Rationalize the formation of the European Union

 

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1.        Question 1. Rationalize the formation of the European Union

 

1.1    Background information of European Union

The European Union (EU) was created in the aftermath of the Second World War. The first steps were to foster economic cooperation: countries that trade with one another are economically interdependent and will thus avoid conflict. Since then, the union has developed into a huge single market with the euro as its common currency. What began as a purely economic union has evolved into an organisation spanning all areas, from development aid to environmental policy (Europa.eu 2011). There are two main ways of explaining the phenomenon of the European Union: adherents to one emphasize the role of the member states and their intergovernmental dealings; adherents to the other give greater weighty to the European institutions (Pinder & Usherwood 2007). Some initiatives of the formation of the European Union will be furthered probed into: wishes for peace, benefits of a common currency and mobility of labor.

1.2    Initiatives of the formation of the European Union

 

1.2.1            Wishes for peace

 

The idea of creating a unified Europe was not a new one.  In the 9 Century, the Frankish emperor Charlemagne dominated much of Europe. At the beginning of the 19 century, Napoleon Bonaparte attempted to control most of Europe.  In the 1930’s, Adolph Hitler intended to conquer all of Europe. The key words here are dominated, control, and conquer. Throughout history, wars were fought in Europe over land, religion, and resources—all with devastating results (Indiana.edu 2011). Hence one of the main reasons for the pursuit of the European unity was to achieve the long desired peace in Europe. Also after the World War II, with the dissolution of one of the two superpower, the Soviet Union, the European countries though with still strong economy powers were worrying about the recurrence of the wars as there was a lose of balance in the international political arena, the wishes for a long term peace had thus led to the formation of the European Union.

 

1.2.2            Benefits of a common currency: The European Monetary Union

 

On January l, 1999, the European Monetary Union (EMU) became reality. Based on the Maastricht treaty, signed in December 1991, the Euro as the single European currency replaced the national currencies of the eleven participating countries thus setting an end to the autonomy of national monetary polices in these countries (Kraus 2001, p. 4). The European Central Bank is located in Frankfurt, Germany, and is responsible for the monetary policy and exchange-rate policies of the EMU. The European Central Bank alone control the supply the Euro, sets the short-term euro interest rate, and maintains permanently fixed exchange rates for the member countries. With a common central bank, the central bank of each participating nation performs operations similar to those of the 12 regional Federal Reserve Banks in the United States (Carbaugh 2008, p.286). The benefits of using a single currency in the region are simple to apprehend, one with enough of euro in his or her pocket could buy any goods in any European countries that use the euro currency without any money exchanges. Also based on the optimal currency areas theory which determines the conditions that countries should satisfy to make a monetary union attractive, that is to ensure that the benefits of the monetary union exceed its cost (Grauwe 2007, p.114), economies under the same currency would have similar business cycle and economy structure which bring about more chances for success.

 

 

1.2.3            Mobility of labor

As proposed by Heinz Fassmann, Max Haller and David Stuart Lan (2009, p. 51), with the accession of the ten new members states to the European Union in May 2004, the issue of geographic and labour market mobility within the Europe has taken a very prominent position on the European Union policy agenda. And the fact that the year 2006 was officially chosen as the European Year of Workers’ Mobility reflects that the mobility of labor within the European Union has been activated. And to the companies who operate within the European Union member states, it is convenient for them to have a larger pool of labor pool because of the high mobility of labor force in the union. But the European Union countries have yet to develop efficient systems of management of mobility of the labor, labor relation management and to enact and enforce new labor and social legislation to promote unified trade unions and expand their reach to small and medium-sized enterprises in the private sector and to create frameworks for the organization of tripartite dialogue and the conclusion of collective agreements (Pusca 2004, p.24).

