BUSI2034 Research Project 2015

Due Date: Monday, 4 May 2015, 4pm
Length of Essay: 4000 words excluding tables, figures, reference list, and appendices (if any).
Instructions:
You are required to develop an essay addressing the issues described in the following statement:
‘Geopolitical crises and epidemics haven’t stopped the global economy from expanding by some 3 percent in 2014. However, the Eurozone will remain the world economy’s main problem, with growth in the single-currency bloc expected to be negligible.
Problems in some of the Eurozone’s big economies are worrying analysts. The situation in Italy, for instance, is quite dramatic, with the economy stagnating. In France, high public deficits are a big worry; such a policy could not be continued for much longer. Underperforming fellow Eurozone nations could affect Germany’s own economic growth prospects, since they are the customers for most of Germany’s exports; it is expected that Germany’s gross domestic product will expand by just 1 percent in 2015.
Despite the evident problems in Eurozone, Germany and France are determined to restore a confidence to the Euro.’
Discuss the statement, and use examples to justify your opinion.

1.0 Introduction
The Global Financial Crisis or the ‘great recession’ as it is now known has been widely regarded as the worst global recession since the end of the Great Depression (Drezner, 2014). The events following the collapse of the US housing market and the subsequent financial meltdown has had consequences on a global scale, nowhere is this more evident than in the Eurozone (Allen & Ngai, 2012). The Eurozone, made up of 19 EU member states that have adopted a common currency and monetary policy, have faced increasing levels of public debt, economic stagnation and civil unrest (Ucler et al. 2015). Problems are further compounded by the fact that there is an increasing level of disagreements over the policies and structural reforms to be undertaken.

While it is easy to lay the blame for many of the problems entirely on the GFC, this can be a misleading proposition. Though the GFC and the recession that followed acted as the precursors to the Eurozone crisis, these problems were further exacerbated by the structural bottlenecks and often-contradictory fiscal policies that characterized the various Eurozone nations. This is evidenced by the fact that economic growth for the Eurozone in the year 2015 is estimated by the European commission to be around 1.3% (The Economist, 2015), which though better from previous years, is disappointing when compared to an estimated global growth forecast of 3.0% (World Bank, 2015). This seems especially lacklustre when taking the increasing levels of economic activity in both the UK and US into consideration, where markets have seemingly gained momentum spurred on by healing labour markets and accommodative monetary policy. The fact that the UK and US, both countries that have been significantly affected by the onset of the global recession, have seemingly restored their economic momentum raises the question off, why the Eurozone does not seem to be able to replicate their relative success?

It is within this context that this paper seeks to explore, first the nature of the Eurozone crisis and secondly, the potential solutions for the future. It is postulated that the reason behind the economic stagnation and the fact that the Eurozone seems to have an inability to shake of the lingering affects of the global recession is, at its basic level, a structural problem. The authors will seek to draw from prevalent economic theory and take a holistic perspective in examining the events that precipitated in the crisis, the Eurozone reactions, including the QE programmes and the long-term prospects of the Eurozone. Following which potential solutions shall be identified.

