EURO ZONE CRISIS

Report by: Group No: 6

Varun Bijur Saurabh Kapoor Shyam Kumar Manjul Sankhla Ashish Shukla F16 F24 F28 F46 F51

Ramandeep Singh F62

Contents
1. EURO ZONE CRISIS .................................................................. 3 1.1 Euro Zone A Background: ................................................ 3 1.2 Justification for the Euro: ................................................... 4 1.3 Impact of Global Crisis on the Euro zone: .......................... 5 2. IS-LM Curve analysis of the Crisis ........................................... 7 3. Economic Effects of the crisis ................................................. 8 3.1 Impact on Labour Market and Employment: ..................... 8 3.2 Impact on Budgetary Positions: ......................................... 9 4. Effects of Euro crisis on rest of the world ............................. 10 4. POLICY RESPONSES: Crisis control and mitigation ............... 12 4.1 Banking Support: .............................................................. 13 4.2 Macroeconomic Policies: ................................................. 13 4.3 Monetary Policies:............................................................ 14 4.4 Fiscal Policies: ................................................................... 15 4.5 Labour market policies: .................................................... 15 5. Policy Implications ................................................................ 16 6. The Challenges Ahead........................................................... 16 7. Conclusion: Implications for Today ....................................... 18 8. References ............................................................................ 19

1. EURO ZONE CRISIS

"Almost every achievement contains within its success the seeds of a future problem." The Euro zone crisis of 2010 provides a trenchant example of this phenomenon. When the longsought but controversial implementation of a European Monetary Union (EMU) finally began, it represented a significant accomplishment. Though the idea of a single European currency had been around at least since the Werner Plan of the 1970s, German reunification provided the necessary catalyst. For all the success of that achievement, however, it left behind fateful seeds, which sprouted into the 2010 crisis. The European debt crisis is the shorthand term for Europes struggle to pay the debts it has built up in recent decades. Five of the regions countries Greece, Portugal, Ireland, Italy, and Spain (Popularly known as PIIGS nations) have, to varying degrees, failed to generate enough economic growth to make their ability to pay back bondholders the guarantee it was intended to be. Although these five were seen as being the countries in immediate danger of a possible default, the crisis has far-reaching consequences that extend beyond their borders to the world as a whole. In fact, the head of the Bank of England referred to it as the most serious financial crisis at least since the 1930s, if not ever, in October 2011. The acute phase of the global financial crisis was short; lasting from the collapse of Lehman Brothers on September 15, 2008, to the day the Dow hit a trough on March 9, 2009. But, like a violent heart attack, the interruption of creditthe economys life bloodlasted long enough to permanently damage the industrial countries at the center of the crisis. The damage took three main forms, each of which poses a major risk to the stability of the global economy today: high and rising public debts, fragile banks, and a huge liquidity overhang that will need to be eventually withdrawn. The Euro crisis, which strikes at the heart of the worlds largest trading block, contains only two of the three fateful elementsproblematic sovereign debt in Greece and other vulnerable countries, and fragile European banks, which hold a large part of that debt. Monetary policy in the Euro area and in industrialized countries more generally, remains expansionary and, if anything, the crisis pushes back the time when tightening can occur safely. As a result of the problems in Europe, the world economy has become even more exposed to the three megavulnerabilities.

1.1 Euro Zone A Background:

On January 1, 1999 eleven European countries decided to denominate their currencies into a single currency. The European monetary union (EMU) was conceived earlier in 198889 by a committee consisting mainly of central bankers which led to the Maastricht Treaty in 1991. The treaty established budgetary and monetary rules for countries wishing to join the EMU - called the convergence criteria. The criterion were designed to be a basis for qualifying for the

EMU and pertained to the size of budget deficits, national debt, inflation, interest rates, and exchange rates. Denmark, Sweden, and the United Kingdom chose not to join from the inception. The "Euro system" comprised the European Central Bank (ECB), with 11 central banks of participating States assuming the responsibility for monetary policy. A large part of Europe came to have the same currency much like the Roman Empire, but with a crucial difference. The members were sovereign countries with their own tax systems. Greece failed to qualify, but was later admitted on 1 January 2001. The Euro took the form of notes and coins in 2002, and replaced the domestic currencies. From eleven euro zone members in 1999, the number increased to 17 in 2011.

