The Eurozone crisis started in 2009 and its effects continued to be felt even in 2012 when it became worse. In 2009 Greece defaulted its debt and in three years the situation escalated when sovereign debt defaults were reported by Spain, Italy, Portugal, and Ireland. The European Union with Germany and France in the front line tried to support the member states by initiating bailouts from the international monetary fund and the European central bank. The effects of a sovereign default would have been worse than the financial crisis experienced in 2008. Banks who were the primary holders of sovereign debt would have been adversely affected. Financial institutions would have been exposed to losses and the small ones could have collapsed. They would have cut back on the bank to bank lending thus affecting the labor rate. The European central bank which held a substantial amount of sovereign debt would also have been affected had the default rate been pronounced further. Its future would have been in jeopardy and the survival of the EU in its self would have been at stake. If the default rate went unchecked, it would have resulted in a recession or even a global depression (Morgan et al., 2014; Palley, 2012).
The Eurozone crisis was as a result of many causes including structural flaws in the Eurozone and financial crisis that affected the region from the 2000s leading to the global recession. Differences emerged between the core Eurozone and the periphery where the later was losing its competitiveness in the market. Excessive consumption in the affected countries coupled by low savings led to a deficit in the private sector. Public debt accumulated at an alarming rate following the global financial crisis. There was high current account deficit in the periphery where the debt was accumulating at an alarming rate (Morgan et al., 2014; Palley, 2012).
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Prior to the adoption of the Euro, the affected countries including Germany and France had current account imbalances with some reporting surpluses while others had deficits. Following the adoption of the Euro, the southern economies deteriorated in their current accounts a situation that intensified until the global crisis of 2008. Germany had a balanced current account when it joined the Eurozone but it later experienced a surplus. The southern countries faced current account and fiscal deficit after joining the Eurozone (Morgan et al., 2014; Palley, 2012).
Current Account Imbalances
The fiscal imbalances of the southern economies accelerated the Eurozone fragility. The liquidity of the market in times of upheavals shifts the focus from the fiscal policy to the balance of payment which was driven by the differences in labor productivity. Apart from examining the fiscal stance, it is necessary to consider competitiveness, credit cycle and current account balance as the major causes of the Eurozone crisis. Europe had reported huge intra Eurozone capital flows decades before the crisis. The balance of payment turned out to be a public debt crisis as the much-needed capital stopped flowing. Such a scenario raised concern over the viability of the financial institutions and governments in nations that heavily deeded on foreign lending. Slowing growth led to increased public debt ratios peripheral countries had built a substantial current account deficit as well as external debt. The southern countries lost their competitiveness due to policy mistakes by governments. Such loses justified the use of fiscal austerity as well as structural reforms. It was considered that internal devaluation which comprised nominal wage reductions could be an appropriate mechanism for restoring competitiveness (Constantine, 2014; Morgan et al., 2014; Palley, 2012).
One approach could have involved enhancing expenditure by the lending country and expenditure reduction by the borrower. Surplus countries could stimulate demand by reducing their taxes, raising the wages and investing. Many structural reforms have taken place in the affected countries as wages are considered downward rigidities and a significant problem in the Eurozone. Such reforms have raised the flexibility of wages, therefore, reducing downward rigidity. Some countries built excess deficit from the start of the global crisis and also during the Euro crisis. Some of the countries at the periphery recorded huge pre-crisis deficit had reported diminishing external imbalances probably due to a sudden increase in the interest rates, contraction, stability in domestic demand, movement in the cost and prices and as a result of the decline in oil prices. Capital movement worsened the challenges of the periphery countries as the more productive sectors were not targeted. Macroeconomic rebalancing was needed to address the sudden stop in the inflow of private capital. A single monetary policy was used to address the adjustment process by harmonizing short-term interest rates (Diaz-Sanchez & Varoudakis, 2015).
