Stephanie:
Within the Eurozone, there are two distinct groups of countries, often referred to as the
Core (aka North) and the Peripheral (aka South) countries. The Core is composed of countries
such as Germany, France, and Austria, who are characteristically net savers and run account
surpluses, while the peripheral countries of Portugal, Ireland, Italy, Greece, and Spain are net
consumers who run account deficits. The graph below provides a clear illustration of the
disparities between the two sets of countries, as evidenced by their divergent current account
balances. Given these differences, existence under a common monetary system makes
effective policy decisions nearly impossible. These differences are particularly important to the
stability of a common financial system, as was established over the decades leading up to the
European Monetary Union’s formation.
The integration and deregulation of European financial markets effectively began with
the Single European Act of 1987. A revision of the previous Treaty of Rome from 1957 enacted
by the precursor to the European Union countries, the European Economic Community (EEC),
became the true leap-board for the financial integration and removal of trade barriers among
European countries. Over the course of the 1990s, European countries deregulated more and
more of their financial sectors, while allowing them to become more intertwined, through the
adoption of the European Directions and later the Single Market Program of 1993. The
Financial Services Action Plan of 1999 (FSAP) effectively established a common set of rules for
the financial sectors of all European Union members. These actions led to an unprecedented
growth in the size of European capital markets, and a convergence of interest rates. Although
these policies expanded the available markets and significantly reduced the transaction costs of
trade among member countries, the financial liberalization of European Union members also
fostered a false sense of security of the prosperity and riskiness within their common financial
system.
Antonio:
The European financial crisis was exacerbated by the accumulation of three types of
debt; private, public, and foreign. Between the introduction of the Euro and the beginning of the
global crisis, private debts grew rapidly (as a percentage of GDP) in several of the member
states. Figure 1 shows that the three countries that would face the most turmoil suffered the
highest increases of private debt-to-GDP after their induction to the EU.
Figure 1: Private Debt as Percentage of GDP (Source: OECD)
This became a major issue when the financial crisis struck because most of the household
debt was ultimately owned by foreign investors. Once the bubbles started to burst, the GDP of
many countries fell while simultaneously the fiscal responsibilities of the governments rapidly
rose. The governments had two obligations; first, they had social welfare obligations which were
quickly overexploited by citizens who had negligible savings to draw from. This increased the
amount of public debt each country held, which was drawn from short-term and expensive
sources of credit. Second, the government guaranteed several of their largest corporate debts.
The end result was that these nations had high amounts of foreign-held public and private debt,
which tied up the availability of credit for their entire economies.
Figure 2: Public Debt as Percentage of GDP (Source: OECD)
Figure 3: Interest Rate, GDP Growth, and Public Debt/GDP Ratio (Source: Vox EU)
The explosion of private and public debt in the fiscally irresponsible countries (i.e. Greece, Italy,
Ireland) damaged the financial health of more stable countries, because most of the foreign
investors who owned the debts were German, French, American and UK citizens. Worse, the
governments of the stable countries in the EU were the primary sources of the ECB bailout.
Their economies were suffering from both ends; their private sectors were underperforming
because they lacked the liquidity expected from the defaulted investments, and their public
sectors were overspending due to the unforeseen bailout expenditures. For example, since
2008 Germany alone contributed “22 billion euros in the first Greek bailout, 253 billion euros to
the European Financial Stability Facility and 94 billion euros to ECB purchases of sovereign
bonds, and that's only a few of the highlights. Add it all together, and Germany's commitments
to its neighbors could top 30% of its GDP.”[1]
What are the financial effects of diverting approximately a third of the EU’s (not only
Germany’s) GDP towards repaying debts? We will focus on two areas. First, investors are much
more hesitant about investing in the fringe EU nations. For example, since December 2014 the
Athen’s Stock Exchange has dropped a further 30% as investors divert their funds toward safer
options. Second, exchange rates and interest rates are still very much in flux. This has hurt the
current account balances of the very countries who need to be engaging in trade the most.
[1] http://www.investopedia.com/financial-edge/1112/will-germanys-bailout-save-europe.aspx
David:
It became obvious in 2007 that the global financial system was very fragile. Martin Wolf
gives five reasons to this fragility: changes in liberalization, globalization, innovation, leverage,
and incentives. There has been a movement towards free markets during the past decades and
it has allowed all of this crazy borrowing and lending. Funding has gone global and the
interconnection of the global financial system creates a domino effect when a financial crisis hits
one country. New complex financial assets such as derivatives were created along with shadow
banking and too many people were unfamiliar with them. There was no lender of last resort or
any competent regulator. Many borrowers also leveraged themselves intensely during the years
leading up to the crisis. Finally, there was a big change in incentives as investors became willing
to take on more risk than earlier.
All these factors helped set off some times of wild lending and borrowing in the
Eurozone. Before the crisis broke out, all Eurozone government bonds were considered equally
risky. Part of this problem is a regulation, Basel I, which allows all banks to consider government
bonds as risk free. The interest rates on these bonds were very similar throughout all of Europe
and investors imagined it was just as safe to invest in Greek government bonds as in German.
