EZ Crisis: A Consensus Narrative

These slides are taken from “Rebooting the Eurozone: Step 1 – agreeing a crisis narrative”, CEPR Policy Insight

No.85by Richard Baldwin, Thorsten Beck, Agnès Bénassy-Quéré, Olivier Blanchard, Giancarlo Corsetti, Paul de Grauwe, Wouter den Haan, Francesco Giavazzi, Daniel Gros, Sebnem Kalemli-Ozcan, Stefano Micossi, Elias Papaioannou, Paolo Pesenti, Christopher Pissarides,

Guido Tabellini and Beatrice Weder di Mauro

Feel free to use, change, and distribute these slides, but please cite CEPR Policy Insight No.85 as the source

Today’s situation: EZ Crisis: a long way from recovery

The Eurozone Crisis is far from finished…

• Lacklustre growth and bleak economic prospects

• “Jobless Europe” for the youth

• Extremist views and nationalistic tendencies

…fragilities and imbalances are still present.

• Non-performing banking loans

• Feedback loops between banks and the sovereign via debt holdings

• Risky interest rate normalization

The causes of the EZ crisis The core reality

EZ crisis as a ‘sudden stop’ crisis

• Abrupt end of capital flows slow growth increased public debt

and deficit public debt crisis

EZ Crisis amplifiers

• No lender of last resort

• No devaluation possibilities

• Vicious feedback cycle between banks and government

• Predominance of banking financing

• Rigid labor and product market

EZ crisis: a consensus narrative Plan of lecture

• Building up problems

• Triggers of the crisis

• Phase one: failed bailouts and contagion

• Phase two: contagion spreads to the core

• Denouement

Building up problems

• Sharp drop in borrowing costs and the disappeared spreads

• Critical intra-EZ imbalance

• Current account deficits

• Investment versus saving

• Competitive imbalance

• Public debt build up (not the driving force!)

• Private debt build up

• EZ banks’ cross-border lending

• Crisis prelude

Sharp drop in borrowing costs and the disappeared spreads

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10 yr gov't bond yields (%)

France

Germany

Italy

Japan

UK

US

Source: OECD online database with author’s elaboration.

German long-run interest rates fell in line with global trends

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% per annum

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Source: OECD online database with author’s elaboration.

Critical intra-EZ imbalancecurrent account imbalances

Greece

Ireland

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Portugal

Spain

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% of own GDP

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% of own GDP

Peripheral EZ members generally ran current deficits while Core members general

ran current account surpluses

Critical intra-EZ imbalanceSaving and investment imbalances

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31Savings (% of GDP)

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Savings (% of GDP)

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Ireland

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Investment (% of GDP)

Greece

Ireland

Italy

Portugal

Spain

EZ

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Investment (% of GDP)

Germany

NL

Belgium

France

EZ

GIIPS generally saved less and invested more than average while Core EZ nations

generally saved more and invest less the average

Critical intra-EZ imbalancePublic debt fell in most EZ nations

Government debt ratios improved for most EZ nations (especially Ireland and Spain)

but Portuguese and Greek debt burdens soared

Greece

Ireland

Italy

Portugal

Spain

EZ

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Debt-to-GDP ratio(1990=100)

Critical intra-EZ imbalanceBank debt rose rapidly in some EZ nations

Rapid accumulation of bank debt was a problem especially in Ireland, Spain, Italy and

France

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Portugal70

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Total bank assets to GDP

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NL70

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Total bank assets to GDP

House prices rose in the GIIPS more than in the US

while Germany’s fell

Note: 1999 Q1=100.

Source: OECD online database. House price indices in real terms.

Total landing from core countries’ bank to the periphery

(billion euros)

Prelude and Phase One of the Crisis in EZ Periphery

Greek deficit deceit Greek bailout Irish bailout Portuguese bailout Greece

Ireland

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Prelude Phase One

Spreads

Note: The spreads are the difference between national 10-year government bound yields and those of Germany, in

percentage points.

Source: OECD online database with author’s elaboration.

