Responses of European Countries to the Global Financial Crisis - Literature review Example

INTRODUCTION Much has been written about the ongoing global economic crisis and the response of countries around the world to deal with the falloutof the same. While many commentators have written about the US leading the way in terms of bailing out the ailing banks in order to “save the system” from collapsing or because these banks were deemed to be “too big to fail”, the actions of the member states of the EU (European Union) have also come under scrutiny for their response to the crisis. While the world at large believes that the crisis has been caused mainly due to the exposure of global banks to the sub-prime market in housing, the responses have also been modelled around what the US has done or not done. (Philips, 2009) The approach of the US towards resolving the issue of “toxic debt” on the books of the banks was to inject around a Trillion Dollars of capital into these banks in order to stabilise them and protect them from the effects of going under due to the bad loans that were outstanding on their books. Similarly, the EU countries individually as well as collectively followed in the footsteps of the US in injecting money into the system. Though this kind of bailing out the troubled banks under the TARP (Troubled Assets Recovery Plan) in the US and the efforts of the EU in injecting around 200 Billion Euros into the system drew responses like “socialism for the rich” and the like, nonetheless the rationale given by the Monetary authorities was that these actions were inevitable if a global depression on the scale of the 1930’s Great Depression had to be avoided. This paper looks at the reasons for the response of the different countries in the EU to the global economic crisis. The paper attempts to answer the question: Why did different European countries respond to the global economic crisis in the same way? By reviewing the literature associated with the European response and the actions of the member states. However, there is a significant divergence in the way that different member states of the EU responded to the crisis. This fact runs contrary to the problem statement that this paper is trying to answer. This aspect of the difference in actions and the lack of unanimity are explored in the context of providing a contrarian view to the question that forms the basis of this paper. The central premise of this paper is that the different countries in the EU responded in a similar way to the financial crisis because of a variety of reasons that include the nature of the EU, the nature of the crisis and the fact that the groupings of countries like the G-8 and the G-20 felt that there was a need to have a global response to the crisis. RESPONSES OF EUROPEAN COUNTRIES As outlined in the introduction, the central premise of this paper is about the responses of the European countries to the financial crisis being similar to a large extent. The added argument here is that there are significant points of divergence as well. As shall be argued in the subsequent sections, the crisis is global in nature and hence the actions of the European countries have to be viewed in this context. To have a brief introduction for the present crisis, the housing market was inflated to a large extent because of loans made to borrowers who had bad or no credit history. These kinds of borrowers were called sub-prime of below the prime required for a good credit history. Once the loans were made arbitrarily, the homeowners went for further capitalization by refinancing their mortgages and borrowing against the houses. All this went on till the housing market corrected itself and the housing prices started to come down. This meant that the bubble started to burst. While the housing market bottoming out does not really make the whole economy go bust, it is the aspect of building up value on top of the mortgages through a form known as securitization that we will discuss later. And then the same were collateralized in the form of instruments known as CDS that gave the whole thing the look of a crisis of epic proportions. The argument that is being proposed is that because of the exposure of the European banks to the CDO’s and the derivatives built up on top of the mortgages, the global financial system as a whole suffered because of the failure of the sub-prime market. Hence, the question as to why there was similarity in the approach of the European countries needs to be answered from a global perspective. The fact that the research into the causes of the economic slowdown have focussed on the “global” reasons, the response to the same has been on a global scale. The point here is that European leaders like Nicolas Sarkozy and Angela Merkel as well as Gordon Brown have tended to call for greater cooperation among the member states of the European union as opposed to the protectionist cries heard in the smaller states including the Czech Republic and Greece because of the fact that their economies were more integrated with the global economy. (Castle, 2009) Hence, the argument that is being proposed that is wherever the national economies have tended to be tightly coupled with the US and the other economies, there has been a concerted and coordinated action by the leaders of these economies. On the other hand, the protectionist messages have emanated from the smaller economies. UNIFORMITY IN RESPONSE Among the many reasons cited for the uniformity in the response of the European countries to the financial crisis, the ones related to a sense of purpose that the financial system needs to be bailed out and the banks need to be re-capitalised as well as the near unanimous condemnation of the US as the originator for this crisis have been the ones cited most often. The other reasons for the uniformity in response have been