The Sovereign Debt Crisis 2010-2011 A European Approach Enrique Viaña Rzeszow, 10 May 2011.

The Sovereign Debt Crisis2010-2011

A European Approach

Enrique Viaña

Rzeszow, 10 May 2011

What is de SDC?

• The SDC is a recurring turmoil in the global markets for securities, which makes it difficult por periphery members of the EMU – European Monetary Union – there to finance their budgets.

• Membership to the EMU is a requisite for a country to be listed in the SDC:– Thus, the financial rescues of Iceland and Hungary

by the IMF in 2008 are not episodes of the SDC.– The first country to suffer the SDC was Greece,

early in 2010.

Causes of the SDC /1

Apparent causes: the turn of the EMU from fiscal stimuli to fiscal consolidation, in the fall 2009.- Up to that point, the EMU alongside the whole

EU and other advanced economies followed the IMF instruction in the aftermath of Lehman Brothers’ bankrupcy (Sept 2008) to foster aggregate demand by means of expanding public expenditure.

- The ECB easied the policy through unlimited lending to banks. (Banks bought debt however much there was in supply.)

Causes of the SDC /2

Profound causes: Competition between euro and the US dollar (and, to a much lesser extent, the pound sterling) for the more competitive to be cashed by global dealers as a preferred reserve currency.

- Such competition began in 1999.- It has intensified during the global crisis, which is a crisis ignited in Wall Street, the HQ of the dollar area.

Crisis of the dollar /1

• The US dollar was signaled a reserve currency at a global scale, in substitution for gold, by the Bretton Woods Conference (July 1944).

• While the US economy ran external surpluses, all went well: the US lent others the money they spent in buying American goods.

• The expectation was for the US to build a mature financial position.

1) Building a mature financial position

A B

A sells B as much as X

B sells A as much as M

A lends B as much as X — M

2) A mature financial position

A BB sells A as much as M

B pays A as much as M interest rate

X > M

Balance due = 0

A builds a financial position, not yet mature

Crisis of the dollar /2

• Yet, the US economy began to run increasing deficits before it could build a strong financial position.

• Dollar so overmarched the international necessity for transaction purposes.

• A period of global inflation followed in the 1970s; the gold exchange standard came to an end, and so did the pegged exchange rates as accorded in 1944.

Financial dominance, not mature

A B

A sells B as much as X

B sells A as much as M

A prints money worth of M — X and gives it to B in full payment of the trade deficit

X < M

MARKET FOR GOODS AND SERVICES

B uses A’s money to buy goods and services

GLOBAL INFLATION

Crisis of the dollar /3

• In 1981, President Ronald Reagan of the United States abruptly changed policy.

• US external deficit did not recede but rather boosted—it was its financing what changed.

• Instead of sending dollar abroad to pay for the deficit, the US borrowed in large scale by means of paying high interest rates.

• A long-lasting world recession followed, because of the higher interest rates.

A B

A sells B as much as X

B sells A as much as M

A gives B profitable, safe assets to pay for X — M < 0

X < M

B demands A’s assets in excess of |X — M|

A’s currency gains value

PRESIDENT REAGAN’S ARRANGEMENT

De-regulation, a Requirement

• For President Reagan’s arragement to work, de-regulation of the world financial transactions was a necessity, there to ease anyone from anywhere to buy US Treasure Bills.

• That is how de-regulation was effected throughout the OECD members, first, and through the IMF’s efforts also everywhere else.

Crisis of the dollar /4

• World recession came to an end in Sept 1985—the so-called Plaza Hotel Agreement, in which virtue the Bundesbank and the Bank of Japan agreed to sterilize the American deficit, by cashing every and the last dollar without pouring it into the currency market.

• Thus, both central banks upheld the value of the dollar somehow artificially.

A B

A sells B as much as X

B sells A as much as M

A prints money worth of M— X and gives it to B

X < M

CURRENCY MARKET

B sells A’s money

A’s currency loses value

B accumulates cash balances of A’s money

PLAZA HOTEL AGREEMENT

A’s money keeps its value somehow artificially

Crisis of the dollar /5

• The Plaza Hotel Agreement educated the Bundesbank on the advantages of a hard currency.

• On the one hand, America could buy anything from Germany and Japan it desired without regards of the financial effects—both countries self-paid with very low unemployment rates.

• On the other, the US dollar enjoyed a high purchasing power.

The Birth of the Euro /1

• Early in the 1990s, Germany led a joint European effort to issue a common currency—the Treaty of Maastricht was the outcome.

• The common currency, by name the euro, was seen as a symbol of the EU as much as a flag and anthem were.

• Besides, the euro was believed to be a necessary requirement in order to further the economic union.

The Birth of the Euro /2

• Yet, it was much more than that.

• The 1990s is the globalization decade; it means that many emerging economies joined with Germany and Japan as strong exporters—China among them.

