The Origin and Significance of European Sovereign Debt Crisis - Essay Example

? The Origin and Significance of European Sovereign Debt Crisis In order to increase productivity and competition in the European Union, a single currency was to be inculcated in the project of European Single Market. In addition, this would offer a monetary policy with credible inflation targeting for those countries that had been marred by the challenges associated with high inflation rates. But Germany was attracted by the opportunity for an enlarged internal market where countries facing problems of inflation would not lose competitiveness caused by periodic devaluations. The country’s policies created a trade imbalance in the Eurozone which eventually resulted to a sovereign debt crisis in the region. This paper traces the cause of this debt crisis from the roles played by global ‘financialisation’ to how the Germany policies accelerated the crisis. The voice of the press will also be discussed together with how speculation and crisis affected the crisis. Indeed, despite Germany being at the centre of the origin of the European debt crisis, there were other players who had the authority to save the euro member countries from plunging into this crisis. Introduction Manolopoulos (2011) refers to the European sovereign debt crisis as a financial crisis which has caused some Eurozone countries to have difficulties in refinancing respective government debts unless a third party intervenes. The decade preceding 2009 saw the Eurozone achieve much success economically with the European Central Bank, ECB achieving its policy objectives. The inflation was maintained at low with an almost equilibrium GDP. The use of a single currency reduced the cost of transactions with the greatest effect being on territories of countries where financial interactions were intense. Nonetheless, Grahl (2011) noted that with a single currency, member countries lose control of their currencies. As such, the exchange rate becomes fixed and in times of competitiveness problems, the country would not devalue or allow depreciation of its currency. During the crisis of the sovereign debt crisis, Britain was cushioned against this because of not being a member of the Eurozone. Secondly, these countries lose the control of domestic interest rates which influence investment and consumption effectively affecting the economy. It would only be beneficial if the member economies move at par. But with discrepancies, with others in recession while others face inflation, this becomes costly. The average good performance of the Eurozone hid some of these misgivings and individual performances of these countries. For instance, countries negatively affected by the Eurozone debt crisis had inflation rates of above 2% despite the average inflation of the Germany, the largest economy in the Eurozone being always being lower than 2% (Grahl 2011). While Germany had gradual growth, the other countries had domestic booms and entered into debt crisis with Greece being the first casualty followed by Ireland, Portugal, Spain and Italy in that order, with their account deficits being traced back to 1999. These countries borrowed for their domestic financing from abroad such as the housing developments in Spain and Ireland and government spending in Italy financed by German household savings. These financing was given when these countries were unable to service these debts in the long run. Instead of financing human capital and productive projects that would lead to higher future returns, the investments were on public and private consumption and on wasteful construction projects. According to Conquest (2011), financial crises resulting from housing booms would normally lead to sovereign debt crisis. Grahl (2011) further argues that sovereign debt crisis would be further propelled by fears of government’s insolvency as it would fail to pay capital and interest on its bonds. Eventually, capital markets get closed and the governments forced to default. The local currency would then depreciate followed by sovereign debt crisis as the government bails out banks while increasing budget deficit. The government would finally deplete its foreign exchange and default on its debts. In the Eurozone, the situation was likened to an emerging economy granting a debt in foreign currency. Before the crisis, the bonds issued by the Greek and German governments were treated as close substitutes. But some governments like Greece had huge debts while others like Ireland had small debts. The deficits then increased rapidly as they bailed out banks while receiving lesser recession tax revenues. This scared investors from euro bonds causing wide rifts in interest rates. Greek politicians sought to obtain money and it was easily availed to them as opposed to increasing taxes or cutting spending (Manolopoulos 2011). This has elicited sentiments that Southern Europe was to blame for the sovereign debt crisis because of their weakness and extravagance. German has been accused of being a profligate lender. The mess would squarely be laid on inherent trade imbalance. Use of same currency barred floating exchange rate that would be used to rebalance trade surpluses and deficit. Unlike in the US where the federal government would maintain private sector surpluses because of trade leakage, the southern Eurozone members were left exposed. So, in essence, while the core nation financed the growing budget deficits of these nations, they