Question

What factors led to the present financial crisis in Europe, especially in Greece and Ireland. Discuss the differences between the Greek and Irish economies.

Answer 1

ANSWER:

The European debt crisis is an ongoing financial crisis that has made it difficult or impossible for some countries in the euro area to repay or re-finance their government debt without the assistance of third parties.

The European sovereign debt crisis resulted from a combination of complex factors, including the globalisation of finance; easy credit conditions during the 2002–2008 period that encouraged high-risk lending and borrowing practices; the 2007–2012 global financial crisis; international trade imbalances; real-estate bubbles that have since burst; the 2008–2012 global recession; fiscal policy choices related to government revenues and expenses; and approaches used by nations to bail out troubled banking industries and private bondholders, assuming private debt burdens or socialising losses.

Factors that led to the present financial crisis in Europe, especially in Greece and Ireland are:

• Rising household and government debt levels
• Trade imbalances
• Structural problem of Eurozone system
• Monetary policy inflexibility
• Loss of confidence

Rising household and government debt levels

In 1992, members of the European Union signed the Maastricht Treaty, under which they pledged to limit their deficit spending and debt levels. However, a number of EU member states, including Greece and Italy, were able to circumvent these rules, failing to abide by their own internal guidelines, sidestepping best practice and ignoring internationally agreed standards.

The adoption of the euro led to many Eurozone countries of different credit worthiness receiving similar and very low interest rates for their bonds and private credits during years preceding the crisis. As a result, creditors in countries with originally weak currencies (and higher interest rates) suddenly enjoyed much more favorable credit terms, which spurred private and government spending and led to an economic boom.

Trade imbalances

Commentator and Financial Times journalist Martin Wolf has asserted that the root of the crisis was growing trade imbalances. He notes in the run-up to the crisis, from 1999 to 2007, Germany had a considerably better public debt and fiscal deficit relative to GDP than the most affected eurozone members.

A trade deficit can also be affected by changes in relative labour costs, which made southern nations less competitive and increased trade imbalances. However, most EU nations had increases in labour costs greater than Germany's. Those nations that allowed "wages to grow faster than productivity" lost competitiveness. Germany's restrained labour costs, while a debatable factor in trade imbalances, are an important factor for its low unemployment rate

Structural problem of Eurozone system

One theory is that these problems are caused by a structural contradiction within the euro system, the theory is that there is a monetary union (common currency) without a fiscal union (e.g., common taxation, pension, and treasury functions). In the Eurozone system, the countries are required to follow a similar fiscal path, but they do not have common treasury to enforce it. That is, countries with the same monetary system have freedom in fiscal policies in taxation and expenditure. So, even though there are some agreements on monetary policy and through the European Central Bank, countries may not be able to or would simply choose not to follow it. This feature brought fiscal free riding of peripheral economies, especially represented by Greece, as it is hard to control and regulate national financial institutions.

Monetary policy inflexibility

Membership in the Eurozone established a single monetary policy, preventing individual member states from acting independently. In particular they cannot create Euros in order to pay creditors and eliminate their risk of default. Since they share the same currency as their (eurozone) trading partners, they cannot devalue their currency to make their exports cheaper, which in principle would lead to an improved balance of trade, increased GDP and higher tax revenues in nominal terms.

Loss of confidence

Prior to development of the crisis it was assumed by both regulators and banks that sovereign debt from the eurozone was safe. Banks had substantial holdings of bonds from weaker economies such as Greece which offered a small premium and seemingly were equally sound. As the crisis developed it became obvious that Greek, and possibly other countries', bonds offered substantially more risk. Contributing to lack of information about the risk of European sovereign debt was conflict of interest by banks that were earning substantial sums underwriting the bonds.

Ireland is often regarded as a success story for Eurozone austerity, compared to the total failure of Greece. That can lead to nonsense like this: instead of whingeing, the Greeks should buckle under and get on with it as Ireland has done..

Whether you can describe Irish unemployment rising from 12% in 2009 to 14.7% in 2012 as a success is of course moot. But Ireland does give us a clear example of how austerity is supposed to impact an open monetary union member, according to standard theory. A permanent reduction in government spending or higher taxes will increase unemployment, which will reduce wages and prices. This will improve competitiveness, leading to higher external demand for Ireland’s products (and less imports) which will eventually replace the lost demand due to austerity.

The fact that Ireland is now growing strongly and unemployment is falling reflects this process. The OECD estimates that growth in 2014 was nearly 5%, and this was greatly helped by a 12% increase in the volume of exports. In this sense Ireland’s response to austerity has been textbook. The interesting question is why Greece has been so different. Here is growth in the two economies (all data comes from the OECD’s Economic Outlook).

To sum up, the main reason Greece has suffered so much more than Ireland is that the amount of austerity imposed on Greece has been much greater. Any recession is also likely to be greater because Greece is a less open economy, so a larger internal devaluation is required to offset the impact of austerity. One final factor is that large cuts in wages have not been translated into improvements in competitiveness, in part because of the way austerity was implemented.