euro crisisebajuly7 2010

8/4/2019 Euro Crisisebajuly7 2010

1/59

1

The Eurozone in Crisis:New Phase in the Global Recession

EBA Public Lecture

July 7, 2010

by

Professor Assaf RazinTel Aviv University and Cornell University


2/59

2

Global Crisis: 5 ActsAct I : Credit-fed Asset Bubble

Act II : Financial Collapse after the Burst of

the bubble

Act III : Spillovers to the real economy

Act IV : Aggressive monetary and fiscal

policies

Act V : Slow growth, high persistent

unemployment, sovereign debt crisis


3/59

3

Tracking the Great Depression bymonths into the Crisis

Eichengreen and ORourke
http://www.voxeu.org/index.php?q=node/703http://www.voxeu.org/index.php?q=node/703


4/59


5/59

5

Shocks are of similar magnitude

but different policy actions

The Shocks in the great depression and therecent global crises were of similar magnitudes.In both episodes the interest rate went all theway down to the zero bound.But..Policy reactionin recent crises were swift and powerful: quantityeasing and credit easing, fiscal stimuli, bailingout banks, etc.


6/59

6

Key Differences

1. Responses of both fiscal and monetary policiestoday are much swifter and vigorous than they wereduring the first three years of the great depression

The deficit declined in fiscal 1935 by roughly thesame amount it had risen in 1934.

The US was on a gold standard throughout theDepression. In April 1933, Rosevelt temporaryilysuspended the convertibility to gold and let Dollardepreciate substantially. When US went back on

gold at the new higher price of gold, large quantitiesof gold flowed in and caused expansion of moneysupply. The expansion of money brokeexpectations of deflation.


7/59

7

Fed Rate


8/59

8

Bank bailouts


9/59

9

Budget Balance and Monetary Base

2. Hoovers Federal budget was largely balanced;budget deficit in the current crisis is 8-10 percentof GDP.

Friedman and Schwartz (1963) claim that,during the first three years of the greatdepression, the Fed tolerated and evenreinforced a substantial shrinkage of the money

The monetary base was flat during 1929-33; itwas doubled during 2008


10/59

10

Monetary institutions

3. There are two important differences in

monetary institutions:

First there was no banking depositinsurance at the time. As a matter of fact

deposit insurance was introduced only after

Roosevelt became president in March 1933


11/59

11

Gold Standard

4. US was in the great depression on the gold thestandard. The maintenance of a fixed parity withgold collided with the use of monetary policy to

offset domestic unemployment during the firstthree years of the great depression. For thisreason the US abandoned the gold standardunder Roosevelt. Obviously, since the $ is

floating vis--vis other major currencies, no suchconstraint operates in the current crisis.


12/59

12

Contractionary Policies under theGold Standard

Central banks discount rates in the US, UK andGermany, in the late 1920s and early 1930swere pushed up to prevent gold leakages. Thegood news is that we donot have the GoldStandard now. But East European countries incrisis are now jacking up interest. Especiallythose who are trying to enter the Euro zone.


13/59

13

Great Depression


14/59

14

Informational capital

4. Fourth, the fact that a relatively large number ofbanks disappeared during the great depressionled to the destruction of banking informational

capital about the credit worthiness of potentialborrowers


15/59

15

The global recession: new phase

Sovereign debt crisis in Europe, US slowlyrecovers and emerging markets aregrowing.


16/59

16

Global imbalances


17/59

17

Greece

Greece accounts for lessthan3 per cent of theeurozone economy.

There is also a precedent.

Hungary, Latvia and Romaniahave all won

EU and InternationalMonetary Fund backing,albeit with tough conditions

attached.


18/59

Spreads

18


19/59

19

Greece

Greece

accounting for less than

3 per cent of

the euro-zoneeconomy


20/59

20

Spain, Portugal or Greece cantdevalue to restore lost competitiveness

But, the UK canregain its

competitiveness.


21/59

21

European Bailout Facility

is not easily tapped

By being members of the EMU, Spain, Portugaland Greece

surrendered their ability to extend liquidityunilaterally.


22/59

22

Optimum Currency Area

benefits in the form of lower transaction costs and of thedisappearance of currency risks, and cross country creditpossibilities.The costs

inability of national governments and central banks to pursue

independent monetary policies to stabilize the economy andtheir financial sectors.

The extent to which the loss of this policy instrument will affectthe adjustment to equilibrium after a financial shock dependson

(1) the degree of flexibility of factor markets and the nature of theshocks hitting the economy: the more rigid factor markets andthe more country-specific the shocks, the more important willbe the loss of monetary autonomy.

