From the US subprime mortgage crisis to European sovereign debt 1

Financial struggles in the EU and EA 2

© 2016 George K. Zestos  Portugal was the third country to receive a bailout from the EU and the IMF.  Portugal received a total of €78 billion. The total amount was provided equally by the EFSF, the ESM, and the IMF, each paying €26 billion.  The bailout was announced by Prime Minister José Sócrates on June 4,

© 2016 George K. Zestos  Figure 8.9 below shows the real GDP growth rate of Portugal for the period  Portugal grew at a rate of 3.52% during the first subperiod of  Portugal grew at a very low rate of 0.03% during the second sub-period of ; these were the years after the euro was introduced in  According to Professor Ricardo Reis of Columbia University, this rate of real GDP growth was lower than that of the US during the Great Depression, and lower than Japan’s rate during the lost decade of

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 Figure 8.10 below shows the public debt-to-GDP ratio on the left-hand axis, and the public deficit-to-GDP ratio on the right-hand axis.  Portugal maintained a relatively low public debt- to-GDP ratio between 1990 and 2008, staying below the 60% Maastricht criterion.  After 2008, the Portuguese public debt-to-GDP ratio began increasing until it reached its maximum of % in

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 Many reasons were offered to explain why the Portuguese economy stagnated for such a long period starting in  Rigid markets and fierce competition from abroad are possible factors. Professor Reis, however, claims that after the introduction of the euro Portugal wasted capital on inefficient investments in the non-tradable sector. 8

© 2016 George K. Zestos  Portugal’s €78 billion bailout was accompanied by the usual IMF conditionality: austerity programs, privatization, and fiscal consolidation.  Such programs, instead of quickly helping Portugal to exit the recession, worsened economic conditions. Unemployment reached 18%, causing much distress.  As the economy deteriorated, CRAs became active in downgrading Portuguese government bonds. 9

© 2016 George K. Zestos  Figure 8.11 below shows the credit ratings of Portugal.  Downgrades began in the spring of 2010 when confidence in the EMU began to decline.  All three CRAs drove Portugal’s government bonds to junk status.  The downgrades continued after Portugal received its €78 billion bailout. 10

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© 2016 George K. Zestos  Several economic analysts were very critical of the EU and the IMF. Professor Ricardo Cabral, an economist at the University of Madeira (Portugal), characterized the EU/IMF plan for recovery as one “with no adherence to reality.”  The program required Portugal to outperform Germany in the foreign trade account.  Professor Cabral found this difficult at a time when several of Portugal’s trading partners were advised to generate trade surpluses as well. 12

© 2016 George K. Zestos  Many Portuguese journalists and economists were convinced that the EMU was launched as an incomplete structure.  Professor Ricardo Cabral was very critical of the architects of the EMU and of the EU leaders for adopting policies that deepened the recession.  Cabral claimed that the poverty which struck the EA bailout countries was not a random event, but rather the predictable result of incorrect policies. 13

© 2016 George K. Zestos  The prolonging of the crisis had the most destructive effects on the periphery EMU countries. In each of these countries the groups affected the most were the poor and the unemployed. This was the result of policies imposed by the Troika.  The sacrifices seem in some way to have had positive effects on the Portuguese economy.  In 2013, Portugal generated its first trade surplus in goods and services since

© 2016 George K. Zestos  On May 14, 2014 Portugal exited clean from the bailout program and generated positive economic growth.  As a result, the Portuguese 10-year government bond yield (interest rate) decreased substantially.  The turnaround of the Portuguese economy was achieved at a great sacrifice by the Portuguese people. 15

© 2016 George K. Zestos  The Portuguese voters nevertheless punished the center-right coalition government headed by Prime Minister Pedro Passos Coelho, which had imposed the painful austerity measures.  The new anti-austerity coalition government is headed by Prime Minister Antonio Costa, who is supported by the left-of-center parties in Parliament.  For the first time ever such parties cooperated in order to form a historic coalition that overthrew those parties that imposed painful austerity. 16

© 2016 George K. Zestos  Spain was the third country to receive a bailout.  The Eurocrisis caused detrimental effects on the Spanish economy, and especially on the weaker groups in the society.  After denying for some time that a bailout was needed, Spanish Prime Minister Mario Rajoy eventually agreed to request one.  Initially the Spanish government requested €100 billion, to be used exclusively for its failing banking sector. 17

