Eurozone Crises: A Literature Review

Advances in Applied Economics and Finance (AAEF) (ISSN 2167-6348) 686 Vol. 4, No. 2, 2013, Pages: 686-689 Copyright © World Science Publisher, United States www.worldsciencepublisher.org Eurozone Crises: A Literature Review Sunil Jauhar1, Piyush Tillasi2, Rachana Choudhary3 and Tarun Kumar Sharma4 1,4 Indian Institute of Technology, Roorkee, India, India 2 School of Economics, DAVV, Indore (MP), India 3 RIT, Indore (MP), India E-mail: jauhar.sunil@gmail.com1, ptsameer77@gmail.com2, choudharyrachana24@gmail.com3, taruniitr1@gmail.com4 Abstract - After a strong performance in the first half of 2010, real GDP growth in both the EU and the euro area slowed down in the second half of last year. The deceleration was expected and in line with a soft patch in global growth and trade, which reflected the withdrawal of stimulus measures and the fading of positive impulses from the inventory cycle. Within an uncertain and risky business environment and global competition, firms have to manage not only their internal operations but also all the processes and relationships within their value chains. The purpose of this study is to provide insights for the Eurozone crises, particularly the Europe and emergingmarket economies. 1. Introduction This crisis is analytically separate from the Late-2000s financial crisis, although the two phenomena are linked in their effects. The sovereign debt crisis refers to budget deficits that have been created by insufficient tax revenue, excessive spending, or both in several Mediterranean states including Greece, Italy, Spain, and Portugal. The financial crisis on the other hand began in the U.S. and in countries that imitated the problematic lending practices of the U.S., such as Iceland and Ireland. The two phenomena have become linked because many European banks held assets in financially troubled American banks, and because the need to bail out troubled banks has worsened the budget deficit for governments. The size of the budget deficits has frightened investors, who have demanded higher interest rates from struggling governments. This in turn makes it difficult for governments to finance further budget deficits and service existing high debt levels. Especially in countries where government budget deficits and sovereign debts have increased sharply, a crisis of confidence has emerged with the widening of bond yield spreads and risk insurance on credit default swaps between these countries and other EU members, most importantly Germany. While the sovereign debt increases have been most pronounced in only a few Eurozone countries, they have become a perceived problem for the area as a whole. Concern about rising government debt levels across the globe together with a wave of downgrading of government debt for certain European states created alarm in financial markets. On 9 May 2010, Europe's Finance Ministers approved a rescue package worth €750 billion aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF).In October 2011, Eurozone leaders meeting in Brussels agreed on a package of measures designed to prevent the collapse of member economies due to their spiraling debt. This included a proposal to write off 50% of Greek debt owed to private creditors, increasing the EFSF to about €1 trillion and requiring European banks to achieve 9% capitalization. 2. Literature Review The Eurozone crisis is part of the global turmoil that began in 2007 as a US real estate crisis, became a global banking crisis, turned into a global recession, and thus gave rise to a sovereign debt crisis. At the end of 2011 there is a risk of returning to a banking crisis in Europe and elsewhere. At the heart of bank weakness lies private and public debt accumulated during the period of intense financialisation in the 2000s. The euro is a form of international reserve currency created by a group of European states to secure advantages for European banks and large enterprises in the context of financialisation. The euro has attempted to compete against the dollar but without a correspondingly powerful state to back it up. Its fundamental weakness is that it relies on an alliance of disparate states representing economies of diverging competitiveness. The euro has acted as mediator in Europe of the global crisis that began in 2007. The European Monetary Union (EMU) has created a split between core and periphery, and relations between the two are hierarchical and discriminatory. The periphery has lost competitiveness in the 2000s, therefore developing current account deficits with the core and accumulating large debts to the financial institutions of the core. The result has been that Germany has emerged as the economic master of the Eurozone. Eurozone policy to confront the crisis has been profoundly neoliberal: cutting public expenditure, raising indirect taxes, reducing wages, further liberalizing markets and privatizing public property. Corresponding 687 institutional changes within the EMU – above all for the European Central Bank (ECB) and the European Financial Stabilization Facility (EFSF) – have entrenched the dominance of the core, particularly of Germany. More broadly, policies are threatening to shift the balance of economic, social and political power in favor of capital and against labor across Europe. The association of nation states with their domestic banks has become more pronounced in the course of the crisis. Banks have been acquiring the public debt of their own states; they have also been depositing spare liquidity with their own National Central Banks (NCBs); they have, finally, relied increasingly on Emergency Liquidity Assistance (ELA) provided by their own NCB. The result is that banks and nation