Post on 09-Aug-2020
Its dimensions and implicationsMR Anand
GL Gupta
Ranjan Dash
Optimism and enthusiasm (1999-2007), replacedby pessimism and distrust (2009-11)
Origins of the crisis. 2 main causes, 1 anomaly.
2 causes (1 external, 1 internal):◦ 1. US financial crisis: collapse of markets→ downgrade
of rating on public bonds→dramatic rise in borrowingcosts (PIIGS) → fears of sovereign debt default
◦ 2. Increasing divergencies in a monetary union with economic and political tensions (growth; public accounts; productivity; external accounts etc.)
1 anomaly. ◦ The Euro crisis was not a typical «currency crisis»:
Loss of confidence in a country → capital flight → high interest rates / exchange rate depreciation → collapse of investments → everything goes bad other than exports
◦ The external value of the Euro remained stable/strong. Global investors kept reserves in Euro assets.
◦ The euro crisis was an attack toward the idea/project of European integration: «no man’s land» …
The project was already in the treaty of Rome
Attempt #1 of MU failed (Werner plan, 1970→1980)
Attempt #2 was part of the Single Market Process
SMP (goods, capitals, labor) led to the Maastricht Treaty
MT: “5 convergence criteria” …
budgetary and monetary rules; no real, fiscal, politicalconvergence
Jan. 1, 1999 11/15 countries decide a single currency(Dk, UK, Swe: opt out … Gr: not ready). Today: 19
European Central Bank: unique responsability for monetary policy
Many oddities:
◦ No European budget (very small), no fiscal policy, no tax coordination and harmonization.
◦ Very strict mandates for ECB. Two pillars
Price stability + all the rest (growth, unemployment, environmental sustainability etc.) that comes after
◦ Very strong independence of ECB
It is important for stability and growth
However indepencence of instruments or independence of objectives with no accountability?
◦ Very little was done for: Financial and banking crisis(no bailout clause but … with what credibility?)
Symbol of deep political and social integrationafter WW2: the currency and the army are the symbols of national sovereignty …
But also widespread expectations for … Microeconomic gains◦ Reduce transactions costs◦ Reduce currency risks and increase investments◦ Expected to increase cross-border competition,
integration and efficiency
Macroeconomic gains◦ Price stability◦ Acquire credibility and attractiveness for investments◦ Increase financial integration. Interest rate convergence◦ Create another reserve currency
1. A monetary union without a fiscal (and political) union
Spending-fiscal authorities remain national;
EU budget for public intervention is small
No role for the ECB in financing deficits and stability;
No role for the ECB as a LLR
No role for the ECB in bank supervision
2. US financial crisis provoked new divergencies
Varying productivity
Structural differencies between countries in terms of wages, unemployment, labor mobility, export surplus.
Impossibility to use the exchange rate in case of asymmetric shocks.
Convergence in interestrates on government
bonds
Convergence in interest rates offered by banks
Reduction of spreads to 0
More pronounced fall in nominal rates in the
peripheral economies.
Bond markets (public and private) were integrated
rapidly;
Collapse of the spread. Convergence survives after theUS financial crisis. The spread explodes at the beginningof the debt crisis
Between 1998 and 2008 the spread went and remained around 0 as if allgovernment debt issues had the same degree of riskiness: investors had the
same level of trust toward Germany, Italy, Spain …
Euro favoured a boom in the credit and real estate markets
As currency risk premium and spread went to 0, credit growth
surged.
