The European Financial Crises - Essay Example

Running head: European Financial Crisis The European Financial Crisis Insert Insert Grade Insert 01 August The EuropeanFinancial Crisis The Background The recent experience of the world’s financial crisis was first witnessed in 2007, about 80 years since the world experienced an economic downturn. The 2007 financial crisis resulted in economic meltdown or a recession among many countries and economies in the United States of America and Europe. What has been witnessed is a huge depreciation of public and private funds as well as reduced credibility of currencies such as the Euro among the members of the European economic bloc. Economic integration, particularly in Europe, has been faulted as one of the possible reasons for the crisis in the Euro zone. The origin of the global financial turmoil was the collapse of the real estate bubble in the United States, mainly the sub-primes1 mortgage market, which provided access to housing finance to almost everyone even those without the necessary guarantees. The problem was further aggravated by the securitization2 of sub-primes leading a contagion in the financial system, which resulted from massive defaults on the original loans that had been securitized (Ferguson, 2012, p. 19). There was high mistrust among commercial banks in the financial systems, which led to freezing of the interbank market, severely affecting liquidity distribution and forcing institutions to bankruptcy, both because of reduced activity in the interbank market and as financial institutions continued to sell even the good quality assets in fear of the unknown, or as a consequence of increased uncertainty. In the period 2006-2007, there was increasing panic as news of bankruptcy of firms such as Lehman Brothers and Morgan Stanley in the USA and Dexia in Europe, continued to stream. Some of these firms were however bailed out by the governments of the USA and Europe. In 2008-2009, the financial crisis began to hit the global economy3, introducing the first recession since the times of World War II. In EU alone, GDP went down by about 4.1% while rate of unemployment4 increased by 3.9% between 2008 and 2010 (Manfred, Griesbach, and Jung, 2011, p. 292). These were firm indicators to justify that there was indeed a heating problem that needed quicker action to resolve to avoid dire consequences. This paper will attempt to explain the Euro zone financial crisis and particularly explore the hypothesis that the “European situation has the potential to become a financial “time bomb”, which could destroy the euro as a currency, send global financial markets into a tailspin and global recession”. In doing this, the paper will address the financial crisis in terms of how it all began, context in which the European Union is experiencing the turmoil, the effects of the turmoil, measures taken worldwide and particularly the Euro zone to reduce and/or avert the crisis, as well as the impact the crisis has had on the Euro. What led to World’s Economic and Financial Meltdown Though the subprime mortgage market is said to be the root cause of the financial crisis that later developed into the global economic turmoil, some underlying factors have been identified as having led to the problem through the subprime channel. One of these underlying factors is the failure of comprehensive and strict regulation and financial supervision which experts has attributed to lack of adherence to risk management, as well as regulatory practices and guidelines in financial institutions. The other element identified as an underlying cause of the crisis is macro-economic imbalance in terms of the different monetary policies for different economies. Initially before the crisis, expansive monetary policies encouraged abundance of liquidity and low interest rates, which in turn promoted expansion of credit, stimulating consumption and investments (Ferguson, 2012, p. 19). The real estate bubble then developed as a consequence of this favorable economic and market environment, but its growth was not properly monitored leading to a heavy blast which lead to the crisis as explained above. The European Union and the economic crisis During the period before the crisis, EU’s financial supervision system is said to have been highly fragmented, a fact that was revealed by the occurrence of the crisis. Financial Sector Supervision in the EU was mainly carried out under the umbrella of three European supervisory committees namely; CEBS, CEIOPS, and CESR. These respective institutions carried out their roles independently without a coherent and harmonized supervisory framework which would seal off inspection loopholes for financial activity in the system. Information exchange between the national supervisory authorities was not sufficient and hence no coordinated emergency action could be taken nationally in the event of a financial catastrophe such as the one under discussion in this write up. A good amount of legislative work has been carried out in Europe since 2010 after the crisis. In 2010, the European parliament approved a new European system of financial supervision which comprise of the ESA and ESRB5. ESA is the micro-prudential umbrella body consisting of three regulatory institutions, namely EBA, EIOPA and ESMA. These bodies replaced the supervisory framework that existed before the crisis explained above. National budgets in the Euro region have been heavily smashed by the financial crisis with most states struggling with costly recovery plans for both public and private debt. Public debt as a per cent of GDP in the EU alone rose by about 20 per cent from 65 per cent in 2007 to 85 per cent in 2010. As a consequence, Euro area counties are facing huge refinancing risks, erosion of market confidence in terms of country creditworthiness, high debt servicing costs which has proved unsustainable. Interest rates on debt for countries such as Greece and Portugal are particularly very high partly because speculators are increasing targeting to maximize their gains on defaults on sovereign debt by these countries, rising concerns about financial sustainability and the effect of reports by credit rating agencies about the abilities of these countries to finance their debts. The down grading of Greece to below “A” level in 2009, for example, was a significant blow to the country, calling for the intervention by the EU through budgetary supervision, recovery package and requirement to strictly observe the laid down austerity plan. But even with these efforts, market confidence was still compromised and further country downgrades led to political and social unrest around the country. The burden of debt crisis in the Euro zone rests with Greece and Ireland. Other countries are Spain and Italy. The economies and markets of these countries have some common and heterogeneous characteristics which have potential to create or ignite a financial “time bomb”, which could destroy the euro as a currency, send global financial markets into a tailspin and global recession. Reducing the expanding budget deficits as national revenues decrease and expenditure increases may be untenable. Refinancing of the huge existing debt will be very