EUROPE DEBT CRISIS

SUBMITTED BY:

Manik Singal (11BSPHH010450) Ishita Jain (11BSPHH010340) Jaskaran Singh Kochar(11BSPHH010347)

INDEX
Objectives Methodology: Significance of the project study: Limitations: European union Economic integration Euro Maastricht criteria Begining of the crisis Portugal Ireland Italy Greece Spain Optimal currency area: Sub optimal currency areas: Causes Of euro zone crisis Stage 1: Burgeoning Deficits Stage 2: Ballooning Debt Stage 3: Downgrade Stage 4: Default Objectives of ECB: Role of international monitory fund Impact of direct ECB intervention Proposed solution to crisis management: 3 3 3 3 3 5 5 6 7 8 9 10 10 11 13 13 14 16 17 18 18 19 20 22 23

Objective of the Project

To discuss what Euro zone debt crisis is. To explain the factors that lead to this crisis in Euro zone Give the current status of the crisis situation and suggest the measures need to be taken by various international bodies and governments to turn the crisis around.

Methodology:
The methodology carried out for doing this project consists of research and analysis of secondary data from various sources such as: Economic journals Business magazines Online articles Newspapers Scholar research papers etc.

Significance of the project study:

The project aims to be a single point reference for anyone who intends to know and understand the various aspects of the Euro zone crisis, its underlying causes and implications for the rest of the world.

Limitations:
Time Constraints: Though ample efforts have been put into this project, due to time constrains all the available information might not have been captured in the project. Continuous changes: The crisis is still leading to new revelations day after another and hence new updates are difficult to implement on everyday basis.

EUROPEAN UNION
The European Union (EU), formerly known as the European Community (EC), was formed in the 1950s to encourage and over see political and economic cooperation between numerous European nations. Since the formation of EU, almost in half-century period it has gradually succeeded in becoming the most dominant governing economic body in Europe, and it now affects every aspect of business in its member states. After World War II, European leaders realized that drastic changes needed to be made to ensure that the armed conflicts that had plagued the continent for more than half a century would become a thing of the past. Leaders of the democratic European nations decided that some form of governing body was needed that would encourage cooperation on all levels and have the power to set economic policy for the entire region. In the 1950s, three important treaties were signed that signaled the actual birth of a European union. In 1951, the European Coal and Steel Community (ECSC)was created to oversee those industries. The treaty creating that organization is an important one, because it marked the first time that any European nations had allowed a supranational organization to control an important policy area.In 1957, a second treaty created the European Atomic Energy Community (Euratom), and in 1958, the European Economic Community (EEC) was brought into being by yet another treaty. These two treaties together are known as the Treaties of Rome, and the creation of the EEC was seen as the first step in creating a common economic market in Europe that would allow for free trade between members and the free movement of people, services, and capital.The 1970s and 1980s were a period of growth for the EU. In 1973, Denmark, Ireland, and the United Kingdom joined for the first time, and the parliament expanded to 198 members. In 1981 Greece joined the union, and in 1986, Spain and Portugal did the same. The parliamentwhich had greatly expanded in 1979 to 410 membersgrew again, this time to 518 members.
After the growth period ended in 1986, the union sought to strengthen its powers in the late 1980s and early 1990s. In 1986, the Single European Act (SEA) was passed which targeted the end of 1992 as the date for the formation of a common market and also emphasized political cooperation in foreign policy.

That year, theMaastricht Treatywas ratified,The treaty also marked a distinct shift toward an emphasis on using economic policy as the main tool to increase European unification. The treaty, which went into effect in 1993, officially changed the name of the European Community to the European Union. In addition, it outlined a three-stage plan for conversion to a common market that included the establishment of a central bank and the creation of a common European currency.
In 1994, the EU combined with the seven-member European Free Trade Association (EFTA) to form the European Economic Area, a zone of 19 countries that formed a single market with no trade restrictions. As a result of that cooperative effort, EFTA members Austria, Finland, and Sweden 4

joined the EU for the first time on January 1, 1995. This triggered a concurrent growth in the European Parliament, which expanded to 626 members

ECONOMIC INTEGRATION
Because one of the main roles of the union is to oversee economic cooperation between members, it plays a very large role in how business is conducted throughout Europe. It has established a single market trading system with low, or no, taxes and tariffs, and it encourages economic development.
The most important economic changes in the union have occurred in the last few decades. In 1979, the European Monetary System (EMS) was established to create greater price stability between the currencies of all union members. The core of the EMS was the Exchange Rate Mechanism (ERM), a voluntary system that fixed the price of currencies against each other; rates could be adjusted within a narrow range of prices. The ratification of the Maastricht Treaty in 1992 launched the union's current economic policy by creating a time table to enact a three-stage plan for implementing a single market economy across Europe.

Stage 1It officially recognized that the goal of the European Union was to create an Economic and Monetary Union (EMU) of all member states in which members would strive to cooperate more closely than in the past in managing their economies.
Stage 2 in 1994 with the creation of the European Monetary Institute in Frankfurt, Germany. This was a central banking institution that was the fore runner of the European Central Bank (ECB), which now oversees the control of currencies throughout the union. The Central Bank is the hub of the centralized banking system that also includes 15 national Central Banks that serve as the main bank in each of the member states.

