Download “Nation” state

2008 Global Financial Crises
(especially US & Europe)
International Political Economy
Prof. Tyson Roberts
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Goals
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Capital liberalization & crises review
1980s & 1990s crises review
History of EU and origins of Euro
Origins of 2007- financial crisis in EU, US
Comparison to previous financial crises
Pros & cons of monetary union
Possible responses to financial crisis
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Access to capital => crisis risk
(Opportunity for high returns or disaster)
• When interest rates are low & credit conditions
are lax, borrowers have incentive to borrow more
• High debt to equity = high leverage
– E.g., if I buy a $100k with $5k down and $95k in debt
• High leverage enables high upside, but high risk
– If my $100k house gains 10% in value ($110k), I tripled
my money: $5k in equity becomes S15k (110-95=15)
– If my $100k house loses 10% in value, I owe more on
my house ($95k) than the house is worth ($90k)
Banking crises
• When global capital mobility is high and
interest rates are low:
– Banks have individual and competitive incentive to
get highly leveraged
– Conservative banks cannot generate same high
returns; will attract less capital
– However, when all banks are highly leveraged, the
entire banking system is at risk (can’t turn to
solvent banks for loans or mergers)
A banker/banker Prisoners Dilemma
Bank 2
Bank 1
High leverage
High leverage
Low leverage
High risk, high returns until
banking crisis
B1: High risk & returns
B2: Low risk, low returns
No banking crisis
2, 2
4, 1
B1: Low risk, low returns
B2: High risk & returns
No banking crisis
Low risk, low returns
No banking crisis
1, 4
3, 3
Low leverage
What is/are the Nash Equilibrium/a?
Is it/Are they Pareto Efficient?
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A lender/banker coordination problem
Bank 2
Bank 1
High leverage
Low leverage
High leverage
Low leverage
High risk, high returns until
banking crisis
B1: High risk & returns
B2: Low risk, low returns
No banking crisis
2, 2
4, 1
B1: Low risk, low returns
B2: High risk & returns
No banking crisis
Low risk, low returns
No banking crisis
1, 4
3, 3
What is/are the Nash Equilibrium/a? Everyone leverage (banking crisis)
Is it/Are they Pareto Efficient? No
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High capital mobility => high risk of
banking crises
Figure 3
High 1
Capital Mobility and the Incidence of Banking Crisis: All Countries, 18002007
Share of Countries
in Banking Crisis, 3-year
Sum
(right scale)
0.9
1914
0.8
0.6
20
0.5
Percent
Index
30
25
0.7
Capital Mobility
(left scale)
0.4
0.3
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15
1825
1980
1860
10
0.2
1945
0.1
5
1918
Low 0
0
1800 1810 1820 1830 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Sources: Bordo et al. (2001), Caprio et al. (2005), Kaminsky and Reinhart (1999), Obstfeld and Taylor
(2004), and these authors.
Notes: As with external debt crises, sample size includes all countries, out of a total of sixty six listed in
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Causes of 1980s Crises
• Liberalization of financial markets
(petrodollars) => higher volume of capital
flows to developing world
– Mostly commercial bank loans to governments
• Fixed exchange rates (often overvalued); debt
denominated in foreign currency
• Short-term government debt for long-term
projects (sometimes white elephants)
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Causes of 1990s Crises
• Liberalization of financial markets => higher
volumes of capital flows to developing world
in form of “hot money”
• Each country had some form of fixed exchange
rate
• Each country had heavy reliance on shortterm foreign private capital inflows
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European Union/US & Asia
• Liberalization of financial markets => higher
volumes of capital flows from Germany, Asia,
etc. to Greece, US, etc.
• Fixed exchange rates
– Currency union = extreme fixed exchange rate
– China exchange rate policy
• Large-scale short-term capital inflows to
governments (Greece, Italy, US) and/or private
banks (Ireland, Spain, US)
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Where in the macroeconomic trilemma are
members of the Eurozone?
