Eurozone Debt Crisis Com

Digression:
The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim
Prof.
Prof.Dr.
Dr.Rainer
RainerMaurer
Maure -1-
Digression:
Prof. Dr. Rainer Maure -2-

➤ The Return of the Interest Rate Spreads:

■ After the foundation of the European Monetary Union (EMU)
interest rates spreads between the member states nearly
disappeared.
■ By the end of the year 2008, interest rate spreads reappeared.
■ For some countries interest rate spreads have become large:

Spain
Interest Rate
Interest Rate Spread
10%
9%
8%
7%
6%
5%
4%
2,0%
3%
2%
1%
0%
Jan. 99 Jan. 00 Jan. 01 Jan. 02 Jan. 03 Jan. 04 Jan. 05 Jan. 06 Jan. 07 Jan. 08 Jan. 09 Jan. 10
10Y Government Bond Interest Rate Germany (left scale) Interest Spread compared to Germany (left scale)
Source: Eurostat, Central Bank of Spain, Own Calculations

© www.rainer-maurer.com

Ireland
10% Interest Rate
9%
8%
7%
6%
5%
4%
2,5%
3%
2%
1%
0%
Source: Eurostat, Own Calculations ©www.rainer-maurer.com

Portugal
Interest Rate
10%
9%
8%
7%
6%
5%
4% 3,4%
3%
2%
1%
0%
Source: Eurostat, Central Bank of Portugal, Own Calculations


Greece
Interest Rate
10%
9%
8%
7%
6% 6,9%
5%
4%
3%
2%
1%
0%
Source: Eurostat, Own Calculations


➤ What caused the crisis?

■ Increasing public and private debt positions
....have casted doubt on the ability of governments and banks
safeguarded by governments to pay back debt.
■ Investors fear of a default of governments on their debt and

....demand therefore a higher risk premiums.

Spain
Interest Rate
Interest Rate Spread and Debt-to-GDP Ratios Debt-to-GDP
10% 110%
9% 100%
8% 90%
80%
7%
70%
6%
60%
5%
50%
4%
40%
3%
30%
2% 20%
1% 10%
0% 0%
Total Country Int. Net Debt Position GDP Ratio Total Government Debt GDP-to-Ratio
Source: Eurostat, Central Bank of Spain, Own Calculations ©www.rainer-maurer.com

Ireland
Interest Rate
10% 80%
70%
9%
60%
8% 50%
7% 40%
30%
6%
20%
5% 10%
0%
4%
-10%
3% -20%
2% -30%
-40%
1%
-50%
0% -60%
Prof. Dr. Rainer Maure - 10 -

Portugal
Interest Rate
10% 110%
9% 100%
8% 90%
80%
7%
70%
6%
60%
5%
50%
4%
40%
3%
30%
2% 20%
1% 10%
0% 0%
Source: Eurostat, Central Bank of Portugal, Own Calculations ©www.rainer-maurer.com

Greece
Interest Rate
10% 130%
120%
9%
110%
8%
100%
7% 90%
6% 80%
70%
5%
60%
4% 50%
3% 40%
30%
2%
20%
1% 10%
0% 0%

©www.rainer-maurer.com

➤ The situation is even worse than these figures suggest!
■ The change of a country's total debt position is the negative
current account surplus.
■ We can calculate the current account surplus which is
necessary to stabilize the current international debt-to-GDP
ratio with the following formula (for a derivation see the
digression):
Interest International
Primary Current GDP
Rate Net Debt
Account Balance Growth Position of
the Country
EX-IM-i*D −B  
dY
D
= i − 
dt
Y  Y Y
GDP
Digression: The constant debt-to-GDP ratio budget surplus:
D
k =
■ Debt-to-income ratio: Y
dk dD
Y − dY
dt D
■ 1st derivation with respect to time: = dt
dt Y2
■ Increase of debt = Primary Deficit + Interest Payments

dD = B + i*D
dt

dk dD
Y − dY
dt D
= dt
■ 1st derivation with respect to time: dt Y2
dk B D dY
dt D dk (B + i * D) Y − dY
dt D
= +i − = =
dt Y Y Y Y dt Y2
=
dk B  dY dt  D dk −B  dYdt  D
= + i −  => =0 <=> = i − 
dt Y  Y  Y Y  YY
dt
Condition for a constant debt-income-ratio: dk / dt = 0 !
−B  dY
 D
= i − dt

Y  Y  Y
If GDP growth is smaller than

the interest rate, a country
must run a primary current
account surplus to keep the
debt-GDP-ratio constant!

−B  dY
 D
= i − dt

Y  Y  Y
If GDP growth is larger than

the interest rate, a country can
run a primary current account
deficit to keep the debt-GDP-
ratio constant!