also had their debtors buy goods from them. With increase in the trend, the south was forced to remain in increasing debt in financing their extravagance. The Germans were always willing to lend these nations as they boosted their trade surplus which was the cause of the great 10 year economic boom of Germany. Whyte notes that German and French banks have up to 55% of the debts of Italy, Portugal, Spain and Ireland (2010). The Eurozone countries could initially borrow at low interest rates which caused them to increase their investment capital with this flow being from France and Germany to southern nations. This led to an increase in liquidity which caused wages and prices to rise hence negatively affecting the competitiveness of their exports. Due to the adoption of a unitary currency, they could not take the measures undertaken to cool inflation. The result was rise in public spending with fall in tax revenues during recession so as to pay for unemployment. But the argument has been that if the monetary union was meant to be sustainable and beneficial to all members, then like mined countries only should have been included. The root of the problem was that only eleven countries participated (Blundell-Wignall & Slovik 2011). Role of inequalities and Imbalances Economists have argued that the major cause of this crisis would have been the rising trade imbalances (Whyte 2010). In the run up to the 1999 – 2007 sovereign debt crises, each of the members of the Eurozone had their individual currencies and controlled their monetary supply which made absorbing economic differences easy, relative to inflation differentials and changes in currency value. With the adoption of the euro across the board, it has become difficult to undertake some of these measures. Germany was better placed in its fiscal deficit and public debt in relation to its GDP as compared to most of the other affected Eurozone members. At the same time, Spain, Italy, Portugal and Ireland had poor balance of payments standings. While German surpluses increased, deficits of France, Italy and Spain became worse. Increasing import demand in the other countries caused tremendous growth in German exports. On the other hand, the rigid wage restraint policy constrained German’s import causing a rise in its trade surpluses. The external debts in these countries therefore rose. Recall that the solvency of governments, which refers to its ability to repay its debts, would be determined as a ratio of its external debt to its annual exports since the income arising from exports pay for the debt. Debt crises would mostly arise when the threshold would be surpassed (Hardie 2011). The major question that lingers would be how the Euro regime would worsen this causing recession and austerity. The imbalances in the Eurozone would be considered as a product of varied trends in labour flexibility, productivity and investments rates and national savings among the member states. Before the single European currency took effect, individual members had independent control of their money supply, which made it easy to rectify economic differences through inflation differentials and currency value changes. Today, these countries do not have this capacity. The use of one currency and a central bank, but with fiscal agents and varied economic and governance trends, would imply that the reversal of the debt imbalances and sovereign deficit would only be achieved through the fiscal agents. More so, the only option that these agents have would be to deleverage the balance sheet of the respective governments through secular austerity. There have been plans of substantial fiscal austerity by Eurozone governments in future. The trend in Eurozone defaults and sovereign haircuts could still be a deleveraging outlook. Introducing collective action clauses on the new sovereign debts under the European Stability Mechanism could imply that write-downs, haircuts and private sector subordination in future could still be probable. This would therefore imply that the Eurozone banks, the chief Eurozone sovereigns’ financiers, would have to inject substantial amounts of new capital so as to maintain their balance sheets and finance the real economy towards its growth. If these banks continue operating while undercapitalised, their costs of borrowing could go too high such as to inhibit credit growth which could in turn force them to deleverage commitments of private credit while the Eurozone sovereigns are also trying out the same strategy with fiscal policy. Therefore, the Eurozone economy would not shoulder concomitant deleveraging in the banking system and sovereign balance sheets due to the weak growth forecast. This would be left for ECB to undertake due to its large balance sheet, which is credible and flexible enough to save the banking system and Eurozone sovereigns deleveraging from getting to the inflection point. The ECB should hastily move to be the lender of last resort for the sovereigns with a credible plan. The role of global ‘financialisation’ The aim of securing government debt would be to provide a platform for operating the pressures of financial market. With more borrowings, the government gets to undertake most of its chosen policies. But the borrowing capacity is an important aspect to consider as suggested by Hardie (2011). More so, government debt would be considered as resources transfer to other generations because the debt would have to be paid eventually. Politicians would take