Lesson 11.2 - 80's and 2008 crisis (Current crisis) (2017)

Apunte Inglés
Universidad Universidad Pompeu Fabra (UPF)
Grado International Business Economics - 2º curso
Asignatura International Business & Economic History
Año del apunte 2017
Páginas 14
Fecha de subida 17/03/2017
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Apuntes 23 febrero y 2,3 y 9 de marzo

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a.villagrasa IBE, 2nd Year - 2nd Term Business history Lesson 11.2: Current crisis Outline “FINANCIALIZATION” ........................................................................................................ 2 PRECEDENTS OF THE CRISIS OF 2008 ............................................................................... 3 a. Elimination of regulations ......................................................................................... 3 b. Financial innovations ................................................................................................ 3 COLLAPSE OF THE BUBBLE................................................................................................ 4 ALTERNATIVES .................................................................................................................. 5 Bail out .......................................................................................................................... 5 Bail in ............................................................................................................................ 6 CRISIS OF THE EURO ......................................................................................................... 8 Structural problems ...................................................................................................... 8 Housing bubble ............................................................................................................. 8 EUROPEAN MONETARY UNION (EMU) ............................................................................ 9 Advantages ................................................................................................................... 9 Disadvantages ............................................................................................................. 10 CRISIS OF THE DEBT ........................................................................................................ 11 Overvaluation ............................................................................................................. 11 Solutions ..................................................................................................................... 11 Forecasts ..................................................................................................................... 12 OPTIMAL CURRENCY AREAS ........................................................................................... 13 When a single currency is a good idea? ..................................................................... 13 Why Europe is not an optimal currency area ............................................................. 13 Problems ..................................................................................................................... 14 How to get out ............................................................................................................ 14 1 a.villagrasa IBE, 2nd Year - 2nd Term Business history “FINANCIALIZATION” During the golden age, wages represented a largest percentage of the total GDP. This implied that the real economy was growing more than the GDP. In the last 30 years, wages have tended to stagnation (losing importance in the total income), meaning that the additional income is profit that has been invested in the financial market. As a result, financial markets have grown a lot, becoming a large share of the GDP.
Companies unrelated with financial activities have started giving the financial sector more importance, showing a tendency to financialization.
The financialization consists in the growth of the financial industry as a percentage of the GDP due financial operations (such as the purchase of shares) carried out by companies that are unrelated to the financial sector.
During the golden age, GDP was growing faster than financial activities, but then the opposite happened.
Joseph E. Stiglitz (1943) Stiglitz predicts that this financialization tendency is going to make financial bubbles more frequent. He also stated that consumption has increased more than wages and that the growing inequality within countries is related to the development of the financial market.
2 a.villagrasa IBE, 2nd Year - 2nd Term Business history PRECEDENTS OF THE CRISIS OF 2008 The current financial crisis is considered to be one of the worst crises in the recent years. The crisis was provoked by a problem of leverage and incentives. There are two possible explanations. They don’t exclude each other but differ in who is blamed.
a. Elimination of regulations The American legislation in terms of financing has been very influenced by the great depression, as it was a problem of liquidity that led to a banking crisis because of the lack of intervention. After the depression, they created federal guarantees for bank deposits (up to $250.000) and regulated bank activities with the glass-steagall act.
But in the recent years there has been a tendency to deregulate. With the elimination of the glass-steagall act, financial institutions merged and started having deposits, giving mortgages and providing credit for investment and became larger.
The American government wanted to incentivize the ownership of houses. To do so, they subsidized and created institutions like Fannie Mae and Freddie Mac that gave mortgages.
The reduction in interest rates was making risky products (with higher interest rates) more attractive. The institutions had the incentives and the mechanisms to speculate and take more risks because they knew that: 1. They would be provided the liquidity they needed 2. The government had extended the protection to credit 3. They could make instant profits making mortgages and selling them in a package According to R. G. Rajan, the development of financial institutions has put the world in a riskier situation.
b. Financial innovations New financial instruments are created faster than regulation, so they lie in a “limbo” for some time.
Example: In the 60’s, the US government tried to regulate the interest rates of bank deposits setting a maximum. It led to the creation of the dollar-euro market, as American banks could pay higher interests to their customers having those deposits in other countries.
