What is the matter this time? It is again “excessive debt financing” of aggregate demand including excessive government spending. But, there are new dimensions this time. First, it is in an “economic union” of countries which agreed to be together but did not. Second, the adverse effects of the US financial crisis were also carried forward in contributing to the Euro zone’s excessive debt financing.
Let us cut short a long story and make it simple. There cannot be an Economic and Monetary Union or, as it is simply known as a “single currency union” unless the member countries agreed upon macro policy coordination and maintaining common macro-economic fundamentals. When the member countries in the Euro Zone which now consists of 17 European countries launch a single currency – Euro in 1999, they also agreed upon maintaining such macroeconomic fundamentals related to budget deficits, debt ratios, inflation rates, and interest rates.
Crossing the boundary lines
Although the member countries in the Euro Zone obliged to maintain a budget deficit at less than 3% of GDP and, public debt ratio less that 60% of GDP, particularly during the last few years after the US financial crisis, these indicators were seen as going out of control. The governments increased spending leading to huge budget deficits, which, as a result became highly indebted countries. The most-indebted countries in the Euro Zone - Greece and Italy reached public debt over 150% and 120% of GDP, while that of Belgium, Ireland and Portugal was around 100% of GDP. France and Germany also had experienced a rising debt ratio over 80% of GDP. One important problem of the Euro Zone policy coordination was the lack of any effective mechanism to deal with the violation of the agreement by the member states. The issue is not only economic, but also political as tensions mounted in some countries.
The problem was not just the high debt, but its accompanied economic progress and the speculation about the ability of the country to repay the loans. Along with high budget deficits and high debt ratios, GDP growth was slower and unemployment was high around 10% and, well above that in Greece, Ireland and Portugal. That is exactly why, the high budget deficits and accumulating debts of Greece, Italy, Ireland, Spain and Portugal became major problematic countries since the beginning in 2009. Not only their debt problem got worsened, but it spread across the region. The latest country coming under pressure is France, while the only country in the Euro Zone which was least affected has so far been Germany.
The problem: origin and transmission
What is the problem, then and, where do you feel the heat? The problem is in the financial market. When the investors who have bought bonds by lending to these countries begin to realize (or rather speculate) that these countries are unable to repay the loans, they become nervous and start selling off bonds. This panic in the financial markets would raise the interest rates. Rising interest rates of the 10-year bonds is a sign of the financial market becoming heated and coming under pressure. The long-term interest rates of the Euro Zone were rising during the past few years and rising fast during the past few months of 2011. During a period of 12 months from mid-2010 to mid-2011, the long-term interest rate doubled reaching 18% in Greece and 12% in Ireland and Portugal. The European Central Bank (ECB) can intervene in cooling the heat by buying bonds, and the ECB actually continued to do so. But it could be only temporary as the speculations deepen and interest rates increased.
Let us look at the global picture of the Euro crisis and the differences in crisis impact. If you are holding Euro-denominated bonds, you are nervous because your financial investment is likely to lose its value. If you are holding Greece bonds you are more nervous than another who is holding German bonds, because the bonds issued by Greece is likely to lose more than those issued by German. Depending on the banks’ exposure to Euro bonds issued by different governments in the Euro Zone, the financial crisis deepens. In fact, the European banks are holding part of the stock of Euro bonds so that they are in a vulnerable position which affects their current lending businesses – further pressure on interest rates.
USA and Euro Zone (which are quite similar in size of the economy and size of the population) are big lenders to each other borrowers from each other. As USA holds Euro bonds, the Euro crisis would hit the USA financial sector as the USA investors lose their assets values. And, it is worthwhile noting that historically USA is a “debt-financing” country as it continued with massive trade deficits, but managed to import what it wants by borrowing from abroad. Therefore, both USA and Euro Zone, which have the biggest consumers in the world and must reduce their expenditure, would be faced with a slump in aggregate demand simultaneously. The two are also the major trading partners of each other as they import from each other and export to each other. If the USA has to buy less from Euro Zone and, vice versa, they both have to face a contraction in international trade too. This is another channel of the spread of crisis impact contributing to the decline in aggregate demand. The eventual outcome is a fall in incomes and a loss of employment, once again.
Will the Euro collapse?
If the Euro crisis persists, there will be greater possibilities for either deeper integration or dis-intergration of the Euro Zone. In fact, both Germany and France are proposing for the former which would strengthen the effective policy coordination and enforcing robust macroeconomic fundamentals among the member countries. In this case, the individual member countries have to surrender their macro policy autonomy furthermore for the sake of the region and not the country, which would include fiscal policy and associated debt-financing as well.
The latter; the dis-intergration of the Euro Zone, which is not yet proposed or expected by anyone, is not an intentional outcome. If the Euro falls apart forcing the member countries to reverse to their national currency, the losses and gains of the Euro crisis would be shared differently by the different member countries. In this case, investors holding bonds of strong countries (such as Germany) would gain, as their national currencies become stronger after a dis-intergration. In contrast, the investors holding bonds of weak countries (such as Greece) would lose, as their national currencies become weaker after dis-integration.
Transmission to Sri Lanka
The possible Euro crisis as such does not leave out a small developing country like Sri Lanka. In general, the USA and European Union are the major export markets for most of the developing countries. As far as Sri Lankan export trade is concerned, USA and European Union, which accounted for about 65% of total exports in the mid-2000s are still buying about 55% even in the midst of the crisis. Therefore, the transmission of the Euro problem to Sri Lanka would be mainly through the “real” sector affecting trade, tourism and investment, which might have a time lag. Then, it may have widespread adverse effects on output and employment as well as the financial markets and outstanding sovereign debts.