result of the excessive loans that are accessed by foreign individuals. These loans have the capability of the expenditure on non-tradable commodities that ends up compromising the tradable sector through raising employee wages. Resources, on the other hand, are drawn away from industries that could have achieved better productivity. In an economic union such as the Euro area, nominal rigidities result in unemployment as soon as the crisis is over. The above scenario explains the rising cases of unemployment in countries such as Greece and Ireland that were greatly affected by the external debt. Indicators of external debt in euro area crisis In reference to Muellbauer (2011), the inability to regain competitiveness through measures such as pursuing deflationary policies makes bonds less attractive thus increasing external debts that undermine the growth of an economy. A rise in bond yields is a primary indicator of a debt crisis. High bond yields affected Greece at a greater impact since foreign private investors were unwilling to lend their finances to Greece as a result of its tarnishing image in terms of external debt progression. Following high external debts, the affected countries underwent a recession immediately after the financial crisis. In a case of recession, the revenue collected from taxes went below the expected figures. As the affected governments allocated more of their budget to expenses related to unemployment, the current account deficit rose and increased the total debt levels of the country. According to Soros (2010), an increase in cases of bank bailouts by the respective governments is yet another indicator of rising external debts in comparison to the levels of internal debts. For example, in Ireland, the external debts rose when the government decided on salvaging the private sector banks by taking on their debts and repaying it with loans obtained from elsewhere within the Euro zone. The government spent an excess of 45 billion euros. Such a huge figure of recurrent expenditure resulted in the Irish government suffering a huge deficit of 32 percent of GDP in 2010. The Irish bailout made up to roughly 30 percent of the Irish gross domestic product. The figure was five times more compared to the intervention made by the United Kingdom in their banks. Problems associated with high external debt: Many investors became more alert on the crisis and opted to avoid investing as a result of the rising numbers of risks. As a result, countries in the Euro area opted to replace equity by debt in an effort to fund their projects. Continued accumulation of external debt made their financial situations to get even worse (Reinhart, 2010). In 2009, a year after the global crisis, the gross external debt of the euro area countries rose to 30 percent. In Greece, for example, the government was in a debt level of about 60 percent inclusive of both internal debts and external debts. In reference to Ford(1962), a high debt level such as indicated above results in the government imposing more taxes on its citizens in a move to settle the debt. As a result, citizens are unable to save accordingly, and the resulting situation puts them at risk of economic development. When settling an internal debt, the taxes imposed by the government result in the transfer of resources from the public to the countable few who act as lenders to the country. In reference to Grauwe (2003), the burden of repaying the external debt can always be minimised by reducing the costs incurred in terms of loan servicing. There also exists a challenge in internal debts that result in the creditors lacking an incentive to work hard. The reduced desire to work results in further loss of productivity thus causing current account imbalances. In addition, Burnside, Eichenbaum and Rebelo (2007) explain that an enormous deficit in the current account balance caused by excessive external debts has a great effect. The deficit causes a number of short-term risks where the inability of foreign investors to spend their money on the affected company triggers unemployment, high taxation and a huge fall in the prices of major assets such as real estate. In Spain, for example, lack of proper funding from external investors has resulted in a lack of better innovation in the housing sector which is a key economic pillar in the country (Lane and Pels, 2012). Conclusion. In reference to Cesaratto and Stirati (2010), the rising value of external debt in Greece escalated to 60 percent. Such enormous figures are a nightmare for other countries that have to dig deeper into their savings in order to save the affected country from insolvency. The membership of a country greatly enclosed in external debts such as Ireland in the Euro area gives a false sense of risk assessment. As a result, the foreign investors develop a risky kind of investment that results in an increase in foreign debt that continues to exceed the internal debt. Continued financing of a country’s expenditure by external debts results in the spread of the crisis to every other country within the economic zone. The excessive foreign debts result in a failure in the key economic industries. As stated by Muellbauer (2011), the effect had traumatizing effects to the bank sectors in the Euro area countries that had previously provided a lot of loans to private companies and had used the property under construction as loan security. By the information obtained about the crisis that occurred in the Euro area, it is clear that excessive borrowing from external sources facilitated the financial trauma by the respective governments. Therefore, it is healthy to conclude that excessive external debts played a key role in ensuring the economic failure. References Bortis H., 1997. Institutions, Behaviour and Economic Theory. Cambridge: Cambridge University Press. Burnside C., Eichenbaum M., and Rebelo S., 2007. Currency crisis models. In: Blume S. and Durlauf L. ed. The New Palgrave: A Dictionary of Economics. Calvo G., 1988. Servicing the public debt: The role of expectations. American Economic Review, 78(4), pp. 647-61. Cesaratto S. and Stirati A., 2010. Germany and the European and Global Crises. Review of Political Economy, 39(4), pp. 56-86. Ford G., 1962. The Gold Standard, 1880-1914: Britain and Argentina. New York: Oxford University Press. Grauwe P. D., 2003. Economics of Monetary Union. New York: Oxford University Press. Marzinotto B., Andre S. and Wolff B.G., 2011. What Kind of Fiscal Union?. Bruegel Policy Brief, 2011(6). Muellbauer J., 2011. Resolving the Euro-zone Crisis: Time for Conditional Eurobonds. 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