to date April 30,  2014

New insights into Debt Crisis= Research Paper 

Table of Content

Introduction. 3

1     Consequences of Crisis. 3

2     The Casy study of Greece. 4

3     Economic Crises. 4

4     The synchronisation between EU stock market 6

5     SMP, LTROs, OMTs. 9

6     Self-fulling debt crises. 11

6.1      Debt intolerance, defaults, crisis. 12

Conclusion. 15

References. 15

Introduction

Particularly, when the government tries to reduce private debt, this results in an increase of public debt. So on the one hand the debt crisis has a significant impact on the Eurozone, as it constantly raises new issues as to its viability and on the other hand the future of the Euro as a common currency as described Blundell-Wingall, Slovic (2010, p.4).

1         Consequences of Crisis

            The real consequences associated with the banking crisis (higher unemployment) describe in general, changes of the current account balance of whatever sign are not necessarily an indication of imbalances. Viewed in this light, they may simply reflect intertemporal saving as well as consumption and investment preferences of private enterprises, households and governments presented by Obstfeld and Rogoff (1994). Moreover, rising prices and unit labour costs and strong investment could be due to a catch-up of periphery countries within the euro area.

            Candelon, Palm (2009, p.3) noticed it may affect government tax revenues, which will shrink, and on the other hand government spending, which will rise, through social security (unemployment benefits) and through measures designed to stimulate global demand. Nevertheless, this automatic stabilizer mechanism deepens the budget deficit and increases the debt. As a consequence, this restrictive fiscal policy could increase the probability of default for households, increasing the amount on non-performing loans, again putting tensions on the banks’ balance sheet.

            Hofmann (2012, p. 2-3) pointed out that a country with unsustainable debt exercises emergency measures to regain sustainability. The goal of economic growth requires measures to increase a country’s competitiveness, that include austerity, default and restructuring, as well as inflation coupled with depreciation of the currency. On the other hand monetary depreciation caused by expansionary monetary policy, potentially coupled with Quantitative Easing, is the easiest way out. As a result, that may raise the country’s competitiveness through boosting exports and potentially attracting capital lured by cheap production cost. Viewed in this light, a country in a currency union lacks the power to control and enforce these measures. In sum, depreciation of the Euro is simply impossible without detrimentally affecting all of the 17 Euro zone countries that are intractably linked by the same currency.

2         The Casy study of Greece

Sakellaropoulos, T. D. (2012, p. 2-5) pointed out that Greece’s economic history during the 19th and 20th centuries shows that the development model followed was a capitalist modernization “pushed” from abroad and characterized by slow progress, an economy characterized by a weak industrial base, the long existence of agricultural structures and institutional backwardness.

Moreover, in the sense of the spill-over of growth and the expansion of enterprises to the South, the expansion of the import-export sector and foreign trade imbalances as well as the increase of international public borrowing and debt, international division of labor has made Greece extremely vulnerable to international fluctuations and turmoils, especially in relation to the monetary/ exchange rate and fiscal sector.

3         Economic Crises

Nevertheless, the real economic crises are either crises of underproduction (that is crises of the old type 1830-1857) or crises related to the overproduction of basic agricultural products in the framework of the prevalent model of monoculture farming and monoexport (e.g. raisins in the 19th century, tobacco crop and cotton in the 20th century). In the latter cases the crises were due to the sudden fall in the international demand (raisin crisis of 1893, tobacco crisis of 1930). An industrial crisis of overproduction leading to a significant de-industrialization took place as late as 1970 and the depression that started with the oil crises of 1973 and 1979. The result of this crisis was a process of deindustrialization that in a period of 10 years resulted in the closing down of almost half of the Greek industry.

The crisis took nonetheless the form of a fiscal and debt crisis.The debate on and the search for the appropriate remedies for the debt crisis and the euro-zone crisis in the framework of globalization, EU, and the need to remain part of the euro-zone needs to take into consideration one basic finding in relation to the real causes of the global crisis which started with Lehman Brothers Bankruptcy in 2008.

