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The European economy has been in recession since 1930s. Financial crisis in Europe began in 2007. This was without precedent in post war economic history (Eichngreen & O’ Rourke 2009). After this, there was the lengthy premia with insignificant risk, a sharp rise in credit growth and development of the real estate industry as well as easy availability of liquidity.
Financial institutions became extremely vulnerable to asset market corrections. This led to a downturn on the financial systems. This actually toppled the whole structure. This however was not a new thing as it had initially happened to other countries before, for example Nordic countries and Asian crisis among others. Just as the 1930s depression was a worldwide phenomenon, there is no difference with the present economic crisis.
How did it begin?
In the late 2009, investors had fears of a sovereign debt crisis concerning government debt levels that were rising worldwide (Eichngreen & O’ Rourke 2009). Fears were also caused by the downgrading of the government debt in various European states. This made it impossible for Greece, Portugal, and Ireland to refinance their debts in early 2010 as the situation intensified (Eichngreen & O’ Rourke 2009).
The Europe finance ministers had to approve a rescue package and eurozone leaders had to come in also by agreeing to another package of money to prevent the collapse of the European economy. The European leaders in addition suggested a creation of a common fiscal union. This union was to be across the eurozone which had to be with very strict rules that were enforceable by the EU treaties. Nevertheless the European currency managed to retain its stability. Greece, Portugal and Ireland were the three most affected countries.
This European crisis was caused by a combination of factors that were complex. These factors included things like globalization of finance, imbalances in international trade, bursting of real estate bubbles, slow economic growth rate, easy credit conditions which encouraged high risk borrowing and lending practices, fiscal related choices in relation to government expenses and revenues, and lastly approaches used to bail out troubled banking industry by nations.
A narrative description of the beginning of the European crisis is that it began with a great increase in savings. These savings were available for investment for the period between year 2000 and 2009 (Wachman 2010). It is argued that during this time, globally the pool for fixed income securities increased greatly.
This enormous pool of money was caused by an increase in savings. These savings were from the high growth countries that entered the global capital market. Investors looked for alternative higher yields in treasury bonds than those offered in the U.S. globally. The readily available savings created a temptation and this overwhelmed regulatory and policy in different countries, as global fixed investors generated bubbles across the world.
These bubbles eventually burst causing prices of assets (for example, commercial property and housing) to decline. The bubbles also caused liabilities to global investors to stay at full prices. This brought about questions on solvency of governments and matters regarding their banking systems (di Magliano n.d.).
Different countries in Europe got into this crisis in different ways. For example, in Ireland, its banks lent money to property developers and this led to a bubble in property (Wachman 2010). When finally the economic bubble burst in Ireland, there was a general takeover of the role of private investors by both the government and the economy’s taxpayers.
In Greece, there was an increase in commitments to its public workers by the government. This was in form of very generous pensions and pay. Some politicians blame bailing out of institutions by public funds to be a cause of the crisis in Greece (Eichngreen & O’ Rourke 2009). Some financial institutions benefited from the debt situation in Greece in the short run.
The banking system in Ireland grew greatly and this in return created global investors. The global investors, who are actually an ‘external debt’, were several times larger than the country’s GDP. Interconnection in financial systems globally means that when a one nation goes into recession or defaults its sovereign debts, this puts external private debt at very great risk. Losses are faced by the banking systems of the creditor country.
Creation of interconnection is based on the concept of debt protection. A credit default swap (CDS) contract is entered by the financial institutions which does the payment incase defaults occurs. The amount on money changing hands most of the times is higher than the debt amount itself due to purchase of the same security by the CDS. There is uncertainty as it is not clear as to which exposures are done by each country’s system in banking in relation to the CDS (di Magliano n.d.).
Impact of EU Crisis on the European countries
The three greatly affected countries were Greece, Portugal and Ireland as mentioned earlier. Definitely the European crisis has not had a positive impact on the European countries. There has been an economic collapse in most of the European countries. Very few countries tried to evade this economic collapse and these countries include Poland, Bulgaria and Romania. The rate at which the UK is recovering is very slow (Khor 2011).
