The euro zone crisis its dimensions and implications

Introduction

Background

The euro area was established on 1 January 1999, when 11 of the then 15 European Union Member
States adopted the euro by irrevocably locking their bilateral exchange rates. The 11 were:
Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal
and Finland. Greece adopted the euro in 2001.The euro banknotes and coins were introduced on 1
January 2002, after a transitional period of three years (one year in the case of Greece) during
which the euro could be used as book money, while national banknotes and coins were still used in
cash payments.
Slovenia was the first of the 10 European countries that joined the EU in 2004 to adopt the euro,
on 1 January 2007. Cyprus and Malta will follow on 1 January 2008, bringing the number of euroarea Member States to 15. The euro area will then include 318 million out of the EU's total 493
million population. As of January 2008, of the 12 EU countries that have not yet adopted the euro,
10 have what is known as a derogation, which means that they do not presently fulfil the necessary
conditions to fully participate in the final stage of Economic and Monetary Union They are the
Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland and Slovakia (of the group that
joined the EU in 2004), Bulgaria and Romania, which became EU members in 2007, and Sweden.
Denmark and the United Kingdom have opted to stay out for the time being, .and negotiated two
Protocols to that end which are annexed to the Maastricht EU Treaty. However, the new Danish
government announced in its programme on 22 November 2007 that it wished to give the Danish
electorate the possibility of a fresh vote on the opt-outs concerning the euro and three other EU
policies.

The euro zone crisis

Over the last two years, the euro zone has been going through an agonizing debate over the
handling of its own home grown crisis, now the euro zone crisis. Starting from Greece, Ireland,
Portugal, Spain and more recently Italy, these euro zone economies have witnessed a downgrade of
the rating of their sovereign debt, fears of default and a dramatic rise in borrowing costs. These
developments threaten other Euro zone economies and even the future of the Euro.

Many experts agree that the eurozone crisis began in late 2009, when Greece admitted that its
debts had reached 300 billion euros, which represented approximately 113% of its gross domestic
product (GDP). Meanwhile, the European Union (EU) had already warned several countries about
their debt levels, which were supposed to be capped at 60% of GDP.
In early 2010, the EU noted several irregularities in Greece's accounting systems, which led to
upward revisions of its budget deficits. Ratings agenciespromptly downgraded the country's debt,
which led to concern among other troubled countries in the eurozone, including Portugal, Ireland,
Italy and Spain, whom also had lofty levels of sovereign debt.
The negative sentiment led investors to demand higher yields on sovereign bonds, which of course
exacerbated the problem by making borrowing costs even higher. Higher yields also led to lower
bond prices, which meant larger countries and many eurozone banks holding sovereign debt in
troubled countries began to suffer, requiring their own set of solutions.
After a modest bailout by theInternational Monetary Fund, eurozone leaders agreed upon a 750
billion euro rescue package and established the European Financial Stability Facility (EFSF) in
May of 2010. Eventually, this fund was increased to about 1 trillion euros in February of 2012,
while several other measures were also implemented to stem the crisis.
Countries receiving bailout funds from this facility were required to undergo harsh austerity
measures designed to bring their budget deficits and government debt levels under control.
Ultimately, this led to popular protests throughout 2010, 2011 and 2012 that culminated in the
election of antibailout socialist leaders in France and likely Greece.

Dimensions and implications of the euro zone crisis

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

The dispersion of country short term rates measured also reduced. Nevertheless. The Euro was also expected to become an important currency in the foreign exchange markets. Interest rate dispersion between the rates offered by different banks in also declined (Figure 2). and later in the physical form in 2002. Bond markets that were segmented got integrated in short period. . and then on.expected to enhance the attractiveness of the euro. Since the euro came into existence in 1999. there was convergence in the yields on government bonds (figure 1). From 1999 to 2002. there remained some skepticism on its future as some members had failed to stay within the norms under the growth and stability pact. the euro area money and financial markets saw rapid changes with the introduction of a new currency.

Figure 1 Source: OECD data .

Figure 2 Source: Eurostat data .

Thus similar instruments traded in the different national markets came to be perceived as close substitutes. These changes were facilitated by the target system that linked large-value national payments in the EU. \ . the establishment of common benchmarks and lower transaction costs led to narrowing of yield and spreads and market liquidity across borders. Construction and financial services grew rapidly thereby increasing macroeconomic vulnerability. Credit growth surged as currency risk premium diminished and competition spurred financial innovations as financial institutions could borrow easily abroad (figure 3).Increased competition. The growth in credit was concentrated in the housing sector. the credit growth got translated into a buildup in debt. While property prices boomed (figure 4).

