Structure and Roles of Monetary and Fiscal Policy in the European Union - Case Study Example

Structure and roles of monetary and fiscal policy in the European Union in dealing with the debt crisis Letter of Transmittal Dear Sir, I am pleased to present my final report, “Structure and roles of monetary and fiscal policy in the European Union (EU) in dealing with the debt crisis,” on how the EU dealt with the current crisis in Greece. The report provides in-depth analysis of the present EU monetary and fiscal policy and adds recommendations for tightening the current policies to avoid such crisis in the future. I hope that the recommendations will be helpful in analysing the gap areas in the EU policies. I look forward to discuss this report with you and with other staff members in the University. Warm regards, Executive Summary The members of the European Union (EU) are witnessing excessive sovereign debts in the last 12 months which has resulted in the occurrence of debt crisis in the region. The crisis has specifically impacted countries such as Portugal, Ireland, Italy, Greece and Spain, also known as PIIGS. The current monetary and fiscal policies of the EU clearly allocate the duty to keep the financial situation of a country stable to the policy makers of that particular country. However, the present debt crisis in Greece has exposed the gap areas in the policy and therefore the paper discusses the structure and roles of monetary and fiscal policy in the EU in dealing with the debt crisis. Experts consider that the bailout of Greece by the EU as a turning point in the integration of the European region, which is discussed in detail in this paper. The current debt crisis in Greece had exposed the issues and problems in the present monetary and financial policy of the EU. This policy does not make it mandatory for the governments to work in a cohesive manner and adopt a singular economic strategy in the euro zone. Also, in case of breaking of rules by a particular country, penalties are not imposed on that country. Further, the policy does not allow bailing out a country during its financial crisis through stimulus packages. Thus, developed economies in the EU are not liable nor can voluntarily help lesser developed EU nations financially during the crisis times. This absence of financial support between the EU nations has also resulted in the lesser developed countries adopting corrupt methods such as hiding the real growth figures. These countries are also employing cost cutting means such as reducing consumption and employment to control their debts and deficits. Working around these caveats, EU decided that the ECB would buy the sovereign bonds from the country. Further the ECB decided to reduce the refinancing rate by around 325 basis points to create price stablisation. It also fixed the tender rates and provided full allotments to such projects. Also, the ECB provided the refinancing option through short term maturities of around one to three months as well as longer maturities of six months to a year. It lowered the country’s rating to BBB- and allowed Greece to accept some selected foreign currencies as well. Other countries in the EU region also helped Greece by providing substantial funding and acting as guarantees to enable Greece to lend from banks. These countries also provided fiscal policy to Greece, first time ever in the EU region as the EU policy states that such fiscal aids should not be given to a country during its financial crisis. The paper recommends that EU should focus on creating such policies wherein the member countries are asked to provide consolidated balance sheets that would reflect all the details together with government taxes and spending plans. Such a policy would help in containing situations such as the Greece debt crisis. It would also build up credibility and reassure investors and households that their investments and savings are safe. EU also needs to create a better economic policy that would focus on creating sustainable economic growth through long-term growth plans and inclusion of all the economies in the region. The commission is required to emphasise on promoting equality among its member countries and promote financial stability in the region. The current Greek debt crisis also led to creating tighter monetary policies and to formulate exit options for the ECBs monetary policies. It was believed that the euro zone did not require tightening of the ECB’s monetary policy before 2011 as the region was witnessing steady development. However, the Greek debt crisis exposed the susceptibility of the region to debt crisis and the ambiguities in the policies to deal with such crisis. Table of Contents Structure and roles of monetary and fiscal policy in the European Union in dealing with the debt crisis 1 Letter of Transmittal 2 Executive Summary 3 Table of Contents 5 Introduction 7 The EU monetary and fiscal policy 8 Flaws in the policy 8 The Greek debt crisis 9 EU bailout of Greece 11 Conclusion 13 Reference 15 Introduction It has been witnessed that in the last 12 months, excessive sovereign debt in a number of European Union members has precipitated a ‘new’ crisis in the global financial system. Specifically, there are debt problems in Portugal, Ireland, Italy, Greece, and Spain. All are members of the European Monetary Union which uses the Euro as the common currency and hence do not have the ability to use independent monetary policy. The present paper therefore discusses the structure and roles of monetary and fiscal policy in the European Union in dealing with the debt crisis. Further, it also provides recommendations to tighten the present policies to avoid such situations in the future. The monetary and fiscal policies of the EU also have