Case- 04, Can the Eurozone Survive.doc

Case Study 4 Business Cycle Can the Eurozone Survive? In November 2009 a newly elected Greek government revealed that previous data had gravely understated the budget deficit. Greece sank into crisis as yields on its bonds sailed steadily upward -past 30% for ten-year maturities. Despite cutting its primary deficit 4.2% per year from 2009 through 2011, arguably the most severe reduction in the developed world in recent decades, Greece effectively went bankrupt, and in early 2012 its lenders were
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  Case Study 4Business CycleCan the Eurozone Survive? In November 2009 a newly elected Greek government revealed that previous data had gravely understated the budget deficit. Greece sank into crisis as yields on its bonds sailed steadily upward -past 0! for ten-year maturities.   espite cutting its primary deficit #.2! per year from 2009 through 20$$% arguably the most severereduction in the developed world in recent decades% Greece effectively went bankrupt% and in early 20$2 its lenderswere forced to take a &$00 billion loss on its debt.   In early 20$2% things started looking up. 'fter the (uropean )nion *()+ had promised a permanent &,00 billionfund to lend to threatened governments and proposed a tough fiscal pact% the (uropean entral ank *(+ looseda /wall of money-&2 trillion of loans to national banks in hopes that they would% in turn% lend to governments andindustry.ut by summer% euro optimism was sinking again. 1hen% on the eve of the summer lympics% ( 3resident 4ario raghi% reiterating a phrase that had beenheard so often before% announced% /5ithin our mandate% the ( is ready to do whatever it takes to preserve theeuro. 'nd believe me% it will be enough. 6  5hy did contagion from tiny Greece so rapidly infect the entire (uro7one8 5ould the accretion of measures promised by the (uropean )nion *()+ and the (% in coordination with the International 4onetary und *I4+%finally be ade:uate to staunch the crisis8 'nd would the euro survive8 Creating the Euro 1he international financial order negotiated in retton 5oods% New ;ampshire% in $9##% fi<ing the dollar against gold and other currencies against the dollar while allowing devaluations in e<ceptional circumstances% proved workable through the $9=0s. ut it fell apart when the )nited >tates devalued the dollar in $96$ and finallyabandoned any fi<ed e<change rate in $96.1he resulting e<change-rate volatility% two oil crises% and other troubles in the $960s led to relatively high anderratic inflation. (<change-rate volatility posed particular problems for nations of the (uropean ommunity *(+% predecessor of the (uropean )nion% as ( members lowered mutual trade barriers. In $969 the ( tried to stabili7e currencies in a system called the (<change ?ate 4echanism *(?4+. renchand Italian politicians hoped the (?4 would lower their rates of inflation by tying their currencies to the Germanmark.   'fter the >ingle (uropean 'ct% entering into force in $9@=% called for eliminating all barriers to trade%financial flows% and migration within the (% many saw a single currency as the natural ne<t step. 1he so-called 4aastricht 1reaty forming the (uropean )nion *()+ and laying the road to monetary union wassigned in $992. 1hat very year% the (?4 came under attack again. inland% >weden% and Norway stopped trying to peg their currencies% while >pain% 3ortugal% and Ireland had to devalue% Italy was forced to let the lira float% and theritish pound crashed. ut by Auly $% $99@% eleven states were deemed to have met the /convergence criteria for adopting the single currency% the euroB among other things% maintaining fiscal deficits under ! of G 3 andlimiting government debt to =0! of G 3. 1hey adopted the euro on Aanuary $% $999. The Euro: More Complicated Than It Loos 1he euro was an unprecedented e<periment. No other maCor nation lacked its own currency. 1he 1reaty on(uropean )nion% deeply held beliefs% and the structure of national economies would profoundly influence thise<periment. 1hese factors help e<plain why the (uro7one% with a =! of G 3 deficit and @,! of G 3 debt in 20$0%was threatened with sovereign crises% while the )nited >tates% with substantially higher deficits and debt% was not.>imilarly% >pain% a (uro7one member with a 9! of G 3 deficit and =$! of G 3 debt% entered into crisis in 20$0%while ritain% still on the pound sterling% with a $0! of G 3 deficit and @0! of G 3 debt% did not. 1  4ost advanced nations such as the )nited >tates could deploy e<pansionary fiscal policies during a recession.4oreover% the ).>. government contributed vastly more to its statesD finances than the (uropean )nion did to itsmembersD finances. 1he ).