The Eurozone Financial Crisis Stanley W. Black Lurcy Professor of Economics, Emeritus University of North Carolina at Chapel Hill May 7, 2010

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 Greece’s Problems

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

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 Government assistance in April and July of 2007 International credit markets froze up in August 2007 when subprime based hedge funds collapsed in Europe and US. No longer able to borrow short-term funds, banks faced much higher risk premia

Interest Rate Spreads in Dollars and Euros

Why did the Crisis Spread? Subprime Debt Obligations made in USA held around the world 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 billion bailout to cover Credit Default Swaps, insurance against bond defaults underwritten without reserves. Stress on banks around the world led to shrinking credit availability. “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.

Banks Under Duress: Writedowns and Capital Raised (US$ billions) Source: International Monetary Fund (2008)

Quarterly Real GDP Growth Rates Source: International Financial Statistics, IMF.

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 Iceland’s banks unable to roll over short term borrowing, default on deposits of foreigners

Credit in the Eurozone (% change) Source: European Commission (2009).

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.

Interest Rates in the Eurozone and the US (interbank rates) Sources: ECB, Federal Reserve Bank of New York

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.

Public Support to the Financial Sector (as of 18 February 2009, % of GDP) Source: International Monetary Fund (2009).

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.”

Changes in Budget Balances, October 2008 Source: IMF (2009)

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.

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

Greece’s 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, and retirement benefits, while collecting a lower share in taxes due to widespread tax evasion. As a result, Greek goods have become increasingly expensive and uncompetitive, causing loss of market share and further reducing revenues.

Relative price indicators based on export prices Source: European Commission (2010)

The Greek Debt Crisis Greek debt/GDP ratio reached 113% and deficit/GDP ratio reached 12.7% in Foreign bondholders became doubtful that Greece 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 $146 billion over three years. Greece to increase sales taxes, reduce public sector salaries, pensions, eliminate bonuses.

Greece’s Debt Dynamics Source: Economist.com

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 large devaluations 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.