1.2 Justification for the Euro:

The overarching justification for the Euro was not merely economic, but political. A single currency was perceived as a symbol of political and social integration in the post WW II Europe and a catalyst for further integration in other spheres. At the micro level, the use of a common currency was expected to increase cross-border competition, integration and efficiency in the markets for goods, services and capital. These developments were expected to reduce transactions costs. The underlying logic for economies to integrate and adopt a single currency was based largely on the Theory of Optimum Currency Areas (OCA), pioneered in the seminal work of Robert Mundell (1961). At the macroeconomic level, a single monetary policy in the euro area was expected to be geared to price stability. According to the ECB, the monetary policy in the Euro system has been guided by two pillars. First, an inflation target broadly based on an assessment of future price developments and the risks to price stability in the euro area measured by the Harmonized Index of Consumer Prices (HICP) and second, a reference value -not a specific monetary target for the growth of a broad monetary aggregate. The Euro system's commitment to price stability was expected to contribute to the long-term stability and credibility of the euro and promote its attractiveness as a trading and investment currency. In the long run, the development and integration of the euro area financial markets was expected to enhance the attractiveness of the euro. The Euro was also expected to become an important currency in the foreign exchange markets. Faster growth hid the weakness in the fiscal system that got revealed with the worsening in the fiscal deficit and public debt. Growth was also accompanied by a rise in demand for imports and, in turn, a larger current account deficit from 2003. The rise in the twin deficits (refer to the chart below) were financed largely through debt, especially, in the case of Greece. So long as growth

was strong, it was hard to make out whether there had been an improvement in the fundamentals, or it was a bubble. Till 2005, the general growth momentum was in place, perhaps waiting for a trigger.

Source: Eurostat

1.3 Impact of Global Crisis on the Euro zone:

The global financial crisis in 200708 acted as the trigger that set the snow ball of debt rolling across Europe and in the euro zone as growth declined sharply. The financial crisis led to disruption in financial intermediation. The credit boom from 2003 lasting till early 2007 was supported by falling interest rates. But from 2006, interest rates across euro zone started to diverge, marking out the weak from the strong economies. Excessive lending had left banks with bad debts and governments with large fiscal deficit and public debt in the peripheral economies (albeit of varying magnitudes).

Source: Eurostat
In order to meet liquidity problem arising from financial crisis, on 11 October 2008, the EU held an extraordinary summit in Paris to define a joint action for the euro zone and agreed to a bank rescue plan to boost their finances and guarantee interbank lending. Coordination against the

crisis was considered vital to prevent the actions of one country harming another and exacerbating bank solvency and credit shortage. The various emergency measures announced to counter financial crisis during 2008-2009, appeared to have been successful in averting financial crisis and supporting short-term domestic demand. However, they aggravated fiscal deficit and debt. In late 2009, Greece admitted that its fiscal deficit was understated (12.7 % of GDP, as against 3.7 % stated earlier). Ratings agencies downgraded Greek bank and government debt. In late 2009, its public debt was over 113 % of GDP, far more that the euro zone limit of 60 %. A crisis of confidence due to high fiscal deficit and debt was marked by widening bond yields and risk insurance on credit default swaps. By early 2010, a sovereign debt crisis in the euro zone was clearly on hand with Greece in the eye of the storm. The problems of Ireland, Portugal and Spain were also out in the open. In May 2010, to reassure investors confidence, the EU and IMF put together a 110bn bailout package for Greece conditional on implementation of austerity measures. This was followed on 9th May 2010 by a decision by 27 member states of the European Union to create the European Financial Stability Facility (EFSF), a special purpose vehicle, in order to help preserve financial stability in Europe by providing financial assistance to euro zone states in difficulty. The EFSF was empowered to sell bonds and use the money to make loans up to a maximum of 440 billion to euro zone nations. The bonds were to be backed by guarantees given by the European Commission representing the whole EU, the euro zone member states, and the IMF. The agreement allowed the ECB to start buying government debt which was expected to reduce bond yields. As per the conditions, Greece was to mobilise $ 70 billion by way of privatisation of its state enterprises. In November, 2010 EU and IMF agree to bail-out the Irish Republic with 85 billion Euros. The Irish Republic soon passes the toughest budget in the country's history. The measures taken in May 2010 had a palliative effect. Serious doubts remained on the ability of Greece to service its debt and bond yields started to spike again. In April 2011, Portugal admitted that it could not deal with its finances and asked the EU for help. In May 2011, European finance ministers approved euro 78 billion rescue loans to Portugal. Meanwhile, Moodys lowered Greeces credit rating to junk status in June 2011. An extraordinary summit was again convened on 21 July 2011 in Brussels. The leaders decided to take measures to stop the risk of contagion. They agreed on a further bailout for Greece for 109 billion Euros with the participation of the IMF and voluntary contribution from the private sector in order to cover the financing gap. The EFSF was indicated as the financing vehicle for the disbursement with regular assessment by the Commission in liaison with the ECB and the IMF. All these measures have so far failed to assuage the financial markets. The indications are that the financial markets continue to be deeply sceptical about their effectiveness. While Greece remains an extreme case, the problem of public and private debt (in varying proportions) in other peripheral economies like Ireland, Portugal, Spain and Italy are also a source of concern albeit with their own peculiarities.

