Starting with the 2007-2008 financial crisis, the future of Europe became a hotly debated question. This was largely due to a confluence of several factors: the robust economic growth that predated the financial crisis had ended, leading to a prolonged, severe debt crisis that laid bare the poor fiscal management of several nations that would challenge the notion of a “unified Europe.” Indeed, the economic slowdown exposed perhaps the key weakness of the “European project”: monetary union based on political consensus that failed to include political union. This failure in planning came to the forefront during the crisis when countries such as Italy and Greece that ran up debt did not have the fiscal resources to pay for it. As a result, the vaunted “Euro Crisis” came to pass- the crisis itself was not merely a one- act play, but has continued since 2008. This paper will look at how the Euro crisis came to pass and the future of the Euro in that currency.
The European crisis was brought about by two main causes 1) a cyclical slowdown that revealed the poor fiscal states of many countries (particularly those on the “periphery;” 2) a structural problem of not integrating the political and fiscal factors needed to make the Euro project successful (OCED,2009).
One could (rightly) argue that the European “crisis” would have happened much earlier if not for the credit-fueled boom that inevitably preceded the crash. This is because robust economic growth “masked” the true fiscal condition of many states via allowing governments to service interest payments. The sclerotic Italian economy grew by roughly 2.5% from the years 2004-2007; the Greek economy even grew 2.0% over the same time period (Economist (Italy), 2012). These growth rates, while far below those registered by Germany and other European powers, allowed these countries to make the minimum payments to service their debt. At the same time, the promise of the “great moderation” and a future of low inflation and economic growth bolstered banks and investors’ confidence to purchase bonds issued by these countries, even though they posed patent repayment risks that would become evident over the long-term.
Thus, while debt-laden countries continued to borrow hoping they could trade off borrowing now for further growth in the future, that intertemporal bargain came to an end with the financial crisis of 2007-2008. Initially, the financial crisis affected Europe through investors’ focus on risk; previous liquid credit markets evaporated; countries that relied on the issuance of debt for basic operations and investment found that investors demanded a much higher interest rate, if they were willing to lend at all. The crisis also hit the countries via the problems emerging in continental banks: during the period of economic expansion, banks were more than willing to lend money to sovereigns with less than stellar balance sheets. As the economy imploded, however, their lending calculus was broken: slower economic growth meant a decreased ability among consumer and governments alike to pay back debts; investors, scared of uncertainty in the markets, withdrew liquidity that exacerbated the existing capital shortage; banks, who lent to both consumers and governments, and some that funded from capital market, saw their balance sheets gradually deteriorate over time. This vicious circle led to the onset of the European crisis.
At its base, however, the financial crisis laid bare the incomplete union in the European Union. When regional leaders originally conceptualized the EU, they planned on closer political union that would eventually lead to closer economic union; however, fiscal union, perhaps the largest challenge, was left undone. This was not by accident: The EU was meant to gradually unite countries and people that were devastated by centuries of war; an immediate call to fiscal union, without the prerequisites of political and economic union, would not be feasible. This intentional oversight, however, made it extremely difficult to deal with a fiscal and solvency crisis on par with the 2007-2008 financial crisis. Indeed, countries in the Eurozone lacked the appropriate policy tools and the bureaucratic structure to deal with the crisis.
This structural deficit, in turn, led to the creation of two different camps of countries that would fight over the future of the Euro. There were three main players in how the Euro crisis unfolded that will ultimately determine the future of the Euro: 1) The northern (surplus) countries; 2) The southern (deficit countries); 3) The European Central Bank as the linchpin to keep the EU together, albeit just for now. The northern (surplus) countries did not necessarily run a budget surplus (noticeably France), but they did run a balance of payments surplus. This group of countries included: Germany, France, Denmark, and the Netherlands (Economist (France), 2012). Their position, although somewhat flexible, advocated for profligate countries to pay the price of a bail out with the sale of assets, needed structural reforms, and a willingness to deal with the Troika over the long-term. Germany, as the main political power in Europe and the most fiscal fire power of the northern states, decided to take the lead in the bailout negotiations with Greece and Cyprus, ultimately leading to heavy bank losses and investor losses in the case of Cyprus (Economist (Germany), 2008). The northern countries have been heavily criticized for imposing “austere” policies on the southern countries; that is, southern countries that had little or no fiscal room for adjustment were forced to slash state budgets that supported already meager growth. Some posited that these policies were shortsighted in that: countries that were already hemmoraging economically would continue to do so under further cuts making the goal of debt payments even harder to accomplish.
