central banker - summer 2012

7/31/2019 Central Banker - Summer 2012

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T H E F E D E R A L R E S E R V E B A N K O F S T . L O U I S : C E N T R A L T O A M E R I C A S E C O N O M Y | S T L O U I S F E D . O R G

CENTRAL

N E W S A N D V I E W S F O R E I G H T H D I S T R I C T B A N K E R S

SUMMER2012

FEATURED IN THIS ISSUE: Earnings and Asset Quality Trending Up | Is the End Near or the Popular TAG Program?

The dubious distinction o historysrst recorded sovereign deaultbelongs to Greecethe same nationat the oreront o the worlds second

major nancial crisis in ve years.The debt woes that began in Greece

and Ireland a ew years ago havemagnied into Europes sovereign debt

crisis, driven by ear that debt owed

by entire countries will not be repaid.The St. Louis Fed explored this crisisin-depth during the rst Dialogue with

the Fed or 2012, Sovereign Debt: AModern Greek Tragedy. Held May 8,

2012, right when tensions picked upagain ater Greeces deault, this discus-

sion gave the general public insightsinto sovereign debt issues and provided

answers to attendees questions. Chris-topher Waller, senior vice president and

director o Research, led the presenta-tion and discussion, with assistance

rom economists Fernando Martin andChristopher Neely.

Martin also led the Spanish-language

version o the sovereign debt DialogueDeuda Soberana: Una Tragedia Griega

Modernaon May 30 in St. Louis.He was joined by ellow St. Louis Fed

economists Carlos Garriga and AdrianPeralta-Alva or the question-and-

answer part o the program.

The Main Culprit: Excessive

Government Debt

Why have sovereign debt woes

become critical in Europe? Ater all,

The Sovereign Debt Crisis:

A Modern Greek Tragedy

its normal or governments to run adecit by using debt to nance under-takings such as wars, civil projects andpublic services. Wallers short answer:palpable ear that excessive govern-ment debt will not be repaid.

As any banker knows, the rewardso borrowing are elt immediately andthe pain is postponed to the utureoten pushed back urther by adding

more debt. Consequently, undisci-plined government borrowing can

rise to unsustainable levels, leading tocrisis, austerity and even deault. This

continued on Page 8

FIGURE 1

Gross Government Debt-to-GDP Ratios, 2000-2011

PercentofGDP

Greece

Ireland

Italy

Portugal

Spain

180

160

140

120

100

8060

40

20

0

2000 2002 2004 2006 20082001 2003 2005 2007 2009 2010 2011

SOURCE: International Monetary Fund, World Economic Outlook database, April 2012. The

Greek and Irish shocks in the late 2000s woke up markets to the specter o sovereign debt, with

debt-to-GDP ratios becoming alarmingly high.


2/12

Useul St. Louis Fed Sites

Dodd-Frank Regulatory Reorm Ruleswww.stlouised.org/rrr

FOMC Speakwww.stlouised.org/omcspeak

FRED (Federal Reserve Economic Data)www.research.stlouised.org/red

St. Louis Fed Researchwww.research.stlouised.org

News and Views for Eighth District Bankers

Vol. 22 | No. 2

www.stlouisfed.org/cb

EDITOR

Scott Kelly

314-444-8593

[email protected]

Central Bankeris published quarterly by the

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Reserve Bank o St. Louis. Views expressed

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The Eighth Federal Reserve District includes

all o Arkansas, eastern Missouri, southern

Illinois and Indiana, western Kentucky and

Tennessee, and northern Mississippi. The

Eighth District ofces are in Little Rock,

Louisville, Memphis and St. Louis.

C E N T R A L V I E W

European Sovereign Debt Crisis:A Wake-up Call or the U.S.

By James Bullard

In recent years, many countries de-icit-to-GDP (gross domestic product)and debt-to-GDP ratios rose as govern-ments increased their borrowing on

international credit markets to nancespending. For some European coun-tries in particular, the ratios reached arbeyond those considered sustainable.Consequently, these countriesinclud-

ing Greece, Ireland and Portugalsawtheir borrowing costs rise dramaticallyas markets began questioning the coun-tries ability and willingness to repaytheir debt.

Although the U.S. continues to have low borrowing costs,the U.S. decit-to-GDP and debt-to-GDP ratios are nearly ashigh as those o some o the countries that have had di-culty borrowing. The current European sovereign debtcrisis serves as a wake-up call or the U.S. scal situation.

Borrowing in international markets is a delicate matter. Acountry cannot accumulate unlimited amounts o debt; there

is such a thing as too much debt, and it occurs at the pointwhere the country is indierent between the temporary ben-et o deaulting and the cost o not having continued accessto international credit markets. Markets understand that at

some high level o debt a country has a disincentive to repayit, and, thereore, markets will not lend beyond this point.