 

2.        Question 2. Rationalize the current Euro crisis

 

2.1    Background information of Euro crisis

The Euro zone was formed in 1999 and the Euro and the European Central bank have served well during the Transatlantic Banking Crisis, and then the inflation rate in the first decade was only close to 1.7% – but nevertheless the Euro zone is on the brink of collapse in the spring of 2010 – hardly 2 years after the Transatlantic Banking Crisis and only a year after the first global recession since the 1930s. Rising interest rate spreads for Greece in the late 2009 and early 2010 have signaled that risk premiums for the country and other “club-med” countries (Welfens 2011, p.99). Since then, the sovereign debt crisis continues to unfold in Europe, with every country appearing to get impacted.  

 

2.2    Important factors that brought about the Euro crisis

 

2.2.1            United States led credit crunch

As proposed by Ipek Eren Vural (2011, p. 44), the Euro crisis has been enforced as a consequence of the global financial and economic crisis started in the United States. The European Union has been particularly hit by the crisis, since economically it is closely inter-wined with the US where the crisis began. Many European banks and other financial players have been very engaged in the US credit and security markets so that the credit crunch quickly spread over the EU where it also caused the familiar problems of a credit crunch and an explosion of public debt. Beside this, the close economy activities also meant that the slowed down US economy will also affect the EU economy significantly.

2.2.2            Members do not have control over the monetary policy

Government debt (also known as public debt, national debt) is the debt owed by a central government. Governments usually borrow by issuing securities, government bonds and bills (Higson 2011). When the government can not afford to pay the government debts because of the excessive growth of public budget’s deficit which has led to incapacity for payment of current liabilities and obtaining new loans from private banks or international institutions, such as the International Monetary Fund, the World Bank or the European Central Bank, there happens the sovereign debt crisis (Termwiki.com 2011). As we know, a government could use an expansionary monetary policy to combat a recessionary gap, the increase in the money supply will lower the interest rate which could help resolve the debt sovereign crisis, and the easiest way is to increase the money supply by printing more money, but the members in the European Union do not have the control over the monetary policy. The Euro is a common currency, currently used by 22 European countries. Decisions on the supply of the Euro are made by a representative body at the European Central Bank. As a member of the Euro zone – using the Euro as its currency rather than the drachma,the result is that it cannot unilaterally change the supply of its currency. It does not have control over monetary policy. To make matters worse, the Euro has held a fairly high value against other world currencies – just opposite of the direction Greece needs to help with its problems (Plain-sense.com 2011).

2.2.3            Loss of confidence

 

Here we use Greece as an example in which the Euro crisis first started. The financial markets awoke to the problems of a Greek tragedy when people saw the interest rate on Greek debt soar to double what is was in the strong countries of the euro currency regime. Although Greece uses the same euro as the other nations of the common currency, investors worried about the continually increasing Greek deficits and demanded high interest rates to compensate for the growing risk. The risk is not in the purchasing power of the euro which is supported by all the member countries; there is risk that Greek government can not pay off the debt (Conrad 2010). What is more the loss of the confidence in the Greek government bonds was strengthened by the slow crisis response of the Greek government as the government in the beginning was still trying the cover the new as well as the European Union leaders in term of spending a lot of time holding meetings but progress had been slow in reaching a solution to the problems. The slow crisis response has thus make the investors fall in panic worrying about the high possibility of default of the Greek government debts.

 

2.2.4            Large spending for public sector account and tax evasion

Though Greece is the 31st most globalized country in the world and is classified as a high-income economy with service sector contributes 78.8% of GDP, industry 17.9%, and agriculture 3.3%, one structural problem of the government that paved the way to the first country suffered from the serious debt crisis is because of the fact that the public sector accounts for about 40% of total economic output (economist.com 2011). Because of the large public sector, and the Greek government continued to borrow heavily and went on something of a spending spree after it adopted the euro, when public spending soared and public sector wages practically doubled in the past decade. It has more than 340bn euros of debt – for a country of 11 million people, about 31,000 euros per person, the problem of debt crisis became eminent and can not be avoided (Bbc.co.uk 2011). What is more the fiscal woes are also due to a simple fact: tax evasion is the national pastime. According to a remarkable presentation that a member of Greece’s central bank gave last fall, the gap between what Greek taxpayers owed last year and what they paid was about a third of total tax revenue, roughly the size of the country’s budget deficit (newyorker.com 2011).