Summary of pre-crisis imbalances

1999 to 2007 (% of own GDP) Bank assets (% of GDP) %

Cumulative current account balance

Cumulative budget deficit

2000 to 2008 increase

(p.p.)Bank assets,

2008Debt-GDP ratio, 2008

Excess inflation

(1999-2007)Portugal -96 -36 44% 262% 72 7.5Greece -84 -47 36% 173% 109 9.9

Spain -60 2 121% 296% 39 9.2Ireland -21 14 464% 783% 43 11.6Italy -8 -26 85% 235% 102 1.8EZ -2 -17 94% 335% 69 0.0France 6 -23 180% 395% 68 -2.9Austria 16 -19 305% 379% 69 -3.2Germany 27 -19 18% 316% 65 -4.8Belgium 47 -5 83% 392% 92 -1.1NL 48 -5 -9% 375% 55 2.8Finland 61 33 101% 197% 33 -4.9Lux'g 98 23 -577% 2367% 14 5.5

Note: ‘Excess’ inflation is the nation’s cumulative inflation rate minus that of the EZ average.

Source: OECD online database with author’s elaboration.

Triggers of the crisis

• October 2009: Greece budget

deficit unmasked

• Six-moth attempt of ‘self rescue’

– failed

• Greece trapped into a public debt

vortex

• Debt loop

• Austerity loop

Phase One: failed bailouts and contagion

• Failed bailouts - Greece’s borrowing cost continued to soar

• Contagion in the periphery

• Public debt vortexes: Portugal

• Bank debt vortexes public debt vortexes: Ireland

Greek deficit deceit Greek bailout Irish bailout Portuguese bailout Greece

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Prelude Phase One

Spreads

Figure : Prelude and Phase One of the Crisis in EZ Periphery

Phase Two: contagion spreads to the core

• Mismanagement of the bailouts give rise to a general fear

• Pro-cyclical fiscal tightening further stoking contagion

• Self-feeding panic: Good equilibrium, bad equilibrium

Fiscal policy turned pro-cyclical from 2010

Note: Inspired by Carrot and de Castro (2015) with author’s elaborating using IMF WEO data.

Pro-cyclical fiscal policy, 2010 to 2014

% of own potential GDP

bill EUR % %

2010 to 2014 swing 2010 to 2014 swing Share of EZ swing Share EZ 2014 GDP

Greece 7% 14 4% 2%Ireland 28% 49 14% 2%Italy 2% 28 8% 16%Portugal 9% 17 5% 2%Spain 5% 53 16% 11%EZ 4% 340 100% 100%Austria 1% 2 1% 3%Belgium 0% 2 0% 4%Finland 0% 0 0% 2%France 2% 46 13% 21%Germany 4% 108 32% 29%

Luxembourg 1% 1 0% 0%

Netherlands 2% 15 5% 6%

Phase Two: contagion spreads to the core

Spreads started to rise for Belgium, France and Austria – as well as

Italy and Spain

Greek bailout Irish bailout Portuguese bailout 2nd Greek bailout

Spain

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France & Austria

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Phase One Phase Two

Spreads

Denouement

• Agreement on Banking Union and the Fiscal compact

• Draghi’s “whatever it takes”

Draghi speech

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Figure: Yields converged again after Draghi’s intervention

Proximate causes, and causes of the causes

Proximate cause

• Sudden stop in inter-EZ lending

• Loss of independent monetary policy after euro adoption

Cause of the cause

• Policy failures that allowed the imbalance to get so large

• Failure to control national debt

• Failure to control excessive bank leverage

• Lack of institutions to absorb shocks at the EZ level

• Failings in real-time crisis management

Concluding remarks

This essay has identified proximate causes, the causes of the proximate

causes of the RZ crisis and provide and crisis narrative.

How we got here…

• Fundamental design flaws of the EMU

…the way ahead

• Lots of suggestions, no consensus

• Both on where to go, and on how

• We need a systematic rethinking how to get Europe working again

The End