That Stage 3 would begin on January 1, 1999. On that day, the union officially began the move towards a single European currency unit, which is called the euro. Currency conversion rates in participating member states were fixed and a single monetary policy and foreign exchange rate were implemented. A "euro zone" was created that included the following participating countries EURO The euro(sign:;code:EUR) is the official currency of the euro zone: 17 of the 27member states of the European Union. It is also the currency used by the Institutions of the European Union. The currency is also used in a further five European countries Montenegro, Andorra, Monaco, San Marino and Vatican City) and the disputed territory of Kosovo. Ten countries

(Bulgaria, the Czech Republic, Denmark, Hungary, Latvia, Lithuania, Poland, Romania, Sweden, and the United Kingdom) are EU members but do not use the euro. The euro is the second largest reserve currency as well as the second most traded currency in the world after the United States dollar. As of July 2011, with nearly 890 billion in circulation, the euro has the highest combined value of banknotes and coins in circulation in the world, having surpassed the U.S. dollar. Based on International Monetary Fund estimates of 2008 GDP and purchasing power parity among the various currencies, the Euro zone is the second largest economy in the world.

MAASTRICHT CRITERIA
The euro convergence criteria(also known as the Maastricht criteria) are the criteria for European Union member states to enter the third stage of European Economic and Monetary Union(EMU) and adopt the euro as their currency. The four main criteria are based on Article 121(1) of the European Community Treaty.
In 2009 the International Monetary Fund floated a suggestion that countries should be allowed to "partially adopt" the euro - adopting the currency but not qualifying for a seat on the European Central Bank(ECB).

For Euro zone members, there is the Stability and Growth Pact which has similar requirements for budget deficit and debt. However some Euro zone countries have without action from the EU severely violated these criteria (e.g. Greece 10.5 % deficit in 2011), which has resulted in European sovereign debt crisis.

Criteria:
1. Inflation rates: No more than 1.5 percentage points higher than the average of the three best performing member states of the EU. 2. Government finance: Annual government deficit: The ratio of the annual government deficit to gross domestic product(GDP) must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases. Government debt: The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.

3. Exchange rate:Applicant countries should have joined the exchange-rate mechanism(ERM II) under the European Monetary System(EMS) for two consecutive years and should not have devalued its currency during the period. 4. Long-term interest rates:The nominal long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member states. The purpose of setting the criteria is to maintain the price stability within the Euro zone even with the inclusion of new member states.

However, with the risk of a default in Greece, Ireland, Portugal and other members in late 2009-10, Euro zone leaders agreed to provisions for loans to member states who could not raise funds. Accusations that this was a u-turn on the EU treaties, which rule out any bail out of a euro member in order to encourage them to manage their finances better, were countered by the argument that these were loans, not grants, and that neither the EU nor other Member States assumed any liabilities for the debts of the aided countries. With Greece struggling to restore its finances, other member states also at risk and the repercussions this would have on the rest of the Euro zone economy, a loan mechanism was agreed. The crisis also spurred consensus for further economic integration and a range of proposals such as a European Monetary Fund or federal treasury.

BEGINNING OF THE CRISIS

As stated in above Euro zone comprises 16 members of the European Union that use a common currency, namely the Euro. The only major European economy that does NOT use the Euro is Great Britain, which retains the pound sterling. The key fact about the Euro zone is that it represents a MONETARY not a fiscal, whose policy is set by the European Central Bank or ECB. Divergence between the monetary and the fiscal policy: The main job of the ECB is to set interest rates for the entire Euro zone while the fiscal policy is determined by each Euro-area separately. This is the source of potential conflict in between the member countries and the ECB and a primary reason for the crisis. Fallout of European banks after the US crisis in 2008: Eruption of the global financial crisis in Black September 2008 led by the collapse of Lehman Bros, and lending freeze instituted by American Too-Big-To-Fail [TBTF] banks and insurance companies had a major impact on the European nations. As a result of the extensive financial inter-connections between US and European banks significantly, in the NONtransparent derivatives market and mortgage backed securities or MBS the problems in the US housing market set off a chain of potential defaults in European banks, notably in Iceland, the UK, and Spain.
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Division between the stronger and the weaker economies: After the crisis began to emerge UK was able to devalue the pound sterling as part of its policy response to this crisis, such a move was not available to members of the common currency area. It was at this point a division began to emerge for the first time between the stronger economies notably Germany, France, the Netherlands, and other smaller northern European countries and the weaker economies, most of which were located in Eastern and Southern Europe, and became known collectively as the PIIGS Portugal / Italy / Greece / Spain/ Ireland . Default by Stealth: If a country has its own currency, it can print it according to its gold deposits and as per the prevailing needs of the economy. But as Greece was a part of the European Union, it could not print current as per its whims. This led to cascading of its debts as it could never print enough currency to meet its obligations.

PIIGS Nations: Countries under crisis

Introduction
PIIGS is an acronym used by international bond analysts, academics, and the economic press that refers to the economies of Portugal, Italy, Greece, and Spain, and Ireland in regard to matters relating to sovereign debt markets. As mentioned above the strong between the stronger and the weaker nations led to the cascading effects of Greece crisis spreading to other weaker economies like Italy, Ireland, Spain and Portugal.

