Euro Zone Crisis : A macroeconomic study

8/12/2019 Euro Zone Crisis : A macroeconomic study

1/25

2013

12/18/2013

THE EUROZONE CRISIS:

A Macroeconomic Perspective

Prepared By:

ANAND ODEDRA (B13132)

AMITABH VAJPAYEE (B13131)

ANIRBAN CHAKRABORTY (B13134)

ANUPAM MAITY (B13183)

ASHUTOSH SINGH (B13138)

Macroeconomic Theory and Policy

XLRI, Jamshedpur


2/25

MTP PROJECT Page 1

INDEX

THE EUROPEAN UNION ..2

PRELUDE TO THE EUROZONE CRISIS .3

A CHRONOLOGY OF THE MAIN EVENTS .5

CAUSES OF THE CRISISPICTORIAL REPRESENTATION ..6

CAUSES FOR THE EUROZONE CRISIS .6

POLICY MEASURES .11

EUROPEAN CENTRAL BANK .14

ECONOMIC REFORMS AND RECOVERY PROPOSALS .15

LESS AUSTERITY, MORE INVESTMENT .15

INCREASE COMPETITIVENESS 16

ADDRESS CURRENT ACCOUNT IMBALANCES .17

WHAT IS THE WAY OUT? .18

PROPOSED LONG TERM SOLUTIONS .. 19

CONCLUDING REMARKS .. 22

REFERENCES .24


3/25

MTP PROJECT Page 2

THE EUROPEAN UNION

The European Union (EU) is quite unique in the international system. The original goal behind

the integration of Europe was to prevent the recurrence of the devastating wars of the first half

of the twentieth century. The seeds of a united Europe were laid post WW 1. Presently 28

countries are part of the EU. There are various bodies that govern specific functions of the EU.

Here we shall focus on the relevant points for the later part of the discussion.

Convergence Criteria are the necessities that an individual country has to meet so as to become

a part of the Union. It has been observed that the countries have fulfilled the criteria at the

time of joining, however, they have violated these rules time once they become members. The

salient features of the Maastricht Treaty that the country has to comply by are as follows:

Inflation Rate :


4/25

MTP PROJECT Page 3

from countries within the EU which meant that this was recorded as a deficit in the balance

sheets of the other Eurozone countries.

PRELUDE TO THE EUROZONE CRISIS

The Eurozone crisis has several features in common with other similar financial-stress drivenepisodes in the history of Economy. To start with, it demonstrated some of the characters that

are common to such crisis. The parallels that can be drawn are as follows:

Preceded by a comparatively long period of swift credit growth, Copious availability of liquidity Low risk premiums Strong leveraging Soaring asset prices Development of bubbles in the real estate sector.

The collapse of the banking systems and the subsequent crisis that precipitated in the year of

2007 was brought about by a chain of events. These events were to an extent chronological.

The analysis of this can be broken down into several steps which may or may not overlap to a

certain extent. There are sub reasons for these events as well but here we focus on the main

It was believed that the European economy, unlike that of the USA, would be largely immune tothis financial turbulence. This was based on the belief that the real economy, though slowing, was

thriving on strong fundamentals such as rapid export growth and sound financial positions ofhouseholds and businesses

This tuned out to be an illusion of sorts because the major part of international trade that wasbeing done was between the countries of the EU; thereby making it seem that one country was

accumulating a trade surplus. In reality there was little if any growth occuring.

The interbank market virtually closed and risk premiums on interbank loans soared tounprecedented heights. Banks faced a serious liquidity problem, as they experienced major

difficulties to rollover their short-term debt.Policymakers still perceived the crisis primarily as a liquidity problem. This was one of the majorblunders and mistakes made. Concerns over the solvency of individual financial institutions also

emerged, but systemic collapse was even then deemed unlikely.

When the crisis came to be in 2007, uncertainty among banks about the creditworthiness of theircounterparts evaporated as they had heavily invested in often very complex and opaque and

overpriced financial products

This led to the deteriorating loan performance and disturbances in the wholesale funding markets.

Such episodes have happened before. The examples area bundant (e.g. Japan and the Nordic

countries inthe early 1990s, the Asian crisis in the late-1990s). However, the key differencebetween these earlier occurences and the Eurozone crisis was its global dimension.

The presence of stretched leveraged positions as well as maturity mismatches made financialinstitutions in the European Union highly vulnerable to any corrections in asset market.


5/25

MTP PROJECT Page 4

reasons leading up to the crisis. The following Info graphic summarizes the chain of events

leading up to the economic crisis:

As it can be seen, there

was an overestimation of

the trade taking place

between the countries of

the European Union. The

trade surplus that

Germany, the forerunner

of the EU as far as size and

strength of Economy is

concerned, was also

attributable to the nations

of the EU to a large extent.

The nations that it tradedwith were showing deficits

in their balance sheets.

Moreover there was the

ever looming threat of

internal collapse of the

economy. These points and others will be covered in more detail in the rest of the report.

Confidence of both consumers and businesses fell to unprecedented lows.This set chain of events setthe scene for the deepest recession in Europe since the 1930s

The downturn in asset markets snowballed rapidly across the world. As trade credit became scarceand expensive, world trade plummeted and industrial firms saw their sales drop and inventories pile

up.