3.        Recent crisis responses and comments in the responses

 

3.1    European Union summit at Brussels

ü  On 8 December 2011, the last European Union summit of 2011 was held at Brussels. The key item on the agenda in Brussels is a Franco-German plan on budgetary discipline, with automatic penalties for euro zone nations that overspend. The Franco-German plan is based on the following key provisions:

ü  the European Commission to have the power to impose penalties for nations that run excessive budget deficits

ü  all 17 euro zone nations should amend their national legislation to require balanced budgets

ü  the euro zone countries to have common corporation and financial transaction taxes

ü  any future bailouts would not require private investors to absorb part of the costs, as happened in the case of Greece (bbc.co.uk 2011)
After 10 hours of negotiation, the seventeen European countries that use the euro, plus a number of others that would like to use the share currency some day, have signed on to a deal that leaders hope will help save the euro, and stem the debt crisis currently gripping Europe. But UK has not been part of the deal which means that the European leaders, with the exception of the UK, have backed the tax and budget pact aimed at solving the euro zone debt crisis and preventing the implosion of the single currency (Theworld.org 2011). Despite that agreement has been reached among the majority of European Union members and even some of the European countries outside the union and do not use the euro as the countries’ currency had expressed support with the plan. This result of the summit actually shows two things that should be considered carefully: on one hand, the United Kingdom’s denial of the plan suggests that UK in the issue of debt crisis have distinct situations compared to other EU members, it does not have too much debt influencing its normal economy and it is not its interest to control the public expenditure which is necessary under the economy downturn; secondly, the different opinions and demands over the fiscal policy to be adopted in the Euro zone and the fact that UK could disagree with a plan that had been endorsed by over a half of the EU members actually suggests that the European Union or the European Monetary Union does not have sufficient power to enforce the decision that are design to serve the benefits of the union.  

3.2    European Financial Stability Facility (EFSF)

The European Financial Stability Facility (EFSF) is an institution set up in May 2010 by the 16 euro area member states to preserve financial stability. The European Financial Stability Facility (EFSF) can issue bonds or other debt instruments, guaranteed by all the member states, in support of member states in financial difficulty. But it will be replaced by the European Stabilization Mechanism in 2013 (IMF 2011, p.162).  It is headed by Klaus Regling, former Director-General for economic and financial affairs at the European Commission and it is backed by guarantee commitments from the euro area Member States for a total of €780 billion and has a lending capacity of €440 billion. EFSF has been assigned the best possible credit rating; AAA by Standard & Poor’s and Fitch Ratings, Aaa by Moody’s (Efsf.europa.eu 2011). Based on the view of Panagiotis Delimatsis (2011, p.164) in the book “Financial Regulation at the Crossroads” that there is still much uncertainty surrounds the fund as little is known about who will buy the bonds it issues, nor how it will operate, or what will happen if more than one country attempts to draw on it. The fund has attracted criticism as “an attempt to resolve the crisis with imaginary money rather than providing real money and having to find it somewhere”. Moreover, if several countries seek assistance at once, there is a risk that the fund could be exhausted but fund proponents argue that this is unlikely because the foreign investors are returning to the sovereign debt markets. The initiatives of setting up the EFSF are benign and its creation did bring some comfort to the financial market of Europe but there are critical defects of the fund: firstly, since the set up  fund the outbreak of the series of debt problems in a number of EU members had made the initiative fund far away from bailing out all the economies and thus the investors became distressed again worrying the debt crisis can not be contained; secondly, the resolution of debt crisis requires a deep reforming of the sovereign debt restructuring and also the large public sector in the main European countries; thirdly, the preparation of the EFSF funds takes a long time to prepare the enough of fund needed by a member country in crisis.

