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From the American Financial Meltdown to the European Banking and Public Debt Crises

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Modern Financial Crises

Part of the book series: Financial and Monetary Policy Studies ((FMPS,volume 42))

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Abstract

In this chapter, we analyze how, via the banking system, the financial contagion was extended from the USA to Europe. In fact, we observe the extension of the Great Crisis from the international banking system to the European sovereign debts. The problem is that the expansionary fiscal policies of deficit spending implemented by most states to tackle the crisis have created very large deficits, which are difficult to adjust in the short run. To save banks, private debt became public debt. At the same time, with deteriorating public finances, sovereign risk has increased and worsened banks’ balance sheets. In fact, in European countries it is really a sequence of interactions between sovereign problems and banking problems. The genesis of these interactions also focuses on the imbalances in European Monetary Union (EMU) countries’ balance of payments. The European crisis has shown that it can spread quickly among closely integrated economies, either through the trade channel or the financial channel or both.

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Notes

  1. 1.

    Forbes (2012) surveys and assesses the academic literature on defining, measuring, and identifying financial contagion and the various channels by which it can occur, highlighting contagion risks in the euro area. More in general, Das et al. (2012) discuss some salient features embedded in the current generation of sovereign asset and liability management approaches, including objectives, definitions of relevant assets and liabilities, and methodologies used in obtaining optimal outcomes. The European public debt problems are also analyzed by Driffill (2013) and reviewed from an empirical point of view by Tomz and Wright (2013).

  2. 2.

    Kollintzas and Tsoukalas (2015) study bank risk and sovereign risk interdependence in the euro area and find that an increase in capital investment risk shock results in a considerably deeper recession when sovereign risk is also present.

  3. 3.

    In the euro area, the shadow banking system is less developed than in the USA (Bakk-Simon et al. 2011). This explains why European financial crisis follows some years later than in the USA.

  4. 4.

    The mutation of the original financial crisis into a sovereign debt one in the euro area countries is investigated by Candelon and Palm (2010) and De Grauwe (2010). More in general, Sturm and Sauter (2010) analyze the impact of the crisis on Mediterranean countries, while Wyplosz (2010) compares the US and the European situations during the crisis and examines how much of the crisis has been imported by Europe from the USA. The paper argues that Europe never had a chance to avoid contagion from the USA. On the other side, a comparison between Japanese and European crises is made by Schnabl (2013), who argues that Europe may stand at the beginning of a persistent lingering crisis as it is observed in Japan since more than two decades. Finally, the strong relation existing between the soundness of the public budgets and the international financial stability for the Italian case is illustrated by Banca d’Italia (2010) and Albertazzi et al. (2012).

  5. 5.

    Jordà et al. (2013) examine the coevolution of public and private sector debt in advanced countries since 1870 and find that in advanced economies, significant financial stability risks have mostly come from private sector credit booms rather than from the expansion of public debt. However, they find evidence that high levels of public debt have tended to exacerbate the effects of private sector deleveraging after crises, leading to more prolonged periods of economic depression. They uncover three key facts based on their analysis of around 150 recessions and recoveries since 1870: (1) in a normal recession and recovery, real GDP per capita falls by 1.5 % and takes only 2 years to regain its previous peak, but in a financial crisis recession, the drop is typically 5 % and it takes over 5 years to regain the previous peak; (2) the output drop is even worse and recovery even slower when the crisis is preceded by a credit boom; and (3) the path of recovery is worse still when a credit-fueled crisis coincides with elevated public debt levels.

  6. 6.

    Aguiar and Amador (2013) use a benchmark limited-commitment model to explore key issues in the economics of sovereign debt like debt overhang, risk sharing, and capital flows in an environment of limited enforcement. They also discuss recent progress on default and renegotiation, self-fulfilling debt crises, and incomplete markets and their quantitative implications.

  7. 7.

    Kilponen et al. (2012) stress that the economically most significant effects on the bond yields have been due to the announcement of the ECB’s Securities Market Programme.

  8. 8.

    Forbes (2012) surveys and assesses the academic literature on defining, measuring, and identifying financial contagion and the various channels by which it can occur, highlighting contagion risks in the euro area. He shows that a country is more vulnerable to contagion if it has a more levered banking system, greater trade exposure, weaker macroeconomic fundamentals, and larger international portfolio investment liabilities.

  9. 9.