The crisis thus began to feed ontoitself, with banks forced to restrain credit, economic activityplummeting, loan books deteriorating, banks cutting down credit further, and so on.

Panic broke in stock markets, market valuations of financial institutions evaporated,investors rushedfor the few safe havens that were seen to be left (e.g. sovereign bonds), andcomplete meltdown of

the financial system became a genuine threat

Bankruptcy of Lehman Brothers and fears of the insurance giantAIG (which was eventually bailed out)taking down major US and EU financial institutions in itswake


6/25

MTP PROJECT Page 5

A CHRONOLOGY OF THE MAIN EVENTS

The beginning of the crisis is a debatable event however the first clear-cut signs of it came

when in 2007 BNP Paribas froze the redemptions for three major investment funds. The reason

cited was its incapability to value structured products. As a result of this, the confidence of

consumers as well as businesses fell to all-time lows.

The direct repercussion of this was that there was a dramatic increase in the counterparty risk

between banks. This was reflected in the soaring rates of lending charged by banks to each

other for their short-term loans. This indirectly led to an increase in the credit default swaps

and the insurance premium on banks' portfolios. People were also complacent regarding the

onset of a crisis. Most observers were not even alerted that the systemic crisis would be a

threat.

However about half a year later all changed as the list of failed banks grew to such lengths that

indications of a systemic meltdown around the corner were evident. The list includes Lehman

Brothers, AIG, Fannie May and Freddie Mac, Wachovia, Washington Mutual and a few more.Nonetheless the governments were fast to respond. The damage would have been shocking

had it not been for a variety of rescue operations that the governments undertook.

With the fall of Lehmann brothers, investors became even more wary about the risk that bank

portfolios contained. As a result of this, it became even more difficult for such banks to raise

capital via the routes of deposits and shares. It came to a situation that the institutions that

were deemed at risk could no longer finance themselves through conventional means involving

banks. As a result of this, they has to sell assets at 'fire sale prices' and restrict their lending.

Thus the prices of similar assets fell even more and thereby reduced capital and lending further

a vicious cycle came into being. This can be compared to an adverse 'feedback loop' wherein

economic downturn increased the credit risk, eroded bank capital even further.

The primary response of major central banks - those that are situated in the United States and

in Europe was to reduce common systemic factor interest rates down to a historical low

thereby contain funding cost of banks.

They also gave additional required liquidity against collateral so as to ensure that financial

institutions didnt need to resort to fire sales. These measures resulted in huge expansion of

central banks' balance sheets. This bank lending to the non-financial corporate sector

eventually tapered off. The governments soon came to know that the provision of liquidity

albeit essential, were not sufficient to restore normal functioning of the banking system. This

was due to the deeper problem of probable insolvency associated with under capitalization.

The write-downs of the banks were estimated to be well over 300 billion US dollars in the

United Kingdom and well over EUR 500 to 800 billion in the euro area. In both cases this

accounted for almost 10% of the GDP of the country and/or union. It was agreed in 2008 that

countries would put in place financial programs to make sure that the capital losses of the

banks would be counteracted.


7/25

MTP PROJECT Page 6

CAUSES OF THE CRISISPICTORAL REPRESENTATION

Relaxed lending practices

Excessive investment

Risk assessment not proper

Global ImbalancesUSA Subprime Crisis

Improper fiscal policies framed by individual nations

Contagion Problemsno proper contingency measures in place.

A Single Currency

Then there were 27 countries

27 electoral democracies, 54 different points ofview.

Culture, history, technology, language, customs,socioeconomic structure etc are not at all the same.

Crisis:

Hard

Reasons

Crisis:

SoftReasons


8/25

MTP PROJECT Page 7

CAUSES OF THE EUROZONE CRISIS

The Eurozone crisis has been caused from a blend of intricate factors. These factors vary from

the globalization of finance; easy lending norms during the 20022008 period that stimulated

high-risk lending and borrowing; the financial crisis of 200708; international trade imbalances;

real estate bubbles; the Great Recession of 20082012; fiscal policy choices related togovernment incomes and expenditures; and methodologies used by nations to move out

troubled banking units and private bondholders, supposing private debt burdens or socializing

losses. These factors vary from country to country in the entire Eurozone. A few of them fell

into the crisis because of the government debt while others lost a lot of money in the property

bubble. We will now take the country wise analysis of the turnout of events that triggered the

outbreak of crisis in them.

PORTUGAL

Government Spending & public funds mismanagement

The democratic Portuguese Republic governments were involved in over-expenditure and

investment bubbles via hazy publicprivate partnerships. They funded many unnecessary

external aids to the government by consultancies which drilled deep holes in to the government

pockets. This caused significant loss in state-managed public works, extravagant top

management and head officer bonuses and

wages.

Over Employment in public jobs

The Portugal government followed an oldrecruitment program for the public jobs

without keeping an eye on the actual

requirement in the sectors. The public

servants to population ratio was one of the

highest in Portugal (708 as compared to 624 Euro zone average). Also, an example stating that

Portugal judicial system was the second slowest in

Europe despite having maximum number of judges

shows how inefficient and ineffective the public system

was.