2.0 Context

3.1 Origins of the great recession: Global integration for better or worse
On September 15, 2008, Lehman Brothers, one of the largest investment banks in the world and the fourth largest in the United States filed for chapter 11 bankruptcy, resulting in what has now been called the perfect storm (Kensil & Margraf, 2012). Though the spectacular fall of Lehman Brothers and the subsequent asset relief program which culminated in the bailout of AIG are often cited as the starting of the financial crisis, it is perhaps important to look backwards to the previous decades in order to fully understand just why the financial crisis occurred and why its impact caused a contagion specifically in the Eurozone.
From the years 1971-1973, the Nixon administration effectively dismantled the Bretton Woods agreement that had kept much of the global currency supply in check, essentially changing the nature of currency from the previously accepted gold standard to a de facto regime of free-floating fiat currency (Schwartz, 2000). What followed were decades of competitive devaluations and an unprecedented increase in the supply of currency around the world (refer to Figure 1). This was also an era of significant deregulation and financial integration around the world, combined with increasing amounts of savings from oil-rich countries and developing nations such as China (Lanman, 2007). By the early 2000’s it became evidently clear that there was a massive savings glut in the worlds financial markets (Agudelo, 2007).
The combined factors of massive liquidity and low interest rates especially in the developed world such as the US and Eurozone culminated in increased speculation and artificially inflated prices, especially in the housing sector (Dugger, 2014). The problem was further exacerbated by generous government incentives and deregulation that increased the risk-taking propensities of Banks especially in the areas of sub-prime mortgages, essentially creating a housing bubble (Christiano et al. 2015). However, when the housing bubble started to collapse in late 2007 culminating in the eventual folding of Lehman Brothers in 2008, the markets faced an uncertain environment with investors increasingly looking for safer options such as Gold. The stock market value of Banks collapsed and capital dried up almost overnight, what started off as an insolvency crisis turned into a systemic one (Braude et al. 2012).
Similarly in Europe, banks such as BNP Paribas which had taken significant positions in the US markets suffered considerable losses with flow on effects throughout the EU economy. The increasingly untenable positions of Banks within the Eurozone combined with the fact that there were significant housing bubbles in Spain and France meant that capital flows and credit were drying up quickly (Ucler, 2015). The previous global trends of financial deregulation and integration also meant that EU financial institutions had direct exposure to toxic assets in the United States (Ahmad et al. 2014). This essentially meant that Banks were going to have to increasingly consolidate their balance sheets by de-leveraging, effectively cutting down credit access to the economy at large and constraining economic growth (refer to figure 2). This was further compounded by the limitations of various national governments in taking effective measures imposed by the nature of Eurozone.
Figure 1 (Billion Vault, 2015)

Figure 2 (Weisanthal, 2013)