In this period, there was an emergency of a lot of new products such as derivatives and mortgage backed securities (package of debt). These financial assets weren’t supported by a physical asset but gave the right to purchase a good in the future.
Those instruments were actually encouraged in the 90’s by the chairman Alan Greenspan, a monetarist that thought that those products were efficient.
3 a.villagrasa IBE, 2nd Year - 2nd Term Business history COLLAPSE OF THE BUBBLE Eventually, the bubble burst and the housing and the mortgage market collapsed. Until that moment, banks had been giving loans to everyone, even if they couldn’t return the debt. There were incentives to do so because there was an immediate profit when selling them along with other risky mortgages. However, when people started defaulting, house prices fell and it affected everyone because everyone had been participating.
In a bank there are, from less to more risky: 1. Deposits 2. Bond holders: They are the lenders of the bank 3. Shareholders The government was, theoretically, only responsible to guarantee the first ones (deposits) but they extended the protection to the others too to avoid panic.
Banks didn’t go bankrupt thanks to government intervention.
The fact that the government extended protection to all the banking system (bailing out banks) has created perverse incentives. Now banks are as strong as before or even more (because of the concentration process), so they are very powerful. As they have been bailed out once, they might be willing to risk again because they know that they are going to be rescued.
4 a.villagrasa IBE, 2nd Year - 2nd Term Business history ALTERNATIVES The options after a crisis of debt are: a. Bail out: The government provides liquidity to the banks, which creates a problem of incentives because banks are more willing to take risks in the future.
b. Not bail out: If the government doesn't intervene, it might provoke panic and cause a bank run, making the crisis even worst (great depression).
c. Bail in: It consists in depositors, bond holders and/or shareholders assuming part of the bailout instead of the government. This has been done only in Iceland and Cyprus.
The response of the government depends also in the capacity to bail banks out.
Bail out Bailing out banks is usually justified by the potential effects of not bailing out. They are useful to provide credibility and stability and to control panic (avoid bank runs) and expectations. But it has also downsides, as the constant bail out makes the government implicitly responsible for the whole banking system (not only deposits) and creates a tax burden for tax payers (increase in taxes or reduction in government spending).
Bad incentives The main problem of bailing out is the creation of incentives. After being “saved”, banks have incentives to take more risk than it would be optimal for the economy.
The government can’t regulate everything, and with globalization it’s very difficult to hold companies accountable for what they do. A common solution to this is through customers: they are not going to buy bad products, so they punish bad companies. But such regulation doesn't exist in the banking sector. Customers will look for the best conditions, without considering if the bank is good or not because, in the worst case, all of them are going to be bailed out. There isn’t distinction between good and bad types.
Perverse incentives because bad types are rewarded or punished as good types.
Once banks have been bailed out, the banking system should be restructured to control the monopolistic power of those institutions and avoid incentive problems.
They tried to do so in the US, but Trump has opposed. Meanwhile, in Europe, credit requirements for banks have increased to regulate banks’ leverage.
The problem with the crisis is not which banks were doing worst but which government had more capacity to bail out.
5 a.villagrasa IBE, 2nd Year - 2nd Term Business history Is risk always bad? Risk is not always bad. For example, any kind of research or investigation is risky, because it uses a lot of resources and it can go wrong. However, it is good for the society because if it goes well everyone can benefit (a new drug).
The problem is that there isn’t good management of risk, as banks don’t distinguish between the risk of lending to researchers and lending to someone that can’t repay, which is a risk that doesn't produce anything.
The US The US opted for a drastic bail out at the beginning of the crisis, starting the quantitative easing. It was able to do so because it has a flexible exchange rate. As opposite to Europe, the bailout is going to be paid by future tax payers, so there’s no need of contractionary policies in the present.
Spain The Spanish strategy was to delay the problem as much as possible. Banks couldn’t be immediately bailed out because the government couldn’t afford it, not because it didn’t want.
In Spain deposits are guaranteed up to 150.000€, but this is only symbolic because Spain can’t afford it.
The first response was to try to minimize losses. As the magnitude of the problem depended on how much house prices fell (the more they fell, the largest the leverage of the banks so the worst the solvency problem), they tried to encourage people to keep buying. The other reaction was to increase profits to cover losses. They did so through bank mergers that were supposed to increase efficiency (fewer offices, less personnel...) and take advantage from economies of scale. The strategy didn’t work because banks don’t have many economies of scale.
