European debt crisis



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EUROPEAN DEBT CRISIS
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CHAPTER OUTLINE
Introduction

In the Beginning There Were 17 Currencies in 17 Countries

The Effect of the Euro

Why Couldn’t They Pull Themselves Out? The United States Did

Is It Too Late to Leave the Euro?

Where Should Europe Go from Here?

Summary

LEARNING OBJECTIVES
LO1: Understand that the creation of the euro integrated monetary policy across member nations without effective integrating fiscal policies.
LO2: Understand that the integration of the monetary systems in the European Union allowed for the influx of relatively cheap capital into poorer European nations.

LO3: Understand that the causes of the Irish and Spanish crises differed markedly from the Italian and Greek crises.

LO4: Understand that the policies that the United States used to mitigate the Great Recession were largely unavailable to those European nations faced with crises.

LO5: Understand that the exit of individual countries from the euro could have set off a Europe-wide banking crisis had it occurred during the crisis.



DISCUSSION QUESTIONS



  1. Why did several countries of the European Union decide to use a common currency?




  1. Why did some countries of the European Union refuse to join the euro?




  1. Mention three provisions of the Maastricht treaty on the functioning of the European Union.




  1. What promoted rapid growth in some southern European countries after the creation of the euro?




  1. Why did the bursting of the housing bubble in Ireland and Spain severely damage several banks?




  1. What are reasons behind the decline of Italy’s economy?




  1. Mention one reason behind the debt crisis in Greece.




  1. What were the three things that the United States did to counter the impact of the Great Recession?




  1. Why could the European nations not introduce the same monetary policy used by the United States to

counter the impact of the recession?
10. Why does austerity lead to high unemployment rates?


THE WEB-BASED QUESTIONS
Part I.

The following article briefly discusses how the Irish economy is recovering from the recession and some of the challenges it still faces.

http://www.bbc.com/news/business-24867347



  • Mention two features of the Irish economy that are helping it to recover from the economic crisis.




  • How has the recession in Ireland affected the job market in Ireland?

Part II.

Read the following article and answer the question that follows.

http://www.huffingtonpost.com/dimitri-b-papadimitriou/are-eu-bankers-trying-to-_b_5696270.html

Is there a need for a government-backed jobs guarantee program in Greece Explain your answer with reference to

the article.




ANSWERS TO STUDY QUESTIONS

SUGGESTED ANSWERS TO THE DISCUSSION QUESTIONS


  1. After World War II when country borders were redrawn by the allied powers, each of the countries of Europe reestablished their individual currencies. Very quickly it became clear to the various governments that the European economies would recover more quickly with a free trade union allowing freight to travel between the countries without having to stop at each border crossing. In1958, the European Union’s predecessor, the European Economic Community, was created to establish travel and trade rules throughout the member nations. Through the years, the movement for European integration intensified, culminating in a series of referendum votes in the 1990s approving the Maastricht Treaty that created a common currency for 16 countries.




  1. Member-nations of the European Union had to give up a major symbol of their sovereignty, their currency, by joining the euro. They also had to give up the ability to use monetary policy as individual countries because they had to cede that authority to the European Central Bank. It was for these reasons that some European Union nations, most notably the United Kingdom, refused to join.




  1. The Maastricht Treaty on the functioning of the European Union had several provisions. One such provision, Article 126, was that countries were required to maintain a deficit to GDP ratio of less than 3 percent and work to a debt to GDP ratio of less than 60 percent. Another, Article 123, stated that the European Central Bank could not purchase member nation debt. A third, Article 125, prohibited bailouts of one country by the union or by any member state unless it was viewed as necessary to avoid a systemic financial collapse of the entire union.




  1. Some southern European countries, the poorer members of the European Union, saw rapid economic growth after the creation of the euro. That these countries were growing faster than the richer countries promoted considerable lending to poorer member countries largely because interest rates to poorer member countries converged to the already low rates of the richer member countries. This was because investors believed that a loan to a euro-member country or a financial institution in a euro-member country was largely the same regardless of whether that nation was relatively rich or poor.




