Transcript THE GLOBAL FINANCIAL CRISIS CHAPTER 9

From the US subprime mortgage crisis to
European sovereign debt
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Concluding comments
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After millions of homeowners lost their homes
and millions of workers lost their jobs, the US
subprime mortgage crisis entered Europe and
became known as the European sovereign debt
and banking crisis.
The majority of analysts suggest that there were
many causes of the US subprime mortgage crisis.
The decision of the US government to subsidize
housing for the poor, minorities, and the middle
class contributed to the formation of the crisis.
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Similarly, the decision by financial institutions to
pursue high profit opportunities exposed them to
high risk when they adopted the new securitization
model of home financing.
Financial liberalization began with the repeal of the
Glass-Steagall Act in 1999, allowing bankers to sell
their mortgages as soon as the home loans were
signed.
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Under the new home financing system of
securitization banks made as many loans as they
had time to process, without checking the
mortgage applicants’ ability to pay.
Investment banks that purchased mortgages from
loan issuing institutions created securities using
mortgages as underlying collateral. Because many
of the mortgages were of low quality, securities
based on such mortgages were also of low quality.
The latter consequently became known as toxic
assets or toxic securities.
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Most analysts agree that the US subprime mortgage
crisis was the result of both private and public failure.
Moral hazard in the presence of economic asymmetries
was a primary cause of the crisis. Bank executives had
more information than the shareholders. Similarly
investment bankers who created novel financial
products knew more about the securities they created
than the investors who unknowingly purchased them.
Once the crisis exploded in the US, the President,
Congress, and the Fed took extraordinary measures to
reverse it.
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Fiscal and monetary stimuli of unprecedented
magnitudes were injected into the economy.
When US monetary and fiscal authorities were
certain that the economy was back on a safe path,
they both began pulling back the stimuli.
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Unlike the US experience, the crisis in Europe prevailed for a
long time, and as of winter 2016 is still ongoing; this is
particularly evident if the crisis is evaluated by the
unemployment rates, which are in the double digits in almost
all of the bailout countries.
The imposition of contractionary fiscal policy by the IMF and
EU in the midst of the recession turned out to be an incorrect
decision that prolonged the crisis.
This was the policy preferred by Germany and its northern
allies, which imposed draconian austerity measures on the
bailout recipient countries. Such programs were implemented
under the close supervision of the Troika.
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Such an approach was adopted because the EU country
leaders were convinced that the European sovereign debt
crisis was caused exclusively by reckless fiscal management.
Once the crisis spread it became difficult to reverse, because
the EMU was introduced as an incomplete (unfinished)
structure. In order to join the EMU, member countries
surrendered their national monetary and exchange rate
policies, and for the most part their fiscal policies.
Consequently, the EMU countries were unable to defend
themselves against the “perfect storm” that emerged. The
crisis threatens the very existence of the EMU and the single
European currency: the euro.
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Monetary policy in the EMU is conducted by the
ECB, but the ECB is not an independent bank like
the Fed, the Bank of Japan, or the Bank of England.
Because the ECB is not an independent central
bank, it cannot purchase government securities of
EMU member countries at risk. Thus the ECB
cannot serve as a lender of last resort.
ECB government security purchases would have
kept the interest rates low, enabling EMU member
governments to borrow in the markets and
refinance their public debt at low interest rates.
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The ECB kept the interest rates in the EMU higher than the US
interest rates prior to the crisis. Such a policy contributed to a
strong euro versus the dollar, and this had a negative effect
on the level of EA countries’ exports.
Throughout the crisis, Germany’s central bank, the
Bundesbank, consistently tried to prevent the ECB from
monetizing the public debt of financially distressed countries.
Germans feared such a monetary policy by the ECB would
create inflation and would shift the public debt of the rescued
countries to the German taxpayers.
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The EU has a small budget, close to 1% of all the EU
countries’ combined GDP. In addition, the EU
budget has to be annually balanced.
Furthermore annual budgets of EMU member
countries must be approved by the European
Commission.
The EMU member countries also signed several
other agreements that require them to respect
fiscal discipline. Consequently neither the EU nor
the member states have discretionary fiscal policy.