Eventually, in 2010, Spain received a bail out from Europe “for the banks”. In practice it was a bailout of the country but it wasn’t called like that to avoid spreading panic. The conditions to receive it were to implement austerity measures.
Bail in In countries that had a bail in (Iceland and Cyprus), the cost of the crisis was assumed by the insiders of the bank. It wasn’t a political decision (the government decides not to bail out because it considers that banks have to pay because they are responsible) but their only alternative.
The main advantage of a bail in is that it doesn't impose any tax burden. The cost of bail out is born by the bank, so no austerity measures are needed. As a result, countries that implement them tend to be bad in the short run but can recover quite 6 a.villagrasa IBE, 2nd Year - 2nd Term Business history fast. On the other side, they can cause panic and a bank run that could, potentially, provoke the collapse of the whole banking system.
Iceland Iceland has an extremely oversized financial market because there’s a lot of foreign investment. Hence, the cost of the bailout would have been impossible to assume for tax payers. Therefore, the government decided to protect only the deposits of Icelanders, who lost their shares and pension plans in the banks.
However, the measure has proved to be effective. At the beginning they experienced a very hard crisis, as the Icelandic króna depreciated 60% and people lost their investments. However, they didn’t need to implement austerity measures and, thanks to the depreciation, they recovered quite fast. The depreciation allowed them to export more and increased tourism, as they become more affordable.
Cyprus Cyprus is a fiscal heaven with a lot of Russian mafia’s money. Fiscal heavens are characterized for having oversized financial markets, so the government couldn’t afford the bail out.
They first asked to the European Union and then to Russia for a bail out, but both denied the help. Eventually, they decided to do a bail in, but it caused panic and a bank run.
7 a.villagrasa IBE, 2nd Year - 2nd Term Business history CRISIS OF THE EURO The crisis of the euro is not the contagion of the financial crisis. In fact, some of the problems of the financial system are related with the capacity of the governments to do bailouts rather than with the problems of the banking system.
Structural problems The euro crisis is called like that because it refers to the fact that some countries are weaker due the euro, so they might be forced to leave it. Southern European countries have some structural problems that have caused the crisis:    Structural unemployment: Trade unions have been typically strong, making a very rigid labour market and a high level of unemployment that is very difficult to reduce. Moreover, most wages are not correlated with productivity.
Low productivity: Countries like Spain and Italy are specialized in low productivity sectors like tourism while Germany is specialized in manufacturing, which is more profitable.
High inflation: Southern inflation is higher than in Germany, in part because our productivity is lower. Another reason is that our economy has tendency to deflation because it is based on no tradable goods, which don’t have competition. Therefore, when prices in those sectors increase, all wages increase, leading to higher prices everywhere.
All of this has lead to a problem of competitiveness and the debt crisis is the result of it rather than the cause. The lack of competitiveness reduced production, which had consequences for the government budget: less taxes (less employment) and increase in spending (unemployment subsidies).
Housing bubble Spain was able to reduce unemployment and have surpluses during the housing bubble, which was hiding the real problem. But many companies, SMEs and entrepreneurs were struggling to survive and seeing the problem of the lack of competitiveness.
The overvaluation of Spain was evident: everything was cheaper outside and it couldn’t export because it was too expensive. This made Spain accumulate a differential in prices.
8 a.villagrasa IBE, 2nd Year - 2nd Term Business history EUROPEAN MONETARY UNION (EMU) The European monetary union is a permanent, forever, fixed exchange rate where all countries share the same currency (€). It is the most credible type of fixed exchange rate because it is very rigid and getting out of it is hard.
There’s a trade off between credibility and flexibility, so countries give up some flexibility to gain credibility.
The EMU was the consolidation (last step) of integration. At the beginning, the European Union had the objective of eliminating tariffs (custom union) to integrate the market and then it became a single market with free movements of labour and capital.
It established:    Euro: A single currency for all the members.
ECB: There’s a central monetary authority (European Central Bank) that makes the monetary policies for all the countries.
Budget limitations: The EMU put limitations to fiscal policies, but they are not being followed. Debt was limited to be 60% of the GDP and deficit the 3%.
