New Policies to Solve the Financial and Sovereign Debt Crisis in Europe - Essay Example

New Policies to solve the financial and sovereign debt crisis in Europe March 28 2013 Type the course name and word count here Type your name here Table of Contents Executive Summary 3 Introduction 5 Why does Euro zone require a sovereign debt mechanism? 5 Past Attempts to develop a Sovereign Debt Restructuring Mechanism 7 Lesson for the Euro Area 8 European Mechanism for Sovereign Debt Restructuring 9 Conclusion 11 References 13 Executive Summary The European Union (EU) faced a sovereign and debt crisis which impacted the growth of economies and was mainly due to the following The fiscal policy rule based framework which was created by EU was unable to develop policies through which Excessive Deficit Procedure & Stability with Growth could be ensured which resulted in a crisis. This was added by the lack of tools to deal with the crisis Presence of no rule which would guide the market and help the government to respond to the debt crisis was missing Stabilization of the economy of Greece and the creation of European Financial Stability Facility helped to reduce the crisis but for a short period of time Lack of public acknowledgement with regard to the fact that debt crisis can occur resulted in the market being weak and didn’t allow any process to be developed that would help to deal with the crisis The problem of the debt and sovereign crisis can be solved by using the European Crisis Resolution Mechanism which consist of two functions as stated below Development of a special court which would handle the negotiation process between the debtor and the creditor so that the present value of the future obligation for the debtor could be reduced. Resolving the issue through financial assistance from other European Union countries on a permanent basis which would be governed by European Crisis Resolution Mechanism and look towards reducing the liquidity problems between the debtor and the creditor. Introduction The sovereign debt crisis which started in 2010 in euro region highlighted the monetary and economy policy framework under which the region performed. The rule based framework which was created bu EU was unable to develop policies through which Excessive Deficit Procedure & Stability with Growth could be ensured which resulted in a crisis. This was added by the lack of tools to deal with the crisis. Lack of rules to deal with the crisis further had an impact on the financial sector and created a liquidity crunch. Stabilization of the economy of Greece and the creation of European Financial Stability Facility helped to reduce the crisis but for a short period of time. This has highlighted the need for finding out reasons through which a process can be developed and rules formed so that crisis of such magnitude is dealt in a proper manner. This report examines the different reason which led towards the financial and sovereign debt crisis in Europe and the manner it had an impact on the Euro zone. In addition to identifying the different reasons which attributed towards the crisis stress is laid to present the different rules and process which will help to reduce such crisis in the future and the manner the Euro zone will be able to benefit. Why does Euro zone require a sovereign debt mechanism? Most of the Euro members including Austria, Greece, Germany, Italy, Portugal and Spain have experienced a debt crisis sometimes or the other which highlights the importance of having a mechanism which will help to control debt crisis (Sturzenegger and Zettelmeyer, 2006). The major reason which can be attributed towards the debt crisis is the Gold Standard which implies that no government can use a strategy of high inflation to reduce the burden of extra debt and has to follow the Gold Standard which has been developed by the zone (Waldhoff, 2004). This is aided by the lack of monetary policy autonomy which the EU has as a national currency for all economies under the Euro zone doesn’t provides a distinctive framework where economies have individual autonomy over their monetary policies (Hattenhauer, 2000). Since, economies are not allowed to use the inflation channel to control their debt burden the economy has to look towards dealing with the crisis either through fiscal retrenchment, default and being bailed out from other members. This can be seen from an example where Bremen and Saarland were being bailed out by Germany in 1990 (Hattenhauer, 2000). Looking it from an economic angle it is seen that the price stability risk of Euro for the region is minimal in case a euro member defaults because the ECB hasn’t monetized the public debt, and government has no access towards the policy of inflation for controlling money supply, ensures that the currency will not be impacted. This will ensure no external stability risk for the entire zone in case a member country defaults as the rules have been framed in such a manner that the effect gets limited. The 2010 euro area clearly highlighted the manner in which financial markets and liquidity became a problem