How the European Economy Works and How This Integration Can Be Affected by the Recession - Coursework Example

European Business Environment Introduction The business environment is largely influenced by macroeconomic and political forces. Business investors are always on the watch for macroeconomic figures such as GDP, inflation, unemployment, exchange rates and interest rates as well as government’s fiscal and monetary policies. They are also concerned with political stability as the opposite indicates threats to business. The European Union is undoubtedly one of the most flourishing business region in the world with rich countries such as France, Germany, Italy and Great Britain. The efforts to build the integration in 25 years have paid off with a formidable team such as the European Union. However, due to increasing global linkages, such as through bilateral and multilateral agreements, it became inevitable that the region be dragged by the recession in other countries such as what happened in the USA. The financial crisis that happened in the United States has affected a lot of its close partners such as Mexico. The European Union is one of those regions with partnership with the US. Aside from this, the region’s economy has also some of its weaknesses. This, together with the global financial crisis that started from the US have become a threat to the region. In this paper, there is an attempt to analyze the effect of the global recession to the European Union and its member countries. First we conduct a short study on what the integration has achieved so far in 25 years, then we look at the current figures to see the effect of recession and lastly we analyze what this means for the future of the European Union, with particular focus on the European business environment. Main Body The success of the EU over the year: A short history Efforts to foster unity and integration between and among the European countries began in 1949, after the Second World War, when West Europe created the Council in Europe, although at this time the continent is sill split between East and West (European Commission). The integration began with six European nations: Germany, France, Italy, the Netherlands, Belgium and Luxembourg when the Coal and Steel Treaty was signed, then expanding to nine in 1973 with the addition of Denmark, United Kingdom and Ireland (European Commission). It took around 20 years before the expansion took place. Prior to the expansion, plans of having a single currency among the EU states was already coined, but was only formally introduced in 2002, distributing them in 12 member countries (European Commission). Currently, the member states of the EU number to up to around 27, with the addition of some countries like Spain, Finland and Greece. The Integration of European Countries: How the EU works There are three main institutions that are responsible for running the day-to-day work of the EU – the European Commission, the Council of the European Union and the European Parliament, with two other bodies-the European court of Justice and the European Court of Auditors (http://www.aueb.gr). It is the Council of European Union that coordinate the broad economic policies of the member states. In this discussion, we focus on how the European economy works and later analyze how this economic integration can be affected by the current recession. We will particularly examine of the integration is helpful in combating recession. The European Union works under a single currency, the Euro therefore one instruction runs the overall-all monetary policy: the European Central Bank (European Union). The adoption of a single currency by 16 of its member states provided ease in doing economic transactions. Trade is the economic aspect that has been most benefitted by this. In 2005, the EU recorded a GDP which accounts for 15% of the world GDP, second only to the United States. The EU Recession The facts The story of the industrial, construction and service sectors. Recession is “defined to be a period of two quarters of negative GDP growth” (About.com). For the EU case, it was a decrease of 0.2% of the GDP in the 3rd quarter and 1.5% in the last quarter of 2008 (Remond-Tiedrez). The graph in Figure 1 shows the decline in the percentage growth of EU GDP. The last time that EU recorded a negative growth was in the 3rd quarter of 2004. It also shows that in the 1st quarter of 2009 a sharper decline was witnessed at almost 4%. This over-all GDP impact can be traced to impacts on different sectors. We will scrutinize this impact later. Figure 1. Source: (http://static.seekingalpha.com) Three of the most affected sectors of Wu economies are construction sector, industrial sector and retail trade. “As such, the onset of the recession was consistent across economic activities, and from the second quarter of 2008 each of these indicators experienced a downturn in activity. There were five consecutive quarter-on-quarter reductions recorded for GDP and for industrial output, while for construction and retail trade, the latest information available for the third quarter of 2009 shows that output continued to fall” (Newson). For periods 1sr quarter of 2008 to second quarter of 2009, EU’s GDP shrank by 5.2% while in the same quarter industrial output fell by 17.6% (Newson). “On the basis of a comparison between the first quarter of 2008 (the relative peak) and the third quarter of 2009, EU-27 construction output fell overall by 14.2 %. In contrast, the extent of the downturn experienced within the EU-27’s retail trade sector was considerably less, as the volume of sales was reduced by 2.7 % between the first quarter of 2008 and the third quarter of 2009. Figure 2 below depicts this scenario. Figure 2. Source: (Koeman) The graph is particularly concerned with the 1st quarter of 2009 figures. Only the service sector recorded positive growth, with the rest including agriculture and fishing, business and financial services, construction and manufacturing showing a decline, the sharpest of which came from the manufacturing sector. The Decline in Production. Over-all the decline in production lasted for 12 