the need for capital adequacy as well as more oversight on the financial system. These two factors are intertwined with the ones discussed above that underpin the stability of the financial system. The reason for the coordinated response of the European countries is because of three factors that have been described in the section related to the literature review. They are bank recapitalization, illiquidity and the threat of recession. If we take each of the factors in turn, we get a comprehensive picture of why the European countries acted in unison. For instance, there was a serious threat of the banks going under if they were not recapitalized. Hence, concerted action was needed from the European central banks as well as the member states to stave off the threat of the banks going under. The next factor was the threat of illiquidity that was ever present with the funds in the financial system drying up and with no chance of the credit crunch easing. The very reason why the economic crisis was triggered was because of the fact that there was not enough liquidity in the system because of presence of too much toxic debt in the books of the banks. Hence, there was an urgent need to pump in as much money as possible to stave off a liquidity crisis. Finally, the threat of recession in the combined Euro Zone made the member countries act together to ward off the spectre of a depression like scenario from happening in the zone. It is in nobody’s interest that a full scale recession takes hold and cripples all the economies in the region and particularly those that have massive exposures to the sub-prime mortgage backed securities. The threat of a worldwide recession is also the reason that the US called upon the global community to take effective measures and support each other in dealing with the crisis. As the reading by Blazey and Xenos states, “If we start with the requirement for capital adequacy as the need driving a coordinated and uniform response, the following extract highlights the urgent need for capital adequacy and greater oversight of the financial system: Two crucial areas for international coordination are capital adequacy and accounting standards. In the case of capital adequacy, reforms will certainly be directed at improving the quality, quantity and international consistency of capital in the banking system, preventing excessive leverage, and creating capital buffers. “(Blazey and Xenos, 2009) Hence the point that is being made here is that for capital adequacy of the banks, reforms need to be undertaken and thought this paper is about the uniformity in response by the European countries, it is better to keep the fact of reforming the financial system in mind when talking about the response of the countries as this fact was often emphasised in the discussions. CONCLUSION This paper has discussed the reasons for the uniformity of response by the European countries to the global economic crisis. After the analysis for the reasons has been made, it is pertinent to look at the policy implications and the theoretical implications of the same. It is clear that unless there are adequate steps taken to maintain the capital requirements in the banks, there are chances for this kind of crisis recurring in the future. Further, there needs to be regulatory oversight over the workings of the banks and adoption of common accounting standards. Apart from these measures, the global nature of the financial system makes it vulnerable to shocks in one part of the world. This interconnectedness means that any exogenous or endogenous shocks to the system in one country means that the tremors would be felt around the world. Hence, the policy responses to the current crises are along international lines rather than local or provincial lines. Globalisation means a “flat world”. (Friedman, 2005) But, it also means that the risks to the financial system are systemic in nature as well. Hence, the responses to the crises have been in the form of injecting trillions of dollars or Euros of capital with a view to maintain the capital adequacy as well as provide liquidity in a system where it has dried up to a considerable extent. Further, the crisis has made the G-8 and the G-20 stronger in terms of international cooperation and coordination among the member countries to resolve the crisis. This is definitely a pointer to the future where challenges to the international order can be expected to be tackled by these groupings more effectively. The responses to the present crisis indicate broader cooperation among these countries in dealing with systemic threats. In conclusion, it is my contention that the current crisis should lead to soul searching among the developed economies as well as the developing ones on ways and means to prevent future instances of these kinds of crises recurring to destabilise the global economy. The question as to why countries in the European Union tended to follow similar trajectories in dealing with the crisis can be best understood from the discussion provided in this paper. Sources Jay Solomon.  "The Financial Crisis: Leaders Seek Global Response to Financial Crisis; At U.N. Gathering, France, Brazil Call For More Oversight." Wall Street Journal, September 24, 2008, Eastern Edition, http://www.proquest.com/ (accessed December 5, 2009). Greene, Edward, Modrall, James, Shutter, Andrew. The EU response. International Financial Law Review; Oct2009 Financial Crisis Supplement, p16-19, 4p Stark, Jurgen. “Europes Forceful Response to the Financial Crisis “. Wall Street Journal. April 22, 2009, European Edition, http://online.wsj.com/article/SB124034710319940279.html (Accessed April 16, 2010) Castle, Stephen and Bennhold, Katrin. “In Europe, Thoughts of a Coordinated Response to the Financial Crisis.” New York Times. October 02, 2008. 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