Agenda Intro and recap The costs of the crisis The real costs of the crisis Conclusions

School of Business and Economics

Studium Generale

The costs of the crisis

prof. Dr. Tom van VeenMaastricht University/Nyenrode Business Universiteit

Maastricht, 10 November 2011


Agenda

1. Intro and recap

2. The costs of the crisis

3. The real costs of the crisis

4. Conclusions


1. Intro and recap

Lecture 1: Joan Muysken

1. Causes of the crisis: global imbalances

2. Rescue packages and solutions


Lecture 2: Bertrand Candelon

1. What is a crisis? Typologies

2. Contagion

3. Policy responses


Lecture 3: Bart Verspagen

1.Theory behind the global imbalances: UIP and the Impossibility Trinity

2.Emerging Asian economies and Chimerica


Lecture 4: Olaf Sleijpen

1. The €-crisis and the role of fiscal discipline

2. The discussions about the solutions


So by now it is clear that the economic crisis started with global imbalances and excessive lending in the US

And spilled over to other countries, in particular Europe because of the intimate connections between the banks

Distrust in the behavior of banks and governments/politicians and malfunctioning of the governance in the EMU has extended the crisis and this evolved in the current crisis in Europe


2. The costs of the crisis

Simple question: what have been the costs of the crisis?

Not so easy to answer.


What do we mean by costs? And for whom are these “costs”?

Cost is an amount of money that has to be paid to obtain something. This definition does not seem appropriate here.

More appropriate seems: the value of all the “losses” that have occurred in the economy.


Direct costs

Indirect costs

Invisible costs

Lost opportunities

Not all costs have materialized yet because these depend on the length of the crisis, the development of the value of real and financial assets


1. Change in Wealth

Change in asset prices

• Houses• Financial assets


House prices: decrease by 2.5-3% on a yearly basis after the crisis

In 2010: value of the houses in the Netherlands € 1170 billion. The decrease in prices is a “loss” of € 30-35 billion per year, which comes down to 5 – 5.5% of GDP.

Average house price is about €250.000. The loss in value comes down to €7.500 per year


Financial assets (stocks and bonds)

Stocks: over 2007-2010 the decrease in the value of the stocks in the hands of households was about €29 billion (€258 billion to €239 billion). This is on average €12.000 per household that held stocks (CBS, STAT-line).


For bonds we see a similar picture

Value has decreased by €5.5 billion (from €33.5 billion to €28 billion).

The number of households holding stocks and bonds have decreased

Are this costs of the crisis?


No because house prices have increased dramatically over the past years; bubble?

No because aging would have led to a decrease in house prices

No because the Dutch housing market has become under pressure

No, because if you do not move/do not sell the assets, what is the point?


Yes, because investments of pension funds decrease in value and this might have an impact on premiums or retirement income.

Yes because the crisis has caused a lack of confidence in the economic future and hence a lack of demand for houses and financial assets

School of Business and Economics 17

2. Changes in the interest rates


Volatility in prices creates uncertainty

Low interest rates benefit borrowers if……

•there are no credit constraints•there are enough profitable investment opportunities


In addition low interest rates benefit investors, because

•there is an inverse relation between asset prices and the interest rate

•low interest rates increases the demand for real assets and for stocks


Bond, face value €1.000 r = 5% (€50/year).

What happens if the interest rate on new bonds decreases to 4%?

Holders of old bonds receive a rate of return of 5%, holders of new bonds receive a rate of return of 4%.

Price of old bonds will increase to €1250 (€50/€1.250 = 4%)


But, low interest rates also increases the value of future commitments

If you need to pay €100 in one year and the interest rate is 11%, then now set aside €90,90 and in 1 year you will have €100. We call €90,90 the present value of €100 to be paid in one year

But, if the interest rate decreases to 5%, yet need to now set aside €95,24 to have €100 in one year


Hence, a decrease in the interest rate is bad for companies that have future commitments, like pension funds because it increases the present value of their future liabilities

Market value of the investments (>105%)Present value of future liabilities

A change in the interest rate influences their coverage ratio


What is the influence of a decrease in the interest rate on the coverage ratio?

