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  • Economic Letter: 'Private Credit and Public Debt in Financial Crises'

    In a new San Francisco Fed Economic Letter , economists Òscar Jordà , Moritz Schularick , and Alan M. Taylor try to settle the debate over whether private credit or public debt was the bigger culprit in the global economic crisis. They award points to each. In short, their research seems to show that private credit booms put economies in difficult positions. And public debt makes it difficult for economies to recover. The narrative of the recent the global financial crisis in advanced economies falls into two camps. One camp emphasizes private-sector overconfidence, overleveraging, and overborrowing; the other highlights public-sector profligacy, especially with regard to countries in the periphery of the euro zone. One camp talks of rescue and reform of the financial sector. The other calls for government austerity, noting that public debt has reached levels last seen following the two world wars. Figure 1 Credit and debt since 1870: 17-country average Credit and debt since 1870: 17-country average Source: Jordà, Schularick, and Taylor (2013). Figure 1 displays the average ratio of bank lending and public debt to GDP for 17 industrialized economies (Australia, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States). Although public debt ratios had grown from the 1970s to the mid-1990s, they had declined toward their peacetime average before the 2008 financial crisis. By contrast, private credit maintained a fairly stable relationship with GDP until the 1970s and then surged to unprecedented levels right up to the outbreak of the crisis. Spain provides an example of the woes in the euro zone periphery and the interplay of private credit and public debt. In 2007, Spain had a budget surplus of about 2% of GDP and government debt stood at 40% of GDP (OECD Country Statistical Profile). That was well below the level of debt in Germany, France, and the United States. But by 2012, Spain’s government debt had more than doubled, reaching nearly 90% of GDP, as the public sector assumed large losses from the banking sector and tax revenues collapsed. Thus, what began as a banking crisis driven by the collapse of a real estate bubble quickly turned into a sovereign debt crisis. In June 2012, Spanish 10-year bond rates reached 7% and, even at that rate, Spain had a hard time accessing bond markets. Once sovereign debt comes under attack in financial markets, banks themselves become vulnerable since many of them hold public debt as assets on their balance sheets. The new bout of weakness in the banking system feeds back again into the government’s future liabilities, setting in motion what some have called the “deadly embrace” or “doom loop.” The conundrum facing policymakers is this: Implement too much austerity and you risk choking off the nascent recovery, possibly delaying desired fiscal rebalancing. But, if austerity is delayed, bond markets may impose an even harsher correction by demanding higher interest rates on government debt. Matters are further complicated for countries in a monetary union, such as Spain. Such countries do not directly control monetary policy and therefore cannot offset fiscal policy adjustments through monetary stimulus by lowering domestic interest rates. In addition, central banks in these countries have limited capacity to stave off self-fulfilling panics since their lender-of-last-resort function evaporates. Fluctuations in fiscal balances over the business cycle are natural. As economic activity temporarily stalls, revenues decline and expenditures increase. With the recovery, fiscal balances typically improve. But the debate on what is a country’s appropriate level of public debt in the medium run continues to rage. It is unclear whether high debt is a cause or a consequence of low economic growth. That said, public debt is not a good predictor of financial crises. Read the full letter here .
  • Bloomberg: 'The European Debt Crisis Visualized'

    The European debt crisis is old news. And while the heat may have come down in the last year, it is not over. The interactive team at Bloomberg News has put together a new way of telling the story of the debt crisis. Some students may find the debt crisis easier to understand through this visualization. And we appreciate that this telling of the story goes back almost a century, so there students get the deeper context of Europe's current challenges.
  • Global Ethics Corner: 'When Banks Fail, Who Should Pay?'