2. IS-LM Curve analysis of the Crisis

The Euro-Zone countries can be divided into two kinds: countries with strong economic power and those with weak economic power. Based on IS-LM model, and taking Germany and Greece as an example, assume that two countries economies are in equilibrium when they just entered the Euro-zone. In the initial state, the real interest rate of the two countries is equal, since European central bank applies unified monetary policy. Because the sizes of two economics are quite different, the German output far outweighs the Greek. Since the monetary policy of the two countries is unified, when the European central bank doesnt take large loose or tightening policy, the real interest rate of the two countries will not change caused by monetary policy. However, due to the great difference in the fiscal policy and factor endowments structure of Germany and Greece, for example, the German people are diligent, Germany has rich resources, advanced technology, advanced manufacturing industry, and reasonable economic policy, which make German people enterprising and Germany with good economic development, the real interest rate of the German rises, and the rapid development of Germany causes serious impact on Greek economy. Since, the capital will flow from the low real interest rates place to the direction of higher real interest rate place, and due to Euro-Zones monetary unification, exchange rate adjustment does not exist between the two countries, and the capital can flow smoothly.
Rate of interest Rate of interest

IS LM

LM IS LM

IS

r2 r1 r3

y1

y2

Income r2 New Interest rate due to inflow of money from Greece

y3

Income

r1 Interest rate at initial equilibrium

r3 Interest rate at New Equilibrium, which is lower than that of r2

IS-LM curve shift in Germany because of inflow of money from Greece

The German economic prosperity makes domestic investment rate of return (real interest rates) much higher than that of Greece, which therefore attracts the Greek capital to flow to Germany.

The outflow of the Greek capital will severely affect the development of domestic economy in Greece, so the Greek economy will appear passively decline, and the Greek recession will inevitably lead to fiscal imbalance. In order to maintain high domestic fiscal spending, Greece issues huge amounts of government bond for debt financing towards its people and allied country at any cost. On the other hand, the inflow of Greek capital to Germany will make the real money supply increase in Germany. Of course, the Greek economy is much smaller when compared with Germany, so the capital inflow into the Germany accounts for relatively small percentage of total German economy, but that can still cause the real interest rate of Germany to fall slightly. The ultimate result is the output of Germany increases, which not only because of its own enterprising spirit, but also because of the absorbed capital transferred from the Greece to make its output further increase.

3. Economic Effects of the crisis

3.1 Impact on Labour Market and Employment:
Until the financial crisis broke in the summer of 2007 the EU labour markets had performed relatively well. The employment rate, at about 68% of the workforce, was approaching the Lisbon target of 70%, owing largely to significant increases in the employment rates of women and older workers. Unemployment had declined to a rate of about 7%, despite a very substantial increase in the labour force, especially of non-EU nationals and women. Importantly, the decline in the unemployment rate had not led to a notable acceleration in inflation, implying that the level of unemployment at which labour shortages start to produce wage pressures (i.e. structural unemployment) had declined. Labour markets in the EU started to weaken in the second half of 2008 and deteriorated further in the course of 2009. In the second quarter of 2009 the unemployment rate had increased by 2.2 percentage points from its 6.7% low a year earlier. The sharpest increases in unemployment have been registered in countries facing the largest downturns in activity, notably the Baltic countries, Ireland and Spain. Almost three years of progress since mid-2005 in bringing the unemployment rate down from 9 had been all but wiped out in about a year. The increase in unemployment has so far been limited also by a contraction of the labour force (which declined by 0.3% in the fourth quarter of 2008 and 0.5% in the first quarter of 2009), which may be due to discouraged worker effects. These effects have been mostly reflected in developments in the number of non-national workers (constituting about 5% of the total labour force in the EU), whose growth rate almost halved from more than 7% over the last three years to a mere 4% on a year on year basis in the first quarter of 2009. Owing to recent reforms in many countries aimed at increasing the flexibility of the labour market and tightening eligibility conditions for access to non-employment and early retirement benefits a large reduction in the labour supply of nationals is not likely to occur though. This implies that further job losses are likely to be largely reflected in a higher unemployment rate.