Advantages The basic advantages that the common currency provided were:     No uncertainty: Having a shared currency fosters trade, transactions and efficiency because it reduces uncertainty.
Lower transaction costs: Because it eliminates the banking fees, charged when exchanging currency.
For customers: Markets are more efficient and transparent, so it is easier for customers to compare prices.
Reputation: It provided price stability and good reputation to countries with typically high inflation.
Reputation The independence of the majority of central banks from the state is recent. The Spanish CB wasn’t independent until the 80’s and, in France, the idea seemed anti democratic. However, the German central bank, the Bundesbank, had been independent since the war, which made it build reputation. One of the conditions imposed by Germany to accept the monetary union was to create a completely independent bank (the ECB). As the decisions of the ECB were controlled by Germany, countries with bad reputation acquired Germany’s good reputation (low inflation rates).
The euro was very credible because it was supervised by Germany.
9 a.villagrasa IBE, 2nd Year - 2nd Term Business history Southerner countries gained reputation, credibility and were able to control inflation because they had the same monetary policy than Germany. It also implied that these countries had access to as much credit as they wanted at a low cost (low interest). It was an opportunity to invest in R&D and modernize. Instead, it was used to speculate and ended up creating the housing bubble. Italy, Greece, and Spain in a lesser extent, accumulated a lot of debt.
Spanish public debt is 40% and private is 100% respect the GDP Disadvantages      Lose monetary tools: Monetary policy is set by the ECB, so countries can’t change their interest rate to be more competitive, for example.
Limited fiscal policy: In addition to the rules, which are not accomplished, fiscal policies depend on the borrowing capacity, which limits governments.
Therefore, some countries can have autonomous fiscal policies (Germany) and others can’t (PIGS1).
Not possible to devaluate: Spain used to devaluate as soon as the crisis started because it generated inflation and reduced the amount of debt (in real terms).
Thanks to it, Spain never defaulted. Devaluation also reduced wages (attracting foreign investment) and increased exports.
Deflation: As they can’t devaluate, countries that have problems are forced to deflation (procyclical policies2), which increases interest rates and the real debt. It makes the crisis worst to avoid bank crisis.
Minor disadvantages: 1. Psychological cost of individuals, who have to adapt to the new currency and calculate prices 2. Administrative cost 3. Cost of creating new institutions Countries are left without instruments of economic policy and forced to apply procyclical measures.
1 2 Portugal, Italy, Greece, Spain.
Procyclical policies: Applying contractionary policies when there’s recession.
10 a.villagrasa IBE, 2nd Year - 2nd Term Business history CRISIS OF THE DEBT A crisis of debt happens when the government can’t finance the debt anymore. It became evident when the cost of borrowing became higher for those southern countries. In summer 2012 Spanish premium of risk, which depends on the risk of default and the exchange rate, was very high and international lending to these countries reduced. At the same time, Germany’s premium of risk was very low or even negative. People were willing to lend them because they were expecting some countries to leave the euro and, consequently, the appreciation of the German currency (euro or the new one), which was undervalued.
The crisis of debt was such because international lenders stopped trusting the repayment capacity of other countries which, apart from their structural problems, had limited policies.
Overvaluation The usual problem of fixed exchange rate systems is overvaluation. However, in this case it didn’t produce inflationary tensions in the bank but in government debt and growth rates, which makes them unable to borrow.
In the case of the countries of the monetary union, they can’t run out of currency. For example, Spain can have as much debt as it wants with Germany because it pays in its own currency. This has made the degree of overvaluation be very high (30% for Spain and 50% for Greece). Moreover, it couldn’t have been sustained without such a credible fixed exchange rate system. The solutions to overvaluation are deflation and devaluation.
Solutions Usually the problem of overvaluation is that countries run out of reserves. In this case, however, the problem is the lack of credibility of the currencies. This lack of credibility, added to the structural problems and the inability of the government to repay the debt, forces countries to make “painful” adjustments.
a. Deflate prices: Prices should decrease as much as the level of overvaluation.
