Fiscal deficit and fiscal management in the EU in the period of financial crisis.

Written by: Ihor Bobyr

Module title: Macroeconomics

Module leader: Johanna Działo

Date of submission: 16.06.17

Fiscal policy

Everybody knows that the 2008 financial crisis was the biggest economic catastrophe since the US Great Depression in 1929.It brought a high unemployment and discouraged many employees who had been looking for the job. The whole history began with the collapse of subprime mortgage market in the US in 2007, however the first premonition that the economy is in danger occurred in 2006 when housing prices started to fall. The US government within the Community Reinvestment Act (CRA) encouraged Americans to take long-runs loans, the vast majority of these bonds were not paid by homeowners. They also could not sell their homes. Despite the belief of the Federal Reserve that these mortgage crises would only hurt housing sector, it spread its damage on financial markets all over the world. In economic theory various fiscal actions could be taken in order to cover fiscal deficits, stabilize public finances and provide further sustainable development. However, the tricky situation with this financial crisis was that the world faced such a complex, structural problem for the first time. According to International Labor organization (ILO) the global unemployment rate increased up to 6.2% in 2008 (ILOSTAT database), in the EU-27 it increased by 5.2 and 2.9 percentage points for young men and women, respectively and in the case of developing countries the segment of poverty increased dramatically, which resulted in complex of social and humane problems, which cannot be solved until today. The aim of this essay is to denote major causes and consequences of global financial crisis and further recession, compare fiscal regulations and effectiveness of different actions, which were taken by the EU countries and measure how successful was the EU policy in covering global financial crisis.

To begin with we should describe how the fiscal policy works in the economy. Fiscal policy is a government spending policies that influence macroeconomic conditions, regulate unemployment rates, control inflation, stabilize business cycles and influence interest rates in an effort to control the economy (Investopedia, official website). The government acts in increasing and decreasing taxes, raising or lowering its expenditures, stimulating various sectors in this way, but the problem with fiscal policy always arise in the fact, that it affects different groups disproportionally. The crises began because of the politics of Federal Reserves, which lowered Federal funds rate from 6.5% to 1.75% in one year 2001, in response to a recession in the US economy. The environment of high liquidity and easy credits was created, thousands of people with low incomes, with no jobs or assets started to borrow money from banks, while on the other side investment increased dramatically in mortgages and prices for houses rose as well. The politics of lowering interest rates continued and reached its record for the last 45 years of 1%.These loans were transformed by bankers into debt obligations and sold them to investors, in this way the situation of selling everything with huge discounts was created. This situation exploded when interest rates became to rise, as result thousands of borrowers went bankrupt as they were unable to pay their credits, on the other side lenders (huge banks) did not receive their money and started to claim bankruptcy as well. During the whole crises 67 banks bankrupt with more than $1 trillion debt in mortgages and securities. Financial markets did not know how to deal with this situation, requiring governments all over the world to act together in order to prevent further distribution of a collapse.

In order to describe briefly the consequences of financial crises we should look at repletion of government revenues and measure government expenditures. The following table shows us the budget deficits of European countries.

Budget deficits of main European economies in % of gdp (2007-2012)

	2007	2008	2009	2010	2011	2012
Germany	0.2	-0.2	-3.2	-4.2	-1	0
France	-2.5	-3.2	-7.2	-6.8	-5.1	-.4.8
United Kingdom	-2.9	-4.9	-10.2	-9.6	-7.6	-8.3
Italy	-1.5	-2.7	-5.3	-4.2	-3.7	-2.9
Spain	2	-4.4	-11	-9.4	-9.6	-10.5
Austria	-1.4	-1.5	-5.4	-4.5	-2.6	-2.2
Ireland	0.3	-7	-13.8	-32.1	-12.6	-8
Poland	-1.9	-3.6	-7.3	-7.3	-4.8	-3.7
Norway	17	18.7	10.3	11	13.4	13.8
Greece	-6.7	-10.2	-15.1	-11.2	-10.3	-8.8
European Union	-0.9	-2.4	-6.6	-6.4	-4.6	-4.3

Source: Trading Economics official website (viewed 27.05.2017)

It is visible from the table that all economies experienced falls during the world crises and further years of recovering, budget deficits started to increase in 2008 and reached their picks in 2009 or 2010.Some economies, remain showing sustainable growth, but this required significant donations, for instance China spent US$585 billion in order to cover recession and showed a growth of 8.7% in 2009, and the US accumulated over $700 billion within the National Economic Stabilization Act of 2008, in order to buy unpaid assets (mortgages and securities). As far as the financial and economic crisis has had a very profound impact on public finances in the euro area, the previous projections suggest that the government deficit in the euro area will climb to almost 7% of GDP in 2010, and all euro area countries will exceed 3% of GDP limit. Thanks to stabilization of confidence within monetary policy reactions and expansionary fiscal policy measures the predicted falls were slightly defalcated in the EU. The crises surmounted the US boarders after the default of the US investment bank Lehman Brothers, because more and more European financial institutions started to experience painful liquidity problems and lowered their own credit quality undertaking massive asset write-downs in response.(according to ECB 2009). To ensure stability of banking and financial systems, the European G-8gathered for summit in Paris on 4 October 2008, the leaders of all EU-27 joined them on 6 October 2008, they negotiated further steps, which should be taken by each of them on national and supranational level to reinforce bank deposit protection schemes The ministers of finance of Member States introduce common principles to restore the proper functioning of financial sector, they claimed that all national measures on systematic financial institutions would be done within a coordinated framework, also they agreed to put the coverage of national deposit guarantee schemes at the level of EUR50,000, as a result the European Action Plan was presented on 12^TH of October 2008.It included several steps:

-at the macroeconomic and structural level, ensure domestic policies are in place to support growth in a sustainable manner

-restore confidence on financial markets and avoid excessive tightening of credit toward SMEs in the EU

-on the external front, contribute to a more favorable environment

Acted under such common strategy some countries provided broad-based schemes of guarantees and recapitalization process e.g. Germany, Austria, Greece, Spain, France and the Netherlands, others acted not under a general scheme, but introduced interventions to support or nationalize individual financial institutions, to affect specific banks solvency threats e.g. Ireland, the Netherlands, Belgium and Luxemburg. Spain and Italy used asset purchase schemes, some temporary swap arrangements and debt assumptions or cancellations. Ireland used blanket guarantees on all deposits and debts of foreign subsidiaries and domestic banks. The policy of incorporating financial incentives for early repayment in their support packages was also popular among some euro countries; they even introduced an obligation to provide a credit for the economy. The structural result of such an exposure is visible on the following graph.