Reasons for financial crisis

the Eurozone financial crisis first started when the US mortgage market collapsed as a complex network of financial derivative products held globally, started to un-ravel. The second layer of the iceberg was the collapse Lehman Brothers in the autumn of 2008. The collapse of Lehman led to an abrupt re-pricing of risks globally, according to Praet. It caused a temporary freeze in trade financing and a global trade decline and as a result it reduced global demand and output. According to the ECB member, the main channels through which the crisis was transmitted internationally are well understood, but the extent and strength of the interconnectedness was quite surprising in real time. The third layer of the iceberg behind the Eurozone financial crisis, according to Praet was the sovereign debt crisis in some Eurozone states. The debt crisis resulted in three facts: (i) that the solvency of some EU banks was strained by significant exposures to domestic sovereign debt; (ii) that the market value drop of government bonds led to liquidity strains, as these bonds were widely used as collateral in interbank markets and (iii) in some instances, EU governments had to provide funding to vulnerable domestic banks, at the expense of their countries debt. the tip of the iceberg for the Eurozone financial crisis were the markets rumours about the break-up of the euro area. The so-called redenomination risk, had become so popular because of the inequalities between the sovereign spread of euro area countries relative to other euro area countries. Reasons for debt crisis

-Violation To EU Rules Countries such as Greece and Cyprus did not give real data about the financial and economic situation and the EU probably knew but ignored and accepted the accession of such counties to enlarge the European cartel. The problem does not stand at that extent but that the EU also accepted high budget deficit and debt levels by many countries during the crisis . Banking Sector Problem The usage of financial instruments that included high risk such as CDOs in addition to Credit Default Swaps that was ignited by speculations the euro bloc will collapse have left banks in a weak position as they have to use their money in financing government budgetdeficits rather than doing their key role of providing lending to businesses and households. Rating Agencies It is clear that rating agencies have played a principle in letting the crisis reach what it has reached so far as they continued, since the beginning of the crisis Political Conflict

European decision makers as Germany and other rich nations were on one hand refusing to let taxpayers pay for the crisis and have refused any decisive methods including violation to their sovereignty while the other camp, which is so-called peripheral nations, have been asking for more flexibility.

In spite of the changes in Parliaments throughout the years of the crisis, Germany has remained stick to its austerity-led strategy to deal with crisis even if this would come at the expense of nations that have refused sharp spending cuts and tax levies and have expressed their rage in the form of strikes and giving punishing votes to anti-austerity parties like what happened in elections in Greece and Italy.
Slow And Indecisive Actions From European Officials The debt crisis which was triggered by Greece did not remain only in the Hellenic country but transferred from one country to another due to the slow response from European leaders to solving the problem as their actions were always late and not decisive. Actions announced by European officials, aside from being late, were not decisive and was like transferring the problem from place to another instead of cutting the cancer from its roots. The main remedies to the crisis were mainly in the form of bailouts for troubled nations and loans by the ECB to ailing banks, while lacked effective methods such as having banking union, using Eurobonds to ease concerns in bond market, or forming a fiscal union. The most recent problem in Cyprus has showed that European officials have adopted new methods that also come at the expense of nations as they agreed to let depositors and stakeholders participate in financing bailout.
What has caused the Eurozone crisis? Excessive spending in the private and public sector due to the cheap availability of credit. Governments held an unequal fiscal stance due to a combination of taxes not being high enough and the expansion of the welfare state (increased welfare payments). Consequences This has ultimately led to a financial crisis and a breakdown of long run growth. Two types of crises 1. A banking crisis which led to a fiscal crisis (Ireland, Spain, UK) Expansionary monetary policy led to commercial banks lending a large amount of credit at low interest rates fuelling a private sector boom, particularly in the housing market. As the housing bubble burst, households and firms defaulted on their loans, causing banks to default themselves. This was because they failed to hold sufficient capital as a ratio to the loans they loaned. Government had no choice but to bail them out, through provided large loans or in some cases being a majority shareholder (nationalisation e.g. Northern Rock, RBS). A global recession followed, causing mass unemployment. Households have been doubly squeezed; not only from a loss of income, but due to the rising costs of raw materials throughout the world, there has been above target inflation. 2. A fiscal crisis which led to a financial (banking) crisis. (Greece) Systematic overspending by the government as they expanded the welfare state and politicians became more popularist promising more spending (the Santa Claus effect). In Greece this coincided with the adoption of the Euro. Its well known that the Greek government accounts did not reflect the true size of the budget deficit. Otherwise they would not have met the Maastricht criteria of a low

