Budget Deficit And National Debt Levels In The Euro-Zone - Essay Example

Budget Deficit And National Debt Levels In The Euro-Zone Introduction Even the economies in the Euro-zone could not escape the wrath of the recent financial crisis as the government finances in many euro countries were severely battered. A number of euro countries such as Greece, Italy, Portugal, Spain and Ireland, saw their budget deficits and national debt grow astronomically. The debt crisis in the euro-zone has been mostly revolved around the developments in Greece, where the growing concerns about the rising cost of financing government debt led to ebbing of the investors’ confidence. In May, this year, the IMF and the Euro-zone countries took a concerted effort and agreed to disburse a €110 billion rescue package for Greece, conditional on the implementation of harsh austerity measures on Greece. Subsequently, the Finance Ministers of European countries met and arranged a comprehensive rescue package to the tune of nearly one trillion dollars specifically targeted at ensuring financial stability in the European continent. In recent months, these measures have started to show results as the euro-zone’s crisis is showing signs of easing and there are now distinct signs of a return of investor confidence. Though, in recent months Europe has staged a come back from the brink of crisis, but still it would be a big mistake to unfurl the ‘mission accomplished’ banner. (Taylor, 2010). Budget deficit The budget deficits in many countries in the Euro-zone and Germany are soaring. Germany surely is destined to incur a greater budget deficit in 2010 than Italy. Germany has traditionally been the symbol of fiscal rectitude in the European continent. According to Deutsche Bank’s estimates, the budget deficit in Germany is expected to reach 6.5% of GDP in 2010 whereas in case of Italy, the budget deficit is expected to touch 6.2% of GDP in 2010. Many countries in the euro-zone, which have been traditionally running huge fiscal deficits even in good times, went for bigger deficits to give a Keynesian solution to the crisis. Many deficit figures for many other European countries such as Greece, Portugal, Spain, Ireland are indeed alarming. Greece indeed looks vulnerable despite the huge stimulus package. For, Greece, the fiscal deficit is nearly 13.5% of the GDP and the value of public debt/GDP is 115%, but has a possibility to reach 140% by 2014 irrespective of rescue measures and there are still doubts in the markets regarding solvency of Greece. For, Portugal, the fiscal deficit figure is nearly 9.3% of national GDP and ratio for public debt to GDP is around 77%. For Spain, the fifth largest economy in Europe, though the public debt to GDP ratio of 53% is not alarmingly high but its fiscal deficit of 9.3% is indeed worrying and there is a widespread fear that contagion effect of Greece crisis may also spread to Spain. The terms of the treaty in the formation of the euro-zone (Growth and Stability Pact) requires every country in the euro-zone to keep the budget deficit of less than 3% of its GDP. Pitifully, none of the 16 member countries in the euro-zone is expected to meet that goal. The year 2011 has been set as the deadline for the euro-zone nations to initiate the process to dig out of the stimulus measures and the process of deficit spending has already started. Given the sharp rise in public deficits and the enormous strain that it will exert on future budgets, the fiscal exit strategy will have to be kick-started as the recovery process is firming up. Now, there is a concern that the countries in the euro-zone such as Greece, Portugal, Spain, Ireland etc. have to resort to budgetary cuts which may again lead to stagnation in the economy by fueling more unemployment and creating social unrest. Whatsoever, the case of budget cuts goes far beyond the euro-zone countries. In 2008, when the world economy got entangled with the scars of recession, many countries in the world almost acted simultaneously to give a boost to their ailing economies through deficit spending. Many experts are of the opinion that this was the right policy as it helped check prolonging the crisis and somewhat diminished its impact. Now, since the crisis has started showing some signs of easing, it is the time to gradually scale back the stimulus measures. The governments across the globe will commit a mistake if they hurry up the process of withdrawing the stimulus measures—in fact, it is averred in some quarters that recklessly speedy withdrawal of the stimulus measures would backfire and would again lead to crisis. Rather the governments should follow a cautious approach for balancing their budgets over say five years. This is applicable for developed countries like the United States, Japan, and the United Kingdom as applicable for fiscally weak nations of the euro-zone. Few euro-zone nations including Greece, Spain, Portugal and Ireland are now taking actions, being triggered by the nervous bond markets. Portugal, Spain and Ireland have declared that their budget will be cut by 2-3% of GDP by 2011. Together, these four economies account for less than 20% of the region’s GDP, so these measures announced by these nations will have a smaller impact on the euro-zone as a whole. In the month of May 2010, even Italy, the world’s seventh largest economy, joined the bandwagon and decided to lower its fiscal deficit by $30 bn by 2012. Even the credit worthy nations of Europe like Germany and France, have joined