3.2 Impact on Budgetary Positions:

The pace of deterioration of fiscal positions in the EU is comparable to earlier financial crisis episodes, with the fiscal deficit on average set to increase from less than 1% of GDP in 2007 to an estimated 7% of GDP by 2010. Similarly, the deterioration in the fiscal deficit as a share of GDP averaged about 7 percentage points for the major financial crises in the early-1990s in Finland, Norway, Sweden, Spain and Japan. The distribution of the increases in fiscal deficits, however, is uneven, even though fiscal positions have deteriorated virtually everywhere in the EU. Generally speaking, countries that had comparatively solid fiscal positions at the onset of the crisis are likely to remain below or close to the 3% of GDP mark this year and next. But otherwise there will be an almost universal breach of the 3% mark next year, if not already this year. By far the sharpest (projected) deficit increases rising to two-digit levels as a percent of GDP will occur in Latvia, the United Kingdom, Ireland and Spain. It is no coincidence that these countries' fiscal positions are being is proportionally hit, given that some of the mechanisms that shaped the crisis were particularly prevalent there. The United Kingdom and Ireland are important financial centers and all four countries have also seen major housing booms. Credit growth and soaring asset prices, in particular housing prices, tend to buoy government revenues during the boom and to result in large shortfalls in the subsequent slump. Link between fiscal shortfalls and housing and suggests that countries which had comparatively large construction sectors and/or elevated real house prices in 2007 have also registered the most rapid deterioration in their fiscal positions. A more formal analysis of the relationship between asset price and associated developments and fiscal outcomes is reported in European Commission. It distinguishes between a direct channel (transaction taxes and tax revenues stemming from construction activity) and an indirect channel that runs through the wealth and collateral effects on consumption and investment. It suggests that tax revenues grew strongly in response to the asset boom, although its impact on the fiscal position was muted since expenditure adjusted upward. In the downturn, revenues have responded equally heftily, in the opposite direction, but this has so far not been offset by adjustments in expenditure, which explains the sharp deterioration in fiscal positions. Regression analysis in the same report shows that the main determinants of the revenue windfalls (or shortfalls) reside in growth surprises (i.e. errors in growth projections). But after controlling for these growth surprises, house price developments explain a significant share of the windfalls in Ireland, Spain and the United Kingdom. Deteriorating trade balances associated with rapid growth in imports and weak exports in the run up to the crisis also yielded windfalls in several countries, reflecting that imports are part of the VAT tax base whereas exports are not. Both internal and external imbalances thus exacerbate the cyclical swings in the fiscal balance Obviously it would be wrong to attribute the entire increase in fiscal deficits since the onset of the crisis to the induced evolution of public expenditure and revenue, for example due to shrinking demand for housing, higher cost of unemployment insurance or other 'automatic' responses. In addition, governments have adopted fiscal stimulus measures under the aegis of the European Economic Recovery Plan (EERP). This fiscal stimulus is estimated to amount to up to 2% of GDP on average in the EU. With the rise in the fiscal deficit over that period estimated to average about 5% of GDP, the induced budgetary developments thus amount to around 3%.

4. Effects of Euro crisis on rest of the world

The global impact of a full on European credit crisis, which is one of the principal sources of global risk would be very bad indeed, slamming output by as much as 3 percent for the world's biggest economies. The impact on the world would be worse than the Lehman collapse. A Greek exit could trigger bank runs and capital flight in Portugal, Ireland, Italy and Spain and beyond, causing collapse in asset prices and large GNP falls. According to the IMF the euro zone accounts for about 14.5% of world economic output in 2010. The euro zones share of world trade is even greater than its share of output. It accounts for over a quarter of both world exports and imports in goods and services. From these figures alone it should be clear that a substantial downturn in the euro zone would have a significant effect on the global economy. With the eurozone accounting for almost a fifth of global output and over a quarter of world trade the knock-on effects are likely to be high. Eurozone imports could well fall sharply while many financial institutions would face difficulties. However, it is wrong to examine the eurozone question through the concept of contagion. If the rest of the world economy were healthy then it would be fairly resilient to a euro shock. The impact would be at least partly compensated for by activity elsewhere.

