Project: The Euro zone Crisis and its impact on Global economy

PROJECT REPORT SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS OF THE ASSIGNMENT POST GRADUATION DIPLOMA
IN

Marketing Management By Kushagra Tiwari FT(MM-11-107)

What is European debt crisis?

The European debt crisis is the shorthand term for Europes struggle to pay the debts it has built up in recent decades. Five of the regions countries Greece, Portugal, Ireland, Italy, and Spain have to varying degrees, failed to generate enough economic growth to make their ability to pay back bondholders the guarantee it was intended to be. Although these five were seen as being the countries in immediate danger of a possible default, the crisis has far-reaching consequences that extend beyond their borders to the world as a whole. In fact, the head of the Bank of England referred to it as the most serious financial crisis at least since the 1930s, if not ever, in October 2011. This is one of most important problems facing the world economy, but it is also one of the hardest to understand. Below is a Q&A to help familiarize you with the basics of this critical issue.

How did the crisis begin?

The global economy has experienced slow growth since the U.S. financial crisis of 2008-2009, which has exposed the unsustainable fiscal policies of countries in Europe and around the globe. Greece, which spent heartily for years and failed to undertake fiscal reforms, was one of the first to feel the pinch of weaker growth. When growth slows, so do tax revenues making high budget deficits unsustainable. The result was that the new Prime Minister George Papandreou, in late 2009, was forced to announce that previous governments had failed to reveal the size of the nations deficits. In truth, Greeces debts were so large that they actually exceed the size of the nations entire economy, and the country could no longer hide the problem. Investors responded by demanding higher yields on Greeces bonds, which raised the cost of the countrys debt burden and necessitated a series of bailouts by the European Union and European Central Bank

(ECB). The markets also began driving up bond yields in the other heavily indebted countries in the region, anticipating problems similar to what occurred in Greece.

Causes
The European sovereign debt crisis resulted from a combination of complex factors, including the globalization of finance; easy credit conditions during the 20022008 period that encouraged high-risk lending and borrowing practices; the 20072012 global financial crisis; international trade imbalances; real-estate bubbles that have since burst; the 20082012 global recession; fiscal policy choices related to government revenues and expenses; and approaches used by nations to bail out troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

The Debt Trap

If the annual interest payable on a government's debt were to continue to rise faster than the national income, it would eventually exceed the feasible revenue from taxation. The process is normally hastened by the fact that government debt is traded in a well-informed market. Operators in that market would be aware of the approach of the point at which the government would be forced to default on its debt, and they would be increasingly reluctant to allow that government to continue to roll over its debt. The government concerned could seek to overcome that reluctance by offering them higher interest on future loans, but an increase in the interest to be paid would hasten the process and increase the reluctance of further potential investors. That is what is known as the debt trap, the price formulation of which is the the debt trap identity. The debt trap could be escaped:

- (i) by repudiation of the debt; - (ii) (temporarily) by a negotiation with creditors to ease the terms of repayment (termed restructuring); - (iii) (temporarily) by getting the country's central bank to purchase the debt; or, - (iv) by a programme of reductions in public expenditure and/or increases in rates of taxation. Options (i) and (ii) have the drawback of making future investors reluctant to buy the government's bonds. Option (iii) can also have that effect if it causes an inflation that reduces the value of the currency in which the debt is to be repaid. Option (iv) is free from that drawback, but is effective only if it avoids creating a recession that increases the deficit (by the operation of the country's automatic stabilisers). Fewer options are available to members of a currency union, however. Option (iii) may be excluded by the fact that monetary policy is no longer under the control of the borrowing government. That fact also prevents the use of monetary policy to counter the recessionary consequences of (iv), (without which that option may be ineffective); and the rules of the currency union prevent the exchange rate deprecation that might otherwise counter them. To make (iii) possible and (iv) easier, a further option would be (v) - to leave the currency union. The Euro Debt Crisis and Its Impact on the World Britain may be in the front line of the Euro crisis, but it is not the only country affected. The Euro zone is a massive market for businesses from the United States, China, India, Japan, Russia and the other major world economic powers. China has considered lending money to Europe, they are that concerned that the Euro may collapse. Meanwhile, the International Monetary Fund (IMF), which was set up to help countries

in economic difficulty, set aside hundreds of billions of dollars for a bailout of some of the Euro zone countries. The wider world is so keen to see the Euro survive even if that means it has fewer members for the following reasons.

