The European Monetary Union and the Current Debt Crisis

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    The European monetary unionthe current debt crisis: developments, trends, policy responses

    and future prospects1/23/2012

    Prof. P. Aganidis

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    European Institutions Marianna Retzi

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    The European monetary union and the current debt crisis: developments, trends, policy responses and

    future prospects.

    The idea of the European Monetary Union (EMU) did not start just a couple of years before the

    introduction of the Euro. On the contrary, it existed as a vision since the 1960ies. In 1970 a committee

    was set up, headed by Luxemburgs Prime Minister Pierre Werner, in order to figure out how the EMU

    could be formed by 1980. Finally, the European Monetary System (EMS) was created in 1979 together

    with the European Currency Unit (ECU) which was nothing more than the weighted average of all the

    countries participating in the EMS. This was one of the step stones into looking further into how a

    monetary union could also be achieved. In December 1991 the Maastricht convergence criteria were

    agreed upon, namely: a) inflation rate no higher than 1.5%, b) maximum percentages on government

    deficit (3%) and debt (60%), c) members of the EMS and the exchange rate mechanism for at least two

    years and d) interest rates no higher than 2%. In 1998 the European Central Bank is created and on

    January 1999 the Euro is introduced into the Central Bank system (in a non-physical form). This is when

    the European Union further established itself as a new global player. The new Euro coins and notes were

    introduced on January 1st 2002 .1

    The creation of a common currency signified the beginning of a unified monetary policy for the

    participating countries. By joining the Euro a country is privy to many advantages but also

    disadvantages. The elimination of currency exchange rate costs is greatly advantageous to businesses

    since they do no longer face the risk of exchange rate fluctuation, thus making investments much easier

    for them. With price transparency businesses can become more competitive and consumers can

    compare prices of products across the countries of the euro-zone. The common currency also provided a

    1ECFIN

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    boost to tourism since crossing the border does no longer mean incurring the cost of exchanging

    currency. Combining all of the above, it is apparent that the Euro is a currency strong enough to

    compete against the US dollar and the Japanese Yen. Currently, the Euro-zone, with population of 331.9

    million2 people, is the area with the largest population that has a common currency, closely followed by

    the US and the dollar with a population of 312.8 million3 and Japan with 127.08 million4. The Euro is a

    new hard currency with high bargaining power.

    However, the main disadvantage of the common currency is that the countries participating had to

    give up control of their monetary policy. Adjusting ones interest rate in order to attract investments, for

    instance, is no longer an option since interest rates are set by the European Central Bank. Needless to

    say, devaluating ones currency in order to adjust the exchange rate is out of the question. Apart from

    the common monetary policy, the control of over the individual countries fiscal po licy imposed by the

    Stability and Growth Pact5

    makes it more difficult for governments to be flexible with their budgets

    when they need to spend money in order to overcome economic difficulties (feed their economy with

    money through government spending in order to encourage spending). Governments have no longer in

    their policy toolkit any stabilization tools resulting in weak economic governanance.

    But did we, with the creation of the European Monetary Union, forget the goal of political

    integration? A year before the creation of the European Central Bank, in 1997, Giscard d Estaing and

    Helmut Schmidt were quoted saying in the International Herald Tribune: One must never forget that

    monetary union, which the two of us were the first to propose more than a decade ago is ultimately a

    political project. It aims to give a new impulse to the historic movement towards union of the European

    states. Monetary union is a federative project that needs to be accompanied and followed by other

    2TGM

    3US & World Population Clock

    4Japan

    5ECFIN

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    steps.6Europes Monetary Union is something that aims to bring the members of the EU a step closer

    to their political union. A future common fiscal policy (which seems to be becoming more and more

    likely) will bring the countries even closer to this goal. A common currency means giving up part of the

    member-countries national sovereignty. In order to achieve political convergence the EU nations will

    need to give up an even bigger part of their national sovereignty. In a matter of speaking, the monetary

    union is preparing the EU countries for giving up a greater part of their sovereignty in the future.

