The Eurozone Financial Crisis
The Eurozone Financial Crisis
• Transmission from the United States
• Housing Price Bubble and Collapse
• Financial Market Freeze and Collapse
• Policy Response
– Support for Financial Sector
– Monetary Policy
– Fiscal Policy
• Effect of the Euro Currency Zone
• Greece’s Problems
Transmission from United States
• US Housing Bubble created by
– Low interest rates
– Lax regulation of sub-prime mortgages with
adjustable rates, two year teaser rates
– Securitization of mortgages, sold to unwary
buyers as highly rated
• US Bubble popped when
– Interest rates rose in 2006, housing prices fell
– Subprime mortgages and securities defaulted
European Crisis Began Later
• US Housing Prices peaked in late 2006
• European Housing Prices peaked a year later
• Financial Crisis struck Europe & US at same time,
August 2007, after Bear, Stearns, Fannie Mae &
Freddie Mac taken over with US Government
assistance in April and July of 2007
• International credit markets froze up in August 2007
when subprime based hedge funds collapsed in
Europe and US. No longer able to borrow short-term
funds, banks faced much higher risk premia
Why did the Crisis Spread?
• Subprime Debt Obligations made in USA held around the
world caused global financial shock.
• Housing bubbles burst in UK , Ireland, Spain as well as US.
• Failure of Lehman Bros in September 2007 caused massive
panic over counterparty risk. AIG required $180 billion
bailout to cover Credit Default Swaps, insurance against
bond defaults underwritten without reserves.
• Stress on banks around the world led to shrinking credit
availability. “Shadow” off-balance-sheet banking sector
collapsed as short-term funding vanished.
• Falling demand spread from US to all countries; as US
imports dropped, other countries’ exports fell.
Banks Under Duress: Writedowns and Capital Raised
Source: International Monetary Fund (2008)
Quarterly Real GDP Growth Rates
Source: International Financial Statistics, IMF.
European Financial Institutions under
• BNP-Paribas forced to close funds in August 2007
• UK bank Northern Rock taken over by government
• German state banks IKB, WestLB, BayernLB and
SachsenLB bailed out by government
• Irish banks given government deposit guarantees
• Switzerland injects funds into UBS
• Iceland’s banks unable to roll over short term
borrowing, default on deposits of foreigners
Credit in the Eurozone (% change)
Source: European Commission (2009).
Monetary Policy Response by
European Central Bank (ECB)
• ECB injected liquidity into European banks
unable to obtain short-term funds in market.
• Federal Reserve used Euro-dollar swaps to
make dollars available to ECB to lend to banks.
• ECB did not lower interest rates until October
2008 because of its focus on inflation.
• Euro fell against the dollar due to “safe haven”
flight to US Treasury securities.
Interest Rates in the Eurozone and the US
Sources: ECB, Federal Reserve Bank of New York
Financial Sector Bailouts in US & Europe
• TARP and Federal Reserve programs in US
• National programs in European countries, due
to absence of Eurozone-wide regulator.
• “Beggar-thy-neighbor” effect, as first Ireland
gave deposit guarantees, then UK, then
Netherlands, to avoid bank deposit flight.
Public Support to the Financial Sector
(as of 18 February 2009, % of GDP)
Source: International Monetary Fund (2009).
Fiscal Policy Responses to Recession
• Automatic Stabilizers of falling taxes, rising
welfare and unemployment payments kick in
as incomes fall and unemployment rises.
• Discretionary Fiscal Stimulus enacted in most
countries, depending on their fiscal positions.
• European countries limited by Stability and
Growth Pact to 3% fiscal deficits, except in
time of “exceptional economic distress.”
Changes in Budget Balances, October 2008
Source: IMF (2009)
The Role of the Euro
• Previous economic crises in Europe have led
to large devaluations of currencies.
• Within eurozone, single currency prevents
devaluation , provides automatic financial
support through capital markets.
• Non-euro currencies depreciated sharply in
2008, British pound sterling, Swedish kronor,
Polish zloty, Hungarian forint.
Exchange Rates vs the Dmark or euro
(Left Index: 1970q1 = 100 Right Index: 2007m1 = 100)
Source: International Financial Statistics, IMF, Monthly Bulletin, European Central Bank
Greece’s Financial Problems
• Since joining the euro, Greece has had higher
inflation than other Eurozone members.
• Greece has also increased debt faster than others
to finance generous public sector pay, welfare,
and retirement benefits, while collecting a lower
share in taxes due to widespread tax evasion.
• As a result, Greek goods have become increasingly
expensive and uncompetitive, causing loss of
market share and further reducing revenues.
Relative price indicators based on export prices
Source: European Commission (2010)
The Greek Debt Crisis
• Greek debt/GDP ratio reached 113% and
deficit/GDP ratio reached 12.7% in 2009.
• Foreign bondholders became doubtful that Greece
could continue to roll over its increasing debt,
forced interest rates higher.
• EU faced choice between Greek default and bailout
with tough conditions.
• IMF and EU agreed to lend Greece up to $146
billion over three years.
• Greece to increase sales taxes, reduce public sector
salaries, pensions, eliminate bonuses.
• Cautious Eurozone response to Financial Crisis
– Interest rate policy reaction delayed: concentration on
– Fiscal policy reaction muted: Stability & Growth Pact
• Common currency members avoided large
devaluations and foreign currency debt.
• European governments have tried to act together, not
• Limited impact of falling exports due to extensive
internal trade relationships.
• Greece facing difficult adjustment problems, European
banks avoiding losses on Greek bonds.