What caused the Eurozone crisis?

Lecture to 3rd year ‘Current Economic Problems’ group, Spring 2015, Bristol

Tony Yates

Overview of the topic

• What caused the crisis? [this lecture]– Requiring us to characterise what the crisis was

and how it unfolded

• Evaluating how Eurozone authorities have responded to the crisis [2nd lecture]– Unconventional monetary policy, Troika and

limited debt forgiveness, OMTs, banking union, QE, no fiscal stimulus, ‘structural reform’

Reading

• Reading list for this topic on my homepage• Karl Whelan lecture• Brugel think tank survey.• Piece by the infamous conservative Hans

Werner Sinn putting the ‘German view’.• Commission of investigation into the banking c

risis in Ireland• Obstfeld [Pioneer of open economy macro

and finance] review.

What caused the EZ crisis

• Characterising the crisis:– Political origins of and context to EMU– Economic gains envisaged for EMU– Macro-financial received wisdom before the crisis– Low-frequency crisis ‘timeline’

Crisis diagnoses, 3 views

• Mainstream view• Two dissident views, considered briefly at the

end:– Dissident, freshwater view– Bank for International Settlements view

EMU and EPU, post-war nation building

• EMU in part a political project to entrench European union and continental peace.

• A way to end destructive, zero-sum fighting between European nation states.

• Realise an alternative to reliance on US defence umbrella in face of perceived Soviet threat.

• Lock in and enhance democratic and institutional gains from transition out of dictatorship of Spain, Portugal, Greece + later Communist bloc countries.

• Lead to certain willingness to overlook or colour economic benefits of monetary union?

Those econ benefits of EMU

• Enhance benefits of price-transparency of the European single market.

• Lock in Bundesbank mon pol credibility without sacrifice and credibility problem of FX pegging, removing inflation bias, and option of seigniorage.

• Further guarantee fiscal stability, having removed option of excessive deficit finance with the SGP.

• Old Mundel-Fleming idea of ‘Optimal Currency Area’.

Pre-crisis macro and financial received wisdom

• There would not be another global financial crisis.• Monetary policy and inflation targeting sufficient

to guarantee macroeconomic stability; responsible for ‘Great Moderation’

• Highly active fiscal stabilisation not needed, and in fact hazardous. Automatic stabilisers ample.

• Fiscal union anyway not possible, yet. Monetary union a stepping-stone.

• We would not hit the zero bound, as Japan did.

Perils of catch-up

• Poor periphery growing fast, large current account deficits, borrowing to finance real estate boom too.

• Inflation higher than North, one monetary policy.

• Banking system sucking in the borrowing running up large, undiversified risks, prudential systems overwhelmed.

Borrowing to catch up.

Source: Karl Whelan

Catching-up sovereigns

• Peripheral sovereigns benefit from common borrowing rates post EMU.

• SGU implementation patchy.– Laxity tolerated to expand the union– Some data manipulation by peripherals– Failure to appreciate implicit financial risks to sovereigns posed by

financial sector• Understatement of structural deficits• Under-appreciation of chance of sovereign spreads opening up

again• Over-estimate of fiscal solidarity implied by the narrow spreads

Credibility bonanza for peripheral sovereigns

Source: Karl Whelan

German political/economic context

• Conservative approach to use of monetary policy for smoothing the business cycle

• Likewise belief in fiscal prudence• Both partly bi-products of experience of pre-

war hyperinflation and monetary financing. ‘Never again!’

• ECB adopts conservative ‘price stability’ mandate to conform to German constitution

Northern sovereign misdemeanours

• Not all countries abide by SGP themselves, so enforcement on South weakened

• They, in part, via their own banks, are engaged in lending – to Southern sovereigns, and Southern banks

• Their own banking systems not prepared for the closure of wholesale funding and securities markets

• Sovereigns strained by potential banking failure, and operation of automatic stabilisers.

US sub-prime crisis trigger• Losses on ‘sub-prime’ mortgages mounted in US.• Eventually triggered collapse of ABS markets. No-one knows

what a security leaves you on the hook for. • This triggers collapse of wholesale intermediary funding markets.

No-one knows who is exposed to what, so better safe than sorry and not lend.

• Banks can’t fund loans, so need to shrink lending. Loans turning bad, worsening funding prospects. Vicious circle. Fire-sales of property causing prices to fall. Contraction of credit hits firms and consumers, demand falls, more loans stop performing…

• Contagion across countries via international wholesale funding market for banks and other intermediaries.

Greece: context

• Another fast catch-up country. Easy to overdo expectations of end-point.

• No pressure for structural reform.• Bloated public sector workforce; endemic tax

evasion.• Long history of dysfunctional state. Ottoman

occupation breeds distrust of centre, custom of evading taxes; get bad public goods in return, cycle repeats.

Greece: crisis

• Greece: recession hits, Greek banks struggling for funding, govt bond yields soar due to expectation they have to stand behind those banks.

• Increase in bank/govt funding rates make collapse self-fulfilling.

• Deposit flight from banks, credit crunch, fiscal tightening from automatic stabilisers.

