Examining The economic Crisis Within The European Union


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The financial crisis begun at 2007 at the United States of America and took no more than a year to visit the European Union. The time the crisis reached Europe it already had 27 members. The crisis has been called by leading economists the worst financial crisis since the Great Depression of the 1930s. The rapid rise in prices for energy, food and other commodity prices adversely affect both inflation and economic activity worldwide. Oil prices, after rising to very high, fell recently and the economic slowdown is likely to lead to further reduction. However, they remain high, while the uncertainty about their future development is increased and is likely to continue to vary a lot. High food prices particularly affect the economically disadvantaged (within each country) and emerging economies (among the countries of the world).

In its early stages, the crisis manifested itself as an acute liquidity shortage among financial institutions as they experienced ever stiffer market conditions for rolling over their (typically short-term) debt. In this phase, concerns over the solvency of financial institutions were increasing, but a systemic collapse was deemed unlikely. This perception dramatically changed when a major US investment bank (Lehman Brothers) defaulted in September 2008. Confidence collapsed, investors massively liquidated their positions and stock markets went into a tailspin. From then onward the EU economy entered the steepest downturn on record since the 1930s. The transmission of financial distress to the real economy evolved at record speed, with credit restraint and sagging confidence hitting business investment and household demand, notably for consumer durables and housing. (bja.oxfordjournals.org/cgi/reprint/60/3/274.pdf)

The cross-border transmission was also extremely rapid, due to the tight connections within the financial system itself and also the strongly integrated supply chains in global product markets. EU real GDP has shrunk by 4% in 2009, Although there have been signs of recovery it is expected to be slow-moving as demand will remain low due to deleveraging across the economy as well as painful adjustments in the industrial structure. Unless policies change considerably, potential output growth will suffer, as parts of the capital stock are obsolete and increased risk aversion will weigh on capital formation. The ongoing recession is thus likely to leave deep and long-lasting traces on economic performance and entail social hardship of many kinds. Job losses can be contained for some time by flexible unemployment benefit arrangements, but eventually the impact of rapidly rising unemployment will be felt, with downturns in housing markets occurring simultaneously affecting (notably highly-indebted) households. The fiscal positions of governments will continue to deteriorate, not only for cyclical reasons, but also in a structural manner as tax bases shrink on a permanent basis and contingent liabilities of governments stemming from bank rescues may materialize. An open question is whether the crisis will weaken the incentives for structural reform and thereby adversely affect potential growth further, or whether it will provide an opportunity to undertake far-reaching policy actions. (www.euromonitor.com/Q2_2009_Is_the_world_on_its_way_to_recovery -)

Analysis of the crisis

Main causes:

The causes of the crisis have been much discussed and are clearly complex. Much as in a war, the definitive account, if it is ever written, will probably have to wait for the' fog of crisis' to lift. What is undisputed is that the centre of the storm was in the USA from where it moved directly to Europe and also indirectly via emerging markets. Behind this development lay a whole series of imbalances at different levels and in different spheres that interacted with developments in the way advanced capitalist economies have been operating, particularly but not exclusively in their financial sectors. This section looks at some of these fundamental drivers behind the crisis, focusing on seven key developments, and provides a provisional interpretation of some of the causal linkages between them. It will be necessarily schematic and the trends identified will apply with greater force in some countries than others. Further analysis will be required to tease out the interactions between these trends more precisely. It then shows how these trends served to accelerate a downturn in economic activity in Europe that had more direct and also more familiar causes. A prominent feature of global economic developments has been pronounced and persistent current account imbalances. Most notably the USA (but also, in Europe, the UK and Spain) have run large current account deficits, offset by corresponding surpluses in, notably, China, Japan and Germany. Total domestic consumption and investment in the US has been persistently and substantially (of the order of 5-6% of GDP) above domestic output. The gap has been met by borrowing: surplus countries have piled up financial assets which have kept long-run interest rates in the US low(and thus helped sustain the imbalances).Surplus countries have sought to export their way out of unemployment (Germany, Japan)or into rapid industrialization (China). Increasingly dissatisfied with meager returns on safe assets, such as Treasury bills, they(alongside domestic investors) have purchased more complex, opaque assets provided by Wall Street financial alchemists (to which we return)that offered higher rates of return. In Europe, Germany's persistent trade surpluses are one important fundamental reason why its banks held large amounts of what subsequently proved to be toxic financial products originated in the US .( www.marketoracle.co.uk/Article38 , www.escwa.un.org/information/publications/.../ead-08-tm1.pdf)

