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EUROZONE CRISIS

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Jemma Rethman

on 9 December 2013

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Transcript of EUROZONE CRISIS

DATE: December 9, 2013
CREATED FOR: International Economics
TEAM: Chris Z, Dennis P, Mike B, Jemma R
I. Foundation of EU and Euro
II. History of the Eurozone Crisis
III. The Crisis Itself
IV. Future outlook for the Eurozone

...
...
1950
1960
1970
1980
1990
2000
2010
1951
1957
1973
1986
1989
1992
1999
2002
The Treaty of Rome signed
~ establishing the European Economic Community (EEC) or the "common market"
Denmark, Ireland and the United Kingdom formally enter the European community ~ (9 member states)
The Single European Act is passed to harmonize trade regulations over a 6-year period.
France supports German Reunification in exchange for German support of a common European currency
NOVEMBER 9th
Berlin Wall torn down
The Euro is introduced in 11 countries (joined by Greece in 2001) for commercial and financial transactions.
6 member states sign a treaty to run their coal and steel industries under common management

Euro notes and coins come into circulation
2001
2013

Current EU and Eurozone
1957
1973
1981
1986
1995
2004
2007
2013
Future of the EU
The Maastricht treaty signed.
Turning a "community" into a "union"
1979

European Economic Community (EEC) governments set up the Exchange Rate Mechanism (ERM)
How does it work?
1. Settling a reasonable trading range for a currency’s exchange rate and then enforcing the range via interventions:
- printing currencies, tariffs, quotas, domestic interest rates, monetary and fiscal policy or by switching to a floating ERM

+ In practice it functioned as a semi-pegged currency, however there were many issues that caused failures in the system
United Kingdom joins the ERM, but was forced to withdraw following "Black Wednesday"
1992
George Soros bet against the Bank of England costing them around 3.3 billion Pounds and left the bank unable to defend the currency in world markets
British Pound pegged at 2.95
Deutsche Mark’s
- Problem was that the UK had an inflation rate 3x that of Germany and interest rates showed signs that economic growth in the UK was unsustainable
- As a result of the crisis, the UK was forced to withdrawal from the ERM, allowing its currency to float at much lower market rate.

Lessons
Interest rates were set for EEC nations using the ERM by Germany.

Instead, interest rates should have been set by a
transnational organization
or each nation should have had
separate interest rates
to adjust to individual conditions.

More broadly, nations need to either
share full fiscal/political union
or have
more flexibility
to respond to shocks or downturns in the business cycle individually.

The current situation leaves nations in the Eurozone in an
unsatisfactory middle state
where they have all the disadvantages of fiscal union, but lack the institutions to respond effectively to problems.

2 choices following the collapse of the ERM system:
Full free floating exchange rates between European currencies
2.
1.
Monetary union
III. Economic lead-up and effects of the Crisis
Budget Deficit (in % of GDP)
Government Debt (in % of GDP)
It is clear that
Greece
and
Italy
had/have problems with high government debt

Spain
and
Ireland
both kept Maastricht criteria until 2007 (while
Germany
did not)
Private Sector Debt (in % of GDP)
Both
Spain
and
Ireland
experienced a boom in their real estate market which was fueled by private borrowing
Trade Balance (in % of GDP)
Industries loss of competitiveness over the last decade led to huge trade deficits for
Spain
and
Greece
How did the crisis evolve?
18 October 2009
Greece's new Prime Minister admits the budget deficit will be double the previous government's estimate and will hit 12% of GDP

+ Rating Agencies downgrade Greek government debt
+ Financial Markets start to worry about the ability of the Greek and other governments to pay back their debt & overall situation of economies in several 'periphery' countries of the EU

Standard & Poor's sovereign debt credit rating by country
Yield of 10-year maturity bonds (%)
9th May 2010

Formation of the
European Financial Stabilisation Mechanism
(EFSM) and the
European Financial Stability Facility
(EFSF) is announced

- EFSM -

Emergency funding program for EU-members in financial trouble run under supervision of the EU commission

− authority to raise up to 60 billion Euro on the financial markets
− collateral for investors: budget of the European Union

- EFSF -

Emergency funding program for EU-members in financial trouble run as a
Special Purpose Vehicle

− authority to raise up to 500 billion Euro on the financial markets
− collateral for investors: Eurozone countries' guarantees (amounts based on ECB capital key weightings)

How do the programs work?

− Both programs retain a AAA rating from all three rating agencies; borrowing costs lower than it does for the countries in fiscal trouble (higher credit ratings = lower borrowing costs)

Two 'bailouts' for Greece

1st bailout in May 2010:
− €110 billion in loans (IMF: €30bn; Eurozone (bilateral loans): €80bn)

2nd bailout in February 2012:
− €130 billion in loans (IMF: €28bn; EFSF: €102bn)
− Private investors accept 'haircut' of 53,3%

Other measures

- Loans of over 1 trillion Euro with very low interest rates offered by the ECB to European banks over the next three years

- ECB keeps its prime lending rate ('key interest rate') to 0,25%, deposit rate for banks at 0%


Conditions for receiving help

− strict austerity (reduce government spending)

− induce structural reforms (strengthen tax collection, privatize public companies, structural reforms of the public sector)

Eurozone Bailouts in Billions (€)
Help for
banking sector
Spain
100
Greece
240
Ireland
85
Portugal
78
Lack of Central Fiscal and Budgetary Authority


1. Unlike the US government, the EU is sustained primarily by the belief that nations see it as more beneficial to remain within the currency union than leaving it


2. There is a lack of comprehensive political and fiscal union that prevents a more rapid and effective response to shifts in the business cycle.
a. policy is still in the hands of the member states
b. lack of binding restraints and enforcement mechanisms on the size and financing of budget deficits. Common fiscal policy never emerges in the Eurozone.
The Maastricht Treaty forbids the ECB to purchase government bonds as part of a “no-bailout” philosophy

2. Despite the official policy of “no-bailouts”, there is an implicit promise of them because of the perceived need to maintain the currency and political union.


