Economic Problems of European Union

Since 2007, the EU has experienced a deteriorating economic situation. This has been most concerning for southern members of the Eurozone, such as Greece, Italy, Portugal and Spain. Economists fear that with the current EU economic problems, we could see a lost decade of high unemployment, low economic growth and deteriorating social conditions.

Main Problems Facing European Union

 

1. Unemployment. Unemployment in the EU has reached a critical point. In Spain, unemployment has increased to over 25%, and youth unemployment rates have reached 50%. The recent rise in EU unemployment is primarily due to the prolonged recession. Long term structural unemployment is also a problem.
2. Prolonged Fall in GDP



After the deepest recession since the 1930s, Europe has still not been able to recover. Weighed down by austerity measures and a weak global economy, the EU economy has fallen back into recession. The concern is that structural problems and the current monetary and fiscal policies will create several years of below trend economic growth. (Evaluation of EU Policies for economic growth)  

 
3. Competitiveness Problem. The Euro has caused a divergence in competitiveness. Countries who face higher labour costs cannot regain competitiveness in the usual way through depreciation. Prices become uncompetitive, leading to lower domestic demand, and high current account deficits. Since 2011, current account deficits have fallen in countries like Ireland and Spain, but it has been at the high cost of reducing domestic demand and rising unemployment. Countries are seeking to regain competitiveness through internal devaluation (lower demand, pushing down prices) But, this is much more damaging to the economy than the traditional approach of depreciating exchange rates. more on EU competitiveness.
4. The ECB is too concerned with low inflation The ECB has been accused of giving too much priority to the goal of low inflation. It is argued they have sought to maintain low inflation at the expense of lower growth. The ECB have rigidly stuck to an inflation target of 2%, despite the rise in unemployment and poor performance of nominal GDP.
   




5. Bond Yields. Membership of the Euro, has created a tendency for bond yields to rise much more quickly. After concerns were expressed over Greece, market fears soon spread to other Eurozone countries, like Ireland, Spain and Portugal. This increased borrowing costs and also put countries under pressure to pursue austerity measures to reduce budget deficits. However, these austerity measures have been implemented when the economy is already weak, causing a big negative multiplier effect and causing the economic downturn. Countries with their own currency and ability to print money have been able to maintain low bond yields, which reduces borrowing costs and gives them more time to reduce budget deficits. See more at Euro Debt crisis  - Note - although bond yields fell in last half of 2012, they are still higher than they should be, and there is concern without strict austerity, the ECB may be unable to prevent rising bond yields in the future.
6. Stability and Growth Pact. This is a constraint on expansionary fiscal policy because in theory it limits governments borrowing to 3% of GDP. In a recession a European government is unable to use monetary policy (ECB set rates for whole Euro zone) but also they are unable to reflate the economy through higher spending and borrowing. 
7. Inflexible Labour Markets. This is frequently held up as a constraint on economic growth and a cause of structural unemployment. In particular rigidities in the labour market discourage investment from abroad. For example in France there are laws which makes it difficult to fire workers once they are hired. This discourages firms from expanding and investing. Both the IMF and OECD have argued that further labour market liberalisation is needed to regain competitiveness. Even many of the European leaders acknowledge it is a necessity. However such reforms often face stiff opposition from powerful interest groups who wish to protect the interests of their members. Thus reform has proved very difficult and exceedingly slow. As Luxembourg’s Mr Juncker once said.
   ”We all know what to do, we just don’t know how to get re-elected after we’ve done it.”
8. Demographic Changes. Countries like Germany and Italy have a declining birth rate. This means that the population structure is becoming weighted towards those who are over 50. The traditional population pyramid is being inverted. The increased demands placed on benefits and decline in tax revenue is a serious burden for government spending. It is reflected in burgeoning public debt. As of 2006 Italy’s public debt stood at 105%. German and France just below 70% of GDP. Such high levels of debt are argued to cause crowding out of private sector spending. Unfortunately this problem is likely to be exacerbated as the 1960s baby boomers retire. Again there is much opposition to the reform of generous state pensions.

See also:

• Why UK will not join Euro
• Blog entries on Europe
• Costs of Joining Euro
• Should UK leave the EU?

References

• EU economic growth

European Recession

After the first European recession in 2009, the EU is heading back into another recession only three years later. But, this recession is much more worrying. There is less room for maneouvre, attempts to solve the debt crisis have failed, and have left countries with both low growth, but continuing debt problems.