For example, Spain should decrease prices 30%, so in average wages should decrease 30%. However, this is hard to do because of the rigidity of the labour market. Since not all wages (especially “old” ones) can’t be reduced, new wages will be lower to compensate (60% lower instead of 30%).
b. Devaluate: The cost of devaluing is very high, which is what makes the system so credible. For example, for Greece to leave the euro it should: 11 a.villagrasa IBE, 2nd Year - 2nd Term Business history 1. No transition: The abandonment of the euro should be announced and done immediately to avoid people expecting it and causing a bank run and a banking crisis.
2. Choose the exchange rate: The government should convince people that there’s not going to be future depreciation for them to keep the currency instead of exchanging it. The value of the exchange rate can be: a. Real value: There might be speculative attacks and you have to convince people that you’re going to keep it.
b. Undervalued: Choosing a value under the real one to avoid speculative attacks can cause hyperinflation or depreciation because your imports are going to be very expensive (what happened in Germany after the war).
3. Pay the debt: They can’t implement expansionary policies because, to avoid having problems borrowing in the future, they have to repay it.
Forecasts Options for Greece aren’t very optimistic. Any of the options is bad because of the magnitude of the needed adjustment as the consequence of being in a very rigid exchange rate.
The situation in Spain is not as bad as in Greece but is not as good as the government says. At least the situation stabilized after the ECB started purchasing Spanish and Italian debt. However, if there’s another crisis or problem it is going to lead to another crisis because there aren’t more instruments that can be used (interest rates are negative).
12 a.villagrasa IBE, 2nd Year - 2nd Term Business history OPTIMAL CURRENCY AREAS The creation of the euro was part of the global objective of being a unified country, consolidating peace and avoiding war. The approach to the creation of the monetary integration was to create a single (integrated) market while keeping the individualism of the different countries. In other words, they created a totally integrated economy without political integration.
They said “we agree today that we’re going to agree in the future”.
When a single currency is a good idea? Some experts argue that the EMU was not a good idea because Europe doesn't constitute an optimal currency area. There is a lot of literature defining what an optimal currency is. In summary, the regions to be integrated should have either: a. Similar business cycles Countries that share the same currency also have to share the same monetary policies, so they give up economic tools. Therefore, regions in an optimal currency area will all need expansions or contractions at the same time (don’t suffer asymmetric shocks).
b. Flexibility In case that there are asymmetric shocks, they should be addressed without using economic policy. It can be done with: 1. Labour mobility: Unemployed people moves to a region without unemployment.
2. Flexibility of prices and wages: If wages and prices can decrease, the region will regain competitiveness and will attract investment again.
3. Automatic transfers: If there’s fiscal policy at the regional level, depressed regions will pay fewer taxes and receive more government spending (unemployment subsidies) automatically.
Why Europe is not an optimal currency area Europe suffers from asymmetric shocks because countries are specialized. Therefore, a terrorist attack that reduces tourism, will affect more Spain and Italy. As a consequence, there’s a reduction in the growth rate and an increase in unemployment in those countries.
However, the US is considered an optimal currency area despite its asymmetric shocks because it compensated them with flexibility (b). In Europe, labour mobility has been historically low (now it is increasing), so Spain has 20% unemployment while Germany has 5%. In addition, as seen before, the labour market is very rigid, making it difficult to change wages and, thus, prices.
13 a.villagrasa IBE, 2nd Year - 2nd Term Business history Problems Many economists argue that the euro was a bad idea, especially without making also a fiscal union, which will be a step further in integration.
However, the more integrated a market is, the more asymmetric the shocks its regions suffer. Those asymmetric shocks will have permanent effects in growth rates and unemployment because there’s no reason to go to the previous situation. For example, engineers going to Germany and the firms that have left Spain are not going to return.
Thus, Germany is gaining importance (investment and workers are moving there) while Spain is losing it. Krugman defends an European common fiscal policy because, if not, there are regions that are becoming more and more depressed that are also forced to do procyclical policies.
Spain has to assume that it’s one of the worst of the group because it specialized in a low productivity sector (tourism).
How to get out Countries like Spain have problems of competitiveness but can’t use monetary policy or devaluate to solve it. Moreover, fiscal policies are constrained by the borrowing capacity. Nowadays it is clear that Europe was not a good currency area and a bad idea for some countries, so there are two options: 1. Break the euro 2. Became an optimal currency that can compensate asymmetric shocks 14 ...

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