Question

Describe why the following factors made the Eurozone vulnerable to sovereign debt crises

(a) Member countries issued debt in a currency they did not control.

(b) National governments were responsible for the solvency of their banks.

Answer 1

The eurozone (debt) crisis was caused by (i) the lack of a(n) (effective) mechanisms / institutions to prevent the build-up of macro-economic and, in some countries, fiscal imbalances and (ii) the lack of common eurozone institutions to effectively absorb shocks.

The ECB played a crucial role in the crisis response. From the start of the crisis, particularly through its longer-term refinancing operations (LTRO) programs, the ECB mitigated the negative effects of rapidly reversing cross-border private capital flows. Growing divergence in Target II balances within the Eurosystem substituting for private intra-eurozone loans reflected this assistance. By providing cheap credit the ECB has thus saved the banking sectors in, and thereby the economies of, the crisis-hit countries from a collapse. Other eurozone member states also benefitted, as a collapse would have had a severe, and possibly fatal, impact on the monetary union as a whole

The debt crisis began in 2008 with the collapse of Iceland's banking system, then spread primarily to Portugal, Italy, Ireland, Greece, and Spain in 2009, leading to the popularization of an offensive moniker (PIIGS). It has led to a loss of confidence in European businesses and economies.

The crisis was eventually controlled by the financial guarantees of European countries, who feared the collapse of the euro and financial contagion, and by the International Monetary Fund (IMF). Rating agencies downgraded several Eurozone countries' debts.

Greece's debt was, at one point, moved to junk status. Countries receiving bailout funds were required to meet austerity measures designed to slow down the growth of public-sector debt as part of the loan agreements.

Eurozone countries benefited from the euro's power. They enjoyed the low-interest rates and increased investment capital. Most of this flow of capital was from Germany and France to the southern nations, and this increased liquidity raised wages and prices—making their exports less competitive. Countries using the euro couldn't do what most countries do to cool inflation: raise interest rates or print less currency. During the recession, tax revenues fell, but public spending rose to pay for unemployment and other benefits.

Around the world, central banks stepped in to shore up financial institutions that were deemed “too big to fail,” and they enacted measures that were designed to prevent another, larger banking crisis. Finance ministers of the G7 countries met numerous times in an attempt to coordinate their national efforts. These measures ranged from cutting interest rates and implementing quantitative easing—an attempt to increase liquidity through the purchase of government securities or bonds—to injecting capital directly into banks (the method used by the United States in the Troubled Asset Relief Program) and the partial or total nationalization of financial institutions.

In October 2008 the ECB discovered that there is more to central banking than price stability. This discovery occurred when it was forced to massively increase liquidity to save the banking system. The ECB did not hesitate to serve as lender of last resort to the banking system, despite fears of moral hazard, inflation, and the fiscal implications of its lending.

Things were very different when the sovereign debt crisis erupted in 2010. This time the ECB was gripped by hesitation. A stop-and-go policy ensued in which it provided liquidity in the government bond markets at some moments and withdrew it at others. When the crisis hit Spain and Italy in July 2011, the ECB was compelled again to provide liquidity in the government bond markets.

In banking systems without such backstopping, one bank’s solvency problems can quickly lead deposit holders of other banks to withdraw their deposits (in other words, a bank run). This sets in motion a liquidity crisis for the banking system as a whole. The next step comes as banks try to sell off their assets—thus pushing down their prices. This asset-price collapse can go on until the point when the banks owe more than they own. This is how the liquidity crisis triggered by a bank run can degenerate into a solvency crisis—thus justifying the fears that led depositors to run in the first place.

It was exactly this sort of instability that was solved by requiring the central bank to play the role of a lender of last resort. The point is that when people know that they will in any event get their money back, they do not panic and withdraw funds. The really neat thing about this solution is that is it rarely has to be used. The very existence of a lender of last resort prevents the cascading loss of confidence.

The government bond markets in a monetary union have the same structure as the banking system.

Failure to play the lender of last resort role for government bond carries the risk of forcing the ECB to actualise their lender of last resort promise to banks in the countries hit by a sovereign debt crisis. And this sort of lending is almost certainly more expensive than backstopping the government debt. The reason is that typically the liabilities of the banking sector of a country are many times larger than the liabilities of the national government. This is shown in Figure 1. We observe that the bank liabilities in the Eurozone represent about 250% of GDP. This compares to a debt-to-GDP ratio in the Eurozone of approximately 80% in the same year.

The ECB has been unduly influenced by the theory that inflation should be the only concern of a central bank. It is becoming increasingly clear that financial stability should also be on the radar screen of a central bank. In fact, most central banks have been created to solve an endemic problem of instability of financial systems. With their unlimited firing power, central banks are the only institutions capable of stabilising the financial system in times of crisis.

In order for the ECB to be successful in stabilising the sovereign bond markets of the Eurozone, it will have to make it clear that it is fully committed to exert its function of lender of last resort. By creating confidence, such a commitment will ensure that the ECB does not have to intervene in the government bond markets most of the time, very much like the commitment to be a lender of last resort in the banking system ensures that the central bank only rarely has to provide lender of last resort support.

While the ECB’s lender of last resort support in the sovereign bond markets is a necessary feature of the governance of the Eurozone it is not sufficient. In order to prevent future crises in the Eurozone, significant steps towards further political unification will be necessary. Some steps in that direction were taken recently when the European Council decided to strengthen the control on national budgetary processes and on national macroeconomic policies. These decisions, however, are insufficient and more fundamental changes in the governance of the Eurozone are called for. These should be such that the central bank can trust that its lender of last resort responsibilities in the government bond markets will not lead to a never-ending dynamic of debt creation.