Download The Global Financial Crisis Chapter 4

From the US subprime mortgage crisis to
European sovereign debt
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Why the European sovereign debt crisis has
lasted so long
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Several explanations are provided in this chapter as
to why the crisis has lasted so long.
The EA unemployment rate increased during the
crisis at an unprecedented two-digit rate.
Furthermore, GDP declined for several consecutive
quarters.
After an anemic recovery, several EA countries are
still at risk.
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The ECB’s one-size-fits-all interest rate policy
proved incapable to help financially distressed
countries.
Similarly, the small budget of the EU (1% of the
total EU GDP) proved insufficient to allow the EU to
pursue discretionary countercyclical fiscal policy.
◦ As a result the crisis in the EU was prolonged.
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The European approach to coping with the
recession was much different than that of the US,
which employed an extraordinarily expansive
macroeconomic policy to pull it out of the
recession relatively quickly.
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The first countries affected by the crisis in
Europe were a few Central and Eastern European
(CEE) countries. EU country leaders decided to
help these CEE countries by increasing their IMF
country contributions.
◦ As a result, the IMF doubled its resources and helped the
CEE countries with relatively small bailouts.
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Before the crisis spread to Europe in 2008,
country leaders adopted the European Economic
Recovery Plan (EERP).
◦ This was a €200 billion joint stimulus program between
the EU Commission and the EU member countries.
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Soon it was realized that the EERP was too small
and, as a result, the EU member countries
launched a much larger program of €3.5 trillion
to aid financial institutions.
◦ The funding provided by the EU states supported four
different programs:
 Bank deposit guarantees (the largest of the four
programs amounting to €2.9 trillion)*;
 Bank recapitalization;
 Liquidity support;
 Treatment of impaired assets.
*
This program allowed Ireland to guarantee all the
country’s bank deposits.
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EU leaders and the EU Commission invited the IMF
to extend joint EU/IMF bailouts to financially
distressed countries, provided they adopt austerity
programs (This is the familiar IMF conditionality).
◦ Such programs included:
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Reduction in government expenditure;
Increase in taxes;
Reduction in private and public wages and pensions;
Privatization programs, i.e., sale of government assets.
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Austerity programs and fiscal consolidation
constitute contractionary fiscal policy during a time of
recession.
Such policies are opposite to mainstream
countercyclical policies strongly recommended by the
vast majority of economists during recessions.
The aim of such policies was to help bailout recipient
countries gain international competiveness and attain
growth by improving their trade balances. Germany
followed such policies before the Eurocrisis and
attained growth. Such policies are known as internal
devaluation.
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To evaluate the effectiveness of the bailout programs,
we analyze the Real Effective Exchange Rates (REER)
and the real unit labor costs of five southern EA
countries and five northern EA members.
According to Figures 4.1(a) and (b), substantial
declines in the REER and the real unit labor costs took
place after the crisis due to austerity programs and
due to the recession.
The decline in REER and real unit labor costs had a
positive effect on the trade balance of all southern EA
countries, and Ireland, which helped those countries
return to growth.
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However, it took a long time for the recovery to
come. If instead growth policies had been adopted,
the recession would have been shorter and the pain
and suffering of the people could have been
prevented.
Figures 4.1(a) and 4.1(b) also show that Germany,
due to its adopted neoliberal policies, was able to
reduce both the REER and the real unit labor cost
thus improving its international competiveness.
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A possible reason for the prolonging of the
Eurocrisis may be the EMU’s overvalued currency.
Many economists believe that the euro was
overvalued upon its introduction vs. the US dollar
in January 1999.
Figure 4.2 below shows the value of the euro in
terms of dollars since the introduction of the euro
in 1999.
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The Euro was introduced on January 1, 1999 at $1.179.
Many economists believed this exchange rate made the
euro an overvalued currency.
The euro depreciated in its first 10 months and reached a
minimum value of $0.8252. It then continuously
appreciated and reached its maximum value at
approximately $1.60 in July 2008. It then fluctuated
around $1.35 until 2014.
In the first half of 2015, the dollar/euro exchange rate
depreciated vs. the US dollar and in the middle of
November of 2015 it was close to $1.05.
Many economists are convinced that because the euro was
an overvalued currency, the crisis was prolonged.
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The ECB is responsible for the monetary policy in
the Economic and Monetary Union (EMU). During
the Eurocrisis the ECB employed existing policies,
and also launched new policies to help fight the
recession. Such policies include:
 The Repurchase Agreement (REPO) rate
 Securities Markets Programme
 Long-term refinancing
 Quantitative easing
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Since October 11, 2008, the ECB has followed an
expansive monetary policy (see Figure 4.3 below),
where the key monetary policy variable (the REPO
rate) is depicted together with the US equivalent
monetary variable, the federal funds rate.
The ECB lowered the REPO rate starting on October
11, 2008 until it approached the zero lower bound
and reached 5 basis points, 0.05% of one percent,
on September 5, 2014.
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In 2011, there was a small interval when the ECB raised the
REPO rate as inflation was a threat to the EA economy.