>. government paid for% among other things% social security% 4edicare for those over =,%4edicaid for the poor% and housing subsidiesE the militaryE much of the infrastructure such as highwaysE and someeducation% police% and other primarily state responsibilities. 5hen a ).>. state fell into recession% for every dollar of  per capita income that residents lost% federal ta<es were reduced by # cents and federal transfers to the stateincreased by = cents. In the (uropean )nion such ta< reductions and transfers amounted to practically 7ero.1he 1reaty on (uropean )nion stated that the /primary obCective of the (uropean entral ank *(+ was to/maintain price stability. y contrast% ).>. (mployment 'ct of $9#= enCoined the government% including the ed% to promote full employment% and the ank of (ngland traditionally could do the same. 5hether they succeeded wasanother :uestion% but they had the mandate.ut the culture of the ( had enormous practical effect. 5hile the ed was created with the primary goal of staunching financial crashes such as had plagued the nineteenth- and early twentieth-century ).>. economy% the( was created with the primary goal of preventing inflation such as had plagued many nations in the $960s. uring the 200@ financial crisis% the ed not only loaned hundreds of billions of dollars to troubled banks butdeployed an alphabet soup of programs to purchase trillions of dollarsD worth of troubled financial instruments. It bought mortgages and commercial paperE it channeled loans through financial institutions to consumers and businesses% large and small. y contrast% the ( had a weak mandate to act as a lender of last resortE buyingsovereign bonds particularly troubled officials.1he structure of (uro7one banking made it vulnerable to crisis. 1otal (uropean bank assets were large% generally between 200! and #00! of national G 3% while ).>. bank assets were less than $00! of G 3.   's well% national(uro7one governments% responsible for rescuing troubled banks% lacked authority to print euros to rescue them.1hese governments had to take on euro debt if they needed resources to rescue national banks. y contrast% the ed%responsible for rescuing maCor troubled banks along with other ).>. agencies% could% of course% print unlimiteddollars.1he close relationship between (uro7one governments and banks meant that sovereign-debt crisis would be particularly perilous. ecause of historical practice% national banks held large portions of their governmentsD debt.anking regulations encouraged this practice by counting sovereign debt as risk-free.In 20$$% Greek% Irish%3ortuguese% >panish% and Italian banks held 20! to 0! of their own governmentsD debt% while ).>. banks held 2!of )>. debt *see E!hi it # +. ' sovereign debt crisis therefore could build into a vicious cycle% as the governmentwould have to provide funds to rescue banks% but banks would have to continue lending to the government to rollover its debt.urther doubts about the euro concerned the e<tent to which (uropeans saw themselves as (uropean rather thanGerman% Italian% or Greek. $ermany uring the crisis% as () officials urged troubled nations to spur growth via /structural reforms such as makinglabor markets /fle<ible or lightening business regulation% they often pointed to the German model.1he reforms hardly crippled German unions. 1he rganisation for (conomic o-operation and evelopment*( +% a group of mostly advanced nations% assesses economic characteristics of its member states * E!hi its %and & +. If /fle<ible labor markets are defined as weak protection for workers-few obstacles to dismissal and lowunemployment benefits - they certainly did not characteri7e Germany. ompared with several other (uro7onestates% as well as the )nited >tates and >weden% Germany had the strongest protection against dismissal for /regular% non-temporary% employees% e<cept for 3ortugal. It had the most generous long-term insurance and other assistance for the unemployed% e<cept for >weden and Ireland. uring both the global financial crisis and the euro sovereign-debt crisis% German firms rarely resorted to layingoff workers% as the labor /fle<ibility slogan might imply% but reduced working hours per employee. 1ransfers fromthe government-the famous German social safety net-helped soften pay losses. ;ealth% pension% and unemploymentinsurance benefits were unaffected. Spain and Italy  1hough the peripheral (uro7one nations-Greece% Ireland% 3ortugal% >pain and Italy-shared commonalities% theunderpinnings of these current-account deficits differed sharply. ecause of their si7e% >pain and Italy posed the gravest threats to the euro when crisis erupted. >painDs troubles 2  stemmed largely from a housing bubble. 