A second feature has been the rapid internationalization of production, investment and financial linkages - in short 'globalization' -without a corresponding development of supervisory and other forms of regulation at an appropriate (global, European) level. Global institutions still reflect the geo-political realities of the post-Second World War period and, at best, their policies and activities reflect the needs of isolated (developing) countries requiring support. One consequence of this lack of appropriate institution-al arrangements has been regulatory competition between jurisdictions in areas such as taxation, corporate law, financial sector regulation, etc. The lack of effective global governance allowed the problem of current account imbalances to fester. Partly as a result of these shortcomings, but partly also in the wake of a major political shift in advanced capitalist economies since the early 1980s, we have seen, thirdly, a sustained and far-reaching process of state withdrawal from involvement in the economy. Amongst other things, state ownership (not least of financial institutions) has been reduced, labor market and welfare state institutions have been weakened, commercialized, or privatized, enforced (or at least enforceable) legal regulation has been dropped in favor of codes of conduct and so-called self-regulation. Legal and social constraints on the operation of businesses, and not least the influence of trade unions, have been massively reduced in favor of' right to manage' and 'shareholder value' approaches. Key in the present context is that it is not the case that governments have simply failed to keep up with financial innovation. The financial services sector has been actively de-regulated at the explicit behest (and in the US, at least) with the help of substantial political donations of financial institutions that are now holding out their hand for state support. Ironically, many of the regulations repealed - such as the Glass Steagall Act in the US had been introduced in the wake of the Great Depression. These trends, perhaps enhanced by technological developments, have led, fourthly, to very substantial shifts in income distribution in most advanced capitalist countries. Almost all advanced capitalist countries have seen major shifts in the functional distribution of income (i.e. From labor to profits)and wideningdisparities in personal

( www.etui.org/research/Media/Files/EEEPB/2008/3-2008, www.globalresearch.ca)

The crisis was initiated by the deflating of the US housing bubble (and later the equity bubble), which set off a vicious chain reaction, with a number of negative feedback mechanisms. This had a direct effect on consumer demand as rising house prices had been the cash cow of stretched US consumers (equity withdrawal, mortgage refinancing). Defaults and foreclosures increased. Worse, the securitization of the underlying assets swiftly led to the implosion of the US financial sector, as losses emerged and confidence in the solvency of counter-parties evaporated. The resulting credit crunch then impacted consumers and non-financial businesses that could no longer rollover loans, causing consumers to retrench and firms to lay off workers.

There were (and continue to be) four main transmission mechanisms across the Atlantic.

• US consumer retrenchment (and also stalling business investment) directly affected the sales opportunities of European exporters, already squeezed by past currency appreciation.

• The European financial sector had been a major purchaser of 'toxic' assets from US banks. Their collapse in value of or the cessation of trading in these assets led to a knock-on implosion of the European banking sector, which then hit European companies (and to a lesser extent consumers, especially homeowners).

• The massive rate cuts by the US Federal Reserve in response to the crisis (initially unmatched in Europe) led to a sharp further fall in the USD against the euro, exacerbating the competitive pressure on European producers.

• Finally, and after a lag, the crisis also hit emerging economies (not least, China, where recent reports suggest a major increase in unemployment is likely),which led them to cut their import demand.

