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

sold to unwary buyers as highly rated • US Bubble popped when – Interest rates rose in 2006. housing prices fell – Subprime mortgages and securities defaulted . two year teaser rates – Securitization of mortgages.Transmission from United States • US Housing Bubble created by – Low interest rates – Lax regulation of sub-prime mortgages with adjustable rates.

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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. banks faced much higher risk premia . after Bear. No longer able to borrow short-term funds. Stearns. August 2007.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.

Interest Rate Spreads in Dollars and Euros .

insurance against bond defaults underwritten without reserves. AIG required $180 billion bailout to cover Credit Default Swaps. Ireland.Why did the Crisis Spread? • Subprime Debt Obligations made in USA held around the world caused global financial shock. • Falling demand spread from US to all countries. Spain as well as US. “Shadow” off-balance-sheet banking sector collapsed as short-term funding vanished. as US imports dropped. • Housing bubbles burst in UK . . • Stress on banks around the world led to shrinking credit availability. • Failure of Lehman Bros in September 2007 caused massive panic over counterparty risk. 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. default on deposits of foreigners . 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. WestLB.

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

. • 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. • Federal Reserve used Euro-dollar swaps to make dollars available to ECB to lend to banks.Monetary Policy Response by European Central Bank (ECB) • ECB injected liquidity into European banks unable to obtain short-term funds in market.

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

as first Ireland gave deposit guarantees.Financial Sector Bailouts in US & Europe • TARP and Federal Reserve programs in US • National programs in European countries. then UK. • “Beggar-thy-neighbor” effect. due to absence of Eurozone-wide regulator. 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).

• European countries limited by Stability and Growth Pact to 3% fiscal deficits.Fiscal Policy Responses to Recession • Automatic Stabilizers of falling taxes.” . except in time of “exceptional economic distress. depending on their fiscal positions. rising welfare and unemployment payments kick in as incomes fall and unemployment rises. • Discretionary Fiscal Stimulus enacted in most countries.

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

• Non-euro currencies depreciated sharply in 2008. . Polish zloty. Hungarian forint.The Role of the Euro • Previous economic crises in Europe have led to large devaluations of currencies. single currency prevents devaluation . British pound sterling. • Within eurozone. provides automatic financial support through capital markets. Swedish kronor.

Monthly Bulletin. IMF.Exchange Rates vs the Dmark or euro (Left Index: 1970q1 = 100 Right Index: 2007m1 = 100) Source: International Financial Statistics. European Central Bank .

Greece has had higher inflation than other Eurozone members. • Greece has also increased debt faster than others to finance generous public sector pay. and retirement benefits. .Greece’s Financial Problems • Since joining the euro. causing loss of market share and further reducing revenues. welfare. Greek goods have become increasingly expensive and uncompetitive. • As a result. while collecting a lower share in taxes due to widespread tax evasion.

Relative price indicators based on export prices 120 115 110 105 100 95 90 85 80 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Germany Greece Spain France Source: European Commission (2010) .

eliminate bonuses.The Greek Debt Crisis • Greek debt/GDP ratio reached 113% and deficit/GDP ratio reached 12. • EU faced choice between Greek default and bailout with tough conditions.7% in 2009. reduce public sector salaries. forced interest rates higher. • IMF and EU agreed to lend Greece up to $146 billion over three years. pensions. . • Foreign bondholders became doubtful that Greece could continue to roll over its increasing debt. • Greece to increase sales taxes.

com .Greece’s Debt Dynamics Source: Economist.

• Limited impact of falling exports due to extensive internal trade relationships. European banks avoiding losses on Greek bonds. .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. not always successfully. • Greece facing difficult adjustment problems. • European governments have tried to act together.