Figure 4.Source: IMF. IFS data Figure 5 Source: FT. com .

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).Global crisis to the Euro zone crisis The global financial crisis in 2007 to 2008 acted as the trigger that set the snow ball of debt rolling across Europe and in the euro zone as growth declined sharply (figure 5). The credit boom from 2003 lasting till early 2007 was supported by falling interest rates. The financial crisis led to disruption in financial intermediation. Figure 6 Source: Eurostat . But from 2006.

However. private debt and bank lending across these economies was considerably different. 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. its public debt was over 113 % of GDP. In late 2009. they aggravated fiscal deficit and debt. albeit differentiated After all.7 % of GDP. the configuration of fiscal deficit. a sovereign debt crisis in the euro zone was clearly on hand with Greece in the eye of the storm. far more that the euro zone limit of 60 %. Greece admitted that its fiscal deficit was understated (12. Ratings agencies downgraded Greek bank and government debt. A crisis of confidence due to high fiscal deficit and debt was marked by widening bond yields and risk insurance on credit default swaps. The various emergency measures announced to counter financial crisis during 2008-2009. Portugal and Spain were also out in the open. public debt.that on the extreme. appeared to have been successful in averting financial crisis and supporting short-term domestic demand. all private debt could potentially be public debt. Even though. . In late 2009.In order to meet liquidity problem arising from financial crisis. the global financial crisis had brought home an important lesson . By early 2010. The problems of Ireland. as against 3. on 11 October 2008.7 % stated earlier). the financial markets passed a similar judgment through a rise in the CDS premiums. Coordination against the crisis was considered vital to prevent the actions of one country harming another and exacerbating bank solvency and credit shortage.

The economy expanded rapidly during 1997–2007 with investment stimulated. The property price crash by the first half of 2009 broadly coincided with the tightening of credit control.Critical dimensions of the Euro zone countries We recount some of the specificities of the problem faced in these economies before reverting to the overarching dimensions and implications of the euro zone crisis and are as follows: Ireland The case of Ireland has been marked by an almost whole sale nationalization of the banking sector that translated into severe fiscal stress. there was rapid expansion of credit and property valuations from 2002 to 2007. Portugal While the Financial Crisis affected the Portuguese economy on account of which its fiscal deficit and public debt deteriorated from -3. in part. due to a low corporate tax rates. Spain Spain like Ireland. The economy witnessed a real estate boom with construction representing close to 16 per cent of GDP. The rise in mortgages was accompanied by banks relying heavily on whole sale external borrowing.1 per cent and 68 per cent of GDP (in 2007) to -10 per cent . In cumulative terms. As the real estate boom collapsed there was a rise in the levels of personal debt. On the public finances front. This changed with the global crisis. With low interest rates. the Ireland was hailed as the Celtic tiger for its economic dynamism. was considered a dynamic economy and till 2005 and attracted significant foreign investment. housing prices fell significantly from 2007. As property prices showed a downward movement from 2007 Irish banks stood exposed and came under severe pressure. tax revenues collapsed. deficits soared and the budget position moved to a deficit of over 11 per cent in 2009 Interest rates on lending to companies and other categories showed an upward turn and financing continued to decline indicating weakness of the economy. But not long back.

Italy‘s public debt and external debt ratios at 119 and 108 are rather large.south divide with the southern parts witnessing chronically high unemployment rates. Public debt and deficit is also lower than Greece. the down turn in GDP growth for Portugal was one of the mildest (only -2.bust situation. has a significantly large external current account deficit and external debt fuelled largely by private sector borrowing.4 per cent is lower than the average for the euro zone. . In that respect. it has large private tradable debt which makes it very difficult to rescue. It has been a slow growth economy with GDP growth averaging just about 1 per cent per annum over 2000-07 as compared to close to 2 per cent for the euro zone. Portugal. Italy has always been characterized by north. While its fiscal deficit at -4.5 %) compared to a sharper decline in the rest of the euro zone.6 per cent of GDP in 2010 is lower than the . however. Italy Italy is the eighth-largest economy in the world and the fourth-largest in Europe in terms of nominal GDP (in 2010).6 per cent for the euro zone. While its unemployment rate at 8.and 83 percent in 2009. the situation of Portugal is unlike the other peripheral economies that witnessed a boom. Even though much of the public debt is held by its residents.

