The European Sovereign Debt Crisis

According to Lane (2012), the number of Euro-member countries to withstand adverse macroeconomic and financial shocks was identified as a major problem for the success of the Euro from the beginning. The option of switching off for national currency devaluations which act as a traditional mechanism between national economies was removed. Also, the euro union did not match the design of the United States "dollar union" in the main respects, since the monetary union was not accompanied by a significant degree of fiscal union or banking union. Instead, it was deemed feasible to retain the national responsibility for monetary policy and financial regulations. On the other hand, the ability of the national government to borrow in a common currency leads to free-rider problems especially if there are strong incentives to bail out a country that borrows excessively. When the national currencies are eliminated, it means that the national fiscal policy took an additional significance as a tool for countercyclical macroeconomic policy as asserted by Lane (2012). Individuals' government, on the other hand, continued to carry the risks of banking crisis: both the direct and indirect fiscal costs since the tax revenues and GDP tend to remain low for a sustained amount of time in the aftermath of a banking crisis.

The relationship between the euro and European sovereign debt crisis is divided into three phases. The first step is the initial institution that is a design of the euro plausibly which increased financial risks during the pre-crisis period. Secondly, once the crisis occurred, these design flaws increase the fiscal impact of the crisis dynamics through multiple channels. The third phase is the restrictions imposed by the monetary union which helps to shape the tempo and durations of the anticipated post-crisis period, together with Europe's chaotic political response and failure to have institutions in place for the management of crisis.

Europeans countries face a lot of problems to curb Sovereign Debt crisis. Their GDP is slowed down by various factors that affect the economy. The first constraints that European countries faced are inefficiencies within the micro-economy. When European economies remain closed to competition, or when local economies dominate them, the prices, in the end, might not reflect the marginal cost of the production. However, opening up the economy to free trade, and privatization of industry helps to promote a more competitive environment, and reduce allocative inefficiency. The second constraints that lead to European Sovereign Debt crisis are imbalances. Here, there is little opportunity for economic growth since the impact of human and real capital development and marginal factor productivity is very low. Europeans countries also face limited financial markets (Lane, 2012). Asymmetric information lenders in the credit markets may not be aware of the full creditworthiness of borrowers thus leading to scarce financial markets in European countries. 

Due to asymmetrical effects across the euro area, the world's financial crisis prompted a reassessment of item prices and growth prospects, especially for those countries that displayed macroeconomics imbalances. According to Lane (2012), the pre-crisis current account deficit and rate of domestic credit expansion correlates to the scale of the decline in output and expenditure between 2007 and 2009. In 2008 and 2009, euro area sovereign markets remained relatively calm without significance changes. During this times, the primary focus was on the stability of the area-wide banking system Europeans countries specific fiscal remaining in the background. Furthermore, demand for sovereign debt of euro area countries was probed up by banks which valued government bonds to be highly rated collateral in receiving short-term loans from the European Central Bank.

In 2009, the European sovereign debt crisis entered a new phase. Some countries reported larger than expected increases in deficit/GDP ratios. For instance, fiscal revenues in Spain and Ireland decrease more quickly than the GDP due to the high sensitivity of the tax revenues to declines in the construction activity and product prices. Additionally, the scale of recession and rising estimates of prospective banking sectors tend to lose on bad loans. Some of the countries also had a negative indirect impact on sovereign bond values, since investors recognized that a depreciating banking sector posed financial risks. 

There are several risks of multiple equilibriums when sovereign debt is high. A country which has a high level of sovereign debt is subject to increase in the interest rate which it pays on its debt. An increase in perceptions of defaults risks induces investors to demand higher yields, which in turn makes default more likely. Contrarily, if the default risk is perceived to be low, interest rates tend to remain low, and default does not occur. This multi-equilibrium problem has a greater force in the multi-country currency union as a small negative shift in the fundamentals of one country can trigger a massive decline in demand for sovereign debt of Europeans countries as investors seek to switch to the sovereign debt of other safer euro area countries.

To encourage a healthy equilibrium, there is the need to create a firewall through the availability of an official net. This helps to reduce the risk of imbalance that arises because investors will not fear roll over on their debts. Another alternative that Europeans have considered to encourage healthy equilibrium is to sell sovereign bonds to European Central Banks. This helps to provide liquidity and depth when certain sovereign debt markets are troubled. Furthermore, it will increase the firepower stability mechanism by allowing it to borrow from ECB. The bank would then announce a ceiling on the interest rate that will tolerate on the sovereign debt of countries that meet certain economic criteria and guarantee to buy the debt at that price if needed.

Several reforms can be used to address sovereign debt concerns. These improvements are based on two principles: high public levels that pose a threat to fiscal stability and fiscal balance which should be zero over the cycle. The pre-crisis financial rules tend to focused on the overall budget balance, with a maximum annual budget deficit that is set at 3 percent of GDP. The new system, on the other hand, focuses on structural budget balance which as a result strips out cyclical effects and one-off items. A structural budget balance helps the government to bank cyclical revenue gains during upturns in exchange for greater slippage in the overall budget balance during recessions. 

In conclusion, to curb European sovereign debt crisis, there is a need to create a banking union, as the diabolic loop between national banking systems and nationals sovereigns is central to financial crisis. The second attribute is to introduce a common area-wide "Eurobonds" with specific goals of preventing the disruptive effects of destabilizing speculative attacks on national sovereign debt markets inside the euro area. When the national currencies are eliminated, it means that the national fiscal policy took an additional importance as an instrument of countercyclical macroeconomic policy. Eurobonds will provide an opportunity to implement reforms that are necessary for the stable monetary union but would not have been politically feasible in its absence. Therefore, reforming the process will deliver a monetary union that can survive, even if it remains vulnerable to recurring crises.

Reference

Lane, P. (2012). The European Sovereign Debt Crisis . Journal of Economic Perspectives , Vol 26; Pp 49-68.