Introduction To The Euro Crisis Flashcards
Interest-Rate Spreads
- Interest rate paid by borrower A -> Interest rate paid by borrower B (problem occurs due to different ‘prices’ without the Eurozone itself)
- Due to “risk premium”
- In the Eurozone the benchmark rate is Germany’s as it’s considered the safest government to lend to so it pays the least interest (different governments have different interest rates and provide different loans)
Higher interest rates for ‘bad’ countries, they’ll depreciate currency due to printing money to pay debt (spreads increased as countries started defaulting)
Before Euro, inflate debt away (depreciation), real value of money less and real value of debt less -> therefore charge higher interest rates
Causes: worsening of fiscal outlook
- In 2008-2009, countries enacted fiscal stimulus and expensive bank rescues, leading to large government debts
- Meanwhile, the severity of the crisis meant slower or negative growth
- Govern,etc deficits and debts went up as a share of GDP, spooking investors -> worries of insolvencies of government
- Exacerbated by concerns of possible further problems in banking and sluggish growth -> deadline in GDP may be persistent
Causes: changes attitudes to sovereign debt
- Spread becomes larger so focus on fiscal not monetary policy
- Governments facing risk of insolvency forced to cut spending and increase taxes (austerity)
- High interest rates on benchmark government bonds spread it to the rest of the economy (credit crunch)
- Austerity + Credit Crunch = Recession
Was a Fiscal not Monetary crisis
Vicious Cycles
- Recession weakens the economy, which reduces tax revenues, which forces further austerity
- Recession weakens the Banks, increasing implicit government liabilities, forcing further austerity
Austerity and Debt Sustainability
- Austerity causes recession, but may still make sense if it improves debt sustainability
- Debt sustainability may worsen if multiplier is greater than 1 (because of negatives)
- If Government reduces G, Y also reduces e.g. Y = kG
- K (the multiplier) then affects by how much that reduces by and it is over one, then this will cause serious problems if G decreases (good if G increases!)
Sovereign Crisis hit the periphery more than central
- People ran to central i.e. Germany, so further demand for their government bonds increases and money flows (actually helps central)
- no one wants to buy bonds = rolling over debt, keep issuing debt but no one buys bonds
Response from the rest of EU: “Bailouts”
- Loans to the most desperate/urgent cases
- Disbursement’s spread over time and conditional on austerity/reform targets
The “German dilemma”
- Failing to bailout may mean:
Losses for domestic banks on periphery-country assets
Exacerbated by contagion -> it you let one country default, other worry they wont be bailed out
Possible Eurozone breakup -> If Greece defaults, may leave Eurozone (ECB pushed them out or wants to leave so you can issue a new currency)
Bailing out means:
- Creating moral hazard -> other countries may not worry about fiscal prudence if a bailout is expected
- Condoning tax invasion, evasion, corruption, and lack of reform
- “Solution”: bailout with tough conditionality
- Critics balance not right
- Too much austerity worsens debt sustainability
- Politically unsustained in programme countries
Response from the ECB
- 2010-2012: occasional secondary-market purchases of government bonds
- 2012, cheap loans to banks, commitment to buy newly-issued government debt if necessary
- 2014: QE starts
- 2015: QE, negative rates
- 2016: QE, negative rates, free long-term loans to banks
From a sovereign crisis to a (new) banking crisis
- Recession weakens banks’ balance sheets
- Declines in the market-value for Government bonds also weaken balance sheets
- A diabolical loop:
Government bonds lose value because of implicit liability from banks
Banks balance sheet lose value because of losses on government-bond valuations
E.g.
Bank fails - less trust in gov(recapitalise) - bond prices decline - lowers bank balance sheet - recapitalise banks - increase debt - decrease bond value - decrease in balance sheet
Banking union
- idea: break the nexus between governments and domestic banks
- Done: unite banking regulator for Europe (ECB)
- To do: joint deposit insurance scheme
Debt-GDP Ratio
Debt-GDP ratio is increasing if:
- Debt/GDP = Debt increases greater than GDP increases
- Debt/GDP = Debt decreases less than GDP decreases
Fiscal Multiplier
M = 1: GDP will change exactly by 1 unit
M < 1: GDP will change by less than 1 unit
M > 1: GDP will change by more than 1 unit
Government Debt
Options to raise funds for debt:
1) Pay the debt through austerity and taxation
- Cut spending and increase government revenue
- Unpopular option because taxpayers bear the burden
2) Pay by Inflation
- Since debts are often in nominal terms, a government can print money to pay the debt
- Central bank to control Monetary policy and hyperinflation
3) Default: Not rolling-over maturing debts
- Why pay when you can choose not to pay
- Someone from somewhere will come and save the day anyway (e.g. creditors or creditor-taxpayers bear the burden)
