Introduction to Microeconomics
Question 1: Name some of the microeconomic (and to lesser extent macroeconomics) problems with the initial creation of the EU and the Euro economically and financially. Elaborate your answer from the case study and individual research.
In 2010, the finance ministers from 16 nations in the eurozone came together to come up with solutions and responses to address the financial crisis that was continually spreading through Europe. Two weeks before this gathering, the Standard & Poors credit rating agency had downgraded the sovereign debt if the Greek government to a BB+ status-pushing its bond yield of two years to 10 percent and its bond yield of ten years to 19 percent.
Since the Greek government was not able to finance the operations, and since it lacked a pledge of support from the EU, the government of Greece decided to approach the International Monetary Fund for help. The EU agreed to lend the nation 110 billion euro as a support package, but as it follows, the support package did not calm the markets. As a result, another meeting soon followed that aimed to come up with solutions that are more robust to the debt crisis that still affected the nation.
These challenges and problems facing the eurozone have not just started recently. Challenges and difficulties started to present themselves in the initial stages of the formation of the union, and they had to do with numerous microeconomic and macroeconomic issues. One of these initial challenges resulted from the Roman treaty. While iron and coal presented the region with numerous challenges, these challenges were only the starting points. In 1955, during a meeting, the ECSC, which had six members, proposed that the union would create two new European authorities. These two would include the Euratom whose main function would be to coordinate the research into the realization of atomic energy, with the EEC, or the European Economic Community focusing on developing a common market that would include all services, goods, capital, and people.
As soon as the union created these two unions, they ran into roadblocks that were political. In the early 1960s, the German government had come under pressure to exclude agricultural goods from the newly established common market. The farmers insisted upon this because they worried that a free European market in agricultural produce would favor the French farmers more. After two years of debate upon the issue, the committee created a policy in 1962, which the committee referred to as the Common Agricultural Policy, or simply CAP. This policy established common markets internally in agricultural goods as France had wished, and included export subsidies, price supports, and restrictions on imports and other types of support to producers in those countries that utilized agricultural practices that were less efficient.
As it follows, the programs were extremely expensive, and funding for them accounted for about 76 percent of the total budget of the European Commission in 1973. The most significant cost was borne by the customers, who by the end of 1960 were purchasing goods at a price four or three times larger than the right price. Other markets dealing with other products also became difficult to unify. While states in the eurozone lowered barriers of trade that, were formal, differences in technical standards and regulations arose raising barriers that are more informal.
Furthermore, efforts that the member- states employed to address these formal barriers only worked towards the creation of more upset within the member states. For instance, legislation to unify standards of mineral water required not less than 15 years. As a result, the member states never made into law most of the efforts to standardize goods that the member states took, and even those standards that passed were never transcribed into the legislation of the member states.
By the mid-1980s, it was quite clear that the barriers that were nontariff were blocking more progress towards the realization of a market that was common. Contracts drawn by the governments favored producers who were local. On the other hand, subsidies from the state provided domestic firms with special advantages, especially in sectors that were declining. In addition to this, national standards of products that were distinctive kept on competing with products that were foreign out of the domestic markets. Limits that existed on financial assets and currency exchange also presented a problem to the capital flows derived from across the borders.
By 1986, these challenges were too extreme such that the SEA or the Single European Act had to seek for solutions to overcome the nontariff challenges through the alteration of the European Commission procedures of making decisions in the Council of Ministers and in the European parliament. One of the ways through which the Single Europe Act could achieve its goals in creating a common market was through the alteration of the governance procedures of the EC. It managed to do this by formalizing the mutual acknowledgment standard that had initially been created by the Court of Justice in Europe.
The member states could now use the legislative initiatives to pass more than 71 percent support rather than through unanimity. As it follows, this had the possibility of blocking coalitions of the minorities. However, majority voting that was qualified opened paths for the elimination of numerous nontariff barriers. Under the new voting rule, members were able to quickly pass new directives that could be useful in regulating public procurement, in creating structures for setting common product standards and technical standards, and for harmonizing value-added taxes. This new voting rule, also made it possible for the committed member states to allow flows of capital that were unrestricted, in addition to, the right to open and operate bank accounts of the European Union citizens in most of the member states.
