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ESSAY : SOVEREIGN DEBT CRISIS AND THE LESSONS
Thursday, 10 July 2014 04:30



SOVEREIGN DEBT CRISIS AND THE LESSONS

 

Introduction

Hailed as the “Celtic Tiger” for the rapid growth of its economy, in the space of three years the Irish Republic has gone from boom to bust. Much of its growth was built around the property market, but since 2008 this has suffered a dramatic collapse. Since the onset of the global financial crisis from mid- August 2008, house values have fallen by between 50% and 60%, and bad debts - mainly in the form of loans to developers - have built up in the country's main banks. This almost wrecked the institutions, leaving them needing bailing out by the government at a cost of 45bn Euros (£39bn; $60.1bn). This has opened a huge hole in the Irish government's finances - which will see it run a budget deficit equivalent to 32% of GDP this year.  Another challenge facing the country is the very sharp deterioration in tax revenues. The fiscal deficit- gap between what the government spends on public services and what it receives in tax revenues- is a substantial (and unsustainable) 12% of GDP.

The economic crisis and its spread to Euro Area

The economic crisis in the form of sub-prime crisis that surfaced in late 2007 in the United States and thereafter engulfed the whole world, more especially the developed world, has bottomed up. Developing countries led by China and India have responded well to the crisis and their economy is in the recovery mode. Yet the dangers remain of a “double-dip” recession. This is because of, firstly, inadequate fiscal stimulus in the US that has not been able to cure the problem of unemployment, and secondly, the sovereign debt crisis in the European Economic and Monetary Union (EMU) that has followed the global financial crisis.

The sovereign debt crisis of the EMU first started in Portugal and Spain. It slowly spread to Italy albeit in milder form and then affecting the Greece economy most severely has now spread to Ireland. The crisis has raised the dangers of “double-dip” recession and the possible contagion effect.

Though Europe initially appeared to be an innocent bystander, the Great Recession quickly implicated it, exposing vulnerabilities similar to—but in many cases worse than—those in the United States. In a few countries such as Ireland and Spain, housing bubbles even larger than the one in the United States had inflated and burst, and banks were taking excessive risks. As we argued above, compared to the United States, Europe depended more on banks, manufactures, and construction, and its private sector was slower to respond, all of which help explain the deeper downturn. But the crisis also exposed a set of vulnerabilities entirely unique to Europe and to its Euro area in particular—namely, a secular loss of competitiveness and fiscal vulnerability in Greece and other countries that had adopted the single currency a decade earlier. In hindsight, Europe had a loaded gun aimed at it from the outset of the crisis, even if the trigger happened to have been pulled from across the Atlantic.

The Greek disease affected a significant number of countries, including large Euro area economies like Italy and Spain, as well as smaller members like Ireland and Portugal.  Newly acceding non-Euro area countries whose exchange rates are officially tied to the euro, such as those in the Baltic and Bulgaria, and countries whose ability to devalue is impaired by large foreign currency liabilities, such as Hungary and Romania, were also infected. Together, these countries account for about one-third of European Union GDP. The disease manifested itself somewhat differently across these countries. In some, such as Greece, Spain, and Ireland, the economy grew too rapidly on the back of consumer and housing booms, ample credit, and immigration surges, and ran unsustainable current account deficits. In others, such as Italy and Portugal, the economy depended too much on sluggish domestic (non-tradable) activities. In most, government spending expanded too rapidly amid unsustainable fiscal revenues. The surge in government indebtedness was particularly large in Ireland, mostly due to the massive banking crisis and bailout there.

The market punished all of these disparate countries in similar ways, however, by demanding much higher yields on their government debt. Remedies will be painful across the board. To restore competitiveness and put their fiscal accounts in order, they will have to face a deflationary adjustment over many years, during which they will remain vulnerable to a variety of internal and external shocks.

The recent European experience shows that the macroeconomic policy and sovereign debt of the world’s richest countries are now subject to just as much market scrutiny as are those of developing countries. No country is exempt.

However, the most important lesson for Europe to draw from its experience is that even within a monetary union, divergences between countries in competitiveness and external balances matter greatly. Even when the source of the external imbalance originates in the private sector, the cost of correcting it can eventually spill over into the public sector and threaten fiscal sustainability. The problems such divergences entail are compounded in the absence of pooled fiscal resources and other conditions necessary to adapt to shocks within a monetary union—most importantly flexible labour markets and international labour mobility. Though labour can move freely within the European Union, in practice intra-European migration is small.

Conclusion

The economic crisis included 5 major surprises. These are

(a) the severity of the global trade and output collapse,

(b) milder than expected recession in the US,

(c) the onset of a severe sovereign debt crisis in the Europe,

(d) the extraordinary growth witnessed in China after the recession, even though it is a major exporting country, and

(e) remarkable resilience shown by the Latin American countries.

The economic crisis holds some important lessons for the policymakers. It ranges from the need to rein in unbridled risk taking in the financial sector to the importance of a vigorous response from the private sector to the crisis, and to the importance of re-establishing sound macroeconomic fundamentals. Beyond the generally applied lessons, the surprises also hold lessons for specific region, notably the need for reforms to strengthen the institutional mechanism underpinning the Euro area.

While the governments world over reacted quickly and appropriately with stimulus measures and bank rescues to prevent a descent into depression, they unfortunately have not acted forcefully enough on the lessons emerging from the five surprises. In particular leaders have failed to enact the structural and regulatory reforms needed to protect the world against the next crisis.



 

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