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Straining the Bond: Europe in Crisis Evening at the Fed December 2012 Mark A. Wynne Vice President FRB Dallas Director Globalization & Monetary Policy.

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Presentation on theme: "Straining the Bond: Europe in Crisis Evening at the Fed December 2012 Mark A. Wynne Vice President FRB Dallas Director Globalization & Monetary Policy."— Presentation transcript:

1 Straining the Bond: Europe in Crisis Evening at the Fed December 2012 Mark A. Wynne Vice President FRB Dallas Director Globalization & Monetary Policy Institute

2 Overview The story so far… The (increasingly global) fallout – Contagion from periphery to core – Contagion to the rest of the world The fundamental challenges – Burned ships (the Cortes strategy) – The world’s greatest game of chicken Lessons from history End game – Move to a political union? – Or lost decade(s) à la Japan?

3 The euro crisis: a chronology May 2010: Greek bailout €110 bn November 2010: Irish bailout €85 bn April 2011: Portuguese bailout €78 bn July 2011: Second Greek bailout €130 bn December 2011: Fiscal compact agreed; ECB LTROs April 2012: Greek default Summer 2012 – Yields on Spanish government debt reach record highs – €100 bn bailout of Spanish banks – Yields on stronger sovereigns go negative on safe-haven flows – ECB cuts deposit rates to zero July 26: “…the euro is irreversible…. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” – ECB President Mario Draghi

4 Major developments August- December 2012 September – ECB announces plans to conduct Outright Monetary Transactions (OMTs) “…to safeguard the monetary policy transmission mechanism in all countries of the euro area” and “…address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro” One dissenting vote: Bundesbank President Weidmann – German constitutional court rules that Germany can contribute to the European Stability Mechanism – European Commission publishes proposals for a European banking union Focus on bank supervision; issues of deposit insurance and bank resolution unaddressed October – S&P downgrades Spain to BBB- – European Union wins Nobel Peace Prize November – Third Greek “bailout” Lower interest rates & extended terms on loans; recycling of SMP profits back to Greece

5 The story so far (10-year government interest rates) Jan 1, 1999 Euro launched Jan 1, 2001 Greece joins

6 Greece: in depression EmploymentGDP Millions Bil. Ch euros Aug 2012 UR: 25.4% Aug 2012 youth UR: 57.0% Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June 2012.

7 Gross government debt as a percentage of GDP Greek budget report Oct. 31, 2012 IMF's World Economic Outlook October 2012 Review of bailout program March 2012 (Estimates overlap with 2012 IMF data for ) Original bailout program May 2010 EstimatesProjections Percent

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9 Ireland: life after austerity? Millions Bil. Ch euros Sep 2012 UR: 15.1% Sep 2012 youth UR: 34.5% Peak-to-trough decline through 2011: 14.5% Peak-to-trough decline through 2011: 6.9% Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June July 26, 2012: Ireland returns to financial markets for first time since September 2010 EmploymentGDP

10 Portugal: further contraction expected Sep 2012 UR: 15.7% Sep 2012 youth UR: 35.1% Millions Bil. Ch euros Peak-to-trough decline through 2011: 7.0% Peak-to-trough decline through 2011: 3.2% Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June EmploymentGDP

11 Spain: latest bailout request Millions Bil. Ch euros Sep 2012 UR: 25.8% Sep 2012 youth UR: 54.2% Peak-to-trough decline through 2011: 11.1% Peak-to-trough decline through 2011: 3.7% Note: Diamonds indicate OECD November 2012 forecasts. Dashed lines indicate OECD forecasts in June EmploymentGDP

12 OECD NEET Ratios, 15 to 24 Years OECD = Organization for Economic Cooperation and Development NEET = not in education, employment, or training Source: OECD Employment Outlook 2012 Percent

13 Housing booms and busts Residential investment as a share of GDP U.S.

14 Housing booms and busts Residential investment as a share of GDP Arizona U.S. Florida Nevada

15 Housing booms and busts Residential investment as a share of GDP Arizona Spain U.S. Florida Nevada Ireland

16 Germany PMI in contraction phase Index Services Composite Manufacturing

17 Broader euro-area PMI also in negative territory Index Services Composite Manufacturing

18 Global fallout Exports to the U.S. and euro area: share of world total Euro area

19 Global fallout United Kingdom – 50 percent of exports to euro area – “The greatest threat to the recovery stems from the risk that an effective policy response is not implemented sufficiently promptly in the euro area” (Bank of England) China – EU is China’s largest export market, overtaking U.S. in 2007 – “capricious development of the European debt crisis” as drag on growth (People’s Bank of China) United States – 20 percent of exports to Europe – “…strains in global financial markets continue to pose significant downside risks to the economic outlook” (FOMC)

20 German cross-border lending Net Balance Bil. euros

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22 The story so far (10-year government interest rates) Jan 1, 1999 Euro launched Jan 1, 2001 Greece joins

23 One-size-fits-all monetary policy: Euro & U.S. (Taylor rate range)

24 Labor mobility a hindrance to a common monetary policy (Regional variation in unemployment rates)

25 Fixes Monetary union can exist without a fiscal union – But need rules to make it work – Tried and failed in Europe Fiscal & political union along U.S. lines – Tighter constraints on ability of member states to run deficits – Pooling of regional risks, especially of banking system risks

26 Lessons from history The United States in 1780s – Fiscal crisis associated with servicing debt incurred during Revolutionary War Solution: strengthen powers of federal government (replace Articles of Confederation with U.S. Constitution) – Federal government assumed debts of states – One-time bailout: states allowed to default in 1840s – States adopted balanced budget rules thereafter

27 Deficits in peripheral European countries comparable to U.S. deficits Percent Budget deficits as a share of GDP

28 Fiscal situation of Europe as a whole relatively sound Percent Note: Diamonds indicate OECD forecasts. U.S. Euro area Government debt as a share of GDP

29 Disunion Declining trust in European institutions – Just 31 percent compared to 57 percent before crisis Less favorable image of the EU Majority (52 percent) still support the single currency – Down from 61 percent before crisis

30 Conclusions Euro crisis is spreading from the periphery to the core, and increasingly weighing on global economic activity LTROs of December 2011 and February 2012 have bought time – ECB rate reduction and possible revival of securities market program can ease strains – ECB is involved in a game of chicken with national governments OMTs will also buy time when implemented New “fiscal compact” – A significant improvement over earlier Stability and Growth Pact? – EMU 2.0 workable? Challenges – Achieving consensus on new rules: loss of sovereignty – Market rigidities – Austerity programs – Potential for social unrest Europe 1914

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