Interest rates alone are not the best way to determinewhether a nation is borrowing too much or to evaluate theprobability o a debt crisis. Witness Greece and Portu-galtwo o the latest countries to ace this borrowing limit:Interest rates tend to stay low until a crisis occurs, at whichtime they rise rapidly. Today the U.S. has low borrowing

rates, but these low rates should not be comorting regardingthe likelihood o hitting the debt limit.

A Drag on Economic Growth

So, what is the limit or debt accumulation? While it canbe dicult to evaluate, research has ound that once a coun-trys gross debt-to-GDP ratio surpasses roughly 90 percent,the debt starts to be a drag on economic growth.1 In general,the European countries that continue to have poor economicperormances are the ones that borrowed too much andare beyond this ratio. Over the past couple o years, they

have tended to have relatively high (and requently increas-ing) unemployment rates and low or negative GDP growth.O course, slower growth tends to exacerbate a countrysdebt problems. In contrast, countries that have not car-ried too much debtin particular, Germany and some o its

James Bullard ispresident and CEO of

the Federal Reserve

Bank of St. Louis.

continued on Page 5

2 | Central Banker www.stlouised.org


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Q U A R T E R L Y R E P O R T

Earnings and Asset QualityTrending Up in District, Nation

By Michelle Neely

Bank earnings and asset qualitymeasures continued to improvewithin District states and nationallyin the rst quarter o 2012. Return on

average assets (ROA) averaged 0.95percent in District states, up 36 basispoints rom year-end 2011 and 33 basispoints rom a year ago. This result vir-tually mirrors the 0.94 percent national

average and the improvement rom itsquarter-ago and year-ago averages.

Within the District, banks in Arkan-sas, Indiana and Kentucky postedaverage ROA ratios above the Districtand national averages.1 Illinois bankshad the lowest average ROA at 0.74percent, but that result is a huge turn-around rom the -0.09 percent ROArecorded two years ago.

Lower loan loss provisions areprimarily responsible or the earnings

improvements, both nationally and inDistrict states. Loan loss provisionsas a percent o average assets ell 24basis points to 0.36 percent between

year-end 2011 and the end o the rstquarter o 2012 or U.S. banks as agroup; the ratio is also well below(down 26 basis points) its rst-quarter2011 level, meaning the improve-ment is not just the result o season-ally higher loan loss provisions in theourth quarter o the year.

The average loan loss provision(LLP) ratio or banks in District statesas a group was slightly higher than thenational average in the rst quarterat 0.40 percent but showed the sametrend as ar as large declines rom

year-end and year-ago levels.The average loan loss provision

ratios were below the all-District andnational levels in Arkansas, Indiana,Mississippi and Tennessee. Illinois

banks, still recovering rom a larger-than-average asset quality problem,posted the highest average LLP ratio:

0.55 percent.

TABLE 1

Earnings Performance1

2011: 1Q 2011: 4Q 2012: 1Q

RETURN ON AVERAGE ASSETS2

All U.S. Banks 0.61% 0.68% 0.94%

All Eighth District States 0.62 0.59 0.95

Arkansas Banks 1.00 1.08 1.16

Illinois Banks 0.46 0.39 0.74

Indiana Banks 0.41 0.90 1.06

Kentucky Banks 1.28 0.68 1.48

Mississippi Banks 0.56 0.73 0.91

Missouri Banks 0.64 0.66 0.90

Tennessee Banks 0.36 0.04 0.89

NET INTEREST MARGIN

All U.S. Banks 3.87 3.93 3.89







Missouri Banks 3.62 3.79 3.67Tennessee Banks 3.83 3.89 3.92

LOAN LOSS PROVISION RATIO

All U.S. Banks 0.62 0.60 0.36








Tennessee Banks 0.63 0.95 0.34Compiled by Daigo Gubo

SOURCE: Reports o Condition and Income or Insured Commercial Banks

NOTES: 1 Because all District banks except one have assets o less than $15 billion, banks

larger than $15 billion have been excluded rom the analysis.2 All earnings ratios are annualized and use year-to-date average assets or average

earning assets in the denominator.

continued on Page 4

Central Banker Summer 2012 | 3


4/12

Net Interest Margins Down

The drops in loan loss provisionswere more than enough to osetdeclining net interest margins (NIMs).The average NIM ell 4 basis points orU.S. banks as a whole to 3.89 percentand 5 basis points or District statebanks to 3.86 percent. Among District

states, all states but Kentucky andTennessee recorded declines in theaverage NIM. Arkansas and Missouribanks posted the largest declines inNIMs, 15 basis points and 12 basispoints, respectively. Their ratherlarge declines in NIMs were the resulto much sharper declines in interest

income than interest expense. Fiveo the seven District states reportedhigher average NIMs than the nationalaverage. (See Table 1 on Page 3.)