This resulted in major private capital flows streaming to southern Europe but also Ireland. The
capital came mostly from countries with excess savings and low credit demand. Instead of
investing at home, they turned to countries where the credit demand was higher and rate of
return seemed to be higher. The crisis would probably have been easier on us if the importing
countries had invested the borrowed money in projects that would have yielded a rate of return
similar to the interest rate they were paying. This was not the case, though, and the Greek
government especially spent their borrowed money on unsustainable projects. They gave out
ridiculous bonuses to employees, had a very low retiring age, which created a casual working
environment in the country. So when the lenders realized the risk and came to get their money,
the borrowing countries were standing there with close to empty pockets.
Brett 1:
The Ireland housing bubble started in the 1990’s. The government had lowered interest
rates to stimulate the economy. During that time people wanted to find a safe and sustainable
long term asset, so they turned to real estate. In addition, banks were encouraging people to
take out loans by offering 100% mortgages. Knowing full well that those taking out the loans
couldn’t pay them back causing the people to foreclose, which helped keep the supply stable.
Although when others started realizing that housing was the industry to enter the supply began
to increase. By 2006 the bubbled ballooned and supply and demand stabilized. When 2007
rolled around housing prices dropped because property prices are unsustainable,and rental
yields have fallen below the risk free rate of over 3.5% offered by Government bonds.
Allyson:
A major factor in the account imbalances experienced by many Eurozone countries was the
common belief that the euro was equal among member states as if the Eurozone were its own
independent country. In the early years of the euro, capital largely flowed from richer countries
to poorer countries (especially those in southern Europe) based on gamble that returns would
be higher in these areas. The recipient economies became very reliant on the large capital
inflows and thus, when the financial crisis of the late 2000’s hit, the sudden turnaround of capital
inflows caused deep economic turmoil. The chart below illustrates the increased spending of the
euro area by plotting the ratio of foreign assets plus foreign liabilities to GDP. Notice the graph
peaks around 2007.
Another major factor contributing to the widening imbalances was that the newly found capital
making its way through southern Europe was placed in the non-tradable sector, and as a result
many countries experienced construction and housing booms. Additionally, when the
turnaround of capital used to finance many of the construction projects seemingly evaporated
during the financial crisis, it caused financial devastation in the respective countries. What
remained was severe account imbalances due to the increased demand for capital that fueled
an increase in imports while exports did not raise enough to maintain a balance.
The above graph depicts the current account to GDP in relation do a particular country’s growth
rate. The countries further to the right experienced positive balances while also achieving
growth. The countries to the left (note, mostly southern countries) were experiencing similar
growth, only their accounts show that the growth was funded through debt. Ireland stands out as
achieving remarkable growth in the years spanning 1999-2007, this is explained by a massive
housing bubble, funded by shady loans, which severely inflated the Irish housing market. The
graph below is a snapshot of the imbalances in 2007.
Stephanie:
Many viewed the differences in the balances as a result of the convergence hypothesis.
According to this theory, countries with lower GDP per capita are attractive investments as they
represent greater potential for growth and large rates of return. Anticipating their own future
growth, such countries save less and consume more, assuming they will be able to finance their
foreign debt through their increased future productivity. Unfortunately, empirical evidence has
not supported this theory in the context of the periphery countries of Europe (Holinski, Kool,
Muysken 2010,
Despite the blatant discrepancies among the current account balances of the Eurozone
countries, up until 2009, Spain, Germany, and Ireland were given the same AAA rating. Once
investors began recognizing the riskiness of the countries began being downgraded, it became
a self-fulfilling prophecy. Credit downgrades led to higher expected bond yields due to their
increased riskiness, which resulted in short-term losses for current bonds holders. These
losses then made it more expensive and difficult to issue new debt or for governments to
refinance, which in turn led to ever greater risk-aversion by investors, and higher costs, leading
to eventual insolvency.
●
“in 2007 the spread between 10-year government bond yields of Greece and Germany
was only 0.27 percentage point”
Credit default swaps--meant to spread risk better, but ended up just concentrating it
●
Herding Effect:
○ Herding during the boom drove prices away from fundamentals in the Peripheries
■ consumers
■ investors
■ financial institutions
○ Herding in debt and currency markets may result in self-fulfilling prophecy
■ The role of rating agencies
■ The role of hedge funds
Brett 2:
The Portugal account balance was dominated by non-trade factors. Remittances started
to come down in the mid 90’s this was due to two factors. The first factor was outward migration
during the 60’s, then attracting inward migration from places like Brazil and Eastern Europe.
The second factor was the rising disposable income levels and ability to receive cheap credit
reducing the need for transfers from the Portuguese; however, some of the decline was due to
the accounting feature of moving official EU structural adjustment funds from the current to
capital account. Portugal had a lot of money flowing into it and ran up a deficit that was not
sustainable over the long run. Eventually in 2014 Portugal created and followed through with a
bailout plan to stabilize their deficit and return growth to the economy.
·
In response to the myriad of financial failures and inadequacies of Eurozone countries,
several corrective measures have been taken. To address issues of financial supervision and
inaccurate risk assessment, the European Systemic Risk Board (ESRB) was established in
2010. They work in conjunction with the European Supervisory Authorities and the European
System of Financial Supervision. The overarching goal of each of these is to regain and
maintain future financial security within the European Monetary Union.