Portugal
Economy, in European Union: 15th largest Latest GDP growth figure:0% (Second Quarter 2011) Gross debt in 2010, forecast: 93% of GDP Jobless rate: 10.4% Population: 10,560,000 Inflation Rate: 2.90%(2011) Portugal with its high borrowing and sudden reversal in economic fortunes - has been lumped in the same category as its Mediterranean neighbors.
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The country has vowed not to leave the euro zone, with its finance minister telling the BBC that it faced "an extraordinary and exceptional situation, due to a major financial and economic crisis without precedent in our recent history". MoU with the European Union: Portugals 78 billion Memorandum of Understanding (MoU) was finalized with the EU and International Monetary Fund (IMF) on 3 May 2011, with emphasis on tackling the countrys long-standing structural problems, strengthening fiscal policy and ensuring the stability of the financial sector. The EU has pledged a total of 52 billion and the IMFs. The countrys underlying problems of weak competitiveness and low economic growth remain unchanged, and the risk of debt restructuring, once the international money runs out in 2013, is still significant. With the rate of GDP growth averaging just 1% over the past 10 years, Portugals main problem is largely structural. Indeed, boosting productivity and competitiveness is the key to resolving Portugals economic troubles, failing which the country faces, at best, low growth for many years to come. Contribution will amount to 26 billion. The funding will be available for a period of three years, up to 2013.

Ireland
Economy, in European Union: 13th largest Latest GDP growth figure:1.60% (Second quarter of 2011) Gross debt in 2010, forecast: 96.20% of GDP Jobless rate: 13.3% Population: 4,450,000 Inflation Rate: 2.20% (2011) The Irish Republic was one of the biggest success stories of the recent boom, with its economy nicknamed the "Celtic Tiger". But its economic growth was dependent on a property bubble. It became the first Euro zone country to fall into recession in 2008. It has pumped 7bn Euros into its two biggest banks, Allied Irish Banks and Bank of Ireland, and created a state-run agency to handle their bad debt. The Irish economy emerged from recession last year, but there was widespread public anger at the level of public spending cuts that have been made. The Irish economy is still very weak, though encouraging steps have been taken to restore economic health. While rising international demand and improving price competitiveness will allow exports to grow strongly, domestic demand continues to remain downbeat. The outlook for investment is particularly weak due to ongoing troubles in the banking sector and housing market, while high levels of debt, a weak labor market and strict fiscal consolidation will weigh down on consumer spending as per a latest study conducted by Ernst and young.
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Italy
Economy, in European Union: 4th largest Latest GDP figure:0.80% (Second quarter of 2011) Public debt in 2011, forecast: 119% of GDP Jobless rate: 8.4% Population: 60600,000 Inflation Rate: 3.10% (2011) Italy has the largest outstanding debt in the euro area -- about 1.9 trillion Euros ($2.6 trillion). The US credit ratings agency, Standard & Poor's, downgraded Italy's debt to 'A', saying that the nation's weakening economic growth and political uncertainty have dented its financial stability. S&P downwardly revised its estimates for Italy's GDP growth to an annual average of 0.7% between 2011 and 2014 -- a far cry from its previous projection of 1.3% . Additionally, it gave Italy the worst marks of any nation in Europe. For many years, the country has had problems with balancing its budget. The Italian economy was still very weak at the beginning of 2011, as GDP increased by just 0.1% on the quarter for the second consecutive quarter. Although recent data for the public finances showed an improvement in the budget deficit compared with a year earlier the target of a deficit below 3% of GDP in 2012 to remain challenging. Low growth implies that unemployment will decline only gradually in 2011 and 2012.

PIGS

Greece
Economy, in European Union: 11th largest Latest GDP figure:0.20% (Second quarter of 2011) Gross debt in 2011, forecast: 142.80% of GDP Jobless rate: 9.7% Population: 11,330000 Inflation Rate: 1.70% (2011) Greece benefited from joining the euro in 2001. But the Greek government went on something of a spending spree and public spending soared. Now, it is suffering from its huge spending - and widespread tax evasion - as it finds itself unable to cope with its huge debt loads and meet EU deficit rules. Greece's deficit is, at 12.7%, more than four times higher than European rules allow. It remains to be seen whether the EU's deal on Greece will help soothe markets, and ease concerns over other indebted nations.

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Spain

Economy, in European Union: Fifth-largest Latest GDP figure: 0.2% (Second quarter of 2011) Gross debt in 2011, forecast: 60.10% of GDP Jobless rate: 19.5% Population: 46,100,000 Inflation Rate: 3% (2011) Spain has been very hard-hit by huge declines in its property markets. With recent figures showing its economy contracted in the last three months of 2009, Spain remains the last major economy in Europe still in recession. While its banks have withstood the economic downturn better than in the Irish Republic or the UK, the government announced a 50bn-euro austerity package, including a civil service hiring freeze, at the end of January. With the International Monetary Fund expecting Spain to contract by 0.6% in 2010 compared with predicted growth for the 16-nation Euro zone - many investors feel it will be the next country to rattle financial markets. Much of the markets worries about Spain relate to the state of the banking sector and the potential for spillover into public finances. There is a risk that the cost of recapitalizing the regional savings banks (cajas) could prove much higher than the Government expects, which could derail the fiscal consolidation effort.