Falling net noninterest expensesalso provided a boost to rst-quarter

Quarterly Reportcontinued from Page 3

prots. For the seven District states,the ratio o net noninterest expensesto average assets declined 16 basispoints to 1.86 percent. Five o theseven states experienced drops in thisratio, with Arkansas banks showing

just a 1-basis-point uptick and Missis-sippi banks recording a 5-basis-point

increase. In most cases, the trendsin the two components o the rationoninterest income and noninterestexpensewere both avorable as non-interest income rose while noninterestexpense ell.

Nonperorming Assets Ratios

Continue Declining

Asset quality remained on theupswing, both nationally and in Dis-trict states. The nonperorming assetsrationonperorming loans plus otherreal estate owned (OREO) to totalloans plus OREOcontinued its steadydecline in the rst quarter. For allU.S. banks, the nonperorming assetsratio declined 7 basis points between

year-end 2011 and the rst quarter o2012 to 4.64 percent; the ratio is down66 basis points rom its year-ago level.

For District states as a group, thenonperorming assets ratio remains

higher than the U.S. average at 5.02percent but is showing similar trends,

with a 15-basis-point decline romyear-end 2011 and a 41-basis-pointdecline rom a year ago. All three

major categories o loansconsumer,commercial and real estateexperi-enced drops in the portions that werenonperorming at both the nationaland District state levels. Deteriorationin portolios occurred in Kentuckyscommercial and real estate loans and

Arkansas and Tennessees consumerloans. Illinois banks continue to leadthe District in loan quality problems,especially in real estate, with a non-perorming assets ratio that still tops 6percent.

Coverage Ratios Up a Little

Loan loss reserve coverage ratioscontinue to inch up, meaning bank-ers have set aside more unds to cover

potential loan losses. At the end othe rst quarter, U.S. banks had 62cents reserved or every dollar ononperorming loans, compared with61 cents at year-end 2011 and 58 centsa year ago. District states had about

TABLE 2

Asset Quality Measures1

2011: 1Q 2011: 4Q 2012: 1Q

NONPERFORMING ASSETS RATIO2

All U.S. Banks 5.30% 4.71% 4.64%









LOAN LOSS COVERAGE RATIO3

All U.S. Banks 57.92 61.02 62.40




Indiana Banks 71.57 64.11 67.05





Compiled by Daigo Gubo

SOURCE: Reports o Condition and Income or Insured Commercial Banks

NOTES: 1 Because all District banks except one have assets o less than $15 billion, banks

larger than $15 billion have been excluded rom the analysis.2 Loans 90 days or more past due or in nonaccrual status, plus other real estate owned

(OREO), divided by total loans plus OREO.3 Loan loss reserves divded by nonperorming loans.



5/12

Quarterly Reportcontinued from Page 4

Wake-up Callcontinued from Page 2

61 cents reserved or every dollar ononperorming loans, versus 59 centsat year-end 2011 and 56 cents a year

ago. Within the District, Mississippibanks posted the highest coverage

ratio at 74.69 percent, up more than500 basis points rom year-end 2011.Missouri banks have the second high-est coverage ratio o 73.40 percent.Illinois banks, with higher levels ononperorming assets, have an averagecoverage ratio o just under 50 percent.Although these ratios have improved,they remain low compared with theirpre-nancial-crisis levels.

Tier 1 leverage ratios are stillincreasing nationally and in District

states. The national average rose 11basis points to just under 10 percentat the end o the rst quarter, whilethe District state average increased 17basis points to 9.58 percent. Arkansasbanks posted an average tier 1 lever-age ratio o 10.09 percent. Indiana

immediate neighborshave tendedto have relatively low (and requentlydecreasing) unemployment rates andpositive GDP growth.

The U.S. gross debt-to-GDP ratio ishigher than 90 percent, and projec-tions indicate that it will rise urther.Now is the time or scal disciplinein order to maintain the credibility ininternational nancial markets thatthe U.S. built up over many years.Failure to create a credible decit-reduction plan could be detrimental toeconomic prospects. Furthermore, asthe European sovereign debt crisis hasshown, by the time a country reachesthe crisis situation, scal austeritymight be the best o many unappealingalternatives. Returning to more nor-

mal debt levels will take many years,but the economy would likely benet

i the U.S. were to get on a sustainablescal path over the medium term.

