U.S. Financial Crisis

1. Introduction

Since the U.S. financial crisis of 2008-09, world economy was experiencing slow growth exposing Europe and other countries towards unsustainable fiscal policies. Such growth was insufficient to deal with jobs crises in most developed economies and drag down income growth in developing countries. In this regard, Greece was the first country who faced tax revenue shortages due to slow growth and ultimately the country debts exceed the entire economy’s size and problem become prominent.

Source: Growth of World Gross Product 2006-2013 (World Economic Outlook 2012)

2. Fiscal Policy before Debt Crisis

During the 1998-2000, fiscal consolidations were not undertaken in the euro zone member states when the growth was satisfying. The cyclical adjusted public balance was deteriorated because of cyclical improvement of public finances and the reduction of interest charges allowed public balances to move away from the excessive deficits threshold. The European authorities criticized that member states did not use the cyclical upturn to bring more rapidly their deficits close to balance. The Economic and Financial Affairs Council (ECOFIN) announced that no euro area country was under an excessive deficit procedure (EDP), while five countries in the euro area were under an EDP. (Sterdyniak, 2010)

Source: Overcoming the Debt Crisis and Securing Growth 2010, OFCE, Paris

There were three main reasons associated for such crisis. First the member states expected unemployment rate of 5%, which was below then the actual (9.3%). Secondly, member states of the euro area considered a significant budgetary room (around 2 points) as a whole, and lastly, country with high unemployment, rapid GDP growth and no inflationary pressures may wish to see the continuation of this economic cycle. With such excessive public deficits and the weak activity level, restrictive policy becomes a contra-productive.

3. The Debt Crisis

The sovereign debt crises worsened in the second half of 2011 in many European countries and aggravated weaknesses in the balance sheets of banks. Governments took bold steps to escape from such sovereign debt because of heightened concerns of debt default in large economies of the euro zone. In Greece and Italy, austerity measures were taken to repair financial sector balances as well as encourage job prospects but all such measures further weakened the economy and make debt crisis more challenging. The rapidly cooling economy became both a cause and an effect of the sovereign debt crises in the euro area, and of fiscal problems elsewhere. Three