5ith little more than #0 million inhabitants in 2000% it received nearly =million immigrants through 200@% largely from Fatin 'merica% (astern (urope% and 'frica. 4any retirees arrivedfrom northern (urope% and a rise in divorces created new households. 'll these groups took out mortgages and builthomes. apital flowing in from abroad% principally from core (uropean banks% supplied the funds for themortgages.>panish productivity growth from 2000 through 200@ was a poor 0.6! per year.   ' possible culprit was the labor relations system. Fike other peripheral (uro7one nations% >pain had a dual market 5orkers on long-term contractswere costly to lay offB firms had to pay #, days salary per year on the Cob. 5orkers on short-term contracts of up toa year could be laid off cheaplyB firms only had to pay @ days of salary or less. ounger workers thus constituted acontingent labor force hired and fired at will% so firms had little incentive to invest in training them.5hen the global financial crisis hit% the >panish government deployed e<pansionary policies% providing a &#00credit to each ta< payer and &2%,00 per newborn. 1he budget went from a $.9! surplus to a #.,! deficit . espitethese efforts% after growing .,! in 2006% the economy barely grew in 200@ and contracted .6! in 2009 fficialunemployment reached 20! in 20$0 3art of the problem was the collapse of the construction sector that had propelled growth during the housing bubble. Italy posed an even larger concern than >pain. espite the fiscal austerity effort government debt% having toppedout at $22! of G 3 in $99#% fell only to $0! of G 3 by 2006% and then during the crises it shot right back up to$20! of G 3.1he key problem was poor growth. ItalyDs productivity growth was Cust 0.$! per year from 2000 through200@. ,0  's with >pain% the labor-relations system might have been a cause. Italy did not have standardunemployment insurance that compensates workers who lose their Cob. Instead% if a firm laid off employees% it couldsecure income protection for them from the government% and when it was able to e<pand production again% it hiredthem back. The Eurozone 'eriphery Syndrome uring the decades when Italy% >pain% Greece% and 3ortugal had their own currencies% with inflation levelshigher than GermanyDs% they were periodically forced to devalue against the mark. >ensibly fearing further devaluation% lenders charged borrowers in those nations high interest rates. 's these nations were believed to berealigning their economic policies to adopt the euro% confidence soared. 1hey would devalue no more. et their interest rates remained relatively high% so banks in Germany and other nations saw profitable opportunities and poured loans into the periphery. If capital inflows to these economies had been invested in productive industries% all might have been well% butthey were not. apital flows into >pain% channeled through the private sector% drove a housing bubble. apital flowsinto Greece% channeled through the public sector% allowed government salaries and benefits to support consumption.apital flows into Italy supported neither blatant government profligacy nor an obvious asset bubble% but did keep astagnant economy afloat.apital flows% by inflating periphery economies% allowed workers to boost wages. 5ith fast-rising wages andstagnant productivity growth% Italy and >pain saw unit labor costs rise more than 20!% while Germany% with slow-rising wages and better productivity growth% saw flat unit labor costs. 1he periphery thus lost some 20! of itscompetitiveness against Germany. In other words% it lost the potential to e<port to repay loans.apital inflows prepared the way for other problems as they passed through the banks% temporarily boostingtheir profits but making their balance sheets more precarious. f course% the peripheral banks used the funds thusobtained to increase their assets% for e<ample% by providing mortgages or buying government bonds% that paid highreturns.1he banks thus increased their leverage% a common process during a boom. It works this wayB /1ier $ capital is bank e:uity plus retained profits. It increases as profits rise in a boom. ut being optimistic about future profits% banks often borrow *or otherwise increase liabilities+ and make loans *or otherwise increase assets+ even faster thantheir capital increases. Feverage% the ratio of assets to capital% rises. ank leverage rose in many countries in theearly 2000s% but (uro7one banks became especially leveraged% with assets reaching , times capital.Feverage boosts profits while things go wel l but causes trouble if things go badly. 