1. After entry into the EMU, the ECB was bound to treat all member country bonds equally. The EMU works as a fiscal discipline mechanism as a means to entry into the currency union, but not so well afterward.



3. European leaders saw currency union as a way to avoid potential shocks, but the currency integration instead allows for shocks to spread rapidly from nation to nation.

The effects of monetary union
Some countries (such as
Portugal, Netherlands, Greece
and
Spain
) lost price competitiveness, while countries like
Germany
and
Austria
became more competitive.
Effectively weakened the currency in stronger nations, while strengthening currency in economically weaker nations.
a. This allowed nations such as
Germany
to become more competitive and a build up a huge current account surplus based on exports.

On the other hand
Greece
,
Ireland
,
Italy
,
Portugal
and
Spain
have become less competitive in terms of exports.
Because of ECB rules to keep inflation below 2%, it is hard for the nations that have lost competitiveness to regain it without introducing outright deflation.

- They have to lower their prices to compete because there is no way to devalue their real exchange rates.

The guarantee of transfers in the event of shock raises moral hazard, especially when it comes to maintaining the currency union.
Lack of fiscal discipline
The rules put in place in Maastricht and thereafter were weakened or repealed.
The Greek government in 2004 revealed that the previous government cheated on the Euro entry requirements, but went unpunished.
- With the help of
Goldman Sachs
, Greece hid it's budget deficits from
2002 until 2009
, by using credit default swaps to meet the 3% annual deficit requirement.

Following 2004 the Stability and Growth Pact was weakened.
Purpose of the SGP

All countries need to use national fiscal policies as an instrument to deal with business cycle shocks. Over the medium term countries are allowed to increase their budget deficits up to 3% per year during a downturn.
Following Greece’s admission to the Eurozone,
France
and
Germany
ignored the SGP and had it suspended.
- In 2005, the SGP requirements were made discretionary. New provisions make it harder to take action against non-compliant states. Fiscal discipline in Europe deteriorated in the 2000s.

Those changes combined with very open financial markets perverted incentives for individuals, financial institutions and nations.
Growth and transfer payments from the ECB were used to finance development, but without sufficient unity of fiscal or regulatory policy the financial sector binged on cheap credit leading to a system-wide breakdown, first in the US in 2008 and then in the EU from 2009.
1. Bordo, Michael D. and Harold James. The European Crisis in the Context of the History of Previous Financial Crises. Cambridge: National Bureau of Economic Research. Working Paper. 2013.

2. Busch, Klaus. Is the Euro Failing? Structural Problems and Policy Failures Bringing Europe to the Brink. Friedrich-Ebert-Stiftung. International Policy Analysis. Berlin. 2012

3. De Grauwe, Paul. What Have we Learnt about Monetary Integration since the Maastricht Treaty? JCMS Volume 44. Number 4. pp. 711–30. Leuven. 2006.

4. Henningsen, David M., The Origins of the Italian Sovereign Debt Crisis. CMC Senior Theses. Paper 379. 2012. http://scholarship.claremont.edu/cmc_theses/379

http://europa.eu/about-eu/eu-history/

http://www.telegraph.co.uk/finance/markets/8170326/Timeline-history-of-the-euro.html

http://www.economist.com/node/21536871

http://www.bbc.co.uk/news/business-13856580

http://www.cepr.net/index.php/blogs/beat-the-press/nyt-reinvents-history-of-euro-crisis

http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/weorept.aspx?pr.x=103&pr.y=12&sy=2004&ey=2007&scsm=1&ssd=1&sort=country&ds=.&br=1&c=136%2C423%2C182%2C174%2C184%2C178&s=GGXCNL_NGDP&grp=0&a= (highly indebted Euro Zone countries borrowing as a % of GDP 2004-07)

http://internationalinvest.about.com/od/glossary/a/What-Is-An-Exchange-Rate-Mechanism-erm.htm

http://www.ekathimerini.com/4dcgi/_w_articles_wsite2_1_12/11/2013_527371

http://internationalinvest.about.com/od/gettingstarted/a/Black-Wednesday-George-Soros-Bet-Against-Britain.htm

http://www.bloomberg.com/news/2011-05-26/greece-cheated-to-join-euro-sanctions-since-were-too-soft-issing-says.html

http://www.spiegel.de/international/europe/greek-debt-crisis-how-goldman-sachs-helped-greece-to-mask-its-true-debt-a-676634.html

http://news.bbc.co.uk/2/hi/europe/1101811.stm

http://www.thenation.com/article/168716/deepening-spanish-debt-crisis#

http://www.csmonitor.com/layout/set/r14/World/Europe/2013/0426/Greece-starts-firing-civil-servants-for-first-time-in-a-century

http://www.nytimes.com/2013/01/06/world/europe/greece-tax-scandal-shifts-focus-from-collection-problem.html

Sources
Measures Taken
Future of the Eurozone

Cut spending



May deepen the recession

In the short and intermediate term...

Don't cut spending



Risk financial collapse
In the long run...

More integration:

- Fiscal union
- Banking union
- Political union?





Disintegration:

- Exit of struggling states
- Feasible option?
Based on data from www.tradingeconomics.com
Based on data from www.tradingeconomics.com
Based on data from stats.oecd.org
Based on data from ec.europa.eu/eurostat
Based on data from ec.europa.eu/eurostat
Unemployment (in % of labor force)
Based on data from ec.europa.eu/eurostat
Full transcript