To preserve the Euro zones massive consumer market. A staggering 322 million Europeans use the Euro every day. Its the currency of seventeen nations. Besides daily activities, these people use the Euro to buy goods and services from overseas if there was a collapse in its value, and then they would be less able to buy imports. To prevent a global recession. A collapse of the Euro or a situation where some European governments would be unable to repay their debt would have a huge, negative impact on the world economy. It would resemble the financial crisis of 2007 and 2008 (in truth, it could be much worse than that). At the very least, businesses around the globe would think twice about investing and taking on new staff while others might start to trim their operations and cut jobs. A global economic recession would be highly likely. To protect the world financial system. Banks around the globe have invested in the government debt of Euro zone countries. These banks also hold large amounts of Euros. If the current crisis gets much worse, then the government debt and currency that they hold will fall in value, which could undermine their own financial well being. It could be like the 2007 and 2008 financial crash all over again, with the global banking system under threat. This would be bad news for everyone.

Its not just the 322 million people in the Euro zone which depend on their currency there are 150 million people in African countries whose currencies are pegged to value the Euro. If the Euro zone fragments and the value of the Euro collapse, these African countries will see the value of currency collapse too.

The global economy is interrelated, so if major trading blocs like the Euro zone or countries like the US or China go into recession, its likely to affect economic growth around the world.

Q: How has the European debt crisis affected the financial markets? The possibility of a contagion has made the European debt crisis a key focal point for the world financial markets in the 20102012 period. With the market turmoil of 2008 and 2009 in fairly recent memory, investors reaction to any bad news out of Europe was swift: sell anything risky, and buy the government bonds of the largest, most financially sound countries. Typically, European bank stocks and the European markets as a whole performed much worse than their global counterparts during the times when the crisis was on center stage. The bond markets of the affected nations also performed poorly, as rising yields means that prices are falling. At the same time, yields on U.S. Treasuries fell to historically low levels in a reflection of investors "flight to safety." Once Draghi announced the ECB's commitment to preserving the eurozone, markets rallied worldwide. In fact, the second half of 2012 brought none of the crisis-related disruptions that had characterized the prior two years.

Affect on India
The Indian Government said the global slowdown due to the euro zone crisis has affected the Indian economy and steps are being taken to tackle the situation.

Global slowdown due to unfolding of euro zone sovereign debt crisis has, inter-alia, affected the Indian economy through deceleration in exports, widening of trade and current account deficit, decline in capital flows, fall in the value of Indian Rupee, stock market decline and lower economic growth, finance minister Pranab Mukherjee (at present The president of India) said in a written reply to the Rajya Sabha. Export-oriented industries and the capital investment are the most affected sectors, he said. Mukherjee said the government is taking a number of steps to arrest the decline of rupee, which breached the psychological 55-level on Monday. A number of steps have been taken to augment the supply of foreign exchange to stem rupee decline, he said, adding measures have also been taken to increase direct foreign investment for infrastructural development. He said the steps included liberalization of external commercial borrowings (ECB) policy and portfolio investment norms besides steps to improve access to corporate bond market through Infrastructure Debt Funds. A number of legislative measures/amendments have also been taken for fiscal consolidation/reforms and financial sector reforms, said Pranab Mukherjee. The resilience of the Indian economy is very often cited by many in advocating the 'India is insulated from the Euro zone crisis' theory. In my view, that is a myopic view. The 2008-09 global melt down was fallout of corporate greed, malpractices and lack of government control. Banks and companies collapsed for their own fault. While the band-aid came in the form of government bail-outs or, in simple terms, socializing private losses, one has to bear in mind that we are no longer looking at the prospect of failing companies or banks. We are looking at prospects of collapse of countries altogether.

How Keynes can help us solve the Euro zone Crisis

The Euro zone as a single country Lets begin by imagining that the Euro zone was a single country, like the United States. The US is currently undertaking significant austerity, even though there is no market pressure to do so. In fact, quite the opposite is the case it is an excellent time to borrow to invest. So why are the US, and also the UK, undertaking austerity? The main argument is that government debt is too high. The Keynesian response is that this is the wrong time to be worrying about government debt. In a recession which is due to an increase in private sector saving, the government needs to run matching deficits to prevent output falling. For the world as a whole, if government deficits come down, private sector surpluses must fall to match. Normally monetary policy would encourage the private sector to save less by lowering real interest rates. However in many countries the monetary authorities have already lowered nominal rates (almost) as far as they can. In addition these authorities, or their governments, seem unwilling to let real interest rates fall by encouraging above target inflation in the future. Following the Great Depression, Keynes taught us the need for countercyclical fiscal policy when monetary policy is absent or ineffective. Keynesian economics is hardly a school of thought, but mainstream macroeconomics, as contained in nearly every textbook, and as practiced in nearly every central bank. That does not prove it is right, but it increases the personal responsibility of policy makers who choose to ignore it. With this perspective, fiscal policy in the Euro zone as a whole seems particularly misguided. Overall government deficits as a share of Euro zone GDP are much lower than in the US or UK, yet the speed of fiscal consolidation is more rapid in the Euro zone. The obvious question is