Ireland – pre-crisis

• Irish current account deficit mirrors rise in wholesale funding to Irish banks.

• They are borrowing to finance their client’s commercial and residential property borrowing..

• Some charts….

Irish current account ‘imbalance’

Source: IMF Article IV on Ireland, 2007

Could be borrowing to finance genuinely higher future income.

Actually we’ll see that it’s borrowing wholesale by banks….

Bank wholesale funding in Ireland

Source: IMF Article IV on Ireland, 2007

Ratio of deposit to loan ratio falls, implying wholesale funding is rising.

Wholesale funding is very short term, and highly mobile.

Deposits, although short term, are usually, outside of a crisis, very sticky.

Commercial property lending in Ireland

Source: Commission of investigation into the banking sector in Ireland, 2011

Commercial property unusually risky as has a very volatile price.Fast build up in both kinds of property lending strains risk management in banks, and prudential standards in the regulator.

Commercial property lending in Ireland and other countries

Source: IMF Article IV on Ireland, 2007

Ireland much more exposed pre-crisis to this peculiarly risky form of lending – commercial property.

Why are commercial property prices more volatile?

Perhaps because commercial property volatile because firm value is volatile.

Ireland-crisis breaks

• Banks in crisis: govt hastily announces 100% deposit guarantee.

• But it’s a bluff as govt can’t afford it. Markets call government’s bluff and un from government bonds.

• Govt can’t roll over its short maturity debt.• Has to be bailed out by Troika [IMF/EU/ECB]• Analyse the bail outs in the next lecture.

Spain, Italy

• These countries are large, and are the ones that really matter.

• Prob no-one cares about Ireland, Portugal, Greece! Too small.

• But how they are/were dealt with affects how markets will value Spanish and Italian bank and sovereign assets.

Italy

• Long stagnation.• Endemic structural govt deficits.• Uncompetitive, over-regulated product and

labour markets.• Tax evasion, systemic extra-state [organised

crime] activity, bad public goods in return.• Central state young and dysfunctional.• Bad position to weather large recession and

banking crisis.

Spain• Very fast catch-up, pre-crisis. Country held back previously by

Franco dictatorship, economic isolation.• Public finances in good shape before 2008. Even had ‘dynamic

provisioning’ ‘macro-pru’ for banks.• [DP=find more equity-based funding, which you don’t have to

‘pay back’ if your loan book increases a lot].• But still sunk by scale of property boom and bust and its effect on

banks and the real economy.• Inflexible labour markets; extra-state social security network;

Italy-like problems of product market regulation, tax-evasion.• Govt avoided bail out, but only just, thanks to OMTs, which we

will discuss in the next lecture.

Spreads reopen

Private debt crisis socialised via implicit and explicit guarantees.Markets question commitment of North to keeping Euro together.Spreads fall after Draghi’s ‘whatever it takes’Speech on OMTs.

Source: Karl Whelan

Crisis increased correlation of bank and sovereign credit default swap spreads, on account of govt inability to fund implicit or explicit bail-outs.

Source: Merler and Pisanni-Ferry (2012), BdF.

The crisis – freshwater dissident view

• ‘Freshwater’ derives from – associated with universities near the Great Lakes in US [eg Chicago]. [vs ‘saltwater’ – Berkeley, Harvard].

• Source of problem is implicit and explicit bail-outs and sclerotic supply-side.

• This is what generated accumulation of inappropriate risks. And the anticipated tax burden of the bail out is what is depressing demand now.

• Solution: don’t intervene.• Sooner you start the pain, sooner things improve.

Mainstream critique of the freshwater view

• Fwater view is that all fluctuations are efficient.

• This view at odds with the data on the effects of monetary and fiscal policy on the economy.

• Sticky prices, wages, financial frictions + more indicate role for stabilising inefficient cycles.

Cause of the crisis – BIS view

• Bank for International Settlements, Basel, Switzerland. Central bank for central banks, and a think-tank.

• Believed build up of real risks in financial system, increase in asset prices, should have been dealt with by monetary policy.

• Central banks instead followed inflation targets too slavishly.

BIS view of the crisis -ctd

• Identified low nominal rates as cause of build up in risk: ‘the risk taking channel’

• Investors [that’s banks too] try to preserve nominal rates of return by moving into riskier assets.

• Form of ‘nominal illusion’ [they don’t appreciate real returns are not increasing].

Mainstream critique of the BIS view

• Their forecasts of doom were right, but are like ‘stopped clocks’, right eventually.

• Mon pol has effects only over shorter run.• Not responsible for 2-3 decade build up of risk

in the real economy.• Many other more promising culprits.

Mainstream diagnosis of the EZ crisis: Recap.

• Highly divergent trajectories of EZ economies suffered with common mon pol.

• Stability and growth pact [SGP] failed to discipline fiscal authorities.

• Fiscal authorities failed to appreciate or prepare for implications of implicit bailouts in event of a crisis; or for the automatic stabiliser impact in a crisis.

• Prudential failures on funding and lending side of banks, particularly -but not just- in periphery.

• No fiscal stimulus or transfer when it was needed.