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The financial crisis begun at 2007 at the United States of America and took no more than a year to visit the European Union. The time the crisis reached Europe it already had 27 members. The crisis has been called by leading economists the worst financial crisis since the Great Depression of the 1930s. The rapid rise in prices for energy, food and other commodity prices adversely affect both inflation and economic activity worldwide. Oil prices, after rising to very high, fell recently and the economic slowdown is likely to lead to further reduction. However, they remain high, while the uncertainty about their future development is increased and is likely to continue to vary a lot. High food prices particularly affect the economically disadvantaged (within each country) and emerging economies (among the countries of the world).
In its early stages, the crisis manifested itself as an acute liquidity shortage among financial institutions as they experienced ever stiffer market conditions for rolling over their (typically short-term) debt. In this phase, concerns over the solvency of financial institutions were increasing, but a systemic collapse was deemed unlikely. This perception dramatically changed when a major US investment bank (Lehman Brothers) defaulted in September 2008. Confidence collapsed, investors massively liquidated their positions and stock markets went into a tailspin. From then onward the EU economy entered the steepest downturn on record since the 1930s. The transmission of financial distress to the real economy evolved at record speed, with credit restraint and sagging confidence hitting business investment and household demand, notably for consumer durables and housing. (bja.oxfordjournals.org/cgi/reprint/60/3/274.pdf)
The cross-border transmission was also extremely rapid, due to the tight connections within the financial system itself and also the strongly integrated supply chains in global product markets. EU real GDP has shrunk by 4% in 2009, Although there have been signs of recovery it is expected to be slow-moving as demand will remain low due to deleveraging across the economy as well as painful adjustments in the industrial structure. Unless policies change considerably, potential output growth will suffer, as parts of the capital stock are obsolete and increased risk aversion will weigh on capital formation. The ongoing recession is thus likely to leave deep and long-lasting traces on economic performance and entail social hardship of many kinds. Job losses can be contained for some time by flexible unemployment benefit arrangements, but eventually the impact of rapidly rising unemployment will be felt, with downturns in housing markets occurring simultaneously affecting (notably highly-indebted) households. The fiscal positions of governments will continue to deteriorate, not only for cyclical reasons, but also in a structural manner as tax bases shrink on a permanent basis and contingent liabilities of governments stemming from bank rescues may materialize. An open question is whether the crisis will weaken the incentives for structural reform and thereby adversely affect potential growth further, or whether it will provide an opportunity to undertake far-reaching policy actions. (www.euromonitor.com/Q2_2009_Is_the_world_on_its_way_to_recovery -)
Analysis of the crisis
The causes of the crisis have been much discussed and are clearly complex. Much as in a war, the definitive account, if it is ever written, will probably have to wait for the' fog of crisis' to lift. What is undisputed is that the centre of the storm was in the USA from where it moved directly to Europe and also indirectly via emerging markets. Behind this development lay a whole series of imbalances at different levels and in different spheres that interacted with developments in the way advanced capitalist economies have been operating, particularly but not exclusively in their financial sectors. This section looks at some of these fundamental drivers behind the crisis, focusing on seven key developments, and provides a provisional interpretation of some of the causal linkages between them. It will be necessarily schematic and the trends identified will apply with greater force in some countries than others. Further analysis will be required to tease out the interactions between these trends more precisely. It then shows how these trends served to accelerate a downturn in economic activity in Europe that had more direct and also more familiar causes. A prominent feature of global economic developments has been pronounced and persistent current account imbalances. Most notably the USA (but also, in Europe, the UK and Spain) have run large current account deficits, offset by corresponding surpluses in, notably, China, Japan and Germany. Total domestic consumption and investment in the US has been persistently and substantially (of the order of 5-6% of GDP) above domestic output. The gap has been met by borrowing: surplus countries have piled up financial assets which have kept long-run interest rates in the US low(and thus helped sustain the imbalances).Surplus countries have sought to export their way out of unemployment (Germany, Japan)or into rapid industrialization (China). Increasingly dissatisfied with meager returns on safe assets, such as Treasury bills, they(alongside domestic investors) have purchased more complex, opaque assets provided by Wall Street financial alchemists (to which we return)that offered higher rates of return. In Europe, Germany's persistent trade surpluses are one important fundamental reason why its banks held large amounts of what subsequently proved to be toxic financial products originated in the US .