© 2016 George K. Zestos  Figure 8.12 shows the economic performance of the Spanish economy for the period in terms of real economic growth rate.  It is clear from Figure 8.12 that Spain maintained a relatively high rate of growth, of about 3%, for almost three decades until  Such a prolonged rate of growth transformed Spain from a developing to a developed economy.  The last sub-period covers the Eurocrisis, during which Spain’s economy stagnated. 18

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© 2016 George K. Zestos  Similar to Ireland, Spain’s problems can be traced to a booming real estate and construction sector.  Excessive demand in the real estate sector required substantial financial capital beyond what the domestic banks could have provided.  To accommodate the excessive demand in the housing industry, domestic banks borrowed heavily from abroad. 20

© 2016 George K. Zestos  In 2012 credit conditions deteriorated in the periphery EA countries.  In Spain, interest rates increased 4.2% above German rates. This took place after S&P downgraded Spain’s 10-year government bonds by two notches in October  Additionally, in 2012 Spanish unemployment increased to reach 25%, from only 8% in

© 2016 George K. Zestos  Heavily indebted Spanish banks were initially bailed out by the Spanish government, which spent €34 billion for this purpose.  These banks, which mainly specialized in real estate, are known as cajas.  At the outset of the crisis the Spanish government nationalized the fourth largest bank, Bankia, which was created in 2010 when several smaller cajas merged. These smaller cajas merged since they were too vulnerable to survive through the crisis. 22

© 2016 George K. Zestos  On December 11, 2012 the Spanish government requested only €41 billion of the €100 billion bailout approved by the EU/IMF.  All the money received was used to capitalize the banks that had been nationalized by the Spanish government.  Catalunya Caixa bank, Banco De Valencia, and Novo Banco were three of the nationalized banks which received bailout funding.  The Rajoy government then implemented several austerity measures in July 2012, when a €65 billion austerity package was also introduced. 23

© 2016 George K. Zestos  The public deficit and public debt-to-GDP ratios of Spain are shown in Figure 8.13, on the right-hand and left-hand axis respectively.  Figure 8.13 clearly indicates that the crisis in Spain was not a sovereign debt crisis.  The public debt-to-GDP ratio in Spain was kept at very low levels for many years.  Just prior to the crisis, in 2007, the public debt-to- GDP ratio was 36.3%. 24

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© 2016 George K. Zestos  The public deficit-to-GDP ratio decreased drastically from  Spain generated a government surplus of 2.4% in  From the outset of the crisis, however, both the public deficit-to-GDP and the public debt-to-GDP ratios began increasing exponentially.  The public deficit reached a maximum of 11.1% in 2009, and declined slightly to 10.6% in

© 2016 George K. Zestos  The public deficit then started to fall rapidly after the launch of the fiscal consolidation program to reach 5.7% in  The public debt-to-GDP ratio continued to increase after 2006, to reach 98.6% in  Spain also generated positive economic growth in

© 2016 George K. Zestos  The financial crisis in Spain was signaled by the rising interest rates, the increase in the price of CDSs to insure public debt, and the big drop of the blue chip stock market index.  CRAs became active in downgrading the Spanish public debt between 2011 and  Nevertheless, CRAs stopped short of driving Spain’s government bonds down to speculative/junk status. 28

© 2016 George K. Zestos  It is likely that CRAs did not reduce Spain’s government ratings to junk because they feared this would trigger contagion of the crisis throughout Europe.  Two other factors that contributed to keeping the Spanish bonds above speculative junk level were the announcement by the ECB President Mario Draghi to do “everything it takes to save the euro,” and the decision of Spain’s government to accept a bailout.  In January 2014, Spain exited the bailout “clean,” i.e., without a credit line from the IMF or the EU.  Figure 8.14 below shows the credit ratings for Spain 29

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© 2016 George K. Zestos  To understand how liquidity dried up in Spain, particularly in , it is helpful to consider the level of the claims of the German and French banks on Spanish banks during the first quarter of  These bank claims amounted to €315 billion and €209 billion for the German and French banks respectively.  In the fourth quarter of 2012 the above amounts were reduced to €120 billion and €100 billion respectively as the French and German banks pulled out their funds. In this way, the Irish banking crisis story was repeated in Spain. 31