as the sovereign debt resulted in which spread volatility in the bond yield which ultimately affected the Greece economy and led towards a crisis (Thomas, 2004). The lack of rules and framework to address the issue created doubts and didn’t provide the required framework which would provide the path to deal with the crisis (Krueger, 2002). To avoid such a situation and to ensure that market turmoil doesn’t happen again in the future it is important that a mechanism is developed which will look towards addressing the crisis. This has to be backed by the fact that a process has to be developed which will help to deal with the crisis and will provide a path for the future based on which the economies will be able to handle the situation is a better way. Past Attempts to develop a Sovereign Debt Restructuring Mechanism The past period highlighted that maximum sovereign debt was either due to lenders or private banks which slowly changed after the Mexican crisis in 1994 (Rey 1996). The Mexican crisis highlighted that the debt crisis was issued in the form of bonds which was later changed by a report from G10 which allowed bond holders increased participation through the process of vote so that they could raise their voice for the process of restructuring the debt. The process finally continued and looked towards presenting a treaty based approach which would indulge banks as well and all the members had to abide with the provisions that were mentioned therein (Reinhart, Rogoff and Savastano, 2003). Under the mechanism IMF was provided additional power and entailed towards a mechanism which would put a stay on the creditors claim so that the debtors who are indebted are not exploited. This implies that the bond holders will have to determine certain percentage of the creditors to agree of the manner the restructuring will be done and had to propose a method through which the aspect of debt crisis will be looked. This will be followed by the fact that the debtors will have to details pertaining to his indebtedness and highlights the intention that the debtor has. This will help to understand the future debt paying intention of the debtor based on which negotiations will be conducted and a process through which the debt crisis will be handled can be developed. The proposal was seen enthusiastically by proponents but highlighted a problem as to make the proposal effective it had to be passed by a majority of 85% and it was not possible. This slowly reduced the enthusiasm that the proposal generated and created doubts regarding the feasibility of the proposal. In addition to it the US has veto rights and the US objected to the proposal leading towards a situation where the proposal wasn’t accepted. Lesson for the Euro Area The process in which the sovereign and debt crisis happened in the Euro area highlights that the conflict of interest between the debtors and the creditors are bound to happen. This will certainly ensure that creditors have a relative control over the manner restructuring will take place and will require reasonable adjustments regarding the magnitude and timing of financial assistance so that the negotiation process between the creditors and the debtors provides positive results Secondly, the proposal highlighted that both the creditors and debtors would be provided with money and would benefit but developing a policy which would address the realties of indebtedness is crucial in developing a mechanism which will look into the aspect of restructuring the debt. Lastly, the proponents didn’t recognize the fact that the debt cannot be sustained all the time and the manner in which the authorities will be able to reduce debt which would thereby have an impact on reducing GDP and will affect the future growth was not discussed. This would have an impact on the performance of economies as the different members in the EU will be affected differently. European Mechanism for Sovereign Debt Restructuring Sovereign debt crisis is different from a crisis which a private company experiences and will thereby require development of a formal process through which the crisis is dealt. It is different from a crisis which a private company witnesses as the sovereign entity cannot be dissolved, liquidation of the assets is not possible and ownership cannot be passed on to the creditors (Kratzmann, 2002). This states that debt restructuring is possible only when the debtor declares itself being incapable to paying the debts. The sovereign debt crisis is different from other private crisis which looks towards favoring the creditors and requires that a procedure is developed which addresses the sustainability of the sovereign public finance, and ensures to protect the interest of both the debtors and the creditors (Eichengreen and Mody, 2004). The role of government also gets marginalized due to the fact that all economies have a democratic form of government and taking steps which helps the government to reduce the debt but passes the impact on to the citizens is unjustified. The government could resort towards taxation to solve the issue of