Fixed exchange rate
Capital mobility
Monetary autonomy
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Where in the political trilemma of the world
economy are members of the Eurozone?
Democratic politics
Monetary policy, trade policy, etc.
Hyperglobalization
Fiscal policy
Nation state
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Brief History of Europe
• 1914-1918: WWI, Axis powers lose, war
reparations
• 1921-1924: Hyperinflation in Weimar Republic
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Brief History of Europe
• 1939-1945: WW2
• 1951: Eur. Coal & Steel Community
• 1957: Bundesbank established
–Inflation mandate
• 1957: EEC established
– Internal tariffs abolished, uniform external
tariff
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Brief History of Europe
• 1971: End of BW destabilizes trade
• 1972: The snake. Crisis-ridden
• 1978: EMS: virtual currency union
with ECU as nominal currency unit
managed by ERM
• 1987: Capital controls phased out
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Brief History of Europe
• 1990-92: German unification
– France conditioned support for unification on
German support for monetary union
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• Q: Why do you think France was reluctant to
support German unification?
• Q: Why was Germany reluctant to support
European Monetary Union?
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Brief History of Europe
• 1990-92: German unification
– France conditioned support on monetary union
– Boom => inflation => interest rates raised => wage
discipline
– Bundesbank: Credible commitment to low inflation
• 1992: UK, Italy, France can’t maintain peg;
ERM “shattered”
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Post-Unification Germany
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• 1991: Maastricht Treaty signed
– Inflation, exchange rate, budget deficit, &
public debt criteria to enter EMU
• 1999: EMU/Euro launched, ECB est’d
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Optimal Monetary Union Theory
Benefits
• Benefits of economic integration
– Economic efficiency
• Increased trade & factor flows
• Benefits of monetary union
– Monetary efficiency
• Avoid uncertainty, confusion, calculation, transaction
costs of flexible exchange rates
– Increases efficiency benefits of economic
integration
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Birth of the dollar
• How many currencies were in circulation in US
in early 1800s?
• What were some economic costs of multiple
currencies?
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Monetary efficiency benefits increase
if economies highly integrated
Source: Krugman 9th ed.
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Optimal Monetary Union Theory
Costs
• Monetary union reduces ability to adjust to
recession w/depreciation
– Economically integrated + monetary union +
recession:
• Drop in prices => exports to rich members, quick
recovery
• Drop in wages => workers move to rich members
– Not integrated + monetary union + recession:
• Lower exports, workers trapped => high stability loss
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Costs of stability loss decrease if
economies highly integrated
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Rational choice: Join monetary union if gains exceed
losses (more likely if high economic integration)
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If low economic integration, costs exceed benefits
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If high economic integration, benefits exceed costs
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Where would you place the United States (pre-greenback)?
Where would you place the US & Argentina (dollarization)?
Argentina & US
(1990s)
United States
(1850s)
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Monetary Union benefit:
Introduction of Euro led to all members having
inflation rates similar to Germany’s
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Monetary Union benefit:
Introduction of Euro reduced borrowing costs
for many “less developed” European economies
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Low interest rates facilitate borrowing and
higher growth
LOW INTEREST RATE,
HIGH GROWTH
HIGH INTEREST RATE,
LOW GROWTH
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Monetary Union benefit:
More trade (exports for Germany)
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Monetary union risk:
Economic imbalances
• Germany had large trade surplus, which it
invested in Spain, Ireland, Greece, etc.
– Greece developed large public debt
• (like Latin America in 1970s)
– Ireland and Spain had public budget surpluses, but
developed large private bank debt
• (like Asia in 1990s)
• (China invested its trade surplus in the US)
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system was de-regulated and de-supervised. To label this a sovereign debt problem is quite misleading. The
dynamics are surely complex but it is clear that there is something that is driving debt growth in the developed
world that cannot be reduced to runaway government budget deficits. Nor does it make sense to point fingers at
Mediterraneans since it is (largely) the English-speaking world of the US, UK, Canada and Australia that has se
some of the biggest increases of household debt—the total US debt ratio reached 500%, of which household deb
alone is 100%, and financial institution debt is another 125% of GDP.
