The Great Recession, the Balkans and the Euro

By Tahir Mahmutefendic

The recession, which started in the USA in autumn 2007, spread to the rest of the world in 2008 and 2009. The Balkan countries were hit hard by the recession. Closely tied to the European Union, they felt the full blow of the crisis in the Eurozone. In a narrow sense, this crisis was caused by weaknesses, contradictions, and inconsistencies of the EMU. In a wider sense, the common denominator of the Great Recession and the crisis in the Eurozone could be found in huge imbalances generated by market fundamentalism and the inability of the neoliberal concept of capitalism to achieve major socioeconomic goals.

• Language: English
• Publisher: Xlibris UK
• Release date: Aug 21, 2015
• ISBN: 9781514461990

Tahir Mahmutefendic

Tahir Mahmutefendic was born in Tuzla, Yugoslavia, now Bosnia and Herzegovina. In 1959 his family moved to Sarajevo, where he finished his education in 1978, gaining a first class honours from the Faculty of Economics at the University of Sarajevo, where he subsequently worked as a lecturer in Political Economics and Finance. In 1987 he earned a Master of Philosophy degree in International Economics from Belgrade University and in 1996 a PhD degree from the same university. Tahir Mahmutefendic published six books and tens of articles and book reviews. Currently he is a professor of Economics at Sarajevo School of Science and Technology and a private university in Vitez/Travnik. Tahir Mahmutefendic was a youth chess champion of Bosnia and Herzegovina in 1975 and is a Bosnian chess master. He speaks eight languages.

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Copyright © 2015 by Tahir Mahmutefendic.

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Rev. date: 08/19/2015

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CONTENTS

Acknowledgements

List of Tables

List of Abbreviations

Preface

Introduction

PART ONE

WORLD ECONOMIC PERFORMANCE

2009-2013

Chapter 1 Recession in 2009

Chapter 2 Recovery in 2010

Chapter 3 World Economic Performance in 2011

Chapter 4 World Economic Performance in 2012

Chapter 5 World Economic Performance in 2013

PART TWO

THE EURO

Chapter 6 A History of Monetary Unions

Chapter 7 A Theory of Optimum Currency Area

Chapter 8 A Brief History of the Euro

Chapter 9 The Great Recession and the Euro

Conclusion

Bibliography

Dedicated to Moenes and the Memory of Ekbal

ACKNOWLEDGEMENTS

I owe a debt of gratitude to the following individuals and institutions:

