Eurozone financial crisis and its effects on global markets

Finance

The Effect of the Eurozone Today on Global Financial Markets

Global markets are so intertwined today that what affects one is definitely going to have an impact on another. Case in point, the recent issues in Greece and other European Union (EU) countries have had a global effect and have wrought havoc on the Eurozone. Because if this global connectedness, large banks and organizations like the International Monetary Fund (IMF) are even more important today than they were in the past.

The EU's finances are powered by the countries that have become member nations, but those finances are guarded by the European Central Bank (ECB) and the IMF. The ECB is the institution that is responsible for the Euro, the currency of the EU, and it is also the organization responsible for negotiations regarding the economic difficulties of EU member nations. Since Greece, Spain, Italy and others have had financial problems, the ECB has worked with those countries and the rest of the EU to shore up the damaged economies. Unfortunately, the measures have not worked as well as hoped in all cases and sluggish growth has been the inheritance. However, some of the problems are being resolved.

The larger issue, and the reason for this report, is the fact that the downturns within the Eurozone affect markets all around the world. The sluggish growth of the EU's economy has had adverse effects on global markets, and has caused potential, and essential, investors to shy away in recent weeks as the problems continue. This paper looks at the IMF, EDB and the situation within the Eurozone and examines how markets are affected by the financial difficulties that are occurring and why the Eurozone problem has global effects.

International Monetary Fund

World War II had a devastating effect on the world economy ad especially those countries that were directly affected by the fighting. There was a need to create a global organization which could help member nations both rebuild and sustain their economies, so the International Monetary Fund was born. The IMF is "an organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world" (IMF). The IMF works to foster the cooperation and growth that will bolster national economies, but the body can only make suggestions as it has not regulatory power.

The IMF influences the global economy through its member states which includes almost every nation on Earth. Every member state is required to maintain a fund with the IMF whose amount is set by the percentage of the global economy that the nation occupies. For instance, the United States quota is set at 42,122.40 million SDR. The SDR, or special drawing right, is an amount fixed by several key global currencies (IMF). This SDR figure, which is the amount of capital that the U.S. is required to keep in the Fund as a voting member, also gives that member nation so many votes when decisions are being made. Currently, the United States holds 16.75% of the total votes cast on any issue because of the capacity of the U.S. economy and the influence the U.S. economy has on the world markets. The voting power is also set up so that there is a slight bias toward smaller member states as a group. Basically, the quota determines a certain number and percentage of votes (for the U.S. that figure is currently 17.69% (IMF)), but for the larger economies that percentage is reduced through accounting which initially allows that "The number of basic votes attributed to each member is calculated as 5.502% of total votes" as a base and then each member is allowed an one additional vote per 100,000 SDR that it contributes (IMF). Thus, smaller states start on an equal footing with the larger which will reduce the total influence of the larger states.

However, there are issues with the IMF that critics specifically state has to do with the fact that larger nations still have too much voting power; it is said that this is especially true of the United States. Because the U.S. economy is so much larger than any other in the world, the U.S. has more than 10% more votes than any other country (IMF). This means that actions by leaders who have some control over the U.S. economy can adversely affect the financial philosophy of the IMF to too great an extent. An example of the switch in logic from a national outlook to a more global outlook has changed the face of the IMF (IMF). One overriding criticism that countries have of U.S. influence is that states considered close allies of the U.S. also seem to get more favorable terms when negotiating loans (Jensen). This criticism has been denied by both the U.S. And the IMF, but the influence that the U.S. exerts still produces this type of belief.

Nations have also tried to subvert U.S. influence by banding together in coalitions. The European Union does not vote as a bloc, but it is more of an economic union than a political one. Although there are European central courts and other advantages because of the EU, the primary reason the countries came together was to form a partnership that would be strong enough to withstand the influence of the U.S. And emerging economies such as India and China. As a group, the EU nations would form the largest voting bloc within the IMF, but, unfortunately, the member countries of the EU rarely vote as a cohesive unit. But, the enormity of the combined economic force behind the EU member nations is large enough to cause a great amount of global economic turmoil. The Union itself works to control the issues of its member states with its own means though.

Eurozone and the World Financial Markets

Any large economy is going to have a significant effect on the rest of the world. Case in point, the latest financial crisis that started in 2008 was primarily a result of poor lending practices by U.S. banks, but it spread to the entire world. It can easily be said that the crisis exposed poor banking and lending practices around the world and was a correction that would have occurred sooner or later anyway (Dam), but the fact remains that the United States economy has a large effect on global markets, and the same can be said of the Eurozone economy.