Within European economies, this then set in train a standard negative interaction between the corporate and the household sectors typical of any recession. Firms cut investment and reduce working hours and staffing levels. Households - facing increased uncertainty, wealth-reducing asset price declines and tougher credit constraints - save more and some of them suffer income losses; over-all consumption falls, worsening the situation of companies, which intensify job loss-es, etc. On top of this come negative feed-back loops between the banking system and the household and non-financial corporate sectors .Before turning to discuss issues of economic policy, it will be useful to sum up three key findings of the preceding analysis, which are decisive for the assessment of the crisis and what can and must be done about it. They are also important in that they are rather at odds with widely held views on the nature of the crisis. Thirdly, the European Union as a whole -this is not true of all its members individually - was clearly not overheating and did not suffer many of the major economic imbalances that so characterized the United States economy and to which the crisis is - in part a necessary response. As has happened before (for instance in 2001), a downturn/crisis has been 'imported' from the US at a point in time at which, in terms of the supply side of the European economy it self, further sustained growth and, notably, reductions in unemployment would have been possible.(www.realinstitutoelcano.org- www.etui.org/research/Media/Files/EEEPB/2008/3-2008 , www.oxfamblogs.org/.../GEC_research_report_consultation_draft_27Jan2010.pdf)

Main consequences:

The financial crisis has had a pervasive impact on the real economy of the EU, and

This in turn led to adverse feedback effects on loan books, asset valuations and credit

supply. But some EU countries have been more vulnerable than others, reflecting

differences in current account positions, exposure to real estate bubbles or

the presence of a large financial centre. Not only actual economic activity has been

affected by the crisis, also potential output (the level of output consistent with full

utilisation of the available production factors labour, capital and technology) is likely

to have been affected, and this has major implications for the longer-term growth

outlook and the fiscal situation. Against this backdrop this chapter first takes stock of

the transmission channels of the financial crisis onto actual economic activity (and

back) and subsequently examines the impact on potential output

The financial crisis strongly affected the EU economy from the autumn of 2008

onward. There are essential three transmission channels:

• Via the connections within the financial system itself. Although initially the losses

mostly originated in the United States, the write downs of banks are estimated to be

considerately larger in Europe, notably in the UK and the euro area, than in the

United States.

According to model simulations these losses may be expected to produce a

large contraction in economic activity. Moreover, in the process of

deleveraging, banks drastically reduced their exposure to emerging markets, closing

credit lines and repatriating capital. Hence the crisis snowballed further by

restraining funding in countries (especially the emerging European economies) whose

financial systems had been little affected initially.

( ec.europa.eu/competition/publications/cpn/2009_1_3.pdf - ec.europa.eu/economy_finance/publications/publication16055_en.pdf)

With real GDP expected to contract this year by around 4% on average in the EU,

this recession is clearly deeper than any recession since World War II, as noted in

In general recessions that follow financial market stress tend to be more

severe than 'ordinary' recessions, mostly because these are associated with house price

busts and drawn-out contractions in construction. The decline in consumption during

recessions associated with house price busts also tends to be much larger, reflecting

the adverse effects of the loss of household wealth. Output losses following banking

crises are two to three times greater and it takes on average twice as long for output

to recover back to its potential level (But also in comparison with other financial and

real-estate crisis driven recessions in the post-war period it is relatively severe.

The extent to which the financial crisis has been affecting the individual Member

States of the European Union strongly depends on their initial conditions and the

associated vulnerabilities. The financial crisis has hit the various Member States to a

different degree. Ireland, the Baltic countries, Hungary and Germany are likely to

post contractions this year well exceeding the EU average of -4%

By contrast, Bulgaria, Poland, Cyprus and Malta seem to be much less

affected than the average.

The fiscal costs of the financial crisis will be enormous. A sharp deterioration in

public finances is now taking place. The decline in potential growth due to the crisis

may add further pressure on public finances, and contingent liabilities related to

financial rescues and interventions in other areas add further sustainability risk.

Part of the improvement of fiscal positions in recent years was associated with

growth of tax rich activity in housing and construction markets. The unwinding of

these windfalls in the wake of the crisis, along with the fiscal stimulus adopted by EU

governments as part of the EU strategy for coordinated action, is likely to weigh

heavily on the fiscal challenges even before the budgetary cost of ageing kicks in

(which will act as a source of fiscal stress in its own right). Against this backdrop, this

chapter takes stock of the short-run fiscal developments and analyses the forces that

have shaped them. It also looks at the implications for interest rate differentials


An issue of major concern is that public indebtedness is rapidly increasing.