in the deficit reduction exercise. In June, this year, the government of Germany has announced some measures which are targeted at reducing the budget expenditure by nearly €80 billion by 2014. Angela Merkel, the chancellor of Germany said that Germany, the largest economy in Europe should set a precedent of fiscal prudence to its euro brothers. Again, France pledged to abolish tax exemptions and to stall many spending program from 2011, which are likely to curb its fiscal deficit in future. (Budget cuts in the euro area: Nip and tuck. 2010). On the other hand, in order to keep the budget deficits in check, the roles played by the EU and the European Central Bank (ECB), have to be reshuffled. If we go by the underlying treaty behind the creation of the EU and the ECB, these two institutions are not entitled to address the problems that the euro-zone is encountering. Whatsoever, the experts are recommending few changes in the EU so that it can also work as an effective institution to deal with the fiscal crisis in the euro-zone nations. One of their suggestions is that the European Union should be in a position to effectively control the fiscal policies of the member nations. Anyways, this will have political ramifications and will be difficult, if not impossible to bring political unanimity among the euro-zone nations. The other suggestion is to establish a European Monetary Fund in the line of International Monetary Fund. Like the arrangements in the IMF, member countries would regularly give subscriptions to the European Monetary Fund, which will be able to help the member nations in case of any crisis. This idea is not politically infeasible but whether it would be able to garner sufficient funds to deal with contingencies is a matter of serious debate. Moreover, the existence of such institution in the Euro framework, may lead to complacency among the member nations as they may become fiscally more imprudent. (Reforming the Euro-zone, 2010). National debt The recent financial crisis has adversely impacted the public finances of euro-zone countries. Huge borrowings by the public sectors have badly hit the basic ‘stability and the growth pact’ which is the core behind the formation of the euro-zone. It is estimated that for the euro-zone, as a whole, government debt may exceed 100% of GDP within few years. According to a projection, by 2010, government deficit will climb to nearly 6% of the GDP in 2010 and for all the countries in the euro-zone it will cross the threshold limit of 3% of GDP. According to an estimate by ECB, Euro-zone debt in 2008 stood at almost 70% of GDP, and the ratio could surge to about 88% in 2011. In 2009, the national debts of both the euro area and that of the EU27 (enlarged European Union) increased in comparison to the previous year, while the GDP plummeted. While in the euro area, consisting of 16 member nations, the ratio of public debt to GDP went up from 69.4% in 2008 to 78.7% in 2009, in the EU27 zone, it increased from 61.6% to 73.6%. In 12 member nations of the European Union, the ratios of public debts to GDP in 2009 were higher than 60%. Among those 12 member nations, in 2009, debt to GDP ratio was more than 100% in Italy (115.8%) and in Greece (115.1%). Belgium (96.7%), Hungary (78.3%), France (77.6%), Portugal (76.8%), Germany (73.2%), Malta (69.1%), the United Kingdom (68.1%), Austria (66.5%), Ireland (64.0%) and the Netherlands (60.9%) are the other European Union member states where debt to GDP ratio exceeded 60% in 2009. Among the member states of the European Union, in 2009 comparatively lower public debt to GDP ratios were recorded in the Czech Republic, Lithuania, Romania, Bulgaria, Luxembourg and Estonia. Between 2008 and 2009, both in the euro and in the EU27 areas, revenues for the governmet declined whereas government expenditures increased. (Provision of deficit and debt data for 2009 - first notification. 2010). According to a research by two US economists, Carmen Reinhart of Maryland University and Kenneth Rogoff of Harvard University, for the countries with public debt to GDP ratio of more than 90%, economic growth tend to slow down. In their study, they have shown that, in case of rich countries with public debt to GDP ratio more than 90%, annual economic growth rate is 2% low than the countries with public debt to GDP ratio less then 30%. Now, it is feared that within few years public debt to GDP ratios in many countries of the European Union would reach alarming proportions and the situation will aggravate if the respective governments do not adopt strong corrective measures. Moreover, in many European countries, the aging related increases in expenditures will add to the fiscal burden in the medium and in the long term. For many nations in the European Union, persistence with massive public borrowing program has not only put enormous pressure to state’s coffers but at the same time it has had its adverse impacts on economic growth, long term interest rates and on the long term stability of the euro area as a whole. In addition to huge borrowing programs, the massive support program targeted towards the banking sector, has added to the already rising public debt which according to many economists could put at risk the fiscal solvency of the country in the medium term. This has also resulted into changing investors’ understanding about the creditability of the euro-zone countries. Whatsoever, all these would likely to jeopardize the governments’ capacity to issue long-term debt and may