Delving into the European Crisis, trying my best to solve some puzzles!
What is the crisis ? Why do we have this crisis?
Nations mostly spend more than their income,this is done in order to increase future economic growth through the increase in expenditure. (The increase in expenditure will increase growth if the country spends on capital expenditure,any expenditure that will feed economic activity. If the expenditure is to meet current interest payments or consumption expenditure such as short term subsidies,then the country is leading its way to a debt trap). So what really happened for the PIGS nation was ( Portugal, Ireland, Greece ,Spain )that their debt increased to very high levels and these nations were not able to generate high enough economic growth so as to reduce the size of the debt. The reasons for the crisis therefore fall on the increasing debt. The debt has been growing and this is because some nations such as Greece have been indulging in reckless spending in the form of unemployment insurance and other benefits. These measures are successful if the world economy is growing and the animal spirits (that is the investor sentiments) show an optimistic outlook.. But once the world economy growth slowed these measures could not lead to an increase in spending and growth. Hence the problem of high spending, budget deficits and inability to control /restrain expenditure is at the heart of the European Crisis.Other Reasons for debt were also that in many countries the property bubble was transferred to the banking system bailout which further increased the debt. The Global Financial crisis was a proximate cause which further restricted the ease of access to the capital markets for these countries. Moreover the crisis were because of high risk lending made during 2002-2008
One of the reasons of the Debt crisis come down to the Euro-a unified currency for the European Countries. Countries who are under the Euro are not a homogenous group and by bringing all countries under the same currency, many countries could access funds at cheap interest rates and indulge in reckless spending. Thus because of the Euro , these countries did not face the true borrowing costs. Market become inefficient when the buyers/sellers do not face the true costs/prices of the product. Hence the Euro by tinkering with the borrowing costs led to excessive borrowing by some countries.
What happens if the country's DEBT increases?
Now if the debt of the country increases , all the lenders that is those people who have purchased the government bonds/securities will lose confidence in the government to return their money. As we are aware of the risk return trade off, the investors will be willing to buy the bonds of the country only if they are compensated for the high risks and are offered a high return. This is where the crisis begins to become a 'vicious circle'. The country crippling with debt and unable to meet interest payments borrows further to meet the recurring interest payment, as the investment sentiment erodes the investors demand for higher returns which leads to again high interest costs for the country.
There a close interconnection in the global financial system because if one nation defaults on its debt it puts some of the external private debt at risk, the banking systems of creditor nations face losses. So if Country X defaults on its debts then in this case the other country will also be affected be under pressure which would further lead to this cycle and spread of Financial Contagion.
What can be done?
- On way is to reduce spending and bring in austerity measures! But this can again counteract! A reduction in government spending will further reduce consumption,reducing the multiplier. So a situation where the economic growth is low bringing about austerity measures does not sound feasible. Secondly this measure may lead to political risks as we have seen the protests by Greece and Spain's citizens
- Bailout!- The other measure that can be brought about is that The European Central Bank sanctions a bailout package for the debt stricken economies. This may seem as a good idea but this in turn leads to the problem of Moral Hazard. If the banks know that they will be bailed out , what would stop them from taking precarious steps!. Secondly the ECB can also save these economies only in a limited way. Economies such as Italy and Spain are 'too big' to be saved and hence cannot be rescued just by the bailout package.
- Increasing Competitiveness : Without economic growth these countries will never be able to get out of this situation. Depreciating the currency in order to increase exports can work to be effective.
So the inherent flaw of the Euro Currency was that it instituted a monetary union without a fiscal Union. Now through measures such as European Financial Stability Facility and European Fiscal Compact , the European Union hopes to amend its folly. So the question arises ! Will it Work? This is where the political problems creeps in and hence makes it difficult to go ahead with Fiscal union and austerity measures.
Will Greece exit? What will happen in case of a Exit?
As a default seems unavoidable , Greece may sought to default and exit from the Euro Zone. This may be the only way out ,but will be effective only in the long term. In the short term this would lead to a financial contagion (domino effect) and as mentioned above will put the creditor nations under great pressure. Once Greece can exit from the Eurozone , it can devalue its currency and regain competitiveness. This will in turn help to increase its exports leading to increase in economic growth.Secondly it will be effective because Greece would be able to reduce and increase its fiscal spending depending on its areas of interest. Presently the Germans want control over its fiscal spending in return of the bailout package. It can either go ahead with the tight fiscal measures as wanted by the Germans and get the bailout package OR exit from the Eurozone in order to start afresh and build on its competitiveness.
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