The Eurozone Financial Crisis

University of the Philippines Ermita, Manila
The Eurozone Financial Crisis
Submitted by: Lorenzo Daniel L. Antonio
Submitted to: Maam Regatta Antonio
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Over the last few years, the euro area has been going a financial crisis, presently called the eurozone crisis. Greece, Ireland, Portugal, Spain and more recently, Italy, have witnessed a downgrade of the rating of their sovereign debt, fears of default and a dramatic rise in borrowing costs. These developments threaten other eurozone members and the future of the Euro. This paper attempts to understand the implications and impacts of the eurozone crisis subsequent to the creation of the euro. A Background of the Eurozone The eurozone, formally called the euro area, is a collective group of nations and states part of the European Union (EU) that use the euro () as their shared currency and legal tender. There are presently 17 countries in the euro area. It consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, and Spain. By adopting a single currency, management of the economies of the members of the euro area become unified. Monetary policy of the euro area is the duty of the European Central Bank (ECB), which is centered in Frankfurt, Germany, and comprises the central banks of the euro area member states. The ECB is responsible for a single authority and monetary policy in the area, primary to maintain price stability and keep inflation in control. Though ECB is present, a large portion of the responsibility for economic policies still remains with individual member states. As a development goal of the EU, the eurozone came into existence. The current situation of the euro area is far from the optimism and vision that was hoped for in the creation of the eurozone on January 1, 1999, where 11 European Union countries (Austria, Belgium, Finland,
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France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain) decided to delimit their currencies into a sole currency. The justification for the creation of a single currency was primarily, but not only, economic. There was also a political justification1 as a single currency was perceived as a symbol of political unity in the post-World War II world, and a spur for further harmony with other domains. In the small-scale, usage of one currency would likely increase cross-border and international competition in the market and prices of goods, services, and capital. Seeing the big picture, a single currency was assumed to be a contributing factor in price stability and keeping inflation in control. As consequences of currency exchange, there was a temporary rise in prices as some businesses and services took advantage, and legacy currencies tender used by countries still remain and is not fully exchanged with the new currency. All member nations of the EU, except for Denmark and the United Kingdom (who chose not to join from the beginning), are obligated to adapt to the euro and join the eurozone. Before doing this, they must meet certain criteria, called convergence criteria (table 1). The
convergence criteria are a set of budgetary and monetary rules for countries wishing to join the eurozone. The Maastricht Treaty2 in 1991 established this set of rules.
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The success of the Europe Recovery Program led visionaries to push new cooperative initiatives and spurred growth in Europe. 2 The European Monetary Union (EMU), conceived in 1988-1989 by a committee of central bankers, led to the treaty.
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The Eurozone Financial Crisis Table 1 Convergence criteria Price Stability Sound public What is finances measured How it is measured Convergence criteria Consumer price inflation rate Not more than 1.5 percentage points above the rate of the three best performing member nations Government deficit as % GDP3 Reference value: not more than 3%
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Sustainable public finances Government debt as % GDP Reference value: not more than 60 %
Durability of convergence Long-term interest rate
Exchange rate stability
Deviation from a central rate Not more Participation than 2% in ERM II above the rate (Exchange of the three Rate best Mechanism performing II) for at least member states 2 years in terms of without price stability severe tensions
Note. Data from European Commission (26 February 2013). According to the European Commission (2013), the ERM is an exchange-rate mechanism in the European Union, consisting of three stages. The ERM mechanism was introduced in 1979 to reduce exchange rate volatility and achieve stability in Europe. After the creation of the euro area, the mechanism changed to ERM II. The policy changed to linking currencies of other countries outside the euro area, but inside the EU, to the euro area. Fulfilling the criteria of ERM II would allow an EU country to be a potential candidate for entering the euro area. In ERM III, the actual currencies in the participating member countries are replaced by euro banknotes and coins, thus, entering the euro area. Aside from the initial 11 countries that joined, an additional six countries have joined the euro area through these criteria. Slovenia joined the euro area 2007, Cyprus and Malta in 2008, Slovakia in 2009, and Estonia in 2011.