Some people say that the U.S. cannotreduce the decit and debt because theeconomy remains in dire straits, butthe experience o the 1990s suggests

otherwise. During the 1990s, the U.S.

had substantial decit reduction andthe debt-to-GDP ratio declined. Theeconomy boomed during the secondhal o the decade, which helped toreduce the debt more quickly. Whilereviving economic growth would alsohelp now, temporary scal policies andmonetary policy are not the best wayto do that. Having a credible decit-and debt-reduction plan in place wouldlikely spur investment in the economy,as it did during the 1990s.

This essay originally appeared in the

St. Louis Feds 2011 Annual Report,

published in May 2012.

ENDNOTE

For example, see Cecchetti, Stephen G.;

Mohanty, M.S.; and Zampolli, Fabrizio. The Real

Eects o Debt, inAchieving Maximum Long-Run

Growth. Presented at the Economic Policy

Symposium, Jackson Hole, Wyo., Aug. 5-7,

.

banks lagged their District state peersjust a bit, with an average leverageratio o 9.34 percent.

Michelle Neely is an economist at the Federal

Reserve Bank of St. Louis.

> > R E L A T E D O N L I N E

Current Senior Loan Ofcer Survey

www.ederalreserve.gov/boarddocs/snloansurvey/201205

ENDNOTE

Kentuckys very high ROA o .48 percent can

be attributed primarily to Republic Bank in Lou-

isville, which is winding down a very lucrative

income tax reund loan business.



6/12

I N - D E P T H

Is the End Near or the Popular TransactionAccount Guarantee Program?

TAG was originally designed as anopt-in program when the FDIC intro-duced it in October 2008. Participatingbanks paid premiums to help supportthe program, which was intended toprovide liquidity support and stabil-ity or banks as well as to help protect

the deposits o small businesses andmunicipal governments. As part othe Dodd-Frank legislative process,the programs termination date wasextended and the program mademandatory or all banks; the programsestimated costs were olded into the

By Michelle Neely

The Transaction Account Guarantee(TAG) program, launched duringthe nancial crisis and extended bythe Dodd-Frank Act to support liquid-ity and bank stability, is set to endat year-end 2012.1 By design, moneydeposited in accounts covered by TAGearns no interest. Nonetheless, in thecurrent low interest rate environment,

TAG has been extremely popular; atyear-end 2011, TAG-insured depositstotaled $1.6 trillion and accounted or20 percent o total U.S. bank deposits.

Deposits in TAG-Insured Accounts as a Share ofTotal Deposits

Groups by Asset SizePercent as of

Dec. 31, 2010

Percent as of

June 30, 2011

Percent as of

Dec. 31, 2011

ALL EIGHTH DISTRICT BANKS 5.2% 6.8% 7.1%

District < $1 billion 3.4 3.8 4.6

District $1 billion - $15 billion 5.0 7.6 7.6

District > $15 billion* 18.1 21.4 19.7

ALL U.S. BANKS 14.5 16.5 20.2

U.S. < $1 billion 5.0 5.7 6.7

U.S. $1 billion - $15 billion 9.2 10.5 11.8

U.S. > $15 billion 14.5 19.7 24.0

SOURCE: Reports o Condition and Income

*NOTE: There is only one District bank with assets o more than $15 billion: First Tennessee,in Memphis.

risk-based deposit insurance premi-

ums paid to the FDIC.

Banks o All Sizes Benefted rom TAG

TAG has proved to be extremely

popular with bankers and depositors.The combination o low interest rates

and the benets o ull FDIC coverage

has boosted the program. Between

year-end 2010 and year-end 2011,

TAG-insured deposits at U.S. banks

increased almost 60 percent to $1.6trillion. Banks o all sizes have ben-

eted rom TAG, and at year-end 2011,

deposits in these accounts made up 16percent o the liabilities on the books

o U.S. banks.

The importance o deposits in

TAG-insured accounts varies consid-erably by bank size, and large banks

dominate. At year-end 2011, U.S.

banks with assets o more than $15

billion held almost 90 percent o allTAG-insured deposits, compared with

holding 74 percent o all U.S. bank

deposits; the ratio o TAG-insured

deposits to total deposits at these

institutions averaged 24 percent. Forsmaller banks, especially community

banks with assets o less than $1 bil-

lion, TAG-insured deposits make up a

airly minimal source o liquidity. Atyear-end 2011, TAG-insured deposits

averaged 6.7 percent o total deposits at

U.S. community banks and 4.6 percentat District community banks.