Portugal Banking system breakdown

Other reason for the failure of the Portugal economy

was failure of the Portugal banking system attributed to

large scale bad investments, embezzlement and

accounting frauds. In the grounds of avoiding a

potentially serious financial crisis in the Portuguese

Government Expenditure (annual % GDP)


9/25

MTP PROJECT Page 8

economy, the Portuguese government decided to give them a bailout, eventually at a future

loss to taxpayers.

ITALY

Accumulating Government Debts

Italy has been very strangely has been shouldering the debt to GDP ratio well above 100% for

decades but very astonishingly no one cared as it was paying back the interest. In the year

1999, while Italy officially accepted the euro, its debt-to-GDP ratio was 126%. It was staying

afloat because of the slow steady growth which helped in the credibility of Italy. But then the

economy became stagnant and was slowly moving towards negative dip. This cause panic

among the investors and they raised the interest rates.

Low Productivity of Italy

Italy lacks in big industries to compete with the growing giants in Asia and rest of the world.Because the Italian economy is ruled by small and medium sized businesses, this can be thought

of all those charming artisanal cheese and pasta makersthe capital markets are poorly

developed. And these small scale industries are unable to reach either economics of scale or

efficiency owing to their small sizes.

Unemployment disparity, Mafia & Poor Governance

Some other factors that played minor roles are the existence of dual employment treatment in

the economy where old employers are permanent and with higher wages while youngemployers with temporary jobs and lower wages causing a great disparity in the unemployment

among the population. Also, wide spread black money market flourishes in Italy which eats

away a major part of the GDP reducing the government revenues. Poor governance is also a

major attributable cause for the above concerns.


10/25

MTP PROJECT Page 9

IRELAND

Property Bubble engulfed Irish Banks

The Irish sovereign debt unlike other Eurozone

crisis was not a result of government over-

spending, but due the guarantee that governmenttook for the six core Irish-based banks who were

deeply involved in financing a property bubble.

These Irish banks had vanished an assessed 100

billion euros, the unemployment peaked from 4%

in 2006 to 14% by 2010 and the national budget

went from a surplus in 2007 to a deficit of 32%

GDP in 2010. The highest ever in the history of the

Eurozone and the crisis was here.

Asset-Liability MismatchThe Irish banks had invested hugely in the

widespread infrastructure & building project, most

of which were not occupied even after being

completed for years. This led a massive misbalance between the Assets that banks were

banking upon to the liabilities that they were holding to the lenders. The government came to

the rescue of the banks but it was not sustainable as there nothing to cash back the already

occurred disaster. Ultimately the government had to lend money from IMF and European Union

to overcome their deficit.

GREECE

In the early mid-2000s, the economy of Greece was among one of the fastest proliferating in

the Eurozone. It propagated with an annual rate of 4.2%, as foreign money flew into the

economy. In spite of that, the economy remains persistent in delivering high annual budget

deficits. Major causes that led to this are below.

Government spending

The government was involved in huge military

expenditure, public sector jobs, pensions andother social benefits. Greece was able to get

finance for its spending until the world was hit by

the global economic crisis in 2008. It dried up the

global credit and which caused two prominent

industries shipping and tourism affect severely.


11/25

MTP PROJECT Page 10

Government tried to control the economy by borrowing and spending with open hands.

Tax evasion

The revenue from taxes for Greece has always been significantly below the expectation levels.

This was also one of the reason for growing deficit in the annual budget in the Greece economy.

Corruption & unethical deeds

In early 2010, it was exposed that Greece took the assistance of Goldman Sachs, JPMorgan

Chase and numerous other banks to develop the financial products which aided the

governments of Greece, Italy and many other Eurozone economies to conceal their borrowings

and meeting unethically the deficit target as put by the euro union.

SPAIN

Housing Bubble

Spain was relatively better off as far as the Debt to GDP ratio was considered among other

Eurozone economies. Somewhat similar to Irish crisis, the new properties including public

places, landmarks and houses were built massively

which involved huge investments. Subsequently,

there was no one to acquire or consume the

benefits which aroused bubble speculation.

Government could bear and back the deficit caused

owing to the large tax revenues it had generated of

the same construction spree. But this could not lastfor long.


12/25

MTP PROJECT Page 11

Sharp inflation & deflation

As Spain lacks in natural resources, it heavily depends on its import for fuelling the country. Due

to sharp rise in oil prices during the recession of 2008, the inflation reached its peak and a

record height with pressure on government mounting high which was already struggling to

cope with the housing bubble mishap. Then the prices fell drastically and this lead to deflation

in the economy and after that Spain economy could not recover from plunging negatively.

Spain on the Edge of Deflation


13/25

MTP PROJECT Page 12

POLICYMEASURES

European Financial Stabilization Mechanism (EFSM)

It is a mechanism referring on article 122(2) of the TFEU that foresees financial support for

member countries in difficulties caused by extraordinary circumstances beyond their control. It

is an intergovernmental agreement to provide financial assistance of up to EUR 60 billionsubject to strong conditionality in the context of a joint EU and IMF support which will be on

terms and conditions comparable to those levied by the IMF. On 5 January 2011, the European

Union created the European Financial Stabilization Mechanism (EFSM), an emergency funding

program reliant upon funds raised on the financial markets and guaranteed by the European

Commission using the budget of the European Union as collateral. It works under the authority

of the Commission and aims at preserving financial stability in Europe by providing financial

assistance to EU member states in economic problems. The Commission fund, backed by all 27

European Union members, has the authority to generate up to 60 billion and is given a rating

of AAA by agencies like Fitch, and Standard & Poor's.