    Uhlig (2014) argues that in a monetary union, regulators in risky countries have an incentive to allow their banks to hold home risky bonds and risk defaults, whereas regulators in other “safe” countries will impose tighter regulation. As a result, governments in risky countries get to borrow more cheaply, effectively shifting the risk of some of the potential sovereign default losses on the common central bank.

  10. 10.

    In the case of Italy, Albertazzi et al. (2012) show that a rise in the 10-year yield spreads relative to Germany is followed by an increase in the cost of wholesale and of certain forms of retail funding for banks and in the cost of credit to firms and households; the impact tends to be larger during periods of financial turmoil. An increase in the spread also has a direct negative effect on lending growth, beyond that implied by the rise in lending rates. Finally, they document a negative impact of the spread on banks’ profitability, stronger for larger intermediaries. More in general, Di Cesare et al. (2012) show that for several countries the spread has increased to levels that are well above those that could be justified on the basis of fiscal and macroeconomic fundamentals. Among the possible reasons for this gap, the analysis focuses on the perceived risk of a breakup of the euro area. Finally, the sustainability of Italian fiscal policy in the long run is analyzed by Bartoletto et al. (2011).

  11. 11.

    The SGP requires EU member countries to have an annual budget deficit no higher than 3 % of GDP and a national debt lower than 60 % of GDP or approaching that value.

  12. 12.

    Two empirical contributions on sovereign credit risk are Aspergis et al. (2011), who examine whether the efficiency market hypothesis for the Greek sovereign debt holds, finding that spreads and CDS are co-integrated, and Basse et al. (2012), who examine the relation between German and Italian government bond yields and its implication for insurance companies and regulators.

  13. 13.

    Eijffinger et al. (2015) present a theory, which can account for the behavior of sovereign bond spreads in Southern Europe between 1998 and 2012. Their key theoretical argument is related to the bailout guarantee provided by a monetary union, which endogenously varies with the number of member countries in sovereign debt trouble. They incorporate this theoretical foundation in an otherwise standard small open-economy DSGE model and explain (1) the convergence of interest rates on sovereign bonds following the European monetary integration in the late 1990s and (2)—following the heightened default risk of Greece—the sudden surge in interest rates in countries with relatively sound economic and financial fundamentals. On the same topic, see also Bordon et al. (2014).

  14. 14.

    Heinemann et al. (2013) study the determinants of sovereign risk premia in the EU countries between 1992 and 2008 and find that fiscal rules have the largest potential for countries with particularly poor fiscal stability culture in the past. For these countries, the effect of rules on risk premia is stronger than for high-stability countries. It seems that these countries could benefit from the establishment of external debt brakes which is intended by the Fiscal Compact.

  15. 15.

    De Grauwe and Ji (2015) confirm the previous analysis, and in addition they find that the panic-induced austerity, as it occurs mainly in periods of recession, has the effect of reducing the power of the automatic stabilizers in the government budgets. As a result, the economic recessions are made more intense and can lead to social and political instability in the countries concerned.

  16. 16.

    Hale and Obstfeld (2014) analyze the geography of international debt flows using multiple data sources and provide evidence that after the euro’s introduction, core euro area countries increased their borrowing from outside of EMU and their lending to the EMU periphery. Core EMU countries took on extra foreign leverage to expose themselves to the peripherals. The result has been asset-price bubbles and collapses in some of the peripheral countries, area-wide banking crisis, and sovereign debt problems.

  17. 17.

    Also Mersch (2011) points to flaws in the Maastricht Treaty as a factor that explains the deteriorating of the crisis.

  18. 18.

    Farmer et al. (2012) present a model that invalidates the implication that competitive financial markets efficiently allocate risk. Their work demonstrates that financial markets, by their very nature, cannot be Pareto efficient, except by chance. Although individuals are rational, they conclude that markets are not.

  19. 19.

    Ma and McCauley (2013) analyze global and euro area imbalances by focusing on China and Germany as large surplus and creditor countries. In the 2000s, domestic reforms in both countries expanded the effective labour force, restrained wages, shifted income toward profits, and increased corporate saving. As a result, both economies’ current account surpluses widened before the global financial crisis, and that of Germany has proven more persistent as domestic investment has remained subdued.

  20. 20.

