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The Eurozone Financial Crisis

Facts about European Union

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The Eurozone is a term used to describe the region of countries using the Euro (currency). This then includes many of the countries of the EU such as Germany, France and Greece, but not all of them (countries like England and Poland still use their own currencies). The Eurozone crisis then refers to the plunging value of the Euro caused by the economic crisis and amplified by the multitude of countries using the system. The problem is, that while one country might be coping well with the financial hardships, others that are fairing less well (such as Greece) can end up pulling the value back down making it a vicious cycle and one that is hard to escape from.

This Eurozone crisis however is not a problem that is contained to Europe; rather it is one that affects the rest of the world through investments, debt and trade and that is risking serious global economic decline. It is in every one s best interests to solve this crisis as soon as possible. Many meetings have been held between the member states of the EU to this end, but as yet no satisfactory solution has been found.

Germany has been shouldering much of the brunt of the economic turmoil and handing bail outs to Greece, but this not yet enough. Other causes of the Eurozone crisis include too much debt from the member states, a lack of competition between the countries, the differing mechanisms of the various economies tied to one currency, and disagreements coming from the lack of a single authority and so many different member states each with vested interests a 17 headed hydra . Criticisms have been leveled at the very idea of a single currency which some skeptics see as unstable and unfeasible.

What went wrong in Greece?

Greece's economic reforms, which led to it abandoning the drachma as its currency in favour of the euro in 2002, made it easier for the country to borrow money. Greece went on a big, debt-funded spending spree, including paying for high-profile projects such as the 2004 Athens Olympics, which went well over its budget.

Opening Ceremony

The country was hit by the downturn, which meant it had to spend more on benefits and received less in taxes. There were also doubts about the accuracy of its economic statistics. Greece's economic problems meant lenders started charging higher interest rates to lend it money. Widespread tax evasion also hit the government's coffers. There have been demonstrations against the government's austerity measures to deal with its debt, such as cuts to public sector pay and pensions, reduced benefits and increased taxes.

Greece's economic problems meant lenders started charging higher interest rates to lend it money. Widespread tax evasion also hit the government's coffers. There have been demonstrations against the government's austerity measures to deal with its debt, such as cuts to public sector pay and pensions, reduced benefits and increased taxes. The EU, IMF and European Central Bank agreed 229bn euros ($300bn; 190bn) of rescue loans for Greece. Prime Minister George Papandreou quit in November 2011 after trying to call a referendum. If Greece were to default, and even leave the euro, it would cause a major financial crisis that could spread to much bigger economies such as Italy and Spain. Under Prime Minister Lucas Papademos, Greece is trying to negotiate a big write-off of private debts and secure a second bail-out of 130bn euros ($170bn, 80bn) before a 20 March deadline.

The Eurozone Financial Crisis

Transmission from the United States Housing Price Bubble and Collapse Financial Market Freeze and Collapse Policy Response
Support for Financial Sector Monetary Policy Fiscal Policy

Effect of the Euro Currency Zone Greece s Problems

Transmission from United States

US Housing Bubble created by
Low interest rates Lax regulation of sub-prime mortgages with adjustable rates, two year teaser rates Securitization of mortgages, sold to unwary buyers as highly rated

US Bubble popped when

Interest rates rose in 2006, housing prices fell Subprime mortgages and securities defaulted

European Crisis Began Later

US Housing Prices peaked in late 2006 European Housing Prices peaked a year later Financial Crisis struck Europe & US at same time, August 2007, after Bear, Stearns, Fannie Mae & Freddie Mac taken over with US Government assistance in April and July of 2007 International credit markets froze up in August 2007 when subprime based hedge funds collapsed in Europe and US. No longer able to borrow short-term funds, banks faced much higher risk premia

Interest Rate Spreads in Dollars and Euros

Why did the Crisis Spread?

Subprime Debt Obligations made in USA held around the world caused global financial shock. Housing bubbles burst in UK , Ireland, Spain as well as US. Failure of Lehman Bros in September 2007 caused massive panic over counterparty risk. AIG required $180 billion bailout to cover Credit Default Swaps, insurance against bond defaults underwritten without reserves. Stress on banks around the world led to shrinking credit availability. Shadow off-balance-sheet banking sector collapsed as short-term funding vanished. Falling demand spread from US to all countries; as US imports dropped, other countries exports fell.

Banks Under Duress: Writedowns and Capital Raised (US$ billions)

Source: International Monetary Fund (2008)

Quarterly Real GDP Growth Rates

Source: International Financial Statistics, IMF.

European Financial Institutions under Stress

BNP-Paribas forced to close funds in August 2007 UK bank Northern Rock taken over by government German state banks IKB, WestLB, BayernLB and SachsenLB bailed out by government Irish banks given government deposit guarantees Switzerland injects funds into UBS Iceland s banks unable to roll over short term borrowing, default on deposits of foreigners

Credit in the Eurozone (% change)

Source: European Commission (2009).

