The world financial instability and the Euro zone crisis - Chapter 1 Jacques SAPIR CEMI-EHESS

1. The world financial instability and the Euro zone crisis - Chapter 1Jacques SAPIRCEMI-EHESS

2. 0. Predecessors of the current crisis. • (A) The Savings and Loans crash of 1988-1992. • The causes and severity of the thrift crisis have been documented by scholars for more than a decade. Several reasons cited for the collapse include: • *High and volatile interest rates during the late 1970s and early 1980s, which exposed thrifts to the time FIRREA was passed two years later, FICO had contributed $8.2 billion in financing to the interest-rate risk (caused by a mismatch in duration and by interest-rate sensitivity of assets and liabilities);

3. *The phase-out and eventual elimination in the early 1980s of the Federal ReserveRegulation Q, which caused increasing costs of thrift liabilities relative to many fixed-rate assets and adversely affected industry profitability and capital; • *Adverse regional economic conditions; • *State and federal deregulation of depository institutions, which allowed thrifts to enter new but riskier loan markets; the deregulation of the thrift industry without a accompanying increase in examination resources (for some years examiner resources actually declined); • *Reduced regulatory capital requirements, which allowed thrifts to use alternative accounting procedures to increase reported capital levels; • *Excessive chartering of new thrifts during the 1980s; • *The withdrawal in 1986 of federal tax laws (enacted in 1981) that benefited commercial real-estate investments; • *The development during the 1980s of the brokered deposit market (early form of securitization); • *Delays in funding the thrift insurance fund during the 1980s and the RTC during the 1990s, which led to regulators failure to close many insolvent institutions in a timely manner.

4. The US government had to implement a bail out with - mostly - public money. Chronology of Thrift Crisis Events • December 31st, 1986: FSLIC insolvent • August 10th, 1987: FICO created to fund FSLIC • August 9th, 1989: Enactment of FIRREA and FSLIC abolished • FRF created (succeeds to FSLIC assets, liabilities, and operations) • SAIF created to handle thrift failures starting August 9, 1992 • RTC created to resolve thrifts placed into conservatorships or receiverships between January 1, 1989 and August 8, 1992a(RTC to cease operations December 31, 1996)b • REFCORP created to fund RTC • Note: • FSLIC Federal Savings and Loan Insurance Corporation ` • FICO Financing Corporation • FRF FSLIC Resolution Fund • SAIF Savings Association Insurance Fund • RTC Resolution Trust Corporation • REFCORP Resolution Funding Corporation

5. The bail-out cost (In Bln. USD)

6. (B) The 1997-1999 crisis (Korea-Russia-Brazil). • The crisis began in East-Asian economies. • It moved toward West and ended up in Brazil. • It has been mainly a crisis of FOREX reserves. • The crisis has been started by a devaluation in Taiwan. • The impact of over-indebtedness. • Inability of the IMF to stop the crisis. • South Korea: How the USA pushed out the IMF. • Malaysia vs. Indonesia. • The Russian case. • Brazil. • Hedge Fund and the LTCM Wall Street case.

7. (C) Enron and WorldCom (2001/2002) • A crisis of rating agencies. • How is rating done. • The circularity of the process. • The politization of the process. • Is rating an honest benchmark? • The issue of vested interest among rating agencies. • Rating and subcontracting. • Vested interests? • A warning signal ignored. • Rating IS important, but difficult to achieve. • But rating agencies are unreliable. • Why no lessons have been learned. • A “Moral Hazard” problem.

8. 1- A crisis to be expected, and its consequences

9. A. The Fundamentals of a currency union. • 1. R. Mundell initial positions. • Mundell, R. A. (1961). "A Theory of Optimum Currency Areas". American Economic Review51 (4):pp. 657-665. • From the optimum trade area to the optimum currency area. • Minimizing transaction costs. • Enforcing trade specialisation on a given zone. • The Mundell-Fleming model 1962-63 (a variant of IS-LM in an open economy). • Exchange-rate Dependency to interest rates (monetary policy) in a liberalized capital-flows system (the Unholly Trinity). But what if capital flow liberalization is deleted? • Lack of “economic power” of a small open country (no influence on other economies). • Important assumptions (Labour and Capital). • Capital is to be free to move. • Labour is to be free to move. • No strategic dependency between activities (as in newer model).

10. 2. The endogenous argument. • Currency union (Optimal Currency Area or Optimal Currency Region) as a self-fulfilling prophecy. • A currency union enhance trade and creates an optimum trade zone. Peter Kenen: Trade diversification. Ronald McKinnon: Wage flexibility. Robert Mundell: Homogeneous preferences • In an OCA: Stationary or Rationale expectations? • Michel Aglietta’s argument. • Centrality of money for economic behaviours. • The OCA creates by itself conditions for better trade integration (Frankel, Jeffrey A. & Rose, Andrew K. (2001). "The Endogenity of the Optimum Currency Area Criteria". The Economic Journal108, 2001, (449): pp. 1009-1025.)

11. 3. Theoretical problems. • Could a currency union exist without budget transfers? • Roy Jenkins’ speech of 1977 at the European Institute (Florence). • What economic federalism is teaching us? • The current problem of Germany. • Could a currency union exist without being backed by political legitimacy? • The strategy of achieving an economic union before à political union. • The strategy of fast enlargement. • Was Europe mistaken about its recent choices?

12. B. The Euro and the competitiveness problem • 1. Strong divergence of competitiveness levels among Euro zone countries. • A structural problem. • The “North-South” divide. • De-industrialisation. (Greece, Portugal, Spain) • The illusion of convergence? • The situation between 1998-2002. • Why convergence: • A monetary explanation. • A political explanation • How convergence failed. • The result.

15. 2. An increasing process since the 2002-2003 German “internal devaluation”. • The impact of German policies: “Harz IV” and “Agenda-2015”: • A transfer of financial charges from enterprises to households’ shoulders. • Impact on German export prices. • Impact on German internal demand. • Could the German policy be called a “lone rider” policy? • Germany “exploited” its dominant position in Europe by using low-cost countries to produce components to be assembled in Germany (Geographical advantage). • The concentration of German trade surplus on the Euro zone (between 60% to 65% of total German trade surplus). • Could this policy be duplicated by other European countries? • The cost of “internal devaluation” or deflanionary policies. • What would have happened if the German policy would have been adopted by all other european countries?

18. 3. A situation worsened by the Euro-USD exchange rate. • A process of re-evaluation since 2002. • A very step curve. • Speculation and the exchange rate: “subjective factors” of the exchange rate.. • Why is the Euro going down since summer 2011. • Could a single exchange rate work for heterogeneous countries? • The competitiveness issue. • The rate of change of productivity growth. • Estimating the level of equilibrium exchange rate. • France and the problem of the exchange rate. • The INSEE (French Goskomstat…) estimation. • What enterprises are saying. • Import and Export elasticity.

21. Conclusion: • Why the crisis was inevitable. • The race between crisis developments and political union. • The problem of French-German relationship.