3.2 Crisis in Europe: The unique case of the Eurozone
According to prevalent economic theory, specifically the Keynesian view, because of the cyclical nature of the economy, government intervention can be used as a way to stimulate the market in the short-run and to smooth out economic fluctuations (Snowden & Vane, 1995). This is precisely the premise of stimulus packages such as TARP in the USA and the Rudd-era stimulus packages in Australia. However, due to the nature and structure of the Eurozone, individual governments can be severely limited in their implementation of such strategies, some of these issues are explored in the following section.
2.2.1 The common currency
The economic rationale for the adoption of the single currency is based on the premise of a neo-liberal economic philosophy, that is, the best way to improve the economy is through the free movement of capital. At a microeconomic level, there is little doubt that the adoption of a common currency area should improve business and benefit member states through increased efficiency in the allocation of resources. However, from a macroeconomic perspective, it can also conversely limit states in their ability to respond to crises as well as significantly increase the risk of contagion (Ricci-Risquete et al. 2015).
In the broadest terms, states have two avenues with which to intervene in the markets, the first one being fiscal and the second being monetary. However the adoption of Euro by the 19 members of the EU that make up the Eurozone meant that monetary policy was now in the hands of a central bank and out of national jurisdiction. Whereas under the previous free-floating currency regime, the markets had the ability to correct such things as trade imbalances, and if they failed to do so, the national bank could intervene through interest rate cuts and increasing currency supply, the adoption of the single currency and the subsequent loss of policy initiative meant that nations were now faced with a scenario of having only two avenues with which to correct macroeconomic imbalances, namely 1) real wages and 2) Price adjustments (Blankenburg et al. 2013). However, in both of these aspects there were divergent trends with certain states incurring ever increasing macroeconomic imbalances (refer to Figure 3 & 4) whilst not inviting the requisite currency devaluations as a result of the single currency. Similarly, whilst labor productivity increased in some states, there tended to be divergence in per unit labor costs, namely between northern and southern states (Rusek, 2012).
This resulted in a scenario whereby a single monetary policy was adopted without taking into consideration the national differentials that existed. Furthermore, asymmetric shocks exogenous to the Eurozone such as the appreciation or devaluation of the Euro can be extremely harmful to certain vulnerable economies as opposed to resilient ones. This was illustrated by the fact that certain countries such as the PI(I)GS (Portugal, Italy, (Ireland) Greece and Spain) were hit harder then others such as Germany (Dellago et al. 2013) during the great recession. According to extant research, the first reason for this scenario is that macroeconomic and financial disequilibrium shakes the confidence of financial markets in the solvency of vulnerable countries. Secondly, microeconomic and systemic inefficiencies that are internal to the country lead to weak competitiveness. This results in a situation whereby countries are at the mercy of markets. This issue is further compounded by the often-contradictory fiscal policies of individual governments, often precipitating in inconsistencies to the monetary policy undertaken by the ECB whose policy impacts are Euro-wide. 2.2.2 Fiscal Policies
This leads us to the controversial topic of EU fiscal policies. In an ideal situation, fiscal and monetary policies are consistent. For example, in times of high inflation, governments tend to cut back on government expenditure and national banks raise interest rates. However, due to the fact that the Eurozone consists of a diverse range of countries at different stages of development and uniquely dissimilar situations on the domestic front, there have at times been inconsistencies. Whilst various components of the Maastricht treaty and subsequent agreements sought to find agreements to this problem by setting general criteria and frameworks within which to implement fiscal policies, the aim being to promote fiscal restraint. They have been for the most part unsuccessful (Papademos, 2003).
The Maastricht treaty was signed with the agreement amongst member nations that they would avoid excessive deficits, with successive EU governments working to curtail inflation as well as lower government spending. However, as the launch of the Euro neared it became clear that there would have to be formal guidelines for countries to follow once the common currency had been adopted, and to this end the stability and growth pact was signed in 1997. The two main outcomes of this pact included an agreement to curtail government debt to within 60% of GDP and the annual budget deficit to within 3% of GDP. Similarly current account surpluses were to be maintained in the long run, in order to ensure that the common monetary policy would not have any adverse effects (Allen & Ngai, 2012). Nevertheless, the nature of the enforcement mechanism ensured that within a short period of time countries were violating the conditions and there was a lack of political will to enforce the regulations. In fact Germany, which for many years had been seen as a proponent of fiscal discipline was one of the first countries to violate the conditions set, followed soon by France. By 2005, there had been enough ‘reform’ of the original regulations so as to let countries run up large deficits (refer to figures 5&6). This was especially true of countries such as Italy and Greece which had been running deficits even prior to the collapse of Lehman Brothers, the main reasons being profligate social spending combined with insufficient tax collection (Chinn et al. 2013). The latter being especially true in the case of Italy, where tax evasion accounts for 18% of GDP and governments are unable to take affective measures in addressing the problem (The economist, 2013; Hallett et al. 2008; Navarro et al. 2012).
This had three broad implications for affected countries in dealing with the Great Recession. They were namely: 1) The high levels of debt accumulated in the preceding decades gave less room for maneuverability in terms of fiscal stimulus. 2) The short-term debt undertaken immediately following the Financial Crisis had the effect of massively increasing debt levels, during a period in which tax revenue was declining. This had the flow on effect of shaking the confidence of financial markets in the solvency of especially vulnerable nations such as Spain, Greece, Italy and Ireland. As a consequence, the risk premiums and interest associated with government bonds increased (refer to figure 7), further constraining individual governments’ ability to service debt. 3) Whilst running budget deficits are common practices for governments looking to stimulate the economy. In the absence of monetary policy initiative, countries are faced with the conflicting ideas of 1) increasing expenditure and 2) servicing debt through taxation and austerity (which has the effect of decreasing demand and limiting economic growth). Conversely, countries such as the US can take monetary actions and limit the effects of excessive debt through the use of seigniorage (i.e. inflation tax). However, in the case of the Eurozone, such policy initiatives are made next to impossible because of the divergent nature and contrast between resilient nations as opposed to vulnerable nations. For example, the ECB cannot lower interest rates and increase currency supply excessively since this would have adverse effects on countries such as Germany which are not faced with the same problems as the rest of the Eurozone (Leen, 2012). This brings us to the question of regional disequilibria.

