A Discussion on the EU’s Response to the Current Crisis in the Eurozone

1. Introduction:

Since the American subprime economic crisis happened from 2008, it has expanded around the world. Therefore, European Union (EU) also could not avoid this crisis. Actually, recently the crisis in European has gotten worse because the crisis in Greece and Italy had a strong strike to the whole EU. The direct impact is that the prime minister of Greece and the prime minister of Italy announced to leave their positions. Behind news is that Greece and Italy had owed huge debt which could not pay back to the loaner. The Euro has undertaken the great pressure that it is likely going to collapse in the future. The EU member states are unwilling to see the bankruptcy of Greece, and they may agree to decrease the debt the Greece current holding. This is because if Greek would go broke, it would cause the Dominoes Effect around the whole EU. Thus protecting the single Eurodollar becomes the key mission to the EU. This paper will analyze the background of the economic crisis in EU, and discuss the response of EU member states about the crisis happened in the Eurozone.

2. Literature Review:

EU has established a regional business for the deeper integration. After initially creating a customs union, the EU has now achieved something approaching a common or single market among all its members and beyond, and has recently introduced a fledgling monetary union between eleven of its member states. (Aswathappa, 2008)

Misra and Yadav (2009) concluded that the benefits of forming EU are: it has created a very large rich common market, free from barriers, in which organization can sell goods; the companies can minimize the production costs by setting their manufactures at the lower wage cost area; the creation of euro has led to significant savings realizations for the people and the companies; and the euro can make the comparison of prices across the EU much easier. Moreover, Buxbaum (1996) suggested that the benefits of EMU is lowering the transaction costs of doing business in EU, ensuring greater overall price stability in EU, encouraging trade among EU member states, and improving the stability of exchange rate and increased capital formation in EU. De Grauwe (2007) stated that as a country entered into EMU, it lose control over central bank, and therefore can no longer create surprise inflation to reduce the burden of its debt. Thus, the default risk increases in EMU. Boehnke (2003) also argued that risks existed in the EMU, in which EMU is not an optimal currency area, lower social standards, higher rate of unemployment, high average rate of inflation, higher government debt due to lower interest rates, and bailout problem. Notermans (2001) found that the low inflation constraint and loss of potential monetary policy autonomy impose new challenges to the bargaining system. Under the new conditions of a given low level of inflation, the necessary real wage flexibility has to be got through a higher degree of nominal wage flexibility.

On the one hand, EU business are the primary winners of the process of economic integration, as they are directly associated with the opening market frontiers, the growth of market size, and the harmonization of market conditions. On the other hand, the member states lose power as political entities, as they gradually transfer their economic sovereignty to the EU level. (Garcia et al, 2004) Moreover, Balling et al (2001) pointed out that European financial system remains firmly based on banking institutions. Banks play an important role in Europe, where adopted universal banking as its model.

The financial crisis started from 2007 has brought the most serious challenge to EU It revealed the EU institutional structure has shortcomings. The October 2008 Brussels European Council adopted the principles of a Euro Group action plan based on the British Banking Rescue plan. (Craig and Burca, 2011)

