1 ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich

2 Lecture 12: February 24 Ch. 20, 21

3 Financial Crisis 2 Debt wall for Greece (and Italy, and perhaps Spain, Belgium and France) Greece default likely – traders/speculators bet against Greek debt Costs for Greece of rolling over debt and financing ongoing deficits Austerity demanded – impacts on GDP and revenues

4 Financial Crisis 2 Mark-to-market rules – debt would have been reduced and interest costs of Greece would decline Problem: holders of Greek debt, primarily EU banks, did not have to reduce value of Greek and other debt if expectation that interest and principal payments will be made on schedule –If bonds sold, loss would have to be recorded –Capital of banks would decline – need to raise additional equity or merge with stronger banks –ECB: fear of weakening banks and contagion effects because of unknown linkages and size and participants in credit derivatives markets

5 Financial Crisis 2 Pull the plug and restructure Greek debt –Unknown consequences –Banks unable to lend; unwilling to lend to other banks

6 Basel 1975: Concordat –Allocates responsibility for supervising multinational banks between home and host countries 1988: Basel I –Bank capital of 8% of risk-adjusted assets 1997: Core Principles for Effective Banking –25 principles for minimum necessary requirements for effective bank supervision –Licensing, supervision methods, reporting requirements for banks, cross-border banking 2004: Basel II –Capital requirements and new risk adjustments

7 Central Bank Swaps Central banks lenders of last resort to domestic banks in domestic currencies European banks invested in US MBS –Highly rated, so less capital required to backstop under Basel II rules –Interest rate premium for AAA-rated securities (“Money for nothing”) –Borrowed short-term US $ to hedge/finance investments –When financial crisis 1 hit – European banks did not want to sell MBS and incur loss (write-down of capital); needed to roll-over short-term loans in US $ –Inter-bank lending froze

8 Central Bank Swaps US Fed became global lender of last resort –Swap lines to other central banks so that e.g. ECB could borrow from Fed (swap Euros into US $) and lend to domestic European banks –Wound down swap lines in February 2010 –Reactivated later in 2010 as Greek debt crisis erupted

9 Economic Integration Varying degrees of integration Preferential free trade arrangements – lower trade barriers among participating countries Free trade area –All trade barriers removed among participants –Each country retains own barriers against non-members –Sources of products need to be identified Definition of domestic product (domestic content requirements)

10 Economic Integration Customs Union –Common trade barriers against non-members –Trade creation vs. trade diversion Trade creation if tariffs blocked trade prior to customs union Trade diversion if customs union leads to substitution of imports from partner country from non-partner country (lower cost imports from outside union replaced by higher cost imports from union member) –Gains more likely if trade creation more prevalent than trade diversion  high pre-union tariff barriers; low tariffs with ROW; many countries part of customs union; closer geographically are members of union (transportation costs, tastes: lower obstacles to trade among members) Common market –Free movement of capital and labor –Harmonization of labor and other laws

11 Economic Integration Economic Union –Monetary union – single currency –Restrictions on fiscal policy –Harmonization of monetary policy, fiscal policy, tax rates –EU has had difficulty in dealing with economic and financial crisis – no single response as in the U.S. Political union

12 Optimum Currency Area High degree of economic integration Labor and capital mobility Similar economic structures Limited policy autonomy – large spillover effects Limited role for exchange rate movements to insulate against external shocks

13 European Union Treaty of Rome, 1957 –Customs union Single European Act, 1986 – amended Treaty of Rome –Eliminated internal barriers to trade, capital movements and labor migration Maastricht Treaty, 1993 –Single European currency and central bank –Convergence criteria: Country’s inflation rate in year before admission must be no more than 1.5% above average of three EU members with lowest rate of inflation Government deficit < 3% of GDP Government debt below or approaching 60% of GDP

14 European Union Financial crisis: Round 2 Does Greece meet conditions for currency area? Would Greece be better off outside Eurozone with ability to have own currency depreciate – to offset negative impacts of restrictive fiscal policy? No fiscal transfers within EU – compare to US and Canada

15 Sovereign Debt and Defaults Private debt – CCAA, ch. 11 –Convert debt into equity –Convert into new debt with lower face value and lower interest rates –Receive cash for fraction of value at maturity (pennies on the dollar) Sovereign debt –Conversion into equity not an option –Convert into new debt with lower face value and lower interest rates –Defer interest and principal payments, possible reduction in interest rate –Receive cash IMF: provides new loans to make payments on outstanding debt – loans generally made with conditions (re. macroeconomic policies – reduce debt, low inflation rate targets; microeconomic policies – privatization, deregulation)  beneficiaries are current creditors