    Here's a useful conversation starter from the Carnegie Council 's Global Ethics Corner . It sets up the key questions over the IMF, EU, and European Central Bank bailout of Cyprus. While Cyprus as a nation is rather singular, the issues raised by the terms of the bailout are relevant across Europe moving forward:
  • German Exports Set to Hit Record High

    There seemed to be no bright lights for European economies in 2012. But perhaps we were not looking closely enough at what was happening in some of the EU's stronger economies, like Germany. While we were watching Angela Merkel and German citizens struggle with how debt crises in Greece and Spain and Italy would affect everyone in the Euro Zone, German exports, apparently, were doing quite well. From Der Spiegel : In the first 11 months of 2012, exports grew 4.3 percent to €1.018 trillion ($1.335 trillion), the Federal Statistics Office said. Stagnant sales to the rest of the European Union contrasted with a 10.4 percent jump in exports to non-EU nations. Separately, the Federation of German Wholesale, Foreign Trade and Services (BGA) said it expects the value of exports to have reached €1.103 trillion in 2012 as a whole, a four percent rise over 2011, when they exceeded the €1 trillion level for the first time. It also forecast slightly stronger export growth of 5 percent in 2013, to €1.16 trillion. Still, exports weakened at the end of 2012, pulled down by slumping demand in Europe, Germany's biggest market. Some key questions emerge from this report: 1) What does this tell us for the overall global impact of a declining Europe? 2) What role does the weakened value of the euro play in increasing sales of German exports in the U.S., Brazil, China? 3) What might the impact of continuing growth of German exports be on other European economies? Read the full article here .
  • WSJ: How the Euro Survived

    There are still a few days of 2012 left, but it seems safe to say that reports of the euro's death, to paraphrase Mark Twain, "have been greatly exaggerated." The currency remains in tact, and all members of the Euro Zone are currently sticking with it. Wall Street Journal Brussels bureau chief Stephen Fidler gives credit to ECB president Mario Draghi for staying true to his word and keeping the euro going.
  • Lagarde Implores Policymakers to Follow Central Bankers' Lead and Push Recovery

    IMF Managing Director Christine Lagarde was at the Peterson Institute in Washington yesterday, where she urged policymakers to put their feet on the gas pedal. Lagarde argued that recent monetary policy moves have presented an opportunity to build momentum (and, in turn, growth). Let me begin by saying that many of the right decisions have been taken. Most recently, initiatives by major central banks—the European Central Bank’s OMT bond-purchasing program, QE3 by the U.S. Federal Reserve, the Bank of Japan’s expanded Asset Purchase Program—are big policy signals in the right direction. They point the way forward and create an opportunity to build on what has been done; an opportunity to make a decisive turn in the crisis. Just as the Central Banks were misguided during the Great Depression and accelerated that crisis, it may well be that Central Banks will have played a significant role in pulling the global economy out of this great recession. But we should not get ahead of ourselves. The global economy is still fraught with uncertainty, still far from where it needs to be. The situation is a bit like a jig-saw puzzle. Some of the pieces are in place and we know what the picture should look like. But, to complete the picture, we need all the pieces to come together. That will depend on delivering on the policy commitments that have been made and in that respect, there is still a long way to go. You can read the full speech here . And watch Lagarde's address below:
  • Roubini: Europe 'has an austerity strategy but no growth strategy'

    Nouriel Roubini is afraid Europe may be headed toward a very rude awakening to what he calls a "short vacation." At Project Syndicate , he credits Mario Draghi and the European Central Bank with taking important measures that staved off major problems like a liquidity run on Europe's banks. But the positive impact of those moves may have been temporary, and now, Roubini argues, the short-term approach by Europe's policymakers could have medium and long term negative impact on growth and economic stability. To make matters worse, the eurozone depends on oil imports even more than the United States does, and oil prices are rising, even as the political and policy environment is deteriorating. France may elect a president who opposes the fiscal compact and whose policies may scare the bond markets. Elections in Greece – where the recession is turning into a depression – may give 40-50% of the popular vote to parties that favor immediate default and exit from the eurozone. Irish voters may reject the fiscal compact in a referendum. And there are signs of austerity and reform fatigue both in Spain and Italy, where demonstrations, strikes, and popular resentment against painful austerity are mounting. Even structural reforms that will eventually increase productivity growth can be recessionary in the short run. Increasing labor-market flexibility by reducing the costs of shedding workers will lead – in the short run – to more layoffs in the public and private sector, exacerbating the fall in incomes and demand. Finally, after a good start, the ECB has now placed on hold the additional monetary stimulus that the eurozone needs. Indeed, ECB officials are starting to worry aloud about the rise in inflation due to the oil shock. The trouble is that the eurozone has an austerity strategy but no growth strategy. And, without that, all it has is a recession strategy that makes austerity and reform self-defeating, because, if output continues to contract, deficit and debt ratios will continue to rise to unsustainable levels. Moreover, the social and political backlash eventually will become overwhelming. Read Europe's Short Vacation here .
  • Central Bankers Issue Warnings Over 'Easy Money' Policies