Greece: High public debt at start of crisis
Ireland: Private sector debt => Gov’t debt
Take a look at this graph, which shows the debt-to-GDP ratios for the private and government sectors:
Clearly, up to 2007 the really big debt ratios were in the private sector. The story is very similar to that of the US
an invers
tends to be worse in those countries with smaller government debts—there is36
that the problem
But noteRandal
Source:
Wray 2011
relation between private debt ratios and government debt ratios. Now why is that?
When investors realized/told indebted countries could
default (Maastricht Treaty doesn’t include bailouts),
interest rates rose => vicious cycle, crisis
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Real house prices ballooned globally (not just US or EU)
Indicates global causes
(low interest rates, BoP imbalances, financial dereg’n)
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1980s-1990s: US Financial deregulation => new
financial instruments, higher leverage rates,
increased capital flows
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2001: China joins WTO
Exchange rate policy => trade surplus=> capital
flows to US
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2000s Tax cuts => greater borrowing needs (yet interest rates low)
“Bretton Woods II” following 1990s crises => dollar reserves in
developing countries => capital flows to US => low interest rates
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US Financial crisis
• 2007: Freddie Mac stops buying sub-prime mortgages
– Sub-prime mortgage banks file bankruptcy; credit markets
downgrade others
– Risk premiums rise, credit markets freeze up
– Fed reduces primary rate; bank consolidation
• 2008:
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Bush signs stimulus packages & TARP
Lehman Bros. files bankruptcy
Fed takes creative steps to increase liquidity
IMF creates short-term liquidity facility for market-access
countries
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• 2009:
– Obama signs stimulus packages
• Extends TARP; restructures AIG, Citigroup, GM, etc.;
stress tests
– Fed continues to inject liquidity
– S&P lowers UK outlook, stable to negative
– US recession officially ends
– US stock market & GDP growth begins recovery
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Fiscal + Monetary Stimulus in US help US
recover more quickly than EU
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Fiscal spending increases growth
(if government can access funds)
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Austerity reduces growth
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But perhaps the direction of causality goes in
the other direction?
Perhaps countries with low growth are cutting
government spending more?
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So why would anyone in Europe be
opposed to lowering interest rates and
increasing government spending in
response to the financial crisis?
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Eurozone countries in the
political trilemma of the world economy
Democratic politics
Monetary policy, trade policy, etc.
Hyperglobalization
Fiscal policy
Nation state
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US States in the
political trilemma of the world economy
Democratic politics
Monetary policy, trade policy, etc.
AND fiscal policy
Hyperglobalization
“Nation” state
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In response to state-level recessions,
• Workers in high unemployment states can
easily move to a different state
• Businesses can easily move to states to take
advantage of low-wages, efficiency, etc. (e.g.,
auto manufacturers move to Southern states);
can “export” goods to other states
• Some federal benefits (unemployment,
Medicaid, etc.) transfers funds from
prospering to struggling states
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US unemployment by state in October 2015 ranges
from 3% to 7%
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• For workers, moving from Greece to Austria is
more difficult than moving from West Virginia
to North Dakota
• For businesses, Northern businesses building
factories in the South is more challenging in
Europe than in America
• Europe does not have automatic fiscal
redistribution at the continental level
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European unemployment by country in February
2015 ranges from 4% to 26%!
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Recently, some Greeks have begun to leave for
countries with more job prospects
Population growth fell from +0.03% to -0.07%
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Population swings in US States are more dramatic
E.g., Nevada’s population growth rate fell from +4.3% to +0.6%
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Although some
European
countries
continue to
contract, others
(e.g., Germany)
have returned to
positive growth
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Reduced interest rates help debtors,
hurt creditors
• Germans feel responsibility of adjustment lies
with borrowers
– Debt = Schulden = “guilt, fault”
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High borrowing helps growth, but
growth can fuel inflation
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Growth (2-year lag) and inflation in postunification Germany
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Mallaby (2012)
“Some observers fear that the sheer volume of freshly
minted euros (by the ECB) is bound to lead to serious
inflation …. But the best bet is that, with growth flat
and unemployment over ten percent, the threat of
inflation spiking across the continent is remote: with
plenty of spare capacity on hand, any rise in demand
will be met with increases in supply rather than with
higher prices. For the foreseeable future, therefore, the
ECB can keep on printing money to prop up banks.”
