Special TopicEuropean Debt Crisis

Monetary Economics and the Global Economy

Prof. Lukasz A. Drozd

The Wharton School of the University of Pennsylvania

European Debt Crisis

Over past several years Eurozone has seen

one of the largest sovereign default in history

3 of its members being on an IMF program

banking sector under severe distress for about 7 years

3 EU countries going through a Great Depression

European Debt Crisis

Over past several years Eurozone has seen

one of the largest sovereign default in history

3 of its members being on an IMF program

banking sector under severe distress for about 7 years

3 EU countries going through a Great Depression

What happened?

Outline

European Sovereign Debt Crisis

Why Euro Made Sense and Still Does

Debt Crisis in 2 Steps

Key Events and Market Reaction

Response to the Crisis

Global Impact

Prospects / Lessons for the Future

Why Introduction of Euro Made Sense?Introduction of euro was a consequence of deep economic

integration and growing convergence of European countries.

Why Introduction of Euro Made Sense?Introduction of euro was a consequence of deep economic

integration and growing convergence of European countries.

Economic Integration Index For EU Member States

Integration maximized benefit

Why Introduction of Euro Made Sense?Introduction of euro was a consequence of deep economic

integration and growing convergence of European countries.

Dispersion of Output Growth Rates Among Member States

Euro

Convergence minimized cost

Why Introduction of Euro Made Sense?Introduction of euro was a consequence of deep economic

integration and growing convergence of European countries.

Crisis Explained in 2 Steps

Crisis Explained in 2 Steps

Basic implications of introducing euro:

1. Removed ability of sovereign governments to monetize

debt and create inflation

2. Eliminated exchange rates between countries

3. Imposes fiscal restraints due to severed ability to default

(+ 3% max deficit, 60% max government debt))

Step 1

Crisis Explained in 2 Steps

Basic implications of introducing euro:

1. Removed ability of sovereign governments to monetize

debt and create inflation

2. Eliminated exchange rates between countries

3. Imposes fiscal restraints due to severed ability to default

(+ 3% max deficit, 60% max government debt))

Step 1

⇒ same inflation risk

Crisis Explained in 2 Steps

Basic implications of introducing euro:

1. Removed ability of sovereign governments to monetize

debt and create inflation

2. Eliminated exchange rates between countries

3. Imposes fiscal restraints due to severed ability to default

(+ 3% max deficit, 60% max government debt))

Step 1

⇒ same inflation risk

⇒ same exchange rate risk

Crisis Explained in 2 Steps

Basic implications of introducing euro:

1. Removed ability of sovereign governments to monetize

debt and create inflation

2. Eliminated exchange rates between countries

3. Imposes fiscal restraints due to severed ability to default

(+ 3% max deficit, 60% max government debt))

Step 1

⇒ same inflation risk

⇒ same exchange rate risk

⇒ initially similar sovereign default risk

Crisis Explained in 2 Steps

Basic implications of introducing euro:

1. Removed ability of sovereign governments to monetize

debt and create inflation

2. Eliminated exchange rates between countries

3. Imposes fiscal restraints due to severed ability to default

(+ 3% max deficit, 60% max government debt))

Step 1

Everyone will look like Germany, and Did Look Like Germany

⇒ same inflation risk

⇒ same exchange rate risk

⇒ initially similar sovereign default risk

Crisis Explained in 2 StepsStep 2

Since Not Everyone is Germany, Not Everyone Will Act like Germany, and Did Not

Crisis Explained in 2 StepsSince everyone looked like Germany, long term interest rates

converged.

STEP 1Credible EMU design implied:1. Same inflation risk2. Same x-rate risk3. Similar initial sovereign default risk

Crisis Explained in 2 StepsLow interest rates fueled massive credit boom in the periphery.

STEP 2Low interest rates fueled massive credit boom in the periphery(since they are not Germany,

they borrowed)

Crisis Explained in 2 StepsLow interest rates fueled massive credit boom in the periphery.