2.2.3 North vs. South: An asymmetric relationship
Further from the lack of fiscal integration, there was also growing disparity between the various states of the Eurozone, with the emergence of an asymmetric relationship between Northern and Southern Countries. The former having consistently built up current account surpluses in the past, whilst the latter have accumulated long-term current account deficits (De Grauwe et al. 2014). As a result, the Eurozone system was characterized by a bipolar relationship between debtors-creditors.
Since the early 2000s, trade imbalances emerged between Germany on the one hand running a trade surplus and Greece, Italy, Spain and Portugal on the other running up large trade deficits. This resulted in growing difficulties for the Mediterranean countries to find viable routes in order to sustain international competitiveness (Chen et al. 2013). Conversely, Germany was fostering its competitiveness through a strategy of wage less productivity growth, combining strong wage restraints policies and high investments in technological infrastructure, while at the same time curtailing social spending. This resulted in a scenario where domestic demand was supressed and private consumption as a percentage of GDP declined drastically, being substituted by intra-EU net exports (Tylford, 2015). In fact by 2014, Germany’s current account surplus hit a record of 7.5% of GDP, exceeding the limits prescribed by the European excessive imbalances procedure (Blankenburg et al. 2013).
Political Will
Though the Eurozone crisis is often seen as primarily an economic one, the political side of it cannot be underestimated, especially if a long-term solution is to be found. This is especially worrisome given the seeming failure of European Institutions in fostering accountability and gaining legitimacy amongst EU citizens. In May 2014 the elections for the EP saw a massive rejection by European electorates against the mainstream parties, a symptom that arose as a consequence of many of the economic crises and the policy actions taken by EU nations. The elections saw as well a rise in support for Euroskeptic parties such as the French National Front led by Marine Le Pen (The Economist, 2014) and the “Five Stars Movement” led by the Italian comedian Beppe Grillo (Faris, 2013). Both leaders aimed to weaken support for the European Union, riding on a wave of dissatisfaction and anger of increasingly impoverished segments of the population.
Moreover, EU institutions have failed in educating citizens towards an understanding of the role of the European Union. This is underlined by the results of a eurobarometer survey in 2004 where 55 per cent of respondents thought that the EU was created just after First World War and 50 per cent did not know that Members of the European Parliament were directly elected by voters. Furthermore, one in four Europeans thought that the biggest item on the EU budget was the cost of officials, meetings and buildings (McCormick, 2011). Finally, the process of decision-making is often criticized for being cumbersome and extremely slow given that the directives and regulations adopted must be accepted by the majority of the member states (Ray, 2007; Black, 2008).
These problems are further exacerbated by the discrepancy in terms of economic growth between northern and southern states, with France and Germany being perceived as ‘dictating policy’. This was especially true during the years following the great recession where Germany, a nation that was significantly less affected by the great recession, became a visible advocate of fiscal austerity measures that significantly affected struggling EU members considerably more than Germany. This essentially caused widespread political divisions between Germany on one side, and southern countries on the other (Blankenburg et al. 2013).
Figure 3 (Dellago et al. 2013, p. 204)

Figure 4 (Dellago et al, 2013, p.204)

Figure 5 (Allen & Ngai, 2012, p.9)

Figure 6 (Allen & Ngai, 2012, p.10)

Figure 7 (Allen & Ngai, 2012. P.12)