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CONCEPT OF OPTIMAL AND SUB OPTIMAL CURRENCY AREA

Optimal currency area:
An optimal currency area is an economy where a single interest rate policy is equally appropriate. In other words, the one size fits all monetary policy works. If interest rates rise, it is just as appropriate a policy for the north of the area as for the south. If the east of the currency area has an economic downturn, then the west should also be experiencing a similar economic downturn and both sectors should respond in the same way to the policy prescription. Clearly, to have all parts of an economy growing in exactly the same way at the same time is pretty rare. Similarly having all geographic areas of an economy respond identically to a monetary policy shift is pretty rare. However, if the differences are not too large, and are not too persistent, then an area can still be considered an optimal currency area. It is also important that external (or internal) shocks to the currency area do not affect some parts more than others. If sharing a common interest rate is not going to do too much economic damage, then the economic advantages of a common currency which will reduce transaction costs come to the fore. In this instance, economic self interest suggests the monetary union stays together.

Sub optimal currency areas:

What happens when an economy is not an optimal currency area? Most monetary unions, including well established unions like the United Kingdom or the United States, are not perfectly optimal currency areas. Shocks will affect parts of these economies more significantly than others. Consider a rise in food prices: good for rural economies, bad for urban economies, all things being equal. For an economy that includes both rural and urban areas, a rise in food prices is an unequal economic shock an asymmetric shock to the overall economy. So what happens if such a shock hits a sub-optimal monetary union? There will be a divergence in economic experience, including a divergence in the unemployment experience of the different parts of the monetary union. The existence of a single interest rate will then make things worse. The area with high unemployment will find the common interest rate is set too high which risks pushing up unemployment further. Meanwhile the area with low unemployment will find that monetary policy is generally stimulatory, and the bias will be for lower unemployment. Unemployment is generally the focal point for monetary unions because it resonates so strongly in a political sense. Persistent, high unemployment is generally seen as an unacceptable political burden. If that unemployment is being aggravated by the existence of a common domestic monetary policy that is set at an inappropriate level, then the common monetary policy itself is likely to become a target for political action.

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Causes of the Euro zone crisis:

The debt crises in Greece, Ireland and other European nations are presenting the European Economic and Monetary Union with the most serious stress test in its 12-year history. The Euro zone is functioning far worse than its supporters had expected. The European Economic and Monetary Union (Euro zone or EMU) suffers from structural weaknesses that led to substantial imbalances and triggered the debt crises in Greece, Ireland and other countries. The following were the causes for Euro zone to be structurally weak: Prerequisites for a common currency zone are not met The EU nations do not form an optimal currency zone. One of the characteristics of such an area is that events or developments outside this area cannot affect the participating economies in wholly different ways. For example, different economies are affected by a global oil crisis in different ways. An optimal currency zone has internal mechanisms compensating for such differences. This primarily includes a high level of labour mobility, wage and price flexibility and a common fiscal system. Low labor mobility Almost all studies show low labour mobility in the Euro zone. The typical comparison is with the US, where mobility is around three times as great In the EMU, labor mobility is limited, e.g., by the Posted Workers Directive, which requires the same conditions for foreign employees as for domestic ones. Differing regulations for pension and unemployment benefits also complicate the free choice of residence. Another potential problem is the recognition of vocational and professional qualifications and diplomas. Further, it can be assumed that cultural and linguistic differences also pose serious obstacles.