In Japan however, the tsunami effect caused the economy not to grow better as expected. The vehicle industry was particularly affected by this disaster. Austerity measures in British government are slow which have reduced public spending to almost zero and adversely affects the economy. There is a high rate of inflation, very small salary rises, and an increase in unemployment. These result in losing of hope of consumers’ in the future and there has been an increase in demonstrations by these consumers protesting over their frustrations.
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In Greece, the Greeks have totally lost their confidence in any economic recovery in the near future (Wachman 2010). Public spending in Greece is on the rise and this puts the International Monetary Fund (IMF) and EU to come in and help Greece overcome the crisis. Unemployment rate in Greece is high, with more than one in every ten persons in Greece being jobless. There is a fall in contribution to the national budget.
Spending rates are very high. Implementation of measures such as privatization and liberalization of the economy and reduction in civil servants are very low and they are not done quickly by the Greek government. State authorities and public enterprises that are surplus in regard to their requirements have not been cut or closed. Greeks are currently not making any essential purchases and this brings about an economy that is not strong.
The bad economy is attributed by the current unemployment rates that are high and the increase in consumption of taxes and contributions. In Greece there is a low productivity level and a very high deficit in combined capital and current account. With the help of the International Monetary Fund and the EU, it is assumed that with time Greece will slowly recover (Wachman 2010).
In Bulgaria, contrary to the drop in economic growth in other countries, it has seen an increase in its economic growth (Wachman 2010). This growth has been attributed by the export activities. In addition, the tourism industry has contributed to this growth by creating employment opportunities.
Bulgaria has been able to reduce its government deficits. This has resulted in stabilized economy. However, it is argued that the financial crisis and the European debt impact will eventually have a negative effect on the Bulgaria economy. The Greek bailout so far by the Bulgarian country is seen to have some slightly negative impact in the recent times (Eichngreen & O’ Rourke 2009).
A fall in income expectation is another negative impact experienced by the European countries due to this crisis. Consumers in Italy are aware that there is a threat of national bankruptcy. They are actually preparing themselves on hoe to tackle this problem. Sacrifices are being made by the consumers to salvage the situation at hand. Italians are however very unwilling to pay higher taxes like in any other country.
However, they are preparing themselves by suffering cutbacks in income. Those getting high salaries are ready to pay up more taxes. This is perceived to reduce the government debt to a lower level. These cuts are a concern to the social services and they contribute to a low economic growth. Italy has the highest levels of unemployment than any other country in Europe. Income expectation has also fallen down. There is little hope by the Italians in the recovery of their economy in the near future (Szekely 2009).
In Poland, however, the economic status is good. The employment levels too have been rising. This does not mean that the unemployment rate is okay, it is simply improving with time. Uncertainties are also created by the general elections in Poland (Wachman 2010). Political developments in Poland usually generate uneasiness among consumers. Income expectation is greatly affected by these conflicting factors, it actually becomes lower.
Another impact of the European crisis in the European countries is lowering the willingness to buy by the consumers (Wachman 2010). Consumers hesitate whether to buy or make major purchases now or to delay the spending. This is very common in Portugal. In Romania, the situation is changeable currently. Consumers spend their income on non-alcoholic drinks and food. This shows how their spending is limited to necessities only (Szekely 2009).
In Portugal, there is a battle against the crisis by trying to implement the cost-cutting programs (Wachman 2010). These programs are set by the European Union. Austerity measures are putting pressure on citizens by an increase in taxation. There has been no salary increase. Consumers only buy what is necessary since they cannot afford to spend more than what they can afford.
In Spain, inflation has somehow been kept at bay. Currently it is the lowest in European countries (Wachman 2010). This is due to reduced prices in fuels. Despite this, there is no hope in Spain since the economic recovery and the willingness to purchase is still low. Consumers are also affected by the uncertainty on the development of the debt crisis in European Union. Consumers are very cautious on their daily expenditure.
