Financial Crisis in Peripheral Europe

Financial Crisis in Peripheral Europe

Nations on the edge of the eurozone, including some former economic darlings like Ireland, have recently come under intense pressure due to their high debt loads. Germany has been forced to bail out an insolvent Greece in order to maintain stability within the eurozone (Kulish, 2010). The surface-level cause of the trouble was the level of debt. In Greece, the budget deficit was at 13% of GDP in late 2009 and public debt at 125% (Walberg, 2010).

Many of the PIGS became awash in cheap capital. Low interest rates compelled investment in the PIGS nations as there appeared to be better opportunities. In Spain, Portugal and Greece, it was the development of vacation properties; in Latvia and Ireland there was optimism about strong economic growth. The IMF was compelled to bail out Latvia in 2008 in order to avoid a devaluation of the lat, which could have destabilized currencies throughout Eastern Europe (BBC, 2008).

In addition to cheap capital as a cause, internal trade imbalances in the Eurozone have been tabbed as culprit. Germany, a major exporter, saw its current account balance increase from 2003 through 2007, while importer Spain saw its current account balance decrease sharply over the same period. This has been the case with a number of other European countries as well. As a result, Spain saw an increase in inflation. When the real estate bubble burst, Spain was overpriced, which saw capital outflows, leaving the nation with high debt and low income (Krugman, 2010).

Such fiscal imbalances have placed the euro at risk. In the case of Greece, the financial situation was much worse than anybody realized because the Greek government cooked the books. As soon as this was discovered, the euro would naturally have lost value -- its underlying assets not being as strong as previously thought. The bailout of Greece has also caused a decline in the value of the euro as it required Germany to pump money into the country to prop up its economy.

Should the crisis continue, however, the damage to the euro could be far more severe. There are political consequences, in particular since politicians had promised that this scenario would not occur. Beyond that, the euro itself would need to be devalued if the trend towards instability on the peripheral economies continues. Normally, if trade partners have a strong imbalance of trade, their respective currencies can be revalued in order to accommodate that. With the eurozone, however, all of the countries have the same currency, taking away the prospect of currency revaluation as a potential solution. This makes it more difficult to reconcile the disparity in the trade. For example, the current solution of Germany bailing out Greece is essentially a very crude form of the type of redistribution that would be required, given that there is no option of shifting exchange rates between marks and drachmas. Until stronger policy levers are in place, the cycle of instability that this trade imbalance creates will result in general instability in the euro region. Foreign investors in particular will avoid the euro in favor of more stable currencies, ultimately driving down the value of the euro.

An even worse scenario would unfold if there was no bailout of Greece. This is the sort of situation that could occur if a much larger euro economy were to find itself in the same situation as the Greek economy -- Spain or Italy for example. Without a bailout, the offending country would essentially be removed from the euro. While the euro itself would suffer from short-term instability due to the high amount of uncertainty such a scenario would create, it would probably recover as the exercise would essentially be addition by subtraction with regards to improving the euro's long run stability.

One of the underlying problems that has emerged in the discussion of this crisis is with respect to the structure of the euro area. While all nations are essentially in bed together financially -- the bailout of Greece demonstrated that -- each nation is free to run its country as it sees fit. In other words, there are few controls in place to ensure responsible spending or, in the case of Greece, that the books are not cooked. The implication of this is that Greece makes errors and commits fraud, knowing that the eurozone will be forced to bail them out or risk grave instability. The other nations are then forced to bail Greece out, because they share a common currency and therefore a common economic fate, but also because the Germans benefited from the high current account balance in the first place.

There are a number of potential solutions. The eurozone could determine that addition by subtraction is a good strategy. Despite the short-term instability, it would allow the zone to be comprised of major exporting and otherwise fiscally responsible nations. Throwing the PIGS under the bus may be difficult politically and cause severe harm in the short-run, but could benefit the eurozone in the long run, particularly those countries that will otherwise be condemned to endless bailouts.

The second potential solution is to improve oversight. The warning signs of the crisis were there -- current account balances for countries like Spain plummeted in the wake of the housing bubble for example. The crisis is so intense because few safeguards were put in place -- an eventuality of this magnitude was not predicted. Now that we know how bad the damage can be, strong oversight is required, not just to ensure that current account deficits remain under control, but also with regards to basic governance. Greece's problems stem essentially from fraud, which with strong oversight on the part of the wealthy nations could have been avoided.

Another potential solution would address the problem at the systemic level. Germany is a massive exporter to other European countries, which causes the imbalance in European trade. This is caused by a number of factors, but a major one is the underlying differences in competitiveness between different member states. A solution, therefore, would be a tighter political union -- a common budget, common governance, common taxes -- in order to redistribute resources in a non-crisis situation (Fleming & Shipman, 2010). Such a solution would allow for a greater distribution of resources, which is being achieved currently through bailouts and would have been achieved previously by increasing interest rates and devaluing the currency of the weak partner. This potential solution, therefore, is political untenable. It would also create a disincentive to work for many Europeans, crippling the region's economy and further depressing the currency.