Can the Eurozone survive?

Potential prospects for the Euro as common currency beyond the sovereign-debt crisis


Term Paper, 2014

14 Pages, Grade: A


Excerpt

Table of contents

Index of Abbreviations

Introduction

Analysing the past

The Present: Contributing factors and relevant players

Future expectations beyond the sovereign-debt crisis..

Conclusion

Bibliography

Appendix

Index of Abbreviations

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Introduction

This report critically evaluates and addresses the past, current and the possible future situation of the Eurozone. Intended politically as the major contribution to a United Europe, and perceived by many at the time of its introduction as an enormous accomplishment, “The Euro, probably more than any other currency, represents the mutual confidence at the heart of our community” (Wim Duisenberg, President of the ECB in 2002, quoted in Marsh, 2009, p.1). Yet, roughly a decade after Duisenberg´s speech, much of this euphoria has dampened as the Eurozone continues to struggle with the impacts of the economic crisis of 2008. Indeed, little of Duisenberg’s claimed ´mutual confidence´ remained after Greece went effectively bankrupt and bondholders had to accept a €100 billion ´haircut´ in early 2012. Moreover, the risk of contagion from Greece to the economies of Portugal, Ireland, Italy and Spain (commonly referred to as periphery countries or PIIGS, see appendix) and the extensive discourse of “Grexit”, a Greek exit from the common European currency, have increasingly complicated the current situation. To consider the question of whether the Eurozone will be able to survive, the first part of this report provides an overview of past developments regarding the Euro, and how the Euro’s complex history has led to the current situation, including potentially contributing factors to the crisis. The second part then focuses on the present situation: Greece causing the potential threat of a rapid domino effect that could splinter the Eurozone as a whole. Subsequently, this report evaluates if the measures, imposed by the EU, ECB and IMF will be adequate to finally resolve the crisis, before focusing on the potential future of the Euro as a common currency for Europe.

Analysing the past

The creation of the Euro has its origins in the early 1970s collapse of post-war Bretton Woods agreement (see appendix) (Lucarelli, 2013; Chabot, 1999). The subsequent following exchange-rate volatility as well as the oil price shocks (a sudden quadrupling of the oil prices by the OPEC cartel in mid-1973) led to relatively high inflation rates and resulted in a strong European desire for a zone of monetary stability (Lucarelli, 2013). Hence, in 1979, the European Community introduced the Exchange Rate Mechanism (ERM, see appendix) that tied the ´weaker´ European currencies to the relatively stable Deutschmark (Roscini & Schlefer, 2013). In 1986 the EC signed the Single European Act (see appendix) as a pledge to systematically abandon trade barriers, border checks, tariffs, and also financial and labour restrictions (Bishop, et al., 1996).

Many then argued that a single trans-European currency would be the logical consequence, both for a lasting peace in Europe as well as the economic benefits of free trade and monetary stability (Chabot, 1999). Arguably, forming a single currency union was seen as the most effective way to cement 40 years of international cooperation and peace in Europe, the objectives were therefore political as much as economic (Roscini & Schlefer, 2013). German Chancellor Helmut Kohl emphasised in 1997 that “the bitter experiences of war and dictatorship in this century teach us that the unification project is the best insurance against a relapse of national egoism, chauvinism and violent conflict” (Chabot, 1999, p. 38). This emphasis on political hopes of several participating countries and the deeply held aspirations represented a major difference to any other previous currency blueprint. Additionally, ambitious economic goals, such as eradicating exchange rate volatility, enhancing price transparency and decreasing transaction costs also played a significant role (Chabot, 1999).

The Maastricht Treaty (see appendix) officially formed the EU in 1992 and laid the groundwork for the European Central Bank (ECB) (Bishop, et al., 1996; Chabot, 1999). On 1 January, 1999 six (of the original 11) Eurozone members did not actually adhere to the Maastricht criteria (see appendix), yet were able to join the Eurozone and, in practice, some members only attained the Maastricht criteria through ´creative accounting´. Furthermore, the Stability and Growth Pact (SGP, see appendix) was often unheeded as several member countries violated both debt and deficit levels (Arestis & Sawyer, 2012).

With the adoption of the Euro as a common currency the euro members discontinued their own individual monetary policies, yet remained autonomous with their fiscal policies. Arestis and Sawyer (2012) point out, that this may be seen as a key flaw within the Treaty and a major reason for the sovereign-debt crisis. Before implementing the Euro, Eurozone countries were able to respond to economic shocks and crisis through three options: (1) adjustment of interest rates; (2) exchange rate adjustment, hence devaluation of the currency and (3) fiscal adjustment, hence government spending and taxes (Chabot, 1999). All Eurozone members surrendered the first two mechanisms, and with this a considerable degree of autonomy, to the ECB. This resulted in a severely limited scope for the national governments regarding countercyclical policies (Lucarelli, 2013). Arestis and Sawyer (2012, p. 29) point out that without the ability to devalue the currencies, countries with high current account deficits “will be thrown back into deflation”. This becomes particularly clear given that the Maastricht Treaty demanded that governments that had borrowed more than 60% of GDP had to impose a restrictive fiscal policy, even if these measures would intensify a potential recession (Lucarelli, 2013).

The Present: Contributing factors and relevant players This section will provide an overview of contributing factors to the current crisis. In particular, the weaknesses and turbulences of the financial markets will be discussed before addressing the changed conditions in relevant countries since the monetary unification.

Before adopting the euro investors demanded higher interest rates, or “inflation and exchange rate risk premiums”, from the peripheral countries (Chabot, 1999, p. 46). The Euro lowered inflation and eliminated exchange rate risks and therefore countries with a historically high inflation (PIIGS, see appendix) benefited enormously from the downward pressure of interest rates on their government bonds (Chabot, 1999). This increasing confidence led to significantly lower “risk premiums” and encouraged institutional and private investors to pour capital into the periphery countries (Roscini & Schlefer, 2013). Following a common macroeconomic sense (Blanchard, 2011), an increase in government spending contributes to an overall increase in demand and deficit spending of periphery governments skyrocketed after adopting the Euro (Roscini & Schlefer, 2013). Figure 1 (Lucarelli, 2013) illustrates the alignment of European ten-year government bonds and highlights the harmonization of the spread between the currency unification 1999 and the Lehman Bankruptcy 2008.

According to some research, European banks had operated with huge leverage since the early 2000s (Roscini & Schlefer, 2013; Lucarelli, 2013). A strong exposure to mortgage-backed securities and other toxic assets made many banks highly vulnerable to the implications of the US housing bubble, that rapidly evolved to a financial crisis and spread to a global economic crisis (Lucarelli, 2013; Roscini & Schlefer, 2013). The highly leveraged and interconnected banks gave this crisis additional momentum.

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Details

Title
Can the Eurozone survive?
Subtitle
Potential prospects for the Euro as common currency beyond the sovereign-debt crisis
College
Edinburgh Napier University  (Economics)
Grade
A
Author
Year
2014
Pages
14
Catalog Number
V293078
ISBN (eBook)
9783656903611
ISBN (Book)
9783656903628
File size
868 KB
Language
English
Tags
Economics, Makroökonomie, macroeconomics, Eurokrise, euro, euro crisis, Grexit, Brexit, souveraign debt, sovereign debt, European union, European debt crisis, ecb, Greece, IMF, bailout, periphery states, inflation, deficit spending
Quote paper
Franz-Joseph Reisner (Author), 2014, Can the Eurozone survive?, Munich, GRIN Verlag, https://www.grin.com/document/293078

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