Scholarly article on topic 'Investigating the Recovery Strategies of European Union from the Global Financial Crisis'

Investigating the Recovery Strategies of European Union from the Global Financial Crisis Academic research paper on "Economics and business"

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Abstract of research paper on Economics and business, author of scientific article — Şükrü Yurtsever

Abstract The global financial crisis has affected almost all countries in the world. The crisis has hit European economies unprecedentedly hard and its effects have occurred in two phases. The first phase is the economic recession following the global economic downturn. The second phase is the so-called sovereign debt crisis which started in Greece firstly and then appeared in Ireland and Portugal. Like many other countries and organizations, European Union (EU) has also developed strategies in order to tackle the challenges of the crisis. This paper attempted to investigate the strategic initiatives of EU for the economic recovery in Europe. The results of this investigation show that EU's recovery strategies have been executed in two ways: the preservation of Member States’ financial stability and the enhancement of economic governance inside EU. Nevertheless the lack of a political union, in particular the supranational governance of economy policy is delaying the recovery of the EU's economy and causing the contagion of sovereign debt problems in Member States of euro.

Academic research paper on topic "Investigating the Recovery Strategies of European Union from the Global Financial Crisis"

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Procedía Social and Behavioral Sciences 24 (2011) 687-695

7th International Strategic Management Conference

Investigating the Recovery Strategies of European Union from the Global Financial Crisis

§ükrü Yurtsevera a*

aGebze Institute of Techonolgy, No:101, Kocaeli 41400, Turkey

Abstract

The global financial crisis has affected almost all countries in the world. The crisis has hit European economies unprecedentedly hard and its effects have occurred in two phases. The first phase is the economic recession following the global economic downturn. The second phase is the so-called sovereign debt crisis which started in Greece firstly and then appeared in Ireland and Portugal. Like many other countries and organizations, European Union (EU) has also developed strategies in order to tackle the challenges of the crisis. This paper attempted to investigate the strategic initiatives of EU for the economic recovery in Europe. The results of this investigation show that EU's recovery strategies have been executed in two ways: the preservation of Member States' financial stability and the enhancement of economic governance inside EU. Nevertheless the lack of a political union, in particular the supranational governance of economy policy is delaying the recovery of the EU's economy and causing the contagion of sovereign debt problems in Member States of euro.

© 2011 Published b y Elsevier Ltd. Selection and/or peer-review under responsibility of 7th International Strategic Management Conference

Keywords: European Union; Global Financial Crisis; Sovereign Debt Crisis; Recovery Strategies

1. Introduction

2007-2008 global financial crisis, widely referred as to the worst financial and economic shock since the Great Depression has revealed many serious deficiencies in the global financial system. The consequences of the crisis led governments and international institutions to act cooperatively to restore the confidence in markets through several strategies. There is a large consensus that more structural reforms are needed to achieve a transparent functioning of markets.

As a major player in the global financial landscape, European Union (EU) has also taken a set of strategic actions during the global financial crisis. The recovery strategies of EU can be categorized under two headings; the preservation of Member States' financial stability and the enhancement of economic

* Corresponding author. Tel.: +90 532 605 8298; fax: +90 262 654 3224 . E-mail address: syurtsever@gyte.edu.tr.

1877-0428 © 2011 Published by Elsevier Ltd. Selection and/or peer-review under responsibility of 7th International Strategic Management Conference doi:10.1016/j.sbspro.2011.09.132

governance inside EU. In the first phase of the crisis, European states in coordination with European Union tried to stabilize markets via injecting liquidity into the banks with high level of impaired assets. In the second phase, after the eruption of sovereign debt crisis in some Member States, they took new measures for the stabilization and governance of macroeconomic conditions in Europe.

Despite all efforts, the progress of the recovery from the crisis in Europe has lagged behind as compared to other advanced economies. The cause of this gradual recovery is definitely the sovereign debt problems of Member States in the euro area. Moreover, the lack of coordination among Member States and a monetary union without a fiscal union has reduced the effectiveness of strategies.

This paper will attempt to investigate the strategic initiatives of EU for the economic recovery in Europe. In this regard this paper has been divided into three parts. The first section gives an overview of global financial crisis and its effect on EU countries economic crisis in 2010, particularly its causes and consequences. The second sections deals with European sovereign debt crisis and its connection to global financial crisis. Finally, in the last section the EU's strategic steps that have been taken towards economic recovery will be discussed.