This is the case not only because fiscal deficits are (normally) debt financed, but also

because governments have implemented capital injections in distressed banks and

granted guarantees that are debt financed (the latter only if and once guarantees are

exercised) and yet do not show up in the budget balance since they do not entail

public expenditure on goods and services in a national accounting sense. As indicated

in Graph II.3.5, by historical standards the expected increase in public debt - about

20% of GDP from end 2007 to end 2010 - is typical for a financial crisis episode.

However, what is concerning is that the jumping-off point is considerably higher (by

up to 30 percentage points), and that the debt increase coincides with the onset of the

ageing bulge in public (health, pension) expenditure. As discussed in more

detail below, a sharp deterioration of the sustainability of public finances can be

expected even before the budgetary cost of ageing is taken into account, with the

likely decline in long-term growth due to the crisis along with contingent liabilities

related to financial rescues adding further pressure.

As we can see in Graph II.3.6, the largest increases in public debt are projected for

those Member States which also record the biggest increases in fiscal deficits, i.e. the

United Kingdom, Spain, Ireland and Latvia. However, owing to their more favorable

starting points, these are not the Member States that are projected to post the highest

rate of public indebtedness, which remain Italy, Belgium and Greece

Recovery policies

The European Union is continuously evolving, although its driving rationale has

always been the need for coordination of policies, including of economic policy.

Coordination is seen as beneficial if a common interest would otherwise not be

appropriately served, if there are economies of scale and scope, if behavior of

individual actors has significant spillover effects on other actors or if there are

important learning benefits to be reaped. These rationales apply strongly to crisis

management policies in the EU. For expositional purposes it is useful to make a

distinction between:

• 'Vertical' coordination between the various strands of economic policy (fiscal,

structural, financial) and their timing - while always respecting the independence of

monetary policy as essential for its effectiveness and credibility.

• 'Horizontal' coordination between the Member States to deal with cross-border

economic spill-over effects, to benefit from learning effects in economic policy and to

draw benefits from external leverage in relationships with the outside world.

Vertical coordination serves not only to select the appropriate set of policy

instruments but also to manage policy interactions and trade-offs. Financial rescue

packages entail uncertain costs that depend on the future recovery rates of risky

assets, while the slump is protracted that present itself to the policymakers with a lag.

There is an inherent trade-off between financial sector rescue packages and fiscal

stimulus. On the other hand, both fiscal and monetary stimulus can buy time for banks

to consolidate their balance sheets. Fiscal measures help to reduce losses for banks as

they improve their clients' financial situation, while monetary measures facilitate

access to liquidity. Even so, macro stimulus can only be temporary and therefore it is

necessary to start financial market restructuring early. Another complicating factor is

that crisis policies involve multiple policy actors, which also calls for coordination.

Specifically, at each of the three stages - crisis control and mitigation, resolution

and prevention - support for the financial sector involves actions by the regulatory,

monetary and fiscal authorities: • At the crisis control and mitigation stage monetary

authorities provide liquidity injections, implement interest rate cuts and may modify

collateral rules. Regulatory action includes e.g. bans on short selling while fiscal

measures include the increased guaranties on private deposits, bailing out or

nationalizing troubled institutions or relieving debtors' burdens. The purchase of

securities in order to increase liquidity may be carried out by the monetary

authorities, but ultimately commits the fiscal authorities with possibly relevant

implications for fiscal sustainability and macroeconomic stability.

• Crisis resolution measures aimed at the financial system include capital injections, wider guaranties and separating toxic assets from healthy ones imply the fiscal

authorities along with massive intervention by monetary authorities. Dependent on

the severity of the financial crisis policy action may involve non-conventional

intervention, with fiscal authorities taking large shares in private companies and

monetary authorities lending directly to the private sector. Crisis resolution may also

involve changes in the ownership structure of the financial industry. The

restructuring process may start with occasional bankruptcies in the early stages of the

crisis followed by a wave of mergers and acquisitions. But such events are only the

first steps towards systemic consolidation and restructuring, which also requires a

renewed regulatory framework. Management of toxic assets by a 'bad bank' can be

part of this restructuring effort, though the technical difficulties make it slow to

implement (especially when in involves cross-border activities and

ownership structures). Fiscal and monetary authorities thus replace or augment the

private sector in some functions. The fiscal authorities may also embark on brokering

deals of takeovers between financial institutions, owning private firms or by lending

directly to non-financial enterprises.