• Explain Mallaby’s logic, why under current conditions
printing money may not cause (serious) inflation
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In the US, money supply grew dramatically
with little effect on inflation
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Would Greece have been better off if it
hadn’t joined the Euro?
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Floating exchange rates enable automatic adjustment to
recessions through currency depreciation
But Greece is pegged to other European countries, and the Euro
is still relatively strong compared to the dollar
Price of Euro in Dollars
Introduction of Euro
notes and coins
Introduction of Euro
in non-physical forms
Beginning of financial
crisis
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Greece enjoyed a major economic boom when it joined the
Euro, followed by a devastating crisis
It is now roughly where would have been without the Euro
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Is the EU a success?
• What were the goals of the EU?
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Is the EU a success?
• What were the goals of the EU?
• Official goals of Maastricht Treaty:
1) To strengthen the democratic governing of
participating nations. 2) To improve the efficiency of
the nations. 3) To establish an economic and
financial unification. 4) To develop the "Community
social dimension." 5) To establish a security policy
for involved nations.
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Conclusion
• The Euro crisis has similarities to pre-Depression
Gold Standard and 1990s crises (Asia, Argentina)
– Fixed exchange rates and few/no capital controls
facilitated high borrowing, high growth
– Banks became overextended, could not repay loans
– Troubled governments could not use monetary or
fiscal policy to reduce debt, grow economy
– No good options: austerity, bailout, or default
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Conclusion
• Countries not in Euro have option of letting
currency depreciate, monetary stimulus
– Monetary autonomy and/or capital controls vs.
fixed exchange rate
– Nation-state vs. global government
• Costs and benefits of Euro growth and crisis
vary across countries, factors, and sectors
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Conclusion
• For countries such as Greece with structural
issues (high spending, low revenues), no easy
options
– Monetary stimulus? No monetary autonomy, Inflation
risk (ECB doesn’t like, could reduce buying power)
– Bailout? Moral hazard, Germany not very willing
– Default? Moral hazard, reduce investor confidence
– Austerity? Voters protest, political instability
– Exit Euro? Risk of financial panic (savings will
evaporate)
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Conclusion
• In the end, several partial steps taken for
Greece
– In 2011-2012, Eurozone governments gave several
partial bail-outs in exchange for Greek austerity
budgets
– Partial default: 2/3 of sovereign debt creditors
agreed to 50% haircut, others forced to accept
– ECB increased money supply by giving cheap longterm loans to banks, who can then lend to gov’ts
• Initial crisis averted, but…
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Greeks not happy with austerity
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Greek governments respond to protests
with frequent parliamentary elections
Year: Plurality winner (vote share)
• 2007: New Democracy (42%)
– 2008: Recession begins
• 2009: PASOK (43%)
– May 2010 & March 2012: 1st and 2nd bailout/austerity agreements
• 2012 (May): New Democracy (19%)
– No government formed
• 2012 (June): New Democracy (30%)
• 2014: New Democracy (26%)
• 2015 (January): SYRIZA (27%)
– August 2015: 3rd bailout/austerity agreement
• 2015 (September): SYRIZA (36%)
SYRIZA supporters say “This is a really
good night, Ms. Merkel”
This was in January 2015. Since then, SYRIZA agreed to new bailout/austerity package
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“Democracy Surplus”
(Moravcsik)
• Greece resists long-term solutions
– E.g., wage & government discipline, EU-level fiscal
policy
• Germany resists long-term solutions
– E.g., change ECB rules to allow for more stimulus,
higher inflation
• Germany & Greece both democracies, can
block changes to EU institutions
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