Introduction
European debt crisis refers to the challenges that Europe is undergoing when paying for the debts built and accumulated over decades of financial instability.
Five of the world’s largest economies including Greece, Portugal, Ireland and Spain in one way or the other have failed to generate a stable economic growth to cater for their debts. Previously, these countries only considered challenges caused by the crisis; it is now going beyond borders and is affecting the whole world.
Europe is currently facing a serious financial crisis; debts accumulated by the member nations of European Union have raised questions about the effectiveness of European Economic and Monetary Union and what holds of euro in the coming days.
Sovereign debt is considered to be the main cause of Euro crisis. However, most of the affected countries including Greece, Ireland, Portugal and Spain, and other smaller economies that are linked to Euro zone, have severe monetary problems (Lynn, 2010).
The root of the crisis was a result of misallocation of resources and loss of completion within these countries. This was after the adoption of Euro about ten years ago. Currently, the economic problem is no longer the cause of the crises but a consequence brought by the changes.
The worldwide financial crisis associated with Greece raised an alarm about the debt crisis that was facing the Euro zone. The International Monetary Fund and the European Union have attempted to regain confidence in the unstable economies of Greece, Portugal and Ireland. Revealing of financial situation in Greece raised doubts on its capability to pay its debts (Kolb, 2011).
The sovereign debt that had faced these economies has continued to threaten the international monetary fund in trying to save the financial market. In addition, the spread of crisis to bigger economies like Spain and Italy poses a greater risk making the crisis more complicated.
For this reason, a lot of questions have been raised about the effectiveness of IMF and European Union. This has brought doubts concerning the future of these international monetary organizations not forgetting the fact that recovery of these debts seems futile.
Before the start of the crisis around the year 2007, the condition over the public finances was strongest over decades due to promising economic situations. The worldwide financial crisis around 2009 hit the economic activity of European countries in three different ways.
It polluted the financial system and its connectivity; it shook the confidence in wealth and demand and infected the worldwide trade actions. General preview indicated that the sub-prime lending came from US, but in the real state, the financial bodies are large in the UK and the Eurozone.
Basically the remaining financial bodies of these areas have lost considerable value. The Euro debt crisis resulted from different causes.
Some of the major causes include globalizing of money; simple loans around the year 2006 that encouraged risk lending and borrowing; worldwide imbalance of trade; monetary policies concerning government expenses and revenues and bailing out of worthless banks using private bonds (Braga & Vincelette, 2010).
Ireland banks loaned property developers without assessing their credibility. Eventually, the government was affected by the credit imbalance; it had to take all the responsibility using taxpayer’s money. There exists a connection between worldwide financial systems in that if one nation fails to pay its debts putting the outside private debt at stake, the banking system of the lending nation will experience the loss.
One of the main causes of Euro debt crisis was increasing levels of debts held by households and the governments. Around the year 1992, a treaty was signed by the European Union nations. The main agenda of the treaty was to limit the level of debts and deficit spending.
However, some members of European Union failed to abide by agreed terms of the treaty. These members operated against the regulations and ignored the world wide set limits. They used their sovereigns to shadow their debts and deficits using inappropriate means.
Complicated money exchange procedures and contradicting accounting and imbalanced final accounts characterized the initial stages of the crisis. This was accomplished by famous investment banks, and therefore, the consequences were profound.
The introduction of euro reduced interest rates on the bonds belonging to credit worthless nations. According to the IMF report, household debt levels rose from 39 % to about 138% in 2007 (Lapavitsas, 2012).
The imbalance that existed in terms of trade was another cause of Euro debt crisis. According to financial analysts around the year 2007, Germany had an improvement on its public debt and monetary deficits as compared to gross domestic product than most of other involved members of euro zone
During the same period, countries like Portugal, Spain, Ireland and Italy were at a position of paying their debts. As an improvement in trade surplus and its gross domestic product, Germany eliminated these nations out of the market making their deficits to deteriorate.
Deficit in trade also resulted in fluctuations in costs of labor. This made the nations from the south less competitive than northern nations, causing trade imbalances. Between the year 2000 and 2010, the unit of labor cost in Greece and Italy increased compared to that of Germany.
This resulted to loss of competitiveness in the labor market. European nations that have consistent surplus in trade do not realize significant change in their currency due to existence of a common currency. A high level of debt from the public is not a big issue when the government is ready to take responsibility for its debts.
The structural challenge that exists in the euro system has been a challenge a contributing factor to the Euro debt crisis. There is a union in terms of money that is known as the common currency. However, this limits economic union in terms of taxation, pension and funds activities.
Nations under Eurozone have the obligation to pursue same economic path with a different treasury to support it. In other words, nations with same financial systems are free to choose their monetary policies regarding taxes and expenditures. In this case even if there are policies about money that calls for their agreement, they may choose to reject them even if it is in the initiative of European Central Bank (Philip, 2012).