• Policies to prevent repetition of crises are central to the

crisis response a heavily interact. Fiscal policy geared towards the

sustainability in public finances will need to focus on expenditure control, although

tax increases are probably unavoidable. To the extent this is the case, it is important

that good principles of optimal taxation -- to limit distortions, tax arbitrage and

undesirable distributional effects -- be respected. This may raise issues for structural

policy, e.g. due to the heavy interaction between tax and social benefit systems or the

implications for business location choices. Similarly, expenditure restraint would need

to focus on items that are distorting and inhibit economic efficiency and growth,

while creating room for growth friendly government spending such as for education

and innovation. More generally, the 'quality of public finances' along with its

quantitative aspects, is of eminent importance. (ec.europa.eu/...finance/.../article_8885_en.htm,ec.europa.eu/.../een/.../article_8887_en.htm)

Fiscal policies:

All considered, and certainly when taking into account the relative size of the

economies of Member States, the distribution of fiscal stimulus efforts is broadly in

line with the distribution of their needs in term of absorbing slack and with the

distribution of their ability to implement fiscal stimulus - i.e. without running into

severe problems with regard to the sustainability of their balance of payments or

fiscal position. But obviously this conclusion is predicated on the assumption that

the fiscal stimulus packages are indeed temporary and will be fully reversed at the

appropriate time when the economy recovers. If not, there is a danger that fiscal

policy will undermine the sustainability of public finances, notably if the recovery is

slow and potential output growth is slow as well . This outcome

could imply higher long term interest rates, and thus crowd out capital formation and

innovation and complicate the recovery of the financial system. Distortive and jobs-

unfriendly tax increases may then be unavoidable at some stage, which would in turn

weigh again on potential growth.

In some ways the financial and economic crisis has many features in common with

similar financial stress driven recession episodes in the past. It was preceded by

relatively long period of rapid credit growth, low risk premiums, abundant

availability of liquidity, strong leveraging, soaring asset prices and the development

of bubbles in the real estate sector. Excessive leveraging and the spreading of the

associated risk via securitization rendered financial institutions very vulnerable to

corrections in asset markets. As a result, a turn-around in a relatively small corner of

the financial universe (the US subprime market) was sufficient to trigger a crisis that

toppled the whole structure. Such episodes have happened before and the examples

are abundant (e.g. Japan and the Nordic countries in the early 1990s, the Asian crisis

in the late-1990s). The difference with these earlier episodes, however, is that the

current crisis is global. This has at least one major implication for economic policy:

devaluation or other 'solutions' that seek to 'export' the economic effects of the crisis

to neighboring countries which always risk backfiring - are now potentially

extremely dangerous. This is one reason why observers find it appropriate to compare

the current crisis to the 1930s Great Depression. It should be noted,

however, that, while it may be appropriate to consider the Great Depression as the

correct benchmark from an analytical point of view, it has also served as a great

lesson. At present, governments and central banks are well aware of the policy

mistakes that were common at the time, both in the countries that now constitute

the EU and elsewhere. Deposit insurance schemes have avoided large-scale bank

runs and efforts are being made to recapitalize banks or guarantee their liabilities so

as to safeguard their solvency. Monetary policy has been eased aggressively,

complemented with 'quantitative easing' to ensure that liquidity is plentiful. EU

governments, akin to their counterparts elsewhere, have released fiscal stimulus in an

effort to hold up demand and to provide the hardest hit groups with temporary

income support or job protection. And, unlike the experience during the Great

Depression, countries have not, or at least not massively, resorted to protectionism

or other beggar-thy-neighbour policies, which is a very important achievement.

(www.un.org/regionalcommissions/crisis/impact.pdf- www.globalissues.org/.../global-financial-crisis, unstats.un.org/unsd/nationalaccount/workshops/2009/.../AC202-S64)

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