Excessive government debt in the euro area: How it affects the value of the euro?

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School of Economics | Master's thesis
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This thesis was motivated by the European sovereign debt crisis that was initially set in motion by Greece’s budgetary problems, and has since affected the whole euro area. The main objective of this thesis is to find out how excessive government debt in the euro area affects the value of the euro. Particularly this thesis discusses the factors through which a single member country’s debt problem can induce a full euro area wide crisis. In addition, the aim is to find out what kind of prevailing conditions can have a negative effect further worsening the crisis, and thus evoking a change in the value of the euro. In order to see if excessive level of debt in one member country can transform into problems facing the monetary union as a whole, I use the theory of optimum currency areas (OCA) as a theoretical framework. OCA theory aims to define whether certain countries or areas form a currency area that is optimal in the sense that it can as a whole adapt to asymmetric, country-specific shocks. According to the OCA theory, a monetary union without a common fiscal policy is likely to create budgetary challenges at national levels because national economies can no longer rely on their monetary policy tools but are forced to search for other means to adjust to asymmetric shocks. This feature of the euro area’s design, together with the previous global financial crisis’ implications, encouraged excessive debt accumulation, market speculation, contagion, and distorted banks’ incentives, therefore initiating the sovereign debt crisis in Europe. This thesis is conducted as a literature review and its arguments are based on statistics and recent academic discussion related to the subject. Argumentation is supported by the use of examples meant to give the reader information on the current situation while the discussion follows the events occurred in the course of the European sovereign debt crisis in 2009-2011. The main conclusion of this thesis is that a single asymmetric shock of the form of excessive government debt cannot solely weaken the value of the euro unless it also leads to some of the following events: (i) induce a wake-up call –like reaction in investors, (ii) result in a wide intervention by European officials, and/or (iii) endanger the future of the euro area. Furthermore, as the European sovereign debt crisis has shown, the future of the euro area can be endangered due to the currency area’s unsustainable set-up and lack of fiscal policy commitment and control. Thus, if the foundations of the union are not strong enough to survive a severe asymmetric shock, a debt problem in one country can definitely induce problems for the area as a whole by setting off a series of events that will spread the crisis to cover the whole euro area.
EMU, EMU, euro, euro, fiscal policy, finanssipolitiikka, crisis, kriisi
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