Explaining the Eurozone Crisis

Article by Daro Nakshbande (UWCAC ’13-’15)

No longer is it a novelty that the Eurozone has been experiencing weak economic growth. After the 2008 world financial crisis, the European Central Bank (ECB) primarily addressed the weak state of the European economy as well as the struggling markets of individual nation states. This has proven to be rather difficult, in particular for those states that have adapted the Euro as currency. There are several factors that keep the Eurozone economy from a full economic recovery, as has occurred in the United States and, to some extent, in the United Kingdom. The main fear for the Eurozone as of today is that of deflation. Deflation can be described as a sustained decrease in price levels over time (often measured over several months). Contrary to an inflationary cycle, the real value of money increases when deflation occurs.

Deflation could potentially be beneficial for some stakeholders when looking strictly at its dictionary definitions. When consumers experience decreases in the prices of products, they are in theory more likely to increase their consumption. Larger investments, such as that new flat screen TV or even a new car, could become relatively cheaper. This is because if on the short term prices fall while the income of the labour force remains more or less equal, consumers will experience a relative increase in their purchase power. However, in reality deflation is seen as one of the largest economic threats. Anthony Scaramucci, CEO of investment firm Skybridge Capital even goes as far as claiming the following:

“It’s an annihilation. It’s the Darth Vader death star outside of the atmosphere of the earth, shooting a laser to blow up the world’s economy.” [1]

To be somewhat more precise as to what is and has been causing inflation in recent months, it is useful to consider different types, or causes, of inflation. Often, a distinction is made between supply-side deflation and demand-side deflation, where the former is generally benign and the latter rather undesirable. Supply-side suggests that the price level of products is falling due to increased productivity or lower production costs for producers of goods and services. This has in fact occurred, primarily due to the significant fall in oil prices. There remains a substantial threat of demand-side deflation, the cause of which is an overall fall in the demand for goods and services within the Eurozone. Economic theory suggests that expenditure (consumption by consumers and investment by firms) is postponed if consumers and producers lose confidence in the economy and instead await a further drop in the price levels. This however leads to a vicious circle or deflationary spiral. The more people postpone their spending, the more demand for goods and services decreases, the more price levels fall.

Consequences of deflationary spiral include an increase in unemployment. Firms will need to cut their costs of production and labour happens to be one of the most significant costs for most companies. By cutting jobs, they hope to minimise their economic losses. This leads to an increase in unemployment. Another issue of inflation, connected to the relative increase of the real value of money, is increases in real debt. Any stakeholder in debt will be negatively impacted by inflation. This can be explained by looking at average price levels again. If the price for goods and services falls significantly, it becomes possible to buy larger quantities of goods or services for the same amount of money. An implication of this relative increase in the value of money is that the value of debt increases accordingly. This can be detrimental to stakeholders that are bound to be in debt, such as governments and firms.

The ECB aims to prevent deflation in the Eurozone using a variety of monetary policy. Central banks are able to influence the supply of money in an economy, usually by adjusting interest rates for other banks to borrow money from the central bank. In theory, decreasing interest rates would lead to an increased willingness and ability of consumers and companies to borrow money and consume it or invest it, which could increase demand and increase price levels. The implication of low interest rates is that it becomes less attractive to save and more attractive to spend. Recently, the ECB has pumped a staggering 1.1 trillion Euros in the Eurozone economy to buy up loans and bonds from banks and governments.[2] This policy is called Quantitative Easing (QE). The aim of this form of monetary policy is to increase inflation and decrease interest rates, ultimately aiming to increase demand and to help recover the Eurozone. The policy is rather ambiguous and its effects on the Eurozone in particular remain ambiguous for now. Even if ECB’s programme of QE can solve the crisis in the Eurozone, political tensions arising from this economic policy can certainly pose a threat to long term economic stability in Europe.

[1] http://www.dw.de/davos-and-the-fear-of-darth-vader/a-18208120

[2] http://www.nytimes.com/2015/01/22/business/international/ecb-bond-buying-quantitative-easing.html

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