Why european crisis happen

A third key lesson is that the underlying economic problems of monetary union and the key political debates about the structure of Eurozone governance have persisted since the s. In fact, these problems were largely predictable and broadly foreseen by several scholars and observers prior to In the years between the signing of the Maastricht Treaty and the launch of the Euro, it became very clear that, while policymakers were unified in their goal of creating a stable Euro and Eurozone, domestic politics within EMU member-states were such that no country was able to agree to the sorts of policies and institutions that would have enabled the Eurozone to avoid the problems that have plagued it since Faced with the same set of persistent macroeconomic imbalances and similar implacable domestic political barriers to further integration, European policymakers and national-level politicians in EMU member-states have pursued piecemeal, least common denominator responses, which have prevented full collapse of the Eurozone but done little to resolve the core issues and imbalances at the heart of the crisis.

Increasingly, then, the appropriate analogy for the Eurozone is not the Great Depression, but rather Japan, which has been mired in an era of stagnation since the s, and whose persistent problems debt-laden banks, unfavourable demographics, persistent deflationary pressures appear disturbingly similar to those of the Eurozone today. Unless economic growth returns to the Euro area, Greece and other member-states face the possibility of decades of grinding deflation, long-term unemployment, and stagnation.

The future threatens to bring not just lost decades, but also lost generations. This scenario does not bode well for the future of European monetary integration, particularly as economic stagnation and the ongoing refugee crisis amplify political support for anti-Euro and anti-EU parties in both creditor and debtor countries. Lesson 4: Monetary union without fiscal and regulatory coordination is untenable.

The final key lesson, in light of the previous two, is that ensuring the long-term viability of the Euro will require European policymakers to adopt some combination of the policies and institutions — a true Eurozone lender of last resort, some form of fiscal policy coordination, increased labour mobility between member states — necessary to maintain a monetary union among disparate national economies with large and persistent macroeconomic imbalances.

Whether achieving these objectives requires a formal fiscal and political union is not clear. What is clear is that the status quo cannot persist indefinitely if the Euro is to survive in the long term. In this sense, the current political and economic debates in Europe closely mirror those of the United States from the s through the s.

Whether or not European policymakers are able to overcome the domestic and international obstacles to such cooperation is, as always, a political rather than an economic question. Indeed, it is important to note that there are no technical obstacles to the adoption of any of the policy or institutional solutions to resolving the Euro crisis and addressing the imbalances within the monetary union.

The ultimate problem is that adoption of any of them remains, now and for the foreseeable future, politically infeasible. The concluding chapter of European monetary integration is yet to be written. Its contents, along with the long-term prospects of the Eurozone, remain uncertain.

Please read our comments policy before commenting. Featured: the European Central Bank in Frankfurt. Capital is in fact mobile, but this does not apply to labour for several reasons. First and foremost, moving to another country is expensive in comparison to transferring capital between financial centres. However, the biggest obstacle is language.

In the 18 Euro countries there are 16 different languages. English is not the working language everywhere and particularly not in the manufacturing sector.

Moreover, professional qualifications are not easy to transfer from country to country. While nurses have to study at university in Italy, they are only required to complete a course of training in Germany. And most importantly, most people are simply not willing to move from one country to another as they would have to leave their families and friends behind.

However, according to McKinnon , a currency area might still be useful for countries, since the most important factor is openness, not factor mobility. The more open an economy is, the less prices are determined by domestic supply and demand. For a very open economy, revaluation might lead to a worse situation as import prices increase and lead to imported inflation.

If import products are an important input for exports, export prices might also have to go up. Moreover, domestic wages might increase as employees ask for a wage mark-up due to higher domestic inflation.

Both scenarios would reduce price competiveness. Thus, whether a currency area makes sense depends on the interconnectedness of domestic economies. The following table presents some evidence about the role of intra-regional trade of selected regions.

Tables 1 and 2 show average percentage intra-trade of selected regions. First, the table shows that percentage intra-trade within the Eurozone is not that large even though there is no currency risk. The values for the EU 27 are well above those for the Eurozone even though the Euro zone is smaller. Lastly, one can see that average percentage intra-trade in the Euro area has decreased since However, the McKinnon criterion of openness is met for the largest part.

A third theory dealing with currency areas comes from Kenen According to him, asymmetric shocks are not that problematic if countries are highly specialized in producing several goods. A more diversified economy has also a more diversified export sector.

This means that an asymmetric shock affects only part of the economy. Eventually, shocks should balance themselves out.

This means that fixed exchange rates are useful for countries which produce a variety of goods. There are only some studies that discuss whether this applies for Euro countries. According to Baldwin and Wyplosz , product diversification is reasonably high in Europe. However, there are large differences between countries. Taking into account these theoretical assumptions, one could doubt that the Euro area is an optimum currency area.

However, other currency areas like the US are also sub-optimal with respect to the criteria named above. On the other hand, in the US there exists a system of money transfers from prosperous regions to less productive ones. This is not the case in the Euro area as every country conducts its own fiscal and economic policy.

