The European Unions Economic Crisis Economics Essay

In early 2010, there arose fears of a sovereign debt crisis spreading throughout the European Union, as Portugal, Italy, Ireland, Greece and Spain, collectively known as PIIGS, were experiencing increasing government deficits and public debt. The events of the crisis revolved around Greece, as doubts grew regarding the country’s ability to pay its sovereign debt and its rising government deficits.

The EU’s economic problems can be traced all the way back to the late 1990s, when the EU unveiled its grand plan of a single currency for European member states. In 1998, the euro became the single currency for all EU member states. Countries with weak economies, such as Spain, Greece and Italy, were placed on the same footing as the stronger economies of the union such as Germany and France. Membership with the EU came with benefits: lower transaction costs, lower interest rates, and easy access to credit. For the weaker economies of the EU, these benefits created most of the problems they are facing today. In these countries, the advantage of being able to borrow at lower interest rates fuelled domestic consumption and raised costs, especially labor costs. This made these countries less competitive with stronger trading partners in the region such as Germany, France, Sweden and Britain.

Meanwhile, the cost of making products for export increased. The Real Effective Exchange Rate (REER), which is the measure of a country’s currency relative to an index of currencies, adjusted for inflation, is the best measure of a nation’s cost of producing goods. For 35 nations in the EU, REER has fallen 16% to 31% since 1989. Greece fell by by 9%, Spain and Italy by 16%, and Ireland, a world renowned exporter, by 26%.

Also, easy access to debt caused these countries to increase spending dramatically in the last decade. For example, in 1996, Greece’s debt-to-GDP ratio was 96%, today it stands at 126.8% of GDP. For Portugal, it is 52% and 87% at present. Ireland was 54% to 79%. In Italy, it was 115% to 119%. Spain is at an even 67%. Goverment expenditures in these countries also increased since they joined the EU. In 1998, Greece, Portugal, Spain, Italy, and Ireland’s public expenditures accounted for 38%, 40%, 37.3%, 48.5% and 31% of national income, respectively. in 2010, government spending increased to 50.4%, 49%, 44%, 51% and 46.6%, respectively. Joining the EU has made these weaker economies even weaker.

Greece was the first country to show symptoms of the problematic effects of this setup. Before joining the EU, Greece was one of the worst economic performers among the eventual EU members. Its GDP growth was among the slowest in the region; it was paying high interest on debts and it had one of the highest rates of inflation in the region. However, joining the EU seemed to have solved most of its problems. For nine years, from 1999 to 2008, Greece enjoyed rapid economic growth. This was partly due to the benefits they gained by joining the EU in 2001 and also because of the credit boom at the end of the 1990s. Joining the EU allowed Greece to borrow more debt at lowered interest rates. It also allowed them to refinance debt at a lower rate. In 1995, the public-debt-to-GDP ratio fell to 6.5%. The credit boom allowed Greece to gain easy access to long-term borrowing. Inflation fell from an average of 18% from 1980 to 1995 to just above 3% from 2000 to 2007. Long-term government bond yields fell from 1100 basis points to less than 40. Net foreign capital soon flowed in as Greece became an attractive destination. Domestic demand growth surged. From 1997, Greece’s domestic prices rose by 47% compared to only 27% in the Euro region. Wages rose 80% compared to an increase of 23% in the Euro region. This confluence of factors contributed to the rapid growth of Greece’s economy. From 1999 to 2008, Greece’s economy grew at the fourth-fastest rate in the region with an average of 4.2% annually. With increasing tax revenues, government spending also increased dramatically, especially in public sector wages and social transfers.

However, Greece’s public debt had been more than 100% of its GDP since 2001. For the past decade, Greece had financed its spending through heavy foreign borrowing. The Greek economy was hit hard by the 2008 U.S. subprime crisis; its economy relied heavily on shipping and tourism, industries in which revenues fell by 15%, whereas in previous years, its GDP growth had been more than enough to cover debt-interest payments. The global recession, the increase in budget deficits over the last 10 years, and the slowdown of the Greek economy in 2008 contributed to fears in the EU that the Greek economy would be unable to recover in time to pay the country’s mounting debts. In addition, it was discovered that the country was chronically reporting inaccurate statistics; the previous administration had misled the EU, publishing a lower budget-deficit-to-GDP ratio of 5%, when in reality it was closer to 12.7%. In 2008, GDP expanded by only 2%, and the economy contracted by 2% in 2009. In 2009, the deficit was 13.6% of GDP. As of 2010, the total government deficit was €36.1bn and government debt was €288bn, that is, 126.8% of GDP.