    According to Holinski et al. (2012), the growing current account imbalances in the euro area are a cause for serious concern, deserve monitoring, and ultimately require an appropriate policy response. Private agents’ decisions with respect to savings and investment can lead to large external deficits without automatically generating sufficient domestic economic growth and productivity gains. The result can be unsustainable net foreign liability positions that can only be redressed at substantial macroeconomic costs. Once unsustainable imbalances emerge, adjustment mechanisms are scarce and costly. Without productivity gains, the burden of adjustment falls on prices and wages that need to fall and real interest rates that need to rise in southern relative to northern Europe. Such a process is accompanied by a painful period of economic contraction and will take a number of years to resolve.

  21. 21.

    Lane and Pels (2012) show that the European crisis is partly attributable to the sharp increase in external imbalances across Europe during the pre-crisis period. They find that the discrete expansion in current account imbalances during the 2002–2007 period can be attributed to a strengthening in the link between growth forecasts and current account balances.

  22. 22.

    The IMF balance-of-payment definition includes the current account, the capital account, and the financial account. In Mayer’s (2011) reasoning, however, the financial account is mixed with the capital account.

  23. 23.

    The connection between real exchange rates and growth remains an unsettled question in the academic literature. Bussière et al. (2014) try to fill this gap by providing an empirical assessment based on a broad sample of emerging and advanced economies. They assess the impact of appreciations, productivity booms, and capital inflow surges using a propensity score-matching approach to address causality issues. Appreciations associated with higher productivity have a larger impact on growth than those associated with capital inflows. Furthermore, appreciations per se tend to have a negative impact on growth. They provide a theoretical model that delivers a contrasted growth-appreciation pattern depending on the underlying shock. The model also implies adverse effects of shocks to international capital flows, so concerns about an appreciation are not inconsistent with concerns about a depreciation. While the presence of an externality through firms’ destruction leads to inefficient allocations, addressing the inefficiency does not dampen exchange rate movements. Furthermore, Berka et al. (2014) investigate the link between real exchange rates and sectoral total factor productivity measures for countries in the Eurozone.

  24. 24.

    TARGET is the “Trans-European Automated Real-Time Gross Settlement Express Transfer” system. It was replaced by TARGET2 in November 2007, with a transition period lasting until May 2008, by which time all national platforms were replaced by a single platform. The processing and settlement of euro-denominated payments takes place on an individual basis on the participants’ accounts at NCBs connected to TARGET2. The transactions are settled in real time with immediate finality, thus enabling the beneficiary bank to reuse the liquidity to make other payments on that day.

  25. 25.

    While there are many methods to measure the competitiveness of an economy, most of these concepts ignore the fact that competitiveness can change because of market processes like wage negotiation but also because of political decision-making. Governments that compete with others for factors of production face the incentive to adjust key policy variables to improve their competitive position. Increasing country competitiveness is one of the key objectives currently discussed by policymakers in the context of creating an economic union in the euro area, to complement monetary union. Huemer et al. (2013) propose a new competitiveness index that captures the dimensions in which politics can influence competitiveness beyond factor price adjustments. Their index shows that the individual components of institutional competitiveness have developed heterogeneously among EMU member states. To explain these divergent developments, the uneven integration within the EU single market may play a role.

  26. 26.

    Also interesting is the case of Italy. According to Tiffin (2014), in this country, price-based competitiveness measures are not always an accurate predictor of trade outcomes. Tiffin’s paper offers a more comprehensive assessment of Italian competitiveness, focusing on the role of innovation and the evolution of Italy’s export market share. Overall, Italy maintains a high-quality export mix, and the adaptability of small-scale specialized firms is still a source of strength. But, small firm size is becoming less of an asset, and even the most innovative sectors are weighed down by the structural barriers that have depressed productivity more broadly. Tiffin concludes that Italy’s future competitiveness will depend on full implementation of a comprehensive structural-reform agenda.

  27. 27.

    Aizenman (2012) analyzes reforms and adjustments needed in the context of the euro and the global financial crisis, stressing the challenges associated with finding the proper balance between financial integration and financial regulations. As documented by Jakab et al. (2015), the euro area countries are more vulnerable to domestic and external demand shocks because adjustments in the real exchange rate between EMU countries occur more gradually through inflation differentials. Spillovers from tight credit conditions in each country are limited by direct trade channels.

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  1. Department of Economics and Business, University of Cagliari, Viale San Ignazio 17, 09123, Cagliari, Italy

    Beniamino Moro

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Moro, B. (2016). From the American Financial Meltdown to the European Banking and Public Debt Crises. In: Modern Financial Crises. Financial and Monetary Policy Studies, vol 42. Springer, Cham. https://doi.org/10.1007/978-3-319-20991-3_5

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