(i) its magnitude (the standard deviation from its equilibrium level of zero) and; (ii) its duration (the length of time usually measured in quarters taken to return to equilibrium levels or simply stated, the effects of the shock to die out.This return to equilibrium levels is the adjustment process and the critical characteristic of this process is the speed at which it occurs. Longer adjustment processes are often costly as countries need to refer to alternative policies which are detrimental, for example, wage reduction and/or unemployment which often have welfare implications – a measure many eurozone countries bear but can ill-afford. The financial crisis (a negative and catastrophic economic shock) has tested the structural characteristics of global economies, however, the most interesting examination has been that of the eurozone, an area characterised by country asymmetries and loss of autonomous policy making which can be argued, were previously successful in realigning countries back to their previous post-economic shock states.
The main economic shock in 2008 adversely affected global banking systems which induced financial contagion - contagion being the spread of economic changes from one country to the other countries. This shock negatively affected wages, employment, GDP, welfare systems to note a few, and the effects of this shock have yet to die out. It is customary for economic shocks in the pre-EMU period to propagate through the economic system and die out within a few to several quarters before other less popular adjustment measures are required as in this period, countries were able to induce policy themselves.
As EMU countries are now ‘tied-in’ to a similar policy, this has method of self-adjustment has not been possible. As a result, the main negative shock has given rise to a series of aftershocks in terms of smaller country-specific shocks where several EMU countries have continuously required bail-outs following major sovereign debt issues, often needing to borrow at higher interest levels, rendering that country a riskier proposition for investors. Once a smaller country-specific shock occurs, this instigates a further increase in the main shock above its equilibrium level, thus moving it further away from zero leaving the effects of the main shock (the financial crisis in 2008) unable to die out.
When financial markets detect a possibility of another banking crisis, the euro depreciates and the exchange rate is often seen as a source of a shock, particularly if it fails to act as a method of stability – a situation clearly seen in the eurozone. As sovereign debt crises increase risks, high rate rises in bond interest payments become another source of economic shocks. This induces major fiscal implications as countries are required to instigate, for example, reductions in government spending, often translating to unemployment, this in itself being a demand side shock as this event changes household and corporate spending. Shocks such as unemployment tend to be more persistent, that is, the effects last longer as seen in Spain, Portugal, Italy and Greece. If an aftershock is persistent, this gives rise to difficulties and impedes the recovery of the main economic shock.
The impact of trade imbalances cannot be ignored apropos economic aftershocks. In medium-term growth performing countries, if for example, expenditure is increased in the service sector by drawing away resources away from the industrial sector (which has more scope for growth) and wages are increased, this can be detrimental because once the deficit period is over, in the currency union (the eurozone) where nominal rigidities are present, the adjustment required can only happen through increases in unemployment. Also, a reversal in financial markets can occur whereby large deficit reduction measures cease. Again, unemployment and asset price decreases have often resulted as a consequence.
In recent years, there have been calls to modernise the measure of systemic risk. This refers to the collapse of the entire banking system and it has been critical to examine the relationship between financial systems and the real economy, with specific reference to the inter-linkages if economies are to avoid a repetition of the previous crisis. The economic crisis is a major shock, giving rise to independent aftershocks. As eurozone countries are effectively a currency union (although not a fiscal union with similar tax and pensions laws) any major crisis within that union will be borne by the other countries. Therefore, addressing the immediate aftershocks becomes a priority if the effects of the main shock are to die out.
Dr. Victor Chukwuemeka
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