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For many years after World War II, Germany became a
prosperous country by adopting the social market
model. The social market model worked well for
Germany, as it relied on free markets as well as
government intervention in the economy.
During the 1980s several countries, in order to cope
with stagnation, adopted pro-business neoliberal
policies. The US and UK led the way in this direction
under President Reagan and Prime Minister Thatcher,
who launched trade liberalization and financial
deregulation.
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The EU launched the Lisbon Agenda in 2000,
aiming to transform the EU into the most efficient
economy in the world.
Germany adopted its own version of the Lisbon
Agenda, known as the Hartz IV reforms. Many of
these reforms were introduced into German law
between 2003 and 2005 by the government of
Chancellor Gerhard Schröder.
Most of these reforms aimed to promote efficiency
in the economy by making the labor markets very
flexible.
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Germany was successful in turning its economy into one of
the most efficient economies in the world, and such
transformation was achieved by adopting the export-led
growth model.
Following this model Germany destroyed the competing
industries of its trading partners, and reduced protection for
German workers.
Germany relied on many policies which suppressed wages
and benefits for millions of workers. The end result of these
policies was that Germany had created two major economic
classes.
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The first class includes the privileged and highly
paid company and government managers, and the
very skilled workers.
The second class includes workers employed on a
temporary basis under contracts, agency work, and
so forth. These workers receive very low wages and
hardly any benefits; such employment is often
referred to as precarious.
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Germany has evolved as the de facto leading country in the
EU, mainly because it has the strongest economy.
The German government has so far imposed its programs
regardless of whether other countries agree with it.
A few years ago Donald Tusk, then Polish Prime Minister and
later President of the European Council, asked Chancellor
Merkel: “Why do you have to forment division?”
The question from the charismatic President of the European
Council referred the imposition of austerity measures despite
the fact that many country leaders disagreed with this
German approach.
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Although Chancellor Merkel did not answer the question, a
few months later she had her way and the Fiscal Compact
Treaty, which imposed further austerity, was signed by 25 EU
countries.
Germany’s economic dominance cannot be the permanent
model for the EU.
Economic dominance is merely another type of dominance,
and it can be as bad as that imposed through the barrel of a
gun. Like a gun it can kill people, albeit indirectly, by
destroying their economies, thereby increasing poverty,
disease, suicide, and homelessness.
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Greece, the country that triggered the crisis, has had to undergo
several structural changes. The crisis offers Greece the
opportunity to cleanse itself of bad practices.
As a requirement of the bailouts the Greek government, in a
desperate attempt to raise tax revenues, imposed heavy taxes
which led to economic stagnation. This stagnation resulted in a
decline in total tax revenues collected.
Greece has to raise more tax revenues, which the new
government is trying to do by bringing to light cases of tax
evasion. Many of these cases involve other countries’ businesses
and banks. The Greek government has requested help from the
Swiss and German governments to catch tax evaders.
Economic growth is necessary to increase the tax base, which
will help raise tax revenues.
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EU leaders are also responsible for the long recessions in
bailout countries. The EU’s internal devaluation approach to
the recovery of the bailout countries proved to be too long
and painful.
The most logical way to help these countries was through
direct aid, without IMF participation. Since EU country leaders
could not agree to do this for political reasons, the only other
possible alternative was for the ECB to step in and buy up the
government bonds of the financially distressed countries.
Such an ECB solution, however, was not an option since it was
quickly rejected early in the crisis by Germany and its
northern allies.
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Another reason the crisis in Greece was prolonged
was the PSI (haircut) imposed on the investors of
Greek government bonds. These and other
investors are highly unlikely to reinvest in Greece
as a result of this policy.
Prior to the EU Council summit on March 9, 2015
President Donald Tusk stated that the Grexit, or
Grexident, was in no one’s interest. He went on to
characterize the possibility of Greece leaving the
EMU as “The most dramatic chapter in the EU.”
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The President of the European Council went on to
explain that there was more to a Grexit than money
or geopolitics; dignity and emotion were at stake
as well. He concluded that a Grexit would be an
“idiotic scenario.”
The question then arises: if it was so obvious to the
President of the European Council that the
possibility of Grexit should not be an issue, then
why did the EU leaders exhaust themselves for
several years debating whether Greece should be
thrown out of the EMU?