© 2016 George K. Zestos  It is obvious that large foreign capital flows and outflows within and outside the EA countries were a source of financial instability.  The crisis brought poverty and misery to Spain, which was reflected by the development of a new political environment created as a reaction to the crisis. 32

© 2016 George K. Zestos  Spain is no longer a country of two political parties that alternate in government and opposition.  A third party, Podemos (“We can”), has arrived on the Spanish political scene.  Previously, two parties had dominated Spain since shortly after the death of the dictator Francisco Franco in  Podemos was created from the dissolution of the Indignados (‘the Outraged’), a movement created on May 15, 2011 to protest against austerity. 33

© 2016 George K. Zestos  In December 2015 during the national elections of Spain, Podemos ranked third, gaining 69 of the 350 seats in the Spanish parliament.  Another anti-austerity and anti-corruption center party is Ciudadanos, which gained 40 of the 350 seats in the Spanish parliament.  Voters expressed their anger at pro-austerity programs, even if such programs proved to be slowly working. 34

© 2016 George K. Zestos  As of January 2016 the new Spanish elections did not produce a winning party in the government.  The previous party in government (PP) of Mariano Rajoy won the most votes, but was unable to form a coalition government.  Spain’s King Felipe asked the leader of the Socialist party to form a government, which if formed will most likely be anti-austerity. 35

© 2016 George K. Zestos  On October 12, 2011, the IMF and the EU country leaders decided to resolve the Greek public debt problem with a bailout, together with a negotiated haircut on private holders of Greek public debt.  This became known as the Private Sector Involvement program (PSI). The Greek PSI placed Cyprus in great financial trouble.  This was because the two major Cypriot banks, Laiki and the Bank of Cyprus, had invested in Greek government bonds. 36

© 2016 George K. Zestos  The two Cypriot banks had purchased approximately €4.5-5 billion of Greek government bonds. This amount was very large for the small island country.  As a consequence of the Cypriot financial crisis, the vicious cycle from failing banks to failing governments was resurrected.  Cyprus’ economy at the outset of the sovereign debt crisis was in very good shape. Its government had promoted the country as an offshore business service center. 37

© 2016 George K. Zestos  In 2003, to strengthen its economic position as an offshore business center, Cyprus enacted a very low corporate tax rate of 10%.  In 2008, Cyprus signed a double taxation treaty with Russia; the treaty allowed businesses of the two countries to pay taxes in either country.  As a result, Russian businesses were able to pay the lower Cypriot capital gains and dividend taxes of 10%, instead of paying taxes in Russia that were twice as high.  Furthermore Cyprus allowed foreign firms to register as Cypriot firms, and thus gain access to the EU. This became a source of future problems for Cyprus. 38

© 2016 George K. Zestos  Russia’s incoming and outgoing Foreign Direct Investment (FDI) that passed through Cyprus in 2011 amounted to $129 and $122 billion respectively.  These statistics were each several times larger than the GDP of Cyprus, which amounted to $18 billion in

© 2016 George K. Zestos  Cyprus had accumulated too large a banking sector in relation to the size of its economy.  Prior to joining the EU there was a suspicion that money laundering and corruption were taking place in Cyprus, most of which was related to the activities of Russian oligarchs. 40

© 2016 George K. Zestos  Thus in preparation to join the EU, the Cypriot government cleaned up its records to comply with EU law.  At a time when it needed support, the presence of foreign firms proved to be detrimental to Cyprus.  EA country leaders demonstrated a lack of solidarity with Cyprus by showing apathy. 41

© 2016 George K. Zestos  Figure 8.15 shows the real GDP growth rate of Cyprus for the period  From 1980 to 2007, Cyprus’ average annual real rate of growth was very high, close to 5%.  During the last sub-period of the Cyprus economy stagnated, achieving an annual growth rate of 1.08%. 42

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© 2016 George K. Zestos  The public deficit-to-GDP and debt-to-GDP ratios are shown in Figure 8.16 below, on the right-hand and left-hand axis respectively.  According to Figure 8.16, the public debt-to-GDP ratio was kept close to the 60% of the Maastricht reference value, but not always below it. In 2008, public debt-to-GDP ratio was only about 50% of its GDP. 44