In normal times, the market value of the investments increases and the present value of future liabilities increases.

In general, the coverage ratio decreases


In this crisis we have noticed

1.Decrease in the prices of the assets2.Decrease in the interest rates

“Double” attack on the coverage ratio of the pension funds

Market value of the investments Present value of future liabilities


Evidence is given by the Bonenkamp and Ter Rele, CPB Memorandum 1/2009/01, Centraal Plan Bureau

1.A decrease in the interest rate by 1% causes a decrease in the coverage ratio by 14%-points (excluding the effects of the decrease in the interest rate on the price of assets)

2.Between December 2007 and February 2009, the average coverage ratio has decreased by 45%-points (from 140% to 95%). 40% is due to the change in the interest rates, 60% is due to the change in the asset prices.


Coverage ratio

Interest rate


The consequences are clearA large number of pension funds have a coverage ratio < 105% and have to act

1.Increase in premiums and/or decrease in pension benefits

2.But as important, the confidence in the once so solid pension funds decreases


Thus low interest rates

1.Cause uncertainty

2.Have enforced the pension funds to act to the disadvantage of the participants

3.Have not triggered an increase in credits for investments



3. Direct bailouts by the governments

Governments have supported the financial sector. Note that 90% of the support is via guarantees and loans. Hence the costs of this support are not clear yet.


Public Interventions in the Banking Sector, in Percent of GDP

Capital injections

Guarantees on bank liabilities

Relief of impaired assetsLiquidity and bank

funding supportTotal

Approved Effective Approved Effective Approved Effective Approved Effective Approved Effective

Austria 5,0 1,7 27,3 5,1 0,4 0,4 27,3 1,5 60,0 8,7

Belgium 4,2 5,7 70,8 16,3 5,7 5,0 74,6 35,3

Denmark 6,1 0,3 253,0 243,8 0,5

Finland 27,7 27,7

France 1,2 0,8 16,6 3,1 2,3 0,3 20,1 4,2

Germany 4,2 1,6 18,6 7,3 3,6 0,4 26,4 6,3

Greece 2,0 6,1 0,4 3,3 1,7 11,4 2,1

Hungary 1,1 0,1 5,9 7,0 0,1

Ireland 5,1 2,1 225,2 225,2 230,3 227,3

Italy 1,3 1,3

Latvia 1,4 10,9 2,8 10,9 6,1 23,2 8,9

Luxembourg 6,9 7,9 12,4 19,3 18,5

Malta

Netherlands 7,9 7,9 34,3 5,7 4,9 5,8 42,2 24,3

Poland

Portugal 2,4 12,5 3,0 14,9 3,0

Slovenia 32,8 32,8

Spain 9,3 2,8 2,8 1,8 12,1 4,6

Sweden 1,6 0,2 48,5 8,8 0,1 50,2 9,0

United Kingdom 3,5 2,6 21,7 9,5 25,1 18,7 50,3 30,8

Empty cells: Data not available.

Source: European Commission (2009), Economic Crises in Europe: Causes, Consequences and Responses, European Economy 7/2009, accessed at http://ec.europa.eu/economy_finance/publications/publication15887_en.pdf on 12 April 2010.