Angela Merkel in 2012 developed a seven-point plan which was against Francois Hollande proposal of a Eurobond. Hollande also wanted to scale down austerity measures and create an economic stimulus. However, austerity measures were widely applied by leaders. The major austerity measures involved tax increases and less on spending cuts. Greece, for example, implemented substantial spending reductions and tax increases. The institutional shortcomings in the country, however, could not allow any austerity measures to achieve the desired outcome. The type of austerity measures determined the recovery of the other nations and the size had little impacts on the economy. The composition of the fiscal measures is a key ingredient in achieving the desired debt to GDP ratio. Reduced government expenditures are likely to have a positive effect in reducing the debt of an economy compared to tax increases.
Fiscal adjustments that are likely to reduce the debt of a country are those designed to reduce government expenditure and not increasing the tax. Government spending can be reduced in an attempt to improve budget deficits or as a policy change aimed at improving the fiscal outlook of a country. Fiscal adjustments aimed at reducing expenditures are also difficult to reverse and therefore have long lasting effect in the reduction of the debt of an economy relative to its GDP. Successful fiscal initiatives are rooted in reducing the pay to the government workforce and not on reduced investments. Choosing between good policies and politics determines whether austerity measures achieve the desired results. Politicians fear that cutting on expenditure to reduce current account deficits is suicidal as they will not be voted in again (Palley, 2012).
Sound fiscal balance and expenditure reduction affects the GDP in a positive way in the long run. However, there are disagreements as to whether such austerity measure shrinks or expand the GDP. Expansionary fiscal policies are possible. There are however concerns as to how fiscal adjustments can be designed to have the least cost on the economy. Changing conditions might actually make fiscal adjustment costly than in the past. Expenditure-based adjustment is less likely to cause a recession compared to a tax increase. Increasing the taxes fails to reduce the debt of an economy and leads to recessions. There is, however, criticism to the impact of the two given that some economist attributes the changes to the reactions of monetary policy to fiscal adjustments (Morgan et al., 2014).
Lower spending has the potential to reduce the expectations of a high tax regime in the near future, therefore, enhancing confidence in the consumer and investors. It is, however, necessary to note that austerity measures are taken with other growth-enhancing policies and a clear understanding is their success needs to be conducted on each episode. Similarly, it is necessary to determine the influence of the demand and supply of money and how it can be used to address some of the crises. The demand and supply for money can be influenced by the central bank by adjusting the interest rates of Treasury bill to control the money in circulation. As more cash is in circulation, consumers are likely to increase their levels of consumption leading to a shift in the demand which can lead to inflation. According to the post-Keynesian model, the Eurozone crisis was driven by debt and growth in exports which lead to a sudden increase in the current account balance and private debts. The dysfunctional economic modeled to the uneven escalation of the crisis in parts of Europe. The fiscal rules in Europe were designed to impose fiscal discipline and promote pro-cyclical austerity. The separation of the monetary and fiscal spaces led to an increase in the appetite for sovereign debt. the economic policy regime of Europe led to the escalation of the problem to a sovereign debt crisis which led to a depression in southern Europe. The separation of the fiscal and monetary space makes it difficult for a country to combat the recession (Constantine, 2014; Morgan et al., 2014).
There is strong evidence that fiscal deficits have a close relationship with current account deficit. These findings imply that current account imbalances in the Eurozone could be improved using fiscal austerity. However, policymakers should conduct additional research to establish whether reduced government expenditure or increased taxation can improve the current account deficit. Austerity measures, however, affect economic growth and unemployment
References
Constantine, C. (2014). Rethinking the Twin Deficits. Journal Of Australian Political Economy MPRA .
Diaz-Sanchez, J., & Varoudakis, A. (2015). Tracking the causes of eurozone external imbalances: new evidence and some policy implications. International Economics And Economic Policy , 13 (4), 641-668. doi: 10.1007/s10368-015-0316-0
Morgan, D., Boccia, R., Bourne, R., Howden, D., Alesina, A., & Melchiorre, M. et al. (2014). Europe’s Fiscal Crisis Revealed: An In-Depth Analysis of Spending, Austerity, and Growth [Ebook]. Washington: The heritage Foundation.
Palley, T. (2012). The simple macroeconomics of fiscal austerity: Public debt, deficits and deficit caps. European Journal Of Economics And Economic Policies: Intervention , 9 (1), 91-107. doi: 10.4337/ejeep.2012.01.07
