The Sovereign Debt Crisis
2010-2011
A European Approach
Enrique Viaña
Rzeszow, 10 May 2011
What is de SDC?
• The SDC is a recurring turmoil in the global
markets for securities, which makes it difficult
por periphery members of the EMU – European
Monetary Union – there to finance their
budgets.
• Membership to the EMU is a requisite for a
country to be listed in the SDC:
– Thus, the financial rescues of Iceland and Hungary
by the IMF in 2008 are not episodes of the SDC.
– The first country to suffer the SDC was Greece,
early in 2010.
Causes of the SDC /1
Apparent causes: the turn of the EMU
from fiscal stimuli to fiscal consolidation, in
the fall 2009.
- Up to that point, the EMU alongside the whole
EU and other advanced economies followed
the IMF instruction in the aftermath of Lehman
Brothers’ bankrupcy (Sept 2008) to foster
aggregate demand by means of expanding
public expenditure.
- The ECB easied the policy through unlimited
lending to banks. (Banks bought debt
however much there was in supply.)
Causes of the SDC /2
Profound causes: Competition between
euro and the US dollar (and, to a much
lesser extent, the pound sterling) for the
more competitive to be cashed by global
dealers as a preferred reserve currency.
- Such competition began in 1999.
- It has intensified during the global
crisis, which is a crisis ignited in Wall
Street, the HQ of the dollar area.
Crisis of the dollar /1
• The US dollar was signaled a reserve
currency at a global scale, in substitution
for gold, by the Bretton Woods Conference
(July 1944).
• While the US economy ran external
surpluses, all went well: the US lent others
the money they spent in buying American
goods.
• The expectation was for the US to build a
mature financial position.
1) Building a mature financial position
A sells B as
much as X
A
X>M
B
B sells A as
much as M
A builds a financial
position, not yet mature
A lends B as much as X — M
2) A mature financial position
B pays A as
much as M
interest rate
A
B
B sells A as
much as M
Balance due = 0
Crisis of the dollar /2
• Yet, the US economy began to run
increasing deficits before it could build a
strong financial position.
• Dollar so overmarched the international
necessity for transaction purposes.
• A period of global inflation followed in the
1970s; the gold exchange standard came
to an end, and so did the pegged
exchange rates as accorded in 1944.
Financial dominance, not mature
B uses A’s money to
buy goods and
services
A sells B as
much as X
A
X<M
B
B sells A as
much as M
A prints money worth of M — X and gives it to B
in full payment of the trade deficit
GLOBAL
INFLATION
MARKET FOR GOODS
AND SERVICES
Crisis of the dollar /3
• In 1981, President Ronald Reagan of the
United States abruptly changed policy.
• US external deficit did not recede but
rather boosted—it was its financing what
changed.
• Instead of sending dollar abroad to pay for
the deficit, the US borrowed in large scale
by means of paying high interest rates.
• A long-lasting world recession followed,
because of the higher interest rates.
B demands A’s assets in
excess of |X — M|
A’s currency gains value
A sells B as
much as X
A
X<M
B
B sells A as
much as M
A gives B profitable, safe assets to pay for X — M < 0
PRESIDENT REAGAN’S
ARRANGEMENT
De-regulation, a Requirement
• For President Reagan’s arragement to
work, de-regulation of the world financial
transactions was a necessity, there to
ease anyone from anywhere to buy US
Treasure Bills.
• That is how de-regulation was effected
throughout the OECD members, first, and
through the IMF’s efforts also everywhere
else.
Crisis of the dollar /4
• World recession came to an end in Sept
1985—the so-called Plaza Hotel
Agreement, in which virtue the
Bundesbank and the Bank of Japan
agreed to sterilize the American deficit, by
cashing every and the last dollar without
pouring it into the currency market.
• Thus, both central banks upheld the value
of the dollar somehow artificially.
A’s money keeps
its value somehow
artificially
B accumulates cash
balances of A’s money
A sells B as
much as X
A
X<M
B sells A’s
money
B
B sells A as
much as M
A prints money worth of M— X and gives it to B
A’s currency
loses value
PLAZA HOTEL
CURRENCY
MARKET
AGREEMENT
Crisis of the dollar /5
• The Plaza Hotel Agreement educated the
Bundesbank on the advantages of a hard
currency.
• On the one hand, America could buy
anything from Germany and Japan it
desired without regards of the financial
effects—both countries self-paid with very
low unemployment rates.
• On the other, the US dollar enjoyed a high
purchasing power.
The Birth of the Euro /1
• Early in the 1990s, Germany led a joint
European effort to issue a common
currency—the Treaty of Maastricht was
the outcome.
• The common currency, by name the euro,
was seen as a symbol of the EU as much
as a flag and anthem were.
• Besides, the euro was believed to be a
necessary requirement in order to further
the economic union.
The Birth of the Euro /2
• Yet, it was much more than that.
• The 1990s is the globalization decade; it
means that many emerging economies
joined with Germany and Japan as strong
exporters—China among them.