whether this can be explained by the fact that the Euro zone is not one country. Here again a classic Keynesian perspective is instructive. In a monetary union, fiscal policy has to take on a major countercyclical role in response to large idiosyncratic shocks. Yet this was hardly acknowledged in the original Stability and Growth Pact (SGP), and does only slightly better in the current set of Euro zone fiscal rules. I have argued that, by ignoring countercyclical fiscal policy, the SGP encouraged governments in periphery countries to allow a growing loss of competitiveness to persist. In that sense, ignoring basic Keynesian ideas helped cause the Euro zone crisis.

IS-LM Keynesianism, why not and which alternatives?

I am sad that the IS-LM debate devolved into IS-LM vs. close substitutes, because I meant to raise a broader set of objections to one particular kind of technocratic curve-shifting as the foundation for macroeconomic thought. Let me list a few alternative starting points for macroeconomics: 1. Public choice economics (still the most underrated, in todays profession) 2. Growth theory (as distinct from the view that all business cycles are simply fluctuations in the rate of growth) 3. The New Institutional Economics of property rights and incentives 4. Financial asset pricing theory (as distinct from the view that financial markets are always efficient) To see what this all means, lets consider the euro crisis. I start with #4, financial asset pricing theory, and consider whether, if euros in Greek banks and euros in German banks are fundamentally different assets, perhaps they should have different prices. If prices cannot adjust, quantities will.

An IS-LM approach will focus on flows and be distracted incorrectly by claims that Ireland, Spain, etc. were not in bad fiscal positions before the crisis hit. Thats wrong; they were writing intolerable naked puts all along. A macro approach should then move to public choice theory and interpret the governance of the EU and ECB and the coalitions in the various European governments. It wasnt (for the most part) deliberately set up so that politicians could play short-run fiscal games, but that is in fact why a lot of politicians supported the euro zone. Cheap borrowing brought a big party, but it was a ticking time bomb from the beginning, as recognized by Milton Friedman and others. Based on Buchanan and Tullock (Calculus of Consent), the analysis can move forward with some understanding of why its governance is unworkable in a crisis, and with an understanding of why the Germans originally insisted on such a governance scheme at all. I also wouldnt mind a citation to Hayek and his critique of French rationalist constructivism; you wont find that in the IS-LM model either. We can put all that together, combined with a theory of bank runs, and then we see there will be strong and perhaps intolerable deflationary pressures. They are simpler and retain the core point that deflationary pressure can be very bad. As Scott notes, the sort of interest rate issues raised by IS-LM are more of a distraction than anything, at this point for this problem. And no, the euro zone for the most part has not been in a liquidity trap. Nonetheless aggregate demand really does matter in this setting. One often reads that Italy is the linchpin of the euro crisis. To understand Italy we should look to growth theory, the new Institutional Economics, the theory of corruption, theories of political gridlock, and related idea. Italys growth problems predate the immediate mess in the euro zone and they are not plausibly pinned on deflationary forces; the country hasnt grown much in a decade. IS-LM is absolutely silent here,

but if Italy were growing at two percent a year probably the whole mess would be manageable. Demographics matter too, and if this is a messier version of economics sign me up. The idea that Ireland is seeing a partial recovery, piled on top of some deep structural problems in its domestic sectors, flows more naturally from institutions-based approaches than from IS-LM. The all-important interplay between monetary and fiscal policy, critical for understanding this crisis, is forced out of the box by IS-LM. IS-LM should not be foundational for an analysis of this problem, ISLM is not necessary, and arguably it is better not to invoke the model at all. And if I had to give undergraduates only one point on one part of the blackboard, I would use the comparison between Greek and German banks. IS-LM leads one to the mistaken attitude that macro is fundamentally simple, and that all would be well if only people and politicians understood the need to get tough with expansionary policy rather than austerity. Its a lot more complicated than that, yet we can understand these complications by building up from some fairly simple and intuitive models. Its a better approach to use public choice incentives to understand why the current situation is unworkable, rather than preaching about why the flows should be different than they are.

