The Eurozone Crisis and

Emerging Market Balance of

Payments Crises

Aaron Tornell (UCLA)

Frank Westermann (Osnabrück University)

July 2012

Diagnosis

�What ails the Eurozone is neither a lack of ECB

monetary expansion nor the multiple equilibria

syndrome.

�The Eurozone suffers the tragedy-of-the-

commons.

EZ crisis combines two types of emerging market crises:

OLD slow-moving crises and NEW fast-moving crises

�OLD crises caused by a tragedy-of-the-commons

• High fiscal deficits & high real wage & Current account deficits

• More government debt

� NEW-crises caused by a lending boom:

• systemic risk-taking � fragile banks & Large Capital inflows

• Current account deficits

• Bailouts � more government debt

0

5

10

15

20

25

30

35

40

45

1993 Q2 1993 Q3 1993 Q4 1994 Q1 1994 Q2 1994 Q3 1994 Q4

Bil

lio

n U

S D

oll

ars

Mexico prior to the Tequila crisisSachs, Tornell and Velasco(1995)

International

Reserves

Domestic Credit

GIIPS• Capital inflows reversed starting in 2008

• Central bank credit expansion of more than 1000%

GNFL

GIIPS

0

100

200

300

400

500

600

700

800

900

Jan

-07

Ma

r-0

7

Ma

y-0

7

Jul-

07

Se

p-0

7

No

v-0

7

Jan

-08

Ma

r-0

8

Ma

y-0

8

Jul-

08

Se

p-0

8

No

v-0

8

Jan

-09

Ma

r-0

9

Ma

y-0

9

Jul-

09

Se

p-0

9

No

v-0

9

Jan

-10

Ma

r-1

0

Ma

y-1

0

Jul-

10

Se

p-1

0

No

v-1

0

Jan

-11

Ma

r-1

1

Ma

y-1

1

Jul-

11

Se

p-1

1

No

v-1

1

Jan

-12

Ma

r-1

2

Central Bank's loans to credit institutions [bn. €]

There is a tragedy of the commons in the Eurozone

�To borrow from a NCB, a bank must be:

• Solvent

• Have eligible collateral

�Countries, not the ECB, have

�Supervisory power to decide whether a bank is solvent

�Determine the quality of collateral

�Very, very few banks have been closed down in the EZ since 2007.

� Zombie banks?

�Why was there no fall in reserves?

• Target2 imbalances (up to November 2011)

• LTRO (December 2011 and February 2012)

• ELAs

• ESFS/ The Next: ESM

GIIPS

DNLF

-1.000

-500

0

500

1.000

Jan

-07

Ma

y-0

7

Se

p-0

7

Jan

-08

Ma

y-0

8

Se

p-0

8

Jan

-09

Ma

y-0

9

Se

p-0

9

Jan

-10

Ma

y-1

0

Se

p-1

0

Jan

-11

Ma

y-1

1

Se

p-1

1

Jan

-12

Ma

y-1

2

Source: Institute of Empirical Economic Research -

Universität Osnabrück

Net Balance with the Eurosystem / Target [bn €]

DNLF = Germany, Netherlands, Luxembourg, Finland

GIIPS = Greece, Italy, Ireland, Portugal, Spain

0

50000

100000

150000

200000

250000

20

12

W2

1

20

12

W0

9

20

11

W4

9

20

11

W3

7

20

11

W2

5

20

11

W1

3

20

11

W0

1

20

10

W4

1

20

10

W2

9

20

10

W1

7

20

10

W0

5

20

09

W4

6

20

09

W3

4

20

09

W2

2

20

09

W1

0

20

08

W5

0

20

08

W3

8

20

08

W2

6

20

08

W1

4

20

08

W0

2

20

07

W4

2

20

07

W3

0

20

07

W1

8

20

07

W0

6

Other claims (including ELA)

Solution?

� The medicine for the NEW (1990s) crises is massive liquidity

injection

� The medicine for the OLD (1970s-80s) crises is Structural

Reform

�But the Eurozone crisis is a combination of both

�CONUNDRUM:

• �Liquidity injections to stem banking panics reduce the

incentives for reform.

• �Aggravate imbalances

• �The eventual crisis is deeper

Slow Adjustment and NCB credit

-400

-300

-200

-100

0

100

200

300

400

Spain Greece Ireland Italy Portugal

Cumulative current account vs. change in central bank credit

since 2007 [in bn €]

Current account

Domestic credit

Conundrum

Stylized fact

Structural reforms typically occur in the wake of economic crises

Tornell, 1999, “Reform From Within”

�Structural Reform increases long-run growth, but

• Reduces the rents of powerful groups

• Powerful groups have the power to block reform

�Crisis has the magic power to dissolve the collusion of powerful groups and their opposition to reform.

�Can EU, ECB impose reforms on GIIPS?

How big is a big enough rescue?

0

500

1000

1500

2000

2500

3000

3500

4000

4500

Spain Greece Ireland Italy Portugal

Total liabilties Deposits Demestic credit

0

2000

4000

6000

8000

10000

12000

Total liabilties

in GIIPS

Deposits in

GIIPS

GDP-Debt Domestic

credit in GIIPS

Policy implications

Europe needs a vision of a USA-type financial system,

meaning:

- A federal reserve bank system NCBs are just

subsidiaries

- Single supervisory authority for all banks

- An FDIC for small deposits

- No direct recapitalization (don‘t insure all the

liabilities of the banks)

- A no-bailout clause among countries’ public debts

(liquidity loans yes, solvency loans no)

- A reform of voting rights at the ECB (voting

according to capital share)

- A subsidiarity principle (=no joint liability)

Both the central banks and public rescue fonds

should protect tax-payers.