Lack of wage and price flexibility The situation is similar for wage and price flexibility. A 1998 study by the European Parliament lamented the very low level of wage flexibility in large areas of the EMU. The reason given for this was the widespread practice of employment under collective bargaining agreements in Europe. Price flexibility is mostly linked to unit labor costs. Here, the picture is varied. Several countries, including Germany, have greater flexibility than most other large
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EMU nations. However, price flexibility in the Euro zone is regarded as minimal, on the whole, explained primarily by a lack of competition and monopolistic tendencies. Virtually no fiscal policy compensation mechanisms The Euro zone also does poorly in terms of fiscal policy compensation mechanisms. In contrast to other currency zones, such as the US, EMU nations only have fiscal policy stabilizers at the national level. In addition, the EMU has further severely restricted this autonomy through the Stability and Growth Pact, which limits new borrowing to a maximum of 3% of gross domestic product (GDP). This leaves only direct transfer payments from the EU budget, which is much too small for this purpose, amounting to less than 1.5% of EU GDP, with only half a percentage point explicitly used for regional redistribution. By comparison, the federal budget in the US amounts to around one-third of US GDP. Generally, the Euro zone lacks adequate alternative mechanisms to offset the absence of interest and exchange rate adjustments. This severely limits the Euro zones economic functioning in the long term. These problems were recognized at the time the euro was introduced, but the European Economic and Monetary Union is primarily a political project, rather than an economic one. Its supporters hoped that the economic prerequisites would automatically follow on the introduction of the new currency. Consequences of the lack of compensation mechanisms Even before the introduction of the euro, leading economists warned that the cyclical instability of the Euro zone nations would increase, given that the economic prerequisites were not present. The business cycle of upswing, boom, downturn and recession describes the movement of the economy around its long-term growth path. If the economy is in the upswing or boom phases, interest rates generally rise and the domestic currency appreciates. Both of these slow economic activity and reduce the deviation from the stable growth path. Distortions associated with the boom, such as misallocation of resources and excessive borrowings are limited. However, a currency union can lead to a situation where business cycles are prolonged and amplified, with negative consequences on borrowing and competitiveness. Real interest rate effect extends and amplifies the business cycle This happens primarily through the so-called real interest rate effect. The decisive factor here is that the countries in a currency union have different rates of inflation. The causes may be different levels of development or productivity, or an external shock. Where there is a difference in inflation within a currency zone, this means that countries with a higher rate of inflation (p) and a more-or-less uniform nominal interest level (R) have a lower real interest (r) and vice versa, as the following equation shows: r=Rp The real interest rate, i.e., the difference between the rate of inflation and the nominal interest rate, is a very important determinant for investment and consumption, and accordingly for the
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level of economic activity. If the real interest rate is (too) low, this gives additional stimulus to the economy. A low real interest rate is also an incentive for high borrowing. The primary beneficiaries of this positive real interest effect when the euro was launched were Greece, Ireland, Portugal and Spain. In the future, there is reason for concern that the newest EMU members (Slovenia, Slovakia and Estonia) will follow the same path as the current problem nations. In countries with low rates of inflation, the real interest rate has exactly the opposite effect. The real interest rate is relatively higher and possibly too high, for the state of the real economy. This slows economic activity. Here, we can speak of a negative real interest rate effect, which strengthens and prolongs phases of economic weakness. In the first few years of the Euro zone, Germany in particular suffered from this dynamic. Since 2010, however, the situation has changed, and Germany is now benefiting from interest rates that are too low, while rates are too high in several crisis countries. Real exchange rate effect promotes divergence in competitiveness The real interest rate effect is opposed by the real exchange rate effect. Countries with a higher inflation rate lose price competitiveness compared to countries where prices are rising more slowly. The real exchange rate, which is the ratio of the domestic and foreign price levels, appreciates. In other words, while a phase of positive real interest rate effect (low real interest rates) promotes upswings and booms, and hence inflation, the country gradually loses competitiveness because of the regional rise in prices. In the Euro zone this was particularly evident in Greece, Ireland, Portugal and Spain. To sum up, the countries in the Euro zone do not meet the economic prerequisites for a currency area. This results in instability in business cycles and divergence in price competitiveness. Together with other factors, these imbalances played a decisive role in the current debt crises in several EMU countries. The debt crises in the EMU are mainly crises in the euro, and not primarily the result of inappropriate fiscal actions. This also means that proposals for reform that aim only at better compliance with fiscal stability rules will ultimately not be sufficient. They cannot solve the underlying problem of the Euro zone but unless this problem is solved, future crises in the Euro zone are inevitable.

The Stages Euro Zone encountered to reach its Current Crisis Situation:

Stage 1: Burgeoning Deficits

The Euro zones first decade from 1999 was widely viewed as a success; however, the good average performance concealed differences in performance among member countries. The countries in the centre of the Euro zone crisis from 2010 all had inflation rates well above the ECBs 2% target. Countries with higher inflation tended to have domestic booms (house
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price and construction booms). This means they were borrowing from abroad to finance spending at home: for example, high German household savings financed housing developments in Spain and Ireland. In some cases, the borrowing from abroad financed private sector spending as in Ireland and Spain; in other cases it financed government spending (Italy) and in Greece and Portugal it financed both. The large fiscal deficit was usually due to the government spending in pension areas, public sector funds etc. (Greece). The debt crisis was not based on the government spending but it was caused by the property bubble.(Ireland) Over expenditure and investment in bubbles were the primary reasons of why this economy entered into crisis. This allowed the top managers and the head officers to get inflated bonuses and wages.(Portugal)

Banks head-quartered in Euro zone countries were among those that became dangerously leveraged in the 2000s, i.e. they had borrowed too much as they sought to benefit from rising asset prices in what seemed to be a low-risk macroeconomic environment. When asset prices began to fall (initially in the sub-prime housing market in the US), banks found themselves in difficulty. When many so-called highly leveraged financial institutions tried to do this simultaneously there were few willing buyers of risky assets (such as mortgages, mortgagebacked assets etc.) and prices fell further, exacerbating the solvency problems of banks. Governments use taxpayers money to bail out banks. They do this because they believe the economic costs of allowing banks to fail are greater than the costs of bailing them out. But by doing so, they create a moral hazard banks will be less prudent if they know they will be bailed out. This led to increased fiscal deficits which led to doubts about the solvency of governments.

Stage 2: Ballooning Debt

When economies are contracting or even growing slowly, bringing these deficits back down to earth becomes an unenviable challenge. Governments have to make ends meet by turning to the markets. Then those burgeoned deficits turn into growing debt loads. Some Euro zone governments like Greece had large government deficits and high government debt before the financial crisis. Others like Ireland did not. But in the latter, deficits ballooned when the crisis hit because they were faced with bailing out banks, paying higher unemployment benefits and receiving less tax revenue in the recession. A sovereign debt problem does not arise in the same way in a country that has its own currency and where government debt is denominated in domestic currency. In this case, the most likely outcome is that the crisis is followed by a currency depreciation and the central
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bank prints money to fill the gap in debt servicing that remains after tax revenue has been used for the governments spending obligations.

