Economic and Financial Committee Topic: Macroeconomic Governance I. Description of Issue
On September 15, 2008, the Lehman Brothers went bankrupt after the US
government refused to bail out the investment bank. For the past year, there had been numerous signs that the US housing market and mortgage lenders were facing huge, building problems; but for much of the global financial market as well as everyday investors, the fall of the Lehman Brothers and burst housing bubble marked the beginning of the financial crisis and global recession that nations across the world continue to struggle with today, over three years later.
Of the several key issues involved, perhaps what makes the current situation so
much more dangerous than the financial crisis of 2008 that mostly revolved around the collapse of numerous housing bubbles around the globe (particularly that of the US, tied in with subprime mortgages), is the presence of an overwhelming amount of accumulated sovereign debt for countless nations. Questions to be answered include how to deal with the situation now, as much of the debt is no longer feasibly repayable. How much of the debt will be written off and who will end up accepting these losses? Crucially, how can governments prevent the sovereign debt crisis from collapsing straight onto the banking sector? The key example and area of concern is without doubt the European debt crisis. Ireland, Portugal, Spain and Greece are all struggling with massive amounts of sovereign debt, with Greece holding debt amounting to 166% of its GDP in 2011. Greece, while already having received a first bailout jointly provided by the International Monetary Fund (IMF), European Union (EU), and European Central Bank (ECB). The heart of the matter is that if Greece defaults on its debts, Greek banks
holding 50% of that debt will inevitably collapse. French and German banks that are major lenders will also suffer, as will other international banks, funds and investors, effectively pulling the international banking sector into the sink of the sovereign debt crisis. If realized, the resulting global financial crisis would be even more severe than that seen from 2007-‐2010. This possibility produces the highly volatile and high-‐risk situation that in turn causes investors to sell bank shares, spurring a continuous downward cycle where potential investors increasingly lose trust in eurozone countries and banks, making it increasingly difficult (and expensive) for governments to borrow and thus impeding recovery. Economists have proposed numerous solutions for the EU, ECB and IMF to effectively turn the situation around. However, what is particularly lacking in the current situation is political will and political consensus. The World Economic Forum 2012 in Davos ended with much uncertainty. The task of the Economic and Financial Committee is firstly to address methods to reverse the current downward spiral of sovereign debt, keeping in mind the political obstacles necessarily in the way. Secondly, they must consider and address methods, including regulation, to minimize the possibilities of a similar crisis occurring again. While government budget deficits and sovereign debt is a crucial factor, it is not the entire root of the financial crisis and recession. Private-‐sector debt is also a highly important area. An example of this is Spain, whose financial difficulties defy the mold. Unlike Greece, whose troubles originate in governmental over-‐spending and lack of accuracy and transparency in released borrowing statistics, Spain, before the financial crisis, abided by the Growth and Stability Pact introduced by Germany in 1992 when the euro was established, limiting their budget deficit to no more than 3% (something which both Germany and France did not achieve). However, low interest rates in the early 2000s caused the private sector in Spain to vastly over-‐borrow. The resulting
build-‐up of debt in the private sector brought banks to the point of collapse, forcing the Spanish government to bail out the financial institutions, and pulling the country into an economic recession. Low interest rates and the economic boom also had the effect of increasing wages. After the financial crisis, high wages cost workers in both Spain and Greece in terms of competitiveness on the market, in particular when compared to Germany, increasing unemployment. Higher wages also had an effect on the cost of goods produced by these nations, creating an eventually fatal disparity between exports and imports. Low interest rates set by the US Federal Reserve is also an important factor behind the US housing bubble (an event that the Spanish economy also suffered) build-‐up and subsequent bursting in 2007-‐2008. This clearly demonstrates that the financial crisis is deeper than over-‐spending and lack of budget discipline by certain governments, and demonstrates that the regulation of the private sector, especially banking standards, as well as the relationship between the private sector and central banking systems are all concerns the ECOFIN should consider. A third topic that needs to be addressed is the notion of austerity and its role in economic growth. Are stricter regulations on budget deficits and forced austerity the answer or at least part of the answer to ending the financial crisis? As mentioned before, concern over governments' ability to repay their debts increases exponentially the cost of borrowing money for these same governments. Thus in order to decrease deficit, countries with stronger economies such as Germany, and institutions such as the ECB has been pushing for austerity. The issue, however, is that severe spending cuts also slows economic growth. Less growth results in decreased tax revenue, that in turn taxes governments' ability to borrow less and repay their debts, setting out on an endless path of recession. On the other hand, the cost of not cutting spending is heavy as well. With the current recession, the amounts governments are forced to borrow each