2. 2007-2008 Global Financial Crisis and Its Effect on EU Countries

European Union has been constructed on mainly economic concerns. Since the establishment of European Economic Community in 1957, economic integration has been deepened and widened year by year. Second half of the 1980s were the beginning of significant developments. The Single European Act was introduced in 1985 with an ambitious target to finalize full-functioning internal market. Following the completion of internal market in 1992 the next step was to develop monetary union. In this regard, the euro comes into force in 1999. However, soon after its adoption, internal problems arose because of the difficult management of such diverse economies with a single currency. One after another, many countries breached the rules that were set in Stability and Growth Pact, a regulation on effective coordination of fiscal discipline in Member States of euro zone. [1, 2]

During 2000s, European economies performed well until the global financial crisis hit the Member States. [3, 4] The effects of the crisis in Europe occurred in two phases. The first phase is the economic recession following the global financial crisis. The second phase is the so-called sovereign debt crisis which started in Greece firstly and then appeared in Ireland and Portugal.

Early signs of crisis had emerged in the summer of 2007, when the number of delinquent borrowers of sub-prime mortgage loans has increased dramatically in United States. A dramatic decrease in mortgage payments and the resulting rapid devaluation of mortgage-backed securities led to the collapse of the global financial system. In September 2008, the default of Lehman Brothers, one of the major players in mortgage-backed securities market, and the bailout of American International Group, one of the largest insurant of these complex financial products, has tumbled the markets all over the world. [5]

An increasing amount of literature has been published on global financial crisis. Most of these studies have investigated the possible causes of the crisis and its effects on developed and emerging economies. According to Reinhart and Rogoff [6], this crisis has many commonalities with the previous crises in terms of equity market trends, growth slowdowns, housing price changes, and public debt levels. The roots of the crisis can be stretched back to financial deregulation movement which started in the beginning of 1980s. Crotty [7] argues that this "new financial architecture" based on "light regulation" of financial intermediaries has allowed investment banks to expand their activities with innovative financial instruments. As argued by Allen and Carletti [8]; after the failure of dot-com bubble in the late 1990s, the expansionary monetary policies of central banks increased the risk appetite of commercial and investment banks. As a result of the lower cost of financing, financial sector dominated the US economy in 2000s. Financial Crisis Inquiry Commission (FCIC) indicates in its report that the profitability of financial sector has been doubled in the last three decades. [9]

The consequences of the crisis were dramatic for the world economy. In 2009 world output fell by 0,6% and world trade fell by 11%. In advanced economies GDP dropped by 3.2 % in 2009. [10] Claessens et al. [11] provide a comprehensive account of the cross-country experiences during the crisis. They indicate that the most affected group of countries were those which share strong links with US financial markets. Then comes the countries with domestic housing bubbles accompanied by heavy external financing. And the last group are small countries whose economies are driven mainly by the exports.

EU countries are the most severe affected countries during the financial crisis. Real GDP is to drop by 4.2 % in 2009. In some central and eastern Member States, GDP has declined between 8% and 18%. The unemployment rate of euro area increased from 7.5 % in 2008 to 9.4% in 2010. [12, 10] Global financial crisis has exerted the most negative impact on public finances of EU Member States. Budget deficits with levels of 7% of GDP on average and public debts over 80% of GDP exceeds the limits (3% and 60 % respectively) set by Treaties of EU.[13] Currently, 24 out of 27 Member States have been subject to "excessive deficit procedure" which was established by the Stability and Growth Pact to ensure Member States obey deficit (3% of GDP) and debt (6%) limit. It is used avoid excessive budgetary deficits of Member states in order to build a stable functioning of the European Monetary Union

Global financial crisis was not the only reason behind the macroeconomic deteriorations, in particular sovereign debt problems in EU Member States; however it worsened fiscal manoeuvre capability of them and thus lessened their chances to overcome the results of crisis. In the next chapter we will discuss how global financial crisis evolved into the sovereign debt crisis in European countries.