4.        Euro crisis impacts on investment, capital raising and major exchange rates

 

4.1    Euro crisis impacts on investment

 

4.1.1            Finding investment opportunities elsewhere

When it appears inevitable that markets will keep testing the strong resolve of euro zone policy makers, uncertainty and a sense of feeling unsafe continues to dominate the capital market, there is still good opportunity elsewhere as the Euro crisis seems to be confined to Europe and emerging markets are strong and the US economy starts to show some signs of life and recovery. And actually the strong dollar is already a fact indicating the outflow of the capital from Europe to the recovering United States market. Other markets such as the Asian emerging economies are also preferred destination of the global investors.

4.1.2            Investment in the Euro zone by the developing economies

China is a typical developing country that has close relationship with the Euro zone member states and is one of the most vivid countries to rescue the Euro zone economy from the euro crisis by investing its money which is also in accordance with its own benefits. And China certainly has lots of money to invest. its foreign-exchange reserves are reckoned at $3.2 trillion. It trades more with the EU than any other partner. It has exposure to the euro already. How much is not known, but currency analysis’s suspect that about a quarter of those reserves is already euro-denominated, giving it an incentive to keep the currency strong. It also suits China to play the part of a constructive economic actor (economist.com 2011). The recent frequent leaders’ visit to Euro by the Chinese political leaders also shows China’s interest to capitalize the Euro crisis and increase its influence in Europe.

 

4.2    Euro crisis impacts on capital raising

Since the mortgage interest rates are on course to hit a historic low next month as part of Europe’s frantic battle to save the euro. In addition, another cut in interest rates in January is expected to follow yesterday’s 0.25pc reduction and came as the ECB offered banks unlimited cash for three years in its drive to keep European lending institutions afloat according to the new reports (Independent.ie 2011). And with a low interest rate, people would be encourage to spend rather than saving the money in the banks which will increase the difficulties of raising capital by borrowing from the banks as the banks will have less deposits.

4.3    Euro crisis impacts on major exchange rates

 

4.3.1            Pounds to Euros Exchange Rate

 

Figure 1 Euros to 1 GBP
Source: x-rates.com

Sterling climbed to the strongest in 15 months versus the single currency after French borrowing costs increased at an auction this week and reports showed European economic confidence and German factory orders declined. Ten-year gilts completed the first weekly loss since November as yields near a record low damped demand for the securities (bloomberg.com 2012). The relative stable economy conditions has made UK’s pounds appreciate as the Euro devalued after the outbreak of the Euro crisis and there is also increased demand to buy in the Pound which have a less possibility to be affected by the Euro crisis.

4.3.2           
 American dollar to Euros Exchange Rate

Figure 2 American dollar to 1 EUR
Source: x-rates.com

As illustrated in the figure above, the American dollar has been appreciate in the total trend since the mid of last year, and a weak Euro could be understandable because it will help the European companies to export their products to the United States in a lower cost and the economy booming is obviously good for the dealing with the Euro crisis. And if the crisis can not be contained in the near future, the exchange rate will continue the current trend and the dollar will be forced to appreciate against the Euro. But this is not necessarily bad news for the US investors because what they have is the US capital which has been enhanced in term of market value such as cash, and they can watch the investment opportunities in the Euro zone and capitalize the crisis when it almost touch the bottom which will create an excellent opportunity for the US investor to enter into the Euro capital market.

 

 

 

Table of references

 

Bbc.co.uk 2011. Former European Central Bank vice-president Lucas Papademos has been named as Greece’s interim prime minister, following days of negotiations. visited on 7 Jan 2012 [online] available: http://www.bbc.co.uk/news/mobile/business-13798000

 

Bbc.co.uk 2011. Euro zone crisis: Late night summit talks to save euro. visited on 7 Jan 2012 [online] available: http://www.bbc.co.uk/news/world-europe-16100258

 

Bloomberg.com 2012. Pound Rises 5th Week Versus Euro on Europe Debt Woes; Gilts Fall.  visited on 7 Jan 2012 [online] available: http://mobile.bloomberg.com/news/2012-01-07/pound-rises-5th-week-versus-euro-on-europe-debt-woes-gilts-fall.html

 

Carbaugh, R. 2008, International Economics. Natrop Boulevard: South-Western Cengage Learning. p.286

 

Conrad, B. 2010. Profiting from the World’s Economic Crisis: Finding Investment Opportunities by tracking global market trends. New Jersey: John Wiley and Sons.

