Public Policy and Foreign Policy in the European Union in Relation to the Euro Crisis

Essay , 2018 , 12 Pages , Grade: 1.5

Economics - Foreign Trade Theory, Trade Policy

From a retrospective perspective, the Eurozone’s performance within the first decade exhibited outstanding success. One of the key indicators of its success was the attainment of European Central Bank’s policy objectives. Of these policy objectives was reducing and stabilizing inflation. However, the end of the Great Recession of 2008 that led to global financial crisis seems to have ignited the Euro crisis in Europe. This was the case because European banks exhibited faults in the banking system, which were responsible for the global financial crisis. During the pre- euro crisis period, banks in the Eurozone carried out extensive borrowing based on the perceived low-risk macroeconomic environment which was created by the rising asset prices Similarly, other financial institutions within the Eurozone increased their borrowing, in order to gain benefits from increased lending. Unfortunately, asset prices took a downturn, thus prompting European banks to reduce their reverage.

In turn, reveraged financial institutions, especially banks within the Eurozone attracted few investors who were willing to buy mortgage-based assets, leading to further assets prices fall. As a result, European banks within the Eurozone began experiencing solvency problems. Despite the existence of a common monetary policy within the Eurozone, regulatory responses to the increasing Euro crisis were based on national government fiscal policies. In this context, national governments were concerned on the stability of their financial systems. As a result, banks within the Eurozone introduced bank guarantees which accompanied increasing fiscal deficits; thus raising concerns over the solvency of national governments. In retrospect, the issuances of bonds in euros by countries which are members of the Eurozone seem to have driven the Euro crisis.

To the respective Eurozone members, this situation is, more or less the same as that in emerging countries which issue bonds in foreign currencies. This implies that their central banks cannot buy newly issued government debts, leaving the European Central Bank as the only financial institution that can address the euro crisis. Since the beginning of the euro crisis in 2009, malfunctioning of the single European market, primarily the liquidity problem has made it difficult to solve the problem.

From a retrospective perspective, the Eurozone’s performance within the first decade exhibited outstanding success. One of the key indicators of its success was the attainment of European Central Bank’s policy objectives. Of these policy objectives was reducing and stabilizing inflation. However, the end of the Great Recession of 2008 that led to global financial crisis seems to have ignited the Euro crisis in Europe. This was the case because European banks exhibited faults in the banking system, which were responsible for the global financial crisis. During the pre- euro crisis period, banks in the Eurozone carried out extensive borrowing based on the perceived low-risk macroeconomic environment which was created by the rising asset prices (Flandreau & Flores, 2009). Similarly, other financial institutions within the Eurozone increased their borrowing, in order to gain benefits from increased lending. Unfortunately, asset prices took a downturn, thus prompting European banks to reduce their reverage (Reinhart & Rogoff, 2009). In turn, reveraged financial institutions, especially banks within the Eurozone attracted few investors who were willing to buy mortgage-based assets, leading to further assets prices fall. As a result, European banks within the Eurozone began experiencing solvency problems. Despite the existence of a common monetary policy within the Eurozone, regulatory responses to the increasing Euro crisis were based on national government fiscal policies. In this context, national governments were concerned on the stability of their financial systems (Kopf, 2011). As a result, banks within the Eurozone introduced bank guarantees which accompanied increasing fiscal deficits; thus raising concerns over the solvency of national governments. In retrospect, the issuances of bonds in euros by countries which are members of the Eurozone seem to have driven the Euro crisis. To the respective Eurozone members, this situation is, more or less the same as that in emerging countries which issue bonds in foreign currencies (Boone & Johnson, 2011). This implies that their central banks cannot buy newly issued government debts, leaving the European Central Bank as the only financial institution that can address the euro crisis. Since the beginning of the euro crisis in 2009, malfunctioning of the single European market, primarily the liquidity problem has made it difficult to solve the problem. Therefore, this essay provides a comprehensive analysis of the causes and solutions of the euro crisis.

For nearly a decade since the beginning of the euro crisis, the stability of the Eurozone economy has been at stake. From an economical perspective, it is explicit that the consequences of this crisis have incapacitated some Eurozone members, making it difficult for them to repay their debts. Based on the nature of the euro crisis, the underlying causes of the financial crisis within the Eurozone can be elucidated. Some of the causes of the euro crisis have a global scope; thus considered as external causes. However, there are internal causes which were responsible for the onset of the euro crisis. From a critical analysis, it is apparent that the onset of the ongoing euro crisis has been precipitated by a combination of both external and internal factors. Some of the main causes of the crisis include the housing boom during 2002 and 2008 which encouraged high-risk borrowing and lending practices by banks, the recent global recession, governmental regulatory responses to bank bail outs and the assumption of private debt burdens (Lewis, 2011).

In this context, the underlying causes of the euro crisis require a comprehensive analysis, in order to understand the history and evolution of this financial phenomenon. It is apparent that the immediate causes of the euro crisis emerged within the Eurozone. Some of the main causes of the euro crisis were investors’ skepticism, monetary policy failures, trade imbalances, and structural Eurozone system failures.

Economic analyses indicate that increased skepticism was the one of the main factors that led to the onset of the euro crisis. Initially, Eurozone debt was not considered by most markets as a significant aspect that could lead to a financial crisis within the region. Instead, the Eurozone debt was assumed to be safe. The economic rationale behind this assumption was based on the notion that the commitment of all Eurozone countries to maintain a stable economy created an implicit guarantee. As a result, investors continued to offer low interest rates on debt, leading to the soaring of the debt crisis in countries such as Italy and Greece which had high debt levels. Therefore, the inability by Greece to address its debt levels raised skepticism among investors about the European finances. Of concern was the case of Greece, which revealed that bonds of countries with high debt levels were more risk. Unfortunately, most Eurozone banks had invested extensively in bonds from these countries which offered small premium. This scepticism prompted investors to start selling Greek bonds, in order to reduce financial consequences that were associated to the risk of default. As a result, interest rates took an upward turn; thus exacerbating the euro crisis.