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Gross domestic product Gross domestic product (GDP) is a measure of the economic activity, defined as the value of all goods and services produced less the value of any goods or services used in their creation.
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The eurozone entered its first recession in in the third quarter of 2008, as sovereign debts in several economies soared and went out of control. The Eurozone crisis: causes of the recession One cause of the financial crisis is the bursting of the property bubble in the United States and the ensuing contamination of balance sheets of financial institutions around the world (European Commission, 2009). Global imbalances also played an important role in causing a financial crisis. The net saving surpluses of China, Japan and the oil producing economies kept bond yields low in the United States, whose deep and liquid capital market attracted the associated capital flows. The global financial crisis in 2007 and 2008 acted as the switch that put debt across Europe and in the euro zone as growth declined sharply (Figure 1). The financial crisis led to a disruption in financial intermediation4.There was a credit boom from 2003 to 2006, seeing a convergence in falling interest rates. With high debt levels worldwide caused by the global crisis, unsustainable deficits ensued in the euro area in 2007; thus, interest rates started to diverge, eventually marking the weak economies from the strong. Too much lending left banks with debts, and governments with large deficits and public debts.
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A process of channeling funds between surplus and deficit agents
The global financial crisis had begun to have an impact on European economies. Greece, in 2009, admitted that its debt had reached 113% of its GDP, which is far from the 60% cap imposed on euro area economies. In 2010, concerns stemmed from other troubled countries, including Portugal, Spain, and Italy, who had also high levels of sovereign debt.
Figure 1 Real GDP Growth (%) in several euro area nations

8 6 4 2 0 -2 -4 -6
GDP Growth (%)
Greece Spain Ireland Italy Portugal Eurozone 2003 5.9 3.1 3.9
Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 Greece 4.4 2.3 5.5 3.5 -0.2 -3.1 -4.9 -7.1 -6.4 Spain 3.3 3.6 4.1 3.5 0.9 -3.7 -0.3 0.4 -1.4 Ireland 4.4 5.9 5.4 5.4 -2.1 -5.5 -0.8 1.4 0.7 Italy 1.7 0.9 2.2 1.7 -1.2 -5.5 1.7 0.4 -2.4 Portugal -0.9 1.6 0.8 1.4 2.4 -2.9 1.9 -1.6 -3.2 Eurozone 0.7 2.2 1.7 3.2 3 0.4 -4.4 2 1.4 -0.6 Note. Data from European Commission Eurostat (26 February 2013).
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This led investors to demand higher yields on sovereign bonds, which worsened the problem by making borrowing costs much higher. Higher yields led to lower bond prices, which meant larger economies and banks holding sovereign debts in troubled countries began to suffer, thus activating a ripple effect on the euro area.
The Eurozone Financial Crisis Dimensions on the Eurozone Crisis
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By 2011, the euro zone crisis turned predominantly into a sovereign debt crisis intricately woven with bank debt and claims across borders within and outside the monetary union. In that sense, there is uniqueness to the eurozone crisis. Variation among countries has effects on the flexibility of the Eurozone. Within the euro zone, there is substantial variation in terms of productivity. Germany, being the top performing economy in the eurozone, is the benchmark for productivity, having the score of 100. According to the Organisation for Economic Co-operation and Development (2012), the troubled economies have lower labor productivity compared to Germany which stands out in terms of labor unit costs and productivity. The economies generally have a higher labor cost than Germany, rising even higher in recent years. The unemployment rates are also divergent. This shows that differences in a currency union could get exaggerated. It shows that the capacity to weather similar shocks in the economy is different even when there is a currency union to help improve competitiveness and stability. Large fiscal deficit and public debt with interconnected and weak banking systems can then make matters worse if debt is held across borders. The early success of the euro had been dependent on the stronger economies to maintain fiscal discipline and to retain the trust of markets. Although this is the case, according to Anand, M., Gupta, G., Dash, R. (January 2012), it is the integration in the financial and money markets, that in part, was due to a common currency, which makes the euro zone crisis harder to untangle.
