Euro zone crisis

Aim of website

This website provides an ongoing analysis of the attempts of the euro zone to pull itself out of its crisis. It starts from a premise of support for the EU and euro projects, but recognises that the euro project is proving more risky than seemed to be the case in its early years and an ignominious collapse of the euro zone would not only entail a severe financial crisis in the euro zone but also put at risk the earlier achievements of the EU, including its single market.

Background

There are several aspects to the crisis.

1)   The first aspect of the crisis of the euro is a sovereign debt crisis. In this respect it is part of a wider sovereign debt crisis affecting all the main mature economies in the world. Not only most of the euro zone but also the UK, US and Japan have built up too much sovereign debt, and are running too high deficits, partly as a result of poor management of their public finances over a long period, and partly owing to the unexpected impact of the 2008-09 global financial crisis, which led to heavy costs rescuing banks and a severe decline in revenue as economies went into deep recession. In fact the overall debt/deficit predicament of the US, UK and Japan are all worse than the overall position in the euro zone.

2)   An equally perhaps more important aspect of the crisis is that of external current account imbalances. These may overlap with fiscal imbalances implying that a fiscal deficit is largely funded externally. But there have also been severe private sector imbalances and accumulated private sector debt in Ireland, Spain and Portugal. In the first two cases the sovereign debt/deficit problems only arose because of the severe domestic economic effects of these private sector imbalances trying to resolve themselves.

3)   A third aspect is a banking crisis. Banks have been weakened by poor lending practices which in some countries, notably, are the prime cause of the problems. In other countries, such as Greece, the difficulties that banks are experiencing are mainly a result of the impact of the sovereign debt crisis. The banking crisis affects almost all countries in the euro zone, including stronger economies, such as Germany and the Netherlands.

4)   A fourth aspect is competitiveness. The external current account imbalances have resulted from some countries being more inclined to save and others more inclined to borrow. After a time borrowers have to repay their debts which requires increasing exports but this task is only possible if companies are able to produce goods or services of a quality and cost able to competed in foreign markets. Lack of competitiveness impedes the closing of current account deficits.

5)   A fifth aspect is economic growth or its opposite, economic decline. In Greece and Portugal the severity of economic decline is causing severe hardship for large parts of the population. Other countries, Ireland and Italy are overall still wealthy countries but lack of growth (in Italy over a long period) raises their unemployment rates weakens their ability to manage public finances. The vulnerable countries are all struggling to emerge from a vicious circle, in which economic decline reduces revenues and so increases government deficits while austerity measures—expenditure cuts or tax increases—further weaken their economies and so undermine the efforts to close the deficits.

Can competitiveness of weaker countries be restored within the euro zone? This is the crucial question, which is likely to be decisive for whether the euro zone survives intact in the longer term. Currency depreciations are a possible way to restore competitiveness which is denied to weaker members of the euro zone. Such depreciations are not an easy option since they can only work if not eroded by inflation which means that wages need to be held down rather than allowed to compensate for higher prices resulting from the depreciations. But they may appear to be less painful than the alternative which is large actual falls in nominal wages. Greece has gone down this route most dramatically as symbolized by a 22% cut in the minimum wage in early 2012. This has only been politically possible because of the manifold and desperate crisis of the economy. The result should help the economy but how much is uncertain. Greece lacks a substantial manufacturing sector and it is far from clear that a mere improvement in cost competitiveness could create the conditions to create one. Other vulnerable economies have lost parts of the manufacturing to emerging economies. If they can lower their wage costs they can lower their prices but wages would inevitably remain well above those in their competitors so they would still only succeed if they can also compete on quality and innovation.

Risks of break-up.  Another problem of euro area membership now comes from the threat of leaving the euro area. Membership was supposed to be permanent and therefore to reduce risk but since the possibility that a country or countries might be forced to leave has come to be seen as real threat, euro area membership has actually increased risk perceptions, because leaving would be associated both as cause and effect with a breakdown of the country’s financial system, with chain reaction effects on other countries, to an extent which could easily get out of control.

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