1005Black Euro Crisis com

8/6/2019 1005Black Euro Crisis com

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The Eurozone Financial

CrisisStanley W. Black

Lurcy Professor of Economics,

EmeritusUniversity of North Carolina at

Chapel HillMay 7, 2010


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The Eurozone FinancialCrisis

Transmission from the United States

Housing Price Bubble and Collapse

Financial Market Freeze and Collapse

Policy Response Support for Financial Sector

Monetary Policy

Fiscal Policy Effect of the Euro Currency Zone

Greeces Problems


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Transmission from UnitedStates

US Housing Bubble created by

Low interest rates

Lax regulation of sub-prime mortgages withadjustable rates, two year teaser rates

Securitization of mortgages, sold to unwarybuyers as highly rated

US Bubble popped when

Interest rates rose in 2006, housing prices fell

Subprime mortgages and securities defaulted


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http://mjperry.blogspot.com/2009/04/house-price-indexes-usa-vs-europe.html


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European Crisis Began Later

US Housing Prices peaked in late 2006

European Housing Prices peaked a year later

Financial Crisis struck Europe & US at same time,August 2007, after Bear, Stearns, Fannie Mae &

Freddie Mac taken over with US Governmentassistance in April and July of 2007

International credit markets froze up in August2007 when subprime based hedge funds collapsedin Europe and US. No longer able to borrow short-term funds, banks faced much higher risk premia


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Interest Rate Spreads in Dollars and

Euros


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Why did the Crisis Spread?

Subprime Debt Obligations made in USA held around theworld caused global financial shock.

Housing bubbles burst in UK , Ireland, Spain as well as US.

Failure of Lehman Bros in September 2007 caused massivepanic over counterparty risk. AIG required $180 billion bailoutto cover Credit Default Swaps, insurance against bonddefaults underwritten without reserves.

Stress on banks around the world led to shrinking creditavailability. Shadow off-balance-sheet banking sectorcollapsed as short-term funding vanished.

Falling demand spread from US to all countries; as US importsdropped, other countries exports fell.


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Banks Under Duress: Writedowns andCapital Raised(US$ billions)

Source: International Monetary Fund (2008)


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Quarterly Real GDP Growth Rates

Source: International Financial Statistics, IMF.


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European Financial Institutionsunder Stress

BNP-Paribas forced to close funds in August 2007

UK bank Northern Rock taken over by government

German state banks IKB, WestLB, BayernLB andSachsenLB bailed out by government

Irish banks given government deposit guarantees

Switzerland injects funds into UBS

Icelands banks unable to roll over short term borrowing,default on deposits of foreigners


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Credit in the Eurozone (% change)

Source: European Commission (2009).


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Monetary Policy Response byEuropean Central Bank (ECB)

ECB injected liquidity into European banks unable toobtain short-term funds in market.

Federal Reserve used Euro-dollar swaps to makedollars available to ECB to lend to banks.

ECB did not lower interest rates until October 2008because of its focus on inflation.

Euro fell against the dollar due to safe haven flightto US Treasury securities.


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Interest Rates in the Eurozone andthe US (interbank rates)

Sources: ECB, Federal Reserve Bank of New York


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Financial Sector Bailouts in US &Europe

TARP and Federal Reserve programs inUS

National programs in Europeancountries, due to absence of Eurozone-wide regulator.

Beggar-thy-neighbor effect, as first

Ireland gave deposit guarantees, thenUK, then Netherlands, to avoid bankdeposit flight.


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u c uppor o e nanc aSector

(as of 18 February 2009, % of

GDP)

Source: International Monetary Fund (2009).


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Fiscal Policy Responses toRecession

Automatic Stabilizers of falling taxes, rising welfareand unemployment payments kick in as incomesfall and unemployment rises.

Discretionary Fiscal Stimulus enacted in most

countries, depending on their fiscal positions.

European countries limited by Stability and GrowthPact to 3% fiscal deficits, except in time ofexceptional economic distress.


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Changes in Budget Balances,October 2008

Source: IMF (2009)


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Exchange Rates vs the Dmark or euro(Left Index: 1970q1 = 100 Right

Index: 2007m1 = 100)

rce: International Financial Statistics, IMF, Monthly Bulletin, European Central B


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Greeces Financial Problems

Since joining the euro, Greece has had higherinflation than other Eurozone members.

Greece has also increased debt faster than others tofinance generous public sector pay, welfare, and

retirement benefits, while collecting a lower share intaxes due to widespread tax evasion.

As a result, Greek goods have become increasinglyexpensive and uncompetitive, causing loss of

market share and further reducing revenues.


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Relative price indicators based onexport prices

Source: European Commission (2010)


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The Greek Debt Crisis

Greek debt/GDP ratio reached 113% anddeficit/GDP ratio reached 12.7% in 2009.

Foreign bondholders became doubtful thatGreece could continue to roll over its increasing

debt, forced interest rates higher. EU faced choice between Greek default and

bailout with tough conditions.

IMF and EU agreed to lend Greece up to $146billion over three years.

Greece to increase sales taxes, reduce publicsector salaries, pensions, eliminate bonuses.


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Greeces Debt Dynamics

Source: Economist.com


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Conclusions

Cautious Eurozone response to Financial Crisis Interest rate policy reaction delayed: concentration

on inflation target Fiscal policy reaction muted: Stability & Growth Pact

Common currency members avoided largedevaluations and foreign currency debt. European governments have tried to act

together, not always successfully. Limited impact of falling exports due to

extensive internal trade relationships. Greece facing difficult adjustment problems,

European banks avoiding losses on Greek bonds.

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