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If one estimates the total cost involved in debating the
possibility of Grexit, the amount of resources wasted would
be found to be enormous. Imagine the total cost involved to
reach a decision about the Grexit:
◦ Air fares and other transportation expenses of EU country
leaders, officials, and staff to attend the never-ending
debates about a Grexit.
◦ Time and resources spent to cover a possible Grexit by
newspapers, magazines, and articles in journals.
◦ Teleconferences, television time, and radio time allocated
also spent time and resources.
◦ The most important cost of all was the EU leaders’ and
officials’ time spent debating Greece’s expulsion from the
EMU.
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This is what economists call “opportunity cost.” EU
leaders and officials neglected more important issues.
As a result the EU failed to keep peace in Europe,
neglecting the Ukraine-Russia conflict as the European
leaders were preoccupied with the Grexit issue.
Another great opportunity was lost by not capitalizing
on the possibilities offered during the Arab Spring in
2010. The EU, the US, and other democratic countries
could have supported progressive governments that
respect democracy, human rights, and minorities.
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Recent developments in the Middle East and northern
Africa indicate that the EU has failed to promote peace in
the wider region. The destruction of an entire country
(Syria) is evidence that Europe, the US, and other peace
seeking countries have failed to preserve stability in this
region.
Now refugees are arriving in large numbers on the shores
of Europe, seeking asylum and protection. They do this by
risking their lives to cross the Mediterranean Sea, using
the most unsafe means of navigation.
Thousands have drowned, and many have been exploited
by human traffickers as they tried to avoid an almost
certain death scenario if they were to remain in their home
countries.
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The Mediterranean Sea should not be transformed
into a liquid cemetery for those seeking safety and
peace in the EU.
ISIS should not be allowed to destroy Syria and Iraq;
their leadership should soon be tried in the
International Court of Justice in the Hague for the
crimes they have committed against humanity.
It is obvious that an exit from the present refugee
crisis should begin. Several Marshall-like plans, with
the participation of all peace seeking nations, are
needed to boost stability and economic development
in the region.
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Peace projects can be supported by a UN military
presence, and by close cooperation with humanitarian
organizations and the private sector.
The alternative for the EU, if it does not participate in
stabilizing the region, will be isolation.
The EU will only be able to help itself and its surrounding
countries if a new generation of intellectuals and
politicians emerge to reverse the present trend towards
isolationism.
Such intellectuals and leaders would be similar to those
altruistic European visionaries and statespersons who
created the EU from the ashes of World Wars I and II, not
so long ago.
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It was decided at the Brussels summit on July 12,
2015 that Greece would remain in the EMU and
receive a third bailout of €86 billion. The funds came
from the European Stability Mechanism (ESM).
The summit was contentious and lasted 17 hours, the
longest in EU history. The decision was made after a
heated and exhaustive debate.
Germany and its allies were on one side, demanding
the total surrender of Greek financial sovereignty,
and on the other side were France, Italy, and Cyprus
supporting Greece.
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Behind Chancellor Merkel was her Finance Minister
Wolfgang Schäuble, who was determined to punish
Greece.
He wanted to show that the decision of the Greek
government to reject the first EU proposal for a third
Greek bailout was wrong, despite the fact that the
Greek voters rejected it in a referendum on July 5,
2015.
The day before the summit, during the Eurogroup
meeting, Schäuble tried to make sure that there
would be no other solution suggested for Greece in
the next day’s summit other than that of Grexit.
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The second EU proposal for the third bailout of
Greece, agreed on the next day of the summit,
was even worse than the first.
It humiliated Greece and also damaged Germany,
since it showed that some politicians in Germany
were firm believers of old testament
vindictiveness.
Greece received strong support only from France,
Italy, and Cyprus. The French President François
Hollande convinced his colleagues at the summit
that Grexit was not a solution.
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The third Greek bailout provided several conditions for
Greece:
◦ It required an increase in the general tax base, and included a
list of higher tax rates for several commodities and activities.
◦ Reforms to the pension system, and an increase in the
retirement age, to render the pension system sustainable.
◦ Safeguards for the independence of the Greek statistical
agency.