➤ Applying this formula to the data of the countries shows that

their actual account surplus is far away from the surplus
necessary to keep their debt-to-GDP ratio constant:

Spain
Percent of GDP Current Account Surplus Gap
15% 15%
10%
Current account surplus necessary to stabilize the 10%
5% International Debt-to-GDP ratio is 7,5% of GDP. 5%
0% 0%
-5% -5%
-10% -10%
-15% -15%
Acutal current account surplus - 5,5% of GDP!

Constant Intern. Net Debt-to-GDP Ratio Current Account Surplus (right scale)
Actual Current Account Surplus

=> Current account surplus gap = 13 % of GDP!

Portugal
15% 15%
10% 10%
5% 5%
0% 0%
-5% -5%
-10% -10%
-15% -15%
Current account surplus gap = 18,5 % of GDP!

Constant International Net Debt-to-GDP Ratio Current Account Surplus
Source: Eurostat, Own Calculations © www.rainer-maurer.com


Ireland
15% 15%
10% 10%
5% 5%
0% Current account surplus gap = 15 % of GDP! 0%

-5% -5%
-10% -10%
-15% -15%



Greece
15% 15%
10% 10%
5% 5%
0% 0%
-5% -5%
-10% -10%
-15%
Current account surplus gap = 25 % of GDP! -15%



Interest Rates (Average: Sept. 2009 - May 2010) and Constant International Debt
Position-to-GDP Ratio Primary Current Account Gap (Average: Jan. 2009 - Aug. 2009)
6,0%
Nominal Interest Correlation Coefficient: 70,1%
Rates 10Y Bonds
Greece
5,5%
The larger the 5,0%

current account Cyprus
Ireland
gap, the higher the4,5% Malta
risk premium! Slovakia Portugal

4,0% Italy
Slovenia Spain
Belgium
Luxembourg United Kingdom
Austria
3,5% France
Finland
Netherlands
Germany Constant IDP-to-GDP Ratio Current Account Surplus Gap

3,0%
-15% -10% -5% 0% 5% 10% 15% 20%

Interest Rates (Average: Sept. 2009 - May 2010) and Constant Government Debt-to-
GDP Ratio Primary Government Budget Gap (Average: Jan. 2009 - Aug. 2009)
6,0%
Nominal Interest Correlation Coefficient: 65,4%
Rates 10Y Bonds
Greece
5,5%
The larger the
government budget
5,0%
gap, the higher the
Ireland
4,5%
Cyprus risk premium!
Malta
Portugal
Slovakia
4,0%
Italy
Slovenia
Spain
Luxembourg Belgium
Austria United Kingdom
3,5% Finland France
Netherlands
Germany Constant Gov. Debt-to-GDP Ratio Gov. Budget Gap

3,0%
-2% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18%

➤ The situation is precarious!

➤ How to get out of this???
➤ To help countries like Greece, Portugal, Spain and Ireland
their " Current Account Gap" must be reduced:
 − Bo − Bt   dYt
 Dt − Bt
 −  = it − dt  −
 
 Y Yt   Yt  Yt Yt
Depressed
Prof. Dr. Rainer Maure EMU- 25 -

➤ Special problem of indebted countries, which are member
states of a monetary union:
1. They have no own currency they can depreciate to improve
their current account:
e$€ ↓ => P€ e$€ ↓ < P$ => ( EX ↑ – IM ↓ ) ↑
Reduction of current
account gap!
2. They have no own currency to inflate away debt!

Digression: How to "inflate away" government debt ???
The present value (=PVt,T=market value) of government debt

with a face value of 1€ is given by the formula:
The Dark
 1  zT 1 Corners of
PVt ,T 
= 1 − 
T 
+ Fiscal Policy
 (1 + i t ,T ) i
 t ,T (1 + i t ,T ) T
If the market interest rate it,T=2% is equal to fixed interest rate of government
debt zt,T =2%, the market value is equal to the face value = 1€:
 1  2% T 1
PVt ,T 
= 1 − 
T 
+ = 1
 (1 + 2% t ,T )  2% t ,T (1 + 2% t ,T ) T
If an increase of inflation by 3% increases the nominal market interest rate

(=real interest rate + inflation rate) by 3% and the average maturity of
government debt is T=10 years, the market value of government debt falls by
   Creat
nearly one quarter:

  2% T e a little bit
1 1
PVt ,T = 1 − 
10 
+ = 0,77 inflation and
 (1 + 5% t ,T )  5% t ,T (1 + 5% t ,T )10
buy back
Prof.
Prof.Dr.
Dr.Rainer
RainerMaurer
Maure
your debt ! -
- 27

