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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
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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
Transmission from United States
• US Housing Bubble created by
– Low interest rates
– Lax regulation of sub-prime mortgages with
adjustable rates, two year teaser rates
– Securitization of mortgages, sold to unwary
buyers as highly rated
• US Bubble popped when
– Interest rates rose in 2006, housing prices fell
– Subprime mortgages and securities defaulted
http://mjperry.blogspot.com/2009/04/house-price-indexes-usa-vs-europe.html
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,
August 2007, after Bear, Stearns, 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. No longer able to borrow short-term
funds, banks faced much higher risk premia
Interest Rate Spreads in Dollars and Euros
Why did the Crisis Spread?
• Subprime Debt Obligations made in USA held around the
world caused global financial shock.
• Housing bubbles burst in UK , Ireland, Spain as well as US.
• Failure of Lehman Bros in September 2007 caused massive
panic over counterparty risk. AIG required $180 billion
bailout to cover Credit Default Swaps, insurance against
bond defaults underwritten without reserves.
• Stress on banks around the world led to shrinking credit
availability. “Shadow” off-balance-sheet banking sector
collapsed as short-term funding vanished.
• Falling demand spread from US to all countries; as US
imports dropped, other countries’ exports fell.
Banks Under Duress: Writedowns and Capital Raised
(US$ 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, WestLB, 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, default on deposits of foreigners
Credit in the Eurozone (% change)
Source: European Commission (2009).
Monetary Policy Response by
European Central Bank (ECB)
• ECB injected liquidity into European banks
unable to obtain short-term funds in market.
• Federal Reserve used Euro-dollar swaps to
make dollars available to ECB to lend to banks.
• 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.
Interest Rates in the Eurozone and the US
(interbank rates)
Sources: ECB, Federal Reserve Bank of New York
Financial Sector Bailouts in US & Europe
• TARP and Federal Reserve programs in US
• National programs in European countries, due
to absence of Eurozone-wide regulator.
• “Beggar-thy-neighbor” effect, as first Ireland
gave deposit guarantees, then UK, 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).
Fiscal Policy Responses to Recession
• Automatic Stabilizers of falling taxes, rising
welfare and unemployment payments kick in
as incomes fall and unemployment rises.
• Discretionary Fiscal Stimulus enacted in most
countries, depending on their fiscal positions.
• European countries limited by Stability and
Growth Pact to 3% fiscal deficits, except in
time of “exceptional economic distress.”
Changes in Budget Balances, October 2008
Source: IMF (2009)
The Role of the Euro
• Previous economic crises in Europe have led
to large devaluations of currencies.
• Within eurozone, single currency prevents
devaluation , provides automatic financial
support through capital markets.
• Non-euro currencies depreciated sharply in
2008, British pound sterling, Swedish kronor,
Polish zloty, Hungarian forint.
Exchange Rates vs the Dmark or euro
(Left Index: 1970q1 = 100 Right Index: 2007m1 = 100)
Source: International Financial Statistics, IMF, Monthly Bulletin, European Central Bank
Greece’s Financial Problems
• Since joining the euro, Greece has had higher
inflation than other Eurozone members.
• Greece has also increased debt faster than others
to finance generous public sector pay, welfare, and
retirement benefits, while collecting a lower share
in taxes due to widespread tax evasion.
• As a result, Greek goods have become increasingly
expensive and uncompetitive, causing loss of
market share and further reducing revenues.
Relative price indicators based on export prices
120
115
110
105
Germany
Greece
100
Spain
95
France
90
85
80
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
Source: European Commission (2010)
The Greek Debt Crisis
• Greek debt/GDP ratio reached 113% and
deficit/GDP ratio reached 12.7% in 2009.
• Foreign bondholders became doubtful that Greece
could continue to roll over its increasing debt,
forced interest rates higher.
• EU faced choice between Greek default and bailout
with tough conditions.
• IMF and EU agreed to lend Greece up to $146
billion over three years.
• Greece to increase sales taxes, reduce public sector
salaries, pensions, eliminate bonuses.
Greece’s Debt Dynamics
Source: Economist.com
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.
• European governments have tried to act together, not
always successfully.
• Limited impact of falling exports due to extensive
internal trade relationships.
• Greece facing difficult adjustment problems, European
banks avoiding losses on Greek bonds.