3. A discussion on the EU’s Response to the Current Crisis in the Eurozone

According to Jackson (2009), with the bankruptcy of Lehman, US mortgage market and subprime market continued to deteriorate. This in turn led to the credit market froze up and lack of a liquidity. At first, the financial crisis was seemed to happen only in US. The sharp decreasing in mortgage market would have a negative impact on the economy. However, the financial crisis quickly resulted in the liquidity crisis spread beyond the subprime mortgage market. Therefore, the high leverage banks, or financial institutions went broke by the credit problems. The US financial crisis expanded to EU market due to the fact that European banks held asset backed commercial paper. As the ABCP collapsed, European banks holding such commercial papers were forced to add additional funding, which squeezed liquidity in the global financial market. Patrick (2011) demonstrated that the major risk today is the continuing fragility of the economies of some eurozone member states such as Greece, Spain, and Portugal, and the possibility of renewed speculation in the financial market. Moreover, as the bankruptcy of Lehman, it led to the credit market frozen and a lack of liquidity. It triggered clauses in credit default swaps contracts that referenced Lehman. European banks held many short-term debts through Lehman’s global presence. As the investors redeemed the commercial paper, the European banks had to step into the money markets and purchase those securities. (Jackson, 2009) Aslund (2011) found that the EU core, whose exact composition has varied, has expropriated privileges for itself, not least in fiscal policy. This means although the EU adopted the single currency which is euro, it lacked a common fiscal policy agreed by the member states. Botsiou and Klapsis (2011) concluded that countries which were in violation of fiscal criteria (Italy, Belgium, and Greece) were admitted into Eurozone; Germany and France breached the Stability and Growth Pact. Therefore, the financial crisis happened in EU was due to the fact that from 2005, the EU expanded quickly and adopted a relative low interest rate resulted in the overheated economy. The lack of a common fiscal policy regarding the single currency euro because member states hold independent tax policy and bond issuance has led to the conflicts between the member states and EU. Thus, when the financial crisis happened from US and expanded to EU, the debt crisis was deepened in EU.

The European Central Bank has provided around €467 billion to support banks. Germany has put $400 billion to bailout ailing banks. (Wall Street Journal, 2008). Youngs (2010) pointed out that EU has put great emphasis on the governance dimensions of its response to the financial crisis. The G20 meeting has exchanged the views among financial regulators, early warning consultations, prudential regulations, and disclosure rules. Moreover, the Northern Rock bank going bankruptcy in UK in 2008 pushed the UK government launched a series of actions to rescue the UK financial market. Sikka (2009) found that the UK government had set aside £500 billion to support financial enterprises such as London Scottish Bank, Northern Rock and so on. UK government at first set up plans to react the financial crisis. Firstly, it cut in key interest rates of 50 basis points with bank of England, the Federal Reserve, and the European Central Bank. Secondly, it invested $87 billion into the financial markets in order to recapitalize the firms such as recapitalized the Northern Rock. Thirdly, the UK government agreed financial institutions to participate the recapitalization scheme up to $436 billion in guarantee on new short-term and medium-term debt to assist in refinancing maturing funding obligations as they due to three years. Fourthly, UK government injected $352 billion through Special Liquidity Scheme to improve liquidity in the banking industry. (Jackson, 2009)

Jackson (2009) found that UK’s approach provided an example for Eurozone to reference. In 2008, eurozone urged European governments to set rules addressing the financial crisis by which through the recapitalization that government provided funds to banks and guaranteed new debts issued by the banks in eurozone. Eurozone leaders joined with IMF to rescue a Greek bailout worth €110 billion in the May of 2010, debts-crisis storm clouds continued to gather during the week after the Greek package announced. (Baldwin et al, 2010) Nelson et al (2010) proposed that EU leaders announced additional €500 billion in financial assistance available to vulnerable European countries together with IMF additional €220 billion funds. The ECB decided to purchase European bonds and the US Federal Reserve would reopen currency swap lines with major central banks. In addition, EU launched a Special Purpose Vehicle scheme under which Eurozone countries could make available bilateral loans and government-backed loan guarantees €440 billion to stabilize the eurozone. In July 2011, the second around Greek bailout was agreed up to € 190 billion, and the maturity date extended from 7.5-year to 15-30 year and the interest rate decreased from 4.5% to 3.5%.

However, such actions are not sufficient. Moreover, Aslund (2011) criticized that the policy made by Eurozone countries and European Central Bank rather than the EU is not adequate. This is because the member countries in Eurozone told Greece not asking for help from IMF, denying its adequate professional and financial assistance. The eurozone countries denied Greece the right to an emergency loan, which all IMF members enjoy. After the Greece expanded the crisis to SGP, the eurozone governments insisted on guiding Greece, but they had few qualification and professional institutions. Kuklinski and Pawlowski (2010) pointed out that even though the members of eurozone like Ireland and Netherland went much further in deregulating the financial sector in response to the financial crisis, such actions were not adequate. They argued that EU showed its weakness by not providing a common response to the economic crisis. Governments focused on the national crisis management instead of EU level.