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Unfortunately, the weaknesses of the advanced economies stretch beyond the eurozone. The US, Britain and Japan all have trouble generating durable growth and all three have built up high debt levels as a result. America is the most important single economy because of its size. Its yawning current account deficit is merely the most visible expression of how its competitiveness is falling relative to the rest of the world. The eurozone crisis has distracted attention from Americas domestic weaknesses. China is the biggest question mark in relation to the durability of the world economy. However, without its rapid growth the global economy would already be in more serious trouble. Even in 2009, a terrible year for the global economy, China managed to expand by 9.2%. The multi-billion dollar question is whether China can maintain a rapid growth rate or whether it is likely to slow. China faces several potential problems, including the emergence of a financial bubble and weaker export markets. Finding a definitive question to how well it is coping is an urgent task in assessing the health of the global economy. The Euro crisis threatens the economic stability of much more than the Euro area alone. A weakened Europe implies slower export growth in developing countries as well as increased financial volatility. The Euro crisis may also be only the first episode in which post-financialcrisis vulnerabilities converge to such devastating effect, implying that similar dangers for developing countries could emerge from sovereign debt crises in other regions or another global credit crunch. In addition, the crisis underscores the importance of the IMF as a lender of the last resort. Impact of the Crisis on Developing Countries Exports: The Euro crisis is likely to deduct at least 1 percent of growth, and potentially much more, from Europea market that consumes more than 27 percent of developing countries exports, In addition, the euro has already devalued more than 20 percent against the dollar since November 2009 and the two could reach parity before the crisis is over. A lower euro will sharply reduce the profitability of exporting to the European market and will also increase competition from Europe in sectors ranging from agriculture to garments and low-end automobiles. Tourism and Remittances: A lower euro will reduce the purchasing power of European tourists traveling to developing countries, and the value of remittances originating from Europe. At the same time, a lower euro may provide opportunities for consumers and firms to import from Europe at a lower cost. Capital Flows: The Euro crisis will force the European Central Bank to maintain a very low policy interest rate for the foreseeable future. Similarly low rates in Japan and the United States,

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combined with low growth in Europe, may lead even more capital to flow to the fastest-growing emerging markets. This will lead to inflation and currency appreciation pressures, as well as increase the risk of asset bubbles and, eventually, of sudden capital stops in emerging markets. Market Volatility: The Euro crisis will add greatly to the volatility of financial markets and will lead to sharp bouts of risk-aversion. The VIX index, which measures the cost of hedging against the volatility of stocks, has more than doubled in the last two months. This, in turn, has increased the level and volatility of spreads on emerging market bondswhich have risen by more than 130 basis points since Apriland will make currencies more volatile across the globe. Credit Availability: The Euro crisis may constrain trade and other bank credit available to developing countries as it raises questions about the viability of European banksespecially those based in vulnerable countries whose assets likely include large amounts of their own governments bonds. But all international banks will be viewed as having either direct or indirect (through other banks) exposure to the vulnerable countries. The confidence that banks have in lending to each other has already fallen; the TED spread (the difference between the three-month inter-bank lending rate and the yield on three-month Treasury bills) reached a nine-month high of 35 basis points in May, up from this years low of 10.6 basis points in March. Contagious Crises: A failure to contain the crisis in Greece and its spread to Spain or other vulnerable countries will raise the alarm on sovereign debt in other industrial countriesfor example, Japan, whose debt-to-GDP ratio is projected to be nearly twice that of Greece in 2015and inevitably in any exposed emerging market. If more countries are hit, the pressures on trade, global credit, and capital flows to emerging markets will only increase.

4. POLICY RESPONSES: Crisis control and mitigation

Major policy initiatives have been taken in the EU pursuit of crisis control and mitigation. Financial rescue policies have focused on restoring liquidity and capital of banks and the provision of guarantees so as to get the financial system functioning again. Deposit guarantees were raised. Central banks cut policy interest rates to unprecedented lows and gave financial institutions access to virtually unlimited lender-of-last-resort facilities. Governments provided liquidity facilities to financial institutions in distress as well, along with state guarantees on their liabilities, soon followed by capital injections and impaired asset relief. Discretionary fiscal stimulus was released so as to hold up demand and ease social hardship over and above the automatic fiscal stabilizers. These crisis control and mitigation policies are largely achieving their objectives. Economic contraction has been stemmed and the number of job losses contained relative to the size of the economic contraction.