Under the EFSM, the EU successfully placed in the capital markets a 5 billion issue of bonds as

part of the financial support package agreed for Ireland, at a borrowing price for the EFSM of

3.59%.

European Financial Stabilisation Facility (EFSF)

It is a temporary credit-enhanced SPV with minimal capitalization created to raise funds from

the capital markets on its investment grade rating and provide financial assistance to distressed

EAMS at lower interest rates than those available to the latter. The financial support provided

to EAMS through the EFSF shall be provided on comparable terms to the stability support loansadvanced by EAMS to Greece.

The total volume of these two mechanisms is EUR 500 billion. While EFSM is available to EAMS

and non-EAMS member states, the EFSF is only available to the EAMS.

The European Union (EU) finance ministers created the European Financial Stability Facility

(EFSF) to deal with the European debt scenario, which started in 2009, and was a part of the

larger global financial crisis. To realise why the EFSF was created, one must first understand the

fundamental requirements of becoming a member of the European Monetary Union (EMU).

To become a member of the EMU, a country must follow and retain, among other specified

criteria, a deficit below 3% of GDP and debt below 60% of GDP. Once a country becomes partof the EMU, it is subject to a single monetary and foreign exchange policy. However,

essentially, the country does not lose its ability to set its own fiscal policy.

Because of the EMU countries' ability to set their own fiscal policy, many EMU nations, like

Portugal, Ireland, Italy, Greece, and Spain, spent a lot, taxed very less, and issued too much

debt, which lead them into large deficits. This would not have been a problem if these

countries were not part of the EMUthey could have printed more money to pay for their


14/25

MTP PROJECT Page 13

excessive spending and debt issuances. However, with a unitary monetary policy, countries

within the EMU lose the facility to print money, and therefore, lack the ability to pay their debts

by printing more money. This becomes a problem area when, as in the EMU, there are no

limits on fiscal policy. Generally speaking, the easy-going fiscal policies of some EU member

states along with deceptive statistical reporting by Greece were the major causes of the debt

crisis.

In early 2009, Greece claimed that its deficit was 3.7% of GDP. In October 2009, Eurostat,

whose primary responsibilities are to provide the EU with European-level statistical

information, published a press report stating that the Greek government misreported its deficit

and debt figures. Shortly thereafter, the government of Greece adjusted the projected deficit

to 12.7% of GDP, more than four times the 3% limit levied by the EMU. The Greek government

also reported that its debt was 121% of GDP (well above the EMU limit of 60% of GDP). As a

result, the major credit-rating firms downgraded Greek debt while investors became unsettled

about other European countries with large debt and deficits.

Notwithstanding opposition from some EMU member states hoping to restore confidence and

safeguard financial stability in the Euro-Zone area, leaders of the Europian continent and the

International Monetary Fund (IMF) agreed to make available a 110 billion rescue package to

Greece if Greece implemented austerity measures. This did not in any way ease investors

fears.

After the Greek bailout, investors worried that other EU nations would break their promises of

always being capable of paying back their debts or interest on their loans. As a result, euro-

zone nations government bond prices dropped significantly and market interest rates for

financially distressed EU government bonds in Greece, Spain, and Ireland increased. Shortly

thereafter, investors began to worry that government finance problems would spread to

European banks which held a lot of EU governments debt. Because of this, there were news of

rift and that the EMU might break apart. To put an end to this speculation, calm the financial

markets, and fight another sovereign debt crisis, the EU finance ministers created the European

Financial Stability Facilitya limited liability company that could sell up to 440 billion of debt

on capital markets and lend the proceeds to euro area member states in troublewhich was

part of a larger 750 billion rescue facility.

The 750 billion rescue package consists of 500 billion from the twenty-seven countries of the

EU and 250 billion from the IMF. The majority (440 billion) of the European contribution

comes from sixteen-nation euro-zone bloc. The European Commission (EC), a branch of the

governing body of the EU, made 60 billion immediately available at their disposable.

European Stability Mechanism (ESM)

In October 2010 (after financial assistance was provided to Greece and while conditions

continued deteriorating), with the motive of ensuring balanced and sustainable growth, the EU

Council agreed on the need for member states to establish a permanent crisis mechanism to

safeguard the financial stability of the euro area as a whole. It was resolved that consultations

should be undertaken towards a limited treaty change for said purpose but not modifying

the so-called nobail-out clause included in article 125 of the TFEU. Further, the EU Council


15/25

MTP PROJECT Page 14

agreed in December 2010 that there is a need for EAMS to establish a permanent stability

mechanism, i.e. the ESM. This was immediately followed by the Conclusions of the European

Council57 and the EU Council decision 2011/199/EU amending Article 136 of the TFEU with

regard to a stability mechanism for EAMS, both were adopted on 25 March 2011.