It became easier for PIIGS to increase public and private debt
Banks borrowed more easilyfrom abroad, increasing their
leverage
Very strong growth in the Real Estate market: property prices
increased dramatically and favoured further indebtedness
houses were used ascollateral for financial operations
The rise in the twin deficits (public and current account • The crisis produced
a worsening in fiscal decifit (small for Italy, large for Spainand Greece)
• The crisis produceda rise in the demandfor imports and a larger currentaccount deficit from 2003 (G, P, E)
• Key country (Germany) was the only «surplus» economy and didnot act as a leadingcountry (no increasein expenditure)
• DIVERGENCE•
From the financial crisis to the Euro Zone crisis
The US financial crisis triggered the sovereign debt crisis in Europe
The credit boom ended and interest rates start to diverge
Growth declined sharply, 2008-2009
Excessive lending increased bad debts and NPL for banks
Deficit/GDP and Debt/GDP were aggravated by emergency measures
Increased divergence in fundamental indicators (GDP, productivity) and growth of economic imbalances
Before the crisis, large intra Euro Zone capital flows
Countries built up external deficits (PIIGS);
Countries built up external surpluses (G, NL, B)
Poorer nations were attracting investors from richernations … is there anything wrong with that?
Nothing, in principle. However … A big problem was that foreign capital flows were invested in non-
traded sectors (housing, government welfare)
Investment did not increase productivity, competitiveness, exports
Increase in liabilities for Greece etc. was not sustainable and, worse, it contributed to the housing bubbles that inevitably burst
The sudden stop was critical because, in a MU, countries cannotdevalue and the EZ had no bailout mechanism
Strong countriesin surplus, weakcountries in deficit
It’s ok if nationsborrow to investin capacity thathelps the economy
This was not the case: in all GIIPS funds ended up in non tradedsectors
Every crisis hasa trigger: in Europe it wasthe revelation of the Greekdeficit deceit
In October 2009 the newly elected Greek gov. announcedthat the previous gov. had cheated the true size of deficit
The Greek crisis acted as a detonator in two ways:
Large and hidden violation of common fiscal rules can occur (and did occur)
The risk of sovereign default became real and the EU faced it without a mechanism of bailout and a LLR
Fear of debt unsustainability (endless increase of Debt/GDP)
Austerity cycle was started … only to make things worse
Emergency measures were announced after the 2008-9 financial crisis
They were successful in the short run and the financialcrisis was halted;
However they worsened fiscal deficits and debt …
The austerity cycle
Tax rises collapse of aggregate demand recession reduction of tax revenues further increase of deficit further increase of the ratio «deficit/GDP»
Confidence crisis led to a differentiated rise of bond yields and increased costs of risk insurance on CDS (credit default swaps).
Confidence crisis: bond yieldswidened after the Greek deceit (butnot after Lehman bankruptcy)
CDS are financialinstruments thatprovide an insurance againstthe risk of debtdefault
CDS exist since 90s
After 2010 the fearof default increasedand CDS premiumswidened
Could Europe remain still?
A large share of public debt is held across borders
with European banks.
Direct exposure was veryhigh for Germany and
France, particularly
This produced a strong conflict of interest among
European nations
Hard to find a solution.
Decision making system in the Euro zone: financial
assistance requiresunanimity
European banks’ exposure in weak countries
Institutional innovation:the European FinancialStability Facility (ESFS)
2010: bailout packages for Greece (150bn), Ireland (41bn), Portugal(50bn). EFSF loans at low interest rates conditional on theimplementation of austerity measures.
After countries successfully implement fiscal programmes, then (toincrase growth prospects) EIB helps in absorbing public bonds.
However, all these measures failed to convince financial markets;scepticism on their effectiveness. Problems with peripheral countries
EFSF was created to defend financialstability and prevent contagion.
Provides financial assistance (loans) to countries in difficulty.
It is authorised to borrow up to E450bn, issuing EU bonds.
Who paid for emergency funds? Germany, France, Italy account for almost 75%
…have they really succeded in convincing financial markets? NO
No. Apart from Greece “primary surplus” increased on average by only 0.5% GDP
Main reason: confidence crisis in the debt repayment capacities. Interest rates spreads skyrocketed from 0 to 550bps – 1500bps. Confidence crisis depended on:
Greek crisis contagion
Low competitiveness and divergent indicators
High level of indebtedness and fears of debtrestructuring
Lack of efficient EU bailout mechanisms and institutions
Approval of fiscal austerity programmes (Monti gov.) re-established confidence that was then enhanced by Draghi’sturn in monetary policy
A debt vortex in the Eurozone
Widespread fears triggered a rush to unload debt
Sales of the weak nation’s debt, drive borrowing costsup to the point where the nation actually goes broke
How do you break the vortex?