fiscal debt and as percentage of GDP. The fiscal crisis of the Greek government led to a banking crisis as the banks had bought the governments debt, but as time has moved on, the Greek government havent been able to pay back their debts. ECB CUT INTEREST RATE TO 0.25 Borrowers across the struggling eurozone economies received an unexpected fillip on Thursday when the European Central Bank cut interest rates to a fresh record low, in a bid to stave off a slide into deflation. After its monthly policy meeting in Frankfurt, the ECB's governing council announced that it would reduce its key refinancing rate to 0.25%, from 0.5%. While the economy of the 18-member single currency area clambered out of recession earlier this year, Mario Draghi, the ECB's president, warned that the outlook could deteriorate in the coming months. "The risks surrounding the economic outlook for the euro area continue to be on the downside," he said. "Developments in global money and financial market conditions and related uncertainties may have the potential to negatively affect economic conditions. Other downside risks include higher commodity prices, weaker than expected domestic demand and export growth, and slow or insufficient implementation of structural reforms in euro area countries." As well as the rate cut, which took financial markets by surprise, Draghi said the ECB would continue making low-cost loans to eurozone banks until at least mid-2015, to try to prevent the financial sector from seizing up. Howard Archer, of consultancy IHS Global Insight, said: "The fact that the ECB chose to act now rather than wait until December when the governing council will have the ECB staff's new eurozone GDP and consumer price inflation forecasts suggests that the bank felt there was a compelling case for prompt action." With inflation running well below the ECB's 2% target, at just 0.7% in October, a growing number of analysts have started to warn that deflation which can be disastrous for economies carrying a heavy debt burden, as prices and wages fall while debt-levels remain fixed is a real threat. Draghi suggested at his press conference that, "we may experience a prolonged period of low inflation". The recent strength of the euro against the dollar has also raised fears in some member-countries about the competitiveness of the zone's exports on world markets. The euro was down by more than 1% against most major currencies after Thursday's announcement, hitting a seven-week low of $1.3375 against the dollar.Italian prime minister Enrico Letta, speaking on a visit to Dublin, described the ECB's decision as "great news", adding that, "it shows the ECB cares about growth and competitiveness in Europe". The International Monetary Fund also welcomed the move. "The decision is fully warranted by the weak inflation dynamics and substantial slack in the economy," said spokesman Gerry Rice. The muted strength of the economic recovery in many eurozone countries is likely to have been another factor influencing the ECB's decision: earlier this week, the European commission revised down its expectation for growth across the 18 member-countries to just 1.1% in 2014. Nevertheless, Draghi insisted at his Frankfurt press conference that the "fundamentals" of the eurozone are, "probably the strongest in the world". However, some analysts warned that the rate cut should be no substitute for the urgent reforms the eurozone needs to secure recovery and tackle the legacy of unmanageable government debts. "It's a palliative: a legal high," said Danny Gabay, of City consultancy Fathom. "They need to get on with the really important stuff: fiscal union, banking reform, debt mutualisation."

The ECB's move is unlikely to prove popular in Germany, where the Bundesbank whose president, Jens Weidmann, sits on the ECB's governing council has tended to take a hawkish stance, opposing some of the ECB's recession-busting measures. Draghi admitted that Thursday's decision had not been unanimous, saying the governing council was, "wholly in agreement about the need to act, but there were disagreements about when to act". The suprise rate cut was the fifth since Draghi took over from the more orthodox Jean-Claude Trichet in 2011. The decision followed an earlier announcement from the Bank of England that it will leave its own interest rate unchanged at 0.5%, and the total value of assets held under QE at 375bn.