In other words, globalization –starting in 1989- has resulted in an unprecedented unification of financial markets at global level. At the same time, this has not been coupled with supranational regulatory mechanisms that would protect the global and national economies from monetary and exchange rate crises created by the power of limited but powerful financial centers.

Viewed in this light, prospect we demand once more the adoption of common European economic, fiscal and social rules as an effective barrier to the uneven growth of the Eurozone. Those opposing such strategy are those of neoliberal aspirations or those advocating economic nationalism.

Pappas, V., Ingham, H., Izzeldin, M., Steele, G. R. (2013, p. 2) presented that financial markets, retail markets and labour markets were integrating at different speeds. In the broadest macroeconomic context, the Eurozone still had to come to terms with the inconsistent trinity. Where there is a single currency only two of three are possible: a) fixed exchange rate; b) free capital movement; c) independent monetary policy. While constituent nations could not monetize their sovereign debt, they could borrow money at much lower interest rates than (for some) their fundamentals would suggest. For Greece, borrowing financed consumption rather than the investment that might have raised international competitiveness.

However, financial crisis struck, particular stresses within the Eurozone derived from: a) overly cheap credit; b) the bursting of a generalized property bubble; and c) huge variation in productive efficiencies and, therefore, competitiveness across the Eurozone.

As weak economic fundamentals in one nation are brought into the spotlight by a crisis, investors may fear that other nations have similar traits. The reaction can then set contagion in train (Masson 1999). For example, towards end-2009, when problems in Greece were traced to chronic fiscal/debt problems, the fear grew of similar pressures in Italy and Portugal.

4         The synchronisation between EU stock market

Gómez-Puig, M., Sosvilla R., Simón, C. (2014, p. 6-10) examined the synchronisation between EU stock market indices during the recent financial crisis, they used a DCC-GARCH with a Markov-Switching model. The models allow for the time variation in correlation dependencies among the nations, as well as for the endogenous estimation of the crisis transition date.

Their measures are devised for the duration and intensity of the crisis, and for correlation change between precrisis and crisis periods. More specifically, duration and intensity measures build on the fact that all nations neither ‘enter’ nor ‘exit’ the crisis regime at the same time. Dynamic correlation change measures indicate that sub-regions within EU reveal varying contagion patterns. These measures allow us to assess the synchronisation patterns of the financial crisis and to distinguish between regional and sub-regional contagion.

They confirm financial contagion in five of the six nation groups. Not all of Europe’s markets are hit by the crisis at the same time. In particular, the Core EU group is the first to be affected, with the Baltics lagging by one year. On average the nations of the EU-15 are affected earlier than the NMS, with the latter exhibiting a lag of over five months. This gives confirmation to the idea of a varying EU financial integration process. Even within EU-15, however, there are notable exceptions, most notably those of Luxembourg and Greece. Their experience of the crisis comes, respectively, five months earlier/later than their EU-15 counterparts. Nations which were forerunners in the accession talks were also affected relatively earlier.

Again, in the broadest terms, EU-15 was affected most heavily, with Luxembourg and Greece the worst hit. For Luxembourg this may be attributed to the reliance on finance, particularly hedge funds. For Greece, the lack of competitiveness and chronic sovereign debt problems are well-documented. The PIIGS group was the most severely affected; the RAMS II group was the least severely affected. In general, both the degree of industrialisation and market concerns over the financing of sovereign debt are relevant to the intensity of any financial crisis. The distinction between regional and sub-regional contagion is of interest. There are some instances where stock markets become more aligned during a crisis (regional contagion); (i.e., Scandinavian, PIIGS), and others where the greater alignment of stock markets occurs only for nations that share similar (trade and development) characteristics (sub-regional contagion); (i.e., Core EU).

In fact, not only did the period of financial turmoil turn into a global financial crisis, but it also began to spread to the real sector, with a rapid, synchronized deterioration in most major economies. This financial crisis put the spotlight on the macroeconomic and fiscal imbalances within European Economic and Monetary Union (EMU) countries which had largely been ignored during the period of stability when markets had seemed to underestimate the possibility that governments might default (see Beirne and Fratzscher, 2013).

