Definition of Financial Terms

International Relations Essay on European Sovereign Debt Crisis

European Sovereign Debt Crisis

1.0 Introduction

            Questions on the sustainability of the euro project were raised when it was first created since it was politically motivated and lacked sound economic banking (Baldwin et al. 2010, p. 34). The major concern was asymmetry of Euro-area or structural discrepancies of members. According to economists, in the event recession hit such an area, it would lead to what they refer to as ‘idiosyncratic shock’. Under the Economic and Monetary Union (EMU), countries cannot be dependent on policy monetary adjustment, centralization of interest rates and use of countercyclical budgets is constrained. Automatic funds transfer from thriving regions to depressed regions can only take place in a monetary union like that belonging to the US. In the Eurozone, this cannot happen since the Eurozone is not in corresponding to a fiscal union. Additionally, despite legal framework allowing freedom of movement, labor mobility within the EU often tends to be limited. What is more, wages and prices are less flexible which makes it difficult to automatically revert to equilibrium (Paulo 2011, p. 9).

Therefore, from the project’s onset, there were concerns which were genuine that asymmetric shocks could lead to major regional recessions and high rates of unemployment (Johnson and Turner 2006, p. 34). In 2008, the collapse of Iceland’s banking system marked the start of European sovereign debt crisis. During that time, a couple of European countries witness their financial institutions collapse, increase in government debts and bond yields spread in government securities rise rapidly. The crisis lead to a major loss of confidence not just for the European economies but the businesses. The countries that were most affected include Portugal, Italy, Greece and Spain collectively known as PIGS. PIGS countries had the highest danger of not repaying their sovereign dents. In this paper, we are going to argue that to a large extent, the European Sovereign Debt Crisis is a representation of a wide failure of European Integration project since the real genesis of the sovereign debt crisis is traced to the foundations governing the integration of the European project.

2.0 Failures of the European Integration Project and their Contribution to the Sovereign Debt Crisis

2.1 Lack of an Enforcement Mechanism

To start with, the European integration project failed by not providing an enforcement mechanism in the event member countries failed to meet the convergence criteria. The first step in creation of the EU was ratification of Maastricht Treaty on February 7 1992. The treaty had strict economic requirements stipulations which are commonly referred to as “convergence criteria”. That member countries were supposed to satisfy before admission to the common currency zone (Eurozone). Among requirements that were included in the convergence criteria included:

  1. Price developments-These were intended towards ensuring stable and low inflation. Inflation in the year that preceded admission to the Eurozone could only be 1.5% above average of the 3 best performing member countries. In practice, the inflation rate used to determine whether the criterion was met was the average of the earlier twelve month Harmonized Index of Consumer Prices also referred to as EU-Wide inflation index.
  2. Fiscal developments-The aim of these requirements was ensuring that the budget deficit should not exceed 3 percent of the country’s Gross Domestic Product, expect in instances when the country was in temporary and exceptional circumstances. In the same manner, the total sovereign debt was to be below or 60 percent. However, both requirements in the criteria can be waived if evidence shows that the debts of a country were declining continuously and significantly.
  3. Exchange-rate developments-These are intended for purposes of ensuring currency exchange rate for every member country was stable before admission. In particular, a potential member could devalue its currency relative to other member state’s currency in preceding 2 years. Additionally, the trading currency was to occur within the narrow band of ±2.25 percent of other member countries’ currencies.

Despite the clear criteria for convergence, Maastricht Treaty failed to deliver enforcement mechanisms in the course that a member country failed to meet the convergence criteria. Admission to the Eurozone also promised some significant economic rewards since the countries had to lower the ratings of sovereign credit compared to the stronger Eurozone member states entitled to borrow money like they had a rating that was better. Similarly, common currency also gave the promise of protection of member countries against devaluation of currency by trading their partners and consequently, ensures the Eurozone countries are able to compete on a playing field that is level. With a currency that is common but no common fiscal policy, each country is expected to be proactive in the management of its trade and to avoid excessive debt. As such, dual existence of significant economic rewards associated with the admission and lack of enforcement mechanism for countries that failed to satisfy convergence criteria as incentive for countries to overload themselves with debt devoid of fear for punishment.

2.2 Weaknesses of the Maastricht Treaty and Political Interference

According to Holsi (2005, p. 5) economists and politicians criticized criteria relating to prospective countries budget deficits and long term debt (Fiscal developments). The relevance of the criteria used was questioned by economists who argued that by virtue of membership to the Eurozone, then member states no longer possessed any monetary tools that could counter economic downturns, as such, all giving them room to maneuver what would be an excellent idea of being extremely cautious (Begg et al. 2008, p.676). Similarly, Coffey (2001, p.27) critics definitive character of the criteria applied in indicating some countries should never be granted admission to the Eurozone. The admission of members was based on contemporary economic outcomes that failed to take into account the long term  optimality of the candidate. As such, some countries were given entry despite the fact they fulfilled the criteria only during the examination year and often, the expectations that they could gain entry to the monetary union also served in reinforcing their credibility. Consequently, the interest rates also went down resulting to reduced public debt and some deficit levels. As Bagus (2010, p. 31) notes, the developments made it easier for the countries to meet the selection criteria.

