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2008 Global Financial Crises (especially US & Europe) International Political Economy Prof. Tyson Roberts 1 Goals • • • • • • • 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 2 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? 5 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 6 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 35 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 7 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) 8 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 9 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) 10 Where in the macroeconomic trilemma are members of the Eurozone? Fixed exchange rate Capital mobility Monetary autonomy 11 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 12 Brief History of Europe • 1914-1918: WWI, Axis powers lose, war reparations • 1921-1924: Hyperinflation in Weimar Republic 13 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 14 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 15 Brief History of Europe • 1990-92: German unification – France conditioned support for unification on German support for monetary union 16 • Q: Why do you think France was reluctant to support German unification? • Q: Why was Germany reluctant to support European Monetary Union? 17 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” 18 Post-Unification Germany 19 • 1991: Maastricht Treaty signed – Inflation, exchange rate, budget deficit, & public debt criteria to enter EMU • 1999: EMU/Euro launched, ECB est’d 20 21 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 22 Birth of the dollar • How many currencies were in circulation in US in early 1800s? • What were some economic costs of multiple currencies? 23 Monetary efficiency benefits increase if economies highly integrated Source: Krugman 9th ed. 24 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 25 Costs of stability loss decrease if economies highly integrated 26 Rational choice: Join monetary union if gains exceed losses (more likely if high economic integration) 27 If low economic integration, costs exceed benefits 28 If high economic integration, benefits exceed costs 29 Where would you place the United States (pre-greenback)? Where would you place the US & Argentina (dollarization)? Argentina & US (1990s) United States (1850s) 30 Monetary Union benefit: Introduction of Euro led to all members having inflation rates similar to Germany’s 31 Monetary Union benefit: Introduction of Euro reduced borrowing costs for many “less developed” European economies 32 Low interest rates facilitate borrowing and higher growth LOW INTEREST RATE, HIGH GROWTH HIGH INTEREST RATE, LOW GROWTH 33 Monetary Union benefit: More trade (exports for Germany) 34 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) 35 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 37 Real house prices ballooned globally (not just US or EU) Indicates global causes (low interest rates, BoP imbalances, financial dereg’n) 38 1980s-1990s: US Financial deregulation => new financial instruments, higher leverage rates, increased capital flows 39 2001: China joins WTO Exchange rate policy => trade surplus=> capital flows to US 40 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 41 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: – – – – 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 42 • 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 43 Fiscal + Monetary Stimulus in US help US recover more quickly than EU 44 Fiscal spending increases growth (if government can access funds) 45 Austerity reduces growth 46 But perhaps the direction of causality goes in the other direction? Perhaps countries with low growth are cutting government spending more? 47 48 So why would anyone in Europe be opposed to lowering interest rates and increasing government spending in response to the financial crisis? 49 Eurozone countries in the political trilemma of the world economy Democratic politics Monetary policy, trade policy, etc. Hyperglobalization Fiscal policy Nation state 50 US States in the political trilemma of the world economy Democratic politics Monetary policy, trade policy, etc. AND fiscal policy Hyperglobalization “Nation” state 51 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 52 US unemployment by state in October 2015 ranges from 3% to 7% 53 • 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 54 European unemployment by country in February 2015 ranges from 4% to 26%! 55 Recently, some Greeks have begun to leave for countries with more job prospects Population growth fell from +0.03% to -0.07% 56 Population swings in US States are more dramatic E.g., Nevada’s population growth rate fell from +4.3% to +0.6% 57 Although some European countries continue to contract, others (e.g., Germany) have returned to positive growth 58 Reduced interest rates help debtors, hurt creditors • Germans feel responsibility of adjustment lies with borrowers – Debt = Schulden = “guilt, fault” 59 High borrowing helps growth, but growth can fuel inflation 60 Growth (2-year lag) and inflation in postunification Germany 61 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 62 In the US, money supply grew dramatically with little effect on inflation 63 Would Greece have been better off if it hadn’t joined the Euro? 64 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 65 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 66 Is the EU a success? • What were the goals of the EU? 67 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. 68 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 69 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 70 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) 71 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… 72 Greeks not happy with austerity 73 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 75 “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 76