damage the sustainability of state finances because of high debt servicing costs. (Finfacts Team, 2010). Now, it is the top priority among the policy makers in the Euro-zone to fix their economies crippled with the burden of huge debts. To defend the euro and to prevent the contagion to spread beyond Greece, are now most important objectives of the policy makers in the EU circle. One of the effective remedies to tackle the euro crisis is to bring more budgetary discipline. Even introduction of punishments for the European Union nations, in case of not meeting the EU criteria, are high on the agenda. However, the basic treaty of the Economic and Monetary Union (EMU) that was actually instrumental behind the formation of the euro actually persuade member nations to run large deficits. If a country with its own currency sells huge debts to the investors, would witness its currency deteriorate and interest rates rise. On the other hand, since the EMU countries are tied with euro, they are not in a position to tweak their currencies in crisis situation. It is now politically accepted throughout Europe that new rules are required to avoid large deficits, though no such arrangements has been initiated in this regard. Recently, it has been proposed by the European Commission that the budgets of each member country should be scrutinized by the member before their approval. Many countries, however, would likely to dump this proposal as they may be reluctant to tolerate the interference of others in their domestic affairs. (Feldstein. 2010) The long run solution to these crises is the most important concern. In this regard, the leaders of the European Union leaders have framed with two proposals to ensure fiscal stability for a continued period. They have proposed the setting up of European Financial Stability Facility and secondly they recommended for a single authority who will be solely responsible for overseeing tax policy and look into the matter relating to the government spending with EU member countries which is temporarily known as treasury. The EU and the IMF will financially support the stability facility. On the other hand, the European Parliament, the European Council, and the European Commission, would provide support to the treasury. The creation of treasury has been severely opposed by EU members like France and Italy. Even it was opined in some quarters that any emergency bailouts should also entail stringent punishments to the aid recipients. Another school believes that in spite of the corrective measures adopted to tackle any crisis, as long as unfettered capital movements remain unregulated in economies the euro-zone, imbalances in the current account as well as asset bubbles are likely to persist. (Too Much Money, 2005) UK UK is not a member of euro and it has its own currency pound (£). In fact, the UK government has ruled out the possibility of UK joining the euro and it is held in the government quarters in UK that the decision of UK not joining the euro was absolutely right for UK as well as for the Europe as a whole. Whatsoever, in recent times, the UK has also been afflicted by the global downturn. Whereas, in 2007, the public debt to GDP ratio stood at comfortable 35.5%, it reached 56.8% in 2009. In January 2009, it was officially declared that UK was into recession since eighteen years. The leading news daily, The Guardian quoted that, “Six successive quarters of negative growth from spring 2008 until autumn 2009 were the toughest for the economy since the Great Depression of the 1930s, harsher even than the slump of the early 1980s.” It is opined by the experts that Britain’s over reliance on investment in real estates and heavy dependence on financial services led the nation in to protracted recession. Whatsoever, the recent global financial crisis originated in the real estate market in the United States where many financial firms involved in the mortgage business unmindfully extended their credit even to the sub prime borrowers. Subsequently, they bundled this debt on to other countries such as the UK by borrowing from abroad to finance this risky lending. However, as the banks in UK got into serious troubles, the monetary authority of UK allowed the banks to lend among each other in order to boost the liquidity in the market. However, sadly, this added to the already mushrooming debts of the banks and created a situation of panic among them. The first casualty of the crisis was the prestigious Northern Rock. In September 2007, Northern Rock had to approach to the Bank of England (BoE) for financial support and received it from BoE, following the problems in the credit markets caused by the US subprime mortgage financial crisis. Finally, in February 2008, Northern Rock was nationalized. The case of Northern Rock created widespread panic in the market—customers and investors were utterly concerned that the banks would not be financially in a position to pay up. Consumer confidence went down to nadir. Coupled with this, the overvalued housing market, which suddenly started, falling, aggravated the situation in the country. Growth however resumed in more recent quarters as the UK economy responded, though slowly, to the emergency cuts in interest rates, the cheaper pound and higher government spending. Consumer spending declined slightly in the first three months of 2010, with individuals running down their savings in order to finance purchases. Despite the pick up in activity at the end of last year, output was 0.2% lower at the end of the first quarter of 2010 than it had been a year earlier. Though the recovery process has started but still it is very reliant on state spending and that consumers are not able to keep parity yet. The picture remains one of only gradual recovery so far following a record six quarters of deep overall recession through to the third quarter of 2009. (Elliott. 