De Grauwe advances the thesis that one of the key determinants of the European crisis is that countries are incapable of making borrowings in their national currencies. He refers to the examples of two countries, Spain and the UK. The former shows a better financial performance, meanwhile, investment analysts tend to assign a negative prognosis to it rather than to the UK. The author believes that this phenomenon can be explained by the fact that Spain belongs to the monetary union so that it cannot make borrowing in its currency to support its banking sector (De Grauwe 256).
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The assumption that those countries that are independent of the monetary union are in a beneficial position is supported by the fact that financial markets have more influential power over the union members – they can sell the government bonds and invest the euros in the bonds of other countries making the relevant banking system shrink. From this perspective, those countries, which make borrowings in their currency, have a substantial advantage. Thus, if the bond grows and the government has difficulty paying it, the Treasury has an alternative solution, i.e. printing more money.
Therefore, several implications need to be considered for those countries that cannot borrow in their currencies. First, such borrowings make the country exposed to exchange rate risks. In other words, in case the local currency drops in its value, it will be more expensive to cover the international loan. In the meantime, it should be noted that the so-called “original sin” phenomenon does not prevent developing countries from making borrowings in foreign currency. Thus, international borrowings supply LDCs with many profitable opportunities (From note). Meanwhile, these opportunities cannot be applied to the developed countries that compose the EU.
The original sin implies negative consequences for the Euro-zone countries that are currently in crisis. Now that the original sin exists, no exchange rate arrangements might assist in preventing the crisis emergency. Hence, central bankers have two unbeneficial alternatives: to use the external pressure to increase the interest rate or to employ it for weakening the exchange rate. Both alternatives imply weakening balance sheets. As a result, the only solution available resides in asking for the assistance of the International Monetary Fund (IMF) (Eichengreen and Hausmann 8).
Another implication that should be analyzed is associated with investment-related scrutiny. The problem is that investors expect banks to keep the asset-liabilities ratio stable. Therefore, if the value of the sovereign bond drops, the investors will lose their key guarantee (Lasher 789). In other words, investors are not likely to collaborate with countries with international borrowings fearing potential defaults.
It should be taken into account that investors have no institution that would guarantee their recourse in case of default. De Grauwe likewise notes that investors’ scrutiny is associated with the fear of insolvency. The author explains that countries with foreign borrowings are particularly exposed to liquidity crises that, in their turn, transform into insolvency crises. This tendency prevents investors from collaboration with such countries (De Grauwe 260).
The next implication that should be discussed is the tools that Eurozone countries currently possess to overcome the borrowing-related crisis. Hence, as it has been mentioned above, the countries are incapable of printing more money as their borrowings are in foreign currency. Thus, the only regulating tool left is fiscal policy. The latter implies that the country cuts its federal spending and raises the taxes instead. In the meantime, it is essential to note that this policy does not provide any guarantee for the situation improvement.
On the contrary, it might lead to additional negative consequences – the commerce will slow down exacerbating the recession (Lasher 788). In his article, Lane points out the ineffectiveness of the fiscal policy tightening. Thus, Lane assumes that it is determined by the failure to evaluate the associated risks such as “external imbalances, credit growth, sectorial debt levels, and housing prices” (54).
As a consequence, Eurozone countries seem to be obliged to accept the assistance of the IMF to overcome the crisis. Meanwhile, it is essential to note that even though the collaboration with IMF implies immediate wealth, in a long-term perspective, in does not offer any profitable opportunities. Hence, there is little chance that the GDP rate will improve that means that the country will keep experiencing the negative outcomes of the crisis: inflation and unemployment (From note). Thus, Lane points out several negative implications associated with the IMF’s support. First, the period of the required microeconomic adjustment is evidently longer that it is officially set.
Second, the imposed fiscal consolidation is likely to deepen the existing weaknesses of the banking system. Third, the standard penalty that IMF assigns makes the process of borrowings coverage more difficult and creates a negative public image – it appears that EU countries profit at the expense of those countries that are bailed out. Fourth, practice shows that bailout funds that target to recapitalize the relevant banking systems, in practice, tend to raise the public debt and increase the sovereign risk excessively. Th national governments, in their turn, experience too much pressure to support the failing banks. Fifth, the key IMF principle resides in the fact that it is ready to support only those debts that are considered sustainable (Lane 59).
Several conclusions might be drawn relying on the provided analysis. First and foremost, the Eurozone crisis is largely determined by the fact that a large number of the EU members cannot make borrowings in their currency. As a consequence, these countries are more exposed to such risks as exchange rate and increased scrutiny on the part of potential investors. It means that there are strong chances that the national economies will experience a crisis.
Meanwhile, these countries have no tools to overcome the crisis but to employ the tightening of the fiscal policy that is rather ineffective. Hence, they are obliged to receive IMF’s support that implies additional negative outcomes described above.
De Grauwe, Paul. “The Governance of a Fragile Eurozone.” Australian Economic Review 45.3 (2012): 255-268. Print.
Eichengreen, Barry, and Ricardo Hausmann. Other People’s Money: Debt Denomination and Financial Instability in Emerging Market Economies, Chicago, Illinois: University of Chicago Press, 2010. Print.
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Lane, Philip. “The European Sovereign Debt Crisis.” Journal of Economic Perspectives 26.3 (2012): 49-68. Print.
Lasher, William. Practical Financial Management, Boston, Massachusetts: Cengage Learning, 2016. Print.