Eurozone Debt Crisis- Can The Apocalypse Be Prevented?
Posted in Finance Articles, Total Reads: 1209
, Published on 31 October 2012
The Eurozone crisis which has engulfed most of the Europe in a chasm of recession has sparked new debates about the credibility of the solutions which have been used to bring the countries out of the debt-trap and to put them back on the path towards growth. The sovereign debt crisis which resulted due to unsustainable levels of debt by governments and private sectors of different countries of the union was compounded by the fact that the Eurozone ensured monetary union but not fiscal union.Monetary union refers to the acceptance and implementation of a single currency whereas fiscal union refers to convergence of taxation and public policies. Factors further perpetuating the crisis were easy availability of credit at very low interest rates,real estate bubbles and international trade imbalances during the period between 2000 and 2009.
Since then a slew of financial crisis management measures have been implemented to combat the same. First and foremost, the EFSF (European Financial Stability Facility) was established consisting of €750 billion to maintain financial stability among the countries of the union along with banks taking a 50% haircut on sovereign loans to Greece. The EFSF which mainly provides tranches of bailout packages to the debt-stricken economies has been increased to €1.4 trillion which will be replaced by ESM (European Stability Mechanism) effective from 2013 and would be capped at €500 billion. Another popular measure was the LTRO (Long Term Refinancing Option) which involves the European Central Bank lending money to European banks at very low levels of interest who in turn would lend to businesses and consumers passing on the benefit of liquidity.The ECB has carried out two LTROs since December last year, lending a total of more than €1 trillion. Yet another measure was the SMP (Securities Market Programme) which entailed the ECB buying bonds of the troubled economies to keep their borrowing costs at low levels.
Some of the recent measures under consideration include the FTT(Financial Transactions Tax), Fiscal Compact and the Greek Memorandum.The FTT seeks to raise €55 billion a year by taxing the financial services sector exclusively.Fiscal Compact requires member states to hit tough budget targets, which would involve adherence to austerity measures but on the other hand would provide guaranteed access to the European Stability Mechanism.The Greek Memorandum is the treaty that obliges Greece to make swingeing cuts to public spending in return for its second eurozone bailout worth €130bn in addition to a €100bn write-down of debt by the bankrupt country's private creditors.
All these measures are intended to bring down the levels of debt by capping expenditures resorting to austerity measures .Many argue that the Eurozone crisis is a result of the violation of “the stability and growth pact” which capped the annual borrowing at 3% of the output produced and prescribed debt to GDP ratio to be under or equal to 60% both of which were blatantly disregarded by countries like Germany, France, Greece and Italy whereas Spain never violated the rules even once.But still its 10 year bond yields have hit a record high of 7.5%. This explains that debt is not the only major reason for the crisis(Greece is an exception as the debt to GDP ratio rose to 113%).
The reason being that while the money borrowed was used by France and Italy for imports, Germany became an export-power house selling far more to the rest of the world and earning a lot of surplus cash on its exports.Also, Germany kept its wages steady whereas the wage-rates burgeoned in other European countries during the boom years hindering their export-competitiveness.The idea of spending cuts to repay the debts would further deepen the recession as this would increase the unemployment even more driving down the wages lower which in turn would lead to decrease in spending and default on loans aggravating the situation even more.The rationale that lower wages would increase export competitiveness has not held true in the short-run but has led to more strikes and protests spurring nervousness and loss of confidence in the European financial markets.
The solutions do not seem to be working.The situation seems to be going worse with political backlash in countries like Greece leading to questioning the usefulness of the European integration. It has been observed that the political mechanisms in many countries of the European union are unable to deal with the fiscal crises with some European leaders floating the misconceptions about the tax payers making direct payments by way of bailouts to the debt-laden countries which is but a misnomer .The bailouts provide the IMF and EU lending facilities at lower rates than the market but higher than the countries that underwrite the same which works out to be a loan at a profitable rate provided the loan is paid without any default.
The bailouts being used for servicing the existing debts results in socializing the risks and privatizing the profits. In essence, the more debt is bought up by the ECB – or maybe by the lending facilities themselves – the more the taxpayers are liable. The money is not being used for any productive activity that would help the European countries to come out of the recessionary spiral and get back on the growth trajectory.Restructuring the balance sheets of banks even with heavy haircuts without any further delay is an option that is not being considered due to the huge immediate financial impact. Breaking up the Eurozone is an option which is being debated all around the world. But this would be a very costly proposition considering the practical problems along with immediate run on the Greek banks by savers wanting to take out their savings and invest in safe havens abroad. Also the debt to GDP ratio would increase because even after the currency conversion, the debt would still be in euro increasing the chances of default.
The inefficacy of the aforesaid financial measures has led economists to deliberate upon and suggest new measures to combat the downward spiral and to come up with a consistent and precise strategy for revival of growth in these countries.They propose inducing private investment in the economy by creating conducive conditions which can be in the form of guarantees that these crisis countries will pay back their debts by creating a robust ESM(European Stability Mechanism) and by adhering to a common debt –reduction pact suggested by various economists. The competitiveness of the crisis countries can be increased by investing in the industrial infrastructure and by promoting research and development. The funding for the same needs to be arranged from the proceeds of the FTT (Financial Transaction Tax) hoping to bring in about €55 a year.The European Investment Bank can play a key role in creating a comprehensive implementation programme for these investments
Thus, a three-pronged investment strategy of taxing the financial sector,mobilizing investments and promoting research and innovation is the new mantra which the European nations are looking forward to.The focus is now being shifted to value-creation from mere value-absorption giving more impetus to devising and executing a strategic and economically sound industrial policy. Considering the changing dynamics of world business environment, it is absolutely necessary for Europe to come up with a sustainable economic model based on real value addressing the challenges of the future which would really help itself to sustain, withstand and survive the turbulent times.
This article has been authored Soumya Iyer from IIM Shillong.