Reasons for European Economic Crisis - Essay Example

Reasons for European Economic Crisis Introduction The economy of Europe is in its deepest and dire recession for the first time since the 1930s. It is an ongoing economic crisis that has made it difficult and nearly impossible for certain European countries to experience economic growth, finance their budgets, and re-finance he their debts without seeking assistance of other parties (Truman, 2010). The European economic crisis started in 2007 and was preceded by a considerably long duration of low risk premiums, growth of real estate bubbles, abundant liquidity, and fast credit growth. The economic misfortunes sequence that began in 2002 created a fiscal dilemma in Europe that included spiraling debt by the governments and banks of a number of European states (Musetescu, 2012). Some economists and policy analysts believe that the uncontrolled or unregulated debt resulted to the fiscal quandary that went beyond normal proportions. About 20 European states were in debt as of 2012 and this compounded the problem of European economic crisis because they have closely connected economies and shares a monetary currency (Rivera, 2012). What has been of greater concerns to many analysts is how Europe got into the crisis in the first place. It is believed that focus on social welfare and irresponsibility by some European states evidenced by heavy borrowing and not paying heed to balance of payment are main factors that led to the crisis (Desai, 2011). This paper will explain in details the reasons for European Economic crisis. Musialkowska and Wroblewski (2012) point out that no doubt the European economic crisis was as a result of a combination of various complex factors. The factors range from international trade imbalances, 2007 to 2012 global economic crisis to high risk borrowing and lending practices. In addition, the governments in Europe have been accused of not enforcing policies and practices that would have cushioned their respective countries against the economic crisis that is currently ravaging their economy (Noord and Szeekely, 2011). Many European governments had poor fiscal policies and made inappropriate fiscal choices relating to government expenses and revenues. This paper will look at five main reasons for European economic crisis: imbalances in international trade; inappropriate and inflexible monetary policy; increasing levels of households, banks, and governments debts; confidence loss in the economic system; and Eurozone system’s structural problem (Truman, 2010). The first reason for European economic crisis is imbalances in international trade. To many economists, this is the root cause of the European economic crisis. In the run-up to the economic crisis, there was rising trade imbalances among many European countries (Musetescu, 2012). Countries such as Spain, Italy, Portugal, and Ireland had unfavorable balance of trade and payments. Germany was among the few European countries that had a relatively better balance of trade and payments. The trade imbalances were occasioned by changes in labor costs and deficit in production. Labor cost changes diminished European nations’ competitiveness and subsequently raised trade imbalances (Rivera, 2012). For example, Greece’s labor cost had increased much faster compare to that of Germany’s in the last ten years. Also, the labor costs in Italy increased by 33 percent compared to that of Germany. As the labor costs rose faster compared to productivity, affected countries lost their competitiveness. Germany was the notable European country that was able to restrain her labor costs and this helped her to avoid the challenge of trade imbalances. Ability of Germany to restrain its labor costs became a critical factor in maintaining low employment level (Desai, 2011). Imbalances in international trade implied that many European countries experienced trade deficit in the run-up to the economic crisis. This problem was compounded by the Eurozone convergence whose main aim was to converge their productivity (Truman, 2010). In an event that this end is not realized, workers within Eurozone can move to countries that have greater productivity. However, the opposite occurred as the gap between the countries whose productivity was greater and those with lower productivity increased as a result of a big current account surplus that was financed by capital flows (Musialkowska and Wroblewski, 2012). While the capital flows would have been invested in increasing productivity in the low productivity states, they were squandered in investments that are consumptive. Countries such as Germany that had sustained favorable balance of trade did not see the value of their currency appreciate relative to the other European countries because of common currency (Desai, 2011). This made the exports of those countries to be artificially cheaper. The effect of this was seen in 2011 when the trade surplus of Germany within the Eurozone went decreased because its trading partners within the zone were not able to find funds required to finance the deficits in their own countries. It should however e noted that the trade surplus of Germany outside the Europe increased because the value of euro had declined relative to other currencies including the US dollar (Rivera, 2012). The second main reason for European economic crisis is the inappropriate and inflexible monetary policy. It is important to note that the Eurozone membership created a single monetary policy and subsequently preventing individual member states against acting solely or independently (Musialkowska and Wroblewski, 2012). Particularly, individual member states are not in a position of creating Euros in order to eradicate their default risk and to pay credits. Due to the fact that they