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Economic Crisis of the PIIGS Economies

Article written in November 2011 by P. Vijay Kumar

Introduction to European Union

Preface:-

While the history of Europe is fascinating, it is almost impossible to cover all the aspects of this vast and great continent in any single article. This article tries to explain the complex financial history of Europe Union since the World War II. I have covered various other topics such as European Union, European Parliament, the Troika, European Economic Commission, Trade and Commerce within Euro Region and the Future of Euro in other articles. I have also planned a separate article on European History with emphasis on politics and economics and how it had shaped the current Euro region.

About the EU:-

The current European Union is a unique economic and political partnership between 27 European countries. It took countless meetings, deliberations, discussions and negotiations to carve the current shape of the Union. Many people outside the European region might ask as to what all these discussions and arrangements achieved? To answer that one has to look at the situation in Europe prior to World War II. Various nations among Europe had fought numerous battles among themselves for over 2000 years. As per one count by a researcher at Harvard, in the last four hundred years preceding the World War II, there had been at least a war once in twenty five years. This shows the difference in cultures, the mistrust and stark economic differences that the countries within the region had among them before the World War II. However, since the European Union began to take shape just after the World War II, it has provided half a century of peace, stability and prosperity. It has also helped in raising living standards, launched a single Europe-wide market in which people, goods, services, and capital move among Member states as freely as within one country.

The European Symbol:-

The European symbol is represented by 12 stars in a circle symbolizing the ideas of unity, solidarity and harmony among the people of Europe. The stars are coloured in yellow behind a blue background.

Money in the EU:-

The EU (being a union of 27 countries) has a well-defined mandate to bring about prosperity, peace and trading benefits apart from other objectives. The EU acts more like a federation to all the member of EU. Being a federation, the EU has its own budget which is drawn from the member countries. The EU budget is funded from sources including a percentage of each member country’s gross national product. It is spent on efforts as diverse as raising the standard of living in poorer regions and ensuring food safety. The EU also obtains revenue not only from contributions from member countries but also from import duties on products from outside the EU and a percentage of the value-added tax levied by each country.

The EU budget is used to pay for activities such as rural development, environment protection, and protection of external borders, promotion of human rights, payment of staff salaries and other contingent expenses. The European Commission, The Economic Council and the European Parliament all have a say in how big the budget is and how it is allocated.

The European Union has Euro as its currency. It is used by some 327 million Europeans and is gaining popularity and acceptance world over.

The strengths of the Union:-

With just 7% of the world’s population, the EU’s trade with the rest of the world accounts for around 20% of global exports and imports. The EU is the world’s biggest exporter and the second biggest importer.

Around 2/3rd of EU countries’ total trade is done with other EU countries.

The United States is the biggest trading partner of EU followed by China.

EU administration:-

The European Union is governed by the European Commission. The commission is divided into departments known as Directorates General (DGs), very similar to ministries. Each DG covers a specific policy area. Around 38,000 people are employed by the European Commission.

The European Union is represented by a diverse group of countries which differ in language, culture and economy. The EU has 23 official languages. People living in the EU have access to all the EU documents in their official language of their country. They also have the right to write to the Commission in their language and receive a reply in that language. The EU employs the largest translation services in the world. It has a staff of around 1750 linguists and 600 support staff.

The headquarters of European Commission is based in Brussels and Luxembourg. It also has offices throughout the EU.

EU members:-

As on November, 2011 the following are the members of EU.

1. Austria
2. Belgium
3. Bulgaria
4. Cyprus
5. Czech Republic
6. Denmark
7. Estonia
8. Finland
9. France
10. Germany
11. Greece
12. Hungary
13. Ireland
14. Italy
15. Latvia
16. Lithuania
17. Luxembourg
18. Malta
19. Netherlands
20. Poland
21. Portugal
22. Romania
23. Slovakia
24. Slovenia
25. Spain
26. Sweden
27. United Kindgom

EU Institutions:-

The European Union comprises of three main institutions that help in achieving the goals of the Union. The following are the institutions.

1. European Parliament: – It represents the EU’s citizens and is elected by them.
2. The Council of European Union: – It represents the governments of the individual member countries. The presidency of the council is shared by the member states on a rotating basis.
3. The European Commission: – It represents the interest of the Union as a whole.

Apart from the above three there are other numerous institutions that serve specific purposes.