The European Central Bank has suggested that euro interest rates could be cut still further, after slashing borrowing costs to a new record low of 0.25%. The governing council reiterated its forward guidance that borrowing costs will remain at their present or lower levels for an 'extended period of time', and pledged that "our monetary policy stance will remain accommodative for as long as necessary." ECB president Mario Draghi warned that the eurozone faces a prolonged period of low inflation. He denied, though, that there is a real risk of deflation gripping the area. The decision was not fully unanimous, Draghi revealed, with some members of the committee arguing to wait until December. Draghi also rejected suggestions that the euro area is sinking into Japanification. Instead, it has the best fundamentals in the world, he claimed. Not everyone is convinced..... The rate cut has already been welcomed by the Italian prime minister and the French finance minister. The euro remains weaker today, down over 1% against the US dollar at $1.3374 and 0.7% lower against sterling. Stock markets welcomed the cut, with European shares hitting new five-year highs

Article: The worst may be over

THE Prado museum, lined with works by Goya, Velzquez and El Greco, is a sanctuary of peace in busy central Madrid. When the museum advertised for eleven gallery attendants recently, it also seemed the perfect refuge from Spains job -starved economy: 18,700 people applied. As Spain timidly emerges from a blistering double-dip recession that has torn 7% out of GDP over five years, job-seekers remain desperate. Unemployment is stuck at 26% and emigration is picking up. So will the recovery create jobs and send Spain into a virtuous cycle of increased domestic consumption, a higher tax take, healthy public finances and more jobs? Presenting next years budget on September 30th, Cristobal Montoro, the budget minister, did not offer rapid relief. Projected growth of 0.7% next year falls short of the governments own estimates for job creation. And with a planned deficit of 5.8% of GDP adding to an already worrying debt pile, stimulus spending is impossible.

Civil-service pay is being frozen for a fourth year in a row and pensions will not keep up with inflation, yet the public debt will still reach almost 100% of GDP. Spanish companies and households are busy trying to pay off their own debts. After taking a 41 billion ($55.6 billion) bail-out last year, Spains banks find it safer to lend to the government than to business. Even so, Spains story is now one of hope. Mariano Rajoy, the prime minister, says the third quarter will show a return to growth. Deep in the real economy, exciting things are happening. Car plants are humming, taking work from less competitive factories in Europe. Retail sales figures are improving elsewhere. Even consumer credit has crept up in recent months. Recession inflicted a brutal cull on businesses, but those still standing are more efficient and productive than ever. Exports, spurred by Spains new competitiveness, should grow more than 5% both this year and next, doubling their prerecession weight in the economy. With exports booming, the current account has swung into surplus. Recovery in the European Union, Spains main export market, will help further. The stockmarket is soaring, with the Ibex-35 indicator gaining 11% in September. After a bruising 21 months in office, Mr Rajoy predicts economic happiness next year. His Popular Party (PP) has even seen a bounce in opinion polls. But Javier Daz-Gimnez, of the IESE business school, warns that the recovery is anaemic, fragile and unlikely to create jobs. Average GDP growth of 1%, he points out, would not see Spain return to pre-recession levels until 2021. The IMF sees 25% unemployment through to 2018. The danger, warns Angel Laborda of the Funcas think-tank, is relaxation. Already he worries that this years 6.5% deficit target will be missed. Overall fiscal pressure is relatively low for a country that wants a sophisticated welfare system. Structural reforms are still needed, he says, but Spain enters a two-year period of elections in 2014, sapping political courage. Overconfidence threatens to slow the fall in house prices, making it even harder to sell the 700,000 new homes left by the housing bubble that pitched Spain into recession. Fitch, a ratings agency, warns that at current rates of selling it will take six years to clear the extension. Prices have fallen 30% or more from the peak, but Jess Encinar of idealista.com, a property portal, sees a further 20% drop. The next test for Mr Rajoy is pensions. A diet rich in olive oil, wine and fresh vegetables helps make Spaniards among the longest-living people in Europe. The baby-boomers will retire over the coming decade. By 2050, the number of pensioners will have leapt from just over 9m to 15m; and the social-security system already loses the equivalent of 1.4% of GDP. The previous government hiked the retirement age to 67, but that is not enough. To claim that the current system is sustainable is like saying smoking does not cause cancer, says Mr Daz-Gimnez. The government has made bold proposals to calculate pensions according to life expectancy and the size of the state pension pot. But Mr Rajoy is under pressure to backtrack. Even the employers federation has warned of pensioners lost spending power.