By early 2010, a crisis of confidence arose regarding Greece’s ability to pay its debts. This resulted in the downgrading of Greek bonds to junk status and the rising of Greek bond-yield spreads. Fears spread throughout the EU; as a result, European stocks plummeted and the euro hit 2-year lows.

However, Greece was only the tip of the iceberg. Other countries in the EU were in a similar boat. Portugal, Ireland, Italy and Spain were also facing large budget deficits and increasing public-debt-to-GDP ratios.

Portugal’s economic boom was sustained by lower borrowing rates, which it enjoyed as part of the EU. The country experienced rapid wage inflation, making it harder for local companies to compete with foreign firms. Foreign companies pulled out anyway, seeking other countries with lower wages and taxes. In 2010, Portugal had a government deficit of €15.7 billion, that is, 9.3% of GDP, and a government debt of €127.9 billion, or 76.1% of GDP.

Ireland experienced a credit boom similar to those in the UK and the US but fared much worse in the aftermath. The majority of bank lending was to construction and mortgage companies; banks suffered because of bad commercial property loans; household mortgages reached astronomical levels, more than 100 percent of GDP; wages in Ireland remained relatively higher than in its EU trading partners. In 2010 Ireland had a government deficit of €22.9 billion, or 14.4% of GDP, and government debt of €104.5 billion, or 65.5 percent of GDP.

Italy, on the other hand, did not experience credit or housing bubbles as its neighbours had. Its economic woes stemmed from low productivity, inefficient tax collection and huge government debt. In 2010 Italy had a government deficit of €xxx billion, or 5.3% of GDP, and government debt of €xxx billion, or 118.2% percent of GDP.

Spain’s economic troubles were closely linked to its own housing bubble. Productivity was low as result of the housing mania. Since wages are set centrally, it was hard for the government to move skilled workers efficiently from dying industries to blossoming ones. Unemployment reached 20%, mostly among construction workers. Public finances were heavily dependent on housing-related tax revenues. In 2010, Spain had a government deficit of €117.3bn, or 11.1% of GDP, and a government debt of €560.5bn, that is, 53.2% of GDP.

The risk of Greece defaulting on its debts created fears of a “domino effect” involving the entire EU. Over €213bn of Greek bonds were held abroad. French banks held 32 percent of Greek debt, Germany 19 percent, Netherlands 5 percent, and the rest of the euro area 16 percent. Germany, on the other hand, held the bulk of Spanish debt, and Spain owed Italy €31m. In turn, Greece owed Italy €6.9m. If one of these countries defaulted, this web of indebtedness could trigger a European financial crisis.

The EU’s position was similar to what happened to Long Term Capital Management in the late 90’s when the Russian government defaulted on their debts. It was also similar to the position of banks in the US during the subprime crisis of 2008.

The Greek government outlined austerity measures that would help curb the government deficit and restore confidence in the Greek’s government ability to pay their creditors. The EU, fearing that a contagion might spread through all the other economies of Europe, approved a bailout plan through the IMF. The bailout, worth €45bn, would be enough to cover Greece’s government deficit and maturing debts for 2010. However, it is estimated that Greece will need around €70bn more to fund its deficit and debts until 2014.

The EU and IMF agreed on a €750bn bailout package for the EU countries to stimulate recovery and avoid a default. In exchange for this loan, the lenders needed a guarantee from these countries that they would be able to repay these loans plus interest. The guarantee came in the form of ‘austerity measures,’ specifically through increased taxation and decreased government spending. If these measures were not implemented, the government would be penalized through higher interest rates on future loans or outright denial of loans.