Integration in the financial and money markets would affect economies that are exposed, either directly or indirectly, to the debts of the troubled economies of Spain, Italy, Greece, Ireland, and Portugal. There is a large sharing and exposure of public debt across borders, giving European banks trouble engaging with the peripheral economies. Decision making also plays a big part in the crisis. In the national level where there are sub-national identities, management and decision-making is already problematic process. In the case of the euro area, a decision on financial assistance requires unanimous agreement from representatives of member economies. In a currency union, political decisions in one country affect the economies of other countries. The Impact of the Financial Crisis on European Countries There are individual impacts of the financial crisis on several European countries. The effects on United Kingdom (UK), Greece, Spain, France, and Italy are discussed. The UK and the Euro The euro is a decade old and the UK still hasnt decided to adopt it. The case for joining the euro area has never been as pressing as at the start of the global financial crisis. According to Posta and Talani (2011), the possibility of the preferences of the UK financial sector to change after the global financial crisis is a possibility that cannot be discarded. However, it is also essential to take into mind the domestic economic consequences of joining a fiscal union. These are usually included in a loss of sovereignty, and in the case of United Kingdom, this would mean losing the possibility to influence domestic fiscal and exchange rate policies. Given the financial crisis, it is more unlikely that the British government will reopen the possibility of joining the euro area.
The Eurozone Financial Crisis The Greek Debt Crisis
Though there has been a lot of effort to help Greece through bailout loans to help the government pay its creditors, Greece abandoning the euro would have serious impact on the euro area. When it does, if it does, perhaps within a matter of months, there will be a damaging domino effect throughout Europe. On the small-scale, there would be lawsuits over which currency to use, the traditional currency or the euro. On the long term and large scale, big banks would take big losses on Greek debt if they opt out of the currency union. Some banks would fail, and only the strong would remain, making the banking system sound and running again, although this would be at a considerable expense to taxpayers in several member economies of the euro area. Impact on Spain Spains old and still present economic weaknesses were opened up and worsened by the financial crisis. Unemployment and the budget deficit soared in recent years due to the crisis. A severe crisis like this could be used to make much-needed changes in its political structure, and redirecting investments towards higher value sectors. According to Posta and Talani (2011), the crisis could serve to strengthen the Spanish economy by helping it to move from an obsolete model which served the country well in the past but which does not meet its current and future needs. French resistance and steering out Frances bank bears a heavy exposure to Greek debt, thus affecting the French banks stocks and its economy in general.
The Eurozone Financial Crisis Although that is the case, Posta and Talani (2011) state that:
France has resisted the current economic crisis relatively well and has some advantages that will help it to emerge from crisis. The particular characteristics of its labor market and its complex and costly social protection system have acted as shock absorbers in the recession. Looking far and out, France will need to find its own solutions to the broader issues about its productive power in the international market and not just rely on its local goods and services sector, tourism, and food sector. Its characteristics and structure have only provided a temporary distraction. Italy and its labor market Italy has experienced an increase in unemployment rates paired with the highest debt levels in the euro area, even though it is the latest to feel the domino effect among the troubled economies. Even if there is stagnant growth, it isnt enough to pay its debt. An advantage Italy has over Greece is that most of its debt is owed to its own people rather than foreign economies. Implications and Effects, Possible Solutions and Conclusion The euro area crisis has been moving from one peripheral economy to the next, and more recently, is affecting the core economies in the euro zone. The significance of the crisis is not that it comes after a recent global crisis, but more importantly, it threatens the pace of recovery of economies worldwide, because the EU and the euro area has a significant market share for the rest of the world.
