1005Black Euro Crisis

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The Eurozone Financial Crisis

Stanley W. Black

Lurcy Professor of Economics, Emeritus

University of North Carolina at Chapel HillMay 7, 2010


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The Eurozone Financial Crisis

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 United States

US Housing Bubble created by

Low interest rates

Lax regulation of sub-prime mortgages with

adjustable rates, two year teaser rates Securitization of mortgages, sold to unwary

buyers 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 August 2007

when subprime based hedge funds collapsed inEurope and US. No longer able to borrow short-termfunds, 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 massive

panic over counterparty risk. AIG required $180 billionbailout to cover Credit Default Swaps, insurance againstbond defaults underwritten without reserves.

Stress on banks around the world led to shrinking creditavailability. Shadow off-balance-sheet banking sector

collapsed as short-term funding vanished. Falling demand spread from US to all countries; as US

imports dropped, other countries exports fell.


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Banks Under Duress: Writedowns and Capital 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 Institutions under

Stress

BNP-Paribas forced to close funds in August 2007

UK bank Northern Rock taken over by government

German state banks IKB, WestLB, BayernLB and

SachsenLB bailed out by government

Irish banks given government deposit guarantees

Switzerland injects funds into UBS

Icelands banks unable to roll over short termborrowing, 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 by

European Central Bank (ECB)

ECB injected liquidity into European banks

unable to obtain short-term funds in market.

Federal Reserve used Euro-dollar swaps to

make dollars available to ECB to lend to banks.

ECB did not lower interest rates until October

2008 because of its focus on inflation.

Euro fell against the dollar due to safe haven

flight to US Treasury securities.


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Interest Rates in the Eurozone and the 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 in US

National programs in European countries, due

to absence of Eurozone-wide regulator.

Beggar-thy-neighbor effect, as first Ireland

gave deposit guarantees, then UK, then

Netherlands, to avoid bank deposit flight.


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Public Support to the Financial Sector

(as of 18 February 2009, % of GDP)

Source: International Monetary Fund (2009).


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Fiscal Policy Responses to Recession

Automatic Stabilizers of falling taxes, rising

welfare and unemployment payments kick in

as incomes fall and unemployment rises.

Discretionary Fiscal Stimulus enacted in most

countries, depending on their fiscal positions.

European countries limited by Stability and

Growth Pact to 3% fiscal deficits, except in

time of exceptional economic distress.


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Changes in Budget Balances, October 2008

Source: IMF (2009)


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The Role of the Euro

Previous economic crises in Europe have led

to large devaluations of currencies.

Within eurozone, single currency prevents

devaluation , provides automatic financial

support through capital markets.

Non-euro currencies depreciated sharply in

2008, British pound sterling, Swedish kronor,

Polish zloty, Hungarian forint.


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Exchange Rates vs the Dmark or euro

(Left Index: 1970q1 = 100 Right Index: 2007m1 = 100)

Source: International Financial Statistics, IMF, Monthly Bulletin, European Central Bank


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Greeces Financial Problems

Since joining the euro, Greece has had higher

inflation than other Eurozone members.

Greece has also increased debt faster than others

to finance generous public sector pay, welfare, andretirement benefits, while collecting a lower share

in taxes 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 on export prices

80

85

90

95

100

105

110

115

120

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Germany

Greece

Spain

France

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 that Greececould continue to roll over its increasing debt,forced interest rates higher.

EU faced choice between Greek default and bailoutwith tough conditions.

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

Greece to increase sales taxes, reduce public sectorsalaries, 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, notalways successfully.

Limited impact of falling exports due to extensiveinternal trade relationships.

Greece facing difficult adjustment problems, Europeanbanks avoiding losses on Greek bonds.

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1005Black Euro Crisis