Labour reforms have helped to boost productivity, allowing employers and unions to opt for wage moderation rather than firings. More may be needed if jobs are to be created. Lowering, or scrapping, the minimum wage might help. Taxes could also be cut, but only if public spending is cut. Luis de Guindos, the finance minister, says jobs will come when growth reaches 1%. Until then, the Prado museum remains a safe harbour.
Escaping the Crisis (Policy Options) There are six potential options that can be used in attempting to recover from the crisis: 1. Bailouts 2. Austerity measures (reducing the fiscal deficit) 3. Quantitative Easing (Monetary Policy) 4. Debt reduction/cancellation 5. Leave the single currency 6. Reform (Supply-side policies) http://www.economist.com/blogs/freeexchange/2012/05/euro-crisis-0?fsrc=gn_ep Bailouts Balcerowicz believes there has been too much focus on bailouts as a policy option. For a start the IMF and its contributors cannot provide enough funds to completely bail the struggling governments out. It is only a short term solution and more importantly creates a moral hazard, weakening the incentive to reform, not to mention the additional cash can fuel inflation. In addition, there is a political limit to bailouts, as the Angela Merkel is finding in Germany with German taxpayers becoming increasingly frustrated with the amount of money being used to bail out the Greek government. Austerity Measures Its been empirically proven that it is more effective to lower government spending than raise taxes. By lowering government spending governments can at least guarantee a reduction by a given amount, where as it is hard to gauge how effective a tax rise may be (Laffer curve analysis). However, even if a government cuts the deficit, the overall level of debt as a percentage of GDP is dependent on growth. Without growth the ability to repay the debt becomes increasingly difficult. More from the economist here Quantitative Easing As bank credit has all but dried up and base rates are zero-bound, Central Banks have adopted expansionary monetary policy by using quantitative easing. This involves Central Banks buying government bonds from private firms and commercial banks, with the aim of injecting much needed funds into the financial system, increasing lending and investment and thus boosting the economy. Unfortunately, there are limitations to this policy. The additional supply of money in the economy can also contribute to inflation. There is also as a case of asymmetric information, with the CB not knowing how much QE will be effective. Too much of an increase in the money supply will fuel further inflation within the economy. In reality banks have preferred to build up their balance sheets and have not lent as much as the CB may have wished. Having said that, evidence suggests that the UK economy has grown as result of QE being used. Debt reduction/cancellation