2010). Greece The crisis in the euro-zone started with Greece unable to pay its standing debts. Greece was one of the founding members of the euro-zone, which was conceptualized in 1998. During the early years of the new century, Greece was one of the fastest growing economies in the euro-zone, which attracted steady foreign capital inflows. A robust economy along with declining bond yields allowed the government of Greece to run huge structural deficits. Subsequent governments, which came to power, continued running large deficits to fund socially beneficial activities such as pensions and employment opportunities in the public sector. This led to staggering debt-to-GDP ratio for Greece. Along with this, the global financial crisis that began in 2008 had adversely affected Greece’s economy. Two key industries in Greece—shipping and tourism—were both adversely affected by global economic downturn and resultantly revenues from these two industries plummeted appreciably. To meet the guidelines of the European Union, the Government of Greece intentionally misquoted the official economic figures of the country. Greece’s national debt crossed the GDP of the country. The country’s deficits—the excess of expenditure over income—touched 12.7%. Its sovereign credit rating, that is its ability to repay its outstanding debts was lowered down by the leading global rating agencies. This resulted into the country being in a stressful position to pay its debts as interest rates associated with the existing debts also rose. The Government of Greece under the prime ministership of George Papandreou, which took office late 2009, inherited huge financial burden. After coming to power, the new government put on shelf most of its pre-election promises and started adopting austerity measures to stem the crisis through huge cuts. (Q&A: Greece’s financial crisis explained. 2010). In January 2010, total debt of the government was projected to be around €216 billion. Again, according to some other sources, accumulated debt of the government was projected to be around 120% of GDP, for the year 2010. The market for government bond in Greece is very much dependent on foreign investors—according to some estimates, nearly 70% of government bonds of Greece are held outside its geographical territory. (Cutler, 2010) In April 2010, the debt rating of Greece was lowered near to the ‘junk’ status by the leading rating agency Standard & Poor’s amidst widespread fears of default by the sovereign authority of Greece. This bond downgrading led to a rise in the yields on two-year government bonds of Greece to 13.5%. Experts raised eyebrows over the ability of Greece to pay its debts. That time, the rating agency S&P estimated that investors would lose 30–50% of their money in case of default. Stock markets plunged after this announcement. Following the steep downgradings by almost all the rating agencies like Fitch, Moody’s and S&P, bond yields in Greece increased in 2010. Again, in the first week of May, 2010, the European Central Bank (ECB) put on hold its threshold limit for Greece government bond ‘until further notice’ which means that the bonds will still be eligible as collateral even with their junk status. This was aimed at helping Greek banks to access cheap funding provided by the central bank. That time, analysts opined that this would help enhance the allure of Greek bonds’ to the investors. In this regard, the parliament of Greece introduced the Economy Protection Bill which was aimed at saving €4.8 billion through a gamut of measures which even includes reductions of wages for employees working in the public sector. In the month of April, the government of Greece urged that the bailout packages from European Union and IMF should be activated. Subsequently, in the next month, an agreement was set between European nations, including Greece and the International Monetary Fund. The agreement consisted of €45 billion of loans to be disbursed in the year 2010, and more funds will be available subsequently. In fact, a total loan amount of €110 billion was agreed upon. (Cutler, 2010) Analysis (compare and contrast of UK and Greece measure) Though the global downturn aggravated the economic crisis in both Greece and UK, but there are some distinct differences in the causes, nature and the measures adopted to counter the crisis in these two countries of Europe. In Greece, the country’s alarmingly high levels of debt, which it traditionally accumulated through heavy borrowing program, ultimately placed the country in to an abyss. The debt levels in the country, resulted into sovereign downgrading of the Greek bonds and the investors across the globe became cynical about Greece bond market. The contagion effect of the Greece crisis soon spread to other nations of the euro-zone and the situation in the euro-zone as a whole reached such a menacing proportions that many critics started questioning the efficacy of euro. Whereas, in UK, the crisis has its origin in its over reliance on the financial services sector and the real estate market. Prior to the global economic downturn, everything was going smoothly—the real estate