Many bankers, especially commu-

nity bankers, avor the continuation

o the TAG program through at least

2014 and perhaps permanently. Theyear that these depositsabsent FDIC

insurancewill migrate to larger insti-

tutions that are perceived to be too big

to ail. The Independent Community

Bankers o America is leading thecharge to keep TAG permanent, with

support rom the Conerence o StateBank Supervisors. These organiza-

tions argue that TAG levels the playingeld by neutralizing, to a small degree,

the perceived implicit government

guarantee or large banks.



7/12

Arguments Against Continuation

Those who oppose extending TAGpoint to a number o reasons. First,they argue that liquidity is now plenti-ul and that its very unlikely banks willexperience any sort o huge runo indeposits, even when interest rates startto rise. For clients who are concernedabout losing deposit insurance cover-age, banks can use sweep accounts and

services that break up large deposits

and distribute them among mul-tiple cooperating banks to maintainFDIC insurance coverage at the nor-mal $250,000 limit. Other options tomaintain liquidity include using FHLBadvances and increasing interest paidon other deposits and money marketaccounts. Banks also could potentiallygo to the private insurance market tomaintain coverage on these accounts,although the availability and cost eec-tiveness o providers is by no meanscertain.

Other arguments against extend-ing the program emphasize the politi-cal, reputational and regulatory risksthat would come with it. Politically, it

would be very dicult to get legisla-tion extending the program to pass thiselection year. Even i Congress wereto agree to take up the issue, banks

would risk the reopening o proposalsthey have ought hard to deeat, such as

expanded business lending powers orcredit unions and an extension o theDurbin amendment in the Dodd-FrankAct to credit cards. Also troubling tosome is the belie that the continuationo TAG sends a message that the bank-ing industry is still struggling as it didduring the nancial crisis.

Looking Ahead

The TAG program has lost moneybecause current premiums havenot covered the losses the FDIC hasincurred when a bank ails and theagency has to pay out deposits inexcess o the $250,000 coverage limit.The FDIC says it will have to raisepremiums to cover program losses iTAG is still in place in 2020 when the

required reserve ratio jumps to 1.35

percent. The ABA estimates it wouldrequire an extra $15 billion in premi-ums to cover TAG-insured deposits toget to that ratio; premiums totaled justunder $14 billion in 2011.

The FDIC was expected to ormallyweigh in on TAG by the end o June.U.S. Rep. Shelley Moore Capito, R-W.Va., had asked the agency to report toCongress the estimated costs o theprogram to date as well as the eectso TAG on the deposit insurance undand overall liquidity in the bankingsystem. She also wanted the FDICsassessment o what the consequences

would be or the economy and bankingindustry i TAG expires on Dec. 31.

> > M O R E O N L I N E

FDIC Final Rule on Section 343 o the Dodd-Frank Act

www.stlouised.org/CB/DFA343

Michelle Neely is an economist at the Federal

Reserve Bank of St. Louis.

ENDNOTE

Technically, the program is no longer called TAG.

Section 343 o the Dodd-Frank Act superseded

TAG and extended its coverage, but it is still

commonly reerred to as the TAG program.

At year-end 2011, TAG-insured deposits totaled$1.6 trillion and accounted for 20 percent of all

U.S. bank deposits.



8/12

possibility can occur in any nation,even the United States. (See the Cen-tral View on Page 2 o this issue, AWake-up Call or the U.S., by St. LouisFed President James Bullard.)

How High Is Too High?

When considering how deep in thehole a nation is, economists tend tolook at the debt-to-GDP (gross domes-

tic product) ratio instead o just thenations budget decit and the entirenational debt, which is the sum o thecurrent and all past decits/surpluses.The debt-to-GDP ratio measures acountrys ability to pay o the entiredebt with one years income, regard-

less o the nations wealth or total debtoutstanding. Many nations, includingthe U.S., have gross debt-to-GDP ratios

well above 90 percent.A high debt-to-GDP ratio does

not automatically mean a nation is adeault risk, however. Many countries

have deaulted with (relatively) littledebt, and other countries have beendoing ne with very high levels odebt, economist Fernando Martin said

during the May 8 Q&A session. I dontthink there is anything magical aboutaparticular debt-to-GDP number.

Ability Vs. Willingness To Pay

Rather, explained Waller, the criticalpoint or lenders and investors comes

when they are no longer condent ogetting their money back. Its not theability to repay the debt but the willing-ness to repay the debt, he said. Forexample, Japans current debt-to-GDPratio is well above 200 percent, butew holders o Japanese debt see that

nation as a deault risk. However, Bra-zil and Mexico deaulted in the early1980s with lower debt-to-GDP ratios oonly about 50 percent.