• Those emerging countries were not obliged
by the Plaza Hotel Agreement—they could
choose between competing reserve
currencies solely on account of comparing
their intrinsic, not political value.
The Birth of the Euro /3
• Therefore, the euro in its origin was a project to
offer the global exporters a reserve currency of
a high intrinc value, there to replace the dollar
in holdings of cash balances.
• To strengthen the intrinsic value of the new,
common currency a domestic agreement was
implemented—the new currency needed to be
scarce, whereby the 3% of the GDP ceiling for
fiscal deficits and the 60% of the GDP ceiling
for sovereign debt outstanding.
• That is the main contents of the Stability and
Growth Pact (1995).
Dollar v. the Euro /1
• Competition between the two currencies
ran smoothly from 1999 through 2007, but
not without important effects.
• Pressed by the competitive edge of the
euro, Wall Street excelled in financial
engineering.
• WS strove to offer the global exporters
attractive assets there to invest their
surpluses: the 2000s is the decade of the
financial derivatives.
B demands A’s assets
in excess of M — X
A’s currency gains value
A sells B as
much as X
A
X<M
B
B sells A as
much as M
A gives B profitable, risky assets in substitution for money
AN ARRANGEMENTE BASED ON
FINANCIAL ENGINEERING
Dollar v. the Euro /2
• Meanwhile, the euro endured the trouble
of enforcing the discipline of 11, then 12,
now 17 countries that lack homogenity in
many important fields.
• Somewhat candidly, it was believed that
the process of convergence, required to
every country to join the common
currency, ensured success.
• It didn’t.
The Financial Crisis, 2007-2008
• Against that background, the financial
crisis was the unavoidable outcome of an
inflation of US dollar-denominated assets.
• The crisis erupted out of the American
subprime morgatge-backed securities and
CDO, but it might have erupted out of
anything else.
The Next Financial Crisis?
• As much as WS-based Bear Stearns
inflated the real estate bubble until it
exploded in 2007, WS-based Goldman
Sachs now inflates a commodity bubble
that will most likely explode in 2012 or
2013.
• WS works like that: it holds on an
opportunity—this time the surge in oil
prices—and engineers an ample
speculation there to funnel financial
surpluses into the US economy.
The Policy of Fiscal Stimuli
• Just after Lehman Brothers went bankrupt
(15 Sept 2008) the IMF instructed the
developed countries to run huge fiscal
deficits in order both to sustain
employment domestically and to uphold
the international trade.
• In mid-2009 the USA reported the end of
the recession.
Return to the 1995 Pact
• Fiscal stimuli implied that the Stability and
Growth Pact—3% of the GDP ceiling for
fiscal deficit, 60% of the GDP ceiling for
sovereign debt—was temporarily waived.
• In the fall 2009,however, while the IMF
and America still went on in fiscal stimuli,
the EU changed to fiscal consolidation,
and the ECB discontinued unlimited
supply of cheap money to banks.
The Euro Resumes Competition
• The European analysis seemed to be that,
once the recession was over, fiscal stimuli
and accommodating monetary policy
weakened the euro by accelerating
inflation—the greatest danger in absence
of financial discipline.
• However, as the euro adopted a tough
stance while the dollar still did a loose one,
the former climbed in the currency
markets.
Effects on the EMU Countries
• The main such effect was, that countries so far
financing their accumulated debt through
private bank purchases at cheap cost, were
then compelled to seek finance in the global
markets.
• The markets, so far step-sided by expansionary
policy, took on the lead and began to scan the
different borrowers.
• Some of the borrowers were found unreliable.
• That is how the SDC crisis began.
1) RULING BY POLICY
EMU
COUNTRY
BOND
MARKET
If necessary, private
banks sell bonds
in the bond
market
EUROPEAN
CENTRAL BANK
Private banks reapply for cheap
money as necessary
The ECB lends unlimited 1-year
money, at 1% interest rate
Private banks
buy 10-year
bonds at
issuance
PRIVATE
BANKS
2) PART-RULING BY POLICY, PARTRULING BY THE MARKET
BOND
MARKET
When yields rise in the bond market,
governments are compelled to issue
at a higher interest rate
When cheap money at the
appropriate maturity stops
flowing from the ECB, a large
volume of bonds are sold
and their price falls down
—yields rise
EUROPEAN
CENTRAL BANK
EMU
COUNTRY
Private banks
buy 10-year
If necessary, private
bonds at
banks sell bonds
issuance
in the bond
market
Private banks reapply for cheap
money as necessary
The ECB lends unlimited 7-day and 90day money, at 1,25 % interest rate
PRIVATE
BANKS
Two Interpretations of the SDC
• For American and British analysts, SDC reveals
weakness of the euro as a currency that is not
backed by a common, comprehensive
economic policy—therefore it heralds the
collapse of the euro.
• Another interpretation says SDC is a chapter of
a story of competition among currencies, in
which the euro battles out to enforce the
financial discipline that will enable it to
supersede the US dollar as a global reserve
currency.
THANK YOU VERY MUCH
http://purgatorioeconomico.blogspot.com
enrique.viana@uclm.es