  1. In Europe, mortgage loans remained with the originating banks who then sold bonds backed by those mortgages. These bonds were called “covered bonds.” As a result, in Europe, any bank that made the loans and any financial institution that purchased the covered bonds were vulnerable to the economic crisis arising out of an asset bubble. This is the reason why the bursting of the housing bubble in Ireland and Spain severely damaged banks in those countries and also threatened larger German and French banks because this is where the money originated.



  1. Italy’s economy is simply and steadily on the decline and has been for some time. In 2000, its per capita GDP was 18 percent higher than the EU-27 average. By 2010, it was at the EU-27 average. That is, on a relative basis, the Italians spent the decade getting poorer. This has structural and political origins. The structural origin was two-fold. First, Italy is aging more rapidly than any other major European economy because the birth rate has plummeted for the better part of 40 years. Fewer births translate to fewer workers supporting its pension system. Second, it began with a relatively high debt. Politically, Italy’s government has not played an active role in tackling difficult structural issues such as reforming a pension system for a declining population.




  1. Debt was always high in Greece and its deficits were worse. This is because tax evasion by individuals and

businesses in Greece is so pervasive as to be intractable. Everyone uses as their excuse for cheating on their taxes that others are too and that when others start paying their share, they will too.


  1. The United States did three big things to counter the impact of the Great Recession: (1) TARP (the bank bailout), (2) acts of monetary policy on an unprecedented scale, and (3) fiscal policy–induced explosions in deficits in the form of Bush and Obama stimulus packages.




  1. The Federal Reserve of the United States created and exercised authority in the area of monetary policy to counter the impact of the recession. As a result, interest rates throughout the United States were at or near all-time lows. The Treasury was borrowing money on the short-term market for nearly zero interest. In the

long-term market, interest rates were so low that 15-year mortgages were being offered for less than half of previous 1960s era records. The member nations of the European Union could not do so individually because interest rates were too high, and they could not do so collectively because of the Article 123 provision that prohibited the purchase of member-nation debt by the European Central Bank. Further, at its creation, the European Central Bank had one and only one mission—inflation control—and it is governed by the Germans, the Dutch, the French, and the Belgians, who had little interest in generating a threat of inflation for themselves by engaging in monetary policy that would help the Greeks, Spanish, Italians, and Irish, who were most affected by the recession.


  1. From a Keynesian economist’s point of view, high unemployment rate is a predictable result of austerity. A

decrease in government spending and an increase in taxes result in a decrease in aggregate demand. That result in a decrease in economic activity and that result in an increase in unemployment.


SUGGESTED ANSWER TO THE WEB-BASED QUESTION
Part I.



  • First, Ireland was and remains one of the most open, business-friendly economies in the world - with a young well-educated workforce. Second, taxes on profits for all companies, domestic or global, stand at only 12.5%. These two features of the Irish economy have helped it to attract foreign investment from some of the world’s biggest companies.




  • Since the 2008 crisis, unemployment in Ireland has risen to 15%. Several Irish workers have migrated to other countries, such as Australia and New Zealand. Whereas, historically, it was the uneducated who left, now 1,000 well-educated young people are taking their talents overseas every week. Most are leaving because they cannot get the right kind of work in a feeble domestic economy. Although several multinational firms have opened operations in Ireland recently, most of these firms are technology-based. As a result, most people who are not in the technology sector, if they have kept their jobs, have endured huge cuts in their take-home pay.

Part II.


As a result of the austerity policies pursued by the Greek government under the guidance of the European Central Bank, the European Commission, and the International Monetary Fund, the unemployment rate in Greece has increased to exceptionally high levels. Beneath today's EU policies lies the conviction that as growth increases, businesses will hire enough workers to make the employment issue miraculously disappear. However, this is not necessarily true. The link between a GDP boost and higher employment has been declining for decades. Companies strive to keep their number of employees at a minimum and are not legally required to hire as many people that need jobs, or to resolve a national jobs deficit. Even in a best-case growth scenario - no more belt-tightening, and an economic rebound beyond any realistic expectation - it would be well over a decade before employment returned to pre-crisis levels. Therefore, there is an urgent need for a government-backed job guarantee program in Greece.
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