Additionally, the countries that had severe debt and deficit problems, especially Greece and Italy were able to hide, albeit temporarily their fiscal problematic accounts through an unsustainable and short term process of fiscal and monetary tightening. They managed to postpone their expenditures to future dates as well as generate one time revenues a process that is known as fudging (Eichengreen 2012a, p. 123). Even those countries that were the most reputable found it hard to meet the fiscal criteria. For instance, Belgium had a considerably high ratio debt of close to 118% of its Gross Domestic Product in 1998 (Coffet, 2001, p.22). As such, use of approximates and general trend towards the fiscal requirements  was deemed as sufficient, indicating how politics gained precedence over economics (Begg et al. 2008, p.670). Generally, the completion of monetary union was characterized by political compromise that implied the Maastricht criteria was deemed as insufficient and was not categorically applied. A couple of countries also hoped by simply implementing the integration of European project, structural reforms that were needed to support it would follow automatically, such as ultimate achievement of a federal budget or natural convergence of Eurozone member states in respect to competitiveness. The inexistence of such structural reforms is what made the European sovereign debt crisis inevitable (Bagus 2010, p. 90).

2.3 Institutional Weaknesses in the Integration Project

In the same manner, institutional weaknesses inherent in integration of the project also contributed to sovereign debt crisis. Post war era resulted to significant prosperity as well as price stability for the German economy. As such, when it joined the monetary union, Germany was reluctant to surrender its benefits in  exchange for a currency that was common and which would be shared with Greece, Spain, Portugal and Italy, countries that in 1997 failed at Economic and Monetary Union (EMU) test (Cooper 1997, p. 57). Central bankers and academics had already forewarned it would be risky to introduce a common currency among heterogeneous economies in absence of political union (a currency without a country). They made the argument that the euro in itself, should be an end and not means of achieving economic convergence (Bagus, 2010, p. 75). Legal experts as well noted that a political union would prove to be against the constitution of Germany, which needed currency stability. However, the Germany constitutional court ruled in favor of Maastricht Treaty making the declaration it was constitutional but Germany was given exit option from the EMU if it became unstable. Consequently, without the peoples’ consent, Germany politicians made changes to the constitution that allowed transfer of sovereign power over the country’s currency to a supranational institution (Bagus 2010, p. 76).

To calm the anxiety of Germany, Maastricht convergence criteria was developed as a sieve that ensures only candidates who were qualified found their way to the EMU (Eichengreen 2012a, p.125). Additionally, there was also 3 new safeguards introduced so as to address the concerns of Germany. Firstly, the monetary policy responsibility given to the European Central Bank (ECB) that was to be independent politically and charged with the responsibility of price stability maintenance. This, allegedly would protect it from political influence to raise the inflation levels and hence, reduce individual government’s unsustainable debts (Feldstein 2012, p. 105). Additionally, the ECB together with the Euro system central banks got banned from direct financing of national deficits. There was also an introduction of no-bailout provision as the second provision to prevent governments that were in deficit from bailing out (Baldwin et al.2010, p. 2). The third safeguard was the Stability and Growth Pact (SGP) that confirmed the Maastrictht fiscal criteria was still in force though the member countries had already joined EMU. Additionally, it advocated for general trend inclined towards the balance of budgets. Matter of fact, if the EMU was going to retain its credibility, then there was no member state permitted to get a free ride on the reputation of the euro by giving out excessive debt. During that time, it was unimaginable that a member of the EU would allow another member to go bankrupt by issuance of excessive debts (Schwartz 2004, p. 6). Unfortunately though, it did happen because of institutional limitations which pushed countries into sovereign debt crisis.

The remarkable growth across Europe at the beginning made it easy for the member countries to meet the SGP criteria. However, there was soon a decline in productivity and taking into account the centralized monetary policies, the countries became more dependent on countercyclical budgetary tools for purposes of steering their domestic economies (Holsi 2005, p. 24). In addition to having gained admission to EMU, there were little incentives on the part of the countries to pursue restraint policies. What is more, the interest convergence rate provided major benefits to countries that previously, had low rating. As such, the borrowing costs were significantly reduce and the debt was far cheaper (Eichengreen 2012a, p. 127). Despite the fact member countries were faced with peer political pressure to maintain low levels of debt the pressure was never large to guarantee sound fiscal policies.

Consequently, the SGP framework supported the sanctions against EMU member countries that surpassed limits persistently. Little effort, however was devoted towards enforcing the SGP framework. Sanctions did not automatically follow; rather, they got pegged on political considerations.

