Europe’s Sovereign Debt Crisis

Europe’s Crisis
• Easy global conditions during 2002-08 that encouraged high risk taking and borrowing practices – resulting in the real estate bubble and consequent global recession during 2008-12. • Divergence between monetary union and fiscal policies – member countries circumvented the Maastricht Treaty (1992) for limiting deficit spending and debt levels. This feature brought fiscal free riding of peripheral economies. • Bail-out of troubled banks by governments – assuming private debt burdens or socializing losses. For example, in Ireland banks encouraged a property bubble and then were bailed out by the government • In Iceland, the banking system increased tremendously, thus creating debts to global investors • A number of euro economies had high trade deficits

Europe’s Crisis
• In Greece, the economy was especially hit during the recession because of the downward trend in shipping and tourism industries – these industries are especially sensitive to changes in the business cycle. Greece also increased commitment to public workers whose real wage doubled in real terms in 10 years. • Greece hid its growing debt and deceived EU officials with the help of derivative products designed by major banks – resulting in substantial fee income by banks but long term problems were not solved. • When a nation defaults on its sovereign debt or enters into recession, then the banking systems of creditor nations also get affected – financial contagion. Also there was the phenomenon of credit protection through credit default swaps (CDS)

Europe’s Crisis
• The average fiscal deficit in the euro area in 2007 was only 0.6% of GDP but rose to 7% during the financial crisis. The average government debt rose from 66% to 84% of GDP numbers during this period. By themselves, these numbers are not alarming. • Another problem is that the household debt in advanced countries rose 39% to 138% during this period. • Bringing down of Greece’s primary deficit from 10.6% of GDP in 2009 to 2.4% of GDP in 2011 has contributed to worsening of the recession. We perhaps need a soft landing and not hard landing. • Leaving the euro and reintroducing the drachma may not an option – experts fear substantial devaluation, rise of debt to GDP ratio to over 200% and soaring inflation.

Europe’s Crisis
• One trillion euro bail-out package announced for the euro area by creating a European Financial Stability Facility. Further, banks would accept a 53.5% write-off of Greek debt owed to private creditors. To restore confidence in Europe, the focus across all EU member states has been gradually to implement austerity measures. • Many economists believing in Keynesian policies however, have criticized the extent of austerity measures for their negative impact on economic growth. Hence, some encouragement for infrastructure projects as well as easy liquidity to kick start the economies. • Issues relating to welfare measures, old age, stagnating birth rates, etc. complicate the long term prospects of euro economies.

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