    It appears that easy money policies are making some of the world's top bankers uneasy. The Federal Reserve held a conference this past weekend with members of central banks from around the world. Several of the attendees, including the head of the Bank of Japan, argued that central bankers need to watch carefully for the risks associated with policies like quantitative easing. The Wall Street Journal 's Jon Hilsenrath was at the meetings, and he described the scene on the Journal's Markets Hub :
  • Can US Banking Policy Provide Lessons for Europe's Banks?

    At VoxEU , Mathias Hoffmann , of the University of Zurich, and Iryna Stewen , of the University of Mainz, argue that moves to separate banks along national lines could have the opposite effect of that desired by policy-makers. That is, Hoffman and Stewen argue for more integration, not less. They use a simple graph to illustrate the relationship between bank liberalization and uninsured risk. The blue line represents banks that had not been liberalized at the time of the recession. The red line represents banks that had been liberalized. Hoffman and Stewen: Interestingly, the co-movement between interstate risk-sharing and the US-wide business cycle started to weaken during the 1980s, which is the period during which banking liberalisation at the state level got into full swing (in fact, the correlation between the blue line and the red, dashed line in Figure 1 is -0.44 before 1984 and only -0.13 thereafter). We show that it is indeed the liberalisation of state bank branching restrictions that is responsible for this weakening. The role of banking liberalisation for risk-sharing is illustrated in Figure 2, which presents the extent of interstate risk-sharing that a state typically achieves in the years around a typical NBER business cycle trough. In Figure 2, we distinguish between two groups of states: Those that had already liberalised in a given recession (red dashed) and those that had not yet liberalised (blue solid line). The message is clear – for the states that had not liberalised, consumption risk–sharing with other states drops sharply (the fraction of unshared risk goes up in the picture) in a recession, only to recover to 'normal' levels a year after. For the states that have already liberalised during the recession, the extent of risk-sharing with the US as a whole remains stable. In the paper, we then also show that these improvements in risk-sharing overall are actually driven by better access to credit markets (and not some other channel of smoothing or risk-sharing). We believe that these results point towards an important benefit from banking liberalisation: Financial integration facilitates access to finance mainly when it is most urgently needed – during aggregate downturns. Read Recessions and small business access to credit: Lessons for Europe from interstate banking deregulation in the US here .
  • Is the Euro Overvalued?

    The euro hit a two-month high against the dollar earlier this week, prompting some to wonder whether the currency is overvalued at the moment. Time will tell, but the ups and downs of the currency are nothing new. To mark moments in the young currency's history when it has been overvalued, INSEAD 's Antonio Fatas charted the dollar/euro exchange rate against the Purchasing Power Parity. (Note: Fatas used the German mark to estimate what the value of the euro would have been had the currency existed before 1999): Fatas: The Euro has fluctuated from a high value of 1.59 in July 2008 to a low value of 0.59 in February 1995. Are these numbers comparable? Not quite. Currencies are expressed in nominal terms so they are likely to move over time when inflation rates are not the same in both countries. In this particular case, we have witnessed an upward drift of the Euro over the years because inflation was on average lower in Europe. This trend can be captured by estimates of Purchasing Power Parity (PPP), in red in my chart. But even when we take into account this trend, the value of 0.59 in 1985 was a significant undervaluation of the Euro (the German Mark then) in comparison to PPP (around 0.95). Same for July 2008, the value of almost 1.6 represented a large overvaluation of the Euro relative to its PPP value (below 1.2). We also see in the chart that episodes of overvaluation or undervaluation relative to PP are persistent. A strong Euro in the late 70s was followed by a very weak Euro during most of the 80s. During the 90s the Euro was in general above PPP estimates. Before the official launch of the "real" Euro in 1999, the German Mark was already heading down and this trend continued leading to another episode of undervaluation of the Euro. An episode that was stopped by a join intervention of the US Fed and the ECB in November 2000. Since then the Euro became stronger and stronger until it reached its peak of 1.6 in July 2008. So, Fatas sees the euro as overvalued today, though not at an historically unprecedented level. Read The overvalued Euro here .
  • Javier Solana Calls on EU Leaders to Make Economic Growth the Top Priority