The southern (deficit) countries usually ran both budget deficits and balance of payments deficits that led to borrowing. The southern countries placed in this category usually include: Greece, Cyprus, and Italy. From the southern countries’ perspective, they were placed in an impossible position. While many of them acknowledge less than optimal fiscal management leading up to the crisis, they also criticize the northern countries for supporting the idea of a European community in theory, but pulling back from the very (fiscal and monetary commitments) that would make the commitment stick. The southern countries (except for Italy) have all received bailouts from the EU in order to maintain solvency. The southern countries, however, have paid a great price for those bailouts, undertaking structural reforms that in the case of Cyprus will likely lead to the destruction of the island’s main business model.
The final and perhaps most interesting actor in the crisis is the European Central Bank (ECB). The ECB has taken on a highly important role in the crisis if for no other reason that it has had to keep the European Union together (Economist (ECB,2012). The ECB is traditionally known as the promulgator of monetary policy. However, as countries failed to offer robust bailout packages for countries that were essentially financing day-to-day operations, the ECB had to step up to the plate in numerous unorthodox roles. First, the ECB essentially became a “buyer” of the last resort; that is, when market participants would not purchase government bonds of Italy, Spain, and Greece, the ECB would undertake large purchasing schemes. Although the ECB would not necessarily bring down borrowing costs to the lowest point in the Eurozone (usually the German Bund), they did make it possible for countries to finance their operation without paying higher interest rates that would essentially have thrown many countries into bankruptcy. Indeed, the ECB did this on more than one occasion to help ailing countries continue to sell bonds, even though their economic fundamentals were not stellar.
Second, the ECB also provided a life line to central banks and commercial banks through its lending facility that acted as a proxy for bailouts. Although northern countries would only offer financial help through the Troika, the ECB essentially offered help to nation’s central banks and commercial banks through the lending facility. This assistance was very important because it essentially helped central banks offer assistance to banks with damaged balance sheets, while at the same time offering direct assistance to those banks that might have otherwise declared bankruptcy. Overall, the ECB played a path-breaking role in the Euro crisis, and will inevitably play a similar role in the future, even if the EU survives this crisis. This is because the EU lacks the appropriate infrastructure and the political will to help out countries entirely solve their problems (Economist (Span), 2012). They must rely on the ECB to serve as an intermediary between the actors to make the intervention successful. This was a brief overview of the three main actors in the EU crisis.
The Future of the Euro
When discussing the future of the Euro, the question can be conceptualized in two ways. First, is the economic survival of the regional body. Overall, although the EU has suffered greatly during the financial crisis, with some countries such as France experiencing an unprecedented “triple-dip” recession, the EU is likely to survive. This is for two reasons: 1) There is enough momentum among economically strong countries to push the Union forward. Indeed, although many of the southern countries have suffered repeated recessions, Germany and other northern countries are still notching growth that it will make it possible to continue the current situation. At the same time, the crisis has arguably been good for many firms in the Eurozone that previously (over) relied on domestic markets. Firms from across the Eurozone are reaching out to new markets in emerging countries that should not only lead to increased profits and growth, that can help feed economic growth back home, but can also help firms expand their presence and help drive innovation of new products.
This question can also be conceptualized in the following way: will the idea of the existential EU survive beyond the crisis? This question is certainly open for discussion. Overall, the EU has already undergone changes and further changes to the EU’s treaty have been proposed in order to deal with similar challenges in the future. However, the European nations have not fundamentally dealt with the deficit in the union: the tying of fiscal fates across countries so that profligate and other countries will essentially be in the same boat moving forward. Although changes have been made to adopt an early warning system on debt, similar provisions already exist in the EU’s treaty mechanism. The EU will likely survive this tumultuous time in some type of organization; however, it is still open to question whether the EU will survive in its current form into the future and whether the current steps being undertaken will be enough to secure that future. The currency will likely continue on its present form no matter what happens; however, the EU will continue to face numerous difficulties as it tries to steady its ship into the future.
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