6. European Debt Crisis

Effect of GFC on Latin America & Asia

Not affected, they had financial regulation after their crises in the 80s and 90s

How the GFC spread to Europe

the value of European banks’ assets went down from the ties to the US
the banks were suspicious of each others’ financial state
banks stopped lending to each other
interest rates soared
recession

The doom loop when the banks fail first

banks fail → gov needs to give them money → gov budget deficit worsens → gov bond prices fall → banks total assets fall as they hold gov bonds as assets → banks fail

Where there were housing bubbles in Europe

Ireland, Spain, UK

What governments & central banks did to contain the GFC recession

expansionary policy: keep interest rates at 0, give liquidity to banks

Consequence of government policy to contain GFC

worse budget deficit

Why Greek bonds felt risky to investors in 2009

• large government deficit

• no lender of last resort

• not competitive

• deception of former Greek minister about the size of public debt

If Greece went back to the drachma to devalue

it would restore competitiveness and improve trade balance
it would be harder to pay back euro with a weaker currency
euro would be reversible - investors could speculate if other countries would leave, raising their interest rates and causing a repeat of Greece

If Greece stayed on the euro

Greece would default
European banks, which held Greek gov bonds, would suffer losses
Eurozone would be in a financial crisis

What the IMF did in 2010

loaned one year’s budgetary needs to Greece

What the IMF demanded for Greece in return for the 2010 loan

public expenditure cuts
tax increases
structural changes to improve the economy

What structural changes to improve the economy that the IMF demanded of Greece

wage reductions
smaller civil service
privatisation of state-owned companies
pension reform
tax collection improvement

Effect of 2010 IMF loan to Greece

the large size of the loan implied Greece’s financial state was even worse than investors had thought
investors suspected other countries were equally as unhealthy

The countries investors suspected were financially unhealthy

Greece, Ireland, Portugal, Spain, Cyprus

Greece & Portugal doom loop begins with

financial markets stopping their financing of the government

Ireland & Spain doom loop begins with

markets low confidence in banks

2010 - 2013 IMF

emergency loans to Ireland, Portugal, Spanish banks, Cyprus

What stopped the financial panic

President of the ECB announcement: “the ECB is ready to do whatever it takes to preserve the euro”

Aftermath of the EDC

• stress tests by the ECB & European Banking Authority

• Euroscepticism

• proposals on preventing public debt of member states starting another crisis

• 2014 Banking Union

• concern over the lack of a formal European governance system to manage crises

  • the architecture of the euro

Stress tests by the ECB & European Banking Authority

every few years
stimulate shocks such as recessions, unemployment, falling housing prices, financial market crashes, etc… to determine whether banks have enough capital to survive.

Euroscepticism after the EDC

the framework trapped the financially strained members with the currency (limiting their options for recovery) and placed the stronger states at risk of financial contagion. Anti-EU right-wing populist parties got more support while pro-EU centrist, liberal, social democrat, & environmentalist parties got less

Concern for member states’ public debt after the EDC

the Eurozone requires fiscal discipline of its member states to prevent such crises, but they maintain sovereignty, so their budget cannot be controlled

Proposed solutions to prevent crises despite how the EC cannot control member states’ public debts

eurobonds
public debt restructuring

Eurobond pros

they would end the fragmentation of Eurozone financial markets
their market would be big enough to compete with US Treasury bonds as the choice for countries wanting to accumulate foreign reserves
they would be very safe since they would be guaranteed by all member states

Eurobond cons

strong Eurozone economies do not want to underwrite the debt of other governments again, just like they had during the last crisis
eurobonds would freely allow some member states to continually run deficits

Public debt restructuring pros

cancelling public debt, or reducing it, extending repayment periods, lowering interest, keeps borrowing costs low to prevent a crisis

Public debt restructuring cons

investors know they will receive less money → bond prices fall → domestic banks suffer financial losses → doom loop, crisis

2014 Banking Union

common regulations
Single Supervision Mechanism
Single Resolution Mechanism
planned deposit protection

Banking common regulations

rules on capital leverage ratio, liquidity ratio, stricter rules for larger banks

Single Supervision Mechanism

centralised supervision under the ECB of the largest Eurozone banks – the rest are supervised nationally

Single Resolution Mechanism

handles failing banks, all bank deposits by households are fully protected up to 100 000 euros

Planned deposit protection

not completed because countries disagree on the design, but it would create a common EU deposit guarantee system

Concern over the lack of a formal European governance system to manage crises

de facto crisis management was between the two largest economies, France & Germany
this method only worked because the leaders cooperated
decision-making between 19 Eurozone countries is not prompt enough for crisis management

Argument for why the euro will fail

it is not an Optimal Currency Area
lack of fiscal discipline of member states

Argument for why the euro will survive

a breakup would be catastrophic
there is no procedure for expelling a country from the Eurozone