When the EFSF expires, the EU will replace it with a permanent crisis mechanism called theEuropean Stabilization Mechanism (ESM). The ESM will provide funds to any member state

whose debt problems would threaten the euro zone. The ESM would want the private sector

bondholders to share the cost of any debt restructuring on a case-by-case basis.

A solvent euro-zone member experiencing liquidity problems can apply for emergency funding

from the ESM and would have to implement austerity measures similar to those required by

the EFSF. The country would not have to restructure its loans or decide on coming to a

standstill (i.e. cease payments on its debt until a restructuring agreement has been negotiated

with its creditors). However, if the IMF and the European Commission believe the country is

insolvent or that its debt position is unsustainable, the country requesting the funds would

have to negotiate with its creditors to restructure its debt as a condition of further bail-out

funding.

To facilitate the restructuring process, the European Stability Mechanism will require future

bond issuances by member states to include collective action clauses (CAC). The CAC enables a

majority of creditors to pass a legally binding agreement changing the terms of payment

(standstill, extension of the maturity, interest rate cut and/or haircut) in the event the debtor is

unable to pay. CACs are typical of the bonds issued under English law and help facilitate

restructuring.

EUROPEAN CENTRAL BANK

TheEuropean Central Bank (ECB) has taken a series of measures aimed at reducing volatility in

the financial markets and at improvingliquidity.

In May 2010 it resorted to the following actions:

It beganopen market operations buying government and private debt

securities, reaching 219.5 billionin February 2012, though it simultaneously absorbed the

same amount of liquidity to prevent a rise in inflation. According to Rabobank economist Elwin

de Groot, there is a "natural limit" of 300 billionthe ECB can sterilize.

It reactivated the dollarswap lines withFederal Reserve support. It changed its policy measures regarding the necessary credit rating for loan deposits,

accepting as collateral all outstanding and new debt instruments issued or guaranteed by

the Greek government, regardless of the nation's credit rating.

With the aim of boosting the recovery in the Eurozone economy by lowering interest rates for

businesses, the ECB cut itsbank rates down in multiple steps in 20122013, reaching the
http://en.wikipedia.org/wiki/European_Central_Bankhttp://en.wikipedia.org/wiki/Liquidityhttp://en.wikipedia.org/wiki/Open_market_operationshttp://en.wikipedia.org/wiki/Rabobankhttp://en.wikipedia.org/wiki/Currency_swaphttp://en.wikipedia.org/wiki/Federal_Reservehttp://en.wikipedia.org/wiki/Bank_ratehttp://en.wikipedia.org/wiki/Bank_ratehttp://en.wikipedia.org/wiki/Federal_Reservehttp://en.wikipedia.org/wiki/Currency_swaphttp://en.wikipedia.org/wiki/Rabobankhttp://en.wikipedia.org/wiki/Open_market_operationshttp://en.wikipedia.org/wiki/Liquidityhttp://en.wikipedia.org/wiki/European_Central_Bank


16/25

MTP PROJECT Page 15

historic lows of only 0.25% in November 2013. The lowered borrowing rates have also caused

the euro to fall in relation to other currencies, which is expected to boost exports from the

Eurozone and further aid the recovery.


17/25

MTP PROJECT Page 16

ECONOMIC REFORMS & RECOVERY PROPOSALS

The Euro zone debt crisis in the euro area during the spring of 2010 has revealed that the

monetary and fiscal policy framework of the European Monetary Union (EMU) is still

incomplete. Understandably, the rules-based framework for fiscal policy created by the

Excessive Deficit Procedure and the Stability and Growth Pact was insufficient to prevent a debtcrisis despite its emphasis on keeping public sector deficits low and strengthening forward-

looking budgetary planning. Once the crisis occurred and financial markets were stirred up by it,

it became obvious that EMU did not have policy tools to manage and resolve the crisis. Lastly,

the European Union responded to the crisis by agreeing on stabilisation for Greece and by

creating the European Financial Stability Facility (EFSF) that succeeded in calming the markets.

Nevertheless, these responses were developed in an ad-hoc manner and on a temporary basis

only and do not provide an adequate basis for dealing with any possible future debt crises in

the euro area.

Several proposals have been put forward for how to improve the euro zones capacity to dealwith problems of excessive public debts. To prevent sovereign crises, the European Commission

(2010) has proposed a number of measures to strengthen the Excessive Deficit and the Stability

and Growth Pact. The above proposals focus mainly on making the rules of the current

framework more effective and on strengthening their enforcement by introducing stiffer and

more automatic penalties for violating these rules. The European Central Bank (ECB) has made

proposals (2010) on the same lines and, at the same time, has called for the creation of a crisis

management fund for the euro area, which would come into play if the strengthening of the

rules-based framework does not suffice to prevent future debt crises. According to the ECBs

proposal, such a fund should provide last-resort financing at penalty rates to governments

facing difficulties in accessing private credit markets.

We agree that the euro area needs a mechanism for dealing with sovereign-debt crises in an

effective and predictable way. Even the most effectively enforced set of fiscal rules will not do

away with the possibility of future debt crises in the euro area. One of the crucial problems of

the crisis of 2010 was clearly that policymakers had no game plan for dealing with it. The lack of

any sensible rules guiding market expectations about how governments and the Commission

would respond to the crisis contributed to the volatility of financial markets during the crisis

and this contributed to the sense of urgency policymakers felt about the need to act.