Greek Debt Problems and Risk of Contagion to other Countries
The debt problem facing the Greece is a tragedy which is glaring Europe as political turmoil is also accompanying it. It is postulated that dwarfing of the Greek tragedy may come in case there is spread of the problem to its significant neighbors through contagion. According to Khor (2011), bailing out Greece is likely to see the crisis reach countries like Italy thus leading to a severer crisis in Europe since Italy is a large economy.
This is because Italy’s economy is already in debt and thus it would be forced to get new loans at the price of increased interest. Given the Greece problems remains unsolved, one can only expect the European crisis to stay and spread. With Greece facing both solvency and liquidity problems, working out the debt problem by for instance creditors receiving a portion of the remaining loans to Greece would scare banks from major European economies which have kept the Greece loans.
This is among the major reasons why there is a call for bailout, though bailout, such as that done by the IMF and Europe in 2010, did not solve the problem in entirety. It is foreseeable that the probability of Greece getting new loans will reduce given that the default being experienced by the market will discourage lending to Greece.
Contagion is predicted to spread to as far as Spain and Italy since European has not been able to act as a unit on the Greece problem. This has consequently had an impact on confidence in the eurozone. Overall, it is expected therefore that global economy will worsen since no major world economic player (Europe, Japan or the U.S.) currently stands in a position to salvage the global economy.
In the event that Greece defaults on its debt (which is almost inevitable), contagion is almost inevitable in economies such as Portugal and Ireland which are already doing poorly. This risk is also likely to spread to other larger economies like Spain and Italy, but this is less likely given the diversity of these economies.
The likelihood of these wealthier economies experiencing contagion due to Greek’s tragedy is further reduced by the fact that other wealthier European economies are likely to respond fast to avert such a situation since it would affect the entire European region adversely (Vanguard 2011).
A number of measures have been put in place in trying to solve the European crisis. EU emergency measures have been put in place. These include measures like the European Financial Stability Facility (EFSF). The EFSF is a legal instrument that has an aim in preserving financial stability in all European countries (REF). It provides assistance financially to the eurozone states in times of difficulties.
It can issue debt instruments like bonds on the market to raise funds needed in giving loans to the eurozone countries which are in need of financial support. The German debt management office offers support to the EFSF in these debt instrument offerings. These bonds are usually backed up by guarantees that are given by the member states of the euro.
These guarantees are in relation to the share in paid up capital in the European central bank. Members of the states finance ministers expanded the EFSF by creating certificates capable of guaranteeing up to thirty percent. The EFSF raises funds after the government has made a requisition (European Commission 2011).
The European financial stabilization mechanism (EFSM) is a funding program that offers funds on emergencies. These funds are raised on the financial markets (European Commission 2011). The European commission guarantees the EFSM. It uses the European Union budget as collateral.
Its aim is to preserve financial stability in the European countries by providing funds to them during their economic hardships. The funds are backed by the 27 European members. EFSM is supervised by the European commission. Both the EFSM and the EFSF will eventually be replaced by a more permanent programme called ESM.
The Brussels agreement is an agreement made by the Eurozone countries in the Brussels. They agreed to write off fifty percent of Greek sovereign debts. The bailout was held under European finance stability funds. They also agreed to increase up to 9% level on bank capitalism and a set of commitments to make measures in reducing the national debt (European Commission 2011).
The European central bank has also intervened in solving the European Union crisis. There are various measures that it has taken to offer solutions to the crisis. The first one is the open market operations in buying private debt and government securities. This will prevent inflation.
Secondly the central bank offers one six-month and two three-month full allotments in long term refinancing operations. Thirdly, the central bank reactivated all the dollar swap lines. Government debts were subsequently bought by the member banks. These member banks belonged to the European system of central bank. ECB has its policies regarding the credit ratings on loans changed (Costello et al 2009).
Concerted actions from several central banks aided in creating a solution to the crisis. The ECB, the Federal Reserve in the US, the Swiss national bank and Canada’s, Japan’s and Britain’s central bank offer global financial help to the European countries (European Commission 2011).