3. European Sovereign Debt Crisis and Its Connection to Global Financial Crisis

Up to the present, the linkage between banking crises and debt crises haven't received sufficient attention in the literature. [14] After the outbreak of financial crisis and debt crisis in Europe, the researchers begin to treat this issue in much detail. In their recent research, Reinhart and Rogoff [15] analysed a comprehensive dataset of the sovereign defaults from 1800s to the late 2000s. They found that banking crises often precede or coincide with sovereign debt crisis and increase the probability of sovereign default. In a detailed investigation of 2010 EMU sovereign debt crisis, Arghyrou and Kontonikas [16] found that after the global credit crunch, markets began to price both macroeconomic country risks and other international risks more seriously. They concluded that this shift in pricing behaviours caused the crisis in Greece and other European periphery countries.

Besides the global financial crisis, the conditions in EU countries before the crisis were also responsible for the economic downturn. Unproductive use of resources, unsustainable policies in some member countries, faulty management of public accounts, institutional organization of European Monetary Union, the lack of cooperation among Member States are widely referred as inherent causes of the crisis. [17, 13] De Grauwe [18] pointed two 'fault lines' which diminishes the credibility of Eurozone; the lack of mechanisms which can enhance Member State's competitiveness, and the lack of mechanisms to resolve crises.

Sovereign debt crisis was firstly unfolded in Greece in November 2009. Pre-existing conditions in Greece such as low level of structural reforms and macroeconomic deteriorations undermines the Greece's capability to prevent the shocks of the crisis. [19] After the first quarter of 2009, Greece was subject to excessive deficit procedure as specified in Stability and Growth Pact, owing to the forecasted deficit at 4.4 % of GDP. However, this estimate was also wrong, because of misreporting of the public finance statistics. In November 2009 Greek government announced that its deficit will be 12.7 % of GDP. European Union's first reaction to the case was to determine a schedule for implementation of budgetary measures. [20]

European governments didn't give a signal for the bailout of Greek economy until March 2010. As a result Greek fiscal crisis deepened and its public debt became unsustainable. [21] Following the March 2010 meeting of European Council, Eurozone members decided to offer €30 billion for 2010 as three year

loans with an interest rate of 5%. On 2 May 2010, Euro area Member States raised the rescue package to €80 billion with a joint support of IMF with a €30 billion stand-by agreement. However, speculative attacks against euro had continued and European financial ministers met once more extraordinarily on 9 May to adopt a comprehensive package to stabilize Euro area. A European Financial Stabilisation Mechanism (EFSM) and a European Financial Stability Facility (EFSF) were created in this regard with a total budget of €500 billion to provide financial assistance to Member States in difficulties.

The financial problems of Greece have spread to other weak economies in the European Monetary Union (EMU). Ireland requested for financial assistance in November 2009 and most recently, Portugal became the third country which applied for an EU bailout. Similar to the Greek rescue package, EU and IMF jointly launched a three-year loan amounting to €85 billion for Ireland. However, the details of European aid for Portugal haven't been disclosed yet.

4. European Union's Recovery Strategies from the Financial Crisis

The strategies developed by EU to the financial and economic crises can be categorized under three groups: the first group of strategies devoted to the restore of confidence in markets with stimulus plans, the second group of strategies developed for the proper supervision and governance of the financial system and the third group comprises the strategies to enhance economy policy coordination among Member States through economic governance mechanisms.

Right after the crisis enters the most critical stage in September 2008; European Economic Recovery Plan was the first stimulus package introduced by the EU. The strategic objectives of the Plan were to recover the economy by considering the long-term objectives such as enhancing competitiveness and creating green economy and to mitigate the social costs of the crisis. In order to attain these objectives, the Plan proposed a number of strategic actions in accordance with Lisbon Strategy and was supported by a budget of 200 billion Euros. [22]

As the crisis spread the eurozone 'periphery' countries, namely Greece, Ireland and Portugal, European Financial Stabilisation Mechanism (EFSM) and a European Financial Stability Facility (EFSF) were introduced as new mechanisms to avoid financial distress in euro area. Within the framework of EFSM the Commission can contract borrowings from financial markets on behalf of the EU, and then lend it up to €60 billion to the Member State in financial difficulties. Additionally, EFSF was as a special purpose vehicle, which can issue bonds up to €440 billion for lending to Eurozone Member States in difficulties. Both EFSM and EFSF were adopted following the Ecofin Council in 9 May 2010, became fully operational since August 2010 and will remain in force until June 2013. After June 2011, European Stability Mechanism (ESM) will replace ESFM and EFSF as a permanent instrument to safeguard the stability of euro area. [23]