    The last couple of years though, things do not seem that optimistic. The European Monetary Union

    has been lately facing maybe its biggest crisis of all times. It is not only the biggest but a unique crisis,

    since it is sort of a triple crisis because it is financial (banks), economic (affects GDP and

    unemployment) and debt (inability to refinance a countrys debt). There have been hints of a debt crisis

    since 2009, maybe as early as September 2008 when the Irish government announced its first recession

    since the 80ies.7

    Then followed Greece in 2009 with its inability to be consistent with its debt

    obligations, because of increased government spending. And things followed from there like a domino

    effect. Next up was Portugal with its own sovereign debt crisis. Things are bound to go south in other

    European countries as well. Italy, a member of G8 and G30 has been facing problems since the mid of

    2011. There is a problem and it seems to be quickly spreading and affecting not only the smaller

    countries of the European Union, but also countries such as France. (Figures 2, 3, 4) Was Henry Kissinger

    right in saying in The Sun in 1998 that It is difficult to see how monetary union can succeed?8 Is the

    contagious effect of the current debt crisis going to bring the European Monetary Union to its knees?

    It might not have a devastating effect on the EMU but it will certainly bring many changes to the

    countries individually and the European Union itself. We have been observing that in Greece and Italy

    there has a been a new type of governance with interim presidents and prime ministers in order for

    6Excerpt

    7CSO

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    measures against the current debt crisis to be enforced. Appointing a prime minister without election in

    democratic states was unheard of before the current situation. Another change is that through loans

    and other types of financial aid from third parties, such as the International Monetary Fund, countries

    are bound by contracts to form their policies according to guidelines named in said contracts. In

    essence, there is a direct involvement of third parties (whether they are countries or international

    organizations) in the governance of sovereign nations. Apart from the changes that have taken place

    affecting individual countries the current debt crisis is bound to have a profound effect on the structure

    of the European Union itself as well as the laws and policies governing it. There have been talks and

    rumors about the creation of a multi-speed Europe or two-speed Europe, namely the northern and

    the southern members of the EU, based on the strength of their economies.

    Apart from the political part of the EU, the structure of the Europes monetary union will most likely

    change. Having a common monetary policy (which as mentioned before severely limits state members

    reactions to crises such as the current one) which is has proven to be highly rigid and unable to react to

    the debt crisis, accentuates the need of a common fiscal policy too. Since such a change cannot happen

    overnight though, the first crucial step would be to strictly enforce the Stability and Growth Pact

    according to which budget deficits need to be less than 3% and debt should not exceed 60% of GDP.

    Even though the Pact exists a big number of countries (Figure 2) does not abide by it and there have

    been no consequences. Strict enforcement of the Stability Growth Pact, together with some

    complimentary rules and regulations, could eventually bring the European Union closer to a common

    fiscal policy. As it was previously mentioned the convergence of the EU member states on both financial

    and monetary policies will eventually bring political integration.

    The current debt crisis is now said to be of equal magnitude with that of 1932. Still, nobody was

    prepared for such a shock of such magnitude in the European economy and consequently there was an

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    absence of any defense mechanism to prevent such an occurrence or of support system in order to aid

    countries of the European Union found in such a situation. The first signs of structuring such systems

    were seen when the debt crisis in Greece took place. Even though it took some experimentation, it

    seems that there is currently a clearer picture on what needs to be done in the future in cases like the

    one we are currently facing. It is certain that in the near future safeguards will be put into place in order

    to avoid future occurrences of the same issue, through regulatory reforms.

    Unfortunately, it seems that such a debt crisis was needed in order to undermine the architecture of

    European Monetary Union and bring forward both short- and long-term changes in the European Union

    and European Monetary Union. It is certain that Europe will come out stronger out of this situation. In

    the same manner that diamonds are formed in areas of immense temperature and pressure, will the

    member states of Europe and the European Union itself come out unified and become an even more

    formidable player in the worldwide economic and political scene.

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    Appendix

    Figure 1

    Which countries have adopted the euro and when?