In normal times, most nations rollover their debt when its due. Nationsoten choose to get short-term debt

because o lower interest rates ratherthan longer-term debt, at the expense

o rolling over debt more requently.Every time you roll it over, youre giv-ing investors the opportunity to say,Can you meet your debt obligations?I youre borrowing every six months

or every 12 months, youve got toanswer that question a lot more oten,

Greece and the Role o the EU

Greece has deaulted on its sovereign debt many times

throughout history. But the current crisis is much dierent

because Greece is a member o the European Union (EU),

and the debttoGDP ratios o Greece, Ireland, Portugal,

Spain and Italy have become serious concerns.

Even ater orming the EU, Europe never seriously pursued a scal union, Waller said, because nations would have

had to give up their sovereign authority to tax, spend and

issue debt. Rather, EU nations created the Economic and

Monetary Union (EMU, also commonly called the eurozone)

in the 1990s to be a monetary union united under a single

currency. Even though the EU had little say over sovereign

matters, countries could not be admitted to the eurozone

unless they were moving toward specic levels or longterm

interest rates, ination, exchange rates, decittoGDP ratios

and debttoGDP ratios.Greece was denied membership to the EMU in 1998 because

it met none o the ve criteria. Yet two years later, Greece was

admitted to the EMU even though the nationstill met none o

the ve criteriaand was even moving in the wrong direction.

Most notably, it was wellknown that Greeces debttoGDP

ratio in 2000 was 103 percent, ar above the EMUs maximum

level o 60 percent; it remained about 100 percent throughout

the 2000s. Also, Greeces decittoGDP ratio in 2000 was

3.7 percent, above the EMUs maximum o 3 percent. And in

2009, a new Greek government revealed that Greeces decit

toGDP ratio was not 4 percent as the previous government

had claimed but actually near 16 percent.

However, the EU ailed to create contingencies in case a

member nation decided to leave or was kicked out o the EU

or EMU. For many political reasons, it was never discussed,

Waller said. This glaring omission has become critical today,

more than a decade ater Greeces shaky eurozone entry.

Sovereign Debtcontinued from Page 1

EU member only

EU and EMU member



9/12

Waller said. The minute a lenderears you may not be able to settle upthis debt, they may either reuse to rollover the debt or raise the interest ratesthat you have to pay.

This perceived willingnessorgrowing lack thereoto repay govern-ment debt is a major actor in Europes

current sovereign debt crisis.

Wake-up Calls

Even though many nations inEurope had operated with high debtor decades, no developed nation haddeaulted since 1946, Waller said. Butnancial markets were rudely awak-ened to sovereign debt risk in thelate 2000s. Greeces shaky nancialstatus was well-known when it wasadmitted to the Economic and Mon-etary Union (EMU, aka the eurozone)in 2000, but the true depth o thatnations debt became known only in2009.1 (See Greece and the Role othe EU on Page 8.) Meanwhile, ellowEMU member Ireland, long a strong

nancial perormer, had to bail out itsentire banking system in 2007-2008.Between 2007 and 2010, the Irish debt-to-GDP ratio went rom 25 to near 100percent, and its decit went rom zero

to more than 30 percent. (See Figure 1on Page 1.)By themselves, Greece and Ireland

would not cause such consternation:The combined GDP o Greece andIreland is akin to the amount the stateo Pennsylvania generates. Its hardto imagine that i Pennsylvania has anancial crisis, the rest o the country

would collapse, Waller said.But because members o the EMU

are connected economically, smaller

countries such as Greece, Ireland andPortugal (also experiencing sovereigndebt woes) are the gurative canariesin the coal mine. They were telling usthat there was a bigger problem coming:

Italy and Spain, Waller said. Thosenations have much larger economiesand debt outstandingItaly, or exam-ple, has 2 trillion in debt and must rollover 300 billion in 2012, an amountakin to the entire Greek debt.

Markets Lose Confdence

Financial markets had come to

treat the sovereign debt o all EMUmembers as identical by the end othe 1990s, using the bonds issued byscally strong Germany as the unions

FIGURE 3

Yield Spreads Over German 10-Year Bonds

SOURCE: Reuters/Haver Analytics. Once the deteriorating fscal condition o Greece and Ire-

land became well-known, the markets began to incorporate deault risk into the interest rates

charged to governments to roll over their debt. By 2011, the spreads between what Germany

paid on 10-year bonds, or example, and what the less rugal countries had to pay widened

greatlyespecially or Greece.

continued on Page 10

FIGURE 2

Long Term Interest Rates, 1990-2000

SOURCE: DG II/Statistical Ofce European Communities/Haver Analytics. As shown by the

nearly identical long term interest rates, fnancial markets viewed the sovereign debt o

eurozone members such as Ireland, Italy, Portugal and Spain as the same by the end o the

decade, regardless o whether a country had its fscal house in order. Greek long term interest

rates had approached the levels o eurozone members by 2000, when Greece was admitted tothe EMU. This identical treatment o sovereign debt lasted until late 2008.