Public interventions in the banking sectorTotal (% of GDP)

Direct Support Recovery Net Support

Ireland 40.6 2.6 38

Belgium 5.7 0.3 5.4

UK 6.7 1.1 5.7

NL 14.0 8.8 5.1

Germany 13.2 0.8 12.4

Spain 3.0 0.9 2.1

USA 5.0 3.0 3.1

Average 6.8 1.8 4.9

US$ Billion 1,722 452 1,270

32


HW Sinn (2010), Casino Capitalism, OUP, reveals that

1.Total approved package is €5 trillion(€5.000.000.000.000)

2. The big rescuers are US, UK and Germany (in total about 50% of the package). The Netherlands joined with 5% (€250.000.000.000, about 42% of GDP)


1$ 10.000$ 100x10.000 = 1.000.000$

100x1.000.000 = 100.000.000$

10x100.000.000 = 1.000.000.000$


1.000x1.000.000.000 = 1.000.000.000.000$ is 1 trillion$

1.000.000.000$


But, not all money has been “waisted” . Evidence for the Netherlands reveals

Support to SNS, ING and Aegon via loans, €14 billion, against 8% and a premium of 50% on redemption. And the government guaranteed the pay back of US mortgages (€21 billion).

ING has redeemed 70% and will redeem 30% in 2012SNS Reaal has redeemed a large part. Aegon has redeemed all support. The rate of return on this was 18.5 %


ABN AMRO was nationalized by the Dutch government: bought for €16.8 billion. Together with additional capital injections, we invested €30 billion in the bank.

The market value is estimated at €20 billion in 2014 (when the bank might be sold).

This results in a loss of €10 billion (€600 per Dutch citizen)

Thus the loss because of the loans and so on have not been large. The loss of the guarantees still needs to be assessed however.


To summarize:

For the Netherlands (GDP = €600 billion)1.Change in asset prices: decrease in value of about €100 billion (2007-2010)2.Change in the interest rates: average coverage ratio decreased from 140% to 95%. Consequences need to be assessed. 3.Costs of bailouts and guarantees: bailouts €10 billion. Substantial amount of guarantees still pending


We have discussed monetary costs.

But there is more.

The real costs of this crisis are invisible


3. The real costs of the crisis

Decrease and lack of trust and confidence in the economy and in the financial system

Confidence in the future is measured by interviewing a sample of consumers/producers about their consumption and production plans in the next future and about their assessment of the economic and financial situation


Source: CBS, de index van het consumentenvertrouwen in the series: Hoe doet het CBS dit nou?


Consumers confidence: the Netherlands


Consumers confidence index OECD


Source: Ifo Business Survey, October 2011, CESifo Institute, Munich


Lack of trust in general


Delay in economic growth

In the end, uncertainty, lack of confidence, lack of trust materializes in a slowdown of economic growth


Source: The EEAG report on the European Economy 2012, CESifo Munich




-4,0

-3,0

-2,0

-1,0

0,0

1,0

2,0

3,0

4,0

5,0

6,0

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43

Annual growth of GDP, The Netherlands, 1970-2012

Source: MEV 2012, Main Economic Indicators for the Netherlands, CPB.

1975 2002

2007

2009


Back of the envelope calculation for the Netherlands

Average real economic growth over the period 1970-2007: 2.5%

Average real economic growth over the period 2008-2010: 0.5%

Hence, growth over the period 2008-2010 was 6% below the average or

€36 billion in total. These are lost opportunities.


Is a slowdown of economic growth bad?

• Pollution decreases?

• Income per capita decreases

• Tax income decreases and less spending on public goods

• Unemployment increases


0,0

1,0

2,0

3,0

4,0

5,0

6,0

7,0

8,0

9,0

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43

-4,0

-3,0

-2,0

-1,0

0,0

1,0

2,0

3,0

4,0

5,0

6,0

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43

unemployment

% change in real GDP

Source: MEV 2012, Main Economic Indicators for the Netherlands, CPB.




Summary: the costs of the crisis

1.Direct costs including wealth decreases: €110 billion (20% of GDP)

2.Indirect costs: increase in premiums/decrease in pension entitlements (no price indexation would imply about 2% decrease in real income for pensioners, this is about €400 per pensioner. In total max. €1 billion in 2011)


3. Invisible costs and lost opportunities: at least €36 billion (value of below average growth)

Documents

Agenda Intro and recap The costs of the crisis The real costs of the crisis Conclusions