(2) The extent of inter-government fiscal and bank andgovernment debt bailout cooperation.


23/59

If factors of production are not

sufficiently mobile, asymmetricshocks result in high costs ofadjustment, in terms of higher

unemployment in a singlecurrency area. If there is no inter-government fiscal coordination,

the post shock recession isexacerbated.

23


24/59

24

But, the euro-zone is not OCA

(1) Conflicting national fiscal policies

(2) Uncorrelated internal and external shocks


25/59

25

Sovereign Debt

But with similar debt burden spreads are high forItaly (a member of the Eurozone) but low for UK(not a member of the eurozone)


26/59

26

Euro-zone Debt : low average but

highly heterogeneous

Some countries like Greece and Italy havevery high public debt levels, others such asIreland and Spain have public debt levelsthat are increasing fast. This situation hasraised concerns about the capacity of thesecountries to continue to service their debtsin an environment of low economic growth. Amajority of countries in the Eurozone,however, experience a debt dynamics that isbenign certainly when compared to the US(and also the UK).


27/59

27

Sovereign Debt Acrossthe Euro Zone:


28/59

10 year government bondspreads

28


29/59

29

Intra Euro-zone DifferencesSome countries like Greece and Italy have veryhigh public debt levels, others such as Irelandand Spain have public debt levels that areincreasing fast.A majority of countries in the Euro-zone,

however, experience a debt dynamics that isbenign certainly when compared to the US (andalso the UK).Given the overall strength of the government

finances within the Eurozone it should havebeen possible to deal with a problem ofexcessive debt accumulation in Greece, whichafter all represents only 2% of Euro-zone GDP.


30/59

peripheral euro-zone countries

Two-Speed Recovery

30


31/59

31

The Heart of the Problem

The heart of the problem is that the Euro-zone isa monetary union without being a political union.In a political union there is a centralized budget

that provides for an automatic insurancemechanism in times of crisis.


32/59

Ireland Austerity and DebtReduction

32

GNP shrinks 0.5 per cent in2010, after declines of 10.7per cent in 2009 and 3.5per cent in 2008. The debtto GDP ratio is also set toclimb to 87 per cent by the

end of 2010, above theeurozone average of 85 percent.


33/59

33

Insufficient political union

behind the Euro

A weak political union in which the monetaryunion should can be embedded.

Such a political union should ensure thatbudgetary and economic policies arecoordinated, preventing the large divergencesin economic and budgetary

It implies that an automatic mechanism offinancial transfers is in place to help resolvefinancial crises.


34/59

34

No Insurance Mechanism

Insurance can be organized using the techniqueof a monetary fund that obtains resources fromits members to be disbursed in times of crisis

(and using a sufficient amount of conditionality).


35/59

35

How to reduce relative costs andregain competitiveness

What makes Greek problems so intractable isthe fact that theres little hope for growth for

years to come, because Greek costs and pricesare out of line and will need years of painfuldeflation to gain its competitiveness.

Spain wouldnt be in trouble at all if it werent forthe fact that the bubble years left its costs toohigh, again requiring years of painful deflation.


36/59

36

Estonia as a model ofinternal devaluation?

Estonia is being hailed for its fiscalconsolidation, to qualify for entry into the euro.

Latvia is often cited as an example for Greeceas it undergoes a brutal internal devaluation -wage cuts, while keeping its currency pegged tothe euro.


37/59

37

Effects of drastic fiscal adjustments


38/59

38

$ 950 billion (Eurozone plus IMF) bailout

fundBut, rolling over debt cannot solve the problemof insolvency

Greek primary deficit is hugeGreek austerity program will generate amedium term rise in Greece sovereign de

Even if Euro depreciates Greecescompetitiveness does not change vis a vis itseurozone counterparts


39/59

39

New fund authorized toborrow up to440bn to

lend to eurozonecountries frozen out of the

credit markets.


40/59

40

Strings attached and

market confidence

But only Germany and France have a triple Astatus in backing this fund.

Loans to borrowers need to be approved by -borrowers countries parliaments

A difficulty because with loans there are stringsattached, such as labor market reforms


41/59

41

The mechanism for

Eurozone rescue package

A special purpose vehicle, capable of raising

440 Bn euros is backed by member state

individual guarantees, by all 16 members of theEurozone.

Assistance is provided to failing countries only ifa restructuring program is agreed with the

country.


42/59

42

ECB Policy and Bond Yields

One part of the billion750 euro rescue plan wasthe European Central Banks decision to buy

eurozone government bonds to stop the

relentless rise in government bond yields of theweaker economies on the monetary unionperiphery


43/59

43

But, yields went up


44/59

44

A possible breakdown in the euro?

