Posted: August 19th, 2015

The Eurozone Crisis 2010-2011

The Eurozone Crisis 2010-2011

The justification of creation of Eurozone and having a single currency was not merely economic but also political. It was expected that a single monetary policy in the euro area would bring price stability for the EU members. This would create long term stability, increase the credibility of the euro and promote its attractiveness as a trading and investment currency. One of the positive changes of this move was that the bond markets of the newly integrated Eurozone economies (that were initially segmented) got integrated. The bond yields converged and interest rates converged to a lower rate. Initially, the common monetary system proved to be useful in creating a surge in credit growth which was translated into a boom in the housing sector that led to a positive growth for the EU.

A major fall out of this integration was that lower interest rates increased borrowing within EU members which led to increased debt. The monetary-led growth spurred by the EU had hidden the weaknesses of the individual country’s fiscal system in dealing with worsening fiscal deficit (in the range of -3% to -10% of GDP) and public debt (in the range of 40% to 140% of GDP). Simultaneously, the current account deficit across the Eurozone economies worsened (-10% to -2% of GDP). From 2006, poor fiscal policy within member countries caused interest rates to diverge. This divergence brought to light the various differences in the EU economies. In the weaker economies, excessive lending had left banks with bad debts and governments with large fiscal deficit and public debt. These economies have witnessed a downgrade of the rating of their sovereign debt which has induced fears of possible default and has resulted in a dramatic rise in borrowing costs. In late 2009, Greece admitted that its fiscal deficit was understated (12.7 % of GDP, as against 3.7 % stated earlier). In April 2011, Portugal admitted that it could not deal with its finances and asked the EU for help. All this poses a threat to other Eurozone economies and the future of the Euro.

The Eurozone crisis is thus largely a home-grown crisis. In order to respond to the problem, the EU and other international agencies stepped in to provide rescue bail outs for the countries in trouble. . In May 2010, the Greek government received a € 100 billion bailout package from the EU, ECB (European Central Bank) and the IMF. In May 2011, European finance ministers approved euro € 78 billion rescue loans to Portugal.

Questions
Using the tools you learned, discuss Eurozone crisis.

Put yourself in the situation of the European Union. Your only tool is monetary policy.

How would you use the same to clean up the Eurozone recession – affect real interest rates and allow for convergence once again?

Additionally you have some power to make changes within these small economies.

What sort of fiscal policies would you recommend to these governments and why?

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