3.0 Eurozone Reactions
3.1 Bringing it all together
In the preceding section, the authors mentioned and expanded upon the reasons behind the ‘global recession’ and some of the structural as well as institutional constraints that inhibit governments within the Eurozone from taking the necessary steps to address the crisis. These constraints were broadly categorized as monetary, fiscal, structural and political. It is within this context that we propose two scenarios within which nations in the region can stimulate the economy and sustain long-term growth: 1) Fledgling nations exit the Eurozone and deal with economic problems individually with the added weight of an independent monetary policy. However, such a scenario would be costly and maybe detrimental in the long run. 2) Alternatively, the Eurozone could take an integrated approach to addressing the problems at hand and by doing so essentially find ways of circumventing the constraints previously elaborated on.
The second scenario was the preferred outcome by the Eurozone, notwithstanding the recent political divisions. However, much of the focus of recent efforts has been upon addressing the fiscal/budgetary problems of peripheral countries whilst often disregarding the problems associated with such things as trade imbalances. The economic thinking of Eurozone leaders so far has been that the only solutions to the Union’s problems are fiscal austerity and restoring the confidence of the financial sector. Such a view has had the downside of supressing demand and slowing growth within the short-run, whilst at the same time not addressing many of the structural constraints that could inhibit long-term growth.
3.2 Eurozone initiatives
In April 2010, when the euro crisis became increasingly visible, the Greek government negotiated its debt with the Troika in exchange for austerity measures. The Troika’s approach to the euro crisis up to that point had been dominated by its insistence of a market friendly solution aimed at increasing private sector participation in the renegotiation of the sovereign debt of EMU member states (Blankenburg et al. 2013). Such a policy limited the role played by the ECB to indirect interventions. The result being a series of ad hoc policy and institutional innovations, such as the European Financial Stability Facility (EFSF) that consisted of extending large loan packages to bankrupt states, issuing bonds as well as, other more complex debt instruments on the capital markets (Ucler et al. 2015).
The EFSF loan package had moreover stringent austerity conditions attached to it. It’s initial role was limited to that of a stability mechanism, intervening in primary and secondary bond markets as a rescue facility, before going on to become a permanent institution in the October of 2010 (i.e. European Stability Mechanism). Overall, since its creation the ESM failed to restore confidence in the markets, creating instead recurrent speculative attacks on sovereign debts in crisis-ridden EMU member states. The Accord of 27 October 2011 on Greek sovereign debt achieved only a brief stabilization of the European financial markets. However, market volatility that was attributed to an increasing reliance on uncertain cooperation by private creditors and member governments led in December 2011 to the adoption of LTRO’s (Blankenburg et al. 2013). The LTRO’s were essentially refinancing operations undertaken by the ECB as a way to lend to banks within the Eurozone region at generous rates (i.e. 1%), in order to boost liquidity and expand credit. However the results were disappointing since financial institutions were still wary of lending and economic uncertainty, this signalled the end of an emphasis on market friendly solutions (Schmieding, 2012). Further from this, as of 2010 there was still no evidence that these programmes had increased the capacity of the governments of debtor countries to service their debts, this was attributed to the relatively high risk premiums associated with the debt. It became increasingly clear, that the ECB would have to intervene directly in the market in order to restore financial confidence and put downward pressure on sovereign debt yields (Viterbo, 2015; Popescu, 2013).
On 6 September 2012, Mario Draghi, president for ECB finally announced the introduction of OMTs, recognising the ECB’s role as a lender of last resort to the EMU. The introduction of the OMTs implied the ECB assuming a role as the “banker of governments”, effectively buying up government debt. However, in order for OMTs to be effective in stabilising bond markets two features were necessary: first there was to be no quantitative limit on purchases of sovereign bonds of one to three year maturity. Secondly, to qualify for ECB bond purchases, countries have to adopt a full austerity program and/or a less stringent precautionary program for the recovery from short term temporary shocks (Blankenburg et al. 2013). In essence the OMTs appeared to be the only way with which to stabilize the bond market, assuring investors of the stability of the weaker countries and driving down servicing liabilities, providing much needed relief (Jessop, 2014; Buchheit, 2013).
3.2 Limitations