market was in a jovial mood and the banking sector was mindlessly disbursing credit to the consumers even without cross checking the credit worthiness of the borrowers. As the global financial crisis, which started in the subprime real estate, market in the United States soon spreaded to many countries in the world including UK. The real estate market in the UK, also received a serious jolt as the real estate prices soon stated nose-diving appreciably. In a crisis of confidence in the banking sector in UK engulfed the entire country, hastening the recessioany situation. The crisis in Greece reached such an alarming position that even many feared that the country might become bankrupt. It required massive bailout packages from the IMF and the European Union to get the economy extricate out of the crisis. But, at the same time, these rescue measures were provided upon some strict conditions, which Greece has to adhere to in future. Even now it cannot be said that the fear factor is over. Greece has to show more maturity and restraint and abide by the strict conditionalities imposed on it. On the other hand, like many countries in the world, which resorted to rate cut to counter the crisis, UK also followed suit. Moreover, unlike Greece, UK has its own currency and it can tweak it according to its will. It devalued pound so as to boost its exports and to give a fillip to its national output. In addition to this, in UK, there should be more control and oversight over its financial services and the real estate sectors. Whatsoever, it in both these nations the recovery process has only started and these two countries cannot remain complacent in near future. Though, there are some distinct differences in the strategies adopted by these two nations in tackling the crisis, one thing is common for both the nations, i.e, more discipline whether it is fiscal policy or monetary policy. Conclusion Even after the announcement of the huge bailout packages, people were of the view that the economic crisis in the euro-zone, which started with the debt crisis in Greece, may endanger the existence of the euro. As in the aftermath of the Greek crisis, European banks were ever reluctant to lend to each other and as the euro was plunging vis-à-vis dollar, pessimists were painting a grim future of the euro-zone. Even some economists were assigning high probability to a collapse of the euro-zone. Opposition from the big euro countries, mostly the stiff resistance from none other than Germany not to be a part of the rescue package, aggravated the prospects for the aggrieved euro countries as well as the euro-zone as a whole. In a sharp U-turn, in recent months, the prospects for the euro-zone nations have improved dramatically. Not only the crisis has eased to a certain extent but also the debt-stricken regions are now getting good investors’ response. On top of all, the euro is gaining in strength and the many countries in the euro-zone are now staging economic recovery. This good show has been reflected even in the performance of the European stocks, which have outperformed the S&P’s 500-stock index in the month of July. Good half-yearly results from many corporate houses in Europe and, importantly a positive report card from IMF on Greece have added an optimistic aura to the recent good show. But, all is not hunky-dory yet and it will be a big mistake if the countries become complacent. The governments across the globe should not be in a hurry to exit from the stimulus-led strategy. Rather they should tread cautiously in their rate cutting exercise. One thing is clear that it requires discipline, restraint, and judicious oversight over economic policy to make these economies less vulnerable to economic crisis. References: 1. Talyor, P. (2010). Euro Crisis Fades, but Risks Remain. New York Times Retrieved on August 18, 2010 from: http://www.nytimes.com/2010/08/10/business/global/10inside.html?_r=1&src=busln&pagewanted=print 2. Budget cuts in the euro area: Nip and tuck (2010). The Economist. Retrieved on August 26, 2010. from : http://www.economist.com/node/16322542?story_id=16322542&fsrc=rss 3. Reforming the Euro-zone. (2010). Council on Foreign Relations. Retrieved on August 26, 2010. from: http://www.cfr.org/publication/22093/reforming_the_euro-zone.html 4. Provision of deficit and debt data for 2009 - first notification. (2010). Eurostat. Retrieved on August 26, 2010. from http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-22042010-BP/EN/2-22042010-BP-EN.PDF 5. Finfacts Team, (2010). Government debt in Euro-zone may top 100% of GDP with “severe consequences” for growth/ stability says ECB official. Finfacts. Retrieved on August 26, 2010. from: http://www.finfacts.ie/irishfinancenews/European_3/article_1019462_printer.shtml 6. Feldstein, M. 2010). For a solution to the euro crisis, look to the states. The Washington Post. Retrieved on August 27, 2010. from: http://www.washingtonpost.com/wp-dyn/content/article/2010/05/17/AR2010051702808.html 7. Elliott, L. (2010). UK recession even deeper than first thought. The Guardian. Retrieved on August 27, 2010. from : http://www.guardian.co.uk/business/2010/jul/12/uk-recession-deeper-than-first-thought 8. Q&A: Greece’s financial crisis explained. (2010). CNN. Retrieved on August 18, 2010 from: http://www.cnn.com/2010/BUSINESS/02/10/greek.debt.qanda/index.html 9. Cutler, D (2010). . Timeline : Euro-zone Debt Crisis. Reuters. Retrieved on August 18, 2010 from: http://www.reuters.com/article/idUSTRE64I2LW20100519 Read More