Stage 3: Downgrade
Initially, when Greece entered into Euro zone, the market viewed bonds issued by the Greek government as very close substitutes for bonds issued by the German government. This means that either the market viewed the likelihood that a Greek or Irish government would not honor its debts to be as improbable as a German government failing to do so or they believed that a Euro zone government would not be allowed to default. But in the latter, deficits ballooned when the crisis hit because they were faced with bailing out banks, paying higher unemployment benefits and receiving less tax revenue in the recession. Once it became clear that the underlying health of different Euro zone economies in the financial crisis differed markedly, financial markets changed their views about the bonds denominated in Euros issued by different governments. Interest rate spreads widened sharply. Given the underlying problem of liquidity for a Euro zone member government, once financial markets began to see insolvency as a possibility for some members, fear drove up interest rates on their bonds, which made the calculation worse. In this way, a crisis can become self-fulfilling. This helps explain why interest rates on Spanish bonds are higher than on British ones even though the UKs debt ratio is higher. Greeces sovereign debt rating has been downgraded to junk status. Spain has lost its AAA rating and the UK could lose its AAA status if its deficit isnt addressed. Greeces two-year bonds now yield more than the 10-year debt, indicating investors dont believe the EU bailout plan will be enough to sustain Greece. Credit- default swaps to insure against a default in the coming year leaped 104 basis points to a record 744.7.

Stage 4: Default
This is the final and most deadly stage. Thats because downgrades only make the vicious cycle of weak economic activity and growing dependence on debt worse. When investors see more risk, they require more return. Therefore, the borrowing costs for these troubled countries rise. Then it becomes harder to finance spending needs and harder to finance existing debt. And thats when we see defaults. The danger is that a default by Greece will cause investors to lose faith in other Euro zone countries. This concern is focused on Portugal and Ireland, both of whom have high debt and deficit issues. Italy also has a high debt, but its budget position is better than the European average, and it is not considered among the countries most at risk. Spain has a comparatively low debt among advanced economies, at only 53% of GDP in 2010, more than 20 points less than Germany, France or the US, and more than 60 points less
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than Italy, Ireland or Greece. Spain and Italy are far larger and more central economies than Greece; both countries have most of their debt controlled internally, and are in a better fiscal situation than Greece and Portugal, making a default unlikely unless the situation gets far more severe.

ROLE OF ECB AND IMF IN EURO SOVEREIGN DEBT CRISIS

ECB: The European Central Bank (ECB) is the institution of the European Union (EU) that administers the monetary policy of the 17 EU Euro zone member states. It is thus one of the world's most important central banks and was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt, Germany.

Objectives of ECB:
The primary objective of the ECB is to maintain price stability within the Euro zone, or to put it differently to keep inflation low. The Governing Council defined price stability as inflation (Harmonized Index of Consumer Prices) 1 of below, but close to, 2%. In contrast to the American Fed, ECB has only the above mentioned objective to undertake and the other functions are just a support to this task. The key tasks of the ECB are: Define and implement the monetary policy for the Euro zone, Conduct foreign exchange operations, Take care of the foreign reserves of the European System of Central Banks, Promote smooth operation of the financial market infrastructure under the Target payments system It has the exclusive right to authorize the issuance of euro banknotes. Member states can issue euro coins but the amount must be authorized by the ECB beforehand.

As ECB is concentrated with only the monetary policy in the European Union but the fiscal policy is left to individual member states. This model of functioning is inherently unsustainable, as it denies member states monetary policy levers with which to help their recoveries. This also makes deficit-funded fiscal stimulus harder, as monetary policy can be used to keep borrowing costs low. When different countries are hit differently by a recession the common monetary authority will act in ways that help some countries but not others. And as the ECB has pursued tight monetary policy that may prevent inflation in high-growth states like

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Germany but could also be worsening the recession in Greece, Spain, and other struggling states.

And for the given problems, there is a possibility that euro zone may loose members like Greece, Spain and Italy, either by them just leaving or by a default by any one of them, which could unravel the whole monetary union. This could lead to run on banks on huge scale and thus lead to a financial crises even bigger than ever faced in any time. One way to sort out the issue is that European Union could have a unified coordinated fiscal policy via ECB. And this fiscal policy can be coordinated at the continent level as well as monetary policy, bringing the E.U. closer to being a sovereign state.

Role of International Monitory fund (IMF)

The International Monetary Fund (IMF) is an intergovernmental organization that oversees the global financial system by taking part in the macroeconomic policies of its established members, in particular those with an impact on exchange rate and the balance of payments. Its headquarters is in Washington, D.C.2 The IMFs stated objectives are: Stabilize international exchange rates Facilitate development through the influence of neoliberal economic policies in other countries as a condition of loans, debt relief, and aid. Offer loans with varying levels of conditionality, mainly to poorer countries, etc

Monetary funds are generally tools designed to work with short-term liquidity funding problems and therefore the conditions attached to the intervention as lender of last resort must be based on short-term monetary policy issues, rather than long-term fiscal and political objectives. Instead of thinking and acting on these lines, IMF offered financial aid to Argentina and Greece to support a decision (the parity with the dollar and the creation of the Euro zone) made by governments and not by central banks. And thus, the political role of the IMF in this crisis and the Argentine crisis could be an intrinsic problem. Not sufficient attention paid to the fact that the structural reforms that were seen as critical to growth had largely stalled. Fiscal policy assessments were not based on an adequate appraisal of the risks to debt sustainability in the event of a slowdown in growth.

