From the US subprime mortgage crisis to European sovereign debt 1

The crisis spreads to Europe 2

© 2016 George K. Zestos  The US subprime mortgage crisis rapidly spread to Europe at the end of The countries that had accumulated large public-debts-to-GDP ratios were affected the most.  Greece, Ireland, Portugal, Spain, Cyprus, and Italy is a group of such countries. 3

© 2016 George K. Zestos  To prevent bankruptcy, the EU and IMF offered bailouts to Greece, Ireland, Portugal, Spain, and Cyprus.  These bailouts came with the conditions that bailout recipient countries must follow austerity programs. 4

© 2016 George K. Zestos  In the September 2013 German elections, Chancellor Merkel’s Christian Democratic Party came short of the 42% of popular vote needed to form an independent government.  Thus it was forced to form a coalition with the Social Democratic Party (SPD), the main opposition party. 5

© 2016 George K. Zestos  The SPD had promised that one of the conditions for its participation in the coalition government was that Germany would relax its demands on austerity measures imposed on bailout recipient countries. 6

© 2016 George K. Zestos  Despite original expectations, the EU bailout recipient countries did not recover quickly from the recession.  Many believe the austerity programs were responsible for the prolonged recession in the financially distressed EA countries.  This was admitted by the chief IMF executive Christine Lagarde. ◦ German Chancellor Angela Merkel and her finance minister, Wolfgang Schäuble, did not agree. ◦ Schäuble was, and still is, the most fervent proponent of the idea that austerity programs were the only way to get out of the crisis. 7

© 2016 George K. Zestos  High interest rates in periphery EA countries resulted from economic uncertainty, and triggered capital outflows from southern EA countries to northern EA countries.  This was especially true for Germany as it was considered a safe haven country, and as a result Germany experienced low interest rates during the crisis.  This implies Germany had no incentive to resolve the crisis. 8

© 2016 George K. Zestos  The election of French President Hollande ◦ On May 6, 2012 gave rise to the hope that EU policies would change. President Hollande was a great supporter of growth programs and the adoption of Eurobonds as a means to get out of the prolonged recession. ◦ However, after paying a visit to Berlin and discussing with Chancellor Merkel, he toned down his strong position against austerity. 9

© 2016 George K. Zestos  The European sovereign debt crisis was triggered in October 2009, when the Prime Minister of the newly elected government of Greece, George Papandreou, accused the previous Greek government of fabricating the public deficit data in his report to the EU Commission. 10

© 2016 George K. Zestos  As soon as that news leaked out, the Greek government (sovereign) bonds were downgraded rapidly.  This triggered massive sales of Greek government bonds, which drove the price of bonds down. This resulted in an unprecedented increase in the interest rates for a developed country.  Other EA periphery countries were affected via contagion and their interest rates also increased. 11

© 2016 George K. Zestos  Investors sold massive amounts of their holdings of government bonds in the periphery EA countries. ◦ Such a massive sale of government bonds resulted in rapid downgrades by the three CRAs, and large increases in the government bond yields (interest rates) of these EA countries. 12

© 2016 George K. Zestos  Figure 3.1 shows periphery EA countries’ 10-year government bond yield spreads, in relation to the equivalent German interest rates from 2000 until  Figure 3.1 also shows both the convergence and divergence of the EA countries’ interest rates following the introduction of the EMU and the Eurocrisis respectively. 13

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© 2016 George K. Zestos  Figure 3.2(a) shows the interest rate spreads of the northern EA countries from 2008 to It is clear that all interest rates began increasing in  Interest rate spreads decreased when the President of the ECB, Mario Draghi, announced on July 26, 2012 that “the ECB is ready to do whatever it takes to preserve the Euro.” 15

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© 2016 George K. Zestos  Important events that shaped Greek and other EA countries’ interest rates: ◦ May 2, 2010: First Greek bailout; markets were unimpressed as the amount was perceived to be too small. ◦ May 6, 2012: First Greek elections; no political party won a majority in parliament to be able to form a government, thus the interest rates increased. ◦ June 17, 2012: Second Greek elections; a three- party coalition formed a new government. 17

© 2016 George K. Zestos ◦ July 26, 2012: ECB President, Mario Draghi, announced the ECB is ready to do whatever it takes to preserve the Euro. ◦ September 16, 2012: ECB President announces the Outright Monetary Transactions Program (OMT). This enabled the ECB to buy government bonds of a few bailout recipient countries. ◦ October 17, 2014: The Greek government announced it would exit from the bailout program and instead begin borrowing from the markets. However, the move was perceived as premature. 18

© 2016 George K. Zestos ◦ January 2015: The left-wing Greek party, SYRIZA, received the largest percentage of votes in the national elections. ◦ Since SYRIZA had previously declared it would tear up the memorandum of understanding and get out of the bailout, markets reacted negatively and thus Greek interest rates increased. 19

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© 2016 George K. Zestos 28 EA Public Deficit and Debt-to-GDP ratios

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© 2016 George K. Zestos  It makes a difference whether the public debt of a country is owned by foreigners or if it is domestically owned.  A country is better off if its public debt is domestically owned. There are two reasons for this: 1.The country does not have to make interest payments abroad. 2.The government receives taxes on interest (Cabral, 2010). 33

© 2016 George K. Zestos  Figures 3.6(a) and (b) below show the Gross Private Saving as a percentage of GDP for the northern and southern EA countries. It is shown that countries which maintained high private saving rates were more resilient to the crisis and recovered faster than other EA members. 34

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© 2016 George K. Zestos  It is difficult to find accurate measures of international competitiveness. Current Account (CA) and international investment (indebtedness) position can be used as proxies for international competitiveness.  Figures 7(a) and (b) below, show the CA of the southern and northern EA countries.  From 2000 to 2012, southern EA countries generated a sequence of CA deficits. However, since 2013 this trend has been reversed. 38

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© 2016 George K. Zestos  A similar picture is portrayed by Figure 3.8, which shows the international investment (indebtedness) position. This measures the flow of foreign assets minus the liabilities, in relation to foreign countries over time.  Southern EA countries generated an increasing net international indebtedness. Contrary to this, northern EA countries generated a positive net international investment position, which is a mirror image of the international indebtedness position of the southern EA countries. 41

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© 2016 George K. Zestos  Southern EA countries reversed their CA deficits to surpluses. This is an indication that austerity and fiscal tightening (internal devaluation) can work, but for the southern EA countries the reversal took a long time. As a result it devastated a substantial share of the population in such countries. 43

© 2016 George K. Zestos  Trade deficits in the EA countries have been increasing since the launch of the EMU in  As a result of austerity, trade deficits in the southern EA countries declined and were replaced by surpluses in 2014, shown in Figure 3.9 below.  Nevertheless, northern EA countries’ surpluses continued to increase with other trading partners outside the EMU. 44

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