The European Debt Crisis through Economic Theory - Term Paper Example

?The Euro Debt Crisis and Economic Theory European debt crisis, a phenomenon that buffeted many European nations; also impacted the other side of Atlantic. Plenty of explanations often different in nature have been extended in order to find the possible reasons beyond this economic catastrophe. Fiscal policy failure owing to its weak foundations, unprecedented level of sovereign debt, lack of competitiveness arising out of higher labor cost and an inherent balance of payment crisis (mostly due to following a fixed exchange rate system) that was eroding the economic soundness of the European Union for long are some of the reasons forwarded by the experts. However, later a twin debt blow has been considered as one of the most prominent reasons behind the debt crisis. The twin blow came out of the banking crisis together with the previously mentioned extremely high sovereign debt. The European Central Bank (ECB) launched the single currency (euro) in 1999 along with the Economic and Monetary Union (EMU), aiming to gain monetary efficiency. An Economic and Monetary Union offers a series of monetary efficiency gains in forms of accounting ease among the member states that in turn reduces opportunity cost of transforming one currency into another, development among member states would be at par owing to reduction of any possible economic shock (that are often regional in nature), member states under an Economic and Monetary Union following a common currency would also abstain from intra inflow and outflow of speculative capital, furthermore policy formation among member states would be coherent and coordinated in nature that will eventually usher better economic growth and development. While fiscal irresponsibility on the part of periphery countries has been considered by many analysts as the root of the ongoing crisis, this paper argues that the impact on capital flows within the euro-zone of financial deregulation and liberalization and of the adoption of the common currency was critical in exacerbating a growing competitiveness gap between core and periphery countries and explaining the evolution of the crisis. Debt crisis unfolds- credit failures The crisis in Europe began when financial markets lost confidence in the creditworthiness of PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) and interest rates on government bonds soared to astonishing levels that forced the governments of these countries to seek bailouts from the international community, including the European Community, the IMF and the European Central Bank (ECB), collectively known as Troika. This was the period of the great financial crisis of 2007-08 which also affected the US economy. All began with the credit markets and spread to the other sectors of the economy owing to large scale defaulters of loans (ch 31). As determinants of growth, one can say that demand is important for supply or production to expand. The ongoing debt crisis began with defaults of mortgage loans the demand for which led to a rapid boom in the housing sector which led to the final illusion when defaulters began to rise (ch 25). It is often been opined that the utopia of a welfare state amidst the current era of globalization that fuels on competitiveness (both are diametrically opposite in nature) and populist policies like raising the wage of the public sector employees in turn cumulatively burdened the governments with high level of debt. This phenomenon is most evident among periphery countries and can only be reckoned as fiscal recklessness. It is evident from the above argument that fiscal disciplines on behalf of the periphery countries would restore Euro its previous status without any additional measures and to be precise further fiscal incentive. What lies beneath? – Expectations and mal-adjustment A deeper analysis of the dynamics underlying the current Euro crisis exhibits that financial deregulation and liberalization was a major cause of the crisis in periphery countries in the euro-zone. Driving up expectations owing to a sudden boom can led to an equally sudden downfall. According to Rational Expectations Theory people would expect certain results to occur in future beforehand and bring about rapid changes within moments. Thus monetarists and rational expectation theorists believe that the economy will adjust automatically but the euro debt crisis, especially at its initial phase showed how these theories failed (ch. 36). Much like in the United States, financial deregulation and liberalization encouraged the development of new sophisticated financial instruments, like CDS and derivatives, which allowed banks in core euro-zone countries to increase leverage and boost loanable funds, urging a real estate and consumption boom (ch 31). The boom was supported by the adoption of Euro over the European Union as it eradicated the possibilities of erratic currency fluctuation among the member states (especially those in periphery). The market rate of interest also displayed uniformity after the adoption of Euro as common currency by the member states following the financial and economic integration. Furthermore the much higher market rates at the periphery countries gradually moved at par with the much lower core European Union countries. These much needed changes built up confidence among the core European Union countries to channelize their capital to the periphery countries. On one hand this helped their economic growth mainly through greater investment and higher level of effective demand and on the other also created housing bubbles and conspicuous consumption. The glories of economic boom in periphery countries were clearly visible through the rise in government’s fiscal revenue and deficit remained at a level that was permitted under Maastricht Criteria only with the exception of Greece. However, behind the curtain sharp rise in government expenditure mainly owing to the increasing burden of wage bill along with social transfer also kept on tickling like a time bomb ready to blow at any time. Since the consumption in periphery country was an inflated one that could not be sustained in the long run; long run economic growth soon faced its nemesis in form of declining export oriented sectors as well as the manufacturing industries. The core European Union countries practically gained of this situation as their competitiveness together with external surplus realized a sustained growth over the same time frame. Two factors that worked in favor of this growth of the core countries were controlled wage rate and relatively lower value of Euro in comparison with their defunct national currencies (ch.36). Soon the global financial crisis took its toll on Europe and the much hyped real estate boom that was nothing but a bubble busted over the night. With recession looming large over the horizon and Europe already under the fiscal stimulus resorted to higher fiscal incentive to tame the onrush of the recession; but that effort together with the bursting of real estate bubble only imposed huge fiscal deficit on the member states. All the debt indicators