• Those emerging countries were not obliged by the Plaza Hotel Agreement—they could choose between competing reserve currencies solely on account of comparing their intrinsic, not political value.

The Birth of the Euro /3• Therefore, the euro in its origin was a project to

offer the global exporters a reserve currency of a high intrinc value, there to replace the dollar in holdings of cash balances.

• To strengthen the intrinsic value of the new, common currency a domestic agreement was implemented—the new currency needed to be scarce, whereby the 3% of the GDP ceiling for fiscal deficits and the 60% of the GDP ceiling for sovereign debt outstanding.

• That is the main contents of the Stability and Growth Pact (1995).

Dollar v. the Euro /1

• Competition between the two currencies ran smoothly from 1999 through 2007, but not without important effects.

• Pressed by the competitive edge of the euro, Wall Street excelled in financial engineering.

• WS strove to offer the global exporters attractive assets there to invest their surpluses: the 2000s is the decade of the financial derivatives.

A B

A sells B as much as X

B sells A as much as M

X < M

A gives B profitable, risky assets in substitution for money

B demands A’s assets in excess of M — X

A’s currency gains value

AN ARRANGEMENTE BASED ON FINANCIAL ENGINEERING

Dollar v. the Euro /2

• Meanwhile, the euro endured the trouble of enforcing the discipline of 11, then 12, now 17 countries that lack homogenity in many important fields.

• Somewhat candidly, it was believed that the process of convergence, required to every country to join the common currency, ensured success.

• It didn’t.

The Financial Crisis, 2007-2008

• Against that background, the financial crisis was the unavoidable outcome of an inflation of US dollar-denominated assets.

• The crisis erupted out of the American subprime morgatge-backed securities and CDO, but it might have erupted out of anything else.

The Next Financial Crisis?

• As much as WS-based Bear Stearns inflated the real estate bubble until it exploded in 2007, WS-based Goldman Sachs now inflates a commodity bubble that will most likely explode in 2012 or 2013.

• WS works like that: it holds on an opportunity—this time the surge in oil prices—and engineers an ample speculation there to funnel financial surpluses into the US economy.

The Policy of Fiscal Stimuli

• Just after Lehman Brothers went bankrupt (15 Sept 2008) the IMF instructed the developed countries to run huge fiscal deficits in order both to sustain employment domestically and to uphold the international trade.

• In mid-2009 the USA reported the end of the recession.

Return to the 1995 Pact

• Fiscal stimuli implied that the Stability and Growth Pact—3% of the GDP ceiling for fiscal deficit, 60% of the GDP ceiling for sovereign debt—was temporarily waived.

• In the fall 2009,however, while the IMF and America still went on in fiscal stimuli, the EU changed to fiscal consolidation, and the ECB discontinued unlimited supply of cheap money to banks.

The Euro Resumes Competition

• The European analysis seemed to be that, once the recession was over, fiscal stimuli and accommodating monetary policy weakened the euro by accelerating inflation—the greatest danger in absence of financial discipline.

• However, as the euro adopted a tough stance while the dollar still did a loose one, the former climbed in the currency markets.

Effects on the EMU Countries

• The main such effect was, that countries so far financing their accumulated debt through private bank purchases at cheap cost, were then compelled to seek finance in the global markets.

• The markets, so far step-sided by expansionary policy, took on the lead and began to scan the different borrowers.

• Some of the borrowers were found unreliable.

• That is how the SDC crisis began.

EUROPEAN CENTRAL BANK

PRIVATE BANKS

The ECB lends unlimited 1-year money, at 1% interest rate

EMU COUNTRY

Private banks buy 10-year

bonds at issuance

Private banks reapply for cheap money as necessary

BOND MARKET

If necessary, private banks sell bonds

in the bond market

1) RULING BY POLICY

EUROPEAN CENTRAL BANK

PRIVATE BANKS

The ECB lends unlimited 7-day and 90-day money, at 1,25 % interest rate

EMU COUNTRY

Private banks buy 10-year

bonds at issuance

Private banks reapply for cheap money as necessary

BOND MARKET

If necessary, private banks sell bonds

in the bond market

2) PART-RULING BY POLICY, PART-RULING BY THE MARKET

When cheap money at the appropriate maturity stops

flowing from the ECB, a large volume of bonds are sold

and their price falls down —yields rise

When yields rise in the bond market, governments are compelled to issue at a higher interest rate

Two Interpretations of the SDC

• For American and British analysts, SDC reveals weakness of the euro as a currency that is not backed by a common, comprehensive economic policy—therefore it heralds the collapse of the euro.

• Another interpretation says SDC is a chapter of a story of competition among currencies, in which the euro battles out to enforce the financial discipline that will enable it to supersede the US dollar as a global reserve currency.

THANK YOU VERY MUCH

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