From (US) financial crisis to euro crisis: Why are American houses connected to Europe's internal imbalances?: Presentation for UNC Center for European Studies Fall Lecture Series 2012, Beyond the Euro Crisis

1. From (US) financial crisis to eurocrisis: Why are
American houses connected to
Europe's internal imbalances?
Herman Schwartz
University of Virginia
16 November 2012
UNC Chapel Hill / TAM

2. Everything you need to know…

3. Euroland: an Optimal Currency Area?
• Euro only works if Europe is an OCA
• OCA needs:
– Essentially open financial markets (Yes)
– Essentially open goods markets (Mostly, but…)
– High internal labor mobility (No)
– High fiscal transfers (No)
– And – same ideas about proper policy
• Result: regional instabilities that are
magnified by national political structures

4. Productivity vs average wage and average
income of top 1%, in US, 1979+

5. Rising US household debt compared to
incomes
1:1
ratio

6. The 1991-2007 US growth cycle
Fed ↓ interest rates
↑ Tax revenue
Disinflation Housing
Finance
More Consumption
System
Asia Recycles
US Dollars as new
Faster US
Treasury / MBS Debt
Economic Growth
US trade deficits
 Global Growth

7. China’s growth cycle, 2000s
↓ domestic
consumption
Low interest rates
No welfare state State
More investment
Banks &
for exports
party
Central bank elites
Sterilizes $$
Issuing RMB Trade Surplus
Central Bank buys $$

8. The 1995-2000s German growth trap
Tight money
↓ Tax revenue
policy
Wage restraint
Low Domestic Less Domestic
Demand Consumption
Slower job
creation Slower relative
economic growth
Less domestic
investment

9. The 1995-2000s German growth trap
Tight money
policy
↓ Tax
revenue
German banks
buy PIGS debt
Wage restraint
Low Domestic Less Domestic
Demand Consumption Export
surplus
Slower job
creation Slower relative
economic growth
German banks
Less domestic
investment buy US
Mortgage bonds

10. All these cycles are linked
CHINA USA GERMANY

11. Euro16 balance with select countries (€bil)
200 100
150 80
Norway
100 60
Turkey
50 40 Japan
Poland
0 20 Switzerland
-50 0 Russia
ChinaxHK
-100 -20 United States
United Kingdom
-150 -40
EU 16
-200 -60
-250 -80

12. Germany produces but does not consume
– final consumption expenditure growth as
% of German growth (Germany = 100)
240%
Ireland Greece Spain Italy Portugal
220%
200%
180%
160%
140%
120%
100%
80%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

13. Germany’s trade surpluses (€ bil)
140
120
100
80
60
40
Germany to EU27
20
Germanyto ROW
0

14. EU member interest rates 1995 - 2011
EURO Lehman
introduced crash

15. Taylor rule interest rates

16. Export growth, xEU27, index, 1999 = 100
300
250
200
Germany
Spain
150 France
Netherlands
100
50

17. Import Growth xEU27, index, 1999=100
350
300
250
Germany
200 Spain
France
150
Netherlands
100
50

18. EU internal trade balances, € mils
More imports = rising “foreign” debt
300,000
250,000
200,000
150,000 Netherlands
Germany
100,000
France
50,000 Greece
United Kingdom
0
Italy
1999 2000 2001 2002 2003 2004 2005 2006 2007
-50,000 Spain
-100,000
-150,000
-200,000

19. External trade balance, € mils
100,000
50,000
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Germany
-50,000 France
Italy
-100,000 Greece
United Kingdom
-150,000 Netherlands
Spain
-200,000
-250,000
-300,000

20. US trade deficit (goods only, disaggregated, $bil.)
200
100
0 EU x Germany
-100 Lat. America
Canada
-200
Rest of world
-300 Germany
Japan
-400
Middle East
-500 China
-600
-700
-800

21. Central bank currency swap network
2007-2010
FIG 6: Central Bank Currency Swap Network, 2007-2010

22. $100,000
$300,000
$400,000
$500,000
$600,000
$200,000
$0
2007-12-05
2008-01-02
Fig 5:
2008-01-30
2008-02-27
2008-03-26
2008-04-23
Lehman
2008-05-21
2008-06-18
bankruptcy
2008-07-16
2008-08-13
2008-09-10
2008-10-08
2008-11-05
2008-12-03
2008-12-31
2009-01-28
2009-02-25
2009-03-25
2009-04-22
2009-05-20
2009-06-17
2009-07-15
2009-08-12
2009-09-09
Value Central Bank Currency Swaps With U.S. Federal Reserve
2009-10-07
2009-11-04
Currency Swaps
2009-12-02
(Weekly Average) -
2009-12-30
of FED currency swaps ($mil)
Multiplier = 1,000,000
2010-01-27