These were not the only macroeconomic and microeconomic challenges the union was facing. Since the fall of the standards for the exchange of gold under the 1971agreement by Breton Woods, the European Community had tried many times to redevelop a fixed exchange rate program that would be intra- European. Between the period of 1979 and 1972, the main countries in the European region had agreed to limit their fluctuations in exchange rates under the ECMA, or the European common margins agreement. The countries that were participating, and particularly Italy and France, dropped out of the program from time to time to pursue devaluations in competition.
The member states of the European community in 1979 came up with a new system of exchange rate bands that were bilateral in an effort to give the exchange regime that the union had fixed more credibility. The bilateral exchange rate bands were governed by the ERM, the Exchange Rate Mechanism. The ERM came up with a new ECU, or European Currency Unit, a Cooperation Fund and a governing Monetary committee to make offer loans that were short- term to support countries whose currencies were facing the risk of falling outside the bands that had been agreed on.
The European Monetary Union or the EMU came up as a result of a crisis that occurred within the ERM. At the time of the reunification of Germany in the 1990s, the country’s Chancellor at the time decided to change the marks of East Germany into Deutschmarks at a ratio of 1 to 1. This decision, in addition to, the high levels of investment that were deficit-financed used to revitalize the five newly- created states in the country, resulting in inflammatory pressures in the country. This dismayed Bundesbank was extremely, and the bank responded by increasing its interest rates, a move that put the other currencies involved in the market under a lot of pressure.
The member states passed the Capital Liberalization Directive in 1988under the newly passed QMV voting rule that the member state passed in 1986 with the Single Europe Act. The liberalization directive required all the member states to permit free flows of capital at the beginning of 1990. The ERM members had to raise their interest rates because they did not have any access to the controls of capital. The pressures grew and by 1992, they had become highly unsustainable. In the same year in September, a rumor started to spread that Germany and France had come up and agreed on the idea of proceeding with an approach that was two- speed to the integration of monetary that led to attacks that were speculative on the soft currencies that the member states thought were lagging behind.
Spain and Ireland, as a result, reimposed controls on capital, something that slowed down the outflow of money. Italy was allowed to devalue the Lira by not more than 5 percent within the ERM. Britain, on the other hand, was already deep in recession and had to increase its interest rates so as to maintain the value of Sterling at 2.95 DM, the lesser bound for staying within the ERM.
The Bank of England, in the morning of 16th of September 1992 raised its interest rates to 12 percent from 10 percent to protect the pound, and then announced and imposed another increase, raising the interest rate to 15 percent. For a nation that was already experiencing a recession, the political pressure within the local markets proved too much to handle. When Germany and France declined to offer support to the orderly realignment in the ERM, the British pound had to pull out.
Another challenge that the European Union faced had to do with its fiscal policies. The European Union had little and limited resources at its disposal. As it follows, most of its revenues came from contributions made by the member states, from value-added tax and import tariffs. The poorer regions and the support fund consumed more than two-thirds of this revenue for farmers. Forty-seven percent of the revenue went to the agricultural support fund that was established and put in place by the Common agricultural policy.
On the other hand, the structural supports that the European Union gave to the poorer regions of the union took up 30 percent of the total budget. The European Union came up with the Stability and Growth Pact or the SGP to help the union coordinate its national fiscal policy. This enforcement by SGP, however, presented the union with an ambiguity. In the year 2001, the European Union had to give several countries a warning about their breaching of the fiscal deficit limit that the SGP had established, but among all of these states, only Portugal followed the directive.
The efforts to expand the European zone also presented the union with more troubles. For instance, for new countries such as Estonia and Lithuania, their attempts to merge their economies with the rest of the economies in the union by opening their borders to international trade and foreign investments resulted in higher rates of inflation, making them ineligible for the union. This movement to expand the zone to 27 members from 15 also posed new challenges for making decisions for the union. The Amsterdam treaty of 1997 extended qualified majority voting to new policies that included public health, employment, and data protection policies.
