© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure Prof. Dr. Rainer Maurer Digression: The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure Digression: The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ The Return of the Interest Rate Spreads: ■ After the foundation of the European Monetary Union (EMU) interest rates spreads between the member states nearly disappeared. ■ By the end of the year 2008, interest rate spreads reappeared. ■ For some countries interest rate spreads have become large: The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ What caused the crisis? ■ Increasing public and private debt positions....have casted doubt on the ability of governments and banks safeguarded by governments to pay back debt.....have casted doubt on the ability of governments and banks safeguarded by governments to pay back debt. ■ Investors fear of a default of governments on their debt and....demand therefore a higher risk premiums.....demand therefore a higher risk premiums. The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ The situation is even worse than these figures suggest! ■ The change of a country's total debt position is the negative current account surplus. ■ We can calculate the current account surplus which is necessary to stabilize the current international debt-to-GDP ratio with the following formula (for a derivation see the digression): The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010 GDP International Net Debt Position of the Country GDP Growth Interest Rate Primary Current Account Balance EX-IM-i*D

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure Digression: The constant debt-to-GDP ratio budget surplus: ■ Debt-to-income ratio: ■ 1st derivation with respect to time: ■ Increase of debt = Primary Deficit + Interest Payments = +

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure Digression: The constant debt-to-GDP ratio budget surplus: ■ 1st derivation with respect to time: = = => Condition for a constant debt-income-ratio: dk / dt = 0 !

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure Digression: The constant debt-to-GDP ratio budget surplus: If GDP growth is smaller than the interest rate, a country must run a primary current account surplus to keep the debt-GDP-ratio constant!

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure Digression: The constant debt-to-GDP ratio budget surplus: If GDP growth is larger than the interest rate, a country can run a primary current account deficit to keep the debt-GDP- ratio constant!

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ Applying this formula to the data of the countries shows that their actual account surplus is far away from the surplus necessary to keep their debt-to-GDP ratio constant: The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure Current account surplus necessary to stabilize the International Debt-to-GDP ratio is 7,5% of GDP. The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010 Acutal current account surplus - 5,5% of GDP ! => Current account surplus gap = 13 % of GDP !

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010 Current account surplus gap = 18,5 % of GDP !

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010 Current account surplus gap = 15 % of GDP !

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010 Current account surplus gap = 25 % of GDP !

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The larger the current account gap, the higher the risk premium! The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure The larger the government budget gap, the higher the risk premium! The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ The situation is precarious! ➤ How to get out of this??? ➤ To help countries like Greece, Portugal, Spain and Ireland their " Current Account Gap" must be reduced: Depressed EMU The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How to get out of this??? ➤ Special problem of indebted countries, which are member states of a monetary union: 1. They have no own currency they can depreciate to improve their current account: 2. They have no own currency to inflate away debt! ↓ e$€e$€ => P € e $ € => ( EX – IM ) ↓ ↓ ↑ ↑ < P $ Reduction of current account gap! The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure Prof. Dr. Rainer Maurer Digression: How to "inflate away" government debt ??? The present value (=PV t,T =market value) of government debt with a face value of 1€ is given by the formula: If the market interest rate i t,T =2% is equal to fixed interest rate of government debt z t,T =2%, the market value is equal to the face value = 1€: If an increase of inflation by 3% increases the nominal market interest rate (=real interest rate + inflation rate) by 3% and the average maturity of government debt is T=10 years, the market value of government debt falls by nearly one quarter: The Dark Corners of Fiscal Policy => Create a little bit inflation and buy back your debt !

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How to get out of this??? ➤ Special problem of member states of a monetary union: 3. Leaving the monetary union will cause the countries debt position to explode !!! ◆ If Greece would leave the eurozone:  Its new currency (the Neodrachmae) will depreciate against the Euro: e € Neodramae  However, Greek government bonds (as well as private debt) are denominated in Euro D € !  The Greek debt measured in Neodramae will grow in case of a depreciation: D Neodramae = D € / e € Neodramae D Neodramae = D € / e € Neodramae ↓ ↓ ↓ ↓ ( ) The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ The EMU is a monetary union across countries which have asynchronous business cycles: GDP Gap = Actual GDP minus trend GDP in % of trend GDP The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ As a result, inflation rates across the EMU member state are typically quite different: The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ The European Central Bank can set only one main refinancing rate. ■ Therefore, after the start of the EMU, nominal interest rates across the eurozone converged. ■ However, convergence of nominal interest rate and different country-specific interest rates causes a divergence of real interest rates! => Countries with a high inflation rate have low real interest rates! Countries with a low inflation rate have high real interest rates! Countries with a low inflation rate have high real interest rates! The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ Convergence of nominal interest rate & divergence of real interest rates: The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ Real interest rates compared to Germany: The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ Real interest rates and net international debt position: The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ Inflation rates and net international debt position: The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ Consequently, high inflation countries experienced on average lower real interest rates than low inflation countries: The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010 Low inflation country: r L * = i *- π L Excess Supply S(Y) I(Y) S, I r rL*rL* High inflation country: r H * = i *- π H Excess Demand S(Y) I(Y) r rH*rH* S, I The integrated EMU capital market is in equilibrium, while there is a disequilibrium in single countries! r*r*

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ Countries with high inflation rates built up a net international debt position. ■ Countries with low inflation rates built up a net international wealth position. The Eurozone Debt Crisis 2010 The Eurozone Debt Crisis 2010

© RAINER MAURER, Pforzheim Prof. Dr. Rainer Maure ➤ How has it come to this? ■ Consequently, the eurozone debt crisis is not by chance! ■ It is caused by a design faulty of the EMU! ■ What can be done to built a more stable EMU? 4.2. Financial Market Crises The Eurozone Debt Crisis 2010