1

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)

2

The global financial crisis led to concern about the default risk

The global financial crisis started in the summer of 2007 with concerns about house financing in the US (”subprime mortgages”), which involved complex instruments, the consequences of which were purely understood at the time

The crisis erupted after 15.9. 2008, when Lehman Brothers were allowed to go bankrupt, which triggered large-scale panic on global financial markets within weeks. One consequence was renewed awareness of financial risks and higher risk version

Gradually investors realized that they had overextended their lending to certain countries, not least Greece; fear of credit losses led to sharp increases in yields on Greek bonds, causing losses to bond holders (including banks)

Also, investors started to realize that house prices in Ireland and Spain might start falling, undermining the financial stability of the creditors (banks with high leverage)

Concern about the health of banks raised risk premia in the interbank market, thus undermining the functioning of a key part of the financial system

Banks, concerned about their liquidity and solvency, wanted to reduce leverage, implying reduced willingness to lend (”credit crunch”)

Concern about the financial health of banks, notably in Ireland and Spain, caused concern about the financial sustainability of the sovereign (given the role of the government in providing the ultimate guarantee of the banking system); also, concern about the sustainability of public finances, e.g. in Greece and Portugal, caused worries about banks (same reason)

All of these concerns fed each other both within countries and across borders

3

10 year government bond yields

0

5

10

15

20

25

30

Finland

Greece

Germany

Irland

1995 2000 2005 2010

Italy

Spain

Interest rate spreads (differences) used to be rather big because of inflation differentials and exchange

rate expectations. EMU largely eliminated such expectations. Recently spreads have been caused by

the risk of default of governments.

4

1/1/11 1/7/11 1/1/12 1/7/12 1/1/130.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

10-year Government Bond Yields in Selected Countries

Spain Italy UK USA Germany Japan%

Bloomberg, ETLA

The budget deficits and debts in UK, US and Japan are bigger than in the euro area but interest rates on government bonds are much lower: these countries have a lender of last resort (the central bank)

Economic developments in PIIGS- and FANG-countriesbefore 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

Sixten Korkman: EURO – Valuutta vailla valtiota.Lähteet: OECD, Eurostat, AMECO, NIESR, ETLA.

1. Real interest rate 2. Credit expansion 3. House prices 4. Domestic demand 5. Unit labor cost 6. Current account 7. Budget surplus 8. GDP growth9. Unemployment rate

1.5295.6109.1

2.434.0-5.4-2.43.18.0

5.6-4.1

-19.9-2.7-3.9-3.1-8.8-2.015.4

2.496.852.9

1.813.6

3.9-0.12.46.4

0.79.0

11.60.0

12.04.0

-2.90.05.9

1999-2008 2009-2013 1999-2008 2009-2013

PIIGS-cies FANG-cies

6

Crisis: a typical pattern

Rapid credit expansion, rising asset (e.g. real estate) prices, euforia

Bad news, bubble bursts, credit losses, fear takes hold

BANKING CRISIS

Credit crunch, deep recession, falling tax revenues, bank support

PUBLIC DEBT CRISIS

7

Average nominal and real interest rates in 2009-2012

0 2 4 6 8 10 12 140

2

4

6

8

10

12

Nominal interest rate

Real interest rate

GERNET

FRA ITA

SPA

POR

IRE

While there is no relation between the rate of inflation and the real interest rate, the nominal and real interest rates are now strongly corrrelated.

FIN

AUTBEL

GRE

8

Real interest rates and average increase in house prices 2009-2012

0 2 4 6 8 10 12-14-12-10

-8-6-4-20246

Real interest rates

House prices

FIN

GER

FRA

NET

ITA

GRE

SPA

IRE

BEL

High real rates of interest no doubt contributed to the sharp fall in the level of house prices in Ireland, Spain and Greece

9

Average real interest rates and cumulative growth of domestic demand in 2009-2012

0 2 4 6 8 10 12

-30

-25

-20

-15

-10

-5

0

5

10

Real interest rates

Demand growth

AUT BEL

FRAFINNET

ITA

SPA

POR

IRE

GRE

GER

The crisis countries have suffered from quite large reductions in domestic demand (both private and public)

10

Domestic demand growth and change in competitiveness 2008-2012

-30 -25 -20 -15 -10 -5 0 5 10

-25

-20

-15

-10

-5

0

Domestic demand, cumulative change

Change in competitiveness

IRE

GRE

SPA

POR

NET

ITAGERFR

A

FIN BEL

AUT

Sharply falling domestic demand has contributed to some improvement in competititiveness in the crisis countries

11

Competitiveness and the current account (% of GDP)change 2008-2012

-25 -20 -15 -10 -5 0

-6

-4

-2

0

2

4

6

8

10

12

Competitiveness

Currentaccount

GRE

SPA

POR

NET

ITA

GER

FRA

FIN

BEL

AUT

IRE

Improved competitiveness has presumably contributed to the reduction in current account deficits in the crisis countries. Also, lack of growth of domestic demand has improved both the current account and competitiveness.