This situation brings an open ridden central economy experienced in Greece. It is difficult to make decisions concerning the monetary institutions and financial organizations. The resulting problem to the Euro zone is rampant when dealing with emergency monetary issues. With approximately seventeen members, it is difficult for the Euro zone system to make fast and rational decisions.
Inflexibility in terms of monetary policies poses a great problem to the Euro zone system, and results into a debt crisis. Member nations of Euro zone established one monetary policy that restricts them from acting independently. To be specific, they are restricted from manufacturing their own Euros to clear their debts.
This is because they use the same currency; members are not allowed to reduce its value for individual benefits, like making their exports less expensive. However, this plays a role in maintaining trade balance and raising gross domestic product. In other words, the assets that held in a currency that has reduced value will end up at a loss.
Mispricing of risks which was done about ten years before the crisis by the capital markets also contributed to the crisis. The capital markets ensured that capital was misallocated. Convergence of rates of interests along the Euro zone members that was brought by European financial union increased risk of crisis.
Euro zone is experiencing a debt crisis due to the loss of confidence. Before the growth of crisis, banks and money regulators had confidence in euro zone. Banks took extensive holdings of bonds from incapable economies like Greece, which gave little payment.
As a result of development of crisis, it became open that such economies bonds placed a greater risk to those banks. This became a center of conflict between banks due to lack of confidence in these nations (Lynn, 2010).
European financial crisis is not only economic but also political in nature. This comes from the governments responding to their deficit problems and their different interests. Leaders from European nations were found in embarrassing situation in 2010 when they had faith that crisis from payment could not stem from financial unions.
They underrated the crisis, and it has never been evaluated again. This makes surplus nations to be reluctant in endorsing them. Furthermore, resolution of crisis has been put into complication European Union legal framework. This prohibits the members of the union from assuming the debts of other members (Donovan & Murphy, 2013).
Solutions
Though European crisis is considered special because of its involvement with monetary system, it is important to come up with solutions that can be used to cope with future of the crisis. Policy makers should consider different solutions to solve the crisis.
The European crisis should consider worldwide financial integration as a way of solving the European debt crisis. However, European crisis has shown less interest in financial integration. They do not consider it as a lead to capital accumulation. During the euro era, uncontrolled financial integration resulted to unstable and weak balance of trade.
Most of European nations faced what developed nations faced ten years ago. The period is characterized with a lot of capital accumulation, which can stop suddenly. It has been repeated over for a long time. Therefore, it is important for European nations to consider a worldwide financial integration to avoid the crisis.
European debt crisis is not only affecting Europe, but it has extended beyond borders; IMF should also consider the matter of financial integration. A prevention mechanism should be designed to avoid occurrence of another crisis. It is not easy to establish such a mechanism when dealing with the crisis. However, policy makers should work closely with IMF and World Bank to solve the crisis.
European debt crisis is an indication of how fast a crisis can occur and extend to both involved and uninvolved economies. It is important to monitor and survey regional financial markets to avoid occurrence of such crisis in future.
Surveillance and monitoring will strengthen the European Union and the financial stability of its member states. When a financial crisis occurs, banks are among the most affected financial organizations.
It is important to recapitalize banks after the occurrence of the crisis. As seen from European financial crisis, banks need a clean up once they have been hit by a financial crisis. This was not achieved in Europe after their banks were hit by the sovereign debt crisis.
Conclusion
The European debt crisis has given light to major financial challenges and mistakes that have happened occurred in Euro zone. The crisis resulted from insufficient and irrational monetary policies. It would be wrong to conclude that European monetary unification was a mistake.
The political influence that enabled Greece to become a member of the European Union has had dire consequences. Ireland should have controlled its financial sector; it could have avoided its current monetary crisis.
European nations have become exposed to vulnerable conditions; an issue that requires to be addressed by policy makers. European policymakers, regardless of all denunciations, have responded to the crisis with far-reaching reforms of institutional framework, as well as structural reforms at home. However, government’s contributions are slow compared with the pace at which financial markets work.
References
Braga, C. A., & Vincelette, G. A. (2010). Sovereign Debt and the Financial Crisis: Will This Time Be Different? New York: World Bank Publications.
Cline, W. R., & Wolff, G. (2012). Resolving the European Debt Crisis. Washington: Peterson Institute.
Donovan, D., & Murphy, A. E. (2013). The Fall of the Celtic Tiger: Ireland and the Euro Debt Crisis. London.UK: OUP Oxford.
Irving, F. (1933). The Debt Deflation Theory of Great Depressions. Econometrica , 33-57.
Kolb, R. W. (2011). Sovereign Debt: From Safety to Default. New Jersey: John Wiley & Sons.
Lapavitsas, C. (2012). Crisis in the Eurozone. New York: Verso Books.
Lynn, M. (2010). Bust: Greece, the Euro and the Sovereign Debt Crisis. New York: John Wiley & Sons.
Philip, L. R. (2012). The European Sovereign Debt Crisis. Journal of Economic Perspectives , 49-68.