The emergence of euro was aimed to fight with US dollar at the international financial stage. As the financial crisis happened at Greece, Italy, Portugal, and Spain has put a great pressure on the euro. Germany and France as the core countries in the eurozone spent a lot to ease the pressure of financial crisis. This in turn leads to their national GDP did not have any increase in these two years. To some extent, such salvation by the core countries in the eurozone was not sufficient. On the contrary, the national economy of the core countries in the eurozone was affected seriously by the spread of financial debt crisis. Moreover, the core countries now may not have additional effort to save the crisis. Therefore, the trend of euro is hard to say in the near future. Moreover, this financial crisis revealed another problem, which is the ECB’s monetary policy. As the member states in eurozone were able to borrow at a more favorable interest rate than outside the eurozone, it made the countries in euronzone easier to finance the state budget and serve the existing budget. When the crisis happened, it gave a wrong signal to the crisis countries that they were bailout by the strong countries in the eurozone. In other words, the crisis countries were dependent on the core countries in eurozone. Recently the ever serious crisis happened in Italy deepened the debt crisis. Although ECB decided to purchase the Italy bonds, its impatient actions drove the change of Italy’s budget cut everyday from September. The yield of Italy’s bond was a bit decreasing due to the ECB’s intervention. This in turn led to the Italy’s government may loosen the effort to cut the budget deficit. In addition, the broken of the 1997 Stability and Growth Pact regarding the deficit limit among 17 eurozone members is also a key contributor to the European financial debt crisis.

If ECB or EU will not issue a common fiscal and monetary policy available to all member states in eurozone, the euro future trend is likely going to collapse. The second Greek bailout and the first Italian bailout of Italy revealed that ECB’s monetary policy has to balance the interest between the member states. This in turn led to the monetary policy was always behind the member states setting up the national monetary policy. However, if the euro collapse, it will lead to the economic recession happens in EU. Business will lose the confidence conducted in eurozone due to the uncertainty of euro. Patrick (2010) pointed out that EU’s political innovation bumps up against the practical economic requirements of monetary unions and single currencies. No monetary union has ever succeeded without support of political union including fiscal policies. This means EU has to set up the mechanism to prevent severe fiscal crisis and such mechanism should be operated both on EU level and sovereign level. Moreover, the sovereign debt crisis urged the EU to pursue the deeper integration from the long-term perspective. For one thing, the EMU has to set the punishment mechanism when the member states could not meet the requirement of deficit. This action will to some extend stop some countries violate the discipline to pursue their own interest. It will also avoid some countries always depend on the strong countries to bailout. Although the member states in eurozone have the responsibility to stabilize the euro, someone may argue why the strong countries should pay for other countries’ mistake. Therefore, it is necessary for EMU to set up the punishment mechanism to strictly control the requirement of fiscal deficit. For another thing, the EMU has to set up a common fiscal and monetary policy that could intervene member states immediately instead of the lag intervention. It will increase the flexibility for the EMU to react to the crisis instead of the always passive bailout.

4. Conclusion:

The financial crisis happened in US had a strong strike to the EU, especially to the eurozone member states. To some extent, it deepened the financial crisis to the sovereign debt crisis. Although the member states within eurozone response after crisis by the bailout actions, the bailout of Greece and the recently bailout of Italy revealed that the EMU has existed potential problems. Firstly, it lacked of a punishment mechanism for the member states violated the fiscal deficit requirements. Therefore, Greek or Italy would like to take the risk to adopt huge debt. Secondly, EMU always took the action behind the crisis without any professional suggestions. This will miss the best time to rescue the crisis countries and pay more cost. The future trend of euro is hard to say. However, if it collapses, the eurozone will undergo the economic recession without any doubt. It also provided a new way for EMU or EU to consider in the future, which is the further integration. EMU has to set up a common monetary and fiscal policy both under EU level and sovereign level. It will require the member states reach the common agreement instead of its own interest.

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