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As evident from the previous Argentinean crises, the IMF should have only intervened when the three conditions below are met3: 1. A short-term liquidity problem, rather than a long-term solvency issue; 2. The countrys lender of last resort (central bank) does not have enough resources to tackle the liquidity crisis; and 3. Intervention must be conditioned to a change in the monetary policy of the beneficiary. Hence, the fund should have not intervened in the Euro zone crisis and taken on the ECBs role of lender of last resort. The sole condition for the intervention in the Euro zone crisis should have been to help Greece and its central bank to exit the euro area, by providing funding and jointly defining a new exchange rate around its economy and competitiveness, instead the IMF had implicitly decided to support, with the funding of Euro zone member states, a situation fed by a political impasse. Long-term fiscal problems and competitiveness issues should be the right of other supranational institutions such as the World Bank and the European Commission (for the EU) with the independent support of central banks, by setting the right framework for fiscal policies to be most effective. . The existence of the Euro zone itself should come before price stability. The ECB intervention would therefore not have to save a political project but rather to support countries that have been hit by losing control of monetary policies. The ECB should disclose the amounts and modalities of the auctions of its Securities Markets Program. In effect, the intervention of the ECB would be a natural thing, as it should be one of its objectives to participate and support the sovereign bond secondary markets, as lender of last resort in emergency situations 4 , in which markets have lost confidence that current solutions (EFSF and ESM) and political support will be able to rescue huge Euro zone debts. The mandate of the ECB needs to be expanded to include powers of lender of last resort and regulation of financial markets. The European Union needs a real institutional convergence as opposed to simply nominal convergence in economic aggregates. As long as the Euro zone refrains from deploying all its potential resources to make markets believe that countries are doing everything possible to avoid default, the situation will not stabilize.

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Impact of direct ECB intervention:

A direct intervention would create more favourable conditions; even though it is certainly not the only action needed to solve this crisis. In effect, a broad program of government bonds purchases in the secondary market can have multiple effects as follows: 1. It would stabilize market mechanisms more naturally, by minimizing perverse downward market pressures and temporarily recreating more favorable market conditions, boosting appetite for risk in investors. Bonds must be bought through market auctions at current rates to lower haircuts towards zero, which is a typical component of government securities. Improved market conditions would also indirectly benefit the interbank market, the money market and real interest rates. Finally, the ECB must disclose the size of the quantitative easing program, as well as the kind of instruments and maturities of each purchase over time. 2. Booking government debt securities on the balance sheet of the central bank has several positive implications. First, burden sharing through contributions by NCBs to the capital of the ECB may allow the Euro system to provide more flexible and immediate responses to liquidity crises than rescue plans that require lengthy political processing through national parliaments. Second, the political pressure to apply fiscal austerity measures would be exercised by the ECB and other EU institutions on the more credible threat that the program would stop as soon as fiscal measures stop or slow down. The debt will finally sit on the Euro system balance sheet, which would allow more control if the country gets into liquidity troubles or succeed with their fiscal adjustments (sterilization). Finally, it may be partially written off as a reward if the country successfully applies austerity measures and structural reforms. 3. Buying debt will also slow down the procyclical mechanisms of rating downgrades and limit their role in this crisis, even though it does not solve the issue of the role of ratings granted by regulators in capital requirements regulation. 4. It will limit the hold-up of financial institutions (by holding these instruments) as well as limiting their moral hazard, which remains a relevant issue with repo transactions. 5. Most important, a Quantitative Easing would free the European Commission of the heavy political burden to seek approval for rescue plans on behalf of member states. In effect, the ECB intervention would allow the Commission and national
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governments to seek broader political coordination on more fundamental issues, such as internal imbalances and weak growth. A well-designed program can stabilize markets by signalling that the ECB is willing to relax its price stability mission to avoid the default of the Euro zone.

Proposed solution to crisis management:

Key economic conditions for a currency union in the Euro zone are not in place, negatively impacting the economic cycle and the competitiveness of some countries and contributing to the current debt crisis. Whether and how these weaknesses can be put right is therefore of central importance. Any currency union needs substitution mechanisms to compensate for the absence of flexible exchange rates and independent interest rate policy in the member countries. There are basically three ways the Euro zone can create the economic conditions for a functioning currency union: It can strengthen market mechanisms, expand government burden-sharing or reduce the adjustment required. The latter would involve one or more countries leaving the EMU, making the remaining union more convergent. 1) Expanding market mechanisms One obvious idea would be to bring about the necessary convergence of EMU countries by expanding market mechanisms. Mainly, the countries in the Euro zone would have to significantly increase labor mobility and allow wages and prices to adjust flexibly. This would effectively involve bringing the single European market to completion. As we have shown, however, the EMU scores badly on free-market substitution mechanisms. The EU Commission has made efforts to improve market mechanisms in the EU. Cultural, linguistic and institutional barriers will remain limiting factors in the future, though. Even the US, where labor mobility and wage and price flexibility are higher than in the Euro zone, needs additional fiscal adjustment mechanisms. In other words, expanding market mechanisms will not be sufficient to create the necessary economic conditions for a fully functioning monetary union in the EU at least not in the foreseeable future. Nevertheless, free market measures to correct existing divergences, price competitiveness and yawning budget deficits have to be promoted and put into action. The weaker countries in the Euro zone are currently forced to improve their situation by a combination of budgetary discipline and wage and price restraint, or even cuts. Such a deflationary policy also called real devaluation is generally a very slow process and comes at high cost in terms of unemployment and low economic growth. It is possible to bring imbalances back into equilibrium in this way, however the convergence of the sort needed in the Euro zone could not be achieved like this. The same would apply if the European Central Bank could be persuaded to reduce EMU countries debts through higher inflation. Even such a breach of the ECB mandate would not be sufficient to bring about the necessary convergence in the Euro zone.