Dr Eric Beckett-Weaver, Editor in chief of the South Slav Journal

My son Moenes Mahmutefendic for useful suggestions

Staff of The British Library for their help and support

The publishers for their expedience and professionalism

LIST OF TABLES

TABLE 1 – SELECTED ECONOMIC INDICATORS 2009/2010

TABLE 2 – GROWTH AND COMPOSITION OF CREDIT AND CURRENCY COMPOSITION OF LOANS BY COUNTRY, MARCH 2009

TABLE 3 – METALLIC STOCK AROUND 1860

LIST OF ABBREVIATIONS

ASEAN – Association of South-East Asian Nations

CAP – Common Agricultural Policy

CDO – Collateral Debt Obligations

CLUB MED – Club Mediterranean

D-mark – Deutsch Mark

EBRD – European Bank for Reconstruction and Development

ECB – European Central Bank

ECSC –European Community for Steel and Coal

ECU – European Currency Unit

EEC – European Economic Community

EFSF – European Financial Stabilization Facilities

EIB – European Investment Bank

EMCF – European Monetary Cooperation Fund

EMF – European Monetary Fund

EMI – European Monetary Institute

EMS – European Monetary System

EMU – European Monetary Union

EPU – European Payment Union

ERF – European Reserve Fund

ERM – Exchange Rate Mechanism

ERP – European Recovery Programme

ESCB – European System of Central Banks

ESF – European Stability Fund

ESM – European Stabilization Mechanism

EU – European Union

EUA – European Unit of Account

FDI – Foreign Direct Investment

FYR – Former Yugoslav Republic

GDP – Gross Domestic Product

GIPSI – Greece, Ireland, Portugal, Spain, Italy

GNP – Gross National Product

ILO – International Labour Organization

IMF – International Monetary Fund

LMU – Latin Monetary Union

NAIRU – Non-Accelerating Inflation Rate of Unemployment

OCA – Optimal Currency Area

OECD – Organization for Economic Cooperation and Development

OEEC – Organization of European Economic Cooperation

OMT – Outright Monetary Transactions

OPEC – Organization of Petroleum Exporting Countries

Ostmark – East German Mark

PCL – Precautionary Credit Line

PIGS – Portugal, Ireland, Greece, Spain

PTA – Preferential Trade Agreement

REBLL – Romania, Estonia, Bulgaria, Latvia, Lithuania

SBA – Stand-By Arrangement

SDR – Special Drawing Rights

SEE – South-East European

SGP – Stability and Growth Pact

SMEs – Small and Medium Enterprises

SMP – Security Market Programme

SWFs – Sovereign Wealth Funds

T-bill – Treasury Bills

UK – United Kingdom

UN – United Nations

USA – United States of America

VAT – Value Added Tax

WTO – World Trade Organization

WWI – First World War

WWII – Second World War

PREFACE

This book ‘The Great Recession, The Balkans and the Euro’ represents a continuation of research I conducted in my previous book ‘Economic Performance in the South-East European Transition Countries after the Fall of Communism’. In that book the focus was on the South-East European Transition Countries and their performance after the change in the regime in the context of global economic changes. In this book the emphasis is less on the region. The Balkans got a roughly equal share as other countries which were hardest hit by the Great Recession.

The Great Recession is the name commonly used to label the events in the aftermath of the credit crunch in the USA. The other, less used name is The Second Great Contraction.

The Balkans is a synonym for South-East Europe. Relatively recently the name The Balkans was substituted by the latter, the reason being that The Balkans acquired a negative connotation due to the region’s violent past and a relative economic backwardness. The name The Balkans was chosen in the title of the book for the sake of brevity. Its synonym is continued throughout the book.

The analysis of the euro was confined to the founding members. New members of the Eurozone, coming from Eastern Europe, or the so called external periphery of the European Union were not taken into account since they did not cause the crisis in the Eurozone and were much less affected by it.

The book has two parts. The first part is entitled ‘World Economic Performance 2009 – 2013’. Since the recession spread to the most of the world in 2009 this year was chosen as a cut-off point.

The first part of the book consists of five chapters: 1. Recession in 2009, 2. Recovery in 2010, 3. World Economic Performance in 2011, 4. World Economic Performance in 2012 and 5. World Economic Performance in 2013. Each and every chapter is divided into three subchapters. The first subchapter deals with global economic performance. The second subchapter analyses economic performance in the European Union. The third subchapter is devoted to economic performance in South-East European Transition (Balkan) countries.

The second part of the book deals with the Euro. It consists of four chapters. Chapter Six is entitled ‘A History of Monetary Unions’. It gives aims, definitions and classifications of monetary unions throughout history. It also analyses in detail three of the most important monetary unions: The Latin Monetary Union, The Scandinavian Monetary Union and The German Monetary Unification.

Chapter Seven is entitled ‘The Theory of Optimal Currency Area’. The concept was named by Robert Mundell in 1961, who received the Nobel Prize in 1999 for his contribution to research in this field. Over a period of time the concept developed into a full theory identifying eight criteria which a monetary union must fulfil in order to represent the optimal currency area.

Chapter Eight is entitled ‘A Brief History of the Euro’. It deals with European monetary affairs from the end of the WWII until the introduction of the Euro.

The last chapter is entitled ‘The Great Recession and the Euro’. This chapter is divided into four subchapters. The first subchapter deals with the period between 1999 and 2007. This is the period before the credit crunch during which the Euro performed relatively well. The second subchapter analyses the impact of the credit crunch on the Eurozone. The third subchapter focuses on causes of the crisis in the Eurozone. The fourth subchapter deals with the future of the Euro.

The conclusion summarizes the causes of the crisis in the Eurozone which could be perceived on two levels. The first one is related to inconsistencies, weaknesses and contradictions in the structure of the euro. The second level synthetically tries to find common causes for the Great Recession and the crisis in the Eurozone.