European Union Countries

The objective of the tables below is to give an idea of the European region as a whole. Since EU is nothing but a collaboration of independent sovereign countries, a thorough understanding of the countries involved will give a good idea of the concept of EU as a whole.

On comparison of data, we can notice that out of the 27 countries, the top 6 countries constitute around 76% of the GDP of the EU. These important six countries are Germany, France, UK, Italy, Spain and Netherlands. Due to their high GDPs and stable political environment, they are able to muster power within the EU region. They also exert a lot of influence within the EU parliament and EU commission. It is due to their strong economies that they are seen as the torch bearers of the concept of EU.

Table 1: Size of the country (in sq. kilometers) in comparison to EU, Andhra Pradesh and India

This is meant to create an impression of the area of the country. Often area of the country is an essential ingredient in making a country a super power. In the book “Politics among Nations” written by celebrated author Mr. Hans Morgenthau in 1948, he described and emphasized the role that the size of the country plays in self sustenance and in growing to super power status.


Note:-
EU refers to European Union; and
AP refers to Andhra Pradesh (The combined state of Andra Pradesh before division)
Total Area of EU: 43,24,782 square kilometers
Total Area of Andhra Pradesh: 2,75,000 square kilometers
Total Area of India: 32,87,263 square kilometers
EU is roughly 131% of India or has 30% more area than India.

The above table shows that most of the countries in the EU region are small in size. The countries that are well developed and form the bed-rock of the EU are Germany, France, Italy, Spain, United Kingdom, Sweden, Finland and the Netherlands. Though Greece is in the limelight currently due to its economic problems, it does not have a significant GDP to influence EU decisions.

Table 2: Comparision of the countries across various parameters

Note:-
GDP in USD billions; GDP per capita in USD;
Total GDP of EU = 16.28 trillion
Per Capita GDP of EU = $ 31,000
Unemployment = 9.3%
Inflation = 2.1%

Euro Zone and European Central Bank

The European Union is an economic and political union of 27 independent member states located in Europe. The concept of EU started to take shape in the 1958, though at that time it was called the European Economic Community (EEC) and had only six affiliated members. Over the years as trade and trust grew among nations, more and more nations joined the organisation which culminated in the current form. The EEC was named as European Union in 1993 with the signing of Maastricht Treaty.

The primary purpose of EU is to establish long term peace and stability among the member countries through engagement in political diplomacy, trade and commerce and overall welfare of the member states. It is a vision that was shared by all the members who were affected by the World War II in Europe. Most member states had a mandate not to indulge in unnecessary wars within the region and to establish peace through cooperation rather than confrontation.

The concept of EU provided a multilateral platform for diplomacy and trade. However, each member country had their sovereignty. Member countries have the freedom to deal with other countries outside the EU on their own terms, establish their own monetary and fiscal policies, manage their own military and other institutions, and lay down their legal and administrative systems. Most member countries had their own central banks, currency and monetary policy institutions to deal with their economies.

With increasing trade among the EU nations which account for about 2/3rd of the total trade of EU, the system of maintaining different currencies and exchange rate systems started to create hindrance to the smooth flow of capital, goods and services and movement of labour. Thus it was proposed that member countries should consider sacrificing their own currencies for a common currency. The objective of the idea was to remove the limitations of multiple currencies and the exchange rate conversion system.

Though the idea was appealing to many members of the EU and particularly the weaker economies; the stronger economies like UK, Sweden and Denmark did not wish to sacrifice their sovereign right of currencies to an outside institution. Hence, initially, only 11 members agreed to abandon their currencies and form a single currency. These 11 members, after series of deliberations and research studies, launched the official currency named “Euro” on 1st January 1999, while their existing national currencies were still in circulation. The idea was to start the new currency while the existing national currencies were used as legal tender and on a phased manner to abandon the national currencies altogether.

These 11 countries which started the Euro were termed as the “Euro Zone” or “Euro Area” countries. The official name of the Euro zone is Economic and Monetary Union (EMU). All members of the Euro Zone are mandated to adopt the Euro as their common currency and the sole legal tender.

Since the Euro Zone comprises many member countries, a new system of monetary authority and policy had been established. The new monetary authority was named as “European Central Bank” which was represented by the Euro Zone member countries. Individual member countries of the Euro Zone had retained their own Central Banks who had a larger role to play in terms of framing and implementing fiscal policies of their individual countries and also participate in framing the monetary policies for the Euro Zone. The collective system of the European Central Bank with the Central Banks of the individual member countries came to be known as the “Eurosystem”. Countries outside the Eurozone are not part of the Eurosystem.

