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Eurozone Crisis

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Eurozone crisis: A Brief Assessment
In his recent statement before leaving the seventh summit of the G-20, Prime Minister Manmohan Singh expressed his worries over the gloomy Eurozone outlook and the way it could further dampen global markets and adversely impact India’s economic growth. The Eurozone jitters have quite recently shown their impact on the country’s currency and caused it to downgrade and touch the lowest level of Rs.56.23 against the $ as on May 30, 2012. The situation in Europe is of particular concern as it accounts for a significant share of the global economy and is also India’s major trade and investment partner. Clearly, the situation in Europe needs major policy attention not just for Europe but for all major global economies, be it the emerging nations or the major developed economies.

Eurozone Sovereign Debt Crisis: Background
The Eurozone crisis is a term used to describe the soaring debt levels of five of the major Eurozone nations and their inability to pay off a part or whole of this debt that they have accumulated over the recent decades. These five nations including Greece, Portugal, Ireland , Italy and Spain have failed to generate enough growth for their economies to retain the bondholder’s confidence in their ability to hold the guarantee that they promised to deliver. The crisis that blew up has far reaching consequences extending beyond the national boundaries of these five nations painting a gloomy picture for all the major global economies. This sovereign debt crisis has its roots in the global crisis of 2008-09 that shook the world economy and paved the way for the debt crisis in Europe. The global economy including the Eurozone countries have experienced slow growth since the U.S. financial crisis, which then exposed the unsustainable fiscal policies of the countries in Europe. Greece was the first to feel the pinch of weaker growth. When the growth slows down, the tax revenues also tumble making high fiscal deficits unsustainable. Investors responded to this by demanding higher yields on Greece’s bonds which raised the cost of the country’s debt burden and necessitated a series of bailouts by European Union and ECB. This had the contagion effect on the similar weaker Eurozone economies which lost the investor confidence prompting them to demand higher yields and led to continued fiscal strain for these countries. Unsustainable fiscal policies, excessive lending that had left the banks with bad debts and governments with large fiscal deficits were the major root causes for the crisis amongst the Eurozone nations. A series of steps were taken by the governments of these countries to bring down the severity of the crisis. These steps comprised a series of bailouts for Europe’s troubled economies, the establishment of European Financial Stability Facility to provide emergency lending to countries in financial difficulty, availability of cheap credit at ultra-low rates by ECB to the nation’s troubled banks. While these solutions could help in the near term and particularly could save smaller economy like Greece, the situation remains acute for countries like Italy and Spain which are too big to be saved.

Is fiscal austerity an answer?
Not necessarily. A fiscal tightening cannot solve the problem at the root level especially for the smaller nations of Eurozone. It instead would worsen the situation even more. It is important to understand the mechanism at work here. A country, in order to bring down the high persistent fiscal deficit prevailing in the economy can go for austerity measures like a cut in government spending or a hike in taxes. But the key point to remember here is that a deficit reduction of one percentage point of GDP here would bring down the overall output by the same amount if not more. This means slower growth which means lower tax revenues for the countries to pay their deficit bills. Although this would mean lower inflation level in the country but the unemployment levels might rise to a high level so as to completely offset the positive gains coming from the inflation side. A high government debt to GDP ratio can be brought down by two ways, by either bringing down the debt or raising the GDP. We have already seen that the first measure would not help since it can adversely affect the GDP and might not lead to a fall in debt to GDP ratio at all. The simple Keynesian economics (famous IS-LM model) suggests that a cut in government spending would crowd in private investment by the way of lower interest rates and hence trigger an increased demand for private investment. However, the case of Greece shows that there has been no corresponding increase in private investment expenditure and instead the excessive levels of private indebtedness and a collapse of public confidence led the private sector to decrease spending. This led to even lower demand for both products and labor, which further deepened the recession and made it ever more difficult to generate tax revenues and fight public indebtedness.

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What the crisis means for global financial markets?
The Eurozone forms a significant market for the rest of the world. The Eurozone accounts for 19.4 per cent of the world GDP (at market exchange rates). Clearly then the crisis situation is likely to have a spillover effect on the other global economies of the world, be it advanced or developing nations. The banks of two European giants Germany and France have large exposures. Countries like U.K. and U.S. have substantial exposure to debt in the troubled economies of Eurozone. There are close trading links as Europe is US’s largest trading partner and the largest destination for investment by U.S. corporations. American banks have over $600 billion of exposure in the troubled economies of the euro zone as per BIS data. For both China and India, Europe and the euro zone accounts for a significant market. Therefore stagnation or worse, a downturn in the euro zone will dent their export growth. As regards India, EU is a major trade partner accounting for as much as 20.2 per cent of India’s exports (2009-10) and 13.3 per cent of imports. As a matter of recent concern, the negative outlook on Eurozone has adversely affected the major currencies of the emerging nations as it causes investors to take shelter under the umbrella of the safe haven currency dollar causing major currencies to lose their value, with rupee witnessing the steepest fall ever.

What is the need of the hour?
The need of the hour is to restore investor and business confidence within the Eurozone countries and calls for a revival of growth, employment and income in these countries. The contention is that how this can be achieved at least possible risk. A key policy here is a cut in the interest rate levels by the central bank which could spur investment levels. ECB has already gone for interest rate cuts and there is room for further rate cuts as inflation takes a backstage and doesn’t pose a danger. ECB has a crucial role in providing liquidity to solvent banks at cheaper rates in return for adequate collateral. The other policy option can be increasing the competitiveness of these nations and Eurozone as a whole. This is typically done by devaluation of the currency. Since Eurozone countries cannot go for devaluation, they have typically followed the path of internal devaluation, an economic process where a country aims to reduce its unit labour costs. But increasing the competitiveness through this route may not yield the desired results and is typically a long-period adjustment mechanism. Also, if a country's citizens saved more instead of consuming imports, this would reduce its trade deficit. It is therefore been suggested that countries with large trade deficits (e.g. Greece) consume less and improve their exporting industries. This could then prevent steep euro fall which has already been facing a huge downfall. The third policy option is a radical one, of peripheral economies leaving the Eurozone. But if that were to happen, it could lead to insolvency of several Euro zone countries, a breakdown in intra zone payments. This may have disastrous consequences for the remaining Eurozone countries attached by the way of currency bloc.

Concluding observations:
As of May 2012, Europe remains in turmoil. Greece's exit from the euro appears inevitable to economists all around the world. Instability continues to affect the rest of Europe as well: French President Nicolas Sarkozy lost power due in part to his support for austerity measures, and the region had fallen into a recession. Spain, for its part, faces 25% unemployment with no clear path to growth. European policymakers - who already lack unity - face a difficult choice: keep the currency union together, with all of the challenges that would entail, or allow Greece (and possibly Spain and/or Italy) to exit, a path that would likely lead to financial market chaos. As a result, the chance of a further economic shock to the region - and the world economy as a whole - is still a significant possibility, and will likely remain so for several years.

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