23. EU member interest rates 1995 - 2011
EURO Lehman
introduced crash

24. Crisis Fiscal deficits (not the reverse)
4
Sweden
Denmark
-1 2004 2005 2006 2007 2008 2009 2010 Germany
Italy
Netherlands
-6 Euro area (16 countries)
Spain
United Kingdom
-11 Greece
-16

25. What if Greece (Spain) defaults?

26. Who owes and to whose banks
1600
350
1400
300
1200
250
1000 200
800 150
600 100
400 50
0
200
0
Spain Greece Portgual

27. The eurozone is a straw house

28. QUESTIONS?

29. Intra-EU debt, absolute, $bil. @ 3/11
1600
1400
1200
1000
ROW
800 ANY PIIGS
FRENCH BANKS
600 BRITISH BANKS
GERMAN BANKS
400
200
0
ITALY SPAIN IRELAND PORTUGAL GREECE

30. Why the ECB won’t ease rates: Ideas
[We are] calling upon [the] social partners to show a high level of
responsibility. . . [I]t is clear that if one is not satisfied with the
present level of unemployment, wage moderation should
remain of the essence. . . [I]f you are in a position where there
are doubts about your present level of cost competitiveness,
then of course wage moderation remains absolutely of the
essence.
• Jean-Claude Trichet, 12 April 2007
We have only one needle in our compass. That needle is price
stability, our definition of price stability.
• Jean-Claude Trichet, 7 August 2008

31. …and Mario Draghi
“The risk of inflation is rising. There is now
a greater need to proceed with
monetary policy normalization so as to
prevent expectations of higher inflation
from becoming entrenched.”
Mario Draghi, Bank of Italy’s annual
meeting, May 2011

32. Employment gains, 1991-2005
Share of OECD Population, 2005, %
Share of New Jobs, %
60%
50%
40%
30%
20%
10%
0%

33. SIVs (phase 1 – money for nothing)
$640 in
Interest
RoE = 64% SIV ABCP
Bank $1,000 + (your money
$1000 $19,000 = market money)
$20,000 $19,000 dollars
$760 in @ 4%
$1400 in interest
interest
$20,000 of
CDO and Payments from
/ or MBS Subprime
investment borrowers: $1400
@ 7%
interest

34. SIVs (phase 2 – loan contraction)
Bank must
put in $60 ABCP
SIV
Bank $1,000 + (your money
$1000 $19,000 = market money)
$20,000 $19,000 dollars
$760 in @ 4%
interest
$20,000 of
CDO and Payments from
Only $700 in / or MBS borrowers fall:
interest !! @ 7% $1400 => $700

35. SIVs ( phase 3 – bank collapses)
MMF wants whole
loan repaid
SIV ABCP
Bank $1,000 + (your money
$1000 $19,000 = market money)
Bank must $20,000 $19,000 dollars
put in $$$ $760 in @ 4%
to cover re- interest
payment of
ABCP to $20,000 of Payments from
MMF $700 in CDOs now borrowers fall:
interest worth only $1400 => $700
$15,000 & foreclosures
start => ↑ losses

36. Why SIVs’ collapse => AIG collapse
Bank SIV MMF -
$1000 ABCP
$20,000 of
CDOs now Borrowers:
worth only $20,000 mortgages
$15,000
AIG
$20,000 of
CDS

37. Ormand Quay (Sachsen Landesbank’s
gambling unit)
Assets Balance Sheet, July 2007 term
Liabilities (all short
(guaranteed by Sachsen debt with maturity < 1
Landesbank) month)
Residential Mortgage ABCP
Backed Securities $6.3 b $11.3 b
Commercial Mortgage
Backed Securities $2.7 b
Consumer Loans $0.5 b
Other $1.8 b
Total $11.3 b Total $11.3 b

38. Adjustment

39. Adjustment
What?
Trade Trade
Deficit Surplus
Country Country
Excess
Exports

40. Adjustment via labor flow
Outmigration
Trade Trade
Deficit Surplus
Country Country
Excess
Exports

41. Adjustment via time
Future
Trade Exports
Trade
Deficit Surplus
Country Country
Excess exports
(capital goods)

42. Adjustment via exchange rate
Devaluation
 more
Trade exports Trade
Deficit Surplus
Country Country
Excess
Exports

43. Adjustment via wage declines (1)
Trade Trade
Deficit
Country (1)
Surplus
Country
Excess
Exports

44. Adjustment via wage declines (1)
Trade
Trade
Deficit Surplus
Country (1)
Country
Excess
Exports

45. Adjustment via wage declines (1)
Trade Trade
Deficit Surplus
Country (1) Country
Excess
Exports

46. Adjustment via wage increases (2)
Trade Trade
Deficit Surplus
Country Country (2)
Excess exports
 Rising incomes
in (2)

47. Adjustment via wage increases (2)
(2) Imports
more, exports Trade
Trade
less Surplus
Deficit
Country Country (2)
Excess exports
 Rising incomes
in (2)