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4.1 Banking Support:

After the September 2008 events several countries scrambled to rescue their systemically important financial institutions, which exposed serious adverse spillover effects, e.g. associated with cross-border border banking groups or the nationality of depositors which grossly violated levellevel playing field conditions. This prompted an immediate and coordinated EU strategy to prevent an outright collapse of the financial system. Member State governments, together with the Commission, spelled out the principles and objectives for a coordinated approach to tackle the crisis. Rescue packages s for national banking sectors were rapidly set up, in line with the guidance swiftly provided by the Commission on the design and implementation of State aid in favour of banks. The main rationale of this guidance is to ensure that rescue measures can fully ful attain the objectives of financial stability and maintenance of credit flows. Central banks in turn responded by lowering the borrowing costs for banks. They also stepped up earlier measures to enhance market liquidity and later even resorted to unconventional policy measures like quantitative easing (as will be discussed in more detail in the next section). Since October 2008, the Commission has approved a total of over 3.5 trillion (almost one-third one of the GDP) of State aid measures to financial institutions. So far, EUR 1.5 trillion (13% of GDP) have been effectively used under the four main headings of debt guarantees, recapitalization, recapitalization liquidity support, and treatment of impaired assets. State guarantees on bank liabilities represent the largest budgetary commitment among the aid instruments, with EUR 2.9 trillion (25% of EU GDP) of approved measures, out of which EUR 1 trillion (8% of GDP) have been effectively granted. Set up as an immediate response to the drying up of liquidity in the interbank interb market in the early days of the crisis, their aim was to provide a timely solution to the lack of confidence and remedy the liquidity squeeze and its wider consequences. Member States have typically chosen to provide such guarantees in national schemes, schemes with a time limited window during which banks could make use of them them.

4.2 Macroeconomic Policies: Policies

A strongly expansionary stance the financial crisis led to, and was reinforced by, a steep decline in economic activity from the fourth quarter of 2008 onwards. This forced EU central banks and governments to adopt an extraordinary expansionary stance of macroeconomic policies. Besides the lowering of borrowing costs, central banks stepped in as central providers of liquidity,

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thereby ensuring the allocation tion of short short-term bank funding on dysfunctional money markets. Reflecting the discretionary fiscal stimulus adopted, but also, and more importantly, tax shortfalls and inertia in expenditure programs, program government deficits have increased more than twice as much as one would predict from the automatic stabilisers. The overall support of government finances to the economy in 2009 and 2010, as measured by the deterioration in the government balance, amounts to 5 percentage points in the EU (around 4.5 percentage points in the euro area).

4.3 Monetary Policies:

Central banks in the EU did respond decisively to the rising tensions on the money markets after the collapse of Lehman Brothers. The ECB lowered its borrowing costs by 50 basis points to 3.75 percent in early October 2008, in a coordinated move with the Bank of England, the Sveriges Riksbank and various non-EU non central banks. Besides the lowering of borrowing costs, as noted, central banks stepped in as central providers of liquidity, thereby ensuring the allocation of short term bank funding on dysfunctional money markets. To this end, the ECB satisfied all liquidity bids in its main weekly operations at a fixed interest rate, widened the interest rate corridor (with the ECB deposit rate at 0.25% since April Ap 2009, pulling the overnight rates effectively to zero) and provided liquidity in foreign currency. Moreover, the list of collateral eligible for refinancing was expanded, which facilitated banks' access to central bank money. With the objective of supp supporting banks' funding beyond very short short-term horizons, the ECB also raised the volume allotted in its three-month three refinancing operations and introduced sixsix month and twelve month refinancing operations. Comparable measures were also implemented by central banks outside the euro area. For example, the Bank of England extended the maturity of its discount window facility, conducted long-term long repo transactions and temporarily established a special liquidity scheme. In May 2009, the ECB added unconventional policy measures to its support of financial markets, agreeing to purchase euro-denominated euro covered bonds for a total amount of EUR 60 billion. This programme of credit easing is similar in kind to the asset purchase facility introduced by the Bank of England nd in March 2009.