➤ Special problem of member states of a monetary union:
3. Leaving the monetary union will cause the countries debt
position to explode !!!
◆ If Greece would leave the eurozone:
 Its new currency (the Neodrachmae) will depreciate against
the Euro: e€Neodramae ↓
 However, Greek government bonds (as well as private debt)
are denominated in Euro D€ !
 The Greek debt measured in Neodramae will grow in case of
a depreciation:
D€(/ e€Neodramae ↓)
↓ ↓
DNeodramae =

➤ How has it come to this?
■ The EMU is a monetary union across countries which have
asynchronous business cycles:
GDP Gaps of ECU Member States and the USA
(Trend Deviation of GDP in Percent of Trend measured by Hodrick-Prescott-Filter)
8% 0,020
7%
6% 0,015
5%
4% 0,010
3%
2% 0,005
1%
0% 0,000
-1%
2000Q01
2000Q03
2001Q01
2001Q03
2002Q01
2002Q03
2003Q03
2004Q01
2004Q03
2005Q01
2005Q03
2006Q03
2007Q01
2007Q03
2008Q01
2008Q03
2009Q01
2009Q03
2003Q01
2006Q01
-2% -0,005
-3%
-4% -0,010
-5%
-6% -0,015
-7%
-8% -0,020
Germany (left scale)
USA (left scale)
GDP Gap = Actual GDP minus trend GDP in % of trend GDP
Standard Deviation without Cyprus, Malta, Slovenia, Slovakia, USA (right scale)
Source: Eurostat, Own www.rainer-maurer.com

■ As a result, inflation rates across the EMU member state are
typically quite different:
GDP Price Deflator Relative to Germany
Indices Relative to Germany (1999 = 100%)
130%
125%
120%
115%
110%
105%
100%
1999
2000
2001
2002
2003
2004
2006
2007
2005
2008
2009
Euro area (16 countries) Ireland Greece Spain Portugal
Source: EU Commission, AMECO, Own Calculations www.rainer-maurer.com


■ The European Central Bank can set only one main refinancing
rate.
■ Therefore, after the start of the EMU, nominal interest rates
across the eurozone converged.
■ However, convergence of nominal interest rate and different
country-specific interest rates causes a divergence of real
interest rates!
Real Interest = Nominal Interest − Inflation

r = i − π
=> Countries with a high inflation rate have low real interest rates!
Countries with a low inflation rate have high real interest rates!

■ Convergence of nominal interest rate & divergence of real
interest rates:
Variance Coefficients across the 12 EMU Founding Member States
1,5%
1,3%
1,1%
0,9%
0,7%
0,5%
0,3%
0,1%
Jan. 97 Jan. 98 Jan. 99 Jan. 00 Jan. 01 Jan. 02 Jan. 03 Jan. 04 Jan. 05 Jan. 06 Jan. 07 Jan. 08 Jan. 09 Jan. 10
-0,1%
Nominal Interest Rates for 10-Year Government Bonds

Inflation Rates (HCPI)

Real Interest Rates for 10-Year Government Bonds


■ Real interest rates compared to Germany:
Real Interest Rates for 10 Years Government Bonds (based on BIP-Deflator)
9,0%
8,0%
7,0%
6,0%
5,0%
4,0%
3,0%
2,0%
1,0%
0,0%
Jan. 97 Jan. 98 Jan. 99 Jan. 00 Jan. 01 Jan. 02 Jan. 03 Jan. 04 Jan. 05 Jan. 06 Jan. 07 Jan. 08 Jan. 09 Jan. 10
-1,0%
-2,0%
-3,0%
-4,0%
Germany Spain Greece Ireland Portugal


■ Real interest rates and net international debt position:
December 2009 Accumulated Net Debt Position in Percent of GDP
and Average Real Interest Rate from Januar 1999 to December 2009
120%
Net Debt Position in % of GDP
in % of GDP
100% Portugal
Spain
Greece
80%
60% Ireland
40%
Italy
20%
France
Austria
Finland
0%
1,3% 1,5% 1,7% 1,9% 2,1% 2,3% 2,5% 2,7%
Real Interest Rate
-20% Netherlands
Belgium
Germany
-40%
Quelle: Eurostat, Eigene Berechnungen ©www.rainer-maurer.com


■ Inflation rates and net international debt position:
December 2009 Accumulated Net Debt Position in Percent of GDP
and Average HCPI Price Index from Januar 1999 to December 2009
120%
Net Debt Position in % of GDP
in % of GDP
100% Portugal
Spain
Greece
80%
60% Ireland
40%
Italy
20%
France
Finland
Austria Inflation Rate
0%
1,4% 1,6% 1,8% 2,0% 2,2% 2,4% 2,6% 2,8% 3,0% 3,2%
-20% Netherlands
Belgium
Germany
-40%
Quelle: Eurostat, Eigene Berechnungen ©www.rainer-maurer.com

