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7. EMU: the road to the crisis

7. EMU: the road to the crisis. The global financial crisis as a trigger Default risk , interest rates , house prices , demand growth Competitiveness : is internal devaluation possible ? Monetary policy Austerity and growth ( or lack of it ).

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7. EMU: the road to the crisis

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  1. 7. EMU: the road to the crisis • The globalfinancialcrisis as a trigger • Defaultrisk, interestrates, houseprices, demandgrowth • Competitiveness: is internaldevaluationpossible? • Monetarypolicy • Austerity and growth (orlack of it)

  2. The globalfinancialcrisis led to concernabout the defaultrisk • The globalfinancialcrisisstarted in the summer of 2007 with concernsabouthousefinancing in the US (”subprimemortgages”), whichinvolvedcomplexinstruments, the consequences of whichwerepurelyunderstood at the time • The crisiseruptedafter 15.9. 2008, when Lehman Brothers wereallowed to gobankrupt, whichtriggeredlarge-scalepanic on globalfinancialmarketswithinweeks. One consequencewasrenewedawareness of financialrisks and higherrisk version • Graduallyinvestorsrealizedthattheyhadoverextendedtheirlending to certaincountries, notleastGreece; fear of creditlosses led to sharpincreases in yields on Greekbonds, causinglosses to bondholders (includingbanks) • Also, investorsstarted to realizethathouseprices in Ireland and Spain mightstartfalling, undermining the financialstability of the creditors (banks with highleverage) • Concernabout the health of banksraisedriskpremia in the interbankmarket, thusundermining the functioning of a keypart of the financialsystem • Banks, concernedabouttheirliquidity and solvency, wanted to reduceleverage, implyingreducedwillingness to lend (”creditcrunch”) • Concernabout the financialhealth of banks, notably in Ireland and Spain, causedconcernabout the financialsustainability of the sovereign (given the role of the government in providing the ultimateguarantee of the bankingsystem); also, concernabout the sustainability of publicfinances, e.g. in Greece and Portugal, causedworriesaboutbanks (samereason) • All of theseconcernsfedeachotherbothwithincountries and acrossborders

  3. 10 yeargovernmentbondyields Interestratespreads (differences) used to berather big because of inflationdifferentials and exchangerateexpectations. EMU largelyeliminatedsuchexpectations. Recentlyspreadshavebeencausedby the risk of default of governments. Greece Italy Spain Irland Finland Germany 1995 2000 2005 2010

  4. The budgetdeficits and debts in UK, US and Japan arebiggerthan in the euro areabutinterestrates on governmentbondsaremuchlower: thesecountrieshave a lender of lastresort (the centralbank)

  5. Economicdevelopments in PIIGS- and FANG-countries before and after the crisis: 1=average, 2=cumulative, 3=ditto, 4=average, 5=cumulative, 6=relative to GDP, average, 7=relative to GDP, average, 8=average PIIGS-cies FANG-cies 1999-2008 2009-2013 1999-2008 2009-2013 1. Real interestrate 2. Credit expansion 3. House prices 4. Domesticdemand 5. Unitlaborcost 6. Currentaccount 7. Budgetsurplus 8. GDP growth 9. Unemploymentrate 1.5 295.6 109.1 2.4 34.0 -5.4 -2.4 3.1 8.0 5.6 -4.1 -19.9 -2.7 -3.9 -3.1 -8.8 -2.0 15.4 2.4 96.8 52.9 1.8 13.6 3.9 -0.1 2.4 6.4 0.7 9.0 11.6 0.0 12.0 4.0 -2.9 0.0 5.9 Lähteet: OECD, Eurostat, AMECO, NIESR, ETLA. Sixten Korkman: EURO – Valuutta vailla valtiota.

  6. Crisis: a typicalpattern Rapidcreditexpansion, risingasset (e.g. realestate) prices, euforia Bad news, bubblebursts, creditlosses, feartakeshold BANKING CRISIS Credit crunch, deeprecession, fallingtaxrevenues, banksupport PUBLIC DEBT CRISIS

  7. Averagenominal and realinterestrates in 2009-2012 Whilethere is no relationbetween the rate of inflation and the realinterestrate, the nominal and realinterestratesarenowstronglycorrrelated. GRE BEL AUT FIN

  8. Real interestratesand averageincrease in houseprices 2009-2012 Highrealrates of interest no doubtcontributed to the sharpfall in the level of houseprices in Ireland, Spain and Greece BEL

  9. Averagerealinterestratesand cumulativegrowth of domesticdemand in 2009-2012 The crisiscountrieshavesufferedfromquitelargereductions in domesticdemand (bothprivate and public) GER

  10. Domesticdemandgrowthand change in competitiveness 2008-2012 Sharplyfallingdomesticdemandhascontributed to someimprovement in competititiveness in the crisiscountries