Proposed Long-term Solutions to the Crisis
European fiscal union is the first solution. A fiscal union is a long term stable solution as compared to the portfolios that are implemented towards investments (Eichengreen & O’Rourke 2010). A stability and growth pact reform was formed aimed at straightening rules in case of deficit or debt rule breaches. Germany is pressuring other member states into adopting a balanced budget law. This law will help in achieving a clear cap on matters relating to new debts.
There is also a need for a very strict budgetary discipline. There is implementation of debt breaks of the eurozone countries and this implies a tighter fiscal discipline. By the end of 2011, the eurozone countries will have created a fiscal union with strict enforceable rules. There will also be automatic penalties. The eurozone countries agreed to put strict caps on the way their governments are spending and borrowing money. Penalties are put in place for those who violate the stipulated limits (Costello et al 2009).
Another long term solution is the Eurobond. It was suggested that Eurobonds be issued jointly by the euro nations. However this plan was to work properly with the use of tight fiscal surveillance. Economic policy coordination is also vital for the Eurobonds to work effectively. The Eurobonds actually would raise any country’s liabilities in debt crisis (di Magliano n.d.). This would however be best in solving debt crisis.
European stability mechanism is also another long term solution. This is a permanent rescue funding programme (Mission & Watzka 2011). It allows for permanent bailout. This kind of a mechanism offers financial firewall services. It comes in handy in cases where one country defaults in the interconnected financial systems and it ensures protection of downstream nations. It enables management of the single default and limits financial obligation.
Addressing current account imbalances can act as a long term solution. There is need to regulate cross border capital flow in the euro area. This avoids any current account imbalances. A country which imports more than what it exports is a net importer of capital; this means that the country decreases its savings reserves. It also implies that these kinds of countries drive their capital into other countries which have trade deficits (Szekely 2009).
This eventually creates asset bubbles and lowers interest rates. If a country has a large surplus, its currency value appreciates. This in return reduces imbalances since price of its exports increases. Domestic savings can greatly reduce trade imbalances. This can be encouraged by restricting capital flow across the border or raising interest rates. This is however going to increase government interest rates and to offset a slowing down to the economy.
Lastly European monetary fund (EMF) can be seen as a long-term solution to the crisis. There are suggestions that EFSF to be transformed to EMF. EMF provides governments with fixed interest rates on Eurobonds (Borthwick 2011).The rates are usually slightly below the nominal terms.
This renders the bonds untradeable and therefore they can only be kept or held by investors. It can be liquidated by the EMF anytime. The EMF would also ensure fiscal discipline and provide funds to countries meeting the agreed fiscal criteria. This ensures that a government has sound financial policies otherwise they would have to rely on government bonds which have market rates that are unfavorable (Borthwick 2011).
List of References
Borthwick, D., 2011. Introducing the European Monetary Fund. Seeking Alpha. Web.
Costello, D., Hobza, A., Koopman, G. J., Mc Morrow, K., Mourre, G., & Szekely, I. P., 2009. The negative impact of the financial crisis on potential output necessitates an EU-led policy response. VOX. Web.
Di Magliano, R. P., n.d. Sovereign debt problems in advanced industrial countries. Web.
Eichengreen, B. & O’Rourke, K. H., 2010. What do the new data tell us? VOX. Web.
European Commission, 2011. European Financial Stabilisation Mechanism (EFSM). European Commission, Economic and Financial Affairs. Web.
Khor, M. 2011. Rich economies enmeshed in crises. Third World Network. Web.
Mission, S. & Watzka, S., 2011. Financial contagion and the European debt crisis. Ludwig-Maximilians-Universität München, Seminar for Macroeconomics. Web.
Szekely, I. P., 2009. Economic crisis in Europe: Cause, consequences, and responses – a report by the European Commission. VOX. Web.
Vanguard, 2011. What a potential Greek default means for investors. Vanguard. Web.
Wachman, R., 2010. Greece debt crisis: the role of credit rating agencies. The Guardian. Web.