The cause of the second recession is depressingly simple.

• Austerity policies really do cause a fall in aggregate demand, higher unemployment and lower economic growth
• If you cut government spending, you need something else to boost demand in the economy. This could be devaluation, loose monetary policy, higher exports or stronger private sector demand and investment. 
• However, Europe has only deflationary policies. There is no devaluation for southern economies, no loosening of monetary policy and with very low confidence, the private sector has not compensated for even minor spending cuts. 
• The German economy is doing relatively well (though GDP still fell 0.2% in the last quarter). But, the German economy is helped by very strong export demand. Germany has a current account surplus of 6% of GDP. The problem is that some feel everyone should follow German's model of exports and high current account surplus. But, not everyone can have a current account surplus! 
• The flipside of strong German exports is a current account deficit in Greece and Portugal of 10% of GDP. To help economic growth in Greece and Portugal, there needs to be a revaluation of trade within the EU - but that is very slow to occur with a single currency.
• In a liquidity trap and period of very low private confidence, the private sector haven't taken the place of spending cuts. It is why Italy has gone into recession with GDP falling 0.7% in last three months of 2011, following 0.4% contraction in three months before.

Austerity and Lower Tax Receipts

Since Greece increased taxes, and cut spending, VAT receipts have fallen 18% in 201. Simply because 60,000 firms went out of business. This is an example of how austerity policies can be self-defeating in a recession. (Tragedy of Greece)

Yet, Daniel Mitchell, of the libertarian-minded Cato Institute, argues that Europe has not been austere enough and that much more is needed. "European countries talk about austerity but they don't mean cuts," he says. (Guardian Link). At least the IMF are aware that there can be too much of a necessary thing. (IMF blog)

Youth unemployment of 50% - just cut government spending a bit more. This is the logical policy of free market economics.

Yet, despite all the austerity of Greece, Italy and Ireland, they have failed to solve the 'debt crisis'

Depressed with the European economy, I had a look at the Indian economy in 2012 - at quite a different stage of the economic cycle. What India needs is to reduce its budget deficit and liberalise its complex bureaucracy. If India can lears anything from Europe - don't wait for an economic downturn to try and solve persistent budget deficits.

Keynesian economics may support fiscal expansion during a recession, but in India's case, a very different approach is needed.

Related

• Causes of recession
• Euro debt crisis Explained

Gordon Brown's 5 Economic Test for Joining Euro

As Gordon Brown approaches his last budget as chancellor many are reviewing his tenure as Chancellor and evaluating his success or failure. One important contribution he made was to steer the UK away from joining the Euro on the ground that "it would not be in Britain's economic interest". The justification for this was based on his 5 economics tests.

Before deciding whether the UK should join the Euro the Chancellor, Gordon Brown drew up 5 economic tests which the UK must pass for the UK to join. The main principle behind these 5 economic tests was whether the UK would cope with a common monetary policy. The 5 tests are in some ways superfluous. The main test being is really whether the UK has a degree of economic harmonisation with the rest of Europe.

5 Economic Tests for Joining the Euro

1. Economic Harmonisation.
   
   The UK economy must be harmonised with the Euro zone. If the UK economy was growing much faster than EU then UK interest rates would need to be higher. For example, at the moment if the UK joined interest rates would fall and this may cause inflation. Therefore it is essential that the UK has a similar economic cycle to Europe. Even if there is temporary harmonisation there is no guarantee it will continue on a permanent basis.
   
   
2. Is there sufficient Flexibility?
   
   If the UK went into recession could it be able to cope? It would have no influence over Monetary policy but also Fiscal policy is limited by the growth and stability pact. This limits the amount of government borrowing and therefore limits the scope for expansionary fiscal policy.
   
   
3. Effect on Investment.
   
   Would joining the euro create better conditions for firms making long-term decisions to invest in Britain? UK inward Investment has not suffered since the UK decided not to join
   
   
4. Effect on Financial services.
   
   What impact would entry into the euro have on the UK's financial services industry? London as a financial centre has boomed in recent years.
   
   
5. Effect on Growth and Jobs
   
   Would joining the euro promote higher growth, stability and a lasting increase in jobs? There is no clear evidence that it would. UK economy has done better outside the Euro than in the Euro.

