European Crisis: Causes, Austerity Measures, and Economic Impact
The European Economic Crisis
Like other regions, Europe suffered during the latest global crisis. However, its prior situation led to a stronger impact and slower recovery. While it all started in the US with the subprime crisis, it quickly spread across Europe, evidencing some of the underlying malfunctions that were overlooked at that time. The bad investments made by American investment banks were sold to banks in Europe that were unable to cope with them. This led to a credit dry-up, since banks took extreme precautions and faced severe losses. For that reason, the governments of many countries had to rescue the banks. But in some cases, this meant that the government would go bankrupt (like in Ireland), so the European Union had to bail out the country. Socializing losses when banks are too big to fail!
Sovereign Debt Crisis
This banking crisis led to a sovereign debt crisis since markets were unsure about the capacity of governments to save their banks. Investors would look at the public finances of the countries and “punish” them if the debt was too high. They were assuming a higher risk of non-payment. That made government bonds interest rates skyrocket to unsustainable levels, which made markets panic! The fact that the Greek debt exceeded $400 billion (over 120% of GDP) and France owned 10% of that debt, struck terror into investors at the word “default”.
Austerity Measures
Austerity is a political-economic term referring to policies that aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both. Austerity measures are used by governments that find it difficult to pay their debts. The measures are meant to reduce the budget deficit by bringing government revenues closer to expenditures, which is assumed to make the payment of debt easier. Austerity measures also demonstrate a government’s fiscal discipline to creditors and credit rating agencies.
In most macroeconomic models, austerity policies generally increase unemployment as government spending falls. Cutbacks in government spending reduce employment in the public and may also do so in the private sector. Additionally, tax increases can reduce consumption by cutting household disposable income. Some claim that reducing spending may result in a higher debt-to-GDP ratio because government expenditure itself is a component of GDP. In the aftermath of the Great Recession, for instance, austerity measures in many European countries were followed by rising unemployment and debt-to-GDP ratios despite reductions in budget deficits.
When an economy is operating at or near capacity, higher short-term deficit spending (stimulus) can cause interest rates to rise, resulting in a reduction in private investment, which in turn reduces economic growth. However, where there is excess capacity, the stimulus can result in an increase in employment and output.
Across an economy, one person’s spending is another person’s income. In other words, if everyone is trying to reduce their spending, the economy can be trapped in what economists call the paradox of thrift, worsening the recession as GDP falls.
Krugman argues that, if the private sector is unable or unwilling to consume at a level that increases GDP and employment sufficiently, then the government should be spending more in order to offset the decline in private spending.