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Case Study: Euro Area From Financial to Sovereign Crisis and Back

Case Study: Euro Area From Financial to Sovereign Crisis and Back. Initial Shock from Abroad Systemic financial disruption Dollar funding Deep economic downturn and fiscal shock Transforms into fiscal crisis in periphery Contagion amid policy delay Twin crises: sovereign and banking.

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Case Study: Euro Area From Financial to Sovereign Crisis and Back

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  1. Case Study: Euro AreaFrom Financial to Sovereign Crisis and Back • Initial Shock from Abroad • Systemic financial disruption • Dollar funding • Deep economic downturn and fiscal shock • Transforms into fiscal crisis in periphery • Contagion amid policy delay • Twin crises: sovereign and banking

  2. Euro Area: Market Differentiation Source: Sgherri and Zoli, IMF Working Paper, “Euro Area Sovereign Risk During the Crisis,” October 2009.

  3. Euro-area Government Yield SpreadsOver 10-Year Bunds (Basis Points) Source: FSOC Annual Report 2011, citing Bloomberg.

  4. Euro-area 5-yr CDS PremiaBasis Points Source: FSOC Annual Report 2011, citing Bloomberg.

  5. Selected Five-Year CDS Premia Source: ECB Monthly Report, September 2011.

  6. Origins of the Crisis • Political project: EMU, but not political union • One CB, one currency: One policy fits all? • Flexible adjustment to asymmetric shocks sustains fiscal/external balance… • Factor mobility • Price/wage flexibility • Innovation (and growth) • Fiscal burden-sharing • Financial shock absorbers • … but economic rigidities can lead to cumulating imbalances across states.

  7. Benefits and Costs • Periphery • Halt frequent currency crises • Price stability and transparency • Cheap funding (low interest rates) • Core • Stable external markets: reduced risk • Lower transaction costs • Financial economies of scale • Costs: give up credible central banks for ECB • Risks: Bailouts of weaker members; bank exposure

  8. Treaty Rules and Time Consistency • Securing price stability • Independent ECB • “No bailout” clause • Fiscal entry conditions in Treaty • Seek to contain fiscal moral hazard • Fiscal commons and free riders • Pressure to comply weakens after entry • Applied very flexibly even at start • Stability and Growth Pact • Supplement to the Treaty • Excessive deficit procedure • Violated early (2003) by large countries (lost credibility)

  9. Euro Area vs. US • Labor Mobility • Fiscal burden sharing • Financial oversight and burden-sharing • Lender of last resort • Deposit Insurance • Supervision • Sovereign debt on balance sheets • Euro-area states have much larger debts than US states • Subsidy through risk weight • Subsidy through lack of CB haircut

  10. Fault Lines • Widening imbalances (internal/external) • Financial fragility • Credit bubbles • Fiscal deficit/debt • Weak market discipline (credibility of no bailout?) • Banks and sovereigns • Global crisis as trigger • Asymmetric response (fiscal imbalances) • Common exposure through intermediaries • Twin crises (sovereign and intermediation)

  11. Labor Market Restrictions Note: The broad labor measure and the narrower hiring/firing measure both rise as restrictions recede.Source: Fraser Institute, Economic Freedom of the World: 2011 Annual Report (data for 2009).

  12. Unit Labor CostsPercent Change from 1999-2009 (relative to euro-area pct. change) Note: Euro-area percent change = 22.5% Source: European Commission, AMECO database.

  13. Consumer PricesPct. Change 2010 from 1999 (relative to euro-area pct. chg.) Note: Euro-area percent change = 25.5%. Source: European Commission, AMECO database.

  14. Real Effective Exchange RatesBased on GDP deflators (1999=100) Source: European Commission, Price and Cost Competitiveness, April 2011.

  15. Unemployment RateDeviation from Euro-area Average (Pct) Note: Euro-area averages are 10.0% in 2011 and 9.3% in 1999.Source: European Commission, AMECO database. EC forecast for 2011.

  16. Unemployment RatePct. Chg from 1999-2011 (relative to avg. pct. chg. in euro area) Note: Euro-area averages are 10.0% in 2011 and 9.3% in 1999.Source: European Commission, AMECO database. EC forecast for 2011.

