The European sovereign debt crisis occurred with a subprime crisis which started in 2007 in United States of America, with a “bubble” in the real estate devaluation. It is known for a “bubble” since it had repercussions throughout the economy. It happened when people had bought many houses in the real estate market by means of mortgage loans, but these houses had devalued and banks were led into a situation of insolvency. In order to correct the situation, American banks sold these mortgages to European banks that bought expecting them to valorise their systems, but these were “toxic” assets which affects negatively and deregulated the European banks, so a real estate crisis became a bank crisis. In summary, this bank crisis was motivated by unrestrained concession of real estate loans, as well as by failures in the regulation of the financial system that allowed a transfer of the mortgage credits risks to other counterparts.
Following the banking crisis, banks held many titles of sovereign debt and the risk was that the bank’s debt contaminate the sovereign debt and these “toxic” assets contaminate other financial assets that affect the state and created a propagation effect.
The rating agencies began affirming that the states would not pay the creditors, interest began to rise, and the assistance appears. The markets fear that states did not pay sovereign debt. The first country to need help was Ireland. They needed the Troika intervention. It was composed by financial institutions such as the European Central Bank (ECB), the International Monetary Fund (IMF) and the European Financial Stability Facility (EFSF). Ireland was not the only country needing help, Portugal and Greece were the followed.
Remember the Portuguese case, in May 2011, without the possibility of going to the market to get money, they failed to repay or refinance their public debt since they did not have access to the monetary assistance and within an economic crisis and high interest, Portugal had Troika’s intervention. The banks did not grant credit and the market crisis became an economic and credit crisis. The unemployment went high, reached its maximum, in 2012, with 17.5% and it was the point when the economic crisis became social. In 2012, the Portuguese President said they would be in a “recessive spiral”, the GDP decreased, the unemployment increased, the public expense increased with unemployment subsidies and the deficit increased. Briefly, with excessive amount of sovereign debt, lenders had demanded very high interest rates from Euro zone countries with elevated levels of debt and deficit, making it more difficult for these countries to finance their budget deficits when faced with low overall economic growth. Some countries have raised taxes and reduced expenses to combat the crisis, which has contributed to social suffering within their borders and a crisis of confidence among their leadership.
Related to the monetary capacity of each country, the effective exchange rate (REER) concept is the weighted average of a country’s currency against an index of other currencies, adjusted for the effects of inflation. This is an important measure when conducting economic analysis and policy making possible to a country to positively affect its REER through rapid productivity growth. Thus, the country has lower costs and can reduce prices, making REER more advantageous. When this happens the country’s trade capacity increases, and their current import and export situation will present better results.
In Europe, the European Central Bank (ECB) doesn’t change currency and the countries do not have this instrument, but when the euro valorise, these damages the poorer countries in their trade balance, leading to an asymmetry between the European countries.
When the economy was with inflation, in order to correct the indicator, the countries should devalue the euro to cancel out the effect and bring down prices to sell more and export more. If the adjustment is not made by the currency, another possibility is by the real market, with lower wages. The industry that has left Europe in the direction of East, Southeast Asia and Africa goes out in search of cheap labour. It raises unemployment, the prices fall, and consumers do not buy, firms accumulate stock because they cannot sell to the domestic market, so the solution is to divert this stock to the foreign market. This performance will allow to increase exports and decrease imports, improving the commercial balance, this situation only results if companies sell their surpluses.
ECB has no objectives in fighting against deflation, it focuses a lot on inflation rate, and European countries belongs to the ECB the monetary policy, the currency instrument, and the currency sovereignty had been lost and this lost hasn’t been compensated in the European plan. Deflation is a negative decline in prices, unlike disinflation which is a slowing of inflation rate. The worrying thing is when the deflation becomes disinflation. With inflation that is a generalized increase of prices, the exports become more expensive and decrease their value because countries like China sell cheaper. Countries cannot correct their trade balance because they cannot change the value of the currency, devalue it to increase exports, and thus correct the deficit, or decrease imports by valuing the currency because they are more expensive.
Following the above mentioned subprime crisis, economy should recover according, but some countries stay in secular-stagnation. This means that a sustained slowdown in economic growth, with very low investment. Economies of the world suffer from an imbalance resulting from an increasing capacity for economy and a decrease in the propensity to invest. The result is an excessive economic act on demand, reducing growth and inflation and the imbalance between saving and investment decreases as real rates. Demography also partly explains why the investment is so low. Population growth means that people need more things, which means low demand and companies invest in new workers and equipment. Slower growth in the workforce means slower overall growth and if there are fewer employees to hire. An example is the US economy that has not presented the expected growth results, in the GDP and in the employment rate, it presents a slow recovery of the economy.
NOVA SBE – MACROECONOMIC ANALYSIS # 801 4th DECEMBER 2017