some major defects which does not allow providing resources and funds to the lesser developed EU countries from the developed economies of the euro zone to help these countries create or strengthen their economic background (Dewatripont et al 2009). The current financial crisis in Greece has exposed this gap area in the EU policy and if the loophole is not addressed at the earliest, the region might witness more such issues in the coming years. The debt crisis in Greek has not only caused negative impact on the country of its origin but it has also affected the financial and economic health of the major European countries as well. The paper would focus on these uncertainties as well as the issues with the current monetary and fiscal policy of the EU. The EU monetary and fiscal policy The European monetary integration’s goal since the inception of the Euro in 1992 has been to provide benefits of adopting a stable currency to the businesses, governments and individuals of all the countries in the European region (Craig & De Búrca 2008; Magud 2008). Further, for protecting the monetary policy from the wide fiscal policies of various governments, the European Union (EU) drafted a treaty that restricted bailing out and providing monetary support to governments who are facing financial crisis (Bofinger & Ried 2010). It also asks governments not to undertake too much of deficits and even levies sanctions in case a government breaches these fiscal regulations. Even before introducing the Euro, the EU had established these regulations by adopting the Stability and Growth Pact (Beetsma & Debrun 2007; Setterfield 2009). Thus, the monetary and fiscal policies of the EU clearly allocate the duty to keep the financial situation of a country stable to the policy makers of that particular country. These policies also set various rules that the countries need to abide by (Bordo & Haubrich 2010). Therefore, any changes in the fiscal and monetary policy in the euro region need to be monitored through these basic regulations set by the EU during its formation, which were also signed by all the members (Gowan 2009). Flaws in the policy The policy does not state that the governments are obliged to work together in cohesive manner and adopt a common economic strategy throughout the euro zone (Majocchi 2009). Further, in case any of these countries break any rule by not following the euro system, they are not asked to pay any penalty. These countries have separate national economic policies and each one take individual policies without being concerned about the impact of these policies on other countries in the euro zone (Gros & Mayer 2010). Some of the other major defects of the system include the non-inclusion of policies to allow transferring of funds and resources to the lesser developed EU areas from the developed economies of the region to help these countries form a solid economic background (Dewatripont et al 2009). The euro zone countries are not obligated to provide aid to the lesser developed economies to strengthen their economic condition. The lack of financial support between the EU nations has resulted in the weaker nations being adopting methods such as cutting employment and consumption to reduce their debts and deficits (Heipertz & Verdun 2010). The Greek debt crisis The recent financial crisis in Greece characterises one of the first such crises that the EU region may face in the next few years due to its glaring deficiencies in the monetary and fiscal policy. The Greek debt crisis not only impacted the country of its origin but also severely affected the financial and economic set-up of the Europe as well. It also highlighted on the uncertainty surrounding the future monetary and fiscal policy of the EU (Bordo & Haubrich 2010). The Greek debt crisis has exposed the belief that sovereign debt crisis cannot occur in the euro zone. Although, problems with public debt has been around in some of the euro zone countries for a long time, and in some countries since the 1970s, none of these countries have ever undergone such a massive public debt crisis in the contemporary times (Krugman 2009). Many believed that large public debts could be managed easily and therefore, it is unlikely that the situation of a sovereign debt crisis would ever occur (Majone 2009). These experts also considered that the Stability and Growth Pact was just an exaggerated pact and was not required. However, the Greek crisis has led these experts to relook at the policies again and frame some amendments to prevent such a situation to occur again (Martin 2010). The problem of public debt is not a new one and plagues almost all the capitalist economies in the world. Further, Greece is also not the most indebted country in the region. In fact, countries such as Portugal, Ireland and Spain, who are part of the PIGS (which includes Greece) group are also heavily indebted (Mendoza & Quadrini 2010). Italy is also one of the major debtors in the region (De Grauwe 2009). Further, many of the newer economies that have joined the EU in the recent times have undergone similar issues like that of Greece due to their debt situation (Dabrowski 2010). However, the situation went out of hand in the case of Greece due to the unethical and unlawful acts of the country to mask its real debt situation. The government with the help of Goldman Sachs achieved the forgery by showcasing a derivatives deal which helped the country to circumvent the Maastricht deficit rules of the EU, which threatens to impose fines on the member countries in the region that have exceeded the deficit limit. The country was able to mask its expenses and only showed the ceiling to the permitted three per cent through cosmetic changes in its balance sheet (Wyplosz 2010). The