European Financial and Debt Crisis I A Research Paper

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European Financial and Debt Crisis

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The European financial and debt crisis

The European financial and debt crisis refers to the struggle which the European Union region endured while trying to pay off the enormous debts that had built up in the recent decades. There were five countries in the region whose economic growth was stunted, and thus it played wrongly on their ability to pay back to their bondholders the guarantee that they had intended. These five countries are Greece, Italy, Portugal, Spain and Ireland. Their inability to pay was in varying degrees, and although these five countries were in greatest immediate danger to default on their debts, the consequences that would result from the crisis would extend beyond these five countries and would affect the whole world. In October of the year 2011, the head of the Bank of England termed the European financial and debt crisis as the "the most serious financial crisis at least since the 1930s, if not ever," Valiente, 2011()

The European debt crisis began as a result of the U.S. financial crisis of the years 2008-2009. During this time, the global economy was in recession, and there was slow growth that was experienced. The U.S. financial crisis came about as a result of the public taking mortgages of 100% or more of the value of the homes they were purchasing. These mortgages were sold by banks in packages and were part of mortgage-backed securities. The effect of this was expected to be isolated to the real estate business only. However, since the first mortgages that were given to the property owners were chopped up into pieces and resold, the actual derivatives from this process were impossible to put a price on. Therefore, the value of these derivatives on the secondary market was small, and investors began to panic and steer their investments clear of such low prices.

During this U.S. financial crisis, the unstable fiscal policies of the European countries were exposed, and this is what led to the European financial crisis. Greece as a country had spent a lot of money for years, but they had not instituted any financial reforms. It was the first country to feel the effects of this slow economic growth since tax revenues slumped and, therefore, they had high budget deficits that were unsustainable. The new prime minister of Greece, George Papandreou announced in late 2009 that the previous government had concealed the truth of the nation's deficits and the truth was that Greece was so engrossed in debt. These debts were larger than the country's entire economy. Investors responded to this announcement by demanding higher yields on bonds that were given to Greece and this increased the cost of the country's debt burden, and it made it necessary for the European Credit Bank (ECB) and the European Union to make a series of bailouts. Other heavily indebted countries also felt adverse effects as the bond yields were driven up by investors.

The reason why investors demanded a higher bond yield is that they needed to be compensated for the risk since these countries had higher risks of default. This was the beginning of a vicious cycle. Since the investors demanded a higher bond yield, these countries experienced higher borrowing costs and this led to further fiscal strain which prompted investors to demand even higher bond yields. This can be clearly seen in figure 1 and 2. This situation was a contagion since it affected many other countries that were in serious debt.

The European Union (EU) took some action to help resolve this European financial and debt crisis. However, the action that they could take moved at a snail's pace since the EU is required to obtain the consent of all 17 member nations. The EU issued a number of bailouts for the troubled economies in Europe. The first bailout was in spring of 2010 where they disbursed 110 billion euros to Greece together with the International Monetary Fund (IMF). The second bailout for Greece was worth about 106 billion euros, and this was given in mid-2011. Portugal and Ireland also received bailouts in May of 2011 and November of 2010 respectively. The establishment of the European Financial Stability Facility (EFSF) by the Eurozone member states in order to provide emergency lending to the overburdened countries in order to prevent such a financial crisis from happening again Grauwe, 2010()

The ECB also helped to resolve the crisis. Though the ECB was strongly opposed to the 'bazooka' option whereby more money is printed in order to purchase the distressed debt in the region, it instituted a plan in August of 2011 to purchase government bonds if this was needed to keep bond yields from increasing to a dangerous level that certain countries such as Spain and Italy could not afford. The troubled banks in the EU region received 489 billion euros in December of 2011. Many of these financial institutions had debts that were due in 2012, therefore, they were forced to hold on to their reserves rather than taking the option to extend the loans. Since the growth in loans was almost dead, this could weigh down economic growth and worsen the crisis. Investors cheered the move by the ECB since although it did not alleviate the problem of high outstanding government debt, it did not compromise the EU's economies but rather it propped it up.

The actions taken by the ECB and the EU were criticized that they only helped the short-term and did not solve the long-term problems. Another problem of these actions was that they could save smaller economies like Greece. However, the larger economies such as Spain and Italy could not be saved by these bailouts.

The possibility of a contagion brought about by the European debt crisis made it a key focal point for the financial markets of the world in the period between the years of 2010-2011. This is as shown in figure 3. The investors had previously been adversely affected by the U.S. financial crisis and, therefore, they would not risk any such adverse effects again. Therefore, their actions were swift. If anything turned out risky, they would sell as quickly as possible and buy government bonds in more financially stable countries. During the time when the crisis was at peak, stocks of the various European banks performed worse than expected. Other European markets also fared worse. Rising bond yields in the heavily indebted countries meant that bond prices were falling so the bond markets of these countries performed poorly. During the same time, yields on U.S. treasuries fell to a historical low since the investors feared the contagion would catch up with the U.S.

Germany pushed for austerity in the smaller nations in the EU. Austerity is characterized by higher taxes and lower government expenditure in order to alleviate the debts. However, austerity would lead to lower tax revenues and the reduced government expenditure would lead to slower economic growth and thus increase the debt burden. Lower government expenditure caused massive protests by the public and thus policymakers could not step in and resolve the crisis. The entire EU region slipped into a recession in late 2011 as a result of the lost confidence by investors and among other businesses.

Though the effects of the European financial and debt crisis began with the smaller counties, the larger economies also felt adverse effects. As a result, the larger economies had no option but to pressure the smaller ones into instituting fiscal policies to help resolve the problems. The ECB, IMF and EU also came to the rescue with a series of financial bailouts in the tunes of billions. Although the…[continue]

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