Rolling12-

MonthAveragePercent

Greece

Ireland

Italy

Portugal

Spain

30

25

20

15

10

5

01990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Basis

Points

Greece

Ireland

Italy

Portugal

Spain

4000

3500

3000

2500

2000

1500

1000

500

0

500

Jan.

07

April07

July07

Oct.

07

Jan.

08

April08

July08

Oct.

08

Jan.

09

April09

July09

Oct.

09

Jan.

10

April10

July10

Oct.

10

Jan.

11

April11

July11

Oct.

11

Jan.

12

benchmark. (See Figure 2 above.)

But ater the Greek and Irish shocks,

nancial markets stopped viewing

Italian, Greek, Irish, Portuguese and

Spanish debt as close substitutes or

German bonds, and they started hik-

ing interest rates in the all o 2008 to

compensate or the heightened risk

o deault. By January 2012, the yield

spread between German and Greek

debt had increased by3,300 basis

points. (See Figure 3 above.)



10/12

This loss o condence was mirrored

by the rise o prices or credit deault

swaps (CDS, essentially insurance

policies against deault). By late 2011,

CDS on Greek debt stopped trading

when markets gave Greece a 50 per-cent chance o deault. CDS were trig-

gered in March 2012 in response to a

bond swap and restructuring deal that

allowed Greece to eectively deault

on hal o its debt.

Meanwhile, the rollover problem

had hit Greek banks, which held

about 20 percent o the governments

sovereign debt (as o May 2012). The

eventual Greek deault dramatically

weakened the banks balance sheets,

Waller explained. Because they eared

Greeces banks would no longer honor

obligations, markets stopped rollingover Greek bank debt, which in turn

meant that Greek banks could no

longer roll over unding o the govern-

ments debt.

Digging Out o the Deep Hole

Since 2010, the EU and InternationalMonetary Fund have provided a total

o more than 1 trillion in several loan

packages to ease rollover problems,

with Germany and France contributingthe most. The European Central bank

also injected up to 1 trillion o liquid-

ity into the EUs banking system. And

in June, the eurozone agreed to pro-

vide approximately 100 billion to help

Spanish banks.2 But the loans cannotcover all o the debt owed. So, what

is a nation to do when aced with the

deault specter? It has alternatives that

are both dicult and unpleasant:

Austerity measures These are

combinations o sharp tax increasesand deep spending cuts. Greece and

Ireland instituted tough austerity

measures, which lowered Greeces

decit-to-GDP ratio rom about 16 per-

cent to a projected 9 percent or 2011

and reduced Irelands decit-to-GDP

ratio rom its 2010 peak o 31 percentto near 10 percent in 2011. However,

the cost was substantial social unrest.

You upset people. The measures are

unpopular, and we saw the results in

May, Waller said, reerencing the latespring elections, when several govern-

ments were voted out, including the

Greek government that revealed the

nations true debt but also enacted ve

rounds o austerity measures.

Infating away Infating away

debt by printing money is the politi-cally less painul way o doing it, but

that doesnt mean it would be easy,

economist Fernando Martin said.

Economist Christopher Neely agreed

and noted that a substantial portiono sovereign debt is short-term and

other debt is issued in the orm o real

bonds that depend on the price level.

So, unless youre willing to accept

very high infation or a long time, its

dicult to get a decent chunk o yourdebt infated away, and i you do that,

youre going to pay the costs o higher

interest rates or a long time, he said.

The pain associated with these

actions will all on dierent groups,

and that leads to political confict,

Sovereign Debtcontinued from Page 9

Explore More o the ModernGreek Tragedy

Annual Report

Research Director Christopher Waller

and economist Fernando Martin based

their respective Dialogue presenta

tions on their indepth essay in the

St. Louis Feds 2011 Annual Report.

They reveal the historical roots

o sovereign debt to help explain

Europes current crisis, why nations deault and

what may happen in the uture. The essay is available in

English and Spanish.

Visit www.stlouised.org/ar, where you can also see a 10

minute video that captures several o the essays key points.

Dialogue with the Fed Materials

Visit www.stlouised.org/dialogue to view the videos and

presentations rom the May 8 Dialogue; the May 30 Dialogo;

and last alls events on the nancial crisis, the ederal budget

decit and the unemployment picture.