year to cover basic costs are increasing continuously as tax revenues drop. However, interest rates to borrow become higher and higher as a nation’s debt (and thus their ability to repay that debt) increases. Unable to borrow further, and without a bailout from other countries or international institutions, financial collapse would be inevitable. Therefore, a question the ECOFIN also has to consider is the paradox of austerity and whether there is any alternative to the cycle. II. Timeline of Events 1994 – The euro comes into existence in the countries of Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal, and Spain. 2001 – Greece joins the euro. February 2007 -‐ HSCB announces that Household Finance, its mortgage branch in the US, has suffered huge subprime losses, an initial indication of the coming collapse of the US housing market and subsequent effects on the world economy. August 2007 – Growing numbers of defaults in the US mortgage market causes French bank BNP Paribas to suspend three investment funds worth a total of 2 billion euros. The European Central Bank (ECB) offers 95 billion euros in loans to the European banking market in response. September 2008 – US government refuses to bailout the Lehman Brothers. The investment bank subsequently goes bankrupt, sending shockwaves across the world financial markets. December 2008 – European leaders agree on a 200 billion euro stimulus plan to aid European financial growth and recovery.
April 2009 – At G20 summit, nations pledge $1.1 trillion to help the global financial crisis. Notably, the funds of the IMF are tripled to $750 billion for loans to ailing economies. However, not all pledges are April 2009 – The EU calls into question the budget deficits of nations including Spain, Ireland, and Greece, and orders governments to reduce their deficits. October 2009 – George Papandreou’s Socialists win snap elections in Greece. However, by December, Greece’s debt has reached 300 billion euros, 113% of their GDP. Rating agencies respond by downgrading both Greek bank and governmental debt. May 2010 – The EU and IMF agree to a joint bailout of Greece to prevent a Greek default, of 110 billion euros. In return the Greek government must put in place further austerity measures. Later in the month, the EU creates the European Financial Stability Facility (EFSF) with a lending capacity of 440 billion euros, and the European Financial Stability Mechanism (EFSM) with a capacity of 60 billion euros. November 2010 – The Irish Republic receives a similar EU-‐IMF joint bailout of 85 billion euro in exchange for banking reforms, pledges to reduce budget deficit, and reforms for labour market growth. May 2011 – Portugal receives a 78 billion euro bailout package from the EFSF, EFSM, and the IMF. January 2012 – 25 EU countries (all members excluding the UK and the Czech Republic) agree to a fiscal compact that allows the European Court of Justice to enforce compliance to budgetary rules. February 2012 -‐ EU leaders agree to a second Greek bailout of 130 billion euros and negotiate a 50% write-‐off of Greek debt, but Greece must first pass another austerity plan amidst yet more strikes and demonstrations.
III. Key Positions Germany – Germany is the largest economy in the EU currently one of the strongest economies in the eurozone. In contrast to Greece, Italy, and Spain, Germany has experienced the lowest borrowing costs in history during the sovereign debt crisis. Germany views many other European governments’ staggering debt as the result of imprudent overspending and seeks to tighten budgetary rules over the eurozone in the form of a new treaty to create a degree of fiscal unity. It is also the main resistance behind the ECB’s refusal to act as lender of last resort. Germany is owed a high amount of debt from ailing economies. If any sovereign debt is written off, Germany will inevitably shoulder much of the burden. France – France, like Germany, is also one of the currently strongest (and largest) economies in the eurozone. However, French banks, including the two biggest, hold particularly large amounts of Italian debt, as well as significant amount of Greek and Spanish debt that fuels market concerns regarding its stability. France supports the European fiscal compact to enforce stricter budget discipline, and has implemented several austerity plans itself since the financial crisis began. United States of America – The US economy suffered the bursting of their housing bubble in 2007, and the collapse of the Lehman Brothers in 2008. This resulted in the worst recession since the Great Depression. Since then, the US has spent an estimated $1.6 trillion on stimulus. The US has massive amounts of foreign debt, primarily held in Japan and China, but Europe holds a significant amount, linking the US economy to the European sovereign debt crisis. In 2011, the US was faced with the crisis of accumulating debt over their legal debt ceiling. Later in the year, US federal debt was downgraded by the rating agency Standard & Poor's. Although economic growth rates have been rising modestly, the continued recovery of the US is still in question.