12

Domestic demand and the current account (% of GDP)change from 2008 to 2012

-30 -25 -20 -15 -10 -5 0 5 10-6

-4

-2

0

2

4

6

8

10

12

Domestic demand

Currentaccount

GRE IRE POR

SPA

ITA NET

FIN

FRA

BEL

AUT

GER

Falling domestic demand naturally improves the current account

13

Summary of the preceding

The global financial crisis led to a reconsideration of risks, which gradually increased risk premia for government bonds issued by the PIIGS, in some cases dramatically

The interbank market was quite strained in certain periods (late 2008 and again in late 2011)

Countries with high real interest rates experienced sharp declines in house prices and in overall domestic demand

Weak demand was associated with improved competitiveness, better exports (to some extent) and notably improvements in the current account

The development since 2008-2009 has been largely the reverse of developments in 1999-2008: what goes up, comes down (boom-bust cycle and now a banking crisis, a sovereign debt crisis and large current account imbalances)

14

7.4 Monetary policy: Central bank policy rates

- interest rates are roughly as low as you get

ECB

Riksbank

All central banks have taken down their lending rates as low as you get (roughly) but not below zero.

15

Eurosystem

Fed

Riksbank

Central bank balance sheets (expanding as a consequence of “quantitative easing”)

Central banks have been buying various kinds of financial assets,notably government paper

TableFiscal policy tightning 2009–2013

Sixten Korkman: EURO – Valuutta vailla valtiota.Lähde: OECD.

GreeceIrlandPortugalSpainItalyGermanyFinlandEuro 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

-23.22.5

-5.6-3.0-2.08.45.92.3

45.458.848.834.913.510.414.418.1

Fiscalpolicy

tightning(1)

BudgetDeficit

(2)

Outputgrowth

(3)

Public debt

to GDP(4)

Budget2013(5)

4.17.53.46.93.00.22.33.0

(1) Cyclically adjusted budget balance relative to GDP, change from 2009 to 2013 (- = tightning)(2) General government financial deficit relative to GDP, change from 2009 to 2013 (- = gets smallre)(3) Cumulative GDP growth 2009 to 2013(4) Gross public debt relative to GDP, change from 2009 to 2013(5) General government financial deficit 2013.

17

Real GDP in selected EA-countries, 2007 = 100

2007 2008 2009 2010 2011 2012 2013 201470

75

80

85

90

95

100

105

110

GERFINSPAITAIREPORGRE

18

Unemployment rates in selected EA-countries(% of labour force)

2008 2009 2010 2011 2012 2013 20140

5

10

15

20

25

30

GERIREGRESPAITAPORFIN

19

Interest rates and austerity (change in cyclically adjusted budget balance 2010-2012)

0 2 4 6 8 10 12 14 16 18-1

1

3

5

7

9

11

13

15

17

19

Average interest rate in 2010-2012

Degree ofausterity

GRE

IREPOR

SPA

ITANET FRA

BELAU

TGER

FIN

Those countries that had to face the highest interest rates, were the same countries that pursued the most contractionary fiscal policies – voluntarily or ordered to do so by the troika.

20

Austerity and cumulative GDP growth in 2009-2012(austerity = change in cyclically adjusted budget balance)

-2 0 2 4 6 8 10 12 14 16 18-20

-15

-10

-5

0

5

10

Austerity:change in CABB

GDPgrowth

POR

SPA

FRA

ITA NET

BEL

AUTGER

FIN

GRE

IRE

Austerity is bad for growth, at least in the time span here considered

21

Austerity and fiscal consolidation (change in CABB and increase in gen. gov. financial surplus)

-2 0 2 4 6 8 10 12 14 16 180123456789

10

Change in cyclically-adjusted budget balance

Change in Budget balance

GRE

GRE

IRE

POR

SPAFRA

ITA

NET BEL

AUT

GER

FIN

However, austerity is not self-defeating, in the sense that it is still improving the overall budget balance , though the improvement in the latter is typically smaller than in the former

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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 EMU1) 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 encompassing2) 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