Any crisis involving a member nation of the EU is going to cause global issues, but when several different nations are involved in simultaneous corrective environments the problems are greatly exacerbated. That is the state of the Eurozone at present and its financial leadership is desperately trying to find answers that will answer questions other leaders have (Wearden). Though the Eurozone economies generate a great deal of capital, it is difficult to completely support the failing economic system of country. Thus, investment from other nations, generally in the form of bonds (Sinclair), is necessary to offset the enormous costs that have been incurred. The problem with this is that confidence in the entire system can be lost.

One of the most influential and active investors in world markets is China and, more specifically, the Chinese Sovereign Wealth Fund (Wearden). Recently, the head of that group, Jesse Wang Jianxi, discussed concerns when he stated;

"I think the outlook for the European debt crisis is not optimistic yet. We have been investing actively in European countries and if the heavily indebted countries and European Union can provide a more friendly investment environment, I think we can invest more actively in the future (Wearden).

The European debt crisis has been an issue that has plagued the Eurozone for more than two years now and has been exacerbated by the inability of the countries involved in getting spending and debt into line. There are multiple problems which have to be resolved, but the main issue on a global scale is how this crisis, and the Eurozone has affected markets in the rest of the world. That is the crux of this discussion.

The global financial outlook can be seen as a web that connects all of the pieces together with a few major strands supporting the whole. These "major strands" are economies such as the United States and China whose powers of investment have provided for growth in other areas of the world. Another major strand in the global economy is the Eurozone, but the importance of this group of countries has been diminishing for many years. At one time the British pound sterling was the international currency because people recognized the note around the world After World War II this was changed to the U.S. dollar because that country was seen as the new global financial leader (Zimmerman). Europe was devastated by the war and it took a long time and a lot of money for those countries to begin recovery. It did happen eventually though, and Germany's has been the second or third largest economy in the world for more than a decade now.

Unfortunately, other areas in the European region did not follow. The War cannot be blamed for the decreased strength of many economies, but spending can. The European model quickly became one of increased social dependence on area governments and smaller incomes as investors and consumers looked elsewhere. It has been an interesting shift in large market economies because it seems to be slowly following a line from West to East. For many years, trade came from China and India in goods such as spices and silks, then the European countries became the large economies as they used these goods and there vast shipping capacity. The United States and Canada grew through the nineteenth and twentieth centuries to the prominence both nations have today, and now the economic thread seems to be heading toward China and India once again. Over a period of a thousand years, world trade has made a circuit and is finally coming to rest again in the East.

The significance of this is that European ideas of markets and trade seem to be antiquated and this has caused growth in much of the Eurozone to stagnate for more than a decade. There are bright spots like Germany (Rogoff), but there are many more countries that participated in the socialist experiment that have not fully recovered. These issues and other pervade the discussion.

One other issue that has plagued recent entrants to the EU is that they have followed a mode of government in the recent past that was anathema to growth and capitalism. Although, some countries have been able to recover from the spell of Soviet dominance (such as East Germany), it has been too great a burden for some former Soviet bloc countries to overcome. Even with the influx of trade from the EU agreement many are now party to, some countries continue to suffer from slow growth and putrid economies. One of the reasons for this is that the economies of those regions have never completely developed from when they were free from Soviet domination. Although that period ended more than 20 years ago, it still has an effect on how countries' economies progress. Although these countries are not members of the prestigious Eurozone, they still affect the countries that are a part of it because they are member nations of the European Union. The fact that labor costs are out of control in Estonia and Romania (Wearden) means that other EU nations can expect to see financial effects because of the pledge signed by each EU nation. The global effects of such issues are more subtle, but they become magnified when a larger body such as the member nations of the Eurozone suffer.

It seems though that many countries and experts believe that the original exposure of these financial fissures can be traced back to the U.S. "subprime mortgage market" and how it caused an economic slowdown in the United States (Zimmerman). The main method that national economies influence each other was on full display here. The U.S. had a housing boom caused by low interest rates, favorable mortgages (in many cases adjustable-rate mortgages called ARMs), and a large supply of people wanting to be home owners, caused a run on the securities that were produced from this boom. Dam, talking about the reaction to the securities glut by other country's banks, says "Many of the world's most sophisticated banks bought these securities, usually without doing their own investigation and analysis and almost certainly without adequate due diligence. And they did so because, like many U.S. purchasers, they sought higher returns than elsewhere available." The problem here is that they were fooled just as U.S. institutions were and that buying and lending opportunity allowed the European banks to realize, what it thought were, great gains due to the U.S. prosperity, and then see an even bigger crisis of their own develop because of it. This global architecture (Sinclair) is still at work, but it is now happening in reverse.