INTRODUCTION

The Recession, which started in the USA in autumn 2007, spread to other developed countries in 2008, and eventually to the rest of world in 2009. Authorities in developed countries responded with a massive and coordinated action, the aim of which was to rescue the banking system. Massive rescue packages prevented a financial meltdown, but failed to revive the economy completely. Though positive growth rates were resumed in non-European developed countries, unemployment rate in the USA remained high.

Emerging countries in South-East Asia and Latin America showed the best performance during the crisis. They avoided recession and only recorded slowing down in their economies.

South-East European transition countries were hardest hit by recession. Although the Baltic States initially recorded the sharpest fall in GDP they recovered quickly whilst South-East European transition countries experienced a protracted contraction. Being closely tied to the European Union, they felt the full force of the crisis in the Eurozone. There were several channels through which the crisis was transmitted from the Eurozone to South-East European transition countries. Firstly, subsidiaries of foreign banks, which dominate the banking sectors in South-East European countries, stopped landing to businesses and household, ending a credit-driven boom. Secondly, deleveraging produced a reverse flow of financial funds from bank subsidiaries to parent books. Thirdly, remittances as well as FDI decreased considerably. Fourthly, demand for exports from SEE transition countries shrank significantly. As a result, the main components of aggregate demand, consumption, investment and exports fell sharply. In addition, SEE transition countries could not use an expansionary fiscal policy due to high current account deficits. This situation was aggravated in the countries which have a fixed exchange rates regime since they could not depreciate their currencies to boost exports. As a result recovery was mild, uneven and un-sustained. The only positive outcome was that inflation rates as well as current account deficits decreased since a fall in aggregate demand reduced imports by more than exports.

The focus of the world was on a protracted crisis in the Eurozone. In the first decade of its existence, the Euro performed relatively well. However, the credit crunch and the recession which followed exposed some structural weaknesses in the Eurozone. The main one stemmed from a huge competitiveness gap between Germany and some other core countries on one side and the peripheral countries on the other side. Overall the Eurozone recorded a small surplus on the current account of the balance of payments with the rest of the world. But within the Eurozone there were great differences between Germany and the peripheral countries.

There were three causes of an increase in a competitiveness gap between Germany and the peripheral countries. Firstly, the latter entered the Euro with overvalued exchange rates. This was a deliberate strategy to lower inflation. Secondly, inflation in the Eurozone was low, in the range of 2-4 per cent (and later 2-3 per cent), but it was towards the higher end of this range in the peripheral countries. Thirdly, nominal labour unit costs grew faster in the peripheral countries. Labour productivity rose faster in the peripheral countries but it was more than offset by a higher rise in wages since Germany managed to squeeze the wages of their workers. As a result a competitiveness gap of 30-40 per cent was created in favour of German exporting companies. Germany recorded huge surpluses in the current account of the balance of payments, which were mirrored by big deficits in the peripheral countries. These surpluses were recycled through the banking system to the peripheral countries, where they financed a consumption boom in Greece and Portugal and housing bubbles in Ireland and Spain. Once recession spread to the Eurozone banks in the core countries, it stopped landing to the peripheral countries. The banking crisis soon became a sovereign debt crisis since governments of the peripheral countries launched rescue operations in order to prevent a financial meltdown. This was accompanied by coordinated actions on the level of the Eurozone. Several financial mechanisms were established, such as EFSF, ESF, ESM and OMT. In the process the Maastricht rules were twisted. The ECB, which was supposed to be independent, came under intense political pressure. Also, a bail-out clause was ditched and the ECB was allowed to purchase government bonds in secondary market.

These actions were accompanied by austerity measures. These austerity measures consisted of cutting expenditures and an increase in mainly indirect taxes, while corporate taxes were reduced. They also included broadening of a tax base and attempts to tackle tax evasion.

The austerity measures had two aims; to reduce fiscal deficits and public debts, and to restore competitiveness through ‘internal devaluation’. A competitiveness gap between Germany and the peripheral countries was somewhat reduced, but at a huge price. A protracted recession set in motion debt-deflation spiral. Fiscal deficits soared and public debts went through the roof. Unemployment increased manifold exceeding 25 per cent in Greece and Spain, while youth unemployment reached 55 per cent.

