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Coping With Crisis

December 15, 2011

When the euro was created in 1999, it was seen as ushering a new age of European integration, as 11 countries would be now be using the same currency, making it easier for transactions to move across borders.  In the past decade, the euro has grown to 17 members, but the euro has also exposed the economic divisions among countries using the euro.  Since the global recession in 2008, many European countries (typically in northern Europe) have experienced recovers, while others (primarily located in southern Europe) have not seen their economies return to prosperity.  For instance, the German economy grew at its fastest rate since Reunification in 1989 between April and June 2010.  However, Greece has not experienced economic growth since 2007.

 Figure 1:  Members of the Eurozone

The euro has actually helped exasperate this problem, as it is difficult for the EU to implement “one size fit alls” policies for 17 different countries.  Like the Federal Reserve System in the US, the European Central Bank (ECB) is responsible for controlling monetary policy for the entire Eurozone.  For instance, the ECB increased interest rates in 2009 because Germany (which is the largest European economy) was growing, while Greece (which only accounts for 2% of the EU economy) was not.  The United States suffers from this problem as well, as American states grow at different rates as well.  However, the US Federal budget helps smooth out these bumps, but the EU cannot help member states in the same way.  While the US Federal Government’s budget is about 40% of GDP, the EU’s budget is limited to about 1.25% of GDP.  In 2011, the EU budget was only €141.9 billion (approximately €200 billion), which was actually less than this limit.

 Figure 2: Government Bond Rates

(selected Eurozone countries)

 Source:  European Central Bank, Bloomberg

 While it was not apparent until recently, the euro created a second problem for Europe.  As Figure 2 shows, after countries adopted the euro, the interest rate that national governments paid fell dramatically as investors through that many countries were now safer places to invest.  To join the euro, governments had to agree to the Growth and Stability Pact stating that they would keep their budget deficits below 3% of GDP every year and their cumulative government debt would not exceed 60%.  In addition, the EU had a “no bailout” clause, meaning that if one country could not pay its bills, the others would not step in and help them.  Unfortunately, the rules of the Growth and Stability Pact were not enforced, and borrowing in some European countries soared now that they had access to cheap credit.

 Figure 3: Government Debt

(2010, percentage of GDP)

 

Source:  The Economist

 When the recession began, many governments had to borrow more as tax revenues decreased while government spending grew due to increasing unemployment and demands on social spending.  In 2010, investors started to realize that not all Eurozone countries’ finances were the same.  As Figure 3 shows, some countries had government debts well above the 60% threshold by 2011. Greece was the first to see the interest rates that it had to pay on government debt increase to levels that it could no longer afford and received a €110 billion (about $154 billion) bailout from the EU, the European Central Bank, and IMF in May 2010.  Everyone hoped that this would calm the markets and Greece would be able borrow money again internationally in a few years.  However, Greece was followed by bailouts for Ireland in November 2010 and Portugal in April 2011.

These three countries are all small and account for only about 5% of the total EU economy, but the fear is that investors will start to panic and focus on two of the largest EU countries—Spain and Italy.  While the EU and others have been able to attempt to rescue Greece, Ireland, and Portugal, it would be very difficult to bailout Spain or Italy.  Voters in many richer European countries might be willing to loan some money to small economies, the cost of supporting Spain or Italy would probably be too much and a Spanish or Italian default could potentially led to the breakup  of the Eurozone.

 Figure 4:  Indiana’s Exports to selected EU members (2010)


Source: World Institute for Strategic Economic Research

 A major crisis in the Eurozone would directly affect the US and Indiana.  The transatlantic economic ties are among the strongest in the world, and economic problems in Europe would mean less European investment in the US and fewer American exports to Europe.  As Graph 2 shows, Indiana does not have very strong economic ties with Portugal or Greece, but Ireland, Italy, and especially Spain are major economic partners for the state (a more detailed analysis can be found here).  Indiana is potentially exposed to the European Debt Crisis, although to date exports to the Eurozone have continued to grow despite the situation in Europe.

To learn more about the European Debt Crisis and its impact on Indiana, click on the categories to the right:  European Debt Crisis and Europe’s Ties with the US.

For continuing coverage, the BBC and The Economist both have excellent sections devoted to the crisis.

For more information on the One State, One World series, please visit http://indianapublicmedia.org/onestateoneworld/.  This episode of One State One World is produced in partnership of WFIU Public Radio and the EU Center at Indiana University with support from the European Union.

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