ECON 213 PSET 8
1. In a couple of paragraphs, clearly explain 5 factors that Phillip Lane identifies as risk
factors, i.e. things that made the Eurozone more vulnerable to the type of debilitating
crisis that occurred in 2008.
In the Eurozone system, the countries are required to follow a similar fiscal path, but they
do not have common treasury to enforce it. Countries in the Euro-Zone have the same
monetary system and have freedom in issuing their own set of fiscal policies like in
taxation and expenditure. This freedom in adopting fiscal polices led to reckless spending
practices by government of Greece and other Euro zone countries. The tax rate was also
substantially low during the pre-crisis period. The governments ran high deficits and
continued to finance their deficits by obtaining more credit. This left these countries
vulnerable to a time when the investor withdraw their money as a result of a negative
shock, leaving the country with high budgetary deficits. Moreover a lack of centralized
fiscal policy and a centralized banking system left countries more vulnerable to problems
arising from asymmetric socks
Prior to development of the crisis the sovereign debt of the members of the Euro-zone was
considered to be safe by investors and creditor countries. Banks had substantial holdings
of bonds from weaker economies such as Greece that offered a small premium and
seemingly were equally sound. The interest rates in the Eurozone countries were very low
because exchange rate risk and perceived default risk was perceived to be low. As the
crisis developed it became obvious that the sovereign debt issued by Greek and other
PIIGS countries were prone to high default risk.
There was a significant increase in savings available for investment during the 2000–2007
period. The level of savings increased as there was a constant flow of credit from countries
with a CA surplus into countries with a CA deficit. An increase in the inflow of funds led
to a reckless issuance of loans to credible as well as non-credible borrowers. Investors
looked for higher yields globally than those offered by U.S. Treasury bonds as at that time
USA had lowered its interest rates.
There was no self-correction mechanism of deficits as the member of the Eurozone had a
fixed exchange rate. Any form of devaluation to boost exports to correct the deficit
situation was not an option for them. The deficits continued to rise as long as the investors
were willing to invest in that country. Lane provides data that shows that the CA deficits in
Greece and Portugal were around 9 percent of GDP and in Spain around 7 percent of GDP.
There was a misallocation of resources as the inflow of money was not used finance
projects for long-term growth of the economy. The money was invested in new housing
rather than new factories. The inflows did much harm than good as when the inflows
stopped the countries found themselves in an unstable and a more vulnerable position with
rising debt levels and very limited/no way to finance the debt.
2. In a couple of paragraphs, explain clearly how the global financial crisis affected
Europe in general but Greece in particular.
The European debt crisis erupted in the wake of the Great Recession around late 2009, and
was characterized by an environment of overly high government structural deficits and
accelerating debt levels. The states getting adversely hit by the crisis, faced a strong rise of
interest rate spreads for government bonds, as a result of investor concerns about their
future debt sustainability,
The global financial crisis had an asymmetric affect across the Euro area. Cross border
financial flows had stopped by 2008, with investors repatriating funds to home markets
and reassessing their international exposure levels. This process mostly affected countries
with a high dependence on external borrowing, especially international short-term debt
markets. The cessation of credit boom was especially worrisome for countries like Spain
and Ireland since a lack of credit caused the abandonment of the construction projects that
reduced the level of economic activity in these nations. This led to a fall in the property
prices and subsequently large losses for the banks that had a lot of property-backed loans.
In late 2009, a number of countries reported large debt/GDP ratios. Fiscal revenues in
countries like Spain and Ireland fell faster than the rise in GDP because of a decline in
construction projects that increased unemployment and reduced the income level in the
economy.
In 2009 Greece announced that it had a large budget deficit of 12.7 % of GDP. In addition
the fiscal accounts for previous years were also revised to show significantly larger
deficits. These developments led to a high rise in the interest rates on sovereign bonds
caused by an increase in the perception of default risks by Greece, driving them deeper
into the recession. Greece found itself in a situation where the perception of the default
risk determined the policy actions that it should undertake in such a situation. Greece may
not be able to use expansionary fiscal policy if it is facing large budget deficits. Borrowing
from abroad may be difficult, and may make things worse by increasing default risk.
Contractionary fiscal policy may be more appropriate if the austerity program can reduce
or eliminate the default risk. But it the austerity measures do no have the desired effect of
reducing the default risk then that may be a problem. Moreover Greece cannot use
monetary policy or devaluation as methods to reduce the negative effects of the crisis.
Moreover the speculation of Greece exiting the Eurozone has further added on to the
default risk because creditors now also worry about the exchange rate risk.
3. The IMF and the EU provided three bailout packages: $110 billion to Greece in
May 2010, $85 billion to Ireland in November 2010, and $78 billion to Portugal in
May of 2011. In plain language explain what Lane finds to be important problems
with, or limitations of, these packages. I am not interested in your ability to copy and
paste, I want you to absorb the gist of what he’s saying and explain in your words.
Ans. Lane lists six possible reasons for the problems related to the financial packages.
1. The financial packages were given for duration of three years. This was not enough
given the magnitude of the crisis. The countries would require a second stimulus for
macroeconomic adjustment. Countries would find it extremely costly to enact fiscal
austerity measures if it wanted to reduce the debt levels.
2. Moreover by enacting contractionary fiscal polices, the output and income level in the
falls. This leads to a fall in the disposable income and corporate profits which in turn
increases the perceived default risk.
3. The presence of a penalty premium raises the cost of borrowing money and makes it
even harder to replay back the loans that are borrowed to finance the deficits. Although
the penalty premium on European official loans was eliminated, the interest rate on the