2.4 Introduction of the Euro

The negative consequences of the Euro also contributed to the crisis, as a matter of fact, often, the Euro is referred to as the ‘Sovereign-debt emergency’. Often, analysts have highlighted structural resource divergences and mis-allocation in competitiveness between various Eurozone regions. Imbalances in existence before got worse by introduction of the Monetary and Economic Union that planted seeds for European sovereign debt crisis (Dadush 2010, p. 1). Divergence seen between 2 major blocks-the core of which comprise countries such as Germany, France, Luxembourg, the Netherlands, Finland, Belgium and Austria and the periphery which included countries like Greece, Italy, Portugal and Spain. From the start, it was never expected the latter would be considered immediately for EMU membership. Political scientists also argue the move to admission of the smaller PIIGS might have been an indication of the desire by France to limit the power Germany had in the EMU (Eichengreen, 2012a, p. 130). Following their entry, the macro-economic strong environment across Europe resulted to major growth and also boosted the debt-to-GDP ratios or the PIIGS, and consequently, it aided in meeting the SGP and Maastricht requirements (Eichengreen, 2012a, p. 130).

These positive economic masks, however and the subsequent positive prospects for the future of the euro concealed emergency of some tendencies which were negative, all as the result of imposing the Euro within a region economically asymmetrical. Some trends included surging of domestic expenditures which were financed by loss of competitiveness by the PIIGS, credit, high interconnectedness of delicate banking systems and the widening of imbalances between periphery and core (Feldstein, 2012, p. 132). As noted by Krugman (2011, p. 1) the euro brought a new sense of confidence, especially in the periphery that previously, was considered a risk, only to be discovered later that the confidence increased was actually a ‘bait for a dangerous trap”. Before the EMU, states that had severe fiscal problems were known for their declining exchange rates and high rates of interest. The market warnings were a signal to the countries that they should reduce borrowing (Feldstein 2012, p.106). For instance, the risk of making an investment in Greece was reflected in the high interest rates earned for purchasing of Greek bonds as compared to German bonds (Krugman 2011, p. 1) with introduction of the Euro, the external discipline tools were eliminated since the states in the Eurozone already had common rate of exchange and the rates of interest were on the path of convergence. Confidence in stability and growth prospects of countries in the periphery as members of the Eurozone pushed their costs of borrowing down to almost a similar level as that of members such as Germany. This implied they were basically free thanks to the good reputation of the ‘core’. Investors made the assumption purchasing a Greek bond was just as safe as buying Germany bonds (Dadush 2010, p 1). The low rates of interest across Europe made the countries in the periphery that had initially experienced high rates of inflation to have real negative interest rates. The price level increases coupled by the low borrowing costs meant the value of loans to be paid back would get eroded over time (Baldwin et al. 2010, p. 44). Households and governments in the PIIGS response to the cheap borrowing costs was to go on a borrowing spree. Their borrowing, were mostly financed by banks in the European core, leading in huge current account imbalances between the periphery members of the Eurozone and the core and ultimately, it led to the sovereign debt crisis (Krugman 2011, p. 1).

3.0 Conclusion

To conclude, by the time Europe was hit by global recession, members of the Eurozone were in excess public debt already, for instance, Greece or excess private debt, example Ireland. Others like France and Germany were in the debt of countries less competitive. The preconditions for the sovereign debt crisis in Europe to a large extent was created as a result of the incomplete and asymmetrical integration of the European project.

 

References

Bagus, P 2010, The Tragedy of the Euro, Auburn: Ludwig von Mises Institute

Baldwin, R., Gros, D. and Laeven, L 2010, Completing the Eurozone Rescue: What More Needs to be Done? London: Centre for Economic Policy Research.

Begg, D., Fischer, S. and Dornbusch, R 2008, Economics, Ninth Ed. New York: McGraw-Hill Higher Education

Coffey, P 2001, The Euro: an essential guide, London: Continuum

Cooper, Y 1997, Italy and Spain fail EMU inflation test, The Independent, 8th March, viewed 1 January 2014 <http://www.independent.co.uk/news/business/italy-and-spain-fail-emu-inflation-test-1271695.html>

Dadush, U 2010, Paradigm Lost: the Euro in Crisis, Washington D.C.: Carnegie Endowment. Viewed 1 January, 2014 <www.CarnegieEndowment.org/EuroCrisis>

Eichengreen, B 2012a, European Monetary Union with Benefit of Hindsight, Journal of Common Market Studies, Vol. 50, pp. 123-136.

Feldstein, M 2012, The Failure of the Euro, Foreign Affairs, January/February, 91(1), pp. 105-116

Hosli, M 2005, The Euro. London: Lynne Rienner

Johnson, D. and Turner, C 2006, European business, London: Routledge.

Krugman, P 2011, Can Europe Be Saved? New York Times, viewed 1 January 2014 <http://www.nytimes.com/2011/01/16/magazine/16Europe-t.html?_r=1&amp;ref=world&amp;pagewanted=all>

Paulo, S 2011, Europe and the Global Financial Crisis, Fondation Robert Schuman, viewed 31 December 2013 <http://www.robert-schuman.eu/doc/questions_europe/frs-fichecrisefi-qe200-en.pdf>

Schwartz, P 2004, The Euro as Politics. London: The Institute of Economic Affairs.

Voss, J 2011, European Sovereign Debt Crisis: Overview, Analysis, and Timeline of Major Events, viewed 31 December 2013 <http://blogs.cfainstitute.org/investor/2011/11/21/european-sovereign-debt-crisis-overview-analysis-and-timeline-of-major-events/>

 

 

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