The world financial instability and the Euro zone crisis -

Chapter 1

Jacques SAPIRCEMI-EHESS

0. Predecessors of the current crisis.

• (A) The Savings and Loans crash of 1988-1992.

– The causes and severity of the thrift crisis have been documented by scholars for more than a decade. Several reasons cited for the collapse include:

• *High and volatile interest rates during the late 1970s and early 1980s, which exposed thrifts to the time FIRREA was passed two years later, FICO had contributed $8.2 billion in financing to the interest-rate risk (caused by a mismatch in duration and by interest-rate sensitivity of assets and liabilities);

• *The phase-out and eventual elimination in the early 1980s of the Federal Reserve Regulation Q, which caused increasing costs of thrift liabilities relative to many fixed-rate assets and adversely affected industry profitability and capital;

• *Adverse regional economic conditions;

• *State and federal deregulation of depository institutions, which allowed thrifts to enter new but riskier loan markets; the deregulation of the thrift industry without a accompanying increase in examination resources (for some years examiner resources actually declined);

• *Reduced regulatory capital requirements, which allowed thrifts to use alternative accounting procedures to increase reported capital levels;

• *Excessive chartering of new thrifts during the 1980s;

• *The withdrawal in 1986 of federal tax laws (enacted in 1981) that benefited commercial real-estate investments;

• *The development during the 1980s of the brokered deposit market (early form of securitization);

• *Delays in funding the thrift insurance fund during the 1980s and the RTC during the 1990s, which led to regulators failure to close many insolvent institutions in a timely manner.

The US government had to implement a bail out with - mostly - public money.

Chronology of Thrift Crisis Events • December 31st, 1986: FSLIC insolvent• August 10th, 1987: FICO created to fund FSLIC • August 9th, 1989: Enactment of FIRREA and FSLIC abolished

• FRF created (succeeds to FSLIC assets, liabilities, and operations) • SAIF created to handle thrift failures starting August 9, 1992 • RTC created to resolve thrifts placed into conservatorships or

receiverships between January 1, 1989 and August 8, 1992a(RTC to cease operations December 31, 1996)b

• REFCORP created to fund RTC • Note: • FSLIC Federal Savings and Loan Insurance Corporation `• FICO Financing Corporation • FRF FSLIC Resolution Fund • SAIF Savings Association Insurance Fund • RTC Resolution Trust Corporation • REFCORP Resolution Funding Corporation

The bail-out cost (In Bln. USD)

Private sector

Public

sector

Total

Estimated Direct FSLIC/FRF Cost

22 41 63

Estimated Direct RTC Cost

7,1 75,6 82,7

Estimated Total Direct Cost

29,1 116,6 145,7

Estimated Total Cost

29,1 123,8 152,9

(B) The 1997-1999 crisis (Korea-Russia-Brazil).

• The crisis began in East-Asian economies.• It moved toward West and ended up in Brazil.• It has been mainly a crisis of FOREX reserves.

• The crisis has been started by a devaluation in Taiwan.• The impact of over-indebtedness.

• Inability of the IMF to stop the crisis.• South Korea: How the USA pushed out the IMF.• Malaysia vs. Indonesia.• The Russian case.• Brazil.

• Hedge Fund and the LTCM Wall Street case.

(C) Enron and WorldCom (2001/2002)

• A crisis of rating agencies.• How is rating done.

• The circularity of the process.

• The politization of the process.

• Is rating an honest benchmark?

• The issue of vested interest among rating agencies.• Rating and subcontracting.

• Vested interests?

• A warning signal ignored.• Rating IS important, but difficult to achieve.

• But rating agencies are unreliable.

• Why no lessons have been learned.

• A “Moral Hazard” problem.

1- A crisis to be expected,

and its

consequences

• A. The Fundamentals of a currency union.– 1. R. Mundell initial positions.– Mundell, R. A. (1961). "A Theory of Optimum Currency Areas".

American Economic Review 51 (4):pp. 657-665.

– From the optimum trade area to the optimum currency area.» Minimizing transaction costs.» Enforcing trade specialisation on a given zone.

– The Mundell-Fleming model 1962-63 (a variant of IS-LM in an open economy).

» Exchange-rate Dependency to interest rates (monetary policy) in a liberalized capital-flows system (the Unholly Trinity). But what if capital flow liberalization is deleted?

» Lack of “economic power” of a small open country (no influence on other economies).

– Important assumptions (Labour and Capital).» Capital is to be free to move.» Labour is to be free to move.» No strategic dependency between activities (as in newer

model).

– 2. The endogenous argument.– Currency union (Optimal Currency Area or Optimal

Currency Region) as a self-fulfilling prophecy.» A currency union enhance trade and creates an

optimum trade zone.Peter Kenen: Trade

diversification.Ronald McKinnon: Wage

flexibility.Robert Mundell: Homogeneous

preferences

» In an OCA: Stationary or Rationale expectations?– Michel Aglietta’s argument.

» Centrality of money for economic behaviours.» The OCA creates by itself conditions for better trade

integration (Frankel, Jeffrey A. & Rose, Andrew K. (2001). "The Endogenity of the Optimum Currency Area Criteria". The Economic Journal 108, 2001, (449): pp. 1009-1025.)

– 3. Theoretical problems.– Could a currency union exist without budget transfers?

» Roy Jenkins’ speech of 1977 at the European Institute (Florence).

» What economic federalism is teaching us?

» The current problem of Germany.

– Could a currency union exist without being backed by political legitimacy?

» The strategy of achieving an economic union before à political union.

» The strategy of fast enlargement.

» Was Europe mistaken about its recent choices?

B. The Euro and the competitiveness problem

• 1. Strong divergence of competitiveness levels among Euro zone countries.

• A structural problem.– The “North-South” divide.– De-industrialisation. (Greece, Portugal, Spain)

• The illusion of convergence?– The situation between 1998-2002.– Why convergence:

» A monetary explanation.» A political explanation

– How convergence failed.– The result.

• 2. An increasing process since the 2002-2003 German “internal devaluation”.

• The impact of German policies: “Harz IV” and “Agenda-2015”:– A transfer of financial charges from enterprises to households’ shoulders.– Impact on German export prices.– Impact on German internal demand.

• Could the German policy be called a “lone rider” policy?– Germany “exploited” its dominant position in Europe by using low-cost

countries to produce components to be assembled in Germany (Geographical advantage).

– The concentration of German trade surplus on the Euro zone (between 60% to 65% of total German trade surplus).

– Could this policy be duplicated by other European countries?» The cost of “internal devaluation” or deflanionary policies.» What would have happened if the German policy would have been

adopted by all other european countries?

• 3. A situation worsened by the Euro-USD exchange rate.

• A process of re-evaluation since 2002.– A very step curve.

– Speculation and the exchange rate: “subjective factors” of the exchange rate..

– Why is the Euro going down since summer 2011.

• Could a single exchange rate work for heterogeneous countries?

– The competitiveness issue.

– The rate of change of productivity growth.

– Estimating the level of equilibrium exchange rate.

• France and the problem of the exchange rate.– The INSEE (French Goskomstat…) estimation.

– What enterprises are saying.

– Import and Export elasticity.

• Conclusion:

• Why the crisis was inevitable.

• The race between crisis developments and political union.

• The problem of French-German relationship.