months-from April of 2008 to April of 2009, posting an over-all reduction of 18.5% (Newson). A country-to country analysis reveals that the downturn lasted for 5 months in Slovakia, 18 months in Czech Republic and the United Kingdom, 19 months in Spain and Finland with Czech Republic, Portugal, Finland and Sweden being the first to move into recession (Newson). “The end of the downturn, as measured by the low point (or trough) in industrial activity was recorded as early as December 2008 in Romania and Slovakia, and January 2009 in Poland and Portugal. The depth of the downturn (as measured by the overall reduction in industrial output) was largest in Estonia, where production fell by more than one third (35.6 %). There were losses of between 25 % and 30 % registered for Slovakia, Finland, Luxembourg, Slovenia, Hungary, Lithuania and Italy. At the other end of the range, the smallest contractions in activity were registered for Cyprus, Poland, Romania, Ireland and Greece, where industrial output fell by 12 % to 13 %” (Newson). The Decline in Construction Activity. For the construction activity, the index of production fell by 0.4% for each month during the 12-month duration, until November of 2008 (Remond-Tiedrez). In Germany, construction reached its peak in 1995, but in 2008 the figure was about 38% lower while in Spain, the construction boom was in 2006 but fell by 20% after that (Remond-Tiedrez). The Decline in Retail Trade. The retail trade is one of the sectors that has seen decline in activity, although not as sharp as the others such as manufacturing. The figures however fell for the EU-27 for at least five successive quarters, with a recorded decline of 0.74% in the last quarter of 2008 (Newson, http://epp.eurostat.ec)‘The volume of retail sales peaked in Italy in November 1999 and stood more than 14 % below this level in November 2008, contracting by 5.6 % during the 12 months to November 2008. Using the same measure, the volume of retail sales in Spain was 7.8 % lower in November 2008 (than 12 months earlier), having peaked in July 2007” while the figures were almost unchanged in Germany, and have grown in France and United Kingdom (Remond-Tiedrez). The decline in retail consumption was attributed to the rising unemployment and “reduction in working hours (no overtime, reduced working week or temporary stoppages) , coupled with the scarcity of credit and concerns over possible further contractions in labour markets, among others, may explain the downturn in consumer confidence and retail sales witnessed during the past year and a half” (Newson, http://epp.eurostat.ec). The Analysis The Great Depression that occurred in the 1930 is linked with the crack of the Stock Market (Wall Street) and recently, many commentators aired that it is the weaknesses of the financial sector that triggered the latest recession (Newson). “It is apparent that a crisis that started in the financial sector in 2007 quickly spread to the real economy in 2008 resulting in considerable reductions in both stock market prices and industrial output in both the EU-27 and the United States” (Newson). At this juncture, it is inevitable to discuss the financial crisis that has started the recession. The crisis started in the United States but due to increasing country linkages, the European countries got a dose of the crisis. This has started the Europe’s financial crisis which affected real variables such as production, construction and retail trade. Genesis of The Problem. The global financial crisis can be traced from the careless lending of America’s private financial institutions. Careless lending includes issuance of subprime mortgages – mortgages which are extended to people with low credit rating. This made the loans more risky and susceptible to default. Issuance of loan includes two problems associated with the problem of asymmetric information – the adverse selection and moral hazard problems. Frederic Mishkin, an economist from Columbia University define adverse selection as “the problem created by asymmetric information before a transaction occurs: The people who are the most undesirable from the other party’s point of view are the ones who are most likely to want to engage in the financial transaction (2003). The adverse selection problem has exactly occurred America. Contrary to the usual adverse selection problem, which is committed unknowingly, the American financial institutions are so much aware of the bad debts. Thus, the moral hazard problem has become inevitable. The moral hazard problem is defined as “the problem created by asymmetric information after the transaction occurs” because “the borrowers might engage in activities that are undesirable from the lender’s point of view because they make it less likely that the loan will be paid back” (Mishkin). Thus, from the perspective of monetary economics, the financial crisis was due to the moral hazard problem, thus increasing loan default. This led to the bankruptcy of a number of large financial institutions. The chaos in the American financial market has crippled the whole economy. Impact on Other Countries The Mexican economy suffered sharp decline along with the demise of American economy. Unemployment has risen and the GDP was stuck at a slumping rate. What explains this domino effect? Why are countries affected by the American financial crisis? The Susceptibility of the Open Economy. An open economy differs much from a close economy as the former performs interaction with other countries, while the latter does not. Thus the GDP of the open economy is computed as: Y = C + I + G + NX , where Y=GDP/Output, C=Consumption, I=Investment, G=Government Spending and NX=Net Export, computed as Export minus Import. On the other hand, the close economy has its GDP computed as follows: Y = C + I + G Thus an open economy can be affected by the economic recession in other countries through the Net Export. This is exactly what happened to Mexico, where around 80% of the export goes to USA. With the plummet of the USA economy, Mexico’s export was crippled thus hurting its GDP. This phenomenon has led to decrease in production, increase in unemployment