states now face a heightened danger of joint default. The emerging choice for peripheral states is particularly stark: either fully nationalize banks, or lose control over them. The persistence of the split between core and periphery, the absence of effective institutional change for the EMU, the pressures of austerity and the threat to banks are creating harsh conditions for peripheral countries. Future prospects are bleak, including low growth, high unemployment and worsening burden of debt. The ability of peripheral countries to remain within the EMU is in doubt, and the most likely candidate for exit is Greece. Greece is manifestly unable either to service its public debt, or to comply with the conditionality of the rescue plans, making default inevitable. However, default led by the creditors and occurring within the confines of the EMU (so-called orderly default) would not be in the best interests of the country. It would probably lead to loss of control over domestic banks; it would not lift austerity; it would keep the country within the competitive vice of the euro. The social costs would be great. The country would also lose some of its sovereignty as fiscal policy would come under the explicit control of the core. The prospect of eventual exit from the EMU would remain. 3. A ROUTE OUT OF THE EUROZONE CRISIS 1. Default ought to be debtor-led, sovereign and democratic, leading to deep cancellation of debt. Debtorled default would probably precipitate exit from the EMU. Quitting the euro would offer additional options for dealing with public debt since the state could redenominate its entire debt in the new currency. Exit would further allow the state more scope to rescue banks through nationalization and provision of domestic liquidity once command over monetary policy would have been restored. Nonetheless, exit would also create fresh problems for banks as some assets and liabilities would remain denominated in euro. The outcome would probably be the shrinking of Greek banks over time. Exit, finally, would disrupt monetary circulation and cause problems of foreign exchange as the new currency would depreciate. Still, the disruption of circulation is unlikely to be decisive, while depreciation would present the opportunity of rapidly retrieving competitiveness. On balance, if Greece is to default, it should also exit the EMU. 2. Debtor-led default and exit are fraught with risk, and have costs attached to them. But the alternative is economic and social decline within the EMU that could still end up in chaotic and even costlier exit. In contrast, if default and exit were planned and executed by a decisive government, they could put the country on the path to recovery. For that it would be necessary to adopt a broad economic and social programme including capital controls, redistribution, industrial policy, and thorough restructuring of the state. The aim would be to change the balance of power in favor of labor, simultaneously putting the country on the path of sustainable growth and high employment. Not least, national independence would also be protected. 3. More broadly, the Eurozone crisis brings to a close a period of confident economic and political integration in Europe. The ideology of Europeanism which promised solidarity and unity to European people, is in retreat as the core has demonized the periphery in the course of the crisis. The depth and severity of the crisis are eliciting intense social reaction against large banks and enterprises in the EU. The impasse reached by the EMU raises the possibility of more active economic and social intervention by the nation states of Europe in the foreseeable future. 4. The required restructuring of Europe as the EU and the EMU face decline could not be undertaken by neoliberal agents aiming to defend the interests of big business. The restructuring should be democratic in content, relying on the forces of organized labor and civil society; it should draw on the theoretical tradition of political economy and heterodox economics; it should also tread a careful path between declining Europeanism and nascent nationalism. Above all, it should keep firmly in mind the old socialist dictum that European unity is possible only on the basis of workers’ interests. 4. Eurozone crisis and its impact on European Economy at a glance Euro zone debt problem is likely to remain a concern in the near future. Further, the European banks withdrawing credit in order to shrink their balance sheet would deepen impact of the debt crisis on the other economies. Near zero level interest rates are to continue in the advanced countries in the immediate future. Rising fiscal deficit in US and uncertainties over the economic conditions in most developed countries are adding to the worries. 5. Eurozone crisis and its impact on Indian Economy Capital flows into the economy and exports are likely to take a beating. Foreign institutional investor (FII) investment pattern is marked with high volatility. A 688 sudden surge in investment pattern is as detrimental as an unannounced withdrawal. A surge in FII investments will lead to increased inflationary pressures and building of an asset bubble that could burst anytime. India is grappling with high inflation and the central bank has raised the key interest rates a dozen times in the past year and a half. Now, the possibility of Greek debt default affecting the European banking and financial sectors is very real. The crisis is expected to spill over to the other European nations that otherwise appear economically stable. While Greece has embarked on austerity measures, the bailout package from the European Union and IMFfunds is expected to help it navigate out of its