What was the cause of the eurocrisis

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What was the cause of the Eurocrisis?

What we call Eurocrisis today is explained by many and varied reasons, resulting from decisions and mistakes made since the creation of the Eurozone till now.

One of the biggest reasons is the one-size-fits-all monetary policy. In 1999, 11 member countries adopted the Euro as their official currency, giving monetary policy control to the European Central Bank. One important characteristic of the Eurozone being its inequality in terms of growth or economic development, some large countries, such as Germany, had weak growth, leading the ECB to set a low interest rate. This rate was too low for booming countries such as Spain and Ireland, creating housing market bubbles which were enhanced by the focus of European leaders on fiscal issues and the consequent neglect of private sector behavior.

Moreover, by giving up their monetary policy control, countries, especially those carrying a high debt burden, could not use measures and leverages, such as depreciating the currency (to encourage exports) or allowing a higher inflation rate (to reduce the debt burden), to react to the financial crisis for instance. Actually, the Eurocrisis is primarily a function of the inability of member countries to print currency. They can run out of money and be exposed to insolvency risks.

The Eurozone introduced a common monetary policy but nowadays, the lack of a common fiscal policy is contributing to the overall situation. Indeed, no institution is responsible for managing the fiscal position of the Eurozone. Members simply implement the policy considered appropriate for their own economies. But as we can imagine, the aggregation of decentralized fiscal policy is far from optimal for the Eurozone as a whole.

At the creation of Euro, borrowing costs have converged for all European governments as well as for private sector, meaning countries like Greece were now able to borrow more cheaply, causing an increase in government debt in Portugal, Greece, Ireland and Spain. This convergence made every Eurozone country virtually have the same default risk on their loans, assuming they were supporting each other. But after the financial crisis in 2008, financial markets made separated risk assessment, rising back up the borrowing costs of Greece, Portugal and others.

Firstly, the Stability and Growth Pact failed. It was supposed to maintain high stability inside the Eurozone, setting Euro-entry criteria for countries wishing to be part of the area. SGP¡¯s two fiscal criteria were a budget deficit lower than 3% of GDP and a government debt lower than 60% of GDP. Between 2001 and 2006, approximately 1/3 of the members violated these rules, and about half of them today (Appendix 1). These violations diminish the trust in the effectiveness of European surveillance, resulting in high public debt in Greece, Italy and Portugal.

Member countries had different growth rate in the 2000¡¯s. Higher labor costs caused some countries a decline in productivity levels and competitiveness compared to the Eurozone average. Countries like Greece, Spain or Ireland who had a strong growth and imported much in this period became less competitive and attractive, creating a high deficit which had to be funded by large private and public borrowing. In 2008, after the global crisis, and as borrowing costs started rising for them, financing their debts was more difficult and expensive.

Ultimately, there was no crisis-resolution nor bailout mechanism and the series of sovereign debt crises in the euro area took the Eurozone by surprise, forcing policymakers to improvise.

 

 

Why did Europe suffer more than the United States?

Nowadays, the exchange rate 1 US dollar equals 0.88 euro. This rate has continuously increased these past 5 years (Exhibit 1). The way these two economies handled the crisis greatly impacted this factor.

The European Union (EU) was a peculiar experience with political and economical beliefs that vastly diverged from the one of the US. While the main objective of European Central Bank (ECB) was to maintain stable price, the U.S. Employment ACT of 1946 bolstered full employment. The EU was oriented toward the structure of national economies. From 1990 to 2010, the EU countries growth was 1.7% while 2.5% in United States.

Consequently, in 2010, while EU with lower deficits and debts (6% GDP deficit and 85% debt-to-GDP) than US, it was threatened with sovereign crisis. With a centralized country, the solidarity in United States is far higher than between the European Union members. Consequently, U.S. government has been a part of states finances greatly more than EU with its member.

Dealing with recession is particularly easier in United States. If one of the states was in recession, the government had a direct impact through reducing federal taxes and transfer. One other main advantage is having the possibility of using expansionary fiscal policy even if it devaluated the currency. Lowering tax and transfers or using expansionary policy was nearly impossible in the EU.

In 2008, the European countries were highly susceptible to crisis with total European bank assets of 200% to 400% of national GDP while 100% of GDP is United States. The U.S., with the faculty of printing unlimited amount of money could easily saved the banks in trouble whereas Eurozone failed to print the sufficient amount of money. The presence of only one state also permitted borrowing at exceptional low rate. Finally, there isn¡¯t a real unification around a common European identity; the impersonal coins are the perfect example.

By being dependant of the others economy, the EU couldn¡¯t suffer less than the United States which had far more flexibility in its procedures.

Exhibit 1

1096_Eurocrisis.png

Appendix

1816_Eurocrisis1.png

Reference no: EM13856742

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