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During most of the Eurocrisis, nevertheless, the REPO rate
was above the federal funds rate.
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This implies that the Fed applied a more expansionary
policy even at times when the recession was subdued in
the US and was deepening and spreading in the EA.
The ECB employs the Main Refinancing Operations (MRO)
to alter liquidity in the EA by purchasing and selling
securities in these transactions. The ECB sets the REPO
rate.
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In May 2010, the ECB began purchasing both government and
private bonds of financially distressed EA countries.
Such bond purchases were criticized by two prominent German
monetary officials (Alex Weber and Jürgen Stark), both members of
the ECB Governing Council.
The bond purchases were criticized as a first endeavor to monetize
public debt of financially distressed countries, which was prohibited
by EU treaties.
Nevertheless, such a claim was not valid as the ECB stated that all
such purchases were sterilized, i.e., the ECB reduced the money
supply by an equal amount to the government bond purchases using
other methods.
The ECB bought relatively small amounts of bonds compared to the
Fed’s purchases.
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To increase bank liquidity the ECB, with its new
president, Mario Draghi, decided to extend liquidity
to financial institutions on December 2, 2011 and
again on March 1, 2012 through the long-term
refinancing operations for 36-month maturity loans.
In a period of less than 3 months, the ECB lent over 1
trillion euros to financially distressed countries’
banks at very low interest rate of 1%.
However, the program was not very successful at
affecting the real economy as banks were very
hesitant to extend loans.
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The most effective monetary ECB program was announced by its
president, Mario Draghi, on July 26, 2012 when he said “the ECB
is ready to do whatever it takes to preserve the euro.”
The new program, “Outright Monetary Transactions” (OTM),
would empower the ECB to purchase unlimited quantities of 1-3
year maturity bonds of countries that abide by the strict IMF
conditionality.
Many believed that the OMT program saved the euro, as interest
rates in many countries began declining after the announcement,
particularly in Italy and Spain.
Due to the size of these two countries, it would not have been
possible for the EU to provide sufficient bailouts to rescue these
two countries.
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The euro collapse would have been almost certain
if it were not for the OMT program. The OMT
program was supported by 22 out of the then 23
members of the ECB Governing Council.
The President of the German Central Bank
(Bundesbank), Jens Weidmann, opposed the
program in the ECB Governing Council and cast the
sole “no” vote.
Weidmann’s opposition to the OMT program did
not stop in the ECB Governing Council.
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The Bundesbank, represented by Jens Weidmann,
brought the case against the ECB to the Federal
Constitutional Court of Germany
(Bundesverfassungsgericht), where he claimed the
OMT program was in violation of German law.
Weidmann claimed that the ECB’s OMT program was
equivalent to applying fiscal policy to save the EMU
countries, and that therefore the ECB had violated its
delegated authority to pursue a single mandate of
price stability.
The Federal Constitutional Court decided that
German law had not been violated and that the case
should be taken to the European Court of Justice.
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The EU created two rescue funds to prevent
the financial crisis from spreading and
deepening.
◦ (1) The European Financial Stability Facility (EFSF);
◦ (2) The European Stability Mechanism (ESM).
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The EFSF was launched through the creation of a
Special Purpose Vehicle (SPV) in the city of
Luxembourg.
At the same time, more efforts were made to create
a firewall to further prevent the crisis from
spreading.
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The EFSF was created exclusively through borrowed
funds amounting to €440 billion for 2010-2013.
The European Financial Stability Mechanism (EFSM) was also
created by the EU Commission for €60 billion through
issuance of bonds guaranteed by the EU budget.
In addition a new fund was created by the IMF to
safeguard financial stability in Europe for €250 billion.
Total: €750 billion.
In addition to the funds above, the EU added another €340
billion to be used as collateral for the €440 billion so the EFSF
could lend out the entire €440 billion.
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A second rescue fund was created by the European Council
on June 24, 2011, for a total subscribed capital of €700
billion. The ESM’s lending capacity was €500 billion.
The ESM raised its capital by issuing bonds generated by the
EA member countries including Sweden and Poland, which
agreed to contribute, although at that time they were not
members of the EMU. However, €80 billion of the ESM capital
was paid by the EA countries, along with Sweden and Poland.
The ESM, unlike the EFSF, is a permanent EA rescue fund.
Upon the expiry of the EFSF in 2013 the two funds have
merged.
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Greece, Ireland, Portugal, Spain, and Cyprus, were
the most affected EA countries during the crisis.
All five EA countries received bailouts on the
condition that they accept the IMF austerity
measures.
The idea was that the bailouts would protect the
bailout recipient countries from bankruptcy, and
also free the ECB from having to provide additional
liquidity to these countries, thus avoiding the risk
of increased inflation.
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Table 4.1 presents the bailout terms for the first
three bailout recipient countries: Greece, Portugal,
and Ireland.
Two bailouts are shown for Greece, as the first
bailout turned out to be insufficient.