The second group of strategies has started when European Union gave a mandate to a high level group chaired by Mr. Larosiere, in order to identify what has to be done to undertake more deep-rooted reforms. Based on this Larosiere's group report, European Commission launched a set of strategies intended to constitute a more transparent European financial system. In March 2009 a communication was adopted for the formation of European Financial Supervision System. With the establishment of the new system, three existing Committees (Committee of European Banking Supervisors, Committee of European Insurance and Occupational Pensions Committee, Committee of European Securities Regulators) will be replaced by more strengthened Authorities, which will operate at European level and in coordination with national supervisors.[24]

In accordance with the Communication of March 2009, European Commission published a second communication two months later which details the European Financial Supervisory Framework. Commission proposes a system based on two dimensions. The first dimension establishes European Systemic Risk Board (ESRB), which will be responsible for monitoring the macro risks in the financial system. The decisions of ESRB will not be binding on Member States, but an action or explanation might

be demanded in case they didn't act on ESRB's recommendations. The organizational structure of ESRB will be composed of members and observers. President and Vice-President of European Central Bank, governors of national central banks, chairpersons of three European Supervisory Authorities and one person from the European Commission would have a right to vote as members in the ESRB. The representatives of national supervisory authorities and chairperson of European and Financial Committee would join the organization as observers. [25, 26]

The second dimension of financial supervision is the European System of Financial Supervisors (ESFS). The main objective of ESFS is to identify micro risks stem from financial institutions, other sectors' players or consumers. It transforms three existing Committees of financial regulation into the Authorities (European Banking Authority, European Insurance and Pensions Authority and European Securities and Markets Authority) with more power and responsibilities. The Authorities can take binding decisions when a disagreement occurs between national authorities or actors. The organization of ESFS consists of a steering committee, board of supervisors and management board. One representative from each authority would work in Steering Committee to determine the cross-sectoral risks. Board of Supervisors in each Authority will be composed of the chairperson of that Authority and representatives from relevant authorities in Member States. Moreover, a representative of European Commission, of ESRC and of EFTA-EEA country would be involved in as observers. A management board will be responsible for operational tasks, which comprise national representatives and the Commission. [25, 27]

European Commission presented legislative proposals for the European Financial Supervisory Framework in September 2009 and one year after European Council and European Parliament approved the new financial supervision structure. Both ESRB and three Authorities started to work officially in January 2011.

As mentioned above, while dealing with the global financial crisis, Europe has to cope with sovereign-debt problems of some Member States since November 2009. European Monetary Union has been widely criticised because it is based on a single central bank without a common fiscal policy among Member States. The lack of supranational fiscal coordination has become more apparent in the absence of immediate and mutual response to the Greek crisis. Hence, EU initiates a new strategy to "reinforce economic policy coordination" by the invitation of EC Commissioner Olli Rehn in April 2010. [28] EU's new economic governance strategy is based on three pillars; strengthening of Stability and Growth Pact, enhancing macroeconomic coordination within EU and harmonisation of national budget frameworks of Member States.

As a fiscal surveillance mechanism of Euro area member states, Stability and Growth Pact plays a key role in European economy policy coordination. However recent debt crisis has shown that member states couldn't perform in compliance with rules and principles set by the Pact. To enhance its implementation and to avoid the breaches of the rules, Commission set out a strategy that will reinforce so-called the "preventive" and "corrective" parts of the SGP.

The existing preventive arm of SGP operates through stability and convergence programmes in which Member States outline medium-term objectives (MTO) of their budgetary positions in accordance with the rules of SGP. However, as the current crisis proved, Member States are insufficient to achieve their MTO's. A new tool is added to the existing mechanisms, namely "prudent fiscal policy-making", which ensures that "annual expenditure should not exceed a prudent medium-term rate of growth". [29] With the help of prudent fiscal policy-making it is aimed to use unexpected extra revenues for debt reduction instead of spending it.