The European Central Bank is the represented by the finance ministers of the individual countries and is the sole authority in designing and printing of euro bank notes and coins.

Between 1999 and 2011, six more countries joined the Euro Zone increasing the total number of Euro Zone members to 17. The following Table shows the current members of Euro Zone or the European Central Bank.

Table 3: List of members of Euro Zone

1. Austria
2. Belgium
3. Cyprus
4. Estonia
5. Finland
6. France
7. Germany
8. Greece
9. Ireland
10. Italy
11. Luxembourg
12. Malta
13. Netherlands
14. Portugal
15. Slovakia
16. Slovenia
17. Spain

Ten countries namely Bulgaria, Czech Republic, Denmark, Hungary, Latvia, Lithuania, Poland, Romania, Sweden and United Kingdom are members of the EU but are not part of the Euro Zone. Some of these member countries are undergoing the due diligence and are expected to join the Euro Zone soon.

PIIGS Economies

PIIGS Economies refer to the economies of the EU namely Portugal, Ireland, Italy, Greece and Spain. The acronym PIIGS was coined by financial institutions that had heavily invested into the sovereign debt of these countries. Of late this acronym has caused controversy and has been banned by a few financial newspapers. However, as the current crisis unfolds more and more financial newspapers, reports, journalists and other members of the press have increased the usage of this term. The term is used in a restrictive sense only to connote the economies that are being talked about.

To understand the current crisis it is important to understand the root cause of the crisis. This can only be done by understanding the economies of the individual countries in PIIGS economies.

The following paragraphs try to explain the structure of each of the above mentioned individual economies and to understand the problems associated with them.

Greece

Greece is a developed country and is a member of the EU and Euro Zone. It enjoys a high standard of living and is rated “very high” in the Human Development Index. It has a diverse economy. Its main industries are tourism, shipping, industrial products, food and tobacco processing, textiles, chemicals, metal products, mining and petroleum. One is forced to think as to how could a country having such diverse industries to support the economy run into such severe debt crisis? The answer to this is very simply – competition. Greece has been facing intense competition from other countries in all of its industries. The cost of some of products that are manufactured in Greece are about 20% to 25% more than the cost of similar products in Germany. Apart from the competition within the EU, Greece also faces competition from outside EU countries, particularly from developing countries of Asia. The reason for the high costs of manufacturing can be attributed to the lack of economies of scale and expertise. The reduction of trade barriers under the WTO regime has also added to its woes.

The problems of competitiveness have been hounding Greece since mid 1990s. However, the lack of adaptability to create new industries based on competitive advantage and finding other alternative solutions to increase growth has piled up the problems which resulted in the current debt crisis.

Industries tried to reduce costs by cutting wages to stay competitive. However, as the output fell and the per capita income decreased, the Greek government faced increasing fiscal deficits. The government tried to finance the fiscal deficit by resorting to borrowings, both externally and internally. Initially, the government resisted to put in place any austerity measures and tried to keep the public spending at levels similar to what was done in the previous years. The idea was that if the economy expanded then it would lead to higher tax collections, which can be used to service and repay the borrowed debt. However, the economy did not expand, instead it contracted. This resulted in the accumulation of debt and reduction in tax collections, which means that Greece would not be able to service its debt and repay its loans.

The response to this crisis by Government is to put in place various austerity measures such as a 10% cut in bonuses, overtime work salaries and work related travels. The austerity measures also included a 7% cut in the salaries of public and private employees, a rise of VAT, a rise of 15% tax on petrol, a rise between 10% to 30% taxes on imported cars, etc. However, austerity measures have their negative effects as well. A cut in public spending usually results in lower tax collections, lower economic output and high unemployment.

The austerity measures did not bring expected results and it became very clear that Greece would default on its sovereign debt. This forced the government to borrow from external sources. The risk of the impending Greece default and the state of affairs of its economy prompted various Credit Rating Agencies to reduce the country’s rating to Junk status. This meant that Greece could no longer borrow money at the rates that it used to borrow previously. The interest rate on a 2 year government bond increased from 4.5% in 2007 to 26% in 2011, reflecting the markets assessment of risk associated with the Greek economy. This further meant that Greece could no longer afford to borrow at all from the international markets; as borrowings at such high interest rate levels would lead to a vicious debt trap.