Monetary Policy Response by European Central Bank (ECB)

ECB injected liquidity into European banks unable to obtain short-term funds in market. Federal Reserve used Euro-dollar swaps to make dollars available to ECB to lend to banks. ECB did not lower interest rates until October 2008 because of its focus on inflation. Euro fell against the dollar due to safe haven flight to US Treasury securities.

Interest Rates in the Eurozone and the US (interbank rates)

Sources: ECB, Federal Reserve Bank of New York

Financial Sector Bailouts in US & Europe

TARP and Federal Reserve programs in US National programs in European countries, due to absence of Eurozone-wide regulator. Beggar-thy-neighbor effect, as first Ireland gave deposit guarantees, then UK, then Netherlands, to avoid bank deposit flight.

Beggar thy neighbour?

The term was originally devised to characterize policies of trying to cure domestic depression and unemployment by shifting effective demand away from imports onto domestically produced goods, either through tariffs and quotas on imports, or by support to your own banks. The policy can be associated with mercantilism and the resultant barriers to pan-national single markets.

Public Support to the Financial Sector (as of 18 February 2009, % of GDP)

Source: International Monetary Fund (2009).

Fiscal Policy Responses to Recession

Automatic Stabilizers of falling taxes, rising welfare and unemployment payments kick in as incomes fall and unemployment rises. Discretionary Fiscal Stimulus enacted in most countries, depending on their fiscal positions. European countries limited by Stability and Growth Pact to 3% fiscal deficits, except in time of exceptional economic distress.

Changes in Budget Balances, October 2008

Source: IMF (2009)

The Role of the Euro

Previous economic crises in Europe have led to large devaluations of currencies. Within eurozone, single currency prevents devaluation , provides automatic financial support through capital markets. Non-euro currencies depreciated sharply in 2008, British pound sterling, Swedish kronor, Polish zloty, Hungarian forint.

Exchange Rates vs the Dmark or euro (Left Index: 1970q1 = 100 Right Index: 2007m1 = 100)

Source: International Financial Statistics, IMF, Monthly Bulletin, European Central Bank

What is the problem?

The Germans say that some lazy, spendthrift bums (collectively called PIIGS Portugal, Italy, Ireland, Greece and Spain) have run up huge fiscal deficits and debts and want to be rescued time and again by the productive, prudent Northern Europeans like the Germans. Voters in the Northern Europe are now revolting against further rescue of the bums. Such rescues will be made only if the bums accept truly draconian measures to shape up and reduce their deficits.

Greek protests against Austerity Measures

Greece s Financial Problems

Since joining the euro, Greece has had higher inflation than other Eurozone members. Greece has also increased debt faster than others to finance generous public sector pay, welfare, and retirement benefits, while collecting a lower share in taxes due to widespread tax evasion. As a result, Greek goods have become increasingly expensive and uncompetitive, causing loss of market share and further reducing revenues.

Relative price indicators based on export prices

120 115 110 105

100 95 90 85 80 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Greece Spain France

Source: European Commission (2010)

Why is this so?

The Euro s value pools the strength and the weaknesses of individual members. So, the Euro is greatly undervalued for an economy as productive as Germany s, and this artificially boosts German Exports. But the euro is also greatly overvalued for the less productive economies of the PIIGS and prevents them from exporting more. Seen in this light, the PIIGS are providing huge support for Germany s exports at their own expense.

The Irony of the Problem

1) Germany has easily been the biggest beneficiary of the European Union selling its goods to its neighbours without custom duties or tariffs. 2) The bare truth is that one country s exports are another country s imports. Thus if Germany is prospering its because the others are deepening their fiscal deficits by importing German Goods.

3) The PIIGS certainly need to improve their productivity, savings and exports. But they find exports difficult not simply because they are lazy bums but because they are locked into a common currency, the Euro. 4) So they cannot devalue to offset the fact that German Productivity and Quality is higher than theirs and thus they need to lower their prices in order to get export orders. 5) Some Germans want to impose such humiliating conditions on the PIIGS that they will be converted into vassal states. 6) All government spending in these countries will be controlled by a special EU commissioner.

The Greek Debt Crisis

Greek debt/GDP ratio reached 113% and deficit/GDP ratio reached 12.7% in 2009. Foreign bondholders became doubtful that Greece could continue to roll over its increasing debt, forced interest rates higher. EU faced choice between Greek default and bailout with tough conditions. IMF and EU agreed to lend Greece up to $146 billion over three years. Greece to increase sales taxes, reduce public sector salaries, pensions, eliminate bonuses.

Greece s Debt Dynamics


7) The fiscal discipline demanded of them as of now has already plunged the PIIGS into a deep recession with wage freezes and mass unemployment. 8) Any more external control of the Greece s spending and Taxation will be a recipe for the breaking up of the Eurozone. 9) Germans want to have the Euro and the Eurozone. They just don t want to pay the price required for its survival. 10) Something will have to give.

The End