'ccounting for losses on bador risky loans depends on applicable regulations% but those losses must be deducted from capital. If a bank isleveraged  to $Hif its loan portfolio is  times its capital-an appro<imately ! loss on its loans completelywipes out its capital% making it insolvent. 3  ( Crisis Ignites In early 20$0 the new Greek government began to cut spending and raise ta<es. (uropean leaders pledged/determined and coordinated action to support the euro but said Greece must clean up its own finances. ).>.1reasury >ecretary 1imothy Geithner and ed hairman en ernanke% urging decisive () action in 'pril% werestunned to hear that () leaders proposed I4 announced a &$$0 billion package of loans for Greece to bedistributed over three years% in e<change for austerity only a &=0 billion loan fund.n 4ay % global markets plunged. ' week later% the () and I4 pledged to establish a &6,0 billion loan package-&##0 from (uropean states via the so-called (uropean inancial >tability acility *(>+% &=0 from the(uropean ommission% and &2,0 from the I4-to stem the crisis in Greece and other (uro7one nations. =,  1he package was still Cust a promise. nly a month later did (uro7one finance ministers formally approve the nominal &##0 billion (>. It took more than a year for the (>Ds approved lending capacity to reach the nominal &##0- billion level. 'gain and again over the ne<t two years% in e<change for loan installments% Greece passed higher ta<es% cut budgets deeper% legislated more structural reforms-and confronted fiercer protests. >ome ()structural demands were effectively impossible to fulfill. or e<ample% in mid-20$$ the () demanded privati7ing &,0 billion of state-owned enterprises% including ports% the electric utility% and telecom firms. 's proCections of Greek growth sank% proCections of debt swelled. 1he I4 srcinally e<pected itwould top out at about $,0! of G 3 and decline to a supposedly sustainable $20! of G 3 by 2020.   y ecember 20$0% it was to top out at $=0! of G 3% by Auly 20$$ at $60! of G 3. 66  y 4arch 20$2% had private investors not taken a &$00 billion loss% the I4 would have had to proCect Greek debt ase<ceeding 200! of G 3-in effect% virtually guaranteed default. The Crisis Spreads In Auly 20$0 (uropean bank supervisors declared that nearly all maCor banks had passed stress tests% but they had not considered sovereign default since they insisted it would never happen.   our monthslater% in November% Ireland announced that its banks% despite passing the tests in Auly% had lost about ,0!of Irish G 3 on bad real-estate loans% which the government would absorb. Ireland was now forced tofollow Greece% re:uesting a &@, billion loan from the () and I4. In 4ay 20$0% the >panish government barely passed a &$, billion austerity plan to cut the budgetdeficit to =! of G 3 in 20$$. 1hree days later% >panish debt was downgraded% and the unemployment ratehit 20 percent. 3eriodically abating or surging% market fears drove yields on $0-year >panish bonds closeto 6! in late 20$$-about the level at which Greece% Ireland% and 3ortugal had been forced to seek 1roikaloans.y summer 20$$% yields on $0-year Italian bonds touched =!.n 'ugust 6% to :uell surging marketfears% ( 3resident Aean-laude 1richet started buying Italian government bonds but demanded ine<change that erlusconi pass an austerity package and structural economic reforms. The European )*ire+all, () leadersD succession of summit meetings intended to stem the crisis often did little more than createuncertainty% sketch unworkable proposals% or push problems down the road. 's >tandard  3oorDsawarded Greece a  credit rating% the lowest in the world% () leaders prepared for a maCor Auly 2$%20$$% summit to provide a second Greek loan package and build a /firewall for (urope. ut the summitdid little more than set an agenda for debates that would continue well into 20$2.Indeed% after the summit% markets began a precipitous si<-month descent .1he ow Aones Germanystock inde<% which had held almost even from Aanuary $ until Auly 22% plummeted 2,! during the rest of the year. 'nother way to build a firewall might be to sell /eurobonds. Aointly guaranteed by all (uro7onestates-every state would have /Coint and several liability for the entire value of each bond-they could provide secure funds to lend threatened governments. 1he fact that ).>. bonds were guaranteed by asingle federal government% not issued piecemeal by one state here and another there% certainly helped the)nited >tates borrow at record low interest rates. () leaders did pledge to replace the (>% set to e<pire in 20$% with a &,00 billion permanent(uropean >tability 4echanism *(>4+. 1he I4 and the Group of 20 leading economic nations wanted(urope to establish an (>4 *or combined (> and (>4+ totaling &$ trillion. If it did% the I4 pledged to 4
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