causing further rise in bond yields and tensions in bond market as well as creating difficulty in raising money by governments due to the low trust Creditors had after the downgrade in their ability to repay at maturity Political Conflict . The problem does not stand at that extent but that the EU also accepted high budget deficit and debt levels by many countries during the crisis Banking Sector Problem The European banking sector appeared to be vulnerable as it has showed a dramatic collapse since it got involved in the global financial chain that was dragged down in the 2007 financial crisis. The usage of financial instruments that included high risk such as CDOs in addition to Credit Default Swaps that was ignited by speculations the euro bloc will collapse have left banks in a weak position as they have to use their money in financing government budget deficits rather than doing their key role of providing lending to businesses and households Rating agencies It is clear that rating agencies have played a principle in letting the crisis reach what it has reached so far as they continued. which was buoyed by the burst of the mortgage bubble in the United States.Causes of Euro zone crisis Violation to EURules The very beginning of the story is actually coming back to earlier stages at the time European nations were eager to form a monetary union that took several steps ending with the inception of the euro in 1999 as many participants violated the conditions needed under the Maastricht Treaty in 1992 Countries such as Greece and Cyprus did not give real data about the financial and economic situation and the EU probably knew but ignored and accepted the accession of such counties to enlarge the European cartel. since the beginning of the crisis. to downgrade troubled euro area nations due to the risks stemming from the debt crisis.

governments have assumed their debts. the holders of these countries’ bonds demand higher interest rates to compensate them for the risk of default. but since they are too big to fail. Fiscal austerity and the debt trap . Germany has remained stick to its austerity-led strategy to deal with crisis even if this would come at the expense of nations that have refused sharp spending cuts and tax levies and have expressed their rage in the form of strikes and giving punishing votes to anti-austerity parties like what happened in elections in Greece and Italy Fiscal profligacy and rising national debt Some governments have spent much more than their tax revenues over many years. there is the risk of financial contagion. No country that has substantial national debt to be recapitalized is immune from such self-fulfilling prophecy. Thus national debt soared.As is well known. Panic and self-fulfilling prophecy When financial markets doubt that vulnerable countries can repay their debts. which is so-called peripheral nations. thereby causing the national debt to explode. The higher interest rates makes it more difficult for the countries to repay their debt. politics and economics are two sides of one coin and the role of politics in the debt dilemma cannot be ignored as the different political perspectives between parties having different ideologies have created a kind of conflict between European decision makers as Germany and other rich nations were on one hand refusing to let taxpayers pay for the crisis and have refused any decisive methods including violation to their sovereignty while the other camp. Furthermore. Shaky banks that is too big to fail These banks have taken risks that have gone wrong. In spite of the changes in Parliaments throughout the years of the crisis. have been asking for more flexibility. since the countries are financial interdependent.

since their common European identity is not sufficiently strong. But this policy failed because it deepened their recessions. If governments conducted such transfers anyway. the most vulnerable countries were forced to slash government expenditures and raise taxes. open-ended fiscal transfers from creditor countries (like Germany) to debtors (like Greece). The aim was to reduce their debt. which lowered tax receipts and raised government transfers. voters would revolt and thereby put European integration in jeopardy. Fiscal autonomy and weak European identity The crisis could be overcome if all euro area countries combined their budgets and centralized their budgetary decisions. This would require large. long-term. So these countries fell into the debt trap: their debts grew while their ability to repay them shrank.In return for bailouts. But popular consent for such transfers is lacking. . The creditor countries’ populations are unwilling to support the debtors.

since the compression at this juncture would be extreme. A further step would then be to move the ECB into the role of a proper central banker and then floating euro bonds. between what are clearly a few strong and other weaker economies is going to be a major political and economic challenge. in particular. This is the default policy choice. Germany will face a daunting challenge of supporting a large part of the transfers. it may be necessary to build an institutional framework that permits a multi speed Europe rather than hoping for complete convergence that breaks down in times of stress. while the poorer countries facing the problems complain that austerity is only hindering economic growth prospects further. Germany has been through a similar. The second option. step up fiscal transfers and absorb a large and a substantially poorer labour force. the question is whether. A fiscal union. the current strategy of announcing short term palliatives such as further bail outs along with sharp fiscal consolidation may only prolong the agony but not deal with the uncertainty prevailing in the euro zone. in the event of a fiscal union materializing. For dealing with the EZ crisis. at all. the possible alternatives being debated are on three broad lines. (if not the same) experience. would be to go in for a closer fiscal union and a substantially enlarged European budget with a limited system of fiscal transfers from rich countries to the poor countries. The peripheral economies are subject to a large mismatch between revenues and expenditure at the level of the government and at the household level leading to unsustainable governments and private debt. . The first is the route of austerity. the most recent being the experience of German unification where the country had to set up the Treuhandanstalt. (rather an imperative). A forgone conclusion is that this will impose social costs. fiscal consolidation. this choice does not address the structural problems faced in the peripheral economies. In any case. greater cross border investment even if this implies takeover of sick and ailing public sector units by companies from the richer Euro zone states. Real growth is stagnating and prospects of exports leading growth appear dim. Rich countries like Germany have insisted on austerity measures designed to bring down debt levels.Recommendations The failure to resolve the eurozone crisis has been largely attributed to a lack of political consensus on the measures that need to be taken. if that be the future road. Therefore. The possibility that these economies will grow themselves out of the problem seems remote. While fiscal consolidation is desirable. In light of the experience thus far. this choice will lead to sustained growth in the near future. a common form of protection for employment on the German lines with more flexibility. including privatization. Ironically.

