Economics

Case 3-1

The Euro Zone Fights for Its Life

How do you fix a broken economy? Or, more precisely, several broken economies? That is the question facing policymakers in the European Union (EU). Following strong growth in the early years of the twenty-first century, the good times ended as one EU economy after another fell victim to the global economic crisis. At the heart of the problem was the fact that during the boom years several countries had run up huge current-account deficits. Governments were obliged to borrow money to offset the deficits (see Exhibit 3-1). In 2010, 2 years after the collapse of Lehman Brothers, Europe experienced a banking crisis of its own. Property values slumped— in other words, the so-called asset bubble burst—and the banks that had provided the financing faced a cash crunch. As governments intervened to keep banks from failing, they piled up debt. Global investors in New York, London, and elsewhere worried that governments would default on their debt obligations. In the twentieth century, when each European country had its own currency, government leaders could manipulate exchange rates by using devaluation. As you read in Chapter 2, a weaker currency has the effect of making exports more competitive. This, in turn, stimulates the economy. Everything changed in Europe a decade ago when a currency union was created. To date, 23 nations—17 EU members and 5 non-EU states—have adopted the euro. For them, devaluation is no longer an option.

The Euro Zone Fights for Its Life

Exhibit 3-1 The European Central Bank (ECB), based in Frankfurt, Germany, establishes policy for the 23 nations that use the euro. Jean-Claude Trichet was the ECB president from 2003 to 2011, during which time he was sometimes referred to as “Mr. Euro.” The ECB has been in crisis management mode for months, buying bonds from cash-strapped euro zone governments and providing liquidity for the euro zone financial system. Source: Iain Masterton/Alamy.

Despite being...