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4.4 Fiscal Policies:

As noted, the EU has also contributed its fair share in terms of fiscal support to address the global downturn. With its European Economic Recovery Programme (EERP), the EU has defined an effective framework for addressing the economic downturn, combining active fiscal stimulus with structural reforms. The programme, as endorsed by the European Council in December 2008, is estimated to total almost 2% of GDP over 2009 2010, including EUR 20 billion (0.3 % of EU GDP) through loans funded by the European Investment Bank. For 2009, by far the largest fiscal stimulus package (in comparison to its GDP) was adopted by Spain, followed by Austria and, as indicated, the United Kingdom. For 2010, Germany and Poland stand out by their comparatively large fiscal stimulus packages. It should be noted, however, that implementation lags are likely to shift the measures back towards 2010-11. The growth impact of each package may differ across countries, depending on the characteristics of their economies (such as their openness or share of credit-constrained households) and depending on the composition of the packages. The range of the estimates reflects the uncertainty with regard to the extent to which the policy action is credibly temporary. Temporary fiscal stimulus typically has a stronger impact on spending or production given that households and businesses are induced to advance their spending or production plans as they would otherwise miss out on the opportunity. Measures which are not accompanied by a credible sunset clause will fail to produce such anticipation effects and also generate stronger nonKeynesian' saving responses as households and businesses take out insurance against the risks of unsustainable public finances. Another factor that can enhance the impact of fiscal stimulus is the response of the monetary authorities. If they consider the measures as credibly temporary (i.e. with a predefined exit), they may accommodate the fiscal stimulus by adopting an easier policy stance than they otherwise would do. Aside from the effectiveness of the packages, it is important also that the distribution of package sizes is appropriately mapped onto the distribution of countries' needs and their 'fiscal space' (i.e. their ability to temporarily run fiscal deficits without jeopardizing the sustainability of their public finances or their external positions).

4.5 Labour market policies:

The financial crisis and the ensuing global downturn are beginning to be felt in labour markets. Projections indicate that employment will decline over the next two years, leading to a steep rise in unemployment, which, on unchanged policies and labour market behavior, is set to exceed 10% on average in the European Union in 2012. Moreover, access to credit for individuals has become difficult and private pension funds are under severe strain as a result of the correction in capital markets. In a number of EU countries the adoption of temporarily shorter working hours or partial unemployment benefits prevented more significant labour shedding, in particular in manufacturing. The existing social safety nets are also cushioning the social impact of the economic downturn. In addition, Member States are pursuing a wide range of complementary employment policies aimed at containing the impact of the crisis on labour markets under the aegis of the EERP endorsed by the European Council of 12 December 2008. The assessment of crisis-related labour market policies needs to be seen in conjunction with the other features of the policy response to the crisis, in particular the financial markets measures, the fiscal expansion and structural reforms in product markets. In combination these measures are aimed at restoring

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confidence and supporting demand and potential growth and hence indirectly would also support employment.

5. Policy Implications
Though there are no one-size-fits-all prescriptions for developing countries given their very different starting points, some general policy conclusions emerge: Developing countries will need to rely less on exports to the industrial countries and more on their own domestic demand and South-South trade. In some cases, greater caution may be called for in reversing stimulus policies. In other cases, even greater prudence may be called for in containing fiscal deficits and moderating the accumulation of public debt. Given the sharp rise in exchange rate uncertainty, matching the currencies of foreign liabilities with those of export proceeds and reserve holdings will become even more important. The Euro crisis also calls for great caution in the way surging capital inflow is managed. In some countries, regulations to moderate the inflow of portfolio capital and to instead encourage the more stable form of foreign direct investment may be warranted. Countries with large external surpluses and that receive large capital inflows may allow their currencies to appreciate, as this may help both stimulate domestic demand and moderate inflationary pressures.

The crisis has exposed the limitations of regional mechanisms in dealing with financial crisis, even among countries with deep pocketsand underscored instead the vital role that a global lender of last resort, in the form of the IMF, can play. Not only can the institution bring more resources and broader expertise than would plausibly be available to a regional institution, but its distance from potentially divisive regional politics can also be a big asset.

6. The Challenges Ahead

The current crisis has demonstrated the importance of a coordinated framework for crisis management and prevention. It should contain the following building blocks: Crisis prevention to prevent a repeat in the future. It is of high importance to understand the causes of the crisis were and how changes in macroeconomic, regulatory and supervisory policy frameworks could help prevent their recurrence. Policies to boost potential economic growth and competitiveness could also bolster the resilience to future crises.

