7. EMU: the road to the crisis  The global financial crisis as a trigger  Default risk, interest rates, house prices, demand growth  Competitiveness: is internal devaluation possible?  Monetary policy  Austerity and growth (or lack of it) 1

The global financial crisis led to concern about the default risk  The global financial crisis started in the summer of 2007 with concerns about house financing in the US (”subprime mortgages”), which involved complex instruments, the consequences of which were purely understood at the time  The crisis erupted after , when Lehman Brothers were allowed to go bankrupt, which triggered large-scale panic on global financial markets within weeks. One consequence was renewed awareness of financial risks and higher risk version  Gradually investors realized that they had overextended their lending to certain countries, not least Greece; fear of credit losses led to sharp increases in yields on Greek bonds, causing losses to bond holders (including banks)  Also, investors started to realize that house prices in Ireland and Spain might start falling, undermining the financial stability of the creditors (banks with high leverage)  Concern about the health of banks raised risk premia in the interbank market, thus undermining the functioning of a key part of the financial system  Banks, concerned about their liquidity and solvency, wanted to reduce leverage, implying reduced willingness to lend (”credit crunch”)  Concern about the financial health of banks, notably in Ireland and Spain, caused concern about the financial sustainability of the sovereign (given the role of the government in providing the ultimate guarantee of the banking system); also, concern about the sustainability of public finances, e.g. in Greece and Portugal, caused worries about banks (same reason)  All of these concerns fed each other both within countries and across borders 2

10 year government bond yields 3 Finland Greece Germany Irland Italy Spain Interest rate spreads (differences) used to be rather big because of inflation differentials and exchange rate expectations. EMU largely eliminated such expectations. Recently spreads have been caused by the risk of default of governments.

4 The budget deficits and debts in UK, US and Japan are bigger than in the euro area but interest rates on government bonds are much lower: these countries have a lender of last resort (the central bank)

Economic developments in PIIGS- and FANG-countries before and after the crisis: 1=average, 2=cumulative, 3=ditto, 4=average, 5=cumulative, 6=relative to GDP, average, 7=relative to GDP, average, 8=average Sixten Korkman: EURO – Valuutta vailla valtiota.Lähteet: OECD, Eurostat, AMECO, NIESR, ETLA. 1. Real interest rate 2. Credit expansion 3. House prices 4. Domestic demand 5. Unit labor cost 6. Current account 7. Budget surplus 8. GDP growth 9. Unemployment rate PIIGS-ciesFANG-cies

Crisis: a typical pattern Rapid credit expansion, rising asset (e.g. real estate) prices, euforia Bad news, bubble bursts, credit losses, fear takes hold BANKING CRISIS Credit crunch, deep recession, falling tax revenues, bank support PUBLIC DEBT CRISIS 6

Average nominal and real interest rates in While there is no relation between the rate of inflation and the real interest rate, the nominal and real interest rates are now strongly corrrelated. FIN AUT BEL GRE 7

Real interest rates and average increase in house prices BEL High real rates of interest no doubt contributed to the sharp fall in the level of house prices in Ireland, Spain and Greece 8

Average real interest rates and cumulative growth of domestic demand in GER The crisis countries have suffered from quite large reductions in domestic demand (both private and public) 9

Domestic demand growth and change in competitiveness Sharply falling domestic demand has contributed to some improvement in competititiveness in the crisis countries 10

Competitiveness and the current account (% of GDP) change IRE Improved competitiveness has presumably contributed to the reduction in current account deficits in the crisis countries. Also, lack of growth of domestic demand has improved both the current account and competitiveness. 11

Domestic demand and the current account (% of GDP) change from 2008 to 2012 Falling domestic demand naturally improves the current account 12

Summary of the preceding  The global financial crisis led to a reconsideration of risks, which gradually increased risk premia for government bonds issued by the PIIGS, in some cases dramatically  The interbank market was quite strained in certain periods (late 2008 and again in late 2011)  Countries with high real interest rates experienced sharp declines in house prices and in overall domestic demand  Weak demand was associated with improved competitiveness, better exports (to some extent) and notably improvements in the current account  The development since has been largely the reverse of developments in : what goes up, comes down (boom-bust cycle and now a banking crisis, a sovereign debt crisis and large current account imbalances) 13

7.4 Monetary policy: Central bank policy rates - interest rates are roughly as low as you get ECB Riksbank 14 All central banks have taken down their lending rates as low as you get (roughly) but not below zero.

Eurosystem Fed Riksbank Central bank balance sheets (expanding as a consequence of “quantitative easing”) 15 Central banks have been buying various kinds of financial assets,notably government paper

Table Fiscal policy tightning 2009–2013 Sixten Korkman: EURO – Valuutta vailla valtiota.Lähde: OECD. Greece Irland Portugal Spain Italy Germany Finland Euro area Fiscal policy tightning(1) Budget Deficit (2) Output growth (3) Public debt to GDP(4) Budget 2013 (5) (1)Cyclically adjusted budget balance relative to GDP, change from 2009 to 2013 (- = tightning) (2)General government financial deficit relative to GDP, change from 2009 to 2013 (- = gets smallre) (3)Cumulative GDP growth 2009 to 2013 (4)Gross public debt relative to GDP, change from 2009 to 2013 (5) General government financial deficit 2013.

Real GDP in selected EA-countries, 2007 =

Unemployment rates in selected EA-countries (% of labour force) 18

Interest rates and austerity (change in cyclically adjusted budget balance ) 19 Those countries that had to face the highest interest rates, were the same countries that pursued the most contractionary fiscal policies – voluntarily or ordered to do so by the troika.

Austerity and cumulative GDP growth in (austerity = change in cyclically adjusted budget balance) GRE IRE Austerity is bad for growth, at least in the time span here considered 20

Austerity and fiscal consolidation (change in CABB and increase in gen. gov. financial surplus) However, austerity is not self-defeating, in the sense that it is still improving the overall budget balance, though the improvement in the latter is typically smaller than in the former 21

What went wrong? The euro area debt crisis was not caused by the global financial crisis, though it was triggered by it: EMU was anyway heading for a debt crisis, which just waited to materialize, for several reasons:  generic problems 1) deficit bias in public finances 2) inherent instability associated with modern finance (occasionally excessive leverage causing boom and bust) 3) lack of balance between global economy and local/national politics  flaws in the set-up of EMU 1) the no bailout rule was not made operational and all sovereign bonds were treated as risk free (by the BIS and ECB) 2) no lender of last resort for sovereigns, risk of “multiple equilibria” 3) reform of labor markets was insufficient or lacking 4) strong links between national sovereigns and banks proved dangerous  specific mistakes (avoidable) 1) membership in the euro area became too encompassing 2) the SGP was not respected (the fiscal rules) 3) no action was taken to strengthen the banking system 4) countries in the South misused the fall in interest rates (and debt service) by increasing public and private spending 22