Indeed, since 2010, Greece has been bailed out twice and Ireland, Portugal and Cyprus have also needed bailouts to stay afloat. These events brought to light the fact that the origin of sovereign debt crises in the euro area varies according to the country and reflects the strong interconnection between public and private debt (see Gómez-Puig and Sosvilla-Rivero, 2013).

Gómez-Puig, M., Sosvilla R., Simón, C. (2014)  in their research paper: First, to tested for the existence of possible Granger-causal relationships between the evolution of the yield of bonds issued by both peripheral and central EMU countries, second, to determined endogenously the breakpoints in the evolution of those relationships and third, to detected contagion episodes according to an operative definition: an abnormal increase in the number or in the intensity of causal relationships compared with that of tranquil periods, triggered by an endogenously detected shock.

According to their results, we see around two thirds out of the total endogenously identified breakpoints occur after November 2009, when Papandreou’s government revealed that its finances were far worse than previous announcements, suggesting that most of the breakpoints can be explained by systemic shocks directly connected to the euro sovereign debt crisis. Second, the number of causal relationships increases as the financial and sovereign debt crisis unfolds in the euro area, and causality patterns after the break dates are more frequent when EMU peripheral countries are the triggers. Third, in the crisis period we find evidence of 101 causal relationships: 41 represent new causality linkages and 60 are patterns that already existed in the tranquil period. However, they found an intensification of the causal relationship in 42 out of the 60 cases.According to their opinion, these 41 new causality patterns, together with the intensification of the causal relationship in 70% of the cases can be considered an important operative measure of contagion that is consistent with the definition we have proposed.

As a result we what we mentioned above, we can say that regarding to policy implications, their results seem to indicate that EMU has brought about strong interlinkages of the participating countries which are reasonable within a group of countries that share an exchange rate agreement (a common currency in the case of the euro area) and where financial crises tend to be clustered. Therefore, they consider that their results might have some practical meaning for investors and policymakers, as well as some theoretical insights for academic scholars interested in the behaviour of EMU sovereign debt markets.

Casiraghi, M., Gaiotti, E., Rodano, M. L., Secchi, Al. (2013, p. 7) described that during the summer of 2011 sovereign debt market tensions resurfaced in some euro-area countries. The strains affected Italy directly and were rapidly transmitted to the banking sector and other segments of the domestic financial market. Corporate bond yields and money market spreads soared, interbank loans dried up, and stock indexes plummeted. The effects were amplified both by the abrupt interruption of capital flows among euro-area countries and by the sudden funding freeze faced by banks on international markets. In other words, the adverse impact on the cost and availability of credit to the private sector led to a sizeable drop in aggregate demand. In the summer of 2012 fears of a possible break-up of the euro area aggravated financial tensions and further increased the crosscountry disparities in monetary conditions.

In response the ECB took several unconventional measures. It reactivated the Securities Markets Programme (SMP) and extended it to Italian and Spanish government bonds in August 2011, it granted three-year loans to banks (3-year Longer-Term Refinancing Operations, LTROs) in December 2011 and in February 2012, and it announced the Outright Monetary Transactions (OMTs) in September. These instruments were designed to support market segments that were dysfunctional, foster bank liquidity, avert a credit crunch and dispel the fears of a euro-area breakup.

Their results suggest that the SMP, the 3-year LTROs and the OMTs have been effective in offsetting undue increases in government bond yields and easing money markets tensions, with a positive and significant impact on credit supply. Transmitted mainly through the credit channel, the policy measures induced a cumulative output growth response equal to 2.7 percentage points in 2012-2013. In considering these findings, one should bear in mind that a full counterfactual scenario is beyond the scope of this paper. The ECB’s unconventional policies may have avoided a generalised collapse of financial and credit markets, which cannot be studied using the standard econometric tools insofar as the effects would have been very large and highly non-linear.

Nevertheless, their analysis provides an estimate that may be interpreted as a lower bound of the overall macroeconomic impact of the unconventional monetary policy measures considered.

5         SMP, LTROs, OMTs

In order to estimate the impact of the non-standard measures adopted by the ECB in 2011 and 2012 (SMP, 3-year LTROs, OMTs) on the Italian economy, we first adopted specific estimation approaches to measure the impact on money market interest rates, government bond yields and credit availability and then mapped the estimated effects onto their macroeconomic implications, taking advantage of the Bank of Italy quarterly model of the Italian economy.

The first conclusion is that the SMP has been effective in contrasting undue increases in government bond yields. This conclusion is based on a set of regressions linking daily changes in bond yields with SMP purchases and a series of control variables. The estimates indicate that the effect of the SMP on Italian government bond yields is around 2 basis points per billion euros purchased.

Second, the LTROs had a significant impact on credit supply, mainly through a sizeable reduction in money market spreads, associated with the revival of the interbank market. Although bank lending continued to decrease in Italy in 2012, this result suggests that the unconventional operations may have avoided a much more severe credit restriction and helped to counteract the decline in lending to firms both in 2012 and 2013.

Third, the announcement and the design of the OMTs had very large frontloaded effects on the sovereign bond market. Yields on Italian government bonds decreased sharply after President Draghi’s speech at the end of July 2012, and the improvement was reinforced by the ECB Governing Council announcements in early August and September. From a macroeconomic perspective, our simulations indicate that the unconventional measures have had a powerful effect on the Italian economy through several channels. Based on the standard elasticities included in the BIQM, the cumulative GDP growth response comes to 2.7 percentage points over the period 2012-2013. One of the main channels of transmission is the improvement in credit availability, in particular through its impact on investment.

The simulations also show that the set of unconventional operations had a favourable effect on relevant macroeconomic variables that are usually not emphasised in discussions on the effectiveness of monetary policy. They found that the deficit-GDP ratio improves greatly thanks to the combination of lower interest expenses and higher growth. The flow of new impaired bank loans decreases, as lower interest rates and higher growth support businesses’ profits and cash flow. There accordingly appears to be good reason to believe that the unconventional policies helped avoid a further worsening of the adverse spiral between sovereigns, banks and growth.

All in all, while the Securities Markets Programme, the 3-year Longer-Term Refinancing Operations and the Outright Monetary Transactions did not prevent the Italian economy from falling into recession, they did keep it out of a much deeper depression. Even so, interest rates did not completely regain their pre-crisis levels, credit conditions remained relatively tight, and business lending continued to contract, although less sharply than would otherwise have been the case. These findings support the thesis that some of the underlying causes of the sovereign debt crisis could not be addressed and solved by monetary policy alone. Nevertheless, our results provide powerful evidence for the argument that the unconventional monetary measures supported economic activity by avoiding a further downward spiral of the crisis of confidence and a much more severe credit crunch.

6         Self-fulling debt crises

Aguiar, M., Amador, M., Farhi, E., Gopinath, G., (2013, p. 3) presented  model that highlights the fact that partial default via inflation versus explicit default may have asymmetric costs, and the key comparative static is in regard to the relative costs of inflation. Viewed in this light, a useful feature of separating the costs of full default from those of inflation is that a country can credibly commit not to partially default through inflation by issuing bonds in foreign currency; a similar commitment technology for explicit default is not as readily available. They therefore address in their research paper that the positive and normative implications of issuing domestic versus foreign currency bonds in an environment of limited commitment, and how this tradeo varies with the level of inflation commitment when the government issues domestic-currency bonds.

What does it mean? In equilibrium, risk-neutral foreign investors purchase sovereign bonds at prices that reflect anticipated government decisions to repay, default, or inflate. In turn, the government’s optimal policy depends on the equilibrium interest rate, raising the possibility of self-fulling debt crises. According their results, environment allows us to explore how the degree of inflation credibility alters the country’s vulnerability to self-ful.

In turn, the government’s optimal policy depends on the equilibrium interest rate, raising the possibility of self-fulling debt crises. According their results, environment allows us to explore how the degree of inflation credibility alters the country’s vulnerability to self-fulling debt crises. A main finding of their analysis is that inflation credibility and by implication the choice of domestic versus foreign currency bonds has an ambiguous impact on the possibility of a self-fulling debt crises and on welfare.

6.1      Debt intolerance, defaults, crisis

Reinhart, C. M., Rogoff, K. S., (2010, p. 3) presented in their paper following factors of defaults and banking crisis. First, private debt surges—fueled by both domestic banking credit growth and external borrowing are a recurring antecedent to domestic banking crises; governments quite often contribute to this stage of the borrowing boom. (Banking crises in financial centers have also historically helped predict domestic banking crises elsewhere). Second, banking crises (domestic ones and those in international financial centers) often precede or accompany sovereign debt crises. Third, public borrowing accelerates markedly and systematically ahead of a sovereign debt crisis (be it outright default or restructuring); the government often has “hidden debts” that far exceed the better documented levels of external debt. These hidden debts include domestic public debt (which prior to our data were largely undocumented) and private debt that become public (and “publicly” known) as the crisis unfolds. Quantifying public contingent liabilities is beyond the scope of this paper. A fourth related hypothesis (which we document but do not test) is that during the final stages of the private and public borrowing frenzy on the eve of banking and debt crises and (most notoriously) bursts of hyperinflation, the composition of debt shifts distinctly toward short-term maturities.

Debt intolerance described by Reinhart, C. M., Rogoff, K. S., (2010, p. 11) manifests itself in the extreme duress many emerging markets experience at debt levels that would seem quite manageable by advanced country standards. “Safe” debt thresholds for highly debt intolerant emerging markets turn out to be surprisingly low, perhaps as low as fifteen to twenty percent in many cases, and these thresholds depend heavily on a country’s record of default and inflation. However, debt intolerance likely owes to weak institutional structures and a problematic political system that makes external borrowing a useful device for developing country governments to avoid hard decisions about spending and taxing and global investors rightly suspicious about the government’s motives. Simply put, the upper limit to market access is lower when governments suffer from an intolerance to repayment but not to borrowing.

Figure 1  Gross External Debts (public and private), Sovereign Default and Systemic

Banking Crises: Advanced Economies (inset only) and Emerging Markets, 1970-2009

(debt as a percent of GDP)

Source: Reinhart, C. M., Rogoff, K. S., (2010), From financial crash to debt crisis, Working Paper 15795, http://www.nber.org/papers/w15795, National Bureau of Economic Research, p. 23

Al-Saffar, Y., Ridinger, W., and Whitaker, S., (2013, p. 17) described in their paper The role of external balance sheets in the financial crisis, that structural changes in the liquidity risk profiles of banks away from short-term funding mismatches and toward more stable, longer-term funding of assets and business activities, international regulators under Basle III intend to implement a Net Stable Funding Ratio (NFSR) requirement. This will require long-term assets to be funded with at least a minimum amount of stable liabilities. The results in their paper point to fragilities arising from funding long-term assets with short-term debt liabilities, particularly to other banks, consistent with the need for an NFSR. A similar point applies to the related Basle III Liquidity Coverage Ratio, which will require banks to maintain sufficient liquid assets to meet liquidity needs for a 30 calendar day time horizon under a significantly severe liquidity stress scenario specified by supervisors.

The finding that a country’s external bank balance sheet measured on a residency basis — including foreign banks — appears to contain more information about vulnerabilities than the consolidated balance sheets of banks headquartered in that country, reinforces the need for close co-operation between national banking supervisors. National supervisors need to be aware of significant cross-border activity carried out by resident foreign branches which are not within their supervisory control and need to consider the importance of resident foreign branches for financial stability. Indeed, that is why the Basel Concordat on cross-border banking supervision gives host authorities responsibility for the liquidity of resident foreign branches.