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Crisis control to minimise the damage by preventing defaults of banks or by containing the output loss and easing the hardship because of from recession. The main objective is thus to stabilise the financial system and the real economy in the short run. It must be coordinated across the European nations in order to strike the right balance between national disturbances and its resulting effects affecting other Member States. Crisis resolution to bring crises to a lasting close, and at the lowest possible cost for the taxpayer while containing systemic risk, securing consumer protection and minimising competitive distortions in the internal market. This in part requires reversing temporary support measures as well action to restore economies to sustainable growth and fiscal paths. This includes policies to restore banks' balance sheets, the restructuring of the sector and an orderly policy 'exit'. An orderly exit strategy from expansionary macroeconomic policies is also an essential part of crisis resolution.

At the crisis control and mitigation stage, financial assistance by home countries to their financial institutions may have potentially disrupting spill over effects. Moreover, it must be ensured that financial rescues attain their objectives with minimal competition distortions and negative spillovers. The coordinated response put in place in the autumn of 2008 in the face of the risk of financial meltdown shows that EU policymakers became fully aware of the need of a joint strategy. The need for deeper policy coordination and improved cross-border crisis management is a key lesson learnt from the recent crisis. Fiscal stimulus also has cross-border spillover effects, through trade and financial markets. Spillover effects are even stronger in the euro area in the absence of exchange rate offsets. At the crisis resolution stage a coordinated approach is necessary to ensure an orderly exit of crisis control policies. It is important that state aid for financial institutions or other severely affected industries not persist for longer than is necessary in view of its implications for competition and the functioning of the EU Single Market. National strategies for a return to fiscal sustainability should be developed, for which a framework exists in the form of the Stability and Growth Pact which was designed to tackle spillover risks from the outset. The rationales for the coordination of structural policies have been spelled out in the Lisbon Strategy and apply also to the exits from temporary intervention in product and labour markets in the face of a crisis. Within the euro area, the adjustment of excessive current account imbalances should be facilitated by both structural reforms and macroeconomic policies. For instance, surplus countries should implement measures conducive to stronger demand while deficit countries should be urged to not resist the unwinding of their construction slumps. At the global level an appropriate strategy to reduce the global imbalances should be adopted e.g. China should be encouraged to reduce its national saving surplus and change its exchange rate policy. The rationale for policy coordination is thus strong: without it, Member States would not sufficiently take into account the favourable or unfavourable cross-country spillover effects of their policy choice. 'Internalising' these spillover effects in their policy choices would benefit both the European Union as a whole and its Member States.

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7. Conclusion: Implications for Today

The 2010 crisis has had some fortunate consequences. It exposed weaknesses within individual countries and in the Maastricht Treaty. It confirmed that the Euro zone cannot rely on financial markets to address its own weaknesses. It revealed that some kind of permanent bailout procedure is necessary. And it showed that European leaders are still grappling with the seeds sown by the rapidity with which both German unification and the Maastricht Treaty were achieved. The challenge now is governance reform, not expulsion of member states. Reverting to national currencies would drive the values of reissued southern currencies into the ground and the deutsch mark into the sky, thereby undermining Germany's export competitiveness and job market, to say nothing of the collateral damage to the EU and the single market. The Euro zone crisis should not signal the end of the euro but rather the start of a long-overdue overhaul. Germany also needs to reconsider its calls for painful fiscal discipline on the part of the weakest countries until their economies regain footing. Ideally, but perhaps not realistically, Merkel should return to previous German form and spearhead a revision of the Maastricht Treaty, leading a fresh effort to do for political union. The unlikelihood of such a move exemplifies a fundamental problem within the whole EU: there exists a built-in tension between the lofty goals of integration and member states' collective unpreparedness to think through the consequences of their ambitious project. The great achievement of the past has been to reconcile these contradictory impulses by focusing on practical agreements. It is time to do so once again, and to realize that the necessary consequence of monetary union is greater political union. European integration has already transformed most of a famously bellicose continent into a stable zone of peace. Europeans should learn from the woes of 2010 and use them to produce momentum and legitimacy for deeper integration.

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8. References
1. 2. 3. 4. 5. www.wikipedia.com ec.europa.eu/eurostat www.ecb.int.com www.cfr.org Macroeconomics by Gregory Mankiw

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