What caused this crisis??
17 member-Euro area today is going through its worst times. Unemployment is high at an average of 11.5% in the member nations. Productivity levels are low and Euro is not performing with respect to other currencies. Debt-GDP levels, and government deficits are on unacceptable levels as per the rules (60% Debt-GDP ratio and 3% budget deficit mandate) of the euro-zone. The GDP growth rate is in negative 0.20 (-0.20) % as countries contract on the back of reduced production and demand for its products. "Euro" as a currency in the mid of all this is not looking in good shape. Let us see how it all happened.
In the early 2000s till 2006-07, World went from a period called as "Globalization of Finance" wherein easy lending and borrowing was the norm. Housing therefore became an easy target for the lenders and investors. Nobody knew that there was a bubble building up with incorrect valuations. Money started flowing in the developed markets from the developing markets due to financial innovation of the products such as fixed-income securities/Bonds that assured a return to the investors. Such "sovereign" bonds invited money from other nations through capital market route, which was highly risky. The World and especially Euro-area, was now going into a state of "financial contagion" where-in every bank/agency owed money to other(s).The countries used this money for public spending and financing housing projects. Ireland used it for housing to only create a housing bubble. Greece used this money to double the wages of its workers and introduce more pensions. So by now, easy lending had increased the debt of these nations. Now what?? They could have either went for QE (Quantitative easing) or printing money (Which they can't do as per the euro-area norms) or hiding it and restoring confidence (which they actually did) and thus deceiving world investors. The risks were further diluted as the products such as CDOs or collateralized Debt Obligations and CDS (Credit default swaps) came from the investment banks of the US. Actually even today nobody knows how many of these credit derivatives, Euro-area is exposed to.
When the 2008 global financial crisis came and the world went into a recession, euro-area, especially Greece, finally had to admit huge debt and deficit levels. The yields on those government bonds increased to unimaginable heights as Prices came down drastically. In 2010, EFSF (European Financial Stability Facility) was created to bail-out Greece.
Current situation & Structural problem -
Euro-area has a structural problem. When it was created in 1999, it was decided that the region will have a common monetary union and ECB (European central bank) to control inflation only (single mandate). The states were allowed to formulate their own fiscal policies (such as taxation rules, pensions and other public expenditure) but not monetary policies. So different countries with different people, work ethics, production power, consumption levels, trading partners, innovation capability, credit worthiness were all grouped under the same heading "Euro-area" with a common currency "Euro". So now when one country does something and exposes itself to world's financial markets, it was exposing other member states as well because of a common currency. Any appreciation or depreciation affected the balance sheets and profit and loss accounts of other nations too. It also thus created trade imbalances in many countries in the euro-area. During default another issue came out which was a lack of any Banking Union that would take action in case of bank runs or during recapitalization (as happened US). Such a body in euro-area would have helped gain investor's confidence in case of defaults. Efforts to kick start the economy by increasing production in the infested states have met failures as the money has been used in driving consumption and not production.
What a grim situation is this. Consider this - You are president of any one of the PIGS countries. You know that there is a social unrest due to high unemployment, high taxes and reduced public expenditures (to reduce deficits and cover debts), high austerity measures, reduced confidence of global investors, low production levels, no official body to bail-out banks and above all No room for getting fresh notes, as you don't have the right. In the mid of all this, 16 more members are there to decide for you which only adds to delays.
Way forward -
Now after so-many initiatives and efforts, Euro-zone is trying to stay on-board. After bailing out Greece in 2010 and again in October 2011, through EFSF route, Euro-area is considering other options such as ESM, EU-FTT, EFC and Balance budget amendment for its future path in an effort to save Euro from collapsing.
ECB has already provided loans to hundreds of Euro-area Banks at a nominal interest rate of 1% to boost lending and improve depositor and consumer's confidence. Recently European Members in June decided to provide European Investment Bank easy funding to boost the infrastructure spending on promising projects. Another mechanism, EFC (European Financial compact) or TSCG (Treaty on Stability, Co-ordination, Governance in Economic and monetary union), which would come into effect from 1 Jan 2013 would require countries to exercise some serious steps where-in the structural deficit can't be more than 0.5%(if the Debt-GDP ratio has overshot 60% limit) or else a maximum of 1%. They should also include the Balance Budget law in their constitution/laws which would mandate that their expenditure can't be more than their income. Clearly such austerity measures will further stop growth activities and the GDP growth rates are not expected to go beyond 1-1.5% on an average for the Euro-area in the coming year. However a good news here is that the ratifying countries will be eligible to sign for ESM (European stability mechanism),which is designed to Recapitalise banks, provide primary and secondary market support facility along with the loan/bailout requirements. EU FTT (European Financial Transaction Tax) is all set to come into effect by 2014 where 0.1% FTT would be levied on Financial transactions. It would be a source of income for the Euro-Banks that are currently reeling under tremendous pressure. The burden will be passed to consumers ofcourse.
Let's see where does the "Euro-area" go from here....and specially "Euro" :-p
signing out -GuruBussi