Generally, any change that occurred in the union meant that the power of voting of the present members would be diluted, and negotiations resulted in the resurfacing of old grievances. Another extremely crucial problem resulted from the four freedoms. The 1957 Rome treaty had proposed the establishment of four crucial freedoms in the union; the free movement of capital, the free movement of goods, services, as well as, the free movement of labor.
While in principle this proposition was elegant and enticing, securing such elaborate and significant freedoms posed new challenges for the union. This is because this kind of free movement required the union to dismantle all of the existing formal barriers and the development of new standards that would aid in overcoming informal barriers resulting from national regulations and institutions.
These are just some example of the challenges the European Union faced during its initial stages of development.
Question 2: What is your opinion of the future of the EU in terms of Euro, enlargement, and economics? Elaborate your answer with evidence from a microeconomic perspective.
Though the union has eliminated and come up with ways to eliminate most of the challenges it initially faced during its first stages of development, it is still under threat by a number of other challenges that the future might present to the union. Most of the crucial challenges will result from an unstable economy. The other challenges and threats might come in response to changes that might occur in the size of the union and in the euro.
The economy, has for the past few years, presented a lot of challenges for the member states of the eurozone and it is only fair to argue that these troubles will continue to pose difficulties to the European Union in the future. More recently, one such tragedy arose when the Greek government ran into challenges as a result of the weakening economy. While it was clear that the national government would assume the responsibilities for the solvency in finances of the national banks, it was not so clear whose responsibility the national governments’ solvency should be.
Greece was, therefore treated as a test case. Its public debt rose to 12.7 percent in 2009 from 7.7 percent in 2008, the Eurostat later measured and valued the debt to have reached 15.5 percent. As it follows, the country ended the year with a public debt of 113 percent of its total GDP. After a failed attempt to impose austerity of its fiscal budget in 2010, the country sought to refinance its debt of 22 billion Euros. After the downgrading of the sovereign debt of the country to junk by the Standard & Poors, most of the lenders recoiled.
There were concerns that the Greek government would default its debt, something that put pressure on the member states to intervene. The swift rise in the Portuguese government yield in bonds was reminiscent of the economic environment in Greece just several weeks earlier, meaning that a default by the Portuguese government could be possible.
Furthermore, if Greece was to restructure its debts, there was a large chance that the European economies that were weaker like Ireland, Portugal, and Spain could face extremely high increases in the costs of borrowing. This is a clear implication that if such cases would occur in other member states, then the European Union would be facing great challenges. The current and the future economical climate implies that further financial challenges could be faced if this were to happen, then the Eurozone could be facing serious challenges like or more than it faced with such member states as Portugal and Greece.
The euro could also result in several problems for the union. The euro was launched in 1999, and amid its launch, two main concerns resulted. On one side, observers noted that a single Europe would be poorly suited to specific conditions in the local economy of individual state members. As it follows, if some states remained in recession while others grew, no single interest rate would be enough to satisfy the two types of states. Economists warned that in the absence of greater alignments in the economy of the state members, a single currency could result in a civil war in the region. On the other hand, other observers emphasized the risks that a monetary policy that was centralized could have on the region while fiscal authority remained under the regulation of the state members.
Because the advantages of stimulus in fiscal were local and the monetary costs tightening were felt throughout Europe. Critics emphasized that states would have incentivized to stimulate their economies overly through the imprudence of fiscal. According to these critics, this would force the union to impose interest rates that were higher than might be necessary to meet their targets of inflation, leading to growth in an economy that was slower throughout the region. These challenges might be present and even higher in the future, posing possible risks and threats for the union.
The size of the eurozone might also change either by adding or elimination member states leading to further challenges. As we have already seen earlier, the expansion of the eurozone in the past led to a number of challenges for the union, including challenges in decision- making. The same challenges might present themselves to the union in the future if the state allows more state members to join the union.
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