this ‘eventually’ to be quite a long time and would use this weapon to make policies that would serve their current interests. To determine sustainability of these debts, interest rate would be an important factor to consider and financialisation works against sustainability. Hardie (2011) defines finacialisation as the ability in trading risk which would involve trading and taking the risk on an asset’s performance. Various types of risks would be available for sale and purchase in the securities market but the ability to accomplish this would vary significantly. The EU came into being in an environment where the countries involved had quite divergent productivity levels, social spending and technical development. As it achieved prosperity, all the countries were not harmonised upwards to achieve the same, making EU a tool to strengthen its stronger members by making the weaker members dependent and taking advantage of supply of cheap labour in exchange for capital. Blundell-Wignall and Slovik (2011) argue that during a crisis, it would be everyone protecting oneself. So, even though the stronger countries would lay the blame of the crisis squarely on the poor countries, this would just be an EU’s cover up for its failure to deter the forces against cross national unity economically which led to vanishing investment opportunities and shrinking markets. Before 2008, countries had great differences with Ireland not having great government debt while Italy and Greece did. The benchmark in the 2007/2008 financial crisis was as a result of sub-prime American mortgage market and Eurozone sovereign debt crisis triggered by banks in Europe. The governments had to intervene to stabilise the balance sheets of these banks especially in the UK and Ireland. Blundell-Wignall and Slovik (2011) observed that a German bank was among the first victims at a time when France thought it had escaped the crisis. But later, it was to fall victim with difference being that they concentrated with the Sothern Eurozone economies which include Greece, Italy and Spain. Grahl (2011) noted that Greece, Portugal, Spain and Ireland had spent more than what would have been recommended, which left them in a mess. Nonetheless, this Eurozone crisis would not be considered as basically focussed on debt but on the role that banks played before the crisis in Europe and global economy and how governments responded to this fragility in their respective banking sectors. The policymakers have ignored the role that banks played in this crisis and it would even worsen the economy and politics when the benefits of a solution from pan-Europe would be considered. The underlying cause of the sovereign debt crisis in Europe would therefore squarely be pegged on global economy financialisation, which encouraged if not forced governments and consumers alike to borrow more so as to keep production in progress. This financialisation rose from decades of decreasing rates of profit marred together with rising globalisation even as Western corporation moved deeper abroad to cut their costs of production. It would be worth to echo the fact that this resembles the 1970s abuse of Third World countries which were forced to borrow huge amounts from Western banks then forced by the World Bank and IMF to adopt austerity programs to exploit their workers’ value so as to repay the loans. In the Eurozone sovereign debt crisis, the Deputy Prime Minister of Greece, Theodore Pangalos admitted in parliament that the government had been extravagant with borrowed money, stating that “we all ate the money together” (Manolopoulos 2011, pp. 83). The role of Germany and its policies The focus on Germany has been of interest to many in Europe. Whyte refer to Ireland, Greece, Portugal and Spain as “fools’ paradises built on reckless piles of private-sector debt” while Germany has been referred to as a model for economic virtue (2010, p.1). While the other nations spent debt financing, Germany seriously concentrated on beating international competition which has caused its people to live within their means though the country’s “beggar my neighbour policy” (Lapavitsas et al. 2010, pp. 6). The high current account and trade surpluses support this argument. Conquest (2011) argues that this dependence on export while the domestic generated stimulus remains low would still be a problem with Germany. Therefore, Germany’s policies were meant to enable the country achieve its objectives but at the expense of its partners in the Eurozone. Germans have argued that their external surpluses should not be a problem (Whyte 2010). It has been widely argued that global financial crisis has vindicated the country’s economic model. The argument has been based on the argument that a sovereign country should live within its means. The pleas of rebalancing the economy of Germany have been considered as a possible reason to weaken it instead. Germany would not opt to lower the quality of its products if the market has endorsed the products as being high in quality. On the other hand, economists view the export driven growth of Germany’s economy as undesirable. The ideal situation would be one where domestic demand rises with a country’s potential output in cases of countries that have high external deficits like Spain. But for wealthy nations with high surpluses like Germany, the aim should be at exporting capital. These external surpluses of Germany indicate decisions made by the private sector which would not be influenced