countries no longer fall into the debt trap. since the reputations of the other countries are protected through their fiscal rules. Commercial banks would be required to pay for the costs of their risks. Eichengreen 2007) The constitutional amendment sets limits on the government deficit or surplus in each phase of the business cycle. country’s business cycle needs to be estimated. thereby reassuring financial markets and preventing panic. of peripheral economies leaving the euro zone. The European Central Bank (ECB) must develop clear. the sub-prime crisis may almost pale into insignificance (Pagano. it could lead to insolvency of several Euro zone countries. The constitutional limits will also ensure that the country will approach this long-run debt ratio in accordance with the government’s specified fiscal convergence rate and its desired degree of fiscal counter-cyclicality. The fiscal rule eliminates the possibility of fiscal profligacy. who borrow do the same from the ECB. transparent and public criteria for evaluating whether a country is solvent. But if that were to happen. Since each government formulates its own fiscal rule and passes its own constitutional amendment. since . Commercial banks must be required to cover their debts at market rates – rather than the currently practice of borrowing at artificially low rates from central banks. A breakdown of the currency may be a very expensive proposition. ECB lending in times of crisis is then no longer problematic. contagion effects and instability could spread through the financial system. a breakdown in intra zone payments. Notwithstanding the political challenges en route. The strengths of this plan are straightforward. Since the fiscal rule permits countercyclical fiscal policy. it retains fiscal sovereignty.It was successful. For this purpose. a creditable road map towards fiscal union will undoubtedly be a challenge and require considerable groundwork. The ECB has a mandate to lend to such countries when they encounter temporary liquidity problems. this option is hardly finding favour in the big two (Germany and France) due to the fiscal burden that may befall them. this should be done by a independent experts. The process culminated in the adoption of the 2010 plan and Germany bouncing back as the economic power house of Europe. But as of now. Insolvent countries are no longer financially contagious. as specified by the European Stability and Growth Pact. Solvent countries are the ones that can implement their fiscal rules while pursuing positive long-term growth per capita. An insolvent country would follow a specified default procedure. In comparison. The third option is the radical one. 2010. These limits ensure that the country’s long-run national debt remains below 60 percent of GDP. whereby the country’s bondholders would accept a haircut on repayments. Given that public debt in these countries is present in the balance sheets of banks and insurance companies across the world.

. Thus the ECB could remain credibly committed to its objective of keeping inflation under 2 percent.solvent countries are able to service their debt.

if at all. to make the choice on ‘The Euro’ – as Eichengreen put it. we conclude by observing that neither of these two roads would be easy. but the consequences will undoubtedly be economic.Conclusion The sovereign debt problems in the peripheral economies of the euro zone has started to pose a serious threat to the main economies of the Europe and perhaps to the future of the euro‘itself. the options. the one that carries with it the vision of unification still holds a dream but the other route may only take the euro economies further apart. fiscal and financial system. The outcome of the current crisis may be a matter of conjecture. to do what needs to done. Such a situation is a far cry from the optimism and grand vision that marked its launch. The paper shows that the crisis is not merely related to sovereign debt and bank financials but also rooted in the real economy with structural problems. It is an attempt to understand the implications of the ongoing euro zone crisis and the factors that make it somewhat unique as the contradictions of a monetary union without a fiscal union are coming to fore. to ‘love it or to leave it’ and depending on that. The manner in which the crisis is dealt is likely to be of far reaching significance to Europe and to the rest of the world. None of the three choices are simple. Rather. The stage seems set for a change in the way in which the euro zone will need to manage its monetary. As we have argued. The choices will have to be political. The issue is not any more on how to deal with the current crisis. In the end. . before the Euro zone and indeed the EU are very stark. Status quo is also not an option.

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