Monetary policy inflexibility is considered as the second main factor that caused the euro crisis. The lack of exchange rate policy control by Eurozone countries was one of the drawbacks of the Eurozone monetary policy. In principle, the current monetary policy does not allow Eurozone member states to eliminate current account imbalances and competitiveness challenges. Under the single market, the European Central Bank has the supreme mandate to regulate exchange rate. This leaves the member states with no option to control their debts through the ordinary mechanisms. For instance, countries respond to current account deficits and competitiveness issues through currency devaluation. Unfortunately, the Eurozone monetary policy does not allow individual member states to control exchange rates because they do not print the euro. As a result, member states which are experiencing high current account deficit have adopted internal devaluation. Economic experts view internal devaluation as a damaging and deflationary process due to its impact on debt sustainability. In internal devaluation, countries introduce fiscal policy measures which reduce relative costs such as labor cost, in order to increase their competitiveness in the regional or global markets (Blanchard, 2007). However, it is worth noting that a deflationary process decreases economic growth, employment and aggregate demand. These are the main macroeconomic indicators. Therefore, it is explicit that a significant decrease in economic growth, employment and demand causes negative impacts on debt sustainability. This is why some Eurozone members such as Greece have been unable to tackle their current account deficit.

The second cause of the euro crisis is attributable to structural issues within the Eurozone system. From a critical perspective, it is apparent that the establishment of the European single market created a monetary union (Issing, 2008). This implies that the Eurozone member countries were expected to share a common currency, as it is the case for other regional markets such as the United States of America. However, this monetary union was not congruent to the respective fiscal union. In other words, the European single market is, indeed a monetary union that does not have a defined fiscal union. Despite the fact that Eurozone member states share a common currency, the euro, each member has an independent fiscal structure which operates independently. However, it is expected that all member states adopt a similar fiscal path. This does not mean the monetary union is matched with fiscal union. Instead, each member state runs treasury functions, taxation and pension schemes, separately. In principle, the European Central Bank is mandated to print and issue the euro to all banks within the Eurozone. Additionally, there are some monetary policy agreements which are meant to bind member states to the monetary union. However, the European Central Bank lacks the dual mandate of carrying out monetary and fiscal functions. It controls inflation, but it does not control employment. As such, member states have freedom in regulating their fiscal functions through fiscal policies. It is also worth noting that some Eurozone members may decide not to implement some monetary policies which are set by the union. The case of Greece provides an outstanding example on how the Eurozone system allowed some Eurozone member states to continue using peripheral economies. In retrospect, the Eurozone system is quite different from the United States’ monetary union where the Federal Reserve Bank has a dual mandate (Eichengreen, 1990). Therefore, it is argued that this structural weakness of the Eurozone system was one of the main causes of the euro crisis. On the other hand, it is apparent that the Eurozone system exhibits a complex decision making process (Pollack & Young, 2015). According to the structure of the Eurozone system, decision making involves all the 18 member states through which consensus is reached. This implies that if an agreement has to be reached, all members must participate positively. In this context, there was need for a quick response to the global financial crisis to mitigate it. In the United States, the financial crisis was mitigated quickly through monetary and fiscal policy responses. In contrast, the Eurozone was slow to respond to the global financial crisis due to the rigidity of its decision making structure. This is probably, the reason why the union entered into financial crisis, just after the end of the global financial crisis. This explains how the slow response to the global financial crisis has made the union to battle in the euro crisis, long after the global world is out of recession.

Finally, it is apparent that the onset of the euro crisis was created by the trade imbalances within the Eurozone. Since the establishment of the Eurozone, some Eurozone member states experienced weak economies, whereas others were flourishing with surplus production. Trade deficit has always been blamed as the initial cause of the euro crisis (Kopf, 2011). In this context, it is worth analyzing trade deficits across the Eurozone. Since 1999, German had its fiscal deficit consistent to its GDP yet its trade surplus continued to increase until 2007. During this same period, trade deficits for other Eurozone members such as Italy, Spain and France became worse. This phenomenon was caused by the lack of capital inflow to fund the deficit. On the other hand, trade deficits for most Eurozone members were affected by changes in labor costs. For instance, the southern countries exhibited less competitiveness as compared to northern countries. This aspect created further trade imbalances. Overall, Eurozone member states who allowed faster growth of wages than productivity. As a result, these states became less competitive in the region. Over this period, Germany restrained its labor costs leading to a slow unemployment rate. In contrast, Italy experienced a steady increase of labor costs to as high as 32% compared to that of Germany (Malliaropulos, 2010). Therefore, it is explicit that trade imbalances, primarily current account deficits and interest spread precipitated the euro crisis.

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Graph: Illustration of current account deficit within Eurozone from 1996-2009 (Malliaropulos, 2010)

As the euro crisis continues to trouble the Eurozone, several mitigation measures have been proposed. Some of these solutions include the establishment of Eurobond, reformation of the European Union law to extend the function of the European Central Bank, austerity measures, debt write-off, supply side reforms, and competitive friendly approaches.

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• Grade: 1.5
• Author: Caroline Mutuku (Author)
• Publication Year: 2018
• Pages: 12
• Catalog Number: V432829
• ISBN (eBook): 9783668749566
• ISBN (Book): 9783668749573
• Language: English
• Tags: public, policy, foreign, european, union, relation, euro, crisis