© 2016 George K. Zestos  From 2008 the public debt-to-GDP ratio began increasing to reach above 117% of GDP in The drastic increase of the public debt-to-GDP ratio was mainly the result of the government taking over the private debts of the two major banks.  The same phenomenon was observed in Ireland and Spain, i.e., the transfer of private debt to public debt.  Cyprus was able to maintain its public deficit-to- GDP ratio below 6.4% during the crisis. 45

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© 2016 George K. Zestos  Figure 8.17 below shows the credit ratings of Cyprus.  Credit downgrades for Cyprus began in May 2011, after news of the Greek haircut on its creditors spread. Cypriot banks had purchased about €4.5-5 billion of Greek bonds, and so the Cypriot banks were in financial trouble.  All three CRAs downgraded Cyprus’ government bonds to junk/speculative status. 47

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© 2016 George K. Zestos  As soon as rumors of the Greek PSI spread, Cyprus’ public debt began to be rapidly downgraded.  A bailout from the EU of only € 10 billion came with very strict conditions.  For Cyprus to receive the bailout it had to dismantle one of its two largest banks (Laiki), and impose up to a 40% haircut on all bank deposits over € 100,

© 2016 George K. Zestos  Chancellor Merkel, with this bailout program, was aiming to punish the Russian oligarchs. No matter how insistently the Cypriot government asked for a better deal, it was to no avail.  Political analysts pointed out that Chancellor Merkel needed to demonstrate to German voters and opposition parties that she could stand firm against the Russian oligarchs.  At the same time, the lesson to Cyprus was that its economic model had to change, because the Cypriot banking sector was too big for its economy. 50

© 2016 George K. Zestos  Figures 8.18 and 8.19 show two of the most important indicators of countries’ economic performance during the Eurocrisis.  Figure 8.18 portrays the real GDP growth rate of the five bailout recipient countries. It is evident from this Figure that all five economies stagnated, starting in  After a prolonged recession of about seven years, four of the five EA countries returned to growth in Cyprus, the last country to receive a bailout, has not yet returned to growth. Cyprus is, however, making substantial progress, suggesting it will soon be out of the bailout and the recession. 51

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© 2016 George K. Zestos  In Figure 8.19, all countries’ unemployment rates are shown.  It is evident that the crisis in the EA countries is far from over.  All countries, with the exception of Ireland, still have very high unemployment rates of above 10%.  The highest unemployment rates have been experienced by Spain and Greece, which in 2015 had rates close to 20% and 25% respectively. 53

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© 2016 George K. Zestos  Figures 8.20 and 8.21 show the time plots of public deficit-to-GDP and public debt-to-GDP ratios of the five EA bailout recipient members for the period.  These two fiscal variables are at the center of the European sovereign debt crisis. As a result, the name of the crisis is not a misnomer.  Both public deficit and debt-to-GDP ratios began increasing rapidly starting in 2007, a time when the US subprime mortgage crisis broke out. 55

© 2016 George K. Zestos  Although the public deficit-to-GDP ratio of the five EA bailout recipient countries began drastically declining after 2010, their public debt-to-GDP ratios remained very high.  The main reason why the bailout programs have failed to reduce the public debt-to-GDP ratio has been the prolonged recession that reduced the GDP of these countries. 56

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© 2016 George K. Zestos  Congress passed the Dodd-Frank Act to prevent future financial crises similar to the one triggered by the collapse of Lehman Brothers.  After the passing of the Dodd-Frank Act, US legislators kept busy trying to free the banks from restrictions which did not allow them to invest in risky assets.  On October 29, 2013, the House of Representatives voted to support the banks, allowing them to continue trading in some risky derivatives.  On December 11, 2014, the U.S. Congress passed a $1.1 trillion US budget. 59

© 2016 George K. Zestos  The budget bill included provisions allowing banks to gamble using US Federal Deposit Insurance Corporation (FDIC) deposits.  The House and Senate bills received the support of both the Democrats and President Obama.  According to S. Denning (Forbes 2014), this wide support occurred because it was suspected that a new bill in 2015, produced by a Republican Congress, would have been more favorable to the banks.  Such a bill would have given more freedom to banks at the expense of the financial stability of the US economy. 60