However, some economists believe that these austerity measures will only lead to a worse recession. According to Joseph Stiglitz, former chief economist of the World Bank, cutting government spending and increasing taxation at a time when the economies of these countries are still recovering from the 2008 global financial will decrease consumption and productivity. Because there is a shortage of aggregate demand, cutting government spending will lower output and increase unemployment. Lowered aggregate demand will lead to lower tax revenues. Increased taxation will lead to decreased consumption and investment. Cutbacks in investment in education, infrastructure, and technology will cost more in the future in the form of lower growth and lower revenues. High unemployment will lead to deterioration of human capital. All of these factors will eventually lead to a higher national debt and an increased debt-to-GDP ratio in the future.

Critics of austerity programs, such as American economists Paul Krugman and Brad DeLong, point out that these policies will push Europe to the brink of depression. At a time of recession, these economies need stimulation rather than budget cuts. They say that these austerity measures are usually implemented to do two things: (1) maintain the confidence of the bond market that these countries can pay their debts, and (2) inspire economic growth. However, they believe that austerity measures have not actually achieved these effects.

Stiglitz adds that spending cuts are likely to lead to economic disaster for the EU. He argues that austerity measures will only lead to a decline in productivity, increased unemployment, and rising bond-yield spreads. He cites evidence from the recent financial crisis of 2008 in countries such as China, United States and Europe, which showed that financial stimulus worked. He points out the case of two countries, Ireland and Spain. Ireland responded quickly to economic insecurity with harsh austerity measures; Spain adopted budget cuts slowly and reluctantly imposed austerity measures. As of June 2010, Ireland had CDS spread of 226 points compared to 206 points of Spain; and a 10-year bond rate of 5.11%, compared to 4.46% only for Spain.

The Keynesian theory holds that increased spending in times of economic contraction, especially on public investments or tax cuts to inspire private investments, is more to likely restore growth even though it will increase the deficit.

The effects of decreased public spending were already seen in 1997-1998, during the Asian financial crisis, and in Argentina, where austerity measures transformed downturns into recessions, and then depression, because the deficit reduction was always smaller than what was hoped for.

On the other hand, austerity advocates point out that unlike America’s situation in 2008, Europe has no option other than an austerity program. Since most of the countries in trouble rely heavily on foreign investors, they need to regain these investors’ confidence by cutting spending to avoid being shut off from these funds. They have to satisfy the bond markets or risk higher interest rates and higher costs of debt in the future. Austerity advocates believe that as deficits come down, confidence in the economy will be revived, leading to an investment boom. European Central Bank president Jean-Claude Trichet believes that strengthening fiscal credibility and regaining the confidence of the private sector will lead to growth.

Furthermore, austerity advocates argue that cutting public spending and increasing taxation are needed to decrease debt and reduce the budget deficit to restore market confidence in the economies of these countries. They say that restoring investor confidence is essential, as it will lead to lower borrowing rates and easier access to funds in the future.

They claim that a failure to implement tough austerity measures will lead to increasing government debt, high interest rates and high inflation. They also argue that the multiplier for fiscal stimulus policies is zero and has been so with current measures, meaning they never work; regardless of the short-term considerations, risking structural deficits in the long run will lead to economic disaster.

The fundamental problem EU countries face now is how to handle government debt. Policymakers have two options: (1) pay the debt now and cut the budget deficit through budget cuts, or (2) postpone paying the debt, run a budget deficit and borrow more to finance economic growth.

Those in favour of reducing debt now argue that the burden of too much debt will be placed on the shoulders of future generations. Once these debts mature and the interest has to be paid, future taxpayers will need to decide how to come up with money to pay off these loans. They can either increase taxes, cut public spending, or do both. Or they can opt to forgo paying and borrow more. Running a budget deficit will lead to decreased public and private saving, which will cause interest rates to increase and investments to decrease. Decreased investments means less cash for new plants, equipment and business start-ups. This would lead to mean lowered wages, increased unemployment, reduced production of goods and services, less capital for improvements in technology and infrastructure, and decreased support for education and healthcare. As a result, future generations will be born to a lower standard of living conditions and higher taxes.