LESS AUSTERITY, MORE INVESTMENT

In the public sector, as a result of the austerity policy, wages have been frozen or cut. Greece (

20 per cent) and Portugal (10 per cent) have been at the forefront of cuts in real wages

throughout the economy. Spain (5.9 per cent) and Italy (2.6 per cent) have also experienced


18/25

MTP PROJECT Page 17

above-average real wage losses during this period. This showcases an opening of the floodgates

in comparison to the situation before the crisis of 2008/2009.

In pension policy, Portugal introduced reforms in 2007 and Greece, Italy and Spain in 2010,

which many other EU states had launched a decade before. Besides raising of the statutory

retirement age, a toughening of the conditions for early retirement, the equalization of menand women and the abolition of job-specific differences, individual components of pension

reform have been adjusted in such a way that the rise in pension costs in relation to GDP by

2040 has been slowed down significantly. Relative pension levels will fall drastically in the GIPS

states by 2040.

The pension reforms that have been implemented will have long-term negative consequences,

especially for those future pensioner generations who have more adverse employment

biographies. Longer periods of unemployment conditions entail gaps in social insurance

contributions and thus reduce pension levels.

Privatization policy has taken on new impetus in the GIPS states because of the Euro-crisis and

the accompanying austerity policy. In Greece and Portugal, the granting of loans by the EU

states was linked to extensive privatization. Spain and Italy, under pressure from the ECB and

international institutions, have announced far-reaching privatizations. Among the GIPS states,

Greece has been most affected and plans a veritable fire sale of state property.

INCREASE COMPETITIVENESS

Internal devaluationMany policy makers try to restore competitiveness through internal devaluation, an economic

adjustment process, where a country aims to decrease its unit labour costs. In 2012, Ireland

was the only country that had implemented relative wage moderation in the last five years,

which helped decrease its relative price/wage levels by 16%. Greece would need to bring this

figure down by 31%. Wages in Greece have been cut to a level last seen in the late 1990s.

Buying power dropped even more to the level of 1986.

Fiscal devaluation

According to fiscal devaluation, policy makers can increase the competitiveness of an economy

by lowering corporate tax burden such as employer'ssocial security contributions, while

negating the loss of government revenues through higher taxes on consumption (VAT) and

pollution, which is called ecological tax reform. Germany has successfully pushed its economic

competitiveness by increasing the VAT in 2007, and using part of the additional revenues to

lower employer's unemployment insurance contribution. Portugal has taken a similar stance

and France appears to follow this suit.
http://en.wikipedia.org/wiki/Tax#Social_security_contributionshttp://en.wikipedia.org/wiki/VAThttp://en.wikipedia.org/wiki/VAThttp://en.wikipedia.org/wiki/Tax#Social_security_contributions


19/25

MTP PROJECT Page 18

Progress

According to the Euro plus Monitor 2011 report, most critical euro zone member countries are

in the process of rapid reforms. Greece, Ireland and Spain are among the top five reformers and

Portugal is ranked seventh among 17 countries included in the report.

The Lisbon Council in November 2012 finds that the euro zone has slightly improved its overall

health. With the exception of Greece, all Eurozone crisis countries are either close to the point

where they have achieved the major adjustment or are likely to get there over the course of

2013. Overall, if the euro zone gets through the current acute crisis and stays on the reform

path it could eventually emerge from the crisis as the most dynamic of the major Western

economies.

ADDRESS CURRENT ACCOUNT IMBALANCES

Europe is in the grip of three interdependent crises: a sovereign-debt crisis, a banking crisis anda balance-of-payments crisis. Policymakers have primarily focused on the sovereign-debt and

banking crises. However, a convincing strategy for getting the Eurozone back on track needs to

tackle the problem of its large internal imbalances. Rebalancing will require countries with

current-account deficits to devalue. The critical question is how: internally without exiting the

euro or externally after exiting the euro.

Not much attention has been paid to the imbalances within the European Union or the

Eurozone. One of the reasons for this might have been that the current account of the

Eurozone was roughly balanced over the period from 1995 to 2011. The external balance of the

Eurozone, disguised the significant internal imbalances. Greece, Ireland, Italy, Portugal, and

Spain have been running a current account deficit that has been rising since the late 1990s. This

deficit was largely offset by the huge current account surplus in Germany during the whole

period. The rest of the Eurozone was more or less in balance. Current account deficits and

surpluses resulted in corresponding changes in the net international assets position. Germany


20/25

MTP PROJECT Page 19

slowly improved its asset position while Greece, Ireland, Italy, Portugal, and Spain accumulated

a large net liability position.

Greece, Ireland, Italy, Portugal, and Spain relied more and more on public support to finance

themselves internationally. Until 2007 the main source of this public support was ECB Target

credit. The public capital flows as reflected in the increase in the Target balances compensated

for the private capital flows. They have financed or co-financed the current account deficits of

Greece, Portugal and Spain since 2007/2008, and compensated for capital flight from Ireland

after the Lehman crisis.