China – The global financial crisis, particularly its persistence in Europe and the US has impacted China most significantly in the fall in the country’s exports as demand from Europe and the US slows. In January, China’s trade surplus was an all-‐time high at $27.3 billion. This issue has long been a sensitive issue between China and nations such as the US, as China has been accused of deliberately maintaining their currency’s value at low rates to increase the price competitiveness of their exports. China has also engaged in discussions with the EU regarding investment in EFSF bonds, but while China enjoys significant trade surpluses, a large proportion of its population remains mired in poverty, making further aid unlikely. Japan – Japan is the world’s third largest economy, and also the highest amount of public debt in any develop nation. But unlike the majority of other countries owing massive amounts of foreign debt, Japan’s debt is mostly held internally. Also in contrast to Europe and the U.S., Japan has experienced economic stagnancy in its recent past that did not recover from until the mid 2000s. Its current economic gloom is fuelled not just by the global financial downturn of the late 2000s, but also the earthquake and tsunami Japan suffered in 2011. Japan’s government, however, seems confident that Japan’s current deficit will be eliminated by 2020. United Kingdom – The UK, though not part of the eurozone, is a major creditor of Ireland and Italy, and like the rest of Europe, continues to suffer from the global recession. It is one of the two countries to have declined involvement in the new European fiscal compact, shying away from proposed standardized corporation taxes and financial transaction taxes. Though the UK has refused to contribute significantly to recent bailouts (aside from its bilateral loan to Ireland), it has pledged to increase contributions to the IMF.
Greece – Greece owes a massive amount of debt to other eurozone countries. Since the beginning of the debt crisis, Greece has had two changes in government, and is currently in the hands of an interim coalition government led by Lucas Papademos. Greece has been forced by the EU and IMF to implement severe austerity plans and reform measures to encourage economic growth in exchange for the two bailouts it has received, measures that have sparked numerous riots and strikes from the Grecian people. Greece is strongly against and condemns Germany for the suggestion that its national budget policy should be subject to approval by the European Court of Justice. India – India’s banking sector was relatively unaffected by the global economic crisis in 2008, but its economy was largely sustained by stimulus from the government through the recession. Like China, India’s exports will inevitably continue to be affected by falling demand from Europe and the US. Ireland – Ireland’s economic growth in its housing sector up till 2008 was fuelled by the availability of cheap credit. When the property bubble burst in 2007, and defaulted loans brought Irish banks on the verge of collapse, the Irish government chose to guarantee both bank deposits and private bondholders, leading government debt to multiply exponentially. Ireland is one of the three countries to receive a bailout from the EU and IMF, and together with harsh austerity measures, has recovered moderately in the last few years. Ireland’s large financial sector means that it has a relatively high amount of foreign debt, most of it held by the UK. It also means that Ireland strongly opposes changes to its corporation tax as Germany and France attempts to push for a fiscal union. Spain – Spain’s debt, as mentioned previously, is a different case, as its roots are in private sector over borrowing and debt, rather than sustained government overspending and deficit. Spain supports treaty reform, and its new government,
elected late 2011 has been pressured to adopt austerity plans as well. However, Spain has been deep in recession since 2008 and its economy will doubtless suffer from austerity measures. Spain is also Portugal’s largest creditor, who is in turn owed large amounts by Greece. Both countries would be severely affected by a Greek default. Italy – Italy exists in contrast to Spain in that private citizens owe relatively little debt, particularly in terms of mortgages. Furthermore, the large debt ratio of its GDP -‐ over 100% -‐ owed by the Italian government is has been sustained for the pass two decades. Italy mostly suffers from its weak economy with an annual growth rate of .75% in relation to the interest rate Italy must pay on its debt, and thus runs the danger of quickly accumulating an amount of debt that cannot be supported by its economy. While Italy has implemented austerity measures, like Greece, Spain, and Ireland, it opposes interference in its budget policy.
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