( www.marketoracle.co.uk/Article38 , www.escwa.un.org/information/publications/.../ead-08-tm1.pdf)
A second feature has been the rapid internationalization of production, investment and financial linkages - in short 'globalization' -without a corresponding development of supervisory and other forms of regulation at an appropriate (global, European) level. Global institutions still reflect the geo-political realities of the post-Second World War period and, at best, their policies and activities reflect the needs of isolated (developing) countries requiring support. One consequence of this lack of appropriate institution-al arrangements has been regulatory competition between jurisdictions in areas such as taxation, corporate law, financial sector regulation, etc. The lack of effective global governance allowed the problem of current account imbalances to fester. Partly as a result of these shortcomings, but partly also in the wake of a major political shift in advanced capitalist economies since the early 1980s, we have seen, thirdly, a sustained and far-reaching process of state withdrawal from involvement in the economy. Amongst other things, state ownership (not least of financial institutions) has been reduced, labor market and welfare state institutions have been weakened, commercialized, or privatized, enforced (or at least enforceable) legal regulation has been dropped in favor of codes of conduct and so-called self-regulation. Legal and social constraints on the operation of businesses, and not least the influence of trade unions, have been massively reduced in favor of' right to manage' and 'shareholder value' approaches. Key in the present context is that it is not the case that governments have simply failed to keep up with financial innovation. The financial services sector has been actively de-regulated at the explicit behest (and in the US, at least) with the help of substantial political donations of financial institutions that are now holding out their hand for state support. Ironically, many of the regulations repealed - such as the Glass Steagall Act in the US had been introduced in the wake of the Great Depression. These trends, perhaps enhanced by technological developments, have led, fourthly, to very substantial shifts in income distribution in most advanced capitalist countries. Almost all advanced capitalist countries have seen major shifts in the functional distribution of income (i.e. From labor to profits)and wideningdisparities in personal
( www.etui.org/research/Media/Files/EEEPB/2008/3-2008, www.globalresearch.ca)
The crisis was initiated by the deflating of the US housing bubble (and later the equity bubble), which set off a vicious chain reaction, with a number of negative feedback mechanisms. This had a direct effect on consumer demand as rising house prices had been the cash cow of stretched US consumers (equity withdrawal, mortgage refinancing). Defaults and foreclosures increased. Worse, the securitization of the underlying assets swiftly led to the implosion of the US financial sector, as losses emerged and confidence in the solvency of counter-parties evaporated. The resulting credit crunch then impacted consumers and non-financial businesses that could no longer rollover loans, causing consumers to retrench and firms to lay off workers.
There were (and continue to be) four main transmission mechanisms across the Atlantic.
• US consumer retrenchment (and also stalling business investment) directly affected the sales opportunities of European exporters, already squeezed by past currency appreciation.
• The European financial sector had been a major purchaser of 'toxic' assets from US banks. Their collapse in value of or the cessation of trading in these assets led to a knock-on implosion of the European banking sector, which then hit European companies (and to a lesser extent consumers, especially homeowners).
• The massive rate cuts by the US Federal Reserve in response to the crisis (initially unmatched in Europe) led to a sharp further fall in the USD against the euro, exacerbating the competitive pressure on European producers.
• Finally, and after a lag, the crisis also hit emerging economies (not least, China, where recent reports suggest a major increase in unemployment is likely),which led them to cut their import demand.
