the euros three crises

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The Euro’s Three Crises Sub regional meeting May 2 2013 •A banking crisis •A sovereign debt crisis •A growth crisis Interdependence!

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Overview of the three crises in the Euro zone

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Page 1: The Euros Three Crises

The Euro’s Three CrisesSub regional meeting May 2 2013

• A banking crisis• A sovereign debt crisis• A growth crisisInterdependence!

Page 2: The Euros Three Crises

The banking crisisInitial problems

• The size of euro zone banks– 300% of GDP vs. 100% in the US, ING

• Corporate reliance on banks• Cross-border banking• No supervision at euro zone level• No statutory lender of last resort• No euro zone bank rescue facility

Page 3: The Euros Three Crises

The banking crisisUS subprime contagion

Page 4: The Euros Three Crises

The banking crisisHesitant ECB reaction (39% vs. 210%)

Page 5: The Euros Three Crises

The banking crisis

How the two other euro zone crises worsen it:

• The growth crisis– Weak economy and falling asset prices damage

banks’ balance sheets

• The sovereign debt crisis– Sovereign defaults bankrupt banks with sizable

sovereign debt holdings

Page 6: The Euros Three Crises

The sovereign debt crisisMixed initial conditions

Page 7: The Euros Three Crises

The sovereign debt crisisLoss of confidence in 2010

Page 8: The Euros Three Crises

The sovereign debt crisisMarkets punishing fiscal profligacy?

Page 9: The Euros Three Crises

The sovereign debt crisisMarkets fearing unsustainability?

Page 10: The Euros Three Crises

The sovereign debt crisisMarkets punishing public and private indebtedness

Page 11: The Euros Three Crises

The sovereign debt crisisThe problem of dual equlibria

• ”Good” equilibrium: A virtuous circleTrust → Low interest rates → Small budget deficit → Sustainable public debt → Trust…

• ”Bad” equilibrium: A vicious circleLack of trust → High interest rates → Large budget deficit → Unsustainable public debt → Lack of trust…

Page 12: The Euros Three Crises

The sovereign debt crisis

How the two other euro zone crises worsen it

• The banking crisis– Risk of bank failures leads to higher expected

public debt as a result of bank support

• The growth crisis– Weak growth raises debt/GDP ratios via higher

budget deficits and lower GDP

Page 13: The Euros Three Crises

The growth and competitiveness crisis

Page 14: The Euros Three Crises

The competitiveness crisisHard to compete on foreign markets

Page 15: The Euros Three Crises

The competitiveness crisisHard to compete on domestic markets

Page 16: The Euros Three Crises

The growth crisisFiscal austerity leads to lower growth

Page 17: The Euros Three Crises

The growth crisisWeak banks are reluctant to lend

Page 18: The Euros Three Crises

The growth and competitiveness crisis

How the two other euro zone crises worsen it

• The banking crisis– Weak banks with higher capital requirements slow

growth through reduced lending

• The sovereign debt crisis– Austerity measures imposed to reduce budget

deficits weaken aggregate demand via lower public spending and lower disposable income

Page 19: The Euros Three Crises

The euro zone’s three crises:Many vicious circles

Page 20: The Euros Three Crises

Solving the euro crisisShambaugh’s suggestions

• Fiscal devaluation plus fiscal revaluation• Monetary policy: Quantitative easing• Recapitalization of banks• Fiscal expansion in solid countries• Banking union– Supervisory agency– Deposit insurance– Bank resolution agency

Page 21: The Euros Three Crises

Solving the euro crisisOther suggestions

The dream solution: Economic growthThe Baltic solution: All at onceThe dissolution solution: Back to square 1The Soros (1) solution: Germany leavesThe default solution: Sovereign defaultThe Soros (2) solution: EurobondsThe realistic ”solution”: Muddling through

Page 22: The Euros Three Crises

The dream solution: Growth

Higher GDP growth leads to:• Less need for public spending + higher tax

revenues = Lower budget deficits• Lower debt/GDP ratios• Less private defaults = stronger banksBut unachievable because:• Low competitiveness = low foreign demand• Austerity measures = low domestic demand

Page 23: The Euros Three Crises

The Baltic solution: All at once

• Nominal wage cuts• Public spending cuts• Migration• Political consensus

Too late for euro zone

Page 24: The Euros Three Crises

The Baltic solution25% public wage cuts

Page 25: The Euros Three Crises

The Baltic solution:Rapid gain in competitiveness

Page 26: The Euros Three Crises

The Baltic solution: Migration

Page 27: The Euros Three Crises

The Baltic solution:Steady growth from a lower level

Page 28: The Euros Three Crises

The dissolution solutionHow it works

• Exchange rate depreciation leads to rapid gain in competitiveness

• Increased competitiveness leads to export led growth• Export led growth leads to higher employment• Higher employment leads to reduced deficits• Lower interest rates lead to stabilized asset prices• Stable asset prices lead to financial stabilityThis was Sweden’s and Finland’s way out of the crisis

Page 29: The Euros Three Crises

The dissolution solutionIs it so unrealistic?

Page 30: The Euros Three Crises

The Soros (1) solutionHow it works

• Germany leaves the euro• The D-mark appreciates• The euro depreciates• Remaining euro zone rapidly gains

competitiveness and goes for the growth solution via export led growth

Economically interesting - politically unrealistic

Page 31: The Euros Three Crises

The sovereign default solution

• Countries with unsustainable public debt enter orderly default proceedings

• Partial debt cancellation, debt restructuring, moratorium

• Defaulted creditors (too big to fail) saved via nationalization

• End of austerity measures – resumed economic growth

Economically interesting - politically possible?

Page 32: The Euros Three Crises

The sovereign default solutionWhich countries?

Page 33: The Euros Three Crises

The Soros (2) solution: EurobondsHow it works

• Pooling of all existing euro zone public debt• = Pooling of all national sovereign risk• = Lower borrowing costs• = Lower budget deficits• = Existing debt sustainable• Conditions on further Eurobond borrowing

Page 34: The Euros Three Crises

The realistic solutionMuddling through

• Continued austerity measures to reduce budget deficits

• Structural policies to raise aggregate supply• Reduced demand and increased supply lead to– Stagnating GDP– Rising debt/GDP ratios– Higher unemployment– Financial instability

Realistic – but politically dangerous

Page 35: The Euros Three Crises

Thank you for your attention!