The Eurozone Financial Crisis Implications for advanced countries
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The manner in which the crisis is dealt with is most crucial to the Eurozone economies themselves, especially for Germany and France. The two European giants are already facing large exposures from debts of the peripheral economies. The markets have been restless in pricing them down. Even the United Kingdom, which remains outside of the currency union, is still affected because of substantial exposure to debt in the troubled economies. The United States is also affected as it also has large market in Europe. Implications for emerging market economies For China and India, Europe and the euro area is a significant market. A decline in performance or even stagnation will affect their ability to export and grow. Regarding China, the advantages and disadvantages are seemingly balanced. It has been looking for opportunities to diversify its foreign exchange assets. The current crisis provides a window to gain a lead and acquire strategic assets by holding troubled assets in troubled economies of the euro area. Possible solutions According to Anand, M., Gupta, G., Dash, R. (January 2012), there are three possible alternatives being discussed. The first is the route of graveness, through fiscal consolidation, including privatization. This is the default policy choice. While fiscal consolidation is desirable, it is uncertain if it will contribute to sustained growth in the near future. It also does not address the structural problems faced by the troubled economies, and the possibility that the economies will grow themselves out of the problem seems remote.
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A second solution would be a fiscal union and a larger European budget, with a limited system of transfers from rich to poor countries, as a form of protection for the core economies in the euro area. In the event of a fiscal union, Germany may have to face a challenge of supporting a large part of the transfers. This option may not be favorable for the two big economies of France and Germany due to the fiscal burden it will bear on them. The third, but radical, solution would be of troubled economies leaving the euro area. A breakdown of currency will have major impact. As said, there will be a domino effect in Europe, leading to the ruin of several euro area countries. This outcome would also mean the end of the grand vision and optimism that was part of creating the Eurozone. The sovereign debt problems in the troubled economies of the euro area has started to pose a grave threat to the core economies of the Europe and possibly to the future of the euro itself. The outcome of the current crisis may be a matter of guessing and assumption. The options for the euro area and the EU are blunt and plain, but not simple. Status quo is not an option, as it may only worsen if nothing is done. The choices done may have to be political, but the effects would be largely economic. Its up to the economies to love the euro or leave it, depending on what needs to be done and what would be better. In the end, choosing is not an easy task: one would carry the dream of a unified Europe, but the other decision may only take the economies further apart.
The Eurozone Financial Crisis Bibliography Anand, M., Gupta, G., Dash, R. (January 2012). The euro zone crisis: Its dimensions and implications. Retrieved from http://finmin.nic.in/ Chibber, K. (2011, September 20). The domino effect in Europes debt crisis. Retrieved from http://www.bbc.co.uk/news/business-14985256
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Economic Crisis in Europe: Causes, Consequences and Responses. (2009). Luxembourg: Office for Official Publications of the European Communities European Commission Eurostat Tables, Graphs, and Maps Interface. (2013, February 26) Retrieved from http://epp.eurostat.ec.europa.eu/tgm/ Euro area member states Eurozone. (2013). Retrieved from http://www.eurozone.europa.eu/euro-area/euro-area-member-states/ Euro area Eurozone. (2013). Retrieved from http://www.eurozone.europa.eu/euro-area/ Jungmann, J., Sagemann, B. (2010). Financial Crisis in Eastern Europe. Germany: Gabler Verlag. Posta, P., Talani, L. (2011). Europe and the Financial Crisis. Great Britain: Palgrave Macmillan The euro. Who can join and when? (2013). Retrieved from http://ec.europa.eu/economy_finance/euro/adoption/who_can_join/index_en.htm What is ERM II? European Commission. (2013). Retrieved from http://ec.europa.eu/economy_finance/euro/adoption/erm2/index_en.htm What is the euro area? European Commission. (2013) Retrieved from http://ec.europa.eu/economy_finance/euro/adoption/euro_area/index_en.htm Sivy, M. (2012). Why a Greek exit could be much worse than expected. Retrieved from http://business.time.com/2012/05/22/euro-crisis-why-a-greek-exit-could-be-much-worsethan-expected/

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University of the Philippines Ermita, Manila