exposure of the Greek manipulation of the balance sheet has also uncovered the faults in the existing monetary and fiscal policy of the EU. However, the bigger problem in front of the EU was to handle the finances of the country which was debt-ridden and impacting the economies of the other countries in the region as well. As the EU stipulates that financial aids and packages should not be provided to any country in the region during crisis, the Greece debt situation became a serious issue and the EU had to come out with various innovative solutions to tackle the situation (Sgherri & Zoli 2009). EU bailout of Greece The bailout of Greece by the EU is considered as a turning point in the integration of the European region. As Greece was not permitted to undertake any fiscal stimulus packages or receive aids from fellow EU countries as per the EU policy, it was decided by that the ECB would buy the sovereign bonds from the country. This step by the EU proved to have immediate affect on the EU’s monetary policy. Further, it also had implications on the valuation for the sovereign debts in the region in terms of mid to long-term impact (Mendoza & Quadrini 2010). At the time of the crisis, the ECB’s governing council undertook various distinct actions through non-standard as well as standard methods. As the question of the price stability was associated with the crisis, the ECB decided to cut the refinancing rate by a cumulative 325 basis point. This was done during October 2008-May 2009, and helped in bringing the rate to the present level of around 1 per cent (European Central Bank 2010). ECB also provided better flexibility for all the liquidity-providing operations. It fixed the rates of the tenders and gave full allotments to such projects. ECB gave the option to receive refinancing through short term maturities of one-month to three-months or opt for longer maturities that ranged from six months to a year. It also provided a widened collateral framework, wherein the rating of the country was lowered to BBB- and allowed the country to accept a few foreign currencies as well (Trichet 2010). These currencies were pre-selected by the ECB and could be traded in securities and assets in the non-regulated markets. All these measures helped in controlling the risk factors associated with investing in the country. The EU also introduced the covered bond purchase programme and the foreign currency-providing operations to strengthen the position of Greece (Wyplosz 2010). The governments in the EU region also dealt with the crisis by adopting various measures. First and foremost, the governments in the euro zone provided substantial funding for supporting and stabilizing the financial sector and the financial institutions in the country (Verney 2009). These governments provided recapitalization and acted as guarantees for enabling lending between banks, issuance of bonds and deposits. They also established ‘bad banks’ for removing the asset problems from the fake balance sheets (Leonard 2010). The governments of the euro area also allowed providing fiscal policy to Greece to support it through the crisis, a first in the EU region as the EU policy states that such fiscal aids should not be given to a country during its financial crisis (Athanassiou 2009). However, due to these various fiscal and monetary steps taken by the EU and the various governments in the region, experts estimate that the government deficit ration of the euro area government which was only 0.6 per cent of the GDP in 2007 had increased to around 6 per cent of the GDP last year. They believe that the deficit ration would remain in this level or may increase to touch 7 per cent this year. This is considered to be a major fiscal implication of the crisis for the region (Feldstein 2009; Palmer 2010). Conclusion The current debt crisis situation has exposed the gap areas in the current EU monetary and financial policy. It is recommended that the EU should focus on asking its member countries to provide consolidated balance sheets reflecting detailed as well as specific information about the government taxes and spending plans. It should also ensure the creation of detailed and credible fiscal adjustment plans. This would help in developing long-term financing set-up and reassuring the investors (Panitch & Konigs 2009). Further, such steps would also help in assuring individual investors and households that their investments and savings are safe. It is also important to maintain a detailed and credible fiscal adjustment plan as it would help in the development of monetary policies, which in turn would create price stabilization. It would finally help the country to return back to its normal financial environment as it was during the post-crisis period (Dullien & Schwarzer 2009). The EU should also learn from the crisis and create a new economic philosophy wherein it should emphasis on developing sustainable economic growth. It should also encourage the growth of social cohesion and not just focus on creating short-term growth of the economies. Further, the EU needs to focus on promoting greater equality among its member states in terms of economic equations (Reinhart & Rogoff 2010). The current Greek debt crisis also had some immediate impact on the requirement to create tighter monetary policies as well as formulating exit options for the ECBs monetary policies. Before the recent crisis, it was believed that the euro zone would not require tightening of the ECB’s monetary policy before 2011 as the region was registering a steady growth. Further, most experts believed that the tightening of the monetary policy of ECB could be attained by just raising the repo rate (Reinhart & Rogoff 2010). 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