The world financial instability and the Euro zone crisis - Chapter 1 Jacques SAPIR CEMI-EHESS

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The world financial instability and the Euro zone
crisis - Chapter 1Jacques SAPIRCEMI-EHESS
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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)

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• 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.

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• 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

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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
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• (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.

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• (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.

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1- A crisis to be expected, and its consequences
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• 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).

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• 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 Agliettas 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.)

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• 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?

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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.

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• 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?

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• 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.

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• Conclusion
• Why the crisis was inevitable.
• The race between crisis developments and
  political union.
• The problem of French-German relationship.