The weakness of the U.S. currency and markets was supposedly exposed because of the crisis. There has been a great deal of talk over the past couple of years to use another reserve currency besides the dollar because of the crisis and the financial incapacity that caused in the U.S. The value of the dollar dropped and that caused other countries to abandon it. The ECB and EU have tried to push the Euro as the perfect alternative since its inception because it has a wide global base that the U.S. cannot compete with. One author notes that

"the euro is a very unusual form of international reserve currency…it has been created ex-nihilo by an alliance of European states. The peculiar construction of the euro is a source of considerable strength but also weakness for it as international reserve currency" (Wague).

The argument for a change in international reserve currency from the dollar to the euro, then does not sound particularly appetizing for at least two reasons. It would put the U.S. And other world markets more at the mercy of the European market, and many of the countries which form the base of the currency are very unstable themselves, as has been demonstrated over the past three or four years. The Eurozone already has undue influence over the global economy, and they would like even more by changing the global reserve currency.

The reason that the Eurozone affects markets around the world so profoundly, and especially the U.S. market is because there is so much interchange between the U.S. And the European system. The American government has considered the main countries in Europe allies since the end of the Second World War and that is unlikely to change. However, these ties make it seem, to the diplomats of the European countries and the U.S. that there is a much greater interplay than is actually healthy economically. The U.S. blunder in subprime mortgage securities devastated Europe while many Asian economies noticed a bump, but just kept on producing. China now seems to be the lender to the world, and China and India account for most global economic growth (The World Economy). The interconnectedness of the U.S. And EU political machines should not have such a large effect on the economies of the two entities, but it does.

The issues with Greece have caused the sluggishness of EU economic growth which means that those countries, which supply much of the export possibilities for U.S. companies (Maidment), are no longer able to buy U.S. goods at the rates they did previously. This means that the U.S. suffers in both manufacturing and service industries. This causes a resultant dip in the U.S. economy which proves that the political connectedness of the U.S. And the EU is problematic for the economy of the U.S. One author asked "Should monetary restraint and stability be compromised to push economic growth and social stability?" (Zimmermann). The question is in reference to the relationship between economies and political entities and the author is advocating for "formal central bank independence" so that governments can no longer "use geopolitical arguments to push their first priority, i.e. economic growth and social stability" (Zimmerman). This issue has become a more present topic among economists because of the way the U.S. social engineering brought caused massive slowdowns for economies around the world, and previous social spending chaos in countries such as Greece ( and even in England) has caused problems with other national economies. Of course, it would be a difficult procedure to internationalize these large institutions, but they would then have more freedom to solve problems caused by political policies, and warn governments that there policies would not be tolerated because of long-term global economic effects.

Of course, this could also give large banks too much power. The way that the EU works right now, the stronger nations are helping the weaker (Halmai & Vasary), but this idea could end that. The EU political machine has just agreed to take more control of banks because political officials are already worried that the ECB and independent banks have too much power (Kanter). This could also be seen in the U.S. crisis. There is no easy solution and the global effect of these crises will likely continue to happen because the economy has truly become global.

Conclusion

The IMF was designed to help ailing national economies, the ECB works to create the best European currency and economy it can, and the downturn that started in the United States has come back around to cause additional problems for the U.S. economy. The ripple effect of this crisis is amazing. The Eurozone has made it possible for European nations to become stronger as a group, and some countries, Germany at the forefront, have benefitted greatly. Unfortunately because of the interconnectedness of nations, whenever there is a problem with one it affects the whole. This is not only true of the countries of the Eurozone, but also true of those that rely on the purchasing power of the EU to bolster their own economies. Some countries, notably China, have almost decided to wash their hands of the entire EU because member countries are such a poor risk, but others, the U.S., are either too connected to the EU nations historically or too clueless to also cut the cord. The main issue seems to be that the U.S. financial improprieties caused a European financial crisis which exposed the weakness of EU member states. Because the U.S. is so connected to these same EU states, the U.S. markets are having a more difficult time recovering also. It is a circular issue that seems to have no end.