A Vicious Cycle in the Euro Area

One day, markets are up immediately after some EU summit but back down again just hours later.  Another day, Spain asks for a bailout because its banks have reached the point where they might fail, all while Greek voters are hitting the streets to protest drastic spending cuts and austerity measures that are meant to fix a seemingly unfixable problem. 

With many players and many problems, it can be a daunting task to make sense of it all.  It is true that the challenges in Europe are very significant, and it is true that these challenges and their outcomes affect all of us, all around the world.  So, let us try to make some sense of what is basically happening in Europe.

At the core of the euro area crisis is a story of high debt, low income growth, and fear.  This fear is based on whether or not the high debt of some euro area countries can even be paid back.  Since many of these countries are running government deficits as they struggle to keep their low growing (or shrinking) economies afloat, their debt is increasing and in turn adding to the fear and perceived riskiness of that debt.  This feeds into a vicious cycle where the riskier the debt is perceived to be, the more expensive it is to borrow and raise more debt, making it more difficult to finance the deficits, putting even further strain on the growth prospects of the economy and its competitiveness. 

On the one hand, income and GDP need to grow to revive the economy and instill confidence that debt can be repaid.  On the other hand, government deficits need to shrink and eventually disappear by making the right adjustments (austerity) to slow down and reverse the total stock of debt.  Herein lies the debate among policymakers between austerity and growth: Should policymakers place their priorities on fiscal adjustments and austerity measures to bring down government deficits (largely by spending cuts), or on growth enhancing measures that may require additional spending? 

As members of a monetary union, the euro area, these countries cannot use national monetary policy to try to jumpstart their economies for income growth, and their already high debts and deficits make it hard to use fiscal policy to jumpstart income growth.  Typically when times are tough, countries can turn to their central banks to take steps to devalue their currencies so that their goods can become cheaper to foreigners who would then have stronger currencies – a classic scenario where a country seeks to improve competitiveness of its exports.  There are other forms of monetary stimulus that central banks have in their toolkits, but in a monetary union where a central bank and a currency is shared across countries, it is not possible to do this.  Therefore, these countries need to turn to fiscal policy, but with already high deficits, increasing debts, and growing fears around the riskiness of government debt, as described above, fiscal stimulus is also very difficult to do. 

This predicament makes it very difficult for these governments to find ways to help their economies start growing again and to find funding for their short term obligations (older debt that is becoming due, public spending on employee wages and government funded programs).  Financial markets realize this and see what kind of trouble these governments are in and how risky it is lend to them.  This perceived risk by the markets is shown by the very high bond yields on these government bonds, which then make it even more expensive for these governments to raise funds in the market to finance their existing deficits that they are trying to bring down.  As described above, the vicious cycle of debt, low income growth and fear exacerbates the predicament.

This is the main story behind the euro area sovereign debt crisis.

In a highly interconnected world, problems in Europe can have significant spillover effects to large parts of the world through trade and financial channels.  A slowdown in Europe can hurt developing countries across Africa and Asia that export to Europe.  The European Union as a whole, and the euro area as a subset, is the largest trading partner of the United States.  As we have seen in late 2008, financial markets are tightly interlinked all across the world.  A banking crisis in Spain and Ireland can have the potential to spread far beyond Europe.  Europe as a whole is the largest economy in the world, and a deteriorating crisis there would inevitably find ways to affect us all.

To get an idea about the problems of the specific countries (Greece, Ireland, Italy, Portugal, and Spain), take a look at The Geography of the Euro Crisis.

To get an idea about has been done to try to solve the crisis and fix the euro area, take a look at The Monetary Union and Its Survival

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2 comments

  1. […] Reading inbetwen the lines, “whatever it takes” means that the ECB is prepared and willing to buy sovereign bonds/debt of the troubled euro area countries.  This would take the bonds off the hands of worried banks and investors that already own those bonds, alleviating a lot of fear, and would lower the perceived riskiness of those sovereign bonds since the ECB would step in.  This would put a lot of the financing pressure off the distressed governments that have been caught in the vicious cycle. […]

  2. […] problems that can threaten the credibility of the union as a whole and its common currency. (See A Vicious Cycle in the Euro Area for more […]

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