Those in favour of postponing debt payments believe that the problem of government debt is exaggerated. Although government debt will be a burden to future generations, it is not large compared to the average person’s lifetime income. For example, in the US, the federal government debt is about $14,000 per individual. If he works for 40 years, earning $25,000 per year, his lifetime income would be $1,000,000. His share of government debt will only be 2% of his lifetime income.

The advocates of postponing debt payments contend that the issue of government debt should be viewed as one part of a larger picture. They point out that the effects of paying government debt and implementing austerity measures will cost the economy more in the future than the cost of the debt today. For example, if the government decide to pay debt and cut back on government spending now on education, healthcare, technology, infrastructure and investments in the economy, how will this affect future generations? Future citizens might have a lower debt burden, but they will be living in a world where they will be less educated, with lower income, fewer health benefits and an overall lower standard of living. Furthermore, it is also reasonable to allow budget deficits to run in certain situations such as during war times and temporary downturns in the economy. During a recession, taxable income falls automatically. It will not be prudent for the government to cut spending and raise taxes during these times of high unemployment because it would only dampen aggregate demand at a time when the economy needs to be stimulated. Reducing government expenditure would increase the effects of the economic recession. According to this school of thought, debt does not have to be paid now, and in fact may be allowed to rise indefinitely. A country’s total income will rise along with its population growth and technological growth; therefore, the ability of a country to pay its debts will rise as well. As long as economic growth grows at a rate faster than the rate of increase of government debt, then it is acceptable for government debt to grow forever.

I believe that budget cuts now would lead to further recession. As John Maynard Keynes said, austerity measures should be instituted during times of economic boom, not during a slump. As of the present the EU countries imposing these measures are in the midst of a recession. Britain…. Portugal…. Spain…blah blah blah

Responding quickly with budget cuts at a time when economies are slowing down will make matters worse and may lead eventually to depression. The main argument of budget-cut supporters is that regaining the confidence of investors and the market will eventually drive economic growth. However, historical data shows that this is a myth and that during times of recession, the government got the economy back on track by pumping more money into it and not cutting spending. As seen during the Great Depression in the U.S. of 1929, the economy grew as the government used money for war spending. Also, in 1937, in the middle of the Great Depression, the Roosevelt administration implemented budget cuts to reduce the budget deficit, causing a second recession.

According to Alberto F. Alesina and Silvia Ardagna (2009), large-scale deficit-reducing policies among different countries produced economic expansion and a decrease in debt-to-GDP ratio within three years of adopting the policies. However, Arjun Jayadev and Mike Konczal (2010) refute this study, saying that upon further examination, the data used by the Alesina and Ardagna do not support this claim. They found that the majority of the instances examined did not show deficit reduction in the middle of the slump. Whenever the deficit was reduced, the reduction came with a decline in growth rate or an increase in debt-to-GDP ratio. Jayadev and Konczal found that historically, countries do not cut deficits in a slump but tackle this problem during times of economic growth; when countries cut spending in a slump, they usually experience decreased growth, increased debt-to-GDP ratio, or both. When countries happen to successful in cutting deficits during an economic slump, it is more a result of low interest rates or exchange rates; no country facing a recession, low interest rates and high unemployment has been successful in reducing debt growth.

We only need to look at the example of the US to see Keynesian economics at work. As noted by Thomas Palley (2010), the recession in the US was due to a fall in aggregate demand caused by the sudden decline of private-sector spending. This decline was due to the destruction of household wealth because of the housing bubble of 2008, the decline of available credit caused by the banking crisis, and the decrease in consumer and business confidence. Tax revenues fell and government spending increased (this included the financial sector bailout), causing the US budget deficit to rise. The increase in the budget deficit prevented the collapse of the financial sector and aggregate demand, preventing a fall in income and unemployment.

The EU situation is similar to the US situation in 2008. The PIIGS are overburdened with debt and are in the midst of an economic slump. Coupled with declining investor confidence, this has resulted in increasing interest rates, decreased tax revenues and increasing budget deficits. The only difference is that these EU countries cannot devalue their currency.