WHAT IS THE WAY OUT?

The first option, the one favored by European

finance capital, is to grant emergency loans toGreece. Loans will allow Greece to continue to

service its debts so that bondholders do not

incur any losses. The conditionalitys include

reduction of government spending on social

sectors, freezing of government jobs, reduction

in wages, privatization of the pensions sector,

labor market reform and other such measures. It

will severely contract the level of aggregate demand in the Greek economy and thereby push it

into a prolonged and deep recession. This will ensure a deflation in the Greek economy relative

to Germany, leading to a possible reduction in the trade deficit.

The second option, the one that should be favored by the working class in Greece and other

countries, is to work out a credible debt-restructuring program with bondholders and force the

German economy to reflate. Debt-restructuring would ensure that some of the cost of re-

adjustment is borne by finance capital. Increasing aggregate demand in the German economy

through a mix of fiscal and monetary policy would revive demand, push up inflation, decrease

real interest rates and thereby boost private investments. Other options will open up, if Greece

and other countries in the periphery decide to opt out of the euro zone altogether.


21/25

MTP PROJECT Page 20

PROPOSED LONG TERM SOLUTIONS

1. EUROPEAN FISCAL UNION:Fiscal union is the integration of the fiscal policy of nations or states. Under fiscal union

decisions about the collection and expenditure of taxes are taken by common institutions,

shared by the participating governments.

It is often suggested that the European Union adopt a form of fiscal union. Most member states

of the EU take part in financial and monetary union (EMU), founded on the euro currency, but

most conclusions about levies and spending remain at the nationwide level. Thus, whereas the

European union has a monetary union, it does not maintain a fiscal union.

Control over fiscal policy is advised central to nationwide sovereignty, and in the world today

there is no considerable fiscal union between independent countries. However the EU has

certain restricted fiscal forces. It has a role in concluding the level of VAT (consumption levies)and tariffs on external trade. It also spends a allowance of numerous billions of euros. There is

furthermore a Stability and Growth Pact (SGP) among members of the Eurozone (common

currency locality) proposed to co-ordinate the fiscal principles of constituent states. Under the

SGP, constituent states report their financial designs to the European Commission and interpret

how they are to accomplish medium-term budgetary objectives. Then the Commission assesses

these plans and the report is sent to the financial and economic managing group for remarks.

Eventually, the assembly of financial and Finance Ministers concludes by qualified majority

whether to accept the Commission's recommendation to the constituent state or to rewrite the

text. However, under the SGP, no nations have ever been penalised for not gathering the

objectives and the effort to penalize France and Germany in 2003 was not fulfilled. Thus, afterthe Eurozone urgent situation, some people in Europe sensed the need for a new union with

more powerful fiscal influence amidst constituent states.

On 2 March 2012, all constituents of the European Union, except the Czech Republic and the

United Kingdom, signed the European Fiscal Compact, which if ratified by the 25 countries

would implement stricter caps on government expending and borrowing, encompassing

automatic sanctions for nations breaking the rules.

However, following are the arguments advocating the introduction of fiscal union in the EU:

1. LOCAL PROBLEMS NEED LOCAL SOLUTIONS

As long as the European Union is made up of independent countries with their own voted-into-

office authorities, their troubles are going to be essentially localized and they will need localized

solutions. Squeezing them into a common monetary straightjacket has clearly failed and

supplementing a fiscal union would just exacerbate an existing unsustainable situation.

Governments need flexibility to deal with their own problems. Fiscal union would involve


22/25

MTP PROJECT Page 21

ballooning of the EU allowanceprovoking endless bickering among the 27 constituent states

on how to share it out, not to mention the amplified scope for graft and bureaucratic

inefficiency. Its a recipe for gridlock.

2. DEMOCRATIC DEFICIT

Fiscal union is often looked upon as detrimental to national independence. Setting budgets isessentially the responsibility of sovereign parliaments. Transferring that power to some distant,

opaque Brussels institution would be deeply undemocratic. History tells us citizens will not

agree to taxation without representation.

3. EVRERYONE PAYS MORE

The tax harmonization that will follow fiscal union will only move in one direction: up. Countries

like Ireland or Slovakia which boosted their economies with innovative revenue policies will be

forced to apply high taxes as part of a French-led crusade against fiscal dumping. This shall be

a major blow to Europes competitiveness.

FOR

NO EMU WITHOUT EFU: Combiningsupranational monetary policies withnational fiscal policies is unsustainable.A fiscal union run by a fullyempowered EU Finance Ministryunder proper democratic oversight willgive the Union strength and stability,mutualizing credit risk while imposingtough fiscal discipline.

UNITED WE STAND: Closer economicunion is the only way to halt Europesdecline in the new global environment.Fiscal union would raise Europesmarket credibility and eurobondswould rival US treasuries.

EFFICIENCY: A European fiscal union,with proper institutions would be ableto provide joined-up management ofthe EU economy as a whole.

AGAINST

LOCAL PROBLEMS NEED LOCALSOLUTIONS: Squeezing the EUmember nations into the samemonetary straightjacket has clearlyfailed and adding a fiscal union wouldjust exacerbate an alreadyunsustainable situation.