share similar currency as their trading partners, individual member states cannot devalue their own currencies in order to make exports less expensive. In an event that this was allowed, it would have improved balance of payment and balance of trade, as well as raising tax revenues and increasing GDP in nominal terms (Noord and Szeekely, 2011). While the euro was introduced to create a pan-European financial and economic superpower and eliminate the messy currency exchanges between individual member states, it is turning out that the currency exchanges was not the real problem. It has become evident that the real problem was that a common currency deters individual member states from ascertaining their fiscal and monetary policy. This problem was complicated by the fact that the Eurozone member states do not have power to print new money and determine the monetary policy. While they can rake in their own revenue and plan their own budgets, they cannot deflate or inflate their own currency (Desai, 2011). The third reason for European economic crisis is the increasing levels of households, banks, and governments debts. In the run up to the economic crisis, there were increased debt levels for households, banks, and governments in Europe. It should be note that when the European Union members signed the Maastricht Treaty in 1992, they had made a commitment to limit their debt levels and their deficit spending as well (Truman, 2010). Nonetheless, several member states such as Italy and Greece succeeded in circumventing the rules. They sidestepped the best fiscal and monetary practices, ignored standards that are agreed internationally, and failed to abide by the treaty’s guidelines (Werthers, 2011). As a result, the member states were able to mask their debt and deficit levels by combining techniques such as off-balance-sheet transactions, inconsistent accounting, suing credit derivative structures, and using complex currency structures (Rivera, 2012). Prior to the economic crisis, many Eurozone countries of varying credit worthiness were able to receive the same and relatively lower interest rates for their private credits and bonds due to the adoption of the euro. Consequently, creditors in member countries whose currencies were originally weak suddenly started to enjoy more credit terms and this spurred government and private spending and economic boom (Noord and Szeekely, 2011). Some countries such as Spain and Ireland this situation contributed to housing bubble that eventually burst during the global economic crisis (Musialkowska and Wroblewski, 2012). Several economists also argue that the increased levels of debt for European banks and governments were largely because of the big bailout packages that were provided during the global financial crisis to the financial sectors (Desai, 2011). They also attribute the situation to the global economic slowdown that followed the global economic crisis. The fiscal deficit of euro grew, on average from 0.6 percent in 2007 to about 7 percent during the global economic crisis. During the same period, it is estimated that the average debt for some European governments grew from 66 percent to about 84 percent of the Gross Domestic Product. Individual member states are also to blame for the rise in debt levels. Greece, for example, demonstrated a great deal of fiscal irresponsibility. Musetescu (2012) notes that financial sector is also to blame for the increase in debt levels; banks lend to individuals and companies excessively. The government’s mounting debts can be attributed as a response to the global economic crisis because spending rose and tax revenues declined. The other main reason for the European economic crisis is confidence loss in the economic system. Before the crisis began there was an assumption that by the banks and the regulators that the economic situation in Eurozone was safe (Musialkowska and Wroblewski, 2012). This assumption was informed by the fact that the substantial holdings of bonds from economies that are weaker like Greece that offer a small premium and seemed to be sound. However, the increase of sovereign CDS prices led to the loss of confidence in the economic system (Werthers, 2011). Also, investors have doubts regarding the possibilities of the situation being contained sooner. Due to the fact that countries that use euro as their currency, their policy options are limited such as inability to print their own currencies and pay debts (Noord and Szeekely, 2011). As such, the solution to the crisis seems to lie more on the multi-national cooperation rather than through measures by individual member states. This serves to further reduce the confidence level on the financial situation in Eurozone (Truman, 2010). The reduced confidence levels of the Eurozone economic situation was indicated by the sovereign ratings by the Standard & Poor. S& P placed the long term sovereign ratings of 15 member states of European Union on “CreditWatch” ratings, a rating that has negative implications (Musialkowska and Wroblewski, 2012). These ratings were informed by the following factors that are interrelated: high risk premiums on increasing number of sovereigns; the increasing economic recession risk in the Eurozone in 2012; persistent disagreements among policy makers in Eurozone regarding approaches of tackling the immediate crisis on the market confidence, as well as in the long term on how to make sure that higher fiscal, financial, and economic convergence among members of Eurozone; Eurozone’s tightening credit conditions; and increased levels of household and government indebtedness across Eurozone (Werthers, 2011). With such low confidence levels, Eurozone’s economy was exposed and it greatly contributed to the European economic crisis (Musetescu, 2012). The final