Debt buyer-of-last-resort buys unlimited amounts of debt with no constraints due to market discipline
Fears+suspicion dissolve and investors hold the debt
Draghi’s speech, July 2012, after long delays
ECB would do «whatever it takes» to keep the Eurozone together Quantitative easing: purchases of bonds to stimulate the economy and increase liquidity.
Change of market expectations: borrowing costsreturned to pre-crisis level
Ireland:
The Celtic Tiger: 1997-2007 economy expanded. Rise in property valuations; drastic fall in corporate tax rates
Collapse in property prices; bankscame under pressure (heavywholesale borrowing)
2009 nationalization of the banking sector
Problems that stemmed from anexcessive build up of bank lending(vs public debt in Greece) thatturned into a fiscal problem
Spain
Very dynamic economy until 2005
2007 housing prices fell and the levels of personal debt rose
On the public finance front, the revenues collapsed, deficit soaredbut the public debt in 2010 is low by eurozone standards.
High foreign exposure to itsprivate debt.
Portugal Its fiscal deficit and public
debt deteriorated from -3.1% (2007) to -10% (2009).
It didn’t witness a boom-bustsituation. Howewer, a largeexternal CA deficit and external debt fuelled by private sector borrowing.
Low productivity because ofother social indicators: lowest% of educated population in Europe, unemployment.
Chronic low rate of growth
Italy Long term decline and 0 growth
with low productivity and bad-quality institutions (bureaucracy, justice, corruption);
fiscal deficit is low but public debtis extremely high with ratherlimited domestic holdings.
Unemployment rate lower thanthe EU average but increasingSouth- North dualism
The EU accounts for 26% of the world GDP, the EuroZone 20%
Implications for the advanced countries: Germany and France whoface large exposures; also the British banks and close trading linksbetween Europe and the US
For the EMEs (Ch, India, Brasil etc.), a downturn in the eurozone willdent their export growth and the globalised banking system couldthreat their financial stability.
Austerity Fiscal Union Euro-exit
•Fiscal discipline and consolidation, includingprivatization (default policy choice)
•Social costs, prospectsof low or stagnatinggrowth;
•it will not address the structural problems ofthe peripheral economiesbut it would be a short term palliative
•Enlarged Europeanbudget and transfersfrom rich to poor EZ countries
•Common measures of protection for employment
•Stimulate greater cross border investments
•Establish a multi speedEurope rather than hopefor complete convergence
• Breakdown of the currency that could leadto insolvency of severalEZ countries
• Contagion effects and instability: inflation and interest rates wouldincrease dramatically
•The new currencies willbe sharply devalued in terms of Euro•Protectionism and nationalism increase
• The end of the European dream
1. Ahead, thisway
2. Just the single market
3. Variablespeed
4.Do less, more efficiently
5. Do more, altogether
Foster furtherintegration in all real sectors
Deepening in some sectors
Who wantsmore, doesmore
Increase some integration:trade, euro, defence, borders
Federal union, one voice, cohesiveness
Small steps, ordinaryadministration
Back to nationalpolicies in others(foreign policy, migration
Differentiatedintegration
Decrease in others (state aids, social and welfare policies)
Redistributionpolicies
Search for consensus, case by case
Unbalancedintegration.Toward a «British» EU
Countries thatdo not agree→«ahead thisway»
Fascinating,thoughanother stepbackward
Greatestsurrender of sovereignty
Inadequate More conflictsand inequalities
Reasonable, realistic butmust prepare#5.
More conflictsand inequalities
Best option, though ratherunrealistic