Back in February, investors foregave 53.5 percent of their principal and exchange their remaining holdings for new Greek government bonds and notes from the European Financial Stability Facility. More here Leave the Eurozone Some economists and media commentators believe that Greece would not be in as much of a mess if they were not part of the European Monetary Union (EMU). By being part of the EMU, monetary policy is controlled by the European Central Bank (ECB) who set one base rate for all 17 member countries. One interest will not also be applicable to all the countries. They will be at different stages in the business cycle and will suffer from asymmetric shocks. This is illustrated when comparing the economies of Ireland and Spain to Germany, prior to the start of the financial crisis. Ireland and Spain were at a different stage of economic development to Germany and required a higher natural rate of interest in order to control their growing economy. Germany, as more established economy, required lower interest rates to encourage further investment and keep the value of the Euro low and thus keep exports competitive. However, the difference in business cycle isnt as great as it might have been given the criteria that accession countries are required to meet, which aims to synchronise the economies prior to entry. The inability of Greece to be able to devalue their currency is a major factor in there struggle for growth, as highlighted by Michael Portillo in a recent BBC documentary (available on iplayer). Leaving the Eurozone would be have major ramifications, not only for Greece, but for the other Eurozone countries and the global financial markets. The policy response to the euro crisis has four elements. A summary of Ian Stewarts remarks on his Monday Briefing blog, outlining the consequences of a country exiting the Eurozone: The precise effects of a country leaving the euro would depend on the circumstances, in particular the degree of preparedness of the euro area and the separating country and the ability of policymakers to resist infection. An exiting country would hope that, by devaluing its currency, defaulting on its external debt and, perhaps, stoking inflation, it could eventually boost growth. The key word is eventually. UBS last year estimated that the economic cost of secession for Greece could be in the range of 40-50% of GDP. The potentially huge costs involved provides perhaps the best reason for thinking a breakup will be resisted and, were one country to separate, European and global policymakers would make great efforts to limit the collateral damage. To limit bank runs and a mass exit of capital the authorities would probably close the banking system and impose capital and exchange controls. A currency law would be needed to specify the new currency as legal tender and to convert existing euro contracts and financial instruments into the new currency. Contracts written in the law of seceding countries would be more likely to be switched from euros to the new currency than contracts written in international law. Legal battles around contracts written in euros would keep lawyers busy for years. The newly introduced currency would probably devalue sharply. Citibank recently estimated that a Greek New Drachma would devalue by 50-70% against the euro.

 Big shifts in currencies would mean large and arbitrary shifts in wealth. Foreigners would see sharp declines in the value of their holdings in the seceding country. And holders of euro denominated liabilities in the seceding country would see a sharp rise in the burden of their debts. The likely result would be a wave of bank, corporate and household bankruptcies. Inflation would also surge on the back of a falling currency. This was seen in Argentina in the 1980s when a sovereign debt crisis and the introduction of a new currency the austral drove inflation above 200%. Such prospects make it difficult to ensure an orderly breakup of the single currency. Foreign holders of assets in a country which was thought likely to devalue would sell to avoid future losses. Domestic holders of euros would take cash out of the bank and either hide it or convert it into hard currencies to avoid forced conversion to the new, devalued currency. Corporates and individuals in a seceding county might well turn to US dollars or euros as an everyday parallel currency, much as happened during Zimbabwes hyper inflation five years ago. There appear to be few strong historical parallels for a euro break-up. Some supposed precedents, such as the fracturing of the Gold Standard or Argentinas breaking of its dollar peg, involve the devaluation of an existing currency. This is a simpler and less traumatic process than exiting a currency union and introducing a new currency with all the legal, logistical and political challenges this involves. If the move succeeds then the pressure on the other weaker economies inside the single currency area (Spain, Portugal) to do the same will be huge. 2 Excellent videosand a well written piece from the FT.

However, as Balcerowicz highlighted, countries are able to improve their international competitiveness without leaving the Eurozone/devaluing their currency. The BELL countries of Bulgaria, Estonia, Latvia and Lithuania suffered deeper recessions following the collapse of Lehman Brothers, but have adjusted quickly in lowering unit labour costs and significantly lowering their current account deficit. Balcerowicz concluded that it isnt fatal that Greece is unable to control its currency, it is a complication. Other policy options are available, such as supply-side reform. However politics can often get in the way of these reforms being implemented in full. Supply-side reform (improve international competitiveness) With the limitations and short term nature of the policies solutions outlined previously, Balcerowicz believes that there is only one viable option left (why should China/ IMF lend more money!?) and that is supply-side reform because growth cant be created out of nothing. Policy suggestions include: Improve the flexibility of labour markets (e.g. increase retirement age, make it easier to higher and fire workers. This would lower the amount of youth unemployment that is currently common place in many European countries. More from the Economist here. Deregulation to increase competition and efficiency of firms, but also the right type of regulation to prevent similar crisis happening in the future. Improve productivity (lower unit labour costs)

Supply side reforms would not only see long term benefits, but Balcerowicz believes they would cause benefits in the short run too as bond yields would fall and confidence would return to the markets when such policies were announced. However, policies can be subject to political bias, so I believe political parties need to become less populist. This poses the question of whether the EMU needs a tighter political union?David Cameron thinks so.