Calls for better monitoring of the risks inherent in national balance sheets and the removal of biases leading to over reliance on short-term debt were prominent in the aftermath of the EME crises of the 1990s, for example the Draghi Report (2000). More recently, the G30 report on ‘Long-term finance and economic growth’ and the Committee on International Economic Policy and Reform have called for policymakers to reduce incentives for short-term cross-border flows and for a reduction of biases in favour of debt over equity financing. The results of this paper are consistent with those recommendations about the structure of national balance sheets. But this paper does not consider the question of the optimal size of balance sheets or the costs and benefits of gross capital flows overall. In this regard, it is notable that large external equity liabilities were not associated with larger falls in GDP.

Conclusion

What we mentioned in this paper shows that macroeconomic national differences in the euro area and their solutions should be transferred only on the shoulders of national economies , but also the EU regulator and monetary authorities. It is necessary to think about their role and its implementation is essential for the recovery of the euro area. The main cause of the crisis in the euro area debt accumulated before the outbreak of the crisis and private debt . In other words, the massive expansion of debt in the euro area continued despite the outbreak of the financial crisis. Fiscal pact envisages that future governments if hit and will again bail the private sector will be punished and it all drawn further implications. However, this proves to be not sufficient and strategic solutions. Troubled euro states clearly faces significant internal pressure in the national economies in the context of pressure on competitiveness through social cuts and rising retirement age.

References

1. Aguiar, M., Amador, M., Farhi, E., Gopinath, G., (2013) Crisis and commitment: Inflation credibility and the vulnerability to sovereign debt crisis, Working Paper 19516, National Bureau of Economic Research, http://www.nber.org/papers/w19516

2. Al-Saffar, Y., Ridinger, W., and Whitaker, S., (2013), The role of external balance sheets in the financial crisis, Financial Stability Paper No. 24 – October 2013, Bank of England, ISSN 1754–4262

3. Beirne, J. & Fratzscher, M. (2013). The pricing of sovereign risk and contagion during the European sovereign debt crisis. Journal of International Money and Finance, 34, 60-82.

4. Blundell-Wingall, A., Slovic, P. (2010) “The EU Stress Test and Sovereign Debt Exposures.” OECD Working Papers on Finance, Insurance and Private Pensions, p. 4

5. Candelon, B., Palm F.C. (2010) „Banking and Debt Crises in Europe: The Dangerous Liaisons?“, CESifo working paper Fiscal Policy, Macroeconomics and Growth,               3001, available at: http://hdl.handle.net/10419/38910

6. Casiraghi, Marco and Gaiotti, Eugenio and Rodano, Maria Lisa and Secchi, Alessandro, The Impact of Unconventional Monetary Policy on the Italian Economy During the Sovereign Debt Crisis (September 27, 2013). Bank of Italy Occasional Paper No. 203. Available at SSRN: http://ssrn.com/abstract=2405451 or http://dx.doi.org/10.2139/ssrn.2405451

7. Gómez-Puig, Marta and Sosvilla Rivero, Simón, Causality and Contagion in EMU Sovereign Debt Markets (February 3, 2014). Research Institute of Applied Economics Working Paper 2014/03. Available at SSRN: http://ssrn.com/abstract=2405929 or http://dx.doi.org/10.2139/ssrn.2405929

8. Hofmann, Ch. (August 1, 2012) „The Euro Zone Crisis“, available at SSRN: <http://ssrn.com/abstract=2121499>

9. Masson, P. (1999) ‘Contagion: macroeconomic models with multiple equilibria’, Journal of International Money and Finance, 18(4), 587-602.

10. Pappas, Vasileios and Ingham, Hilary and Izzeldin, Marwan and Steele, G R, Financial Markets Synchronization and Contagion: Evidence from CEE and Eurozone (October 1, 2013). Available at SSRN: http://ssrn.com/abstract=2411978 or http://dx.doi.org/10.2139/ssrn.2411978

11. Reinhart, C. M., Rogoff, K. S., (2010), From financial crash to debt crisis, Working Paper 15795, http://www.nber.org/papers/w15795, National Bureau of Economic Research

12. Sakellaropoulos, Theodoros D., Debt Crisis and the Welfare State in Greece (2012). Global Dialogue, 2012. Available at SSRN: http://ssrn.com/abstract=2424081

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