Within European economies, this then set in train a standard negative interaction between the corporate and the household sectors typical of any recession. Firms cut investment and reduce working hours and staffing levels. Households - facing increased uncertainty, wealth-reducing asset price declines and tougher credit constraints - save more and some of them suffer income losses; over-all consumption falls, worsening the situation of companies, which intensify job loss-es, etc. On top of this come negative feed-back loops between the banking system and the household and non-financial corporate sectors .Before turning to discuss issues of economic policy, it will be useful to sum up three key findings of the preceding analysis, which are decisive for the assessment of the crisis and what can and must be done about it. They are also important in that they are rather at odds with widely held views on the nature of the crisis. Thirdly, the European Union as a whole -this is not true of all its members individually - was clearly not overheating and did not suffer many of the major economic imbalances that so characterized the United States economy and to which the crisis is - in part a necessary response. As has happened before (for instance in 2001), a downturn/crisis has been 'imported' from the US at a point in time at which, in terms of the supply side of the European economy it self, further sustained growth and, notably, reductions in unemployment would have been possible.(www.realinstitutoelcano.org- www.etui.org/research/Media/Files/EEEPB/2008/3-2008 , www.oxfamblogs.org/.../GEC_research_report_consultation_draft_27Jan2010.pdf)
The financial crisis has had a pervasive impact on the real economy of the EU, and
This in turn led to adverse feedback effects on loan books, asset valuations and credit
supply. But some EU countries have been more vulnerable than others, reflecting
differences in current account positions, exposure to real estate bubbles or
the presence of a large financial centre. Not only actual economic activity has been
affected by the crisis, also potential output (the level of output consistent with full
utilisation of the available production factors labour, capital and technology) is likely
to have been affected, and this has major implications for the longer-term growth
outlook and the fiscal situation. Against this backdrop this chapter first takes stock of
the transmission channels of the financial crisis onto actual economic activity (and
back) and subsequently examines the impact on potential output
The financial crisis strongly affected the EU economy from the autumn of 2008
onward. There are essential three transmission channels:
• Via the connections within the financial system itself. Although initially the losses
mostly originated in the United States, the write downs of banks are estimated to be
considerately larger in Europe, notably in the UK and the euro area, than in the
According to model simulations these losses may be expected to produce a
large contraction in economic activity. Moreover, in the process of
deleveraging, banks drastically reduced their exposure to emerging markets, closing
credit lines and repatriating capital. Hence the crisis snowballed further by
restraining funding in countries (especially the emerging European economies) whose
financial systems had been little affected initially.
( ec.europa.eu/competition/publications/cpn/2009_1_3.pdf - ec.europa.eu/economy_finance/publications/publication16055_en.pdf)
With real GDP expected to contract this year by around 4% on average in the EU,
this recession is clearly deeper than any recession since World War II, as noted in
In general recessions that follow financial market stress tend to be more
severe than 'ordinary' recessions, mostly because these are associated with house price
busts and drawn-out contractions in construction. The decline in consumption during
recessions associated with house price busts also tends to be much larger, reflecting
the adverse effects of the loss of household wealth. Output losses following banking
crises are two to three times greater and it takes on average twice as long for output
to recover back to its potential level (But also in comparison with other financial and
real-estate crisis driven recessions in the post-war period it is relatively severe.
The extent to which the financial crisis has been affecting the individual Member
States of the European Union strongly depends on their initial conditions and the
associated vulnerabilities. The financial crisis has hit the various Member States to a
different degree. Ireland, the Baltic countries, Hungary and Germany are likely to
post contractions this year well exceeding the EU average of -4%
By contrast, Bulgaria, Poland, Cyprus and Malta seem to be much less
affected than the average.
The fiscal costs of the financial crisis will be enormous. A sharp deterioration in
public finances is now taking place. The decline in potential growth due to the crisis
may add further pressure on public finances, and contingent liabilities related to
financial rescues and interventions in other areas add further sustainability risk.
Part of the improvement of fiscal positions in recent years was associated with
growth of tax rich activity in housing and construction markets. The unwinding of
these windfalls in the wake of the crisis, along with the fiscal stimulus adopted by EU
governments as part of the EU strategy for coordinated action, is likely to weigh
heavily on the fiscal challenges even before the budgetary cost of ageing kicks in
(which will act as a source of fiscal stress in its own right). Against this backdrop, this
chapter takes stock of the short-run fiscal developments and analyses the forces that
have shaped them. It also looks at the implications for interest rate differentials
An issue of major concern is that public indebtedness is rapidly increasing.