    With Europe's leaders meeting today to take on the difficult task of righting the EU economy , Javier Solana , former General Secretary of NATO and former EU High Representative for the Common Foreign and Security Policy, weighs in at Project Syndicate . Solana argues that the devotion to austerity measures has proven to be a limited solution, at best, to the EU's problems. "Austerity at all costs is a flawed strategy," Solana writes, and he believes that all efforts at this point should go into priming the pump for growth: Public debt, moreover, should not be demonized. It makes financial sense for states to share the cost of public investments, such as infrastructure projects or public services, with future generations, which will also benefit from them. Debt is the mechanism by which we institutionalize intergenerational solidarity. The problem is not debt, but ensuring that it finances productive investment, that it is kept within reasonable limits, and that it can be serviced with little difficulty. Yet, ominously, the same arguments that turned the 1929 financial crisis into the Great Depression are being used today in favor of austerity at all costs. We cannot allow history to repeat itself. Political leaders must take the initiative to avert an economically driven social crisis. Two actions are urgently needed. At a global level, more must be done to address macroeconomic imbalances and generate demand in surplus countries, including developed economies like Germany. Surplus emerging-market economies must understand that a prolonged contraction in the developed world creates a real danger of a global downturn at a time when they no longer retain the room for maneuver that they had four years ago. Within the eurozone, structural reforms and more efficient public spending, which are essential to sustainable long-term growth and debt levels, must be combined with policies to support demand and recovery in the short term. The steps taken in this direction by German Chancellor Angela Merkel and French President Nicolas Sarkozy are welcome but insufficient. What is needed is a grand bargain, with countries that lack policy credibility undertaking structural reforms without delay, in exchange for more room within the EU for growth-generating measures, even at the cost of higher short-term deficits. The world is facing unprecedented challenges. Never before in recent history has a deep recession coincided with seismic geopolitical change. The temptation to favor misguided national priorities could lead to disaster for all. Read Austerity vs. Europe here .
  • WSJ Documentary on European Economic Crisis

    Europe and the euro start 2012 in the spotlight, as economists around the globe watch to see how policymakers fight what appears to be an oncoming recession. Count the Wall Street Journal 's top editors and reporters among those who see Europe struggling throughout the year. The Journal's multimedia team has put together an impressive--if at times rather gloomy--documentary titled Europe on the Brink . The doc moves from the establishment of the EU and what some WSJ editors see as basic structural flaws to the EU economy, to the beginning of the debt crisis, and through to today's challenges.
  • WSJ Video: Declining Confidence in Europe and the Limits of Austerity

    Few economists truly argued that austerity was a cure-all for Europe's debt woes (though we forgive anyone who interpreted news reports as suggesting just that), it was expected to be the answer for a lot of the problems in the region, and, to a certain extent, around the world. Heard on the Street Columnist Richard Barley says one big problem for Europe is that currently "solutions that might work are solutions that are politically unacceptable." Barley and Nick Hastings , of Dow Jones Newswires, discuss dropping confidence in Europe, the impact of the Euro slump on the global economy, and the central role that Germany must play in efforts to turn the corner: