Financial and Economic Crisis in Europe
Financial and Economic Crisis in Europe
Introduction
Since 2007, the European region has been grappling with an economic and financial crisis. The EU real GDP has contracted by 4% since 2007. The region is also characterized by low investor confidence; high debt and a less competitive currency. This paper has explored into this crisis with the aim of identifying the origin. The paper reveals that the European financial crisis originated from sovereign debt and deficit problem in five European countries. These countries include; Portugal; Italy; Ireland; Greece and Spain. These countries are grappling with large domestic and foreign debt. The crisis in these five countries has been spread to other European countries due to the existence of a common currency and the interdependence of the financial system. .
Origin of the Crisis
The Bubble Burst
The Euro Zone crisis is largely attributed to debt and deficit problems in five EU countries. These countries include; Portugal, Ireland, Italy, Spain and Greece (PIIGS). England is at times included in this category of countries (European Union, 2011). The debt problem in the PIIGS country is believed to have originated from a complex interaction of factors. These factors include bubble in the real estate industry; global recession; international trade imbalances; government fiscal policies and bailout plan for the private sector by some European countries. The crisis began in 2007 when the world experienced a growth in the giant pool of money caused by increased savings by the high growth industrializing nations such as China (European Union, 2010). The pool of money tempted developed countries to borrow these funds and invest them in various sector. The real estate sector was the largest beneficiary and thus, resulting in a real estate bubble. The bubble was characterized by a swelling price of assets.
European countries responded to the growth pool of money in different ways. The PIIGS were much affected by the crisis because they borrowed a lot of these funds. The Ireland relaxed its lending policies allowing its banks to lend the funds to real estate developers (Lean, 2012). The high prices could no longer be sustained the bubble busted leading to a rapid decline in the prices of asset. The liability owed to global investors remained at the same value leading to a debt crisis in the private sector of industrialized nations. The debt crisis led to the near collapse of the financial system of these countries forcing the governments to intervene. The government converted the private debt into sovereign debt by bailing out the private financial companies. The tax payers and the government had to assume the losses associated with burst in order to save the private sector. Government debt in the Euro zone rose from 66% before 2007 to 84 % after 2007 (Lean, 2012).
Lack of Standardized Fiscal Policies
Lack of standardized fiscal policies within the European Union also perpetuated the crisis. The Euro zone makes use of the Euro as the only legal tender (Lane, 2012). Having a common currency meant that the countries had to adhere to standardized monetary policies. However, the monetary policies are not aligned with fiscal policies of the region. The fiscal policies are not standardized but fragmented from one country to another. Fiscal policies concern issues such as taxation; employment; public pension; national spending and many others (Lane, 2012). During the economic bubble, the PIGS countries violated the treaty that limited countries deficit spending. Greece and Italy masked their deficit spending using inconsistent accounting records. Greece used deficit spending to finance wages and pension.
Lending policies were responsible for the debt crisis in Ireland (Lane, 2012). The Irish government allowed its financial institution to engage in high risk lending during the bubble. In turn, the government issued a guaranteed to four of the main financial institutions that were involved in the lending. Once the bubble busted, the Irish government and the tax payer had to shoulder the losses by bailing out the financial sector. Like Greece, Portugal also used deficit spending to finance wages and benefits to an inflated work force within the country (Lane, 2012). Italy and Spain are in a better financial position as compared to Greece and Portugal. Italy and Spain were able to have better control debt internally than Greece and Portugal. However, budget deficits affected the two nations.
International Trade Imbalances
Trade imbalances within the Euro zone are also partly to blame for the European crisis. Prior to the onset of the crisis, international trade favors rich nations such as Germany and France and disadvantaged countries such as Greece and Italy. In 2007, Portugal; Italy, and Spain had a negative balance of payment while countries such as Germany recorded surpluses in the balance of payment. Trade deficit in the PIIGS countries had to be offset by an inflow of capital. This explains why the PIIGS countries were keen to take up the funds once the giant pool of money grew. The giant pool of money provided these countries with what looked like a lifeline for them to offset trade deficits. These led to the creation of the bubble which led to burst and thus establishing the origin of the crisis.
Role of Germany and other European Nations
Raising debt problem in these five countries has become a problem for the entire European region. This is largely because the region is tied together by a common currency (Lane, 2012). The debt crisis in the PIIGS has affected the competitiveness of the Euro within the international market thus affecting the economies of all Euro zone countries. The debt crisis was also spread to the rest of the Euro zone die to the interconnection of the financial systems. The interconnection of the financial systems implies that if one nation is unable to finance its debt, the financial system of other countries is affected. For instance, Italy owes French banks a total of $ 366 billion. This means that if Italy is unable to finance this debt, French financial institution will incur enormous losses (Shambaugh, 2012). This problem has threatened to break up the Euro zone.
In order to save the Euro zone Germany and other governments have been forced to intervene and help the PIIGS country out of this crisis. Germany has been particularly active in providing assistance to the PIIGs nations. The economy of Germany has been the least affected by the crisis (European Union, 2010). The country continues to record trade surpluses against other Euro zone countries, though at a decreasing rate. In the international market, Germany trade surplus continue to swell. One way in which Germany has provided assistance to PIIGS countries is by providing aid. Germany has been particularly instrumental in bailing out Greece from the crisis. The aid offered to PIIGS countries is conditional. These countries are expected to adopt austerity measures that are directed towards reducing debt and deficit. Germany and other government
In 2010, the Euro zone countries established European Financial Stability Facility (EFSF). The EFSF was established with an aim of providing financial aid to cash trapped Euro zone countries (Shambaugh, 2012). The EFSF was mandated with the responsibility of raising funds that would be used to extend loans to the PIIGS countries. Countries are also recommending deeper level of fiscal union. Deeper fiscal union and economic integration will see the standardization of fiscal policies across Europe. This will minimize irresponsible behaviors that were previously encouraged by the free rider effect. Free rider effects are whereby high credit risk countries, such as Greece, were able to borrow at low interest by virtue of using a similar currency as low credit risk countries such as Germany (Lean, 2012). The free rider effect increases incentives for bailing out defaulting countries since a debt default affects all the countries in the Zone. The European countries also agreed to write off debt owed to European banks by the Greek government.
The Eurozone Crisis Financial Situation in the US
The Euro zone crisis has numerous points of connection with the financial situation in the US. Just like in the US, the Eurozone crisis began with a bubble in the real estate industry (Congressional Research Service, 2012). This was largely as a result of high risk appetite by private investors and affinity for debt. The US financial sector was first to be affected. The European countries had initially thought that the crisis will be restricted to the United States. However, the effects on US Wall Street took an impact on Europe and global economy. The global recession caused by the US financial crisis was partly responsible for the Euro crises.
The Euro zone crisis has also had an impact on US financial condition. The US has strong ties with Europe in terms of trade and financial (Congressional Research Service, 2012). Thus, the crisis in Eurozone has had a substantial effect on the financial position of the country. The European problem has emerged as the principal challenge to the revival of the US economy (Congressional Research Service, 2012). Recently, the value of the Euro fell against the dollar. This has shifted trade in favor of Europe. The crisis in Europe has a caused the decline in investors’ confidence leading to volatility and low performance of the stock market.
Conclusion
The European region is currently experiencing the worst economic crisis since 1930. The EU real GDP has declined by an approximate 4% in the last five years. Most countries in Europe are recording recessions of the economies. Investors’ confidence is at an extremely low level. The crisis has also threatened to lead to the collapse of the Euro. The paper has explored the origin of the European crisis. It has been noted that five countries are primarily responsible for the crisis by failing to manage debt and deficit. These countries include Portugal; Ireland; Italy; Greece and Spain. The problems in these countries have rapidly spread to other Euro zone countries due to currency connection and interdependence of financial systems. The debt level in the European zone has risen to over 90% of GDP while the deficit figure has increased to 7% from a figure of less 0.6% before 2007. In order to avoid collapse of the Euro zone, other European nations such as Germany have been compelled to intervene and rescue the PIIGS countries.
References
Congressional Research Service (2012). “The Eurozone Crisis: Issues for Congress”. October 30, 2012. http://www.fas.org/sgp/crs/row/R42377.pdf
European Union (2010). “Economic Crisis in Europe; Causes, Consequences and Responses”. October 30, 2012. http://ec.europa.eu/economy_finance/publications/publication15887_en.pdf
European Union (2011). European Economic Crisis 2010. October 30, 2012. http://mun.soe.ucsc.edu/sites/default/files/European_Union.pdf
Lane P (2012). “The European Sovereign Debt Crisis”. Journal of Economic Perspectives. 26 (3): 49-68
Shambaugh J. (2012). “The Euro’s Three Crises”. October 30, 2012. http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2012_spring_bpea_paper
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