DEMOCRATIC DEFICIT: Setting budgetsis a core responsibility of sovereignparliaments. Transferring that powerto some distance, opaque Brusselsinstitution would be deeplyundemocratic. Citizens will not accepttaxation without representation.

WELL ALL PAY MORE: Countries likeIreland or Slovakia that boosted theireconomies with innovative revenuepolicies will be forced to apply hightaxes as part of a French-led crusade

against fiscal dumping.


23/25

MTP PROJECT Page 22

2. EUROBONDSEuropean bonds are proposed government bonds issued in Euros jointly by the 17 eurozone

countries. Eurobonds are liability investments whereby an shareholder loans a certain amount

of cash, for a certain amount of time, with a certain interest rate, to the eurozone bloc entirely,

which then ahead the cash to the individual national governments.Eurobonds these days are intended as a way to tackle the eurozone debt crisis. The idea,

propounded by the European Commission, appears to be of certificates that will fully replace

existing national bonds. Technically, a eurobond is a debt contract, that records the borrowers

obligation to pay interest at a given rate and therefore the principal quantity of the bond

on such dates.

Because Eurobonds would enable already highly-indebted states access to cheaper

credit because of the strength ofalternative Eurozone economies, they're disputed.

On 21 November 2011 the european Commission instructed European bonds

issued together by the seventeen eurozone nations as a probably effective way to handle

the monetary crisis. On 23 November 2011 a written report was presented, analyzingthe feasibleness of common issuance of sovereign bonds among the EU member states of the

eurozone. Sovereign issuance within the eurozone is presently conducted separately by

each EU member country. The introduction of commonly issued eurobonds would mean a

pooling of sovereign issuance among the member states and therefore the sharing of

associated revenue flows and debt-servicing costs.

3. EUROPEAN MONETARY FUNDGermany and France are designing the launch of a clearing new initiative to strengthen financial

co-operation and surveillance inside the eurozone, encompassing the establishment of a

European Monetary finance (EMF), according to senior government officials.

Their intention is to set up the directions and devices to prevent any recurrence of volatility in

the eurozone arising from the indebtedness of a single member state, such as Greece.

The first minutia of the plan, including support for an EMF modelled on the International

Monetary Fund, were revealed by Wolfgang Schuble, the German investment minister.

The fund would have assets to lend to eurozone constituent states in economic difficulty, but

only subject to very strict situation to constrain excessive allowance deficits and scrounging.

The concept was suggested by Germany and they are now endeavouring to get France onboard.


24/25

MTP PROJECT Page 23

CONCLUDING REMARKS

We believe that a little more prudence with regard to monitoring the fiscal policy of individual

countries of the Eurozone would have helped mitigate the crisis. Moreover, the austerity

measures taken by the Eurozone and especially those that were imposed on PIIGS did little to

improve the condition of those countries. The gaping deficit that was revealed at a later date

could have been seen to using growth measures, which we believe are more sustainable than

imposing austerity measures. Simply putits similar to jailing a person just because they cant

pay their debts. This doesnt help either party involved. The borrower cant make money

because of the restrictions and the lender cant get his principle back as the borrower will still

have little, if any, money to pay.

Policy changes are necessary. Steps in that direction have already been taken. Compliance to

the Maastricht treaty after grant of membership was an issue. As pointed out in the initial parts

of this report, the members of the Eurozone violated the treatys conditions time and again. It

also made membership for those countries failing to meet criteria as some of the criteria were

tied to the current performance of the member countries e.g. the inflation rate had to be theaverage of the three best countries with regard to that parameter. Thus, better compliance and

stricter action has to be imposed for offenders. Contingency measures need to be looked into

especially due to the Eurozone being a union sharing policies as well as a common currency.


25/25

MTP PROJECT P 24

REFERENCES

1) Economic Crisis in Europe: Causes, Consequences and Responses, European Economy Publication Number 7, Year 2009, Economic and Financial Affairs Directorate, EU.

2) The Eurozone Crisis Its dimensions and Implications, January 2012; M R Anand, GLGupta, Ranjan Dash

3) Eurozone crisis: beggar thyself and thy Neighbor, Journal of Balkan and Near EasternStudies, December 2010, Costas Lapavitsas.

4) Eurozone crisis : The corporate perspective, January 2012, Herbert Smith5) Policy Lessons from the Eurozone Crisis - The International Spectator: Italian Journal of

International Affairs, December 2012, Chiara Angeloni.

6) EurostatStatistics Explained: Structure of government debt (October 2011 data)7) Budget deficit from 2007 to 2015 Economist Intelligence Unit 30 March 20118) Rainer Lenz: Crisis in the Eurozone Friedrich-Ebert-Stiftung, June 20119) Global Financial Stability Report International Monetary Fund, April 201210)Story, Louise; Landon Thomas Jr., Nelson D. Schwartz (14 February 2010).11)"Wall St. Helped to Mask Debt Fueling Europes Crisis". New York Times (New York)

September 2011.

12)International Monetary Fund: Independent Evaluation Office, Fiscal Adjustment in IMF-supported Programs (Washington, D.C.: International Monetary Fund, 2003).

Documents

Euro Zone Crisis : A macroeconomic study