expensive as interest rates levels are more than four times of unaffected countries such as Germany (Prinz, Hanno, 2012, p.187). Austerity measures such as increasing tax rates and cutting salaries and pensions may do more harm than good as most of the value creation by these countries is dependent of domestic demand, which has been steadily squeezed by rising inflation, continued austerity measures, sustained fiscal tightening and ineffective monetary policy as evidenced by unsustainable rate cuts and unpromising quantitative easing. Also, with continued laxity in the implementation of budgetary policies as is the case with Greece, it is clear that the Euro area will have to stay with the problem longer than expected. Unemployment in the Euro zone is increasing as well as worsening, with the March 2012 rate at 10.9 per cent. Youth unemployment rate by this time was over 50 per cent in Greece and about 36 per cent in Portugal and Italy. The activity in the manufacturing industry has also declined significantly. The Euro has been on a two-year low though a slight increase in value against the USD was seen in July 2012. The lack of rules that promote orderly resolution of bank failures ensuring not to destabilize the financial system through, for example, well managed deposit protection schemes, has also contributed to the current status of affairs in the Euro area and is a catalyst for worse scenarios in terms of a recession in the future. There is also too much reliance around the globe of credit rating agencies as assessors of creditworthiness of borrowers and also asset quality (Mcardle, 2012, p. 34.). Generally, the Euro is expected to remain bearish and may be continue on the downward trend going forward. These are clear indications that the Euro area is headed for an economic depression if drastic but aggressive measures6 are not taken at the earliest opportunity. Observers are concerned about the slow pace of reaction to the crisis and warn that should Euro zone economy end up in recession, no justification that the worst was unavoidable will be welcome because policy makers have all the time to make policy reforms and take drastic and painful decisions to improve the situation. Averting the Crisis A number of proposals have been brought forward regarding how best the occurrence of an economic recession in the Euro zone as a result of the crisis can be avoided. Among the most critical ones is macro-economic coordination and supervision in the Euro area. Macro-economic imbalances among member states have resulted in substantial differentials in the level of competitiveness where high exchange rates have been evidenced in countries experiencing losses in competitiveness. In order to strengthen competitiveness in the economic bloc and minimize existing gaps, a competitive pact mainly in wage and budgetary policies, was suggested. The other proposed step to deal with the crisis was the establishment of an early warning system through enhanced macroeconomic regulation and supervision. This would entail in part, a yearly evaluation of macro-economic imbalances, as well as a mechanism for enforcement to improve effective and assurance that laid down measures will be implemented in the event that there are macro-economic imbalances. The other reform involves EU’s main budgetary coordination instrument7 and relates to strengthening the budgetary discipline in the Euro zone through actions such as ensuring that public debt is an operation of the SGP, enhancing effectiveness of the sanctions mechanism for the SGP and enhancement of national budgetary institutions. In March 2011, the European council agreed on a permanent crisis management framework where an ESM will among other things have an effective capacity to lend with specified upper limits, offer loans at much favorable terms, ensure that access to aid by member states will strictly be based on positive budgetary and macro-economic reforms and will, on ad hoc basis, accommodate EU member states that are excluded from euro area. The ECB has also plans to purchase government bonds of euro area countries to stabilize financing conditions (Moravcsik, 2012, p. 63). Reforms on capital requirements for commercial banks are meant to enhance resilience to shocks by the banking sector in the future through strict adherence to the international framework of capital requirements as prescribed in The Basel Accords. Conclusion The global financial crisis recently witnessed resulted in an economic meltdown or a recession among many countries and economies in the United States of America and Europe. The origin of the global financial turmoil was the collapse of the real estate bubble in the United States, mainly the sub-primes mortgage market which provided access to housing finance to almost everyone without regard to the necessary guarantees. The problem was further aggravated by the securitization of sub-primes leading a contagion in the financial system. In 2008-2009, the financial crisis began to hit the global economy, introducing the first recession since the times of World War II with EU’s GDP declining by 4.1% while rate of unemployment increased by 3.9% between 2008 and 2010. Other causes of the crisis have been given as failure of comprehensive and strict regulation and financial supervision, identified underlying factors like macro-economic imbalance in terms of the different monetary policies for different economies. In Europe, the financial crisis may continue to a recession because of reasons such as expanding budget deficits as national revenues decrease and expenditure increases, expensive refinancing of the huge existing debt as interest rates levels continue to rise, austerity measures such as increasing tax rates and cutting salaries and pensions may do more harm than good, sustained fiscal tightening and ineffective monetary policy as evidenced by unsustainable rate cuts and unpromising quantitative easing. In addition, continued laxity in the implementation of budgetary policies may hamper the recovery process. It is expected that the Euro will remain bearish going forward. Some measures that have been suggested to bring sanity include and not limited to macro-economic coordination and supervision in the Euro area, strengthening competitiveness in the economic bloc and minimize existing gaps, establishment of early warning system through enhanced macroeconomic regulation and supervision, EU’s main budgetary coordination instrument for strengthening the budgetary discipline in the Euro zone. Also, the European council agreed on a permanent crisis management framework. References Ferguson, N. (2012). The European Farce. Newsweek, Vol. 159 Issue 21, p19-19 Manfred, G., Griesbach, B., & Jung, F. (2011). PIGS or Lambs? The European Sovereign Debt Crisis and the Role of Rating Agencies. International Advances in Economic Research, Vol. 17 Issue 3, p288-299 Mcardle, M. (2012). Europe’s Real Crisis. Atlantic Monthly (10727825), Vol. 309 Issue 3, p32-35 Moravcsik, A. (2012). Europe after the Crisis. Foreign Affairs, Vol. 91 Issue 3, p54-68 Prinz, A., & Hanno, B. (2012). Fighting Debt Explosion in the European Sovereign Debt Crisis. Inter-economics, Vol. 47 Issue 3, p185-189 Read More