But why did countries like Greece want to become members of the currency area even if they were aware of possible problems? The main reason is possibly that these countries hoped that interest rates for domestic debtors including the government would decline since, once they were in the Eurozone. To summarize, the project of a common currency was a political idea. It was politicians who decided to construct the Euro and to let countries take part that did not meet all criteria. We should bear in mind that the EMU has had some defects by its very nature.

These defects did not cause the crisis, but they did magnify here and there. In the last section, we have seen the institutional setting of the Euro zone. It was already mentioned that some countries breached the Maastricht criteria. Thus, the question arises of whether the current crisis is a consequence of excessive government spending. Here, it is instructive to look at government debt and deficits. Tables 3 and 4 show public deficit and debt of all Euro member states. Bold numbers in tables 3 and 4 indicate breaches of the Maastricht criteria.

Some things are noteworthy. First, Greece's and Portugal's public deficit was above the target in every single year of Euro membership. Even countries like Germany failed to meet the deficit criterion several times.

On the other hand, countries like Spain and Ireland which later faced grave difficulties were "model students" regarding public deficits until They even achieved budget surpluses in some years. However, Ireland and Spain could have done much better as tax revenues were high due to credit and housing booms Lane, The data about public debt tells a similar story. Austria, Belgium, Greece, and Italy never met the debt requirement. Germany met the requirement only in one year.

Spain and Ireland were again among the best performing countries and could even reduce their debt-to-GDP ratios until The Euro area as a whole could reduce indebtedness from to with respect to GDP. However, the situation changed completely after Debt-to-GDP ratios skyrocketed in all Euro countries. This development is linked to the financial crisis which started in Thus, the main reason for the current crisis in Europe is not errors made during the construction of the Euro area.

There was no sovereign debt crisis in Europe until The Euro crisis is mainly a result of the subprime crisis that started in in the US. This inevitably leads to the question why Europe was affected so severely. After monetary policy in Europe was relatively expansionary. ABS seemed to be a reasonable option as they obtained consistently good ratings and had higher yields. The other reason for the involvement of Europe in the Subprime sector via ABS was that the US had large current account deficits which it needed to finance.

The US trade deficits were financed by selling ABS to countries with current account surpluses, to Germany and the Netherlands in particular. This triggered massive write-downs of banks' assets and, indeed, created mistrust between banks and between depositors and banks. Consequently, depositors withdrew money from banks and banks were loath to lend money to one another. However, the situation was still relatively calm up to the point when Lehman Brothers failed.

This insolvency caused a crash of stock markets worldwide and led to further write-downs and bank losses. This triggered solvency and liquidity problems for many banks. The difference between continental Europe and Anglo-Saxon countries is that in the latter the financial system is market-orientated and not bank dominated. In Europe, companies and individuals finance investments mainly by borrowing money from their house banks and retaining profits.

Small and medium enterprises rarely issue corporate bonds to obtain liquidity. Thus, banks are essential for the functioning of the real economy. Furthermore, domestic banks are relatively large compared to the size of the domestic economy.

This creates mutual dependency between banks and governments. Banks' solvency depends on the solvency of their home country and vice versa. This dependence forced European governments to rescue banks. Many banks had to be restructured or needed capital and liquidity.

Figure 1 shows the amount of rescue measures in the Euro area. As figure 1 illustrates, rescue measures consisted of guarantees, relief measures, recapitalisation measures, and liquidity measures. Guarantees account for the largest part. In , these amounted to billion Euros. In , the sum was more than twice as high as in The same applies for It is also instructive to take a look at the number of restructured banks between and Italy 19 and Austria 17 restructured most banks during that time.

This is still much lower than the number of restructured banks in the US Most interestingly, Spain closed only three banks. Thus, one would expect that Spain would restructure many more banks, especially because there are lots of distressed small thrifts e.

But why did Spain close only three banks? There are basically two reasons. First, politicians were acutely aware of the problems of the housing market.

Closing more banks would have put more pressure on prices due to higher foreclosure rates. They also wanted that banks keep lending money to the private sector to stabilize the economy. Second, the government was aware of massive fiscal costs that a restructuring would have incurred. Thus, they hesitated to clear up the banking sector. In retrospect, we know that the delay of the banking crisis was a huge mistake.

Countries like the US that cleaned up the mess quickly, are now in a much better situation. However, the main reason for the current sovereign debt crisis is excessive private debt and not public debt. Banks and individuals increased lending. The problem was that these credits were not only used for productivity increasing investments but for consumption and investment in real estate.

Figure 2 shows the development of private debt in selected Euro zone countries. Private debt was apparently on an expansion path until the beginning of the financial crisis.

Only some countries managed to keep private debt as a percentage of GDP stable after the breakout of the crisis. Lending was used for housing purchases. Spain and Ireland had their own housing price bubbles. These bubbles burst shortly after the subprime mortgage bubble. To summarize, the root of the evil lies in the financial crisis.