 

Delimatsis, P. 2011, Financial Regulation at the Crossroads: Implications Forsupervision Institutional Design and Trade. The Netherlands: Kluwer law International. p.164

 

Economist.com 2011. The long shadow of Greece. visited on 7 Jan 2012 [online] available: http://www.economist.com/blogs/freeexchange/2011/10/euro-zone-crisis-3

 

Economist.com 2011. The euro-zone crisis: China to the rescue? visited on 7 Jan 2012 [online] available: http://www.economist.com/blogs/freeexchange/2011/10/euro-zone-crisis-4

 

Efsf.europa.eu 2011. About The European Financial Stability Facility (EFSF).  visited on 7 Jan 2012 [online] available: http://www.efsf.europa.eu/about/index.htm

 

Europa.eu 2011. Basic information on the European Union. visited on 7 Jan 2012 [online] available: http://europa.eu/about-eu/basic-information/index_en.htm
Fassmann, H., Haller, M. & Lan, D. S. 2009, Migration and mobility in Europe: trends, patterns and control. Lansdown Road Cheltenham: Edward Elgar Publishing Limited. p. 51

Grauwe, P. D. 2007, Economics of monetary union. Oxford: Oxford University Press. p.114

 

Higson, G. 2011. Global Economics. London: Economics Online.

 

IMF 2011, Global Financial Stability Report, April 2011: Durable Financial Stability Getting There from Here. Washington DC: International Monetary Fund. p.162

 

Independent.ie 2011. Euro crisis to spark New Year cut in mortgage interest rates. visited on 7 Jan 2012 [online] available: http://www.independent.ie/business/european/euro-crisis-to-spark-new-year-cut-in-mortgage-interest-rates-2959142.html

 

Indiana.edu 2011. INTRODUCTION TO THE EUROPEAN UNION. visited on 7 Jan 2012 [online] available: http://www.indiana.edu/~west/documents/Curriculum/EU/EU_Intro/IntroEU_update.pdf
Kraus, T. 2001, The impact of the EMU on the structure of European equity. Washington, DC: International Monetary Fund. p. 4

Newyorker.com 2011. THE FINANCIAL PAGEDODGER MANIA. visited on 7 Jan 2012 [online] available: http://www.newyorker.com/talk/financial/2011/07/11/110711ta_talk_surowiecki

Pinder, J. & Usherwood, S. M. 2007. The European Union: a very short introduction.Hampshire: Ashford Colour Press Ltd.

Plain-sense.com 2011. Greek Debt Crisis. visited on 7 Jan 2012 [online] available: http://www.plain-sense.com/

Pusca, A. 2004, European Union: challenges and promises of a new enlargement. New York, NY: The international debate education association. p.24

Termwiki.com 2011. Sovereign debt crisis. visited on 7 Jan 2012 [online] available: http://cn.termwiki.com/EN:sovereign_debt_crisis

Theworld.org 2011. Eurozone Deal Reached Without UK.  visited on 7 Jan 2012 [online] available: http://www.theworld.org/2011/12/eu-fiscal-deal/

Vural, I. E. 2011, Converging Europe: Transformation of Social Policy in the Enlarged European and in Turkey. Surrey: Ashgate Publishing Limited. p. 44

Welfens, P. J. J. 2011, Financial Market Integration and Growth: Structural Change and Economic Dynamics in the European Union, Wuppertal, Germany: Springer. p.99

 

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