Q: Why is default such a major problem? Couldnt a country just walk away from its debt and start fresh? Unfortunately, the solution isnt that simple for one critical reason: European banks remain one of the largest holders of regions government debt, although they reduced their positions throughout the second half of 2011. Banks are required to keep a certain amount of assets on their balance sheets relative to the amount of debt they hold. If a country defaults on its debt, the

value of its bonds will plunge. For banks, this could mean a sharp reduction in the amount of assets on their balance sheet and possible insolvency. Due to the growing interconnectedness of the global financial system, a bank failure doesnt happen in a vacuum. Instead, there is the possibility that a series of bank failures will spiral into a more destructive contagion or domino effect. The best example of this is the U.S. financial crisis, when a series of collapses by smaller financial institutions ultimately led to the failure of Lehman Brothers and the government bailouts or forced takeovers of many others. Since European governments are already struggling with their finances, there is less latitude for government backstopping of this crisis compared to the one that hit the United States. Q: Why do bonds yields go up in response to this type of crisis, and what are the implications?
The reason for rising bond yields is simple: if investors see higher risk associated with investing in a countrys bonds, they will require a higher return to compensate them for that risk. This begins a vicious cycle: the demand for higher yields equates to higher borrowing costs for the country in crisis, which leads to further fiscal strain, prompting investors to demand even higher yields, and so on. A general loss of investor confidence typically causes the selling to affect not just the country in question, but also other countries with similarly weak finances an effect typically referred to as contagion.

Q: What did European governments do about the crisis?

The European Union has taken action, but it has moved slowly since it requires the consent of all nations in the union. The primary course of action thus far has been a series of bailouts for Europes troubled economies. In spring, 2010, when the European Union and International Monetary Fund disbursed 110 billion euros (the equivalent of $163 billion) to Greece. Greece required a second bailout in mid-2011, this time worth about $157 billion. On March 9, 2012, Greece and its creditors agreed to a debt restructuring that set the stage for another round of bailout funds. Ireland and Portugal also received bailouts, in November 2010 and May 2011, respectively. The Euro zone member states also created the European Financial Stability Facility (EFSF) to provide emergency lending to countries in financial difficulty. The European Central Bank also has become involved. The ECB announced a plan, in August 2011, to purchase government bonds if necessary in order to keep yields from spiraling to a level that countries such as Italy and Spain could no longer afford. In December 2011, the ECB made 489 ($639 billion) in credit available to the regions troubled banks at ultra-low rates, and then followed with a second round in February 2012. The name for this program was the Long Term Refinancing Operation, or LTRO. Numerous financial institutions had debt coming due in 2012, causing them to hold on to their reserves rather than extend loans. Slower loan growth, in turn, could weigh on economic growth and make the crisis worse. As a result, the ECB sought to boost the banks' balance sheets to help forestall this potential issue. Although the actions by European policy makers usually helped stabilize the financial markets in the short term, they were widely criticized as merely kicking the can down the road, or postponing a true solution to a later date. In addition, a larger issue loomed: while smaller countries such as Greece are small enough to be rescued by the European Central Bank, Italy and Spain are too big to be saved. The perilous state of the

countries fiscal health was therefore a key issue for the markets at various points in 2010, 2011, and 2012. In 2012, the crisis reached a turning point when European Central Bank President Mario Draghi announced that the ECB would do "whatever it takes" to keep the euro zone together. Markets around the world immediately rallied on the news, and yields in the troubled European countries fell sharply during the second half of the year. (Keep in mind, prices and yields move in opposite directions.) While Draghi's statement didn't solve the problem, it made investors more comfortable buying bonds of the region's smaller nations. Lower yields, in turn, have bought time for the high-debt countries to address their broader issues.

Q: Is fiscal austerity the answer? Not necessarily. Germanys push for austerity (higher taxes and lower spending) measures in the regions smaller nations was problematic in that reduced government spending can lead to slower growth, which means lower tax revenues for countries to pay their bills. In turn, this made it more difficult for the highdebt nations to dig themselves out. The prospect of lower government spending led to massive public protests and made it more difficult for policymakers to take all of the steps necessary to resolve the crisis. In addition, the entire region slipped into a recession during 2012 due in part to these measures and the overall loss of confidence among businesses and investors. Q: from a broader perspective, does this matter to the United States? Yes The world financial system is fully connected now meaning a problem for Greece, or another smaller European country, is a problem for all of us. The European debt crisis not

only affects our financial markets, but also the U.S. government budget. Forty percent of the International Monetary Funds (IMF) capital comes from the United States, so if the IMF has to commit too much cash to bailout initiatives, U.S. taxpayers will eventually have to foot the bill. In addition, the U.S. debt is growing steadily larger meaning that the events in Greece and the rest of Europe are a potential warning sign for U.S. policymakers. What is the outlook for the crisis? While the possibility of a default or an exit of one of the eurozone countries is much lower now than it was early in 2011, the fundamental problem in the region (high government debt) remains in place. As a result, the chance of a further economic shock to the region - and the world economy as a whole - is still a possibility and will likely remain so for several years, despite the financial-market rallies that characterized the second half of 2012.