Before the outbreak of the financial crisis, the Euro zone managed to cope with problems which went back to the founding of the currency area. The Great Recession forced countries to rescue banks and companies and to conduct expansionary fiscal policy to fight the recession.

After discussing the causes of the Euro crisis, the next section will show that the current crisis has not just one symptom sovereign debt but a multiplicity. The four major crises are the growth crisis, the labour market crisis, the sovereign debt crisis, and the balance of payment crisis which will be discussed in this chapter.

The Euro zone is not just in a sovereign debt crisis, it is also in a growth crisis. The financial crisis led to a recession of the entire Euro zone in All members were affected by this crisis.

Figure 3 shows real GDP growth rates of selected countries as well as the average among all Euro countries. The figure demonstrates that the euro zone was hit by a double-dip recession, a typical feature of many banking crises.

Before the financial crisis started, Germany was "the sick man of Europe" as growth rates were mostly well below the average of the euro zone. Then the picture changed dramatically. Germany is the stabilizing pillar of the Euro zone economy. Without Germany the euro zone would probably have been in a recession in and as well.

While Germany recovered from the financial crisis, other countries are still stuck in a recession. But why is Europe so divided? There are several reasons for this. The first comes from Keynesian theory. Countries with public debt problems opted for or were forced to adopt austerity measures. Consequently, public expenditures were cut and taxes increased.

In contradiction to the Ricardian equivalence theorem, government spending cuts were multiplied, widening and deepening the recession. Recession forced governments into further austerity measures, which only made matters worse.

At the same time, monetary policy was not effective, as banks were not willing to extend credit to companies and investors because they are still tottering. Second, inflation and wage increase differentials caused different developments in competiveness. Southern states with higher inflation rates lost price competiveness against northern states like Germany, resulting in current account imbalances see section "The Balance of Payment Crisis".

Third, some countries economies are struggling with structural problems. For instance, Portugal was once a textile producing country. Nowadays cheap clothes are produced in Asia and high-quality wear in countries like Italy. Thus, some European economies lack a viable business model. This leads to further problems. Among these problems are labour market distortions which will be discussed in the next section. The deep recession in Europe had a severe impact on labour markets, too.

Increasing unemployment is a typical feature of banking crises see e. This applies to Europe. Figure 4 shows unemployment rates of selected countries and the average among all Euro members.

According to Brada and Signorelli , differences in labour market performance after recessions can mainly be explained by the quality of institutions, the flexibility of labour markets, and structural factors. We have already seen some economies with structural problems Portugal.

To add another example, at the peak of the real estate bubble in Spain around one in four employees was working in the building sector. The whole sector was under pressure once the bubble burst. A second explanation comes from standard neoclassical theory. Thus, we must look at unit labour costs of some Euro countries figure 5. Figure 5 shows unit labour costs on an index basis. Spain's and Portugal's unit labour costs increased over the full time range. Italy's unit labour costs went up until Germany's unit labour costs, on the other hand, increased until and then decreased slightly.

Ireland is the most impressive case as their unit labour costs went down all the time. But how can the increase in labour costs in Spain and Portugal be explained? Unit labour costs remain constant if nominal wages increase by just the sum of inflation and productivity gains. So why did those countries not achieve productivity gains? Nominal wages increased by much more, forcing unit labour costs up.

In addition, labour demand increased as a result of the rise in aggregate demand. However, since capital imports were mainly used for consumption, not investment, productivity only increased modestly. Therefore, these countries lost competitiveness. It should be emphasized that the figure does not tell anything about the absolute differences of unit labour costs between countries.

Germany's unit labour costs are still well above those of countries like Greece. However, it is not just costs that matter. Moreover, eurozone wide contractionary fiscal policy limited the effectiveness of expansionary monetary policy. As members of a currency union, individual eurozone countries were by definition unable to individually employ exchange rate or monetary policy to address competitiveness problems and stimulate growth.

As a result, countries had to resort to internal devaluation, i. Furthermore, euro exit would have created chaos, both for exiting countries themselves and for the other member states, as an exit would have increased uncertainty about the future of the remainder of the eurozone. Greece, Ireland, Portugal, Spain and Cyprus received financial support via these funds. The main difference between monetary financing of government debt within and outside the EMU is that support via the OMT is conditional on an austerity and reform programme.

This is important as structural reforms tend to increase the sustainability of government debt in the long term and this could help to reduce moral hazard risks. Outside the EMU, a Central Bank is unlikely to be able to request the government to push through reforms in exchange for government bond purchases.

That said, the conditionality makes the emergency backstop subject to political risk. Did you like this article? Useful Not useful.

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Do you want us to respond to your remarks? If so, please leave your email address below. Figure 1:Fiscal stance prior to the crisis varies strongly between countries Source: Macrobond, Eurostat Figure 2: Loss of competitiveness in most peripheral member states Source: Macrobond, European Commission. Wijffelaars rabobank. Feedback Did you like this article?