Unit 4 Macro: The Euro Zone Crisis (Revision)

Here is a revision blog on some of the key economic challenges facing the seventeen member nations of the Euro Zone or Euro Area

Europe needs more growth because it is exceptionally hard to emerge successfully from a debt crisis without achieving more growth first. Recovery from the 2008-09 recession has been weak and uneven. Some Euro Zone countries have done well - Germany in particular - but too many of the Euro Zone’s performers are suffering from semi-permanent recession and a fundamental lack of competitiveness

Governments cannot ignore signals from the bond markets. Soaring government bond yields have reflected the growing risk of sovereign debt default with Greece in the forefront of the crisis (the 2011 hair cut is a default by any other name) and Spain and Italy lurking in the background.

Banks hold a lot of sovereign debt so an endemic fiscal crisis leads to a highly fragile and vulnerable banking system which needs to rebuild their balance sheets and which will remain reluctant to expand lending - this limits ther scope for recovery - the credit crunch is not over.

Can the Euro Zone grow their way out of a debt crisis?

Deep and painful fiscal austerity can make the debt problem even worse and for many economists, defaulting on debt is inevitable because of the scale of fiscal austerity needed to cut debt - it is socially and politically unacceptable and it makes little economic sense. Cutting state spending and raising direct and indirect taxes simply takes demand out of already weak economies and causes the welfare bill to rise. This risks creating a spiral of economic weakness, deflationary pressures and high public sector debt.

Democratic institutions in southern Europe are not as well entrenched as in Western Europe. Greece has become dependent on the EU Commission, the European Central Bank and the IMF for their bail-outs - this is known as the Troika. Greece is likely to need a third bailout, of €50 billion, in 2015

Containing the debt crisis does not solve the debt crisis - politicians have spent most of 2011 and the early months of 2012 trying to buy time with bail-outs but unemployment continues to grow and real incomes are declining in many countries. A slowdown in some of the leading emerging nations will also hit export growth from the Euro Zone.

The European Central Bank (ECB) has attempted to relieve the liquidity problems of EU banks by providing them with loans available at very low interest rates. But it makes banks more profitable without having to lend it to real world businesses and consumers. Banks can simply borrow money at low interest rates and then buy high yielding government debt. There is little evidence that economically useful lending to businesses is growing, instead the banks’ exposure to government debt grows and makes the risks from default even higher.

Recession in the Euro Zone will clearly have a significant effect on the UK economy. Over 50% of our trade in goods and services is with Euro Zone countries so a descent back into recession wil be an external demand shock for Britain.

What might happen if the Euro Zone breaks -up and Greece and others default? If a country leaves the Euro Zone and devalues their currency - perhaps by as much as 40% - and the move succeeds then the pressure on the other weakner economies inside the single currency area to do the same will be huge.

The big issue is that too many of the countries inside the Euro Area are uncompetitive with fellow members of the single currency and increasingly uncompetitive with rapid growth countries to the East. The World Economic Forum recently ranked Greece below a number of developing economies, including Namibia, Rwanda and Chile in terms of international competitiveness.

Supply-side economic reforms to make labour markets more flexible, to lift productivity, control unit labour costs and stimulate innovation will take many years to have a major effect, by the time they do, the Euro Zone could be a shadow of the group of seventeen countries that entered with such optimism from 2001 onwards.