Credit Deault Swaps

St. Louis Fed economists Bryan J. Noeth and Rajdeep Sengupta

take A Look at Credit Deault Swaps and Their Impact on the

European Debt Crisis at www.stlouised.org/publications/re/

articles/?id=2231 in the April 2012 Regional Economist.

FederalReserveB ankofSt. Louis| stlouisfed.org 1

AnnuAl RepoRT 2011



11/12

Waller said. Political confict meansdelay in getting the scal situationon rmer ground, and it also erodesinvestor condence.

Taken together, the austerity mea-sures, the international loans andliquidity injections helped calm theoverall situation by early 2012. It

workedor a while, Waller said.

In Conclusion: The Moral o the Tragedy

Uncertainty came roaring back inlate spring because o election resultsin Greece, France and elsewhere in theEMU, and anxiety increased over pos-sible Spanish and/or Italian deaults, thepossible Greek exit rom the eurozone,and the ultimate ate o the euro and theEU. At the May 8 Dialogue, almost two-thirds o the audience believed that aterthe crisis the EMU will continue to exist,albeit with ewer members.

And regardless o the resolution othe crisis, Greece and other nations

will still have to solve their scal prob-lems, Martin said.

Calling Europes turmoil a modernGreek tragedy is not a mere play on

words. Rather, its a tragedy becauseborrowing is seductive, Wallerexplained. Although the ability to

borrow to nance current spendingcan be very benecial, its very tempt-ing to borrow or the short-term gainsand kick the pain down the road.

As a result, governmentslikehouseholdscan borrow too much.And suddenly you wake up one day(realizing that) your debt burden isunsustainable, which leads to a crisis,periods o austerity, and pain and su-ering, he said.

Thats the tragedy o sovereign

debt, Waller said.

ENDNOTES

The European Union (EU) is the organization

ormed in 957. The 99 Maastricht treaty led

to the creation o the Economic and Monetary

Union (EMU, aka the eurozone) and a single cur-

rency, the euro, managed by the pan-European

institution the European Central Bank. Original

eurozone members were Austria, Belgium,

Finland, France, Germany, Ireland, Italy, Luxem-

burg, the Netherlands, Portugal and Spain. As

o this writing, 7 o the 7 EU members are in

the eurozone. The European Central Bank committed to pro-

viding up to trillion between and 4.

Deep Structural Problemsand the Debt Crisis

The May 8 Dialogues audience members asked whether ac

tors such as inefcient tax collection and high unemployment

reasons other than those given in the presentationhelped

push Europe into the sovereign debt crisis.

For example, one audience member pointed out that

extremely inefcient tax collection policies in some southern

European countries are one o the reasons why theyre in

trouble. Are these countries trying to x it, or is tax avoid

ance simply a way o lie? he asked.

Economist Fernando Martin acknowledged that tax eva

sion and other inefciencies are problems. But theyre

systemic problems that have been going on or a long time,

and these countries have adapted to that reality, Martin

said. Those problems are longstanding and not what reallytriggered these current events.

One man said that people in some nations have a mastery

or tax evasion because they are paid under the table or some

worka socalled inormal sector that is not captured by the tax

system. Noting that the U.S. also has such an inormal sector,

Martin said: The connection to this particular crisis is that now

people realize how burdensome these inormal sectors are.

Governments are providing everyone with public works, public

education and more. But only people in the ormal sector pay

taxesand the crisis has increased the political conict becausethe inormal sector does not want to be sucked into the ormal

sector and have to pay the tab.

A Battle Fought on Many Fronts

Turning to Spain, one woman said: They have the highest

unemployment rate in the EU and EMU or people under 24,

a collapsing banking system and problems in the property

market. So, what do you see as their longterm uture, and do

they have willingness to x their problems?

Noting that she was correct, Martin said that Spain and Por

tugal share a similar eature in that unemployment has been

going up quite a lotin Portugal or a longer time, in Spain

more recently. As or the willingness to x those problems,

thats a question or the politicians there and the public that

elects them, he said. Spain and Portugal share structural

problems and other eatures, such as rising expenditures

since 2007 that have only now been coming downand thats

whats generating political conict, which is on top o the labor

market problems. So now you have a battle being ought on

many rontsand its a political conict, Martin said.

Finally, audience members also asked whether the Americaninvestment banking industry and commodity price increases

contributed to the sovereign debt crisis. Economist Christopher

Neely answered that while investment bankers really couldnt be

blamed, commodity prices could have been a trigger: A trigger

but not a undamental cause, he said.



12/12

N E W B A N K I N G A N D E C O N O M I C R E S E A R C H

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Gini in a Bottle: Some Facts on Income Inequality

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