    1999Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, the

    Netherlands, Austria, Portugal and Finland

    2001 Greece

    2002 Introduction of euro banknotes and coins

    2007 Slovenia

    2008 Cyprus, Malta

    2009 Slovakia

    2011 Estonia

    Source:http://ec.europa.eu/economy_finance/euro/index_en.htm9

    9

    ECFIN

    http://ec.europa.eu/economy_finance/euro/index_en.htmhttp://ec.europa.eu/economy_finance/euro/index_en.htmhttp://ec.europa.eu/economy_finance/euro/index_en.htmhttp://ec.europa.eu/economy_finance/euro/index_en.htm
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    Figure 2

    General Government Deficit (-) / Surplus (+), % General Government Gross Debt, %

    2004 2005 2006 2007 2008 2009 2010 2004 2005 2006 2007 2008 2009 201

    Belgium -0.3 -2.7 0.1 -0.3 -1.3 -5.8 -4.1 94.0 92.0 88.0 84.1 89.3 95.9 96.

    Germany -3.8 -3.3 -1.6 0.2 -0.1 -3.2 -4.3 66.3 68.6 68.1 65.2 66.7 74.4 83.

    Ireland 1.4 1.7 2.9 0.1 -7.3 -14.2 -31.3 29.4 27.2 24.7 24.8 44.2 65.2 92.

    Spain -0.1 1.3 2.4 1.9 -4.5 -11.2 -9.3 46.3 43.1 39.6 36.2 40.1 53.8 61.

    France -3.6 -2.9 -2.3 -2.7 -3.3 -7.5 -7.1 64.9 66.4 63.7 64.2 68.2 79.0 82.

    Italy -3.5 -4.4 -3.4 -1.6 -2.7 -5.4 -4.6 103.4 105.4 106.1 103.1 105.8 115.5 118

    Luxemburg -1.1 0.0 1.4 3.7 3.0 -0.9 -1.1 6.3 6.1 6.7 6.7 13.7 14.8 19.

    Netherlands -1.7 -0.3 0.5 0.2 0.5 -5.6 -5.1 52.4 51.8 47.4 45.3 58.5 60.8 62.

    Austria -4.4 -1.7 -1.5 -0.9 -0.9 -4.1 -4.4 64.7 64.2 62.3 60.2 63.8 69.5 71.

    Portugal -3.4 -5.9 -4.1 -3.1 -3.6 -10.1 -9.8 57.6 62.8 63.9 68.3 71.6 83.0 93.

    Finland 2.5 2.8 4.1 5.3 4.3 -2.5 -2.5 44.4 41.7 39.6 35.2 33.9 43.3 48.Greece -7.5 -5.2 -5.7 -6.5 -9.8 -15.8 -10.6 98.6 100.0 106.1 107.4 113.0 129.3 144

    Cyprus -4.1 -2.4 -1.2 3.5 0.9 -6.1 -5.3 70.9 69.4 64.7 58.8 48.9 58.5 61.

    Malta -4.7 -2.9 -2.8 -2.4 -4.6 -3.7 -3.6 71.7 69.7 64.1 62.1 62.2 67.8 69.

    Slovakia -2.4 -2.8 -3.2 -1.8 -2.1 -8.0 -7.7 41.5 34.2 30.5 29.6 27.8 35.5 41.

    Estonia 1.6 1.6 2.5 2.4 -2.9 -2.0 0.2 5.0 4.6 4.4 3.7 4.5 7.2 6.7

    Source : Eurostat Statistical- 2012 Edition Eurostat European Commission

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    Figure 3

    -35 -30 -25 -20 -15 -10 -5 0 5 10

    2004

    2005

    2006

    2007

    2008

    2009

    2010

    General Government Deficit (-) / Surplus (+), %

    Estonia Slovakia Malta Cyprus Greece Finland Portugal Austria

    Netherlands Luxemburg Italy France Spain Ireland Germany Belgium

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    Figure 4

    0 20 40 60 80 100 120 140 160

    2004

    2005

    2006

    2007

    2008

    2009

    2010

    General Government Gross Debt, %

    Estonia Slovakia Malta Cyprus Greece Finland Portugal Austria

    Netherlands Luxemburg Italy France Spain Ireland Germany Belgium

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