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Bailout Terms of Greece, Portugal, and Ireland (euros)
Bailout
Greece:
st
1 Bailout
Greece:
nd
2 Bailout
Ireland
Portugal
Amount
€110 bn
€130 bn
€85 bn
€78 bn
Interest
5.2%
Variable
5.80%
5.7%
Ireland: €17.5 bn
ESM: €22.5 bn
EFSF: €22.5 bn
IMF: €22.5 bn
ESM: €26 bn
EFSF: €26 bn
IMF: €26 bn
Lenders &
Amounts
EU Countries: €80 bn EFSF: €102 bn
IMF: €30 bn
IMF: €28 bn
Maturity
3 years
Date funds
availabe
May 19, 2010
7.5 Years
IMF: 10 Years  Renegotiated Extension
EU: Varies
(4/12/13)
7 Years
2012-2014
November 28, 2010
7.5 Years
 Renegotiated Extension
(4/12/13)
7 Years
May 16, 2011
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The first Greek bailout was offered jointly by the
EA member counties with the participation of the
two rescue funds and the IMF.
The bailouts to Ireland and Portugal were offered
by the European rescue funds (the EFSF and the
ESM) and the IMF.
The three countries agreed to initially pay
relatively high interest rates of 5.2%, 5.8%, and
5.7% and repay the loans within 3 and 7 years.
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EU country leaders were very harsh in their treatment of Greece
because their countries had to directly finance the first Greek
bailout.
It was especially difficult for countries with lower per capita income
than that of Greece to support a Greek bailout.
After receiving such bailouts it was expected that the countries
would immediately return to growth; however, it took much longer
than expected. Greece’s economic conditions deteriorated and EU
country leaders decided to provide a second bailout to Greece.
The second Greek bailout was for €130 billion and was jointly
offered by the EFSF and the IMF.
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The second Greek agreement for the
Memorandum of Understanding (bailout) also
included a Private Sector Involvement (PSI)
program that provided a 52.5% haircut to private
holders of Greek government bonds.
Since a small percentage of bondholders did not sign
the bailout, this triggered a credit event (bankruptcy).
The declaration of the credit event made it possible
for the holders of credit default swaps (CDSs) to
receive payments.
The last two countries to receive bailouts were
Spain and Cyprus.
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Although Spain, the largest of the five bailout
recipient countries, requested and was approved
for a €100 billion bailout, Spain nevertheless
received only €41 billion exclusively for its banking
sector.
The initial hesitancy of Spain to request a bailout is
explained because its government tried to avoid
the IMF conditionality, i.e., the painful austerity
measures and the stigma that goes with
conditionality.
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The Cyprus bailout was much different than the other
bailouts. First, it was for only €10 billion and was offered
with the most severe conditions.
It introduced a new EU policy to tax bank deposits, i.e., to give a
major haircut to bank deposits. This caused great uncertainty all
over the world, as banks were no longer considered a safe place
by bank depositors.
The harsh measures of the Cyprus bailout had to do with
the belief that the two banks of Cyprus were receiving
deposits from Russian oligarchs suspected to be directly
involved in money laundering.
Table 4.2 shows the terms of the bailout agreements for
the last two bailout recipient countries.
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Bailout
Amount
Interest
Spain
€100 bn
Variable
EU Commission
ESM
IMF
Cyprus
€10 bn
2.50%
EU Commission
ECB
IMF
Maturity
15 years
10 Years
Already used funds
€41 bn
€9 bn
Lenders and
amounts
Date funds available 12/11/2012
May 2013
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The Eurocrisis lasted a very long time because markets
revealed that European country leaders were not totally
committed to safeguard the EMU.
A root of the crisis was the over-indebtedness of countries
that violated the fiscal rules for a long time.
Northern EA country leaders, particularly in Germany, blocked
or postponed every proposed program that they perceived
would:
◦ Increase inflation;
◦ Raise interest rates;
◦ Burden taxpayers of their country.
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The fiscal compact treaty reinforced austerity in the
midst of a recession and did not assist in resolving
the crisis.
EU country leaders are solely responsible for the
adoption of such policy.
The haircut imposed on the Greek public debt as part
of the second bailout was mainly demanded by
Chancellor Merkel.
This haircut not only devastated Greece, but is also
responsible for spreading the recession through
contagion to other southern EU countries.
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Many analysts believe that deeper integration along
with suppression of ethnocentric-oriented policies is
required for the EU to pull out of the Eurocrisis.
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Modern EU leaders must follow the founders of the
EU and align their policies with the founders’ visions.
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The EU has to establish a complete monetary and
fiscal union.
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In order to achieve this, the ECB must be given the
full authority to conduct an independent monetary
policy.
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Furthermore, completion of the EMU will
require the formation of a banking union.
◦ (a) A single supervisory mechanism, to introduce
and enforce the same regulations to all EA
countries.
◦ (b) A single resolution mechanism, to be
responsible for the liquidation of failing banks.
◦ (c) A European Deposit Insurance Scheme (EDIS) to
provide a full and uniform protection of all bank
depositors in the EMU.
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