debt crisis but would be incorrect as the citizens might resist it and would thereby result in further turmoil being created in the financial sector. The problems and different procedures being highlighted clearly shows that the Euro debt and sovereign crisis needs to be handled differently and a framework has to be developed which would address the issues better and is as follows A formal process to solve the crisis has to be developed. This process would require that the creditors and the debtors engage in open conversation and pass on the relevant information so that uncertainity with regard to the creditor or the debtor is reduced. The process should be initiated from the debtor government. The process should also look towards having a stay on national and international creditors and the even payments being made to creditors should be stopped until and unless the process is initiated and both the parties are recognized (Gros and Mayer, 2010) Developing a formal process which would ensure that the minority bond holders don’t exploit the majority bondholders, with the intention of having a high bargain as the majority bondholders to gain from the situation might be willing to purchase the holding of the small bondholders. This would require a proper agreement between all which would facilitate the restructuring process and solve the debt crisis (Gros and Mayer, 2010) The process to conduct negotiation between the debtor and the creditor should be conducted by a third party who is neutral and is politically independent. This will facilitate the entire process of taking decision and will have a positive impact on the restructuring decision (Gros and Mayer, 2010) Developing a rule which ensures that the defaulting government has access to market credit and can take new debt so that the government can go ahead with the process of restructuring. This will help the defaulting government to be able to develop a formal process which would allow them to ensure productive growth rate and is able to deal with the crisis and restructure their debt (Gros and Mayer, 2010) The entire process will further be facilitated by developing a special court which would handle the negotiation process between the debtor and the creditor so that the present value of the future obligation for the debtor could be reduced. This will help to act fairly and will ensure that decisions regarding restructuring don’t have an adverse impact on any parties. In addition to it, resolving the issue through financial assistance from other European Union countries on a permanent basis which would be governed by European Crisis Resolution Mechanism and look towards reducing the liquidity problems between the debtor and the creditor. This would allow the defaulting body to be able to get further debt and will assist in the entire process of developing the economy after the restructuring process. Conclusion The report shows that EU notion that sovereign debt crisis wont happen is incorrect and requires the development of a mechanism which will address the issue of restructuring. The rule based framework which was created by EU was unable to develop policies through which Excessive Deficit Procedure & Stability with Growth could be ensured which resulted in a crisis. This was added by the lack of tools to deal with the crisis. Lack of rules to deal with the crisis further had an impact on the financial sector and created a liquidity crunch. This would require that a formal process which looks towards negotiation between the parties is developed so that both the debtors and creditors are not exploited. In addition to it the defaulting government has to be allowed to get new debt in the future so that after the process of restructuring the economy grows and the past events don’t affect the future potential. Thus, working on the different aspect will help to stabilize the Euro zone and will reduce the impact of a sovereign debt crisis. References Eichengreen, B. and Mody, A. 2004. ‘Do collective Action Clauses Raise Borrowing Costs?’ The Economic Journal 114 (April), 247-264 Gros, D. And Mayer T. 2010. ‘Towards a Euro(pean) Monetary Fund’, CEPS Policy Brief No. 202 Hattenhauer, H. 2000. ‘Bonn und Weimar’, in G. Lingelbach (ed.) Staatsfinanzen, Staatsverschuldung – Staatsbankrotte in der europäischen Staaten- und Rechtsgeschichte, Köln: Böhlau Krueger, A. O. 2002. A New Approach to Sovereign Debt Restructuring, Washington DC Kratzmann, H. 2002. ‘Der Staatsbankrott’, Juristenzeitung, 319-325 Reinhart, C., Rogoff, K. and Savastano M. 2003. ‘Debt Intolerance’, Brookings Papers on Economic Activity 1, 1-74 Rey, J.-J. 1996. ‘The Resolution of Sovereign Liquidity Crises’, Group of Ten Report Sturzenegger, F. and Zettelmeyer, J. 2006. Debt Defaults and Lessons from a Decade of Crises, Cambridge: MIT Press Thomas, J. P. 2004. ‘Bankruptcy Proceedings for Sovereign State Insolvency’, World Economy 27, 265-279 Waldhoff, C. 2004. ‘Grundzüge des Finanzrechts des Grundgesetzes’, in: J. Isensee and P. Kirchhof (eds.) Handbuch des Staatsrechts Vol 5, Heidelberg: C. F. Müller 2nd edition. Read More