  17. Unemployment Persistence Unemployment Rate in 2010 Slope=0.73 Unemployment Rate in 1999 Source: OECD.

  18. External Balance10-year change from 1999 and 2009 Level (Pct. of GDP) Source: European Commission, AMECO database.

  19. Private CreditChange from 1999-2009, Pct. of GDP Note: Private credit includes credit from banks and other intermediaries. Source: World Bank.

  20. Residential Property PricesPct. Change from 1999 to 2010 Note: Base year is 2000 for Austria. End-year is 2007 for Ireland and Spain. In some countries, figures cover both existing and new dwellings; in others, existing dwellings only.Source: ECB Statistical Data Warehouse (national sources).

  21. General Government DeficitPercent of GDP Source: European Commission, AMECO database.

  22. General Government DeficitPercent of GDP Source: European Commission, AMECO database. EC forecast for 2011.

  23. General Government Primary DeficitPct. of GDP Source: European Commission, AMECO database.

  24. General Govt Primary DeficitPct. of GDP Source: European Commission, AMECO database. EC forecast for 2011.

  25. Stabilizing the Public Debt Ratio Bt+1 = (1+i)/(1+g) Bt - PSt/(1+g) Bt = Debt/GDP ratio at time t i = nominal interest rate g = nominal growth rate PSt = primary (noninterest) surplus/GDP ratio To reach an equilibrium, the primary surplus ratio must reach:PS = B*(i-g)

  26. General Government DebtPercent of GDP Source: European Commission, AMECO database. EC forecast for 2012.

  27. General Government DebtBillions of Euros Source: European Commission, AMECO database.

  28. Public Age-related SpendingShare of GDP Note: Spending includes pensions, health care, long-term care and unemployment.Source: European Commission, European Economy, 2010, Vol. 4.

  29. Euro-area Public Deficits and DebtShare of GDP, 2009 Debt Deficit Source: IMF Fiscal Monitor

  30. Debt Problems in Periphery Countries Change In Debt/GDP Ratios Debt/GDP Ratios 140% Source: Citi.

  31. Fiscal Tightening in Periphery Euro Area — Fiscal Tightening As Pct. of GDP Source: Citi.

  32. Euro Area Fiscal Tightening Depresses Periphery… Selected Euro Area Countries — Real GDP Growth (YY), 2005-Q2 10 Selected Euro Area Countries — Economic Sentiment Indicator (Long-Run Average =100), 1995-April 2010 Source: Citi.

  33. … and government deficits remain high Central Government Deficit, 12-M Sum Source: Citi.

  34. Pro-cyclical Real Yields Real 10-Year Government Bond Yield (HICP-Deflated), 1996-Aug 2010 % 1.8% = Italy’s 10-Year Real Rate in 2002-20082.4% = Germany’s 10-Year Real Rate in 2002-2008 0.9% = Average 10-year Real Rate for Spain, Ireland, Greece between 2002-2008 Source: Citi.

  35. Real GDP per capitaPct. Change 2011 from 1999 (relative to euro-area pct. chg.) Note: Euro-area percent change = 11.5%. Source: European Commission, AMECO database. EC forecast for 2011.

  36. Slower Trend Growth Outlook in Periphery Real GDP Growth – History (1995-2007) and Projections (2012-2020) Source: Citi.

  37. Commercial Bank FundingWholesale Funds as Share of Total (Pct) Source: IMF Global Financial Stability Report, October 2010, Figure 1.19.

  38. Euribor-OIS SpreadPercent Source: ECB Monthly Report, September 2011.

  39. Euro-area Bank Stock Index Source: ECB Monthly Report, September 2011.

  40. Sovereign Crisis Spreads to Banks and Beyond Selected Euro Area Countries – Banks’ Use of ECB Open Market Operations as a Share of Tot. Assets Euro Area — Interest Rates for Loans to Non Financial Companies (More than 5Y Duration), Sources: Eurosystem and Citi.

  41. Periphery Dependent on ECB Liquidity Source: Deutsche Bank.

  42. Risks Held by Euro-Area Banks Sources: BIS and Goldman Sachs, Mid-2010.

  43. US MMMF ExposureBillions of Dollars as of June 30, 2011 Note: “F D N” is FRA + DEU + NLD. Exposure to GRC and PRT is reported as zero.Source: FSOC Annual Report 2011, Chart 7.1.12, citing SEC FORM N-MFP.

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