I’ve been thinking about writing this post for a while now. However, I’ve been hesitant to do so simply because it’s such an important and complex issue that I wanted to let things play out for a bit before getting down to the nitty-gritty of it all.
So what’s happening in Europe? Well, to put it bluntly, the euro zone is proving to be a complete disaster. I will try my best to explain what’s going on in a way that is easy for everyone to understand, even those of you that aren’t very familiar with economic terms. So, please bear with me - I think this’ll be another long one.
As usual when tackling any problem, it’s helpful to go back to the beginning. With that in mind, let us begin this journey with a very brief summary of how the euro zone came to be.
The earliest precursor to the European Union was the European Coal and Steel Community (ECSC) founded in 1951 to create a common market for coal and steel, some of the region’s most vital resources. Now, keep in mind that Europe had just been devastated by World War II and was therefore seeking a way to encourage cooperation between European states in order to facilitate and speed up recovery. After seeing the success of the ECSC and to allow for even greater integration within Europe, the European Economic Community (EEC) was created in 1957, having as a main goal the establishment of a customs union (a free trade bloc with a common external tariff.) Throughout the 60s, 70s, and 80s, more and more members of Europe joined the customs union (originally there had only been six members), leading up to the Maastricht Treaty of 1993, where the European Union was officially established. By this point, the EU had a common market (freedom of movement of capital and labor) in addition to a customs union.
Theory indicates that the next stage in economic integration is the creation of a monetary (or currency) union, which as you all know by now, the European Union did eventually set up (the euro zone.) This was essentially the purpose of the Maastricht Treaty, to bind members of the European Union to join the euro zone after they’d met the following criteria:
1) Keep inflation rate no more than 1.5 points higher than the EU members with the best inflation rate.
2) Government deficit cannot 3% each year.
3) Government debt must not exceed 60% of GDP.
4) Long-term interest rates cannot exceed that of the three countries with the lowest interest rates by more than 2%.
5) A country must have implemented the Exchange-Rate Mechanism (ERM, consisting of semi-fixed interest rates) for more than 2 years with no signs of currency devaluations.
With a few exceptions (UK, Denmark), once members of the EU had met all of these requirements, they automatically became members of the euro zone. The euro starting circulating in 2002 and since then has become the world’s second largest international currency reserve. Why did European countries feel that they needed to have a common currency? Well, to put it simply, they expected it to provide great benefits to all members of the EU as it would reduce costs of transactions and eliminate exchange-rate risks. Consequentially, all of this would lead to more flexibility and increases in trade and investment.
And for a while, all of this did happen - which brings us up-to-date. If you’re even remotely interested in current affairs, I’m sure that you’ve heard the phrases “European sovereign debt crisis” and “fear of contagion” at least once in the last, oh I don’t know, year and half? So, what’s happened in Europe that’s led to talks of the euro’s demise?
I already explained how the euro zone came to be and how it works, so you must have an idea of the level of interconnectedness that exists between European countries. That said, each country gets to implement fiscal policies of its own. In other words, though they have a common market and use the same currency, the economic policies implemented by the Greek government can be completely different than those set in place by the German one. (Theoretically, this shouldn’t be the case since there is a checklist that euro zone members must abide by. But, we also know that things hardly ever work the same way in the real world as they do in theory.)
Pundits claim that the euro zone was doomed from the start. They argue that stronger economies (mostly Germany) were so eager to create the euro zone that they allowed weaker states to join even if they didn’t meet all of the requirements. Therefore, these countries didn’t have the sound infrastructure or policies that were necessary to thrive in the long-term. Although they all reaped the benefits at the beginning, it soon became clear that the euro zone was divided into a core (again, mostly Germany) and a periphery (Greece, Ireland, Spain, Portugal.)
