Reasons for Euro Crisis

Submitted By: Abhinav Gupta Sagar Kundu

Table of Contents
• • • • • • The Euro Boom Monetary Policy Fiscal Policy Mismatch Other Reasons Reasons for Euro crisis in some countries in particular • References

The Euro Boom
• In February 1992, European leaders signed the Treaty on European Union (also known as the Maastricht Treaty), laying the foundation for monetary union and adoption of the euro • The agreement eventually bound the currencies and monetary policy of the signatories—which included all the GIIPS except Greece—to that of Germany, Europe’s largest and most stable economy, and to those of other successful economies in northern Europe.

Monetary Policy

Fiscal Policy

• The single European monetary policy was too loose for the rapidly growing GIIPS (Spain, Greece, and Ireland) and too tight for Germany, whose domestic demand and wages grew very slowly compared to the European average. This reinforced the loss of competitiveness in the GIIPS

Difference in Expenditure

• The financial crisis in 2008 brought an abrupt end to the post-euro growth model in the GIIPS. As they plunged into recession and tax revenues collapsed, government spending was revealed to be unsustainable and their loss of competitiveness dimmed hopes of turning to foreign demand for recovery. The GIIPS are left with high public and private debts and weak long-term growth prospects, unless they make difficult adjustments to cut deficits and restore competitiveness.

Widening External Imbalances
• Low interest rates and improved confidence fueled a domestic demand surge partly financed by foreign lending. The GIIPS, especially Greece, Ireland, and Spain, saw an increase in domestic spending accompanied by deteriorating current account balances and rising private debt

Expanding Government
• In all of the GIIPS, lower borrowing costs and the expansion of domestic demand boosted tax revenues and tempted governments to expand spending as well. Rather than recognize that the revenue increases from the boom were windfall gains that should be saved, the GIIPS accelerated government spending. • From 1997 to 2007, public spending per person rose by an average of 76 percent and government’s contribution to GDP rose by 3.5 percentage points. In the EUN, average per capita spending increased by 34 percent and the government’s contribution to GDP stayed constant.

No Political Integration

Gain of Some countries
Countries like Germany saved billions of Euros as they had to pay less interest on loan taken compare to other like Greece etc. As such countries benefiting are reluctant to solve this crisis.

Other Reasons
Confidence in the prospects for growth and stability of the economies of Greece, Ireland, Italy, Portugal, and Spain (GIIPS) surged when the euro was introduced, causing their interest rates to decline to those of Europe’s more stable members

• Improved confidence and lower interest rates drove up domestic demand in the GIIPS and investors and consumers were emboldened to increase spending and run up debts, often owed abroad as foreign capital flowed in

• Growth accelerated and the prices of domestic activities (i.e., those least exposed to international competition, such as housing) rose relative to the price of exportable or importable products, attracting investment into the less productive non-tradable sectors and away from exports and industries competing with imports.

• Meanwhile, exports rose sharply as a share of GDP in Germany, the Netherlands, and other historically stable countries in the European core. Growing demand in the GIIPS enabled these core countries to increase exports. The adoption of a common currency whose value was based on broader European competitiveness trends that made it lower than the deutschmark or guilder might have been, made their exported goods more affordable.

• The domestic demand boom in the GIIPS induced rapid wage growth that outpaced productivity, increasing unit labor costs and eroding external competitiveness further. This trend was reinforced by especially rigid labor markets in most of the GIIPS. The emergence of China, as well as currency depreciation and rapid labor productivity growth in the export sectors of the United States and Japan, added to the competitiveness problems of the GIIPS.

• Lower borrowing costs and the expansion of domestic demand boosted tax revenues in the GIIPS. Instead of recognizing this as temporary revenue and saving the windfall gains for when growth slowed, GIIPS governments significantly increased spending. Blatant fiscal mismanagement added to the problems in Greece.

Reasons for Euro crisis in some countries in particular

• Ireland not long ago was described as a Celtic Tiger as it was one of the fastest growing economies. • Number of Irish banks had taken foreign loans to fund the economy’s growth. Most of the money was channeled into property markets. • With the faltering of the economy there was a worry that these loans extended by the banks would go bad. Depositors then started increasingly withdrawing their deposits. • The Irish Govt in order to stop the run on the deposits guaranteed all the bank deposits and took over the commitments of banks. • Many loans given by the Irish banks are now becoming bad. Consequently there is a fear that the Irish Govt has bitten more than it can chew and it may not be able to honor all commitments. It is in such times that lenders typically respond in a manner that makes the crisis get worse.

• Greece had a very liberal social security program for its citizens like early retirement, good pensions, Govt aided healthcare , education etc. In fact though costly, they were heavily subsidized for the citizens, as the Greek Govt was bearing the major part of the expenditure. • Tax collections which were comparatively low due to the high tax evasion further declined due to the recessionary conditions post the subprime crisis. • The Greek Govt had to go on a borrowing spree to finance its expenditure. It is also true that the earlier Govt of Greece had understated the loans it had taken, to gain entry into the Euro. The situation in Ireland is however different.

• Portugal languished for much of the 20th century on Europe’s geographic and cultural margins. From the 1920s until the 1970s, a repressive dictatorship smothered the nation and its economy. Once the center of a global trade empire, Portugal became Western Europe’s poorest nation. • After decades of basing its economy on its low labor costs, Portugal was hit hard by the eastward expansion of the European Union and the loosening of trade barriers with Asia. As its economy dragged along as its European neighbors grew during the early part of the past decade, Portugal accumulated large and growing debts.

• Spain fell into an economic downturn in 2008 due to the collapse of its housing market, and economic conditions worsened when it became clear how entrenched the country’s unregulated savings banks were in the real estate market. • Increased public benefits caused higher government spending and government debt skyrocketed. Like other European nations, with Spain’s rising debt, investors. However, what was a sustainable unemployment level quickly became a drain on the Spanish government. • The reduction in the Spanish government’s tax revenue, which is heavily dependent on real estate, exacerbated the problem.

Long Term Interest Rates

Bond Rate of Govt Bonds

Since 2007 Bond Rates….

Current Account

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