Euro Crisis Explained

Euro Crisis ExplainedIf Greece leaves, the threat of contagion among the other southern Euro states could break the 17-nation bloc.

The Eurozone debt crisis is an ongoing phenomenon that has threatened to tear apart the 17-nation currency bloc. Characterised by colossal debt piles, rocketing bond yields, anaemic economic growth, frayed investor confidence, dangerous trade deficits, unsustainable borrowing, nauseous unemployment, political upheaval and civil unrest the sovereign debt crisis has hit Europe like an earthquake, with tremors felt right across the continent.

When the Eurozone was established in 1999 it set out to improve European integration through the use of a stable single currency with low inflation and low interest rates. It aimed to encourage sound public finances, eliminate currency exchange costs, facilitate international trade and increase price transparency. The size and strength of the Euro area endeavoured to protect its members from external economic shocks such as oil price hikes or financial market instability.

Whilst in many ways the Euro project has shown partial signs of success, the use of a one size fits all monetary policy across a continent as varied and diverse as Europe has led to a chain of catastrophic consequences.

To create an optimum currency union, Nobel Prize winner Robert Mundell posited that there are four vital characteristics: Mobility of capital and labour – money and people have to be willing to move from one part of the currency area to another. Flexibility of wages and prices – prices need to be able to move downwards, not just upwards. Similar business cycles – countries should experience expansions and contractions at the same time (symmetry of economic shocks). Fiscal Transfers – central government support to ensure that all regions are experiencing similar performances.

From Mundell’s perspective Europe is a poor example of a currency union as it possesses almost none of these aspects. The contrast between, languages, customs, histories and values is profound and for this reason the 17-nation bloc is held back.

For example, if an American state goes bust, the labour force can easily move to another state, but if Italy or Spain go bust, there is very little chance that the Italians and Spanish will uproot and move to Slovakia – the language and culture shock is too vast. Similarly, there is no mechanism for a European central government to send fiscal transfers to struggling economies and for this reason competitiveness is lost.

Another factor that has impacted negatively on the Eurozone and caused an uncompetitive market is the one size fits all interest rate. The core member states such as France and Germany have very different growth and inflation rates to those of the periphery Eurozone members such as Greece, Spain, and Portugal.

In the first ten years following the Euro’s inception interest rates were at record lows which encouraged masses of private sector lending in the periphery. The currency bloc boomed with prices and wages significantly increasing in southern Europe as the periphery nation states looked to benefit from rates that were aligned with the core Euro economies. However this inflationary spike was not mirrored in the core countries and this led to hugely uncompetitive pricing in the periphery.

Subsequently the core, and Germany in particular, was able to develop an extremely profitable export industry. During this time Germany managed to export far more than it imported due its competitive edge. As Germany earned itself a formidable trade surplus, the unsustainable lending cycle pushed the periphery nations down into dangerous debt-laden deficits.

Without the possibility of currency devaluation on the foreign exchange market, the periphery Euro members found themselves with insurmountable debt-piles, uncompetitive exports, and liquidity freezes.

This led to heavy recessions and large amounts of government borrowing to try and support the ailing southern Euro economies. However the money rarely reached the real economy and was mostly spent repaying debt in the banking sector to keep the banks afloat.

Eventually debt levels reached the point where exterior help was needed and the International Monetary Fund/European Union were called upon to provide last ditch bailout packages. These aid deals were given in exchange for tough austerity agreements in an attempt to prevent fiscal profligacy reoccurring.

But in reality the crippling cut backs asked of the periphery Euro members have proved unconducive to growth – to the extent that civil unrest has spread like wildfire. Street protests and riots have become commonplace and political leaders have been forced to stand down.

With Greece on the brink of exiting the Eurozone, the project now stands at an important juncture. If Greece leaves, the threat of contagion among the other southern Euro states could break the 17-nation bloc. But if Greece is allowed to stay, then it remains to be seen how they could ever return to growth under the skewed one size fits all monetary policy.

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