The European financial crisis really started in 2008, with the collapse of the entire banking system in Iceland. However, most people (myself included) didn’t really start to pay attention until last year, when concerns over the ever-growing national debt in Greece really started to pile up (Greece’s debt was an exorbitant €400 billion.) With the incentive of low interest rates and “easy money” that came along with the introduction of the euro, the Greek government revealed that it had been running a large deficit (as a result of massive levels of spending and consumption) since its inclusion into the euro zone. The Greek economy, which is largely dependent on its tourism and shipping industries, was particularly hard-hit in the global recession of 2008. In May 2010, Greek government asked for a bailout from the EU/IMF, and after much debate, it was finally loaned €110 billion, with the continued commitment to implement harsh austerity measures (reduction of public spending and increasing taxes.) Also in May 2010, and largely in response to the Greek sovereign debt crisis, the European Union created the European Financial Stability Fund (EFSF) to help alleviate euro zone states in financial trouble.
Something about the economic world that most people don’t understand is that public perception is really important. Say you were a German investor that had bought Greek government bonds. What would happen if the Greek government suddenly revealed that it had manipulated its budget sheets to make its debt seem less than it really was? Fearing the possibility of Greece declaring bankruptcy, you’d try to get your money back as soon as possible, right? Investors no longer wanted to have their money tied to Greek bonds so they started to pull out. This, in combination with the austerity measures implemented by the Greek government, led to even bigger problems, which is why we were still hearing about Greece’s debt crisis a few weeks ago.
However, problems don’t end there. Ireland’s public debt is about 94% of its GDP, whereas its deficit is of 32% (recall that the requirements to be included in the euro zone were for public debt to remain below 60% of GDP and the deficit below 3%.) Similarly, Portugal’s debt is of 83% and its deficit is about 9% of its GDP. Another source of worry is Spain, with a deficit of 9.2% and a debt of about 60%
What about Italy, you ask? Well, Italy’s situation is even more relevant because Italy has one of the largest economies in Europe. Not to mention that Italy’s bond market is the third largest in the world (after the US and Japan only.) Even though Italy has been running current account surpluses, its debt is of about 120% of its GDP. That, coupled with the fact that Italy has been experiencing one of the slowest economic growth rates in the last decade has led investors to perceive Italy as a very risky business. Yields on Italian 10-year-bonds have remained well above 6.5% (they even rose to about 7.5% last week.) Just imagine already being severely indebted (120%!) and on top of that having to repay all of your loans with an additional 7.5% of their additional value. Yea, it isn’t the most promising of scenarios.
Another issue that I’ve failed to mention (mostly because it’s too big of an issue to tackle in this post) is the role that politics has been playing in the euro’s debacle. Both Greece and Italy have seen governments ousted in the last month (Lucas Papademos succeeding George Papandreu in Greece; Mario Monti replacing Silvio Berlusconi in Italy.) Again, public perception and investor confidence play an important role in all of this (one of the reasons why Italian bond yields are so high.) Political unrest has historically been a precursor to economic woes, so its expected that investors will try to pull out of politically unstable markets.
So, can the euro survive? Honestly, if things remain the same, I don’t think it has a significant chance of being around for much longer. As I’ve already explained, I don’t think that austerity measures, the conventional way of tackling the issue, are doing much of anything to ameliorate the situation. In fact, austerity measures will create greater social unrest and if anything, I believe they’ll actually precipitate the euro’s demise. Most European countries are already dealing with higher interest rates and slow economic growth as it is.
That said, nothing is set in stone. Analysts would argue that the power now lies with the European Central Bank to come to the rescue. However, up until very recently (as in yesterday), the European Central Bank was firm in its position of not granting debt relief. The European Central Bank had instead been focusing on buying bonds from the weaker states. However, it’s been said that it’s too little, too late and that the ECB must start to play an even bigger role if it plans on keeping the euro zone alive. Another proposed solution is that the European Financial Stability Fund (EFSF) seek to increase the amount of bailout money available, by attracting private investors from China and other developing countries that have recently experienced unprecedented levels of economic growth.
And there you have it - my take on the European sovereign debt crisis. Forgive me if at times I oversimplified the facts, but you have to understand that I like presenting information in a way that will be easily understood by everyone, from high school students to university professors alike.
If you have any questions, please let me know. And as usual, keep an eye on the developments in Europe. Remember that we live in a highly interconnected world and that what happens in one part of the world will most likely end up having an effect on us all, even if it’s not immediately obvious. Until next time…
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