by policymakers and even if they were to be influenced, stronger demand would not have done much to bring down deficits in the other countries like Greece and Spain. Conquest (2011) argues that Germany’s concentration on Europe with its export trade, where its surplus trade has been generated is undesirable. The general assumption has been that trade surpluses indicate strong economy of a country and any factor that would work against enhancing this should be opposed. But looking critically, this proposition could be odd. Foreign critics for instance do not require Germany to lower the quality of their products but instead suggest that it has been running on a feeble domestic demand and that its reliance on exports for its growth had been excessive. Had other nations not lived far beyond their means, the country would barely have experienced growth. Just like other members of the EU, Germany has to improve its supply performance for long term economical growth. Germany has been keen to raise employment for its citizens with Whyte (2010) reporting that this had risen to 71%. But this has not coincided with reduced working age population in the labour force. The country has thus been active mobilising the workforce better than in the previous decade with over 2 million opportunities having been created since 2000. Albeit the country has achieved much success in this, it should focus on increasing the proportion of women workers involved in full time works. While much effort has been put towards the manufacturing industry, there has been minimal achievement in the service sector with the major cause being regulations restricting competition. If these would be removed, barriers to entry would be lowered and competition increased to spur growth in the service sector. The speculation and panic on the sovereign debt could only worsen the debt crisis further. According to the Keynesian economics, decisions by the private sector cause inefficient macroeconomic outcomes. It is of the proposition therefore of an active policy response by central bank’s monetary policy actions and government’s fiscal policy actions. But Lapavitsas et al. (2010) opposes the applicability of Keynesian proposition on this crisis arguing that taxes collected from the public should not be used to pay these debts. Financial panic has hit Europe amid fears of economic downturn. The effect has been evidenced by French government posting no increase in its 2010 second quarter growth (Conquest 2011). The industrial production across the Eurozone also fell by 0.7% during the same period. Manolopoulos (2011) recounts how the threat by President Sarkozy to withdraw from the euro had negatively affected the euro. In 2008, the mainstream media in the Western world warned of a looming depression if action was not taken immediately to resolve the pertinent issues. But the problems had been foreseen earlier and the problem is that the measures that governments took could not address core systemic issues in the global economy; they were merely aiming at saving the collapse of the banking industry. To accomplish this, governments undertook massive bailout packages which plunged their countries into deeper debts as they saved the banks but charging it to the populace. This was followed by an uproar in the stock market speculation as more was pumped into stocks leaving out the real economy. The recovery has been an illusion which would likely come to a complete collapse in the near future. Conclusion The Eurozone sovereign crisis was a result of violation of the debt-to-GDP ratios which had been set by the founding Maastrich Criteria of the EU. Germany enjoyed economic superiority in the region and changing the whole of the Eurozone into a model to resemble that of Germany because of austerity and wage suppression would be impossible since there would be stagnation of the German export if there would be no periphery deficit. The Eurozone sovereign debt crisis has edged five governments including Greece and Italy, by raising the borrowing costs of these countries to alarming levels. This has caused more investors to pull out of investing in the region altogether. There has been a growing concern for ECB and superior members of the Eurozone, including France and Germany to take major steps to prop the region’s finances up lest the Eurozone could crumble. Austerity measures could bring the much needed solution. Financial markets should desist from speculations which cause investors to undertake unprecedented decisions that would further ruin the economy. References Blundell-Wignall, A & Slovik, P 2011, A ‘Market Perspective on the European Sovereign Debt and Banking Crisis’, OECD Journal: Financial Market Trends, vol. 2010, no. 2. Conquest, R 2011, Policy and the Euro 1999 – 2010, the Bruges Group, London. Grahl, J 2011, ‘Crisis in the Eurozone’, viewed 24 February 2012, . Hardie, I 2011, How Much Can Governments Borrow? Financialisation and Emerging Markets Government Borrowing Capacity, University of Edinburgh. Lapavitsas, C, Kaltenbrunner, N, Lambrinidis, G, Lindo, D, Meadway, J, Michell, J et al. 2010. The Eurozone between Austerity and Default, Research on Money and Finance, Occasional Report. Manolopoulos, J 2011, Greece’s ‘odious’ debt: The looting of the Hellenic Republic by the euro, the political elite and the investment community, Anthem Press, London, UK. Whyte, P 2010, Why Germany is not a Model for the Eurozone, Centre for European Reform, London, UK. Read More