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E.I. (Subject) / The Euro Crisis (Lesson)

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• What is the Euro crisis? The Euro crisis is no currency crisis in traditional sense: no (dramatic) depreciation of € no capital fliight out of Eurozone no balance of payment-crisis in Eurozone no inflation BUT: sovereign dept crisis (Greece, Ireland, Spain, Portugal, Italy?) high spread of interest rates within Eurozone Burst of real estate bubbles in many Member States Zero growth in Eurozone and serious recessions in some Member States
• Is the "one-fits-all" monetary policy in the Eurozone the cause of the crisis? What about asymmetric shocks? Recall: OCA theory focuses on asymmetric shocks Economic structure between the North and the South might be diverse (manufacturing vc. tourism) but are affected by business cycle shock in similar way The "Great Recession" 2008-09 affected therefore countries with strong manufacturing sectors (esport demand shock) at least as much as countries with strong tourism If prices and wages are not flexible, different (productivity adjusted) wage developement can create imbalances in current account which have to be matched by capital inflows In theory, Hume's mechanism would guarante a BoP-equilibrium and in long-term also a current acount equilibrium -> in practice this does not necessarily be the case, since current account imbalances are financed by public transfers in one way or another => Wage growth has been unbalanced in Eurozone but (productivity adjusted) real unit labour costs have been much less unbalanced. This suggests that different rates of growth refeflct different productivity growth patterns. BUT Current account surplus of Germany tended to increase persistently and substantially while current account of Greece, Portugal and Spain deteriorate persistently -> First hin for imbalances in Eurozone
• Public vc. Private debt Conventional wisdom explains Eurocrisis by moral hazard of governments in Eurozone BUT [with exeption of Greece]: (i) public debt has fallen and not increased before crisis, (ii)private debt has increased dramatically before crisis Bank debt has increased more than corporate debt -> banking regulation and moral hazard in private sector underrated? ⇒ With exeption of Greece, the dramatic increase of private debts (real estate loans)are the first cause of financial crisisi Thte crisis of the banking sector forced governments to take over private debts to avoid systemic failure of financial sector -> increased dramatically public debts "Great Recession" increased public debt further through automatic stabilizers and fiscal packages
• Has ECB monetary policies triggered the financial crisis? Hypothesis: low and "one-fits-all" interst rate policies have triggered financial crisis, e.g. real estate bubble Interest rate indeed substantially declined in some countries (Greece, Italy) BUT ECB interest rate policy followed what we expect in case of a strict application of "Taylor's rule" -> i deviated only slightly below rate predicted
• Do low interest rate explain real estate bubble? We cannot explain boost in housing prices by national interest rates in most Euro-countries empirically We can explain the bboost by imprudent banking regulation and subsequent financial packages like subprime mortgages -> right policy response is to reform banking regulation not monetary policy Housing price bubbles is a key reason for public debt problem
• Are government debts different in a currency union? Case 1: Investors fear debt default in country with national currency sell government bonds sell currency on exchange market exchange rate drops but money stock remains same eventually CB buys governmental bonds this generates inflation and exchange rate depreciation but no liquidity risk. Only for countries whcih cannot issue bond in national currencies
• Are government debts different in a currency union? Case 1: Investors fear debt default in CU sell e.g. Greece bonds and buy German bonds Euros leave Greece -> monetary stock contracts government faces liquidity crisis, i.e. cannot lend money at reasonable interest rate no channel to create liquidity, unless ECB buy Greek government bonds -> governmental debts are different because without a CB you cannot generate liquidity by pringting money role of expectation of sovereign debt default become increasingly important multiple equilibria and self-fulfilling prophecies can emerge (Spain, Italy)
• The TARGET2 debts Theory: In CU BoP balance is always guaranted by influx and outflow of money but not true in Euro System Trans-European-Automatic-Real-time Gross Settlement Express Transfer system allows for BoP imbalances ->risk of default is difficult to assess Maybe bad collateral in portfolio of Bundesbank and other CB Deficitis in current account are no longer financed by capital acoount surplus, since that equilibrating forces are distorted Long-run desequilibria may emerge
• Solutions to Euro crisis Abandoning no-bailout policies Financial transfers Change of TARGET2-transfers Eurobonds Leaving the Eurozone Banking regulation
• Abandoning the no-bailout policies treaties rule out (i) buying governmental bonds by ECB and (ii) financial transfers OCA-theory suggests that transfers are needed (European policy makers abandoned rules:  (i) ECB buys bonds from crisis countries and (ii) ESM and ESFM create a transfer union)
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• Bail-out by ECB expectations of debt default can result liquidity crisis and debt default buying governmental bonds can break these expectations difficult: moral hazard of governments and credibility of CB -> solution difficult (conditionality can be hardly imposed by ECB) Announcing that CB buy governmental bonds is a strong commitment (can print money) fast to implement Draghis announcement stabilized expectations of financial market after fiscal transfer commitment failed ->moral hazard problem remains
• Transfer Union European Financial Stability Funds (EFSF) and the later European Stabilization Mechanism (ESM) create a Transfer Union Carrot and Stick principle: support and conditionality Zero structural debt ceiling ("Schuldenbremse") problems lie in details EFSF requests higher interest rates above market rate (e.g. 6% for Ireland) This high risk premium (i) creates further financial difficulties and (ii) signals, that EFSF does not believe in success ESM took over debts from EFSF, but request that private actos participate in debt restructuring -> markets will anticipate this and require risk premium in first instance Establishment was not sufficient to calm down markets Complementary measures from ECB were needed
• Eurobond Would ease refinancing for governments but creates (i) moral hazard and (ii) higher interest rate for "good countries" BRUEGEL modell: blue (up to 60% of GDP) and red (for remaining debts) bonds -> high interest rates for high debt countries, low ones for low debt countries combining this model with different fees for Blue Bonds
• Government bankruptcy in Eurozone Risks: Contagion to other countries by forming vicious circle of bad expectations systemic risk by breakdown of banking sector, at least in affected countries Moderate version: "hair-cut"
• Leaving the Eurozone Would allow to depreciate currency Would not allow solving debt problem by printing money, since debts are issued in Euros Debt default is unavoidable. Risk of systemic failure of financial system and of contagion High risk of new default, since it is likely that new debt are not accepted in new currency Currency depreciation cannot solve long run structural problemns
• Banking regulation It's largely uncontroversial Higher capital demand for banking sector better regulation of derivate -> ECB branch is in charge of regulation -> controversial

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