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2) Fiscal integration expanding government adjustment mechanisms If market mechanisms are not available on a sufficient scale, things can be brought into balance through fiscal redistribution. The fiscal compensation mechanisms scarcely exist in the Euro zone. The current debt crisis has heightened the debate surrounding the expansion of fiscal redistribution, even going as far as fiscal union. This would involve shifting some or all areas of national fiscal policy to the supranational level. Common fiscal policy would then be set by joint supranational institutions, with governments having a say in it at best. In addition to these direct transfers, there are also indirect transfer mechanisms. These arise, for instance, from joint liability for government debt, either as a result of guarantees or through issue of joint bonds. It is also likely that fiscal integration would take on significant momentum, harmonizing and centralizing an increasing number of policy areas. One could hardly expect transfer payments to be generally acceptable if social standards in the beneficiary country are higher than in the donor. Greater harmonization of other policy areas would also raise the potential for indirect redistribution. This creates a conflict of interest between potential donor and beneficiary countries. The former tend to want to limit their liability to the beneficiaries. It is obvious in any event that the desire for fiscal integration is not the same in all countries, and there are hefty debates about the extent to which fiscal burden sharing can be expanded. 3) Currencies break-up a question of cost and benefit If equilibrium cannot be restored within the currency union either by market mechanisms or a Fiscal transfer mechanism, then over the long term the need for adjustment between member countries must be reduced. This happens when less convergent countries leave the union. There is no provision under the Treaty of Maastricht to force a country out. It therefore becomes a decision of an individual country to leave the European Monetary Union, which is possible. It basically involves breaking the Treaty but it is possible that an independent sovereign state could choose to leave the Euro area if it wished. There are three reasons why a country would choose to leave the monetary union in the Euro area: 1. The first is that by departing from monetary union the country regains control of monetary policy and interest rates. 2. Secondly, and related to that, monetization is directly controlled. Of course, monetization can take place under monetary union, but it becomes far more directly controlled if the country is outside of the Euro area. 3. Thirdly, whatever currency is established having left the monetary union, it is something that can then be devalued. Some kind of external competitive advantage by devaluation can therefore be gained.

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So there are some benefits to leaving monetary union. But against this we have to consider the costs. Realistically there are five costs to leaving monetary union; they are huge and can outweigh any conceivable benefit. 1. The first cost is default. Default may happen within monetary union; however default is guaranteed when leaving monetary union. Either because firstly the entire national debt is denominated in a foreign currency over which there is no ability to print and no ability to tax or because the debt is redenominated into the new national currency which would be a technical default. Note that the problem applies also to the debt of corporate, which should trigger a wave of bankruptcies. 2. Secondly, the domestic banking system is likely to collapse. If you are being forced out of monetary union, any sensible depositor in the domestic banking system is likely going to close their bank accounts and get the money out in Euro form as quickly as possible before you leave the Euro area. 3. Third; in all probability the country would have to leave the European Union. It will have broken the Treaty of Maastricht, so it will have sealed its borders to the international movement of capital, and will have effectively abrogated the single market. 4. The devaluation of the currency probably does not work. Any currency which has left the Euro and the European Union is likely to find common tariffs imposed against it. 5. The final issue is that all of this is extraordinarily disruptive. Youve basically debauched the savings of your entire national population in this process and realistically, there is a significant threat of civil disorder. 4) Splitting up the Euro Zone into two parts: The Euro zone could be split in two, creating two different euro currencies. Naturally the composition of the groups would be a matter of negotiation, since some countries do not easily belong in either one group or the other. The broad outline is however clear enough. Germany would form the heart of one group, along with Finland, Holland and Austria. In addition Estonians have been making it pretty that they would also be up for the ride. Spain, Italy and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out. Naturally the technical challenge would be enormous, but it would not be insurmountable. The great advantage of such a move would be that two of the major burdens under which the monetary union is laboring the lack of price competitiveness on the periphery and the lack of cultural consensus between the participants - would be resolved at a stroke. 5) Strengthening the EFSF: The European Financial Stability Facility (EFSF) is a special purpose vehicle financed by members of the Euro zone to combat the European sovereign debt crisis. It was agreed by the 27 member states of the European Union on 9 May 2010, aiming at preserving financial stability in Europe by providing financial assistance to euro zone states in economic difficulty. The EFSF can issue bonds or other debt instruments on the market to raise the funds needed to provide loans to Euro zone countries in financial
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troubles recapitalize banks or buy sovereign debt. Emissions of bonds would be backed by guarantees given by the euro area member states in proportion to their share in the paid-up capital of the European Central Bank (ECB). The current balance of the EFSF stands at Euro 440 billion and further steps need to be taken to increase its strength by making rich European countries like Germany and France to contribute more and thus increase the funds capacity.

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