Though fiscal austerity does have its proponents who cite the fact that government expenditure needs to brought down in order to 1) consolidate and reduce debt pressures and 2) restore confidence. This author postulates that focusing on debt consolidation solely can be detrimental to the economy, since it has the side effects of creating unemployment and reducing demand based economic growth, further increasing government liabilities in the form of social security and decreasing revenue (e.g. less company tax). Furthermore, fiscal irresponsibility is not the sole reason for the crisis, such things as excessive deregulation, trade imbalances and the lack of enforcement mechanisms were also cited in the previous section (Rusek, 2012). Therefore, we propose that whilst financial austerity can put a stop to excessive deficits, it needs to be used moderately and in conjunction with structural reforms in order to promote growth. In the future, there also need to be strict criteria and the will to enforce them, if governments or institutions diverge. A point in case being the fact that the original stability and growth pact, which if it had been enforced, could have potentially avoided the debt crises all together. Although there has been recent momentum in addressing some of these issues, with the signing of the European Fiscal Compact in 2012 (i.e. essentially a newer version of the SGP), the current political dynamics have resulted in a situation where there are still no substantiative enforcement or disciplinary mechanisms created, for example, France within a two year period had already violated several of the criteria set (Alderman, 2014).
It is with the above conditions in mind that the authors propose the following solution:
In order to boost economic growth to similar levels such as the US and UK, it seems urgent that the structural imbalances that undermine the proper functioning of the Euro project be corrected. One possible way forward consists of a radical shift in the domestic economic policies of surplus countries toward measures aimed putting downward pressure on current account surpluses. Such policies could take the form of either direct transfers to southern countries or targeted increases in imports from southern countries. Alternatively, stimulus could also be implemented in order to boost domestic demand.
The most evident case is constituted by Germany, the economic heart of the Eurozone, whose rebalancing could result in major changes and relief for the European economy. In fact, under such a scenario, not only would debtor countries be able to service their debt more easily, there would also be improved investment prospects, hence reactivating the dynamics of demand and supply. Germany could also benefit from the increase in private consumption, in the form of positive effects for domestic business. Similarly, this kind of demand based economic interventions could kick-start inflation in northern countries, making it easier for the ECB to adjust the interest rates accordingly, which would further reduce pressure on debtor countries by increasing domestic investment, as well as reduce debt liabilities.
Similarly, the nature of the political dynamics and demand-side economics also mean that policy initiatives need to be undertaken in order to give greater breathing space for countries in terms of austerity. For example, the OMT’s not only helped give much needed relief to governments within the Eurozone but also restored confidence in the Euro (Lin et al. 2015). A related concept could be increased investments in infrastructure through public-private partnerships, increased investments in education and other strategic sectors; this could reduce unemployment in the long run, boost economic growth and increase competitiveness. However, this would require EU-wide coordination to ensure a equitable and efficient distribution, helped by strong fiscal integration and enforcement mechanisms, so as to ensure that the problems that caused the crisis in the first place do not arise again. 4.0 An epilogue of sorts & Conclusion
Notwithstanding the political divisions, leaders within the Eurozone, especially Germany and France seem determined to restore confidence in the Euro. It must be remembered, first and foremost that the economic and political basis behind the Eurozone project still remains upon solid foundations. Previously, this author mentioned the microeconomic rationale behind the adoption of a single currency and indeed trends in the Intra-EU trade indicate that the adoption of a single currency has been beneficial (figure 4).
Apart from this, it is perhaps pertinent to remember that the adoption of a single currency is part of an overall drive toward greater integration and as such, the failure of the Euro has the potential to undermine and even reverse some of the major political achievements within the broader EU context. Ironically, it is Germany’s export oriented economy and consistent current account surpluses (which this author alluded to previously as one of the structural problems) that provide its government with the most incentive to ensure a stable euro. A break-up of the Euro would see a significant appreciation of its own currency in comparison to the rest of the Eurozone economies, thus hurting its exports in the long run, not to mention its creditor status. Similarly, the repercussions for states such as France with their large public debts would also be drastic, albeit for a different reason. Were they to leave the Eurozone, they would be faced with devaluations in their currencies which, given their debtor status would exaggerate the problem.
It therefore follows that it is in the mutual interest of all parties to ensure a strong Euro into the future, not to mention the long-term costs associated with reverting to a single currency such as, decreased cross-border trade, labor mobility and the increased uncertainty involved with volatile national currencies. However, ensuring growth into the future does involve greater consensus amongst EU leaders in order to address some of the structural and underlying problems aforementioned. Nonetheless, in this authors’ opinion, the initiatives undertaken so far, notwithstanding their significant limitations do show an intrinsic desire and will to undertake policy initiatives.

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