This is the case not only because fiscal deficits are (normally) debt financed, but also
because governments have implemented capital injections in distressed banks and
granted guarantees that are debt financed (the latter only if and once guarantees are
exercised) and yet do not show up in the budget balance since they do not entail
public expenditure on goods and services in a national accounting sense. As indicated
in Graph II.3.5, by historical standards the expected increase in public debt - about
20% of GDP from end 2007 to end 2010 - is typical for a financial crisis episode.
However, what is concerning is that the jumping-off point is considerably higher (by
up to 30 percentage points), and that the debt increase coincides with the onset of the
ageing bulge in public (health, pension) expenditure. As discussed in more
detail below, a sharp deterioration of the sustainability of public finances can be
expected even before the budgetary cost of ageing is taken into account, with the
likely decline in long-term growth due to the crisis along with contingent liabilities
related to financial rescues adding further pressure.
As we can see in Graph II.3.6, the largest increases in public debt are projected for
those Member States which also record the biggest increases in fiscal deficits, i.e. the
United Kingdom, Spain, Ireland and Latvia. However, owing to their more favorable
starting points, these are not the Member States that are projected to post the highest
rate of public indebtedness, which remain Italy, Belgium and Greece
The European Union is continuously evolving, although its driving rationale has
always been the need for coordination of policies, including of economic policy.
Coordination is seen as beneficial if a common interest would otherwise not be
appropriately served, if there are economies of scale and scope, if behavior of
individual actors has significant spillover effects on other actors or if there are
important learning benefits to be reaped. These rationales apply strongly to crisis
management policies in the EU. For expositional purposes it is useful to make a
• 'Vertical' coordination between the various strands of economic policy (fiscal,
structural, financial) and their timing - while always respecting the independence of
monetary policy as essential for its effectiveness and credibility.
• 'Horizontal' coordination between the Member States to deal with cross-border
economic spill-over effects, to benefit from learning effects in economic policy and to
draw benefits from external leverage in relationships with the outside world.
Vertical coordination serves not only to select the appropriate set of policy
instruments but also to manage policy interactions and trade-offs. Financial rescue
packages entail uncertain costs that depend on the future recovery rates of risky
assets, while the slump is protracted that present itself to the policymakers with a lag.
There is an inherent trade-off between financial sector rescue packages and fiscal
stimulus. On the other hand, both fiscal and monetary stimulus can buy time for banks
to consolidate their balance sheets. Fiscal measures help to reduce losses for banks as
they improve their clients' financial situation, while monetary measures facilitate
access to liquidity. Even so, macro stimulus can only be temporary and therefore it is
necessary to start financial market restructuring early. Another complicating factor is
that crisis policies involve multiple policy actors, which also calls for coordination.
Specifically, at each of the three stages - crisis control and mitigation, resolution
and prevention - support for the financial sector involves actions by the regulatory,
monetary and fiscal authorities: • At the crisis control and mitigation stage monetary
authorities provide liquidity injections, implement interest rate cuts and may modify
collateral rules. Regulatory action includes e.g. bans on short selling while fiscal
measures include the increased guaranties on private deposits, bailing out or
nationalizing troubled institutions or relieving debtors' burdens. The purchase of
securities in order to increase liquidity may be carried out by the monetary
authorities, but ultimately commits the fiscal authorities with possibly relevant
implications for fiscal sustainability and macroeconomic stability.
• Crisis resolution measures aimed at the financial system include capital injections, wider guaranties and separating toxic assets from healthy ones imply the fiscal
authorities along with massive intervention by monetary authorities. Dependent on
the severity of the financial crisis policy action may involve non-conventional
intervention, with fiscal authorities taking large shares in private companies and
monetary authorities lending directly to the private sector. Crisis resolution may also
involve changes in the ownership structure of the financial industry. The
restructuring process may start with occasional bankruptcies in the early stages of the
crisis followed by a wave of mergers and acquisitions. But such events are only the
first steps towards systemic consolidation and restructuring, which also requires a
renewed regulatory framework. Management of toxic assets by a 'bad bank' can be
part of this restructuring effort, though the technical difficulties make it slow to
implement (especially when in involves cross-border activities and
ownership structures). Fiscal and monetary authorities thus replace or augment the
private sector in some functions. The fiscal authorities may also embark on brokering
deals of takeovers between financial institutions, owning private firms or by lending
directly to non-financial enterprises.