On the other hand, the existing corrective arm of SGP is implemented through excessive deficit procedure (EDP). EDP is an instrument to prevent excessive deficits and debts of Member States. While current EDP mainly focuses on deficit criterion (3% of GDP), the new strategy puts more emphasis on debt threshold (60% of GDP). In addition to this, the evolution of debt levels would be monitored more tightly. If a Member State's debt level exceeds 60% criterion, that Member State should take appropriate

actions in order to decrease the difference between its debt level and the reference debt values at a rate 5% per annum over the last three years. [30]

Both for the breach of preventive and corrective practices, the Commission developed new sanctioning mechanisms for the Member States in the euro area. If a Member State fails to adopt preventive actions, 0.2% of its GDP would be held as an "interest-bearing deposit". In the case of corrective action, the amount deposited would be the same; however, Member States in would not bear any interest. In addition to these sanctions, Commission developed a "reverse voting mechanism" in order to strengthen their implementations. Through this mechanism, the Commission's recommendation would be adopted, unless Council disapproves of it by the qualified majority. [31]

The rationale of second pillar's formation of economic governance is to prevent and correct macroeconomic imbalances. The reactions of Member states to the financial turbulences could be wideranging. To manage the process more efficiently, first mechanism introduced is an alert system based on Member States' scoreboards in which a series of macroeconomic indicators represented and analysed. An alert threshold would be specified for each indicator that will give a signal to experts for the in-depth evaluation of the problematic situation. The evaluation process of the scoreboards would be conducted on a regular basis. In-depth reviews can lead to two different outcomes for Member States. The first option is to take no action when macroeconomic indicators are stable. The second option is to recommend preventive actions if there is a risk of macroeconomic imbalance.

If macroeconomic imbalances of a Member State produce severe negative consequences for other Member States, the mechanism of "excessive imbalance procedure (EIP)" would be put into effect. In such cases, Member States are obliged to take a corrective action within a specific time period. Similar to implementation of the first mechanism, if the macroeconomic imbalance corrected, EIP will be closed. If the Member State took corrective actions, but its effects didn't occur simultaneously, the procedure will be closed but monitoring would be continued. If a failure in implementing corrective action or non-compliance with the recommendations continued repeatedly, a set of sanctions would be imposed for the Member States of euro. [32] A Member State in euro area has to pay 0.1% of its GDP as a yearly fine if it fails repeatedly to correct macroeconomic balances under EIP. The decision of enforcement will be taken by the reverse voting mechanism.

Third pillar of economic governance aims to harmonise budgetary frameworks of the Member States. This encapsulates the convergence of public accounting systems, forecasting methods, numerical fiscal rules and transparency.

All three pillars have been presented in six legislative proposals to the Council of the European Union in September 2010, and they are planned to be operational in June 2011 with the consent of European Parliament. On the other hand, European Commission has already started the new framework of budget surveillance, so-called "European Semester". Within the scope of the European Semester, a schedule of activities is organised in order to coordinate and evaluate the preliminary draft budgets of Member States. It starts each year in January with the adoption Annual Growth Survey, and after a series of reviews and debates on national budgets of Member States it lasts in June.

5. Conclusion

This paper has investigated the recent global financial crisis and its connection to European sovereign debt crisis in periphery Eurozone member states. In this investigation, the aim was to review EU's recovery strategies from the recession.

During the global financial crisis, EU has helped the financial system through stability mechanism programs to solve the liquidity problems. Moreover, the architecture of European financial supervision was renewed; the legal infrastructure of Stability and Growth Pact has been strengthened in order to overcome weaknesses of fiscal coordination within EU.

Global economic recovery started in the last quarter of 2009, but the risk of the "sovereign-debt contagion" remains high in Europe. Following the Greek bailout in Mai 2009, Ireland and Portugal has also requested EU's aid because of the rising costs of refinancing their debts through financial markets. In addition to this, Spain could be fourth country in seeking assistance as it has the highest unemployment rate in Europe and ongoing banking sector problems.

It is clearly evident that the lack of a political union, in particular the supranational governance of economy policy is delaying the recovery of the EU's economy. The pace and extent of the cooperation are still determined by domestic political conditions in Member States. Thus, markets do not react fully and instantaneously to the bailout packages and other structural reforms and this eventually hinders the ability of weaker EMU members to prevent the economic meltdown.

The current study has only reviewed the recovery strategies of EU; however more research is needed when the Commission's strategic initiatives come into effect entirely in order to better evaluate the impact of these strategies on EU member states.

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