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The Eurozone Financial Crisis


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 ... – PowerPoint PPT presentation

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Title: The Eurozone Financial Crisis

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
  • 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
  • Greeces 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

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

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
  • Falling demand spread from US to all countries
    as US imports dropped, other countries exports

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
  • Icelands 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 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
Greeces 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
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.

Greeces Debt Dynamics
  • Cautious Eurozone response to Financial Crisis
  • Interest rate policy reaction delayed
    concentration on inflation target
  • Fiscal policy reaction muted Stability Growth
  • 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.