  11. Competitiveness and the currentaccount (% of GDP)change 2008-2012 Improvedcompetitivenesshaspresumablycontributed to the reduction in currentaccountdeficits in the crisiscountries. Also, lack of growth of domesticdemandhasimprovedboth the currentaccount and competitiveness. IRE

  12. Domesticdemand and the currentaccount (% of GDP)changefrom 2008 to 2012 Fallingdomesticdemandnaturallyimproves the currentaccount

  13. Summary of the preceding • The globalfinancialcrisis led to a reconsideration of risks, whichgraduallyincreasedriskpremia for governmentbondsissuedby the PIIGS, in somecasesdramatically • The interbankmarketwasquitestrained in certainperiods (late 2008 and again in late 2011) • Countries with highrealinterestratesexperiencedsharpdeclines in houseprices and in overalldomesticdemand • Weakdemandwasassociated with improvedcompetitiveness, betterexports (to someextent) and notablyimprovements in the currentaccount • The developmentsince 2008-2009 hasbeenlargely the reverse of developments in 1999-2008: whatgoesup, comesdown (boom-bustcycle and now a bankingcrisis, a sovereigndebtcrisis and largecurrentaccountimbalances)

  14. 7.4 Monetary policy: Central bank policy rates- interest rates are roughly as low as you get Riksbank ECB Allcentralbankshavetakendowntheirlendingrates as low as youget (roughly) butnotbelowzero.

  15. Central bank balance sheets (expanding as a consequence of “quantitative easing”) Eurosystem Fed Riksbank Central bankshavebeenbuyingvariouskinds of financialassets,notablygovernmentpaper

  16. Table Fiscalpolicytightning 2009–2013 Fiscalpolicy tightning(1) Budget Deficit (2) Output growth(3) Public debt to GDP(4) Budget 2013 (5) Greece Irland Portugal Spain Italy Germany Finland Euro area -19.9 -7.6 -6.3 -7.5 -4.0 -1.3 +0.2 -4.3 -11.5 -6.4 -3.8 -4.3 -2.4 -2.9 -0.4 -3.4 -23.2 2.5 -5.6 -3.0 -2.0 8.4 5.9 2.3 45.4 58.8 48.8 34.9 13.5 10.4 14.4 18.1 4.1 7.5 3.4 6.9 3.0 0.2 2.3 3.0 Cyclicallyadjustedbudgetbalancerelative to GDP, changefrom 2009 to 2013 (- = tightning) General governmentfinancialdeficitrelative to GDP, changefrom 2009 to 2013 (- = getssmallre) Cumulative GDP growth 2009 to 2013 Grosspublicdebtrelative to GDP, changefrom 2009 to 2013 (5) General governmentfinancialdeficit 2013. Lähde: OECD. Sixten Korkman: EURO – Valuutta vailla valtiota.

  17. Real GDP in selectedEA-countries, 2007 = 100

  18. Unemploymentrates in selectedEA-countries(% of labour force)

  19. Interestrates and austerity(change in cyclicallyadjustedbudgetbalance 2010-2012) Thosecountriesthathad to face the highestinterestrates, were the samecountriesthatpursued the mostcontractionaryfiscalpolicies – voluntarilyorordered to dosoby the troika.

  20. Austerity and cumulative GDP growth in 2009-2012(austerity = change in cyclicallyadjustedbudgetbalance) Austerity is bad for growth, at least in the timespanhereconsidered IRE GRE

  21. Austerity and fiscalconsolidation(change in CABB and increase in gen. gov. financialsurplus) However, austerity is notself-defeating, in the sensethatit is stillimproving the overallbudgetbalance , though the improvement in the latter is typicallysmallerthan in the former

  22. Somequestions • Whydidgovernmentbondyieldsrisestarting in 2009 in a number of euro areacountries? • Whatwere the main drivers of the debtcrisis? • How did the ECB react to the crisis? • Didfiscalpolicythightningachieveitsdesiredeffects in 2009-2013 in the euro area? • Austerity: blessingorcurse?

  23. What went wrong? • The euro area debt crisis was not caused by the global financial crisis, though it was triggered by it: EMU was anyway heading for a debt crisis, which just waited to materialize, for several reasons: • generic problems • 1) deficit bias in public finances • 2) inherent instability associated with modern finance (occasionally excessive leverage causing boom and bust) • 3) lack of balance between global economy and local/national politics • flaws in the set-up of EMU • 1) the no bailout rule was not made operational and all sovereign bonds were treated as risk free (by the BIS and ECB) • 2) no lender of last resort for sovereigns, risk of “multiple equilibria” • 3) reform of labor markets was insufficient or lacking • 4) strong links between national sovereigns and banks proved dangerous • specific mistakes (avoidable) • 1) membership in the euro area became too encompassing • 2) the SGP was not respected (the fiscal rules) • 3) no action was taken to strengthen the banking system • 4) countries in the South misused the fall in interest rates (and debt service) by increasing public and private spending

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