also started displaying alarming condition and Greece was first to fall prey of this economic onslaught. Fiscal fallacy A sovereign debt crisis can arise when a government runs persistently high budget deficits (expenditure exceeds revenue) relative to gross domestic product (GDP). Persistently large deficit-to-GDP ratios accumulate as ever-higher and more dangerous values of outstanding debt to GDP. Extremely high debt to GDP ratio started casting doubt in the mind of the market participants as they realized that a default on debt payment might well be only a matter of time now. When a country borrows money from another, it has the responsibility to repay the loan. Failure to repay will lower the credit rating for the country, limiting access to the capital market and potentially straining international relations (ch.25,33). There are two types of bond or loan markets, private and governmental, and they are treated separately in regard to credit risk and lenders’ willingness to lend. For example, if the government of Greece has high credit risk, then one may not want to lend any further money to them, except at a very high interest rate to compensate for the risk. However it is also true that credit unworthiness of the government of a specific country might affect the same for an individual firm but that is not always the case. Why did the adoption of the Euro have such a significant impact on the volume of financial transactions? Mainly, because it abolished the currency risk and led to the convergence of interest rates in periphery countries to the much lower level of core countries. The rapid fall of interest rate that brought uniformity regarding market rate of interest all over the European Union countries might be considered as the most important factor worked towards the unification of the European Union. The sharp hike of bank funds and the fall in interest rates led to a very significant increase in the volume of consumer lending; and in Greece, Ireland and Spain, much of it was channeled into real estate. As a result, from 1997 to 2007, housing prices increased at a mean annual rate of 12.5 percent in Ireland, 9 percent in Greece, and 8 percent in Spain. These figures were much larger than what was registered at the very origin of the real estate bubble that is United States of America (USA) where real estate price realized an average annual growth rate of 4.6% per year (Lin & Treichel). At the onset of the 2010 Greece was the first European country to be hit by the debt crisis that latter spread with much vigor all over the Euro-Zone and became infamous as the Euro-Zone debt crisis. Cyprus is its latest prey. Cyprus – country’s fall in credit rating and instability The nature of Cyprus’s debt crisis is same with Greece and Spain: its government tries to blindly invest in economic enhancement. Cyprus’s urge for assistance comes after weeks of unsuccessful negotiations with Russia. Russia as well as any other country refused to assist Cyprus in its time of crisis considering its low rate of bond rating that makes it an unlikely destination for foreign fund. And as usual, the troika came forward to rescue, announcing a €10bn (?8.4bn) bailout. In the month of May, 2013, at the verge of the banking sector collapse Cyprus managed a shy of relief through fund assistance of €2 billion. This first installment is meant to strengthen the economy of Cyprus. The country also expects to receive another aid of €1bn by 30 June, 2013 (Cyprus receives EU-IMF bailout funds). Greece’s continuous recession impacted Cyprus’s government. Greece's recent €200 billion debt restructuring led the Cyprus Popular Bank PCL to incur a loss of €3.65 billion. Therefore, rigorous implementation of austerity measure is essential by reducing government spending. This fact also reveals that monetary and economic union also brings economic stability loss for the participating nations. Presently Cyprus is disgraced with a very low credit rating and that much owing to the huge government deficit (Huang, 16-17). Furthermore, due to its large financial sector because of its huge amount of foreign money, Cyprus’s foreign liabilities of the banking sector were more than three times the size of annual output at the end of 2011. At this background reduction in government spending and a plea to international funding organizations like International Monetary Fund (IMF) and European central Bank (ECB) are the only way out for the mentioned country to uplift its credit rating and restore its economy. There are potentially two contradictory approaches to remedy the damage of the Debt Crisis. On the one hand stimulating of economic growth is essential; on the other hand spending cut spending is absolute necessary (ch. 23-25). A customized combination of two approaches (depending on their respective debt levels) could be a panacea. Since the affected countries have different levels of debts, different combinations of growth and spending cuts should be applied accordingly to each country based on cost-benefit analysis. For instance, since Greece is so heavily laden in debt, it may be constrained in the short run to cut spending and increase tax. On the other hand, for some of the stronger countries, it is important to stimulate economic growth in order to develop more funds to support the struggling countries. The European Union modeled USA as far as the empowerment of the banks are concerned, however the power entrusted on the hands of the banks were more than that usually required. Financial deregulation also helped the banks to gain more power than the usual circumstances. This readily transformed into availability of funds in the countries belonging to Euro Zone area. Furthermore the adoption of the Euro as common currency catalyzed financial flows to periphery countries which were by that time at par with the core European Union countries in terms of interest rate (which was at a very low level as well). The spiky increase in low-interest funds set off a consumption and real estate boom in periphery countries, leading to higher growth and increases in government revenue and spending. As mentioned earlier before the onset of the global recession fiscal condition never went out of hand much owing to the rising government revenue at par with its expenditure. But soon the recession struck and the housing bubble flattened to the ground the government having no other options left resorted to an expansionary fiscal policy that in turn burdened the government with huge fiscal deficit. Cumulative sovereign debt worsened the economic condition and the countries were caught amidst a dwindling financial position and ever increasing sovereign debt. Works Cited Cyprus receives EU-IMF bailout funds, 2013, May 2013, from http://www.bbc.co.uk/news/business-22506385 Huang Yi Amy, To what extent does the European Debt Crisis affect both the European and the Global Economies, University of Kentucky, 2013, 28 May 2013 from http://uknowledge.uky.edu/cgi/viewcontent.cgi?article=1001&context=honprog Justin Y Lin & Treichel Volker, The Crisis in the Eurozone, 2013, 28 May 2013 from: http://www.worldfinancialreview.com/?p=2303 Read More