The integrated EMU capital market is in equilibrium, while
The Eurozone
there is Debt
a disequilibrium Crisis
in single 2010
countries!
■ Consequently, high inflation countries experienced on average
lower real interest rates than low inflation countries:
r
10
r
10
S(Y) 9
S(Y)
8 8
7 Excess Supply 7
rL* 6 6
5 5
4 4
r* 3 3
2 2
Excess Demand
rH*
1 1
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
I(Y) I(Y)
Low inflation country: High inflation country:
rL*= i*- πL S, I rH*= i*- πH S, I
■ Countries with high inflation rates built up a net international
debt position.
■ Countries with low inflation rates built up a net international
wealth position.
International Net Debt Position of Eurozone Debtor and Creditor Countries
1500
Bn. Euro
1000
500
0
Jan. 98 Jan. 99 Jan. 00 Jan. 01 Jan. 02 Jan. 03 Jan. 04 Jan. 05 Jan. 06 Jan. 07 Jan. 08 Jan. 09 Jan. 10
-500
-1000
-1500
Sum of Net International Debt Position of Spain, Greece, Ireland, Portugal

Sum of Net International Debt Position of Germany, Belgium, Luxembourg, Netherlands

4.2. Financial Market Crises
4.2.5. The Eurozone Debt Crisis 2010
■ Consequently, the eurozone debt crisis is not by chance!
■ It is caused by a design faulty of the EMU!
■ What can be done to built a more stable EMU?

Eurozone Debt Crisis Com

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Digression:

The Eurozone Debt Crisis 2010

Prof. Dr. Rainer Maure -2-

➤ The Return of the Interest Rate Spreads:

Prof. Dr. Rainer Maure -3-

Source: Eurostat, Central Bank of Spain, Own Calculations

Prof. Dr. Rainer Maure -4-

Source: Eurostat, Own Calculations ©www.rainer-maurer.com

Prof. Dr. Rainer Maure -5-

Source: Eurostat, Central Bank of Portugal, Own Calculations

Prof. Dr. Rainer Maure -6-

Source: Eurostat, Own Calculations

Prof. Dr. Rainer Maure -7-

➤ What caused the crisis?

■ Investors fear of a default of governments on their debt and

Prof. Dr. Rainer Maure -8-

Prof. Dr. Rainer Maure -9-

Source: Eurostat, Own Calculations ©www.rainer-maurer.com

Prof. Dr. Rainer Maure - 10 -

Prof. Dr. Rainer Maure - 11 -

Source: Eurostat, Own Calculations

Prof. Dr. Rainer Maure - 12 -

■ Increase of debt = Primary Deficit + Interest Payments

Prof. Dr. Rainer Maure - 14 -

If GDP growth is smaller than

Prof. Dr. Rainer Maure - 16 -

If GDP growth is larger than

Prof. Dr. Rainer Maure - 17 -

➤ Applying this formula to the data of the countries shows that

Prof. Dr. Rainer Maure - 18 -

5% International Debt-to-GDP ratio is 7,5% of GDP. 5%

Acutal current account surplus - 5,5% of GDP!

Source: Eurostat, Own Calculations

Prof. Dr. Rainer Maure - 19 -

Current account surplus gap = 18,5 % of GDP!

Source: Eurostat, Own Calculations © www.rainer-maurer.com

Prof. Dr. Rainer Maure - 20 -

0% Current account surplus gap = 15 % of GDP! 0%

Constant International Net Debt-to-GDP Ratio Current Account Surplus

Source: Eurostat, Own Calculations © www.rainer-maurer.com

Prof. Dr. Rainer Maure - 21 -

Constant International Net Debt-to-GDP Ratio Current Account Surplus

Source: Eurostat, Own Calculations © www.rainer-maurer.com

Prof. Dr. Rainer Maure - 22 -

The larger the 5,0%

gap, the higher the4,5% Malta

risk premium! Slovakia Portugal

Germany Constant IDP-to-GDP Ratio Current Account Surplus Gap

Prof. Dr. Rainer Maure - 23 -

Germany Constant Gov. Debt-to-GDP Ratio Gov. Budget Gap

Source: Eurostat, Own Calculations © www.rainer-maurer.com

Prof. Dr. Rainer Maure - 24 -

➤ The situation is precarious!

➤ How to get out of this???

2. They have no own currency to inflate away debt!

Prof. Dr. Rainer Maure - 26 -

The present value (=PVt,T=market value) of government debt

If an increase of inflation by 3% increases the nominal market interest rate

nearly one quarter:

➤ How to get out of this???

Prof. Dr. Rainer Maure - 28 -

Source: Eurostat, Own www.rainer-maurer.com