◦ The creation of a fiscal council, independent of the
government, to make sure the government meets its primary
annual target surplus.
◦ The most controversial requirement was the creation of a €50
billion account to include public assets that were to be
privatized.
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The EU leaders wanted to place this account in
Luxembourg, to be under the supervision of the
“Institutions” (Troika).
Greek Prime Minister Tsipras considered this
requirement as the most intrusive, as €50 billion
was approximately one third of the Greek GDP.
He told his colleagues that neither his
government nor the parliament would accept
such a requirement.
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Finally, it was agreed that the public assets fund
would remain in Greece, managed by the Greek
authorities, and supervised by the Institutions.
Table 9.1 below lists how the funds from the
third bailout will be allocated. It is evident from
Table 9.1 that the entire amount of the bailout
will be used to repay principle and interest of
public debt, or will be used to recapitalize the
Greek banks.
As a result there will be no money left over for
the real Greek economy.
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Greece’s Third Bailout
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The third bailout was approved by 229 members
of the Greek parliament. This was a signal by the
Greek people, through their representatives, that
they wanted Greece to remain in the EMU.
Not all members of Syriza approved the bailout:
39 members voted against it.
They claimed that the bailout was not what the
Greek people voted for in the referendum of July
5, 2015.
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After the Brussels summit, President Hollande’s popularity
began rising. He stood against Germany and all the other
EU leaders.
President Hollande supported Greece and prevented a
Grexit. After the summit, he announced a proposal for the
EMU members to adopt a common budget, and to form an
“economic government.”
He also claimed to be a proponent of economic
convergence, and supported the adoption of common
social policies by the EMU.
Such programs and policies would counter the strict fiscal
discipline imposed by Germany.
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The agreement on the Greek bailout was a big success for
President Hollande, according to many commentators.
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This showed that France, together with Italy, could
persuade Germany to pursue growth policies in the EMU.
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A compromise between northern and southern EA
countries has to be reached, otherwise the extinction of
the euro will be inevitable.
It is possible for the EMU to split into two groups:
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2.
Germany and its northern allies.
The rest of the EMU members.
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The key to the reversal of the Eurocrisis is held
by Germany. As long as Germany pursues
narrowly defined national interests over European
interests, integration will stall.
Consequently, Germany’s growth and prosperity
will end as well.
Populist politicians, such as Wolfgang Schäuble,
will have to be pushed aside if the long-term
interests of Germany and the EU are to be
pursued.
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The Bundesbank’s rigidity in the early 1990s
contributed to the destruction of the European
Exchange Rate Mechanism (ERM), and the European
Monetary System (EMS).
The German government is very close to destroying
the second sincere attempt at European monetary
and economic integration within the last 25 years.
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Such an outcome must be avoided, even if Germany
has to ask its finance minister to take an early
retirement.
He has done enough damage to his country, as well
as to the EU.
Populist politicians in several EU countries have
inflicted great damage on their countries and on
the European project.
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For the European project to survive, both Greece and
Germany must undergo major fundamental changes.
Greece must modernize its economy and put its
people to work. This can happen if Greece becomes
internationally competitive.
Since Greece is a small country, it is easily feasible for
it to switch into a growth pattern. Similarly,
modernizing the economy is possible if Greece
promotes the sectors that enjoy a comparative
advantage such as tourism, shipping, and agriculture.
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Germany must support growth policies. If this does not
happen, the European project will be remembered as a small
interval of uncoordinated national policies in the troubled
history of the common EU/EMU course.
Because a large number of governing Syriza party members of
parliament (39) refused to support the third bailout, on
August 20, 2015 Prime Minister Tsipras announced his
resignation. Immediately after that he informed the President
of Greece, Prokopis Pavlopoulos, to set a date for national
elections. The date of the national elections was set for
September 20, 2015.
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The left-wing Syriza members accused Tsipras of
reversing the outcome of the July 5, 2015
referendum by signing the bailout, which was
against the preferences of the Greek voters.
Prime Minister Tsipras admitted that he made
mistakes, but he never campaigned to take Greece
out of the EMU and the euro.
He held this position because he knew very well
that the vast majority of the Greek people do not
support an exit from the EMU.
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