At the moment the weight of economic opinion is that the UK is better off not joining the Euro. One important factor is that the UK housing market is very sensitive to interest rates. Many UK householders are homeowners and also many mortgages are variable. Therefore the cost of mortgages fluctuates with changes in the base rate. Thus a small change in European interest rates could potentially have a damaging effect on UK economy. For example, if the UK was to join now, interest rates would fall causing a potentially harmful inflationary boom.

See also:

• Why the UK will never join the Euro.
• Benefits of Joining Euro
• Costs of Joining Euro

Why the UK will never join the EURO.

From a political perspective the UK has always been reluctant to submerge itself in a European identity. The EU, with its prescriptions on the shape and size of bananas,(1) remains an easy target for UK tabloids and satirists. The idea of giving up the £ for a nondescript EURO would hardly make for a populist political agenda. However, political arguments aside, there is increasingly little if any support for the EURO, even from a purely economic point of view.

Firstly the supposed benefits of joining the EURO are becoming increasingly marginal.

1. Exchange Rate Stability. A main advantage of joining the Euro is that it reduces exchange rate volatility with our main EU trading partners. However since 2003 the £ has displayed very little exchange rate volatility. In this article. Stephen King, Chief Economist at HSBC claims that in effect the UK has already in effect joined the Euro. Anyway it is also relatively easy to insure against exchange rate movements through the purchase of currency on the open markets. Therefore at the moment there is little risk associated with exchange rate fluctuations.

2. Inward Investment. Inward Investment has continued to soar even outside the EURO. It was thought joining the EURO was necessary to attract sufficient inward investment. However it appears that a separate currency has not been a deterrent to further inward investment. See: Inward investment in UK

3. Low inflation. There was a time when the UK was known as the “sick man of Europe” its economy characterised by, boom and bust cycles and high inflation. It was thought that joining the EURO would give the UK a strong anti inflation framework. However since the MPC was given independence in 1997 inflation has remained close to the government’s target of 2%. Furthermore this low inflation has been consistent with an enviably high growth rate. When your economy is outperforming the Euro Zone there seems little reason to join.

Joining the Euro would give the UK a small gain in terms of lower transaction costs and greater exchange rate stability. However it must be emphasised for many businesses, both domestic and foreign, these costs are a small % of total costs. However many economists fear that joining the Euro could lead to some significant economic problems.

Disadvantages of Joining Euro

1. Loss of Independent Monetary Policy. On joining the EURO interest rates would no longer be set by the MPC. They would be set by the European Central Bank. The ECB look at the whole EURO economy and not what is best for the UK. Thus if the UK joined now interest rates would fall from 5.25% to the ECB rate of 2.25%. This fall in interest rates could cause and further boost the buoyant Housing Market and cause future inflationary pressures.

2. Difficulty in getting out of a recession. On the other hand if the UK suffered a recession they would be unable to cut interest rates. It would be difficult to boost demand and get out of the recession. To an extent this occurred in 1992; the UK was in a recession but because they were in the ERM (2) they were trying to maintain a high value of the £. Thus interest rates were far too high (15%) these high interest rates exacerbated the UK’s recession.

3. Sensitivity to interest Rates. The nature of the UK housing market means the UK economy is sensitive to changes in interest rates. Unlike European countries most UK householders own their own house, their variable mortgage is a high % of their income. Thus even a 0.25% change in interest rate can significantly affect disposable income. If the UK were to join now and interest rates were to fall by 2% it would very likely cause a further boom in the housing market which would feed through into higher inflation.

4. Loss of independence of Fiscal Policy. The growth and stability pact limits the levels of government borrowing to 3% of GDP. This is another difficulty in getting the economy out of a recession. However it would not affect the UK at the moment. Also France and Germany have conveniently been able to sidestep this rule when necessity demanded.

The UK economy is doing relatively well, by historical standards the UK economic performance is quite remarkable. Thus there seems little incentive for a British politician to take on the entrenched Euro scepticism prevalent in British media and society. There is little to be gained by joining and there are many potential problems, the Queen’s head is safe for the foreseeable future.


By: R.Pettinger

See also:

Benefits of Joining EURO

Costs of Joining Euro

(1) This is actually a myth. The EU never had a regulation about the shape of bananas, but the point is it has entered British folklore.