�Future Alternative Scenarios

1. Reform and convergence

2. The EZ breaks apart

� back to 1980s-style stabilization cycles

3. EZ stays together but no reform

Will inflation increase significantly?

Will the Euro depreciate severely? Can it stop at eurusd=1?

�Lets analyze the experience of Germany in the 1920s

1

1,5

2

2,5

3

3,5

4

4,5

1913 1914 1915 1916 1917 1918

Basis of all curves: 1913 = 1

Germany 1913-1918

Dollar Exchange

Domestic Prices

Volume in

Circulation

0,9

1

1,1

1,2

1,3

1,4

1,5

1,6

1,7

1,8

1,9

2

2,1

2,2

2,3

Eki.18 Kas.18 Ara.18 Oca.19 Şub.19 Mar.19 Nis.19 May.19 Haz.19 Tem.19

Basis of all curves: October 1918 = 1

Germany Oct 1918 – July 1919

Domestic Prices

Volume in

Circulation

Dollar Exchange

0

2

4

6

8

10

12

14

16

Eki.18 Ara.18 Şub.19 Nis.19 Haz.19 Ağu.19 Eki.19 Ara.19 Şub.20

Basis of all curves: October 1918 = 1

Germany Oct 1918 – Feb 1920

Domestic Prices

Volume in

Circulation

Dollar Exchange

Slow Adjustment: Greece

Source: International Financial Statistics, IMF

-50

-40

-30

-20

-10

0

10

20

30

40

50

2000 2001 2002 2003 2004 20 05 200 6 2007 2008 2009 2010

Private financial flowsMonetary authoritiesGovernmentCurrent accountChange in reserves

-20

-15

-10

-5

0

5

10

15

T-4 T-3 T-2 T-1 T T+1 T+2 T+3 Mexico (T=1994)

Korea (T=1997)

Greece (T=2008)

Spain (T=2008)

Current Account Balance

% of GDP

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

1919 1920 1921 1922 1923

Germany 1919 - 1923

Expenditure

Deficit

Fiscal Income

December 8, 2011 press release of the ECB.

• To reduce the reserve ratio, which is currently 2%, to 1% as of the reserve maintenance period starting on 18 January 2012. As a consequence of the full allotment policy applied in the ECB’s main refinancing operations and the way banks are using this option, the system of reserve requirements is not needed to the same extent as under normal circumstances to steer money market conditions.

• To increase collateral availability by (i) reducing the rating threshold for certain asset-backed securities (ABS) and (ii) allowing national central banks (NCBs), as a temporary solution, to accept as collateral additional performing credit claims (i.e. bank loans) that satisfy specific eligibility criteria. These two measures will take effect as soon as the relevant legal acts have been published.

Mario Draghi Q&A July 5, 2012

• What we could do and what we have done with respect to this is

broaden the eligibility rules of collateral so as to attract the greatest

number of banks, including those banks of a small/medium size

which we believe are closest to the SMEs. But we have also done

another thing, recently, at the last Governing Council meeting. We

broadened the collateral eligibility so that banks can actually use the

assets they create in lending to the real economy as collateral in

borrowing from the ECB. So they are not only using government

bonds, they are now also using credit claims and asset-backed

securities of a lower rating, which means that for the banks in a

sense it is now very useful to lend to the real economy because that

way they also generate collateral that they can use for funding

themselves. And we want to do this to keep the risk for the ECB

balance sheet – and I have said this many times – very, very low.

• The Commission will present Proposals on the basis of Article

127(6) for a single supervisory mechanism shortly. We ask the

Council to consider these Proposals as a matter of urgency by

the end of 2012.

• When an effective single supervisory mechanism is

established, involving the ECB, for banks in the euro area the

ESM could, following a regular decision, have the possibility to

recapitalize banks directly.

Euro Area Summit June 29, 2012

The balance sheet of a Central bank

Assets Liabilities

Gold Bills in circulation

Private Securities owned by

central bank

Deposits from private credit

institutions

Public securities owned by

central bank Loans from Euro-system

Other Assets Other liabitlies

Loans to Euro-system

Capital

• Phase 1. 2008-2011

• GIIPS NCBs increase credit to domestic banks

• Other NCBs (e.g. Bundesbank) reduce credit to domestic banks

• Aggregate Monetary Base remains on trend

• Phase 2. 2012-

• Bundesbank hits the limit: its stock of domestic assets is

practically zero .

• GIIPS NCBs still need to extend credit to domestic institutions

�Aggregate Monetary Base starts to increase above trend

• Phase 3.

• ???

Evolution of the Eurosystem Monetary Base:

What is Next?

0

500

1.000

1.500

2.000

2.500

3.000

3.500

19

98

W5

3

19

99

W1

9

19

99

W3

8

20

00

W0

5

20

00

W2

4

20

00

W4

3

20

01

W1

0

20

01

W2

9

20

01

W4

8

20

02

W1

5

20

02

W3

4

20

03

W0

1

20

03

W2

0

20

03

W3

9

20

04

W0

6

20

04

W2

5

20

04

W4

4

20

05

W1

0

20

05

W2

9

20

05

W4

8

20

06

W1

5

20

06

W3

4

20

07

W0

1

20

07

W2

0

20

07

W3

9

20

08

W0

6

20

08

W2

5

20

08

W4

4

20

09

W1

1

20

09

W3

0

20

09

W4

9

20

10

W1

5

20

10

W3

4

20

11

W0

1

20

11

W2

0

20

11

W3

9

Bil

lio

ns

Monetary Base of Eurozone