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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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T h e E u r o z o n e F i n a n c i a l C r i s i s 1
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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.
1The success of the Europe Recovery Program led visionaries topush 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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T h e E u r o z o n e F i n a n c i a l C r i s i s 3
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Table 1
Convergence criteriaWhat is
measured
Price Stability Sound public
finances
Sustainable
publicfinances
Durability of
convergence
Exchange rate
stability
How it is
measured
Consumer
price inflationrate
Government
deficit as %GDP
3
Government
debt as %GDP
Long-term
interest rate
Deviation
from a centralrate
Convergence
criteria
Not morethan 1.5
percentagepoints above
the rate of thethree bestperforming
membernations
Referencevalue: not
more than 3%
Referencevalue: not
more than 60%
Not morethan 2%
above the rateof the three
bestperformingmember states
in terms ofprice stability
Participationin ERM II
(ExchangeRate
MechanismII) for at least2 years
withoutsevere
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.
3Gross 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.
4A process of channeling funds between surplus and deficit agents
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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.
Note. Data from European CommissionEurostat (26 February 2013).
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.
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Greece 5.9 4.4 2.3 5.5 3.5 -0.2 -3.1 -4.9 -7.1 -6.4
Spain 3.1 3.3 3.6 4.1 3.5 0.9 -3.7 -0.3 0.4 -1.4
Ireland 3.9 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 -3.2Eurozone 0.7 2.2 1.7 3.2 3 0.4 -4.4 2 1.4 -0.6
-8
-6
-4
-2
0
2
4
6
8
GDPGrowth(%)
Year
Figure 1
Real GDP Growth (%) in several euro area nations
Greece
Spain
Ireland
Italy
Portugal
Eurozone
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Dimensions on the Eurozone Crisis
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.
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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.
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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 bearsa heavy exposure to Greek debt, thus affecting the French banks
stocks and its economy in general.
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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.
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Implications for advanced countries
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.
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