The Eurozone Crisis Explained

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The 2010 public spending review promised cuts of up to £81bn over the next four years, with welfare, police budgets and, topically, education hit hardest.

In the past month thousands of students have taken to the streets on three separate occasions to protest against the proposed rise in tuition fees and further protests are planned on the eve of the Commons vote.

Yet with the impending eurozone crisis seemingly becoming increasingly severe on an almost daily basis, should we perhaps be more thankful of the current Prime Minister’s frugal attitude towards public spending?

To answer this question, we must first understand the reasons behind the so called ‘eurozone crisis’ currently unfolding in neighbouring EU countries. When investors (in this case, people lending to the government by investing in government bonds) begin to worry public debt is becoming alarmingly large, they demand increased returns on their investments in order to continue lending to governments.

The increased rates investors demand from governments only worsen public debts, and a vicious circle begins.

At some point, no rate of return the government offer on its bonds will be enough to lure investors into lending governments money, leaving governments unable to finance their spending. This creates a state of fiscal crisis, and has been seen recently in both Greece and Ireland.

In such a circumstance, the government can either default on the debt and attempt to renegotiate terms, or it can sell the debt to central banks, who buy it through freshly printed bills. The latter process is known as monetisation, and leads to increased inflation rates as well as currency depreciation.

Neither of the above options is in any way desirable, and either strategy will have long term ramifications for future investors’ confidence in the offending government. Investors for generations to come will almost certainly be hesitant to lend to a government who has historically failed to repay its debts.

To avoid such crises, other countries can lend to struggling governments at below the market rates. This is commonly known as a ‘bailout’, and is usually done in attempts to avoid contagion, the technical term for the cross country spread of financial crises.

We saw EU members come to the rescue of both Greece and even more recently Ireland in attempts to restore investors’ confidence in governments, however the bailouts have seemed to have little effect, with many investors still fearing crises spreading to Portugal and Spain.

That said, promises from the European Central Bank to begin measures such as tightening monetary policy in attempts to ease the eurozone crisis have seen stock markets rise by an average of 2% this morning, as well as Spain finding investors in €2.5bn worth of government debt.

What does all this have to do with the UK’s spending cuts? At the end of 2009, the UK had the 3rd largest amount of government debt of all EU countries. At 11.5% of GDP, third only to Greece and Ireland, the UK could easily have been viewed as poised to fall into the same situation as the struggling nations. It is entirely plausible that the coalition’s promises to cut significant amounts of the public sector debt over the coming four years could have prevented a wavering of investors’ confidence in the UKs finances.

It should be noted that the decision not to adopt the Euro as the UK’s currency (therefore retain independence of monetary policy) is also likely to have protected the crisis from reaching the UK, at least for the time being, and it is difficult to assess the weighting of the cuts on financial crisis deterrence.

Regardless of this point, whether you agree with the cuts or not, it does appear that sidestepping a financial crisis offers a strong argument in favour of the coalitions current actions.

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Discussion2 Comments

  1. avatar

    “It should be noted that the decision not to adopt the Euro as the UK’s currency (therefore retain independence of monetary policy) is also likely to have protected the crisis from reaching the UK”

    Please Clarify this point, if it is about defaulting on debt?

    Chris Bilko
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    NB,

    Thanks very much for your comments. Below is a simplified response to your query.

    Bond prices are inversely proportional to interest rates. Therefore, as interest rates increase, the price investors can sell their bonds for decreases.

    The European Central Bank (ECB) controls monetary policy with the entire eurozone economy in mind, whereas the Bank of England (BofE) set monetary policy solely to meet UK objectives. As the ECB attempts to meet a wider range of objectives than the BofE, there is more uncertainty over which direction eurozone interest rates will move when compared to the UK’s interest rates.

    Investors in UK bonds will almost certainly have more confidence that the BofE will decrease interest rates in the threat of financial crisis looms, and if the BofE does decrease interest rates, bond prices will increase. This makes UK bonds more attractive than bonds from eurozone governments, and therefore monetary independence may help the UK avoid the eurozone crisis.

    I hope this helps. If you disagree with my response, or have any further comments, please let me know.

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