An alternative explanation for the depreciation ofthe euro is the fear of a breakdown of the singlecurrency itself. In order to avoid having to bail-

out weak Eurozone countries through debtmonetization, the strong countries might pushthe weak ones outside the Eurozone.


45/59

45

Will the entire Euro enterprise

collapse?

The answer is no. The decision to join the euroarea is effectively irreversible. Exit is

effectively impossible


46/59

46

Reasons

A country that leaves the euro area because ofproblems of competitiveness would be expectedto devalue its newly-reintroduced nationalcurrency. But workers would know this, and the

resulting wage inflation would neutralize anybenefits in terms of external competitiveness.Moreover, the country would be forced to payhigher interest rates on its public debt. Theprivate-sector balance sheet effects , causing

defaults, will create massive bank runs, as inArgentina in 2001.


47/59

47

More reasons

A second reason why members will not exit, it isargued, is the political costs. A country thatreneges on its euro commitments will

antagonise its partners. It will not be welcomedat the table where other European Union-relateddecisions were made. It will be treated as asecond class member of the EU to the extent

that it remains a member at all.


48/59

48

Why is the euro depreciating?

A concern that the crisis spreads to other largeEurozone countries. Even if Greece can bebailed out by other countries in the Eurozone,

this would not be feasible for the much largerpublic debts of Italy, Spain, and Portugal. But therisk of monetization of the public debt by theECB becomes more concrete.


49/59

49

Global Imbalances and Saving Glut

Ben Barnanke (2005), The Global Saving Glutand the U.S. Current Account Deficit, offered a

novel explanation for the rapid rise of the U.S.

trade deficit in the early 21st century. Thecauses, argued Bernanke, lay not in America butin Asia.


50/59

50

Global Picture (Continued)

In the mid-1990s, Bernanke pointed out, theemerging economies of Asia had been majorimporters of capital, borrowing abroad to finance

their development. But after the Asian financialcrisis of 1997-98, these countries beganprotecting themselves by amassing huge warchests of foreign assets, in effect exporting

capital to the rest of the world.


51/59

51


Most of the Asia cheap money went to theUnited States- hence our giant trade deficit,because a trade deficit is the flip side of capitalinflows. But as Mr. Bernanke correctly pointed

out, money surged into other nations as well. Inparticular, a number of smaller Europeaneconomies experienced capital inflows that,while much smaller in dollar terms than the flows

into the United States, were much largercompared with the size of their economies.


52/59

52


wide-open, loosely regulated financial systemscharacterized the US shadow banking system andmortgage institutions, as well as many of the otherrecipients of large capital inflows. This may explainthe almost eerie correlation between conservativepraise two or three years ago and economic disastertoday. Reforms have made Iceland a Nordic tiger,declared a paper from the Cato Institute. HowIreland Became the Celtic Tiger was the title of oneHeritage Foundation article; The Estonian

Economic Miracle was the title of another. All threenations are in deep crisis now.


53/59

53


For a while, the inrush of capital created the illusionof wealth in these countries, just as it did forAmerican homeowners: asset prices were rising,currencies were strong, and everything looked fine.

But bubbles always burst sooner or later, andyesterdays miracle economies have become

todays basket cases, nations whose assets have

evaporated but whose debts remain all too real. And

these debts are an especially heavy burdenbecause most of the loans were denominated inother countries currencies.


54/59

54

Global Picture (end)

Nor is the damage confined to the originalborrowers. In America, the housing bubblemainly took place along the coasts, but when thebubble burst, demand for manufactured goods,

especially cars, collapsed - and that has taken aterrible toll on the industrial heartland. Similarly,Europes bubbles were mainly around thecontinents periphery, yet industrial production inGermany - which never had a financial bubble

but is Europes manufacturing core - is fallingrapidly, thanks to a plunge in exports.

China US trade imbalance and


55/59

China-US trade imbalance andthe revaluation of the Renminbi

55

markets due to expansionary


56/59

markets due to expansionarymonetary policy in developed

economies

56

Carry trade induces capital


57/59

Carry trade induces capitalflows

57

raz out orea an


58/59

raz , out orea anIndonesia Impose capital

controls

Developed countries loose monetarypolicy drives capital into emergingmarkets.

Emerging markets start imposing capitalcontrols

China Yuan islikely to strengthen

58

Emerging markets capital


59/59

Emerging markets capitalinflows

59

euro crisisebajuly7 2010

Documents