crisis. However, a rapidly shrinking Greek economy needs a fresh lease of life. But if Greece is only the beginning, then the Euro zone crisis could avalanche into larger trouble. The quantum of impact of Euro zone crisis on markets here is yet to be measured. A slump in domestic industrial growth, unaddressed agricultural woes, rising interest rates and escalating fuel costs have compounded the global factors. A series of scandals emerging from under the carpet have diluted the faith of foreign investors. The market volatility has compounded with the concerns of small investors. Sectors across the board including auto, oil and gas, metal, FMCG and healthcare took a beating. Concerns are the current European financial crisis will curb economic growth. The risk associated with otherwise favorite sectors such as banking has increased. Investors have to study global trends before investing in the unpredictable stock markets today. Have a long-term perspective when taking investment decisions. 5.1 impact on Indian Economy Though India is primarily a domestic economy; India’s exports are positively linked to the global economic growth. This is likely to adversely impact India’s export growth in the coming months. However, growth will be only marginally affected by the slowdown in the euro region debt stricken countries as our exposure is low. Software services and other export oriented sectors would benefit from the rupee depreciation. FDI has not been significantly affected by the crisis while the FIIs are showing outflow in the last couple of months. International commodity price moderation is not being translated in domestic prices. Further, exchange rate depreciation would worsen the inflationary conditions in the economy. Therefore, the RBI would have to continue with its anti-inflationary stance in the near term if domestic conditions do not improve. 6. CONCLUSIONS We use the rise and dispersion of sovereign spreads to tell the story of the emergence and escalation of financial tensions within the Eurozone. After the introduction of the euro in January 1999, the fall in risk premia on the bonds of Eurozone sovereigns compressed them into a narrow range across the member countries (Ehrmann et al., 2011) within which short-term movements were essentially random. Markets judged the probability of default by Eurozone sovereigns to be negligible. That changed with the start of the Subprime crisis in July 2007, at which point a Eurozone crisis took shape as an offshoot of the global crisis. But soon thereafter, starting in March 2008 with the rescue of Bear Stearns, the presumption that sovereigns would ride to the rescue of their domestic banking sector, linked the projection of a Eurozone member’s sovereign debt to its domestic financial vulnerabilities: sovereign spreads now rose in response to perceived weakness of domestic banks. And when the fiscal space to deal with those vulnerabilities narrowed, as appears to have occurred around the nationalizations of Anglo Irish, the fates of financial sectors and sovereigns became intertwined. The evolving assessment of global growth potential as well as the differences in growth prospects across countries played a key role in influencing these dynamics. The rescue of Bear Stearns occurred during a period of worsening growth prospects; hence, the expected costs of bank bailout costs increased just when the weaker growth outlook was already threatening to push up debt ratios. The process intensified after the Lehman bankruptcy as markets further downgraded the prospects of the financial sector, which, in turn, reinforced the likelihood of weaker growth and higher public debt. Across countries too, we find strong evidence that countries that entered the crisis with weaker growth prospects and higher public debt-toGDP ratios were more likely to be hurt by domestic financial sector stress. Until the nationalization of Anglo Irish, the nature of crisis was rather straightforward, primarily driven by financial shocks. Policies targeted to supporting the financial sector had therefore a clear potential to alleviate the crisis. Such policies carried the risk of perpetuating the incentives of bankers to behave irresponsibly in the future, and were especially prone to errors in judgment on the scale of help needed. The size and scope of the guarantees provided by the government to ensure liquidity for banks has indeed proved controversial. And an orderly winding down of Anglo Irish, rather than its nationalizations, would certainly in retrospect have been the superior course of action. But most countries had at the time enough fiscal space to finance these interventions, and the reductions in spreads after the rescue of Bear Stearns and even after the nationalization of Anglo, tended to support such activism. The dynamics of the crisis and the policy options available, however, changed markedly during 2009. The contemporaneous association between spreads and domestic fiscal stress suggests that the crisis entered a full-blown phase where sovereign spreads, the health of the financial sector, and growth prospects supported a mutually reinforcing regime.20 The financial sector ceased to be the clear driver of the crisis. Rather, the crisis took on a larger scope involving fiscal and competitiveness problems. Fiscal problems, in turn, had feedback effects. Higher sovereign spreads increased the borrowing costs of domestic banks and generated capital losses on the holdings of public debt, contributing to lower growth. With the fiscal room for intervention much more limited, the Eurozone economies have moved to a 689 new more stressed regime from which there is no quick return. 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