The Greek government, having no other option, had to approach the IMF for support. The IMF extended a helping hand by proving credit lines. However, the amount was not sufficient to service the debt on a long-term basis. The government, thus, approached the European Central Bank (ECB) to help them resolve the crisis. The Greek government proposed the European Central Bank to borrow Euro loans on behalf of it from the international markets. The idea was that if the European Central Bank borrows Euro loans from the international markets then it would be able to borrow at lower rates compared to what Greece can borrow on its individual terms. While this is possible as Greece is a member of the Euro Zone, the idea was resisted by the governments of Germany and France. France in particular is very vocal in not extending any such support to Greece through ECB. Most of the other countries are also not in favour of such an arrangement. The problem lies in the mistrust about Greece seriousness in implementing necessary austerity measures and getting its lackluster economy into shape.

Greece has a history of misdeeds. As a signatory of the Maastricht Treaty, all member countries had pledged to limit their deficit spending and debt levels after joining the EU. However, a number of European member countries, including Italy and Greece, were able to circumvent these rules and mask their deficit and debt levels through the use of complex currency and credit derivative structures. The structures were designed by prominent U.S. Investment Banks, who received substantial fees in return for their services and who took on little credit risk themselves thanks to the special legal protections for derivative counterparties.

When the other EU member countries found about these structures and misdeeds, they opposed the move with regard to borrowing by the ECB on behalf of Greece. This has further deepened the crisis and the likelihood of Greek default.

Table 4: History of Greek debt and deficit

Note:-
Figures of 2012 as forecasts
Figures of 2011 are estimates
Source: Eurostat

Italy

Italy has been categorized as a free market economy with high per capita GDP and low unemployment rate. It is a founding member of the G8, the Euro Zone and OECD. The country is well known for its influential family owned business sector, industrious and competitive agricultural sector and as the world’s largest wine producer. Italian industries have earned a reputation for creativeness, quality and design. Not long ago, it was ranked 8th in the world in terms of quality of life.

Despite the above credentials, the country has been witnessing for the last 10 years significant shifts in demographics, culture, economy, unemployment, inequality and unequal distribution of wealth among its provinces.

Italy has a large number of small and medium-sized enterprises which serve as the backbone of its economy. While most of these enterprises are competitive and have their own niche markets they are, of late, suffering from reduced productivity levels and increased competition from companies in emerging economies. All this has resulted in a substantial fall in the GDP growth rate, which now is among the lowest in the EU. The economy also suffers from structural weaknesses due to its geographical conformation and the lack of raw materials and energy sources. The country imports about 86% of its total energy consumption.

Apart from the problems with its economy, the country also suffers with high levels of immigrants from Africa and China, unequal distribution of wealth between the southern part and northern part of the country, increasing levels of crime, increasing number of old age citizens and political instability. The country has often been described as the Sick Man of Europe due to the above reasons.

The problems with the economy started in the early 1990s; however, due to the lack of political will and support, corrective measures could not be put into place. The gradual slow down of the economy since 1980s and the increased government spending (in an effort to revive the economy) have led to a rise in public debt. A rise in public debt in itself does not pose a threat to the economy as long as the debt money is utilized in increasing productivity and getting the economy on track. However, this is not what has resulted. The presence of high levels of corruption, lack of infrastructure and market reforms, and lack of investment into research and education and inflexible labour laws posed as hindrance to growth.

The government responded to these problems by putting in place various austerity measures but they were not sufficient enough. Though the market does not expect a debt default by Italy, unlike Greece; it is quite wary of the poor economic growth prospects. The S&P downgraded the Italian sovereign rating in 2011 and has maintained a negative outlook for future. This means that further downgrades are possible in the near future.

In the recent months, Italy’s problems were not in the limelight as much as Greece’s were. The reason for this is the seriousness of the Greece’s economic problems compared to Italy’s. While Italy’s problems can be solved (provided the government takes necessary steps in reducing debt burden), Greece’s problems seem to be compounding and might take very long time to get solved. However, sooner or later Italy will need to respond to its structural weaknesses. Without any long term sustainable plan in place and most importantly the implementation of such plans, Italy might become the next Greece.