Poor economic performance is not confined to the peripheral countries. Fiscal deficits exceed 3 per cent in almost all member countries, while the level of public debt exceeds 100 per cent in Italy and Belgium. Stagnant or falling wages, combined with the reluctance of banks to lend to businesses and households keeps consumption and investments depressed. As a result the Eurozone recorded a negative growth rate five years after the onset of recession.

In spite of this plight, there are no signs of a light at the end of the tunnel. Prospects of default and exit from the Eurozone seem likely for Greece and possibly some other peripheral countries.

PART ONE

WORLD ECONOMIC PERFORMANCE 2009-2013

CHAPTER 1

RECESSION IN 2009

1.  WORLD ECONOMIC PERFORMANCE IN 2009

The Recession started in the first half of 2008 in the USA and the other developed countries, spread to the rest of the world in the last quarter of 2008 and the first quarter of 2009. Economic downturn spilled into the rest of the world through two channels; goods markets and financial markets.

The main transmitter of the recession in goods markets was American imports, which accounts for 15% of the world trade. A demand for foreign goods in the USA fell by 7% in 2008 compared to 2007. Hopes that this would be compensated by the rise in imports in Asian countries did not materialize since Asian consumption is only 40% of the American consumption. In addition, Asian economies heavily depend on exports to the USA. As a result growth of world trade decelerated from 6.3% in 2007 to 4.4% in 2008 and only 2% in 2009. ¹

Financial markets transmitted recession in two ways. First, the recession was transmitted by increasing the cost of borrowing and the reversal of financial flows. Second, it was transmitted by exports of toxic assets from the USA to other countries.

Private capital inflows, which grew robustly in the first half of 2008, dropped sharply since the third quarter of 2008. The volume of bank loans to emerging markets declined by around 40% from 2007 due to the fall in interbank lending worldwide. The fall in investment was particularly pronounced in portfolio investment, which fell by 30%, reflecting serious disturbances in equity markets. By contrast, foreign direct investment inflows to emerging markets dropped by only 10% from high levels in 2007.²

The outflow of capital from emerging to developed market economies continued to be larger than the inflow. On balance, emerging market economies continue to be net lenders to the rest of the world, financing the external deficit of the United States and other developed countries. This lending acquires the forms of increase in foreign currency reserves and sovereign wealth funds (SWFs), whose value totalled $ 4 trillion at the end of 2008.

Financial markets exported recession from the USA by selling mortgages abroad through the process of securitization. This channel was enabled by a worldwide deregulation of financial markets and a flood of new financial instruments such as collateral debt obligations (CDO), debts swaps and mortgage securitization. A sale of toxic assets abroad mitigated recession in the USA, but aggravated the situation in the rest of the world. ³

Weaker global demand in the second part of 2008 reversed a rising trend in prices. Oil prices plummeted by more than 60% before the OPEC reacted by cutting the supply. The prices of other commodities, including food, also declined significantly. This led to a sharp decrease in inflation in many countries with some countries facing deflation.

Turmoil in financial markets contributed to a volatility of exchange rates, with the American dollar depreciating in the first half of 2008 and appreciating in the second half of the year. Many countries in emerging markets either had to halt or reverse the appreciation against the dollar in order to maintain their competitive positions in the world market. In export-led growth strategies, widely adopted in emerging markets, shrinking of demand put a strain on their external balances, which had to be tackled with the adjustments in the exchange rate.

The negative developments in the goods and financial markets decreased the world output in 2009 significantly compared to 2008. According to The World Economic Outlook, world output, which rose by 3% in 2008, grew only by 0.5% in terms of purchasing power, and even fell when calculated according to exchange market rates. ⁴

According to The International Labour Organization (ILO), unemployment rose by 50 million due to the Recession. In addition, the number of those who will remain or fall into poverty is estimated between 73 and 103 million, while 200 million will be pushed back into extreme poverty. ⁵

Developed countries responded with a massive,