rate, less consumption expenditure (due to reduction in jobs), and again decrease in GDP. Thus, the GDP is hurt in two ways: reduction in NX to the point of being negative, and reduction in consumption, C. All over the world, the effect of US’ economic slow down was felt in the halt and closure of many business operations with direct contact to the US and massive lay-off. The open economy can also be hurt through reduction in foreign aids and investments. Countries which rely heavily on US for aids and investment were also badly hurt. The Investment component of the GDP,I, is composed of domestic and foreign investments. If bulk of the foreign investment comes from US, this variable can also be drastically reduced. The story of Mexico also happened in the EU. The region has a strong tie with the USA, thus EU exports and production were also affected. What happened in EU is that it had its own financial crisis, plus it was affected by the slumping transaction with the United States and other countries. The Solution and the Future for EU “The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into 2008. Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems” (Shah). The decline in EU retail trade can best be explained by the hangover theory of Paul Krugman’s hang-over theory (Gallagher). “The neo-Keynesians, including National Economic Adviser Lawrence Summers and Council of Economic Advisers chair Christina Romer, think that all recessions are ultimately explained by a sudden preference of a large part of the private sector for holding cash (saving) rather than spending it: an excess demand for money. The more popular “hangover theory” is a moral tale of ‘correction’: the inevitable crash of economic excess as speculative bubbles feed on themselves and run way ahead of rational valuations” (Gallagher). The diminished economic confidence of the European due to financial crisis made them opt to save rather than spend, this is in addition to the fact that their disposable income has also decline due to shorter work hours. Financial crisis or even just rumors of financial crisis can brought much change to the buying behavior of people. If demand declines due to this expectations, the GDP via consumption will decline. Countries have different strategies in solving the economic crisis. The Asian countries for example, such as China, Indonesia, Vietnam and the Philippines adapted the “double-track strategy”. The “double track strategy” of sustainable development is a way of lessening the impact of economic recession through inflating both consumption and exports. With the double-track strategy even if exports decline, due to recession, consumption will be able to sustain the country’s over-all income. There are indeed cases wherein exports have declined but were able to avoid the impact of recession due to a strong domestic market. Using a basic equation, the effect of boosting consumption and investment can be summarized below: Y = C + I + G + NX Effect of recession = NX Effect of stimulus package = C Where Y is Income, C is consumption, I is investment, G is government spending and NX is net export. The increase in C is large enough to cover the decline in NX. Since I is composed of both local and foreign investment, in an open economy such as China. It might have also been affected temporarily by the recession. Nevertheless, the increase in C was enough to counter the impact of both the decline in export and possibly in investment. The CIDSE, an international alliance of Catholic development agencies working together for global justice, has recommendations as to how the EU can combat the recession. Below is its summary: 1. Stepping up transparency and regulation 2. Strengthened regional and sub-regional schemes for monetary cooperation 3. Tackling currency speculation 4. A new design for financial standard-setting bodies 5. Reform of global economic governance 6. A comprehensive and binding response to sovereign unsustainable debt 7. Global action on the financial crisis must be holistic and coherent with action to tackle other global crises Source: (CIDSE) The third one, “tackling currency speculation” is what we have just mentioned a while ago as crucial in determining the demand in all aspects of the economy. Strong negative speculations can drag economic activities down. The European Central Bank has the big role in handling speculations. Current Figures Current EU figures show recovery. The GDP increased in the third quarter of 2009 by 0.4% in the Euro Area and 0.3% in the Euro-27 while last quarter of 2009 figure was posted at by 0.1% for the Euro-27 (Eurostat). Among the member countries, Estonia posted the highest growth rate in GDP at +2.5%, followed by Slovakia at +2.0% and of Poland at +1.2% (Eurostat). “In the fourth quarter of 2009, household2 final consumption expenditure was stable in both the euro area and the EU27 (after -0.1% in both zones in the previous quarter). Investments fell by 1.3% in the euro area and by 1.6% in the EU27 (after -0.9% and -0.6%). Exports increased by 1.9% in both zones (after +2.9% and +2.7%). Imports increased by 1.3% in the euro area and by 1.6% in the EU27 (after +2.9% in both zones)” (Eurostat). The figures for the GDP composition show that EU is starting to bounce back from the financial and economic crisis. With the recent developments, we don’t see any hindrance in EU’s full recovery. References About.com. 17 April 2010 . CIDSE. http://www.cidse.org. 19 April 2010 . European Commission. http://ec.europa.eu. 18 April 2010 . European Union. http://www.eurunion.org. 18 April 2010 . Eurostat. http://epp.eurostat.ec.europa.eu. 7 April 2010. 19 April 2010 . Gallagher, Peter. http://www.petergallagher.com.au. 12 February 2010. 19 April 2010 . http://static.seekingalpha.com. 19 April 2010 . http://www.aueb.gr. 17 April 2010 . Koeman, Linda. http://www.cbs.nl. 2010. 19 April 2010 . Newson, Brian. http://epp.eurostat.ec. 2009. 19 April 2010 . —. http://epp.eurostat.ec. 19 April 2010 . Remond-Tiedrez, Isabelle. http://epp.eurostat.ec.europa.eu. 2009. 19 April 2010 . Shah, Anup. http://www.globalissues.org. 25 July 2009. 19 April 2010 . Read More