Lecture on Sovereign Risk and the Recent Crisis in the Eurozone (part II)

Question 1

What marks the rapid expansion of financial sectors in the USA and Europe?

Answer 1

• Banks became active investors (maturity mismatch, currency mismatch)
• Banks took major risks, implicity borne by governments such as house mortgages in the US to risky people

Question 2

Which lessons followed from the Great Depression did policy makers when the crisis in 2008 emerged?

Answer 2

• Rescue large financial institutions
• Deep distress in the financial system is soon followed by a profound and long-lasting recession
• Central banks must provide liquidity to the financial system and adopt sharply expansionary policies
• Governments must bail out banks and other financial institutions
• Governments must use fiscal policy to prevent a vicious cycle of recession and large budget deficits

Question 3

Why is contagion within the EUrozone highly troubling?

Answer 3

Indebtedness is not enough to explain why these countries, and not others, have faced the wrath of the financial markets

Question 4

What are possible additional explanations why countries faced the wrath of the financial markets?

Answer 4

• Indebtedness
• No lender of last resort
• Competiveness issue
• Policy mistake

Question 5

What bailout institution was formed after?

Answer 5

EFSF: European Financial Stability Fund for availability of financial resources in case of contagion

Question 6

What replaced the EFSF?

Answer 6

ESM European Stability Fund in 2012

Question 7

What is the doom loop?

Answer 7

The “doom loop” refers to a vicious cycle where weakened banks and struggling governments negatively reinforce each other, particularly in the Eurozone. It occurs when banks hold large amounts of their own government’s debt; as the government’s financial health deteriorates, it affects the banks’ stability, which in turn further strains the government’s financial situation.

Question 8

What have we learned from the crisis?

Answer 8

1. Financial Discipline
2. Eurobonds have appealing featurs
3. Debate on debt restructuring
4. Bank Fragility

Question 9

Why do some observers think the eurozone is doomed?

Answer 9

1. Europe is not an optimum currency area
2. Lack of fiscal discipline
3. Gap between well-functioning north and badly wounded South
   - Many international investors do not believe that the euro can survive

Question 10

Why do observers argue that the euro will survive?

Answer 10

1. Breakup would have catastrophic implications
   - A new currency would have to be reintroduced
   - Default does not mean exit
   - No legal procedure for a country to leave the Eurozone exists
   - Euro architecture needs to be improved, solutions exists
   - THe bigger prolbem has been the mishandling/political mismanagement of the cris