• Policies to prevent repetition of crises are central to the
crisis response a heavily interact. Fiscal policy geared towards the
sustainability in public finances will need to focus on expenditure control, although
tax increases are probably unavoidable. To the extent this is the case, it is important
that good principles of optimal taxation -- to limit distortions, tax arbitrage and
undesirable distributional effects -- be respected. This may raise issues for structural
policy, e.g. due to the heavy interaction between tax and social benefit systems or the
implications for business location choices. Similarly, expenditure restraint would need
to focus on items that are distorting and inhibit economic efficiency and growth,
while creating room for growth friendly government spending such as for education
and innovation. More generally, the 'quality of public finances' along with its
quantitative aspects, is of eminent importance. (ec.europa.eu/...finance/.../article_8885_en.htm,ec.europa.eu/.../een/.../article_8887_en.htm)
All considered, and certainly when taking into account the relative size of the
economies of Member States, the distribution of fiscal stimulus efforts is broadly in
line with the distribution of their needs in term of absorbing slack and with the
distribution of their ability to implement fiscal stimulus - i.e. without running into
severe problems with regard to the sustainability of their balance of payments or
fiscal position. But obviously this conclusion is predicated on the assumption that
the fiscal stimulus packages are indeed temporary and will be fully reversed at the
appropriate time when the economy recovers. If not, there is a danger that fiscal
policy will undermine the sustainability of public finances, notably if the recovery is
slow and potential output growth is slow as well . This outcome
could imply higher long term interest rates, and thus crowd out capital formation and
innovation and complicate the recovery of the financial system. Distortive and jobs-
unfriendly tax increases may then be unavoidable at some stage, which would in turn
weigh again on potential growth.
In some ways the financial and economic crisis has many features in common with
similar financial stress driven recession episodes in the past. It was preceded by
relatively long period of rapid credit growth, low risk premiums, abundant
availability of liquidity, strong leveraging, soaring asset prices and the development
of bubbles in the real estate sector. Excessive leveraging and the spreading of the
associated risk via securitization rendered financial institutions very vulnerable to
corrections in asset markets. As a result, a turn-around in a relatively small corner of
the financial universe (the US subprime market) was sufficient to trigger a crisis that
toppled the whole structure. Such episodes have happened before and the examples
are abundant (e.g. Japan and the Nordic countries in the early 1990s, the Asian crisis
in the late-1990s). The difference with these earlier episodes, however, is that the
current crisis is global. This has at least one major implication for economic policy:
devaluation or other 'solutions' that seek to 'export' the economic effects of the crisis
to neighboring countries which always risk backfiring - are now potentially
extremely dangerous. This is one reason why observers find it appropriate to compare
the current crisis to the 1930s Great Depression. It should be noted,
however, that, while it may be appropriate to consider the Great Depression as the
correct benchmark from an analytical point of view, it has also served as a great
lesson. At present, governments and central banks are well aware of the policy
mistakes that were common at the time, both in the countries that now constitute
the EU and elsewhere. Deposit insurance schemes have avoided large-scale bank
runs and efforts are being made to recapitalize banks or guarantee their liabilities so
as to safeguard their solvency. Monetary policy has been eased aggressively,
complemented with 'quantitative easing' to ensure that liquidity is plentiful. EU
governments, akin to their counterparts elsewhere, have released fiscal stimulus in an
effort to hold up demand and to provide the hardest hit groups with temporary
income support or job protection. And, unlike the experience during the Great
Depression, countries have not, or at least not massively, resorted to protectionism
or other beggar-thy-neighbour policies, which is a very important achievement.
(www.un.org/regionalcommissions/crisis/impact.pdf- www.globalissues.org/.../global-financial-crisis, unstats.un.org/unsd/nationalaccount/workshops/2009/.../AC202-S64)