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The European Debt Crisis

Joseph Foudy

Department of Economics

[email protected]

Copyright : Joseph Foudy 2011 (charts and illustrations copyrighted by original sources)

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The European Debt Crisis

1. Europes Debt Problem2. The nature of the Euro and the challenges to its

future

3. A Closer Look at Greece4. The Threat of Contagion

5. Crisis and the Global Economy

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Debts and Deficits

1. Europes Debt Problem

Source: http://seekingalpha.com/article/205457-the-u-s-worse-off-than-greece

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Debts and Deficits

1. Europes Debt Problem

Source: http://seekingalpha.com/article/205457-the-u-s-worse-off-than-greece

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Debt as Percent of GDP (2000)

1. Europes Debt Problem

Source:http://www.ritholtz.com/blog/2010/05/chang

es-in-european-debt-2000-09/

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Debt as Percent of GDP (2009)

1. Europes Debt Problem

Source:http://www.ritholtz.com/blog/2010/05/chang

es-in-european-debt-2000-09/

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Italy has high debt, but lower deficits; Spain low debt, but high deficits

Deficits and Debt Together

Bad

Good

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Normally countries can grow their way out ofdebt

But Europe is aging, labor markets are rigidand growth above 2-3% a year is difficult

Europe is just not projected to grow in future

Hard for weaker countries (PIGS) to get out ofdate, unwillingness of other countries to bailthem

European Debt

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Europe facing Ratings Downgrades Ratings as of August 2011

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Europe facing Ratings Downgrades Hitting both banks and states

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European Response Resistance of core European countries

(especially German) to bail out weaker states

EU has been making incremental measures(too little, too late) since start of crisis This has meant each attempt to solve the crisis fails Critics argue stronger, bolder action early would

have prevented larger crisis and cost less money

Even so, this is a solvency issue for Greece(e.g. it just can not pay this debt) versus othercountries where it is arguably a liquidity issue(e.g. short-term crisis of confidence)

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Nature of the Euro

Advantages and Problems of a FixedExchange Rate System

Lack of Fiscal Union

Accession Rules

2. The Euro

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Fiscal Union Creating the Euro led to two concerns (known

at the time) First was that you can have only one interest rate,

but economies were quite different and movement

of people/payments between states was low Second, if one state becomes particularly indebted

it would put pressure on the Euro zone to bail themout

Entry criteria were meant to mitigate theseissues, but they remained

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US Example US has same concerns on differing economic

conditions When Florida is booming and Michigan is in

recession, what can we do.

But in US, people can move states and governmenttransfer payments help

Heavy indebtedness of one state is also apotential concern (though US state budgets are

a smaller percent of GDP) New York City in the 1970s

California today

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Role of ECB vs. Fed In Crisis, Federal Reserve is the lender of last

resort Infused massive amounts of cash into banking

system in 2008, bought debt to prop up banks, took

unconventional measures like quantitative easing In Europe, European Central Bank (ECB) has

mandate of price stability and has resisted anysteps to take on debt Been forced by member states to take on some

Greek debt (will be lose to ECB)

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NYC in 1970s

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1980s were

not muchbetter

(now NYU studentscomplain about the

number of free cablechannels in dorms)

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New York and California Today

Massachusetts and New York debt levels are high in per capitaterms, California debt high in absolute terms (but what percent

of GDP is $4,800. (US state debts small compared tocountries

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Accession/Entry Rules Euro had strict entry criteria

Inflation must be no higher than 1.5% of average ofbest three states.

Must maintain exchange rates for two years prior.

Interest Rates on Long-term Government Bondsmust be no higher than 2% of average of best threestates.

Budget deficit can be no more than 3% of GDP,

Govt debt 60% of GDP. But Greece and Italy fudged the deficit

numbers with the help of major investmentbanks

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Debt as Percent of GDP (2011 and 2013)

Source:http://www.sta.ethz.ch/Strategic-Trends-

2011/Power-shifts-Emerging-markets-emerged-geopolitics-fractured

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Austerity measures immensely unpopular,

Greece is reducing deficit but not fast enough

Greece has a serious problem collecting taxes

1/3 of Greek Debt has to be rolled over in nextyear

We have perhaps 2 weeks to bail out Greece,force a haircut on borrowers or let it just

default

3. Greece

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Austerity in Greece

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Cost of Greek Debt

Question: Would you buy it at 26% interest?

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Austerity in Greece

Austerity has been a core demand of EU andIMF but it is pushing country in recession

Focus has been on across the board wage cutsfor public workers and pensioners rather than

layoffs Even with austerity, deficit is 10% of GDP

Large tensions between German taxpayers

that do not want to bail out Greece andGreeks resentful of cuts

But spending no longer sustainable

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Tax Avoidance in Greece

Black economy could be 1/4 or 1/3 of GDP.

Tax collection extremely low.

11 Million People and only 5,000 declareincomes over 100,000 Euros

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Data from Nicholas Economides, NYU Stern

Greek Sovereign Bonds:

284.2 ECB (bought in open market) 55.0

Greek banks (held as collateral by the ECB) 40.0

Greek pension funds and insurance comp. 30.0

French banks 56.9

German banks 28.3 UK banks 14.7

Portuguese banks 10.2

US banks 8.7

Dutch banks 5.2

Italian banks 4.5

Austrian banks 3.3

Swiss banks 3.0

Belgian banks 2.0

Japanese banks 1.3

Spanish banks 1.1

Others (insurance, hedge funds) 20.0 27

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Options:

EU lends more money without fixing situation

EU arranges a major hair cut of Greek debtholders

Old debt is exchange for new bonds due 10-30 yearsfrom now and with debt cut 50-60%, some kind ofbroader EU guarantee of debt is needed

Eurobonds or ECB would have to guarantee debt

Greece defaults and stays in Euro Greece defaults and leave Euro

3. Greece

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Problems with leaving the Euro Zone

Reintroduced Drachma would lose a great deal ofvalue

Greece has no competitive sectors and imports

virtually all its good, which would become muchmore expensive

Greece lacks the short term money to pay its civilservants

3. Greece

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If European banks take a haircut on Greekdebt they will need to be recapitalized by the

government. Bailing out banks only slightly more popular

with public in Germany than bailing out

Greece. In France, government aid to banks might cost

it Frances AAA credit rating.

Problems with Haircut withGuarantee Option

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Even France appears vulnerable

4. The Threat of Contagion

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CDS spreads in

Europe

4. The Threat of Contagion

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Look at the VIX

4. The Threat of Contagion

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Whatever the resolution of Greece,

speculators must now wonder which countrywould be next to default or arrange a haircut

Investors will refuse to buy their debt or

demand unsustainably high interest rates Hedge funds will buy bet on default with

CDSs creating system risk

4. The Threat of Contagion

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Global Debt Issuance Looks Something Like

this

4. The Threat of Contagion

C

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Greece is a small part of European economy

and even Greek debt is manageable But if a Greek default or haircut creates a run on

other countries, other countries to large to save.

Contagion to other PIIGS, France

Th Th f C i

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Global Interconnected Banking System (public

and shadow)

4. The Threat of Contagion

Th Th f C i

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European Banks Facing Funding Problems

Fear of lending to them growing

4. The Threat of Contagion

5 C i i d M

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Crisis is weighing not only on Europe but on

US

Story this summer in US was about how debtstandoff in Washington hurt economy

Problems in Greece probably a bigger factor

Even if we avoid a Lehman-like marketmeltdown, this crisis could be the straw that

breaks the camels back and puts us intodouble dip

5. Crisis and Macro-economy

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Questions?