main reason for European economic crisis is Eurozone system’s structural problem. As it is currently, there exists a structural contradiction within the financial system in Europe. There is a common currency and monetary union without corresponding fiscal union including treasury functions, pension, and common taxation (Desai, 2011). While the member countries within the Eurozone system are supposed to adhere to the same fiscal path, they do not have common treasury of enforcing it. This implies that countries with similar monetary system have fiscal policies freedom in expenditure and taxation. Therefore, while there are certain agreements regarding monetary policy, member states may not be simply decide to adhere to it. It is as a result of this that fiscal free riding of peripheral economies were brought to the Eurozone’s economic system (Noord and Szeekely, 2011). This is so because it was difficult to regulate and control national financial sector. The Eurozone system’s structural problem further contributed to the occurrence of the European economic crisis because it has difficult structure of responding quickly to urgent economic situations (Werthers, 2011). In order to make decisions, it is required that there should be unanimous agreement on the particular issue. As such, this can lead to failure to prevent imminent crisis urgently and therefore it would be hard for the Eurozone to respond urgently to the impending crisis (Musialkowska and Wroblewski, 2012). In the light of the magnanimity of the European economic crisis, it is critical that appropriate measures are taken to address the ‘challenge both in the short and the long term. As has been noted most of the reasons for the crisis could have been prevented if stakeholders could have taken appropriate measures (Musetescu, 2012). The individual member states, regulators and financial institutions should have instituted and implemented measures that correspond to the prevailing fiscal and monetary situation in the Eurozone. Since that did not happen, there is need for measures to be put in place to address the problem at the moment and prevent its recurrence in the future. Rivera (2012) suggests that one of the ways of doing this is by establishing an authority that can help in the recovery of financial institutions. Establishment of such an institution would be instrumental in helping these institutions to recover from the crisis. Also, it will be critical in preventing future occurrence of similar crisis by ensuring that these institutions are obliged to put aside a certain amount of deposits that would be covered by their national guarantees for financing resolution of the crisis particularly in the financial sector (Desai, 2011). A number of economists also suggest that as a way of addressing the challenge of economic crisis in the long term, it is important t use Eurobonds. According to them, Eurobonds could be appropriate instruments of solving the crisis as a whole, and particularly the debt crisis that is facing a considerable number of European countries (Musialkowska and Wroblewski, 2012). Considering some of the causes of the crisis, it would be crucial if Eurozone member states would create a common fiscal union. As has been mentioned, one of the main reasons why the crisis occurred was because of weak structural systems mainly occasioned by lack of corresponding fiscal union to existing monetary union (Rivera, 2012). Creation of a fiscal union will help in regulation and reducing the possibilities of recurrence of the crisis in the future. In addition, since some of the European countries are debt-ridden at the moment, dramatic debt write-off will be an important step towards addressing this problem in the short term. Such a move will help those countries to recover much easily. Desai (2011) suggests that here is need to consider the possibility of creating a European Monetary Fund to help cushion Eurozone against getting into financial crisis in the future. Conclusion The discussion in this paper indicates that there were number of reasons for European economic crisis. As has been noted, the main reasons include: imbalances in international trade; inappropriate and inflexible monetary policy; increasing levels of households, banks, and governments debts; confidence loss in the economic system; and Eurozone system’s structural problem. These reasons combined to cause the crisis. The crisis has devastating impact on the European nations and people who live there and it is critical that the problem be addressed in short and long term. Among the suggested proposals of addressing this challenge include using Eurobonds, creation of European Monetary Fund, and initiating dramatic debt write-off in countries that have huge debt burdens among other solutions. References Desai, P. (2011). From financial crisis to global recovery. New York: Columbia University Press. Musetescu, R. (2012). The Economics of State Aid Control in the European Union during the Financial Crisis: the Challenge for a Post-Crisis Rhetoric. Theoretical & Applied Economics, 19(6), 175-184. Musialkowska, I., Sapała, M., & Wroblewski, Ł. (2012). The strengthening of the Single European Market vs. the crisis. Poznan University Of Economics Review, 12(2), 74-105. Noord, P. ., & Szeekely, I. P. (2011). Economic crisis in Europe: Causes, consequences and responses. London: Routledge. Rivera, P. (2012). Crisis and Regional Distribution in the European Union: Considerations of Economic Policy. Journal Of Economic Issues (M.E. Sharpe Inc.), 46(2), 459-468. Truman, E. M. (2010). Sovereign wealth funds: Threat or salvation?. Washington, DC: Peterson Institute for International Economics. Werthers, P. B. (2011). Europe: Financial crisis and security issues. Hauppauge, N.Y: Nova Science Publishers. Read More