Economic Crisis in Europe: Causes, Consequences and Responses

Economic Crisis in Europe: Causes, Consequences and Responses.

 

ROOT CAUSES OF THE CRISIS

     The  depth and breath  of the current global financial crisis is unprecedented in post-war

economic history.  It has several features in common with similar financial-stress driven crisis

episodes. 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. Stretched leveraged positions and maturity

mismatches rendered financial institutions very vulnerable to corrections in asset markets,

deteriorating loan performance and disturbances in the wholesale funding markets.  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). But the  key difference  between

these earlier episodes and the current crisis is its global dimension.  When the crisis broke in the

late summer of 2007,  uncertainty among banks about the creditworthiness of their counterparts 

evaporated as they had heavily invested in often very complex and opaque and overpriced

financial products. As a result, the interbank market virtually closed and risk  premiums on

interbank loans soared. Banks faced a serious liquidity problem, as they experienced major

difficulties to rollover their short-term debt. At that stage, policymakers still perceived the crisis

primarily as a liquidity problem. Concerns over the solvency of individual financial institutions

also emerged, but systemic collapse was deemed unlikely. It was also widely believed that  the

European economy, unlike the US economy, would  be largely immune to the financial

turbulence. This belief  was fed  by perceptions that the real economy, though slowing, was

thriving on strong fundamentals such as rapid export growth and sound financial positions  of

households and businesses. These perceptions dramatically changed in September 2008,

associated with the rescue of Fannie Mae and Freddy Mac, the bankruptcy of Lehman Brothers

and fears of the insurance giant AIG (which was  eventually  bailed out)  taking down major US

and EU financial institutions in its wake. Panic  broke in stock markets, market valuations of

financial institutions evaporated, investors rushed for the few safe havens that were seen to be

left (e.g. sovereign bonds), and complete meltdown of the financial system became a genuine 

threat. The crisis thus began to feed onto itself, with banks forced to restrain credit, economic

activity plummeting, loan books deteriorating, banks cutting down credit  further, and  so on.

The downturn in asset  markets snowballed rapidly across the world. As trade credit became

scarce and expensive, world trade plummeted and industrial firms saw their sales drop and

inventories pile up. Confidence  of  both consumers and businesses fell to unprecedented

lows. 

     This set chain of events set the scene  for the deepest recession in Europe since the 1930s.

Projections for economic growth were revised downward  at a record  pace.

Although the contraction now seems to have bottomed, GDP is projected to fall in 2009 by the

order  of 4% in the euro area and the European Union as whole – with a modest pick up in

activity expected in 2010.

     The situation would undoubtedly have been much more serious, had central banks,

governments and supra-national authorities, in Europe and elsewhere, not responded forcefully.

Policy interest rates have been cut sharply, banks have almost unlimited access to lender-oflast-

resort facilities with their central banks, whose balance sheets expanded massively, and have

been granted new  capital or  guarantees from their governments. Guarantees for savings deposits

have been introduced or raised, and governments provided substantial fiscal stimulus. These

actions give, however, rise to new challenges, notably the need to orchestrate a coordinated exit

from the policy stimulus in the years ahead, along with the need to establish  new EU and  global

frameworks for the prevention and resolution of financial crises and the management of systemic

risk.

 

A CHRONOLOGY OF THE MAIN EVENTS

     The heavy exposure of a number of EU countries to the US subprime problem was clearly

revealed in the summer of 2007 when BNP Paribas froze redemptions for three investment

funds, citing its inability to value structured products.  As a result, counterparty risk between

banks increased dramatically, as reflected in soaring rates charged by banks to each other for 

short-term loans.  Credit default swaps, the insurance premium on banks' portfolios, soared in

concert. The bulk of this rise can be that point most observers were not yet alerted that systemic

crisis would be a threat, but this began to change in the spring of 2008 with the failures of

Bear Stearns in the United States and the European banks  Northern Rock and  Landesbank

Sachsen. About half a  year later, the list of (almost) failed banks  had  grown long enough to

ring the alarm bells that systemic meltdown  was around the corner: Lehman Brothers, Fannie

May and Freddie Mac, AIG, Washington Mutual, Wachovia, Fortis,  the banks of Iceland,

Bradford & Bingley, Dexia, ABN-AMRO and Hypo Real Estate.  The damage  would have been

devastating had it not been for the numerous rescue operations of governments.  When in

September 2008  Lehman Brothers had filed for bankruptcy the TED spreads jumped to an

unprecedented  high.  This made investors even more wary about the risk in bank portfolios, and

it became more difficult for banks to raise capital via deposits and shares. Institutions seen at risk

could no longer finance themselves and had to sell assets at  'fire sale prices' and restrict their

lending. The prices of similar assets fell and this reduced capital and lending further, and so on.

An adverse 'feedback loop' set  in, whereby the economic downturn increased the credit risk,

thus eroding bank capital further. The main response of the major central banks – in the United

States as well as in Europe – has been to cut  official  attributed to a common systemic factor.

     European Commission Economic Crisis in Europe: Causes, Consequences and Responses

interest rates to historical lows so as to contain funding cost of  banks. They also  provided

additional liquidity against collateral in order to ensure that financial institutions do not  need to

resort  to fire sales.  These measures, which  have resulted in a massive expansion  of central

banks' balance sheets, have been largely successful as three-months interbank spreads came

down from their highs in the autumn of 2008. However, bank lending to the non-financial

corporate sector continued to taper off. Credit stocks have, so far, not contracted,  but this may

merely reflect that corporate borrowers  have been forced to maximise the use of existing bank

credit lines as their access to capital markets was virtually cut off. 

     Governments soon discovered that the provision of liquidity, while essential, was not

sufficient to restore a  normal functioning of the banking system since there was  also a deeper

problem of (potential) insolvency associated with undercapitalisation. The write-downs of banks

are estimated to be over 300 billion US dollars in the United Kingdom (over 10% of GDP) and

in the range of over EUR 500 to 800 billion (up to 10% of GDP) in the euro area.

     In October  2008, in Washington and Paris, major countries agreed to  put in  place financial

programmes to ensure capital losses  of banks  would be counteracted. Governments initially

proceeded to provide new capital or guarantees on toxic assets. Subsequently the focus shifted to

asset relief, with toxic assets exchanged for cash or safe assets such as government bonds. The

price of the toxic assets was generally fixed  between the fire sales price and the price at 

maturity  to give institutions incentives to sell to the government while giving taxpayers a

reasonable expectation that they will benefit in the long run. Financial institutions which at the

(new) market  prices of toxic assets would be insolvent were recapitalised  by the  government.

All these measures were aiming at keeping financial institutions afloat and providing them with

the necessary breathing space to prevent a disorderly deleveraging. The verdict as to  whether 

these  programmes are sufficient is mixed, but the order of asset relief provided seem to be

roughly in line with banks' needs.