The situation was exacerbated in real terms through a vicious cycle implied by Fisher equation and common monetary policy

Recall Fisher equation:

The same across EMU!

Crisis Explained in 2 StepsLow interest rates fueled massive credit boom in the periphery.

Unit labor costs

GERMANY

PIIGS

The situation was exacerbated in real terms through a vicious cycle implied by Fisher equation and common monetary policy

Key Events and Market Reaction

Key Events and Market ReactionFinancial crisis exposed bubbles/inefficiencies that this credit

boom partly fueled.

Key Events and Market ReactionFinancial crisis exposed bubbles/inefficiencies that this credit

boom partly fueled.

Global financial crisis exposed asset price bubbles and inefficiencies…

Key Events and Market Reaction

Timeline of events

Greece and other countries were fudging government

debt statistics to make things look better

When this was exposed, it erupted in growing concerns

about sustainability of Greek debt

Financial crisis exposed bubbles/inefficiencies that this credit boom partly fueled.

Key Events and Market Reaction

Timeline of events

Other PIIGS run into problems for other idiosyncratic reasons

Ireland – suffered worse housing price bubble than the US, fueled by

lax credit; major bailout of banking sector put government debt at a

dangerously high level

Spain – suffered worse housing price bubble than the US, fueled by lax

credit provided by corrupt and not so sound local cooperatives (cajas),

rendering them bankrupt, and ultimately put government on the hook

Portugal – really a puzzle, simply failed to generate any sound

economic growth from borrowed funds but its firms (some bubbles)

Italy – unsustainable government debt level, low growth

Financial crisis exposed bubbles/inefficiencies that this credit boom partly fueled.

Housing Price Bubbles: Spain/Ireland

European Debt in NumbersOverall Europe does not look bad at all.

European Debt in NumbersBut the periphery does and they are too big to swallow for the rest

of Europe. Nobody wants to pay someone else’s debt!

European Debt in NumbersBut the periphery does and they are too big to swallow.

Response to the Crisis

Response to the CrisisThe crisis erupted in the form of a run on debt. Resulted in series

of bailouts to stopgap the run and prevent default from happening.

Response to the CrisisThe crisis erupted in the form of a run on debt. Resulted in series of bailouts to stopgap the run and prevent default from happening

All bailouts and interventions were conditional on reforms and severe austerity measures beomgimplemented by PIIGS.

Response to the CrisisThe crisis erupted in the form of run on debt. Resulted in series of

bailouts to stopgap the run and prevent default.

Key motivation If one country exits Eurozone, in the short-run this may find relief by starting from clean state… other PIIGS may want to do the same… destroying euro and ultimately affecting the core.

Options Used and Remaining

Impact on the US & the Global Economy

Impact on the Global EconomyTrade Channel:

US exports to the Eurozone have languished

Impact on the Global EconomyFinancial Channel:

Flight to quality brought down Treasury yields and appreciated US exchange rate significantly, hurting US exporters.

Impact on the Global EconomyFinancial Channel:

Financial institutions already incurred losses on European assets due to fall in prices.

Prospects/Lessons/Reforms

Lessons

EU must impose limits to fiscal freedom so as to limit

government borrowing and indirectly impose no bailout

policy on the private sector

Maastricht Treaty and Stability Growth Pack failed, so

not clear this can be done easily

Core has to pick up the tab, at least to some extent

Again, nobody wants to pay down debt, not mentioning

someone else’s debt… & what it means in the future?

Monetary Union Without Fiscal Restraint and No Bailout Clauses is a Non-starter (sooner or later).

Prospects?PIIGS and Europe just started growing. Even if Greece exits euro

may be sustainable.

Review questions

What factors led Europe to introduce Euro? Why it may be a good

idea?

What factors are behind initial convergence of long-term interest

rate, and subsequent divergence?

Why European periphery experienced credit boom, price inflation

and very low real interest rates? What is the mechanism?

What is the impact on the US economy and the global economy?

What is the future of Eurozone and what reform must be considered

to avoid repetition?

The End

Mario DragiECB President