European Interdisciplinary Studies Programme

Academic Year 2017-2018

EU Macro-Economic Policies and Economic Governance

Describe the sequencing of events during the crisis and the reaction from side of EU
Institutions. Do you think the institutional response has been appropriate?

Professor: Benedicta Marzinotto

Student: Beka Jebashvili

Word Count: 3266

Contents
Contagion: From US subprime Crisis to European Sovereign Debt Crisis .................................... 3

Crisis: The Origins ...................................................................................................................... 3

Crisis Expansion: Danger to the Eurozone ................................................................................. 5

Fixing the Sovereign Debt Crisis .................................................................................................... 7

Bail-out dilemma ........................................................................................................................ 7

The EU Reforms ......................................................................................................................... 9

Monetary Policy ........................................................................................................................ 10

Response to the crisis .................................................................................................................... 11

Conclusion .................................................................................................................................... 13

Bibliography ................................................................................................................................. 14
Introduction

The creation of the European Monetary Union (EMU) is one of the biggest achievements of the
economic integration. Even though it started as a success story of peace, stability and prosperity,
soon it was dramatically challenged by global financial shocks. The crisis which escalated in the
United States (US) rapidly migrated to the whole world including Europe.

Considering that the Eurozone crisis is still an ongoing battle, it is relevant to look back and
reconstruct the sequence of events throughout this challenge and analyse to what extent was the
toolbox of the EU appropriate for overcoming it. Therefore, Firstly, the paper will describe the
process of the crisis contagion from the US to the Euro Area. Secondly, it will explore the EU
ways of coping with a crisis and finally it will offer a critical assessment of the EU efforts.

Contagion: From US subprime Crisis to European Sovereign Debt Crisis

Crisis: The Origins

One of the causes for the US subprime mortgage crisis originates from the abolishment of the
Glass-Stegall Act in 1999.1 The Act provided the legal supervision of both commercial and
investment banks and prohibited activities that would allow institutions to yield higher profits
through undertaking excessive risks. 2

Soon after the repeal of the act and the start of the new century, the US was hit by the dot-com and
corporate scandal crises and 9/11 attacks that slowed down the American economy. In order to
cope with this recession, Federal Reserve used the expansionary monetary policy and decreased
the federal funds rate from 6,5% to 1%.3 Low-interest rates encouraged the economic activities in
the country, however, soon the situation became uncontrollable and it turned into a borrowing-

1
Corinne Crawford, ‘The Repeal of the Glass- Steagall Act and The Current Financial Crisis’ in: Journal of Business
& Economics Research, Vol. 9, No. 1, 2011, p. 127.
2
George K. Zestos, The Global Financial Crisis: From US Subprime Mortgages to European Sovereign Debt,
Routledge, Abingdon, 2016, p. 27.
3
Ibid., p. 21.
spending spree. The boosted consumption and availability of cheap mortgages resulted in the
creation of housing bubbles. 4

In addition to this, the repealed regulation cleared the way for investment banks to use creativity
in order benefit from the existing situation and invent new financial derivatives, namely
Collateralised Debt Obligations.5 CDOs were very complex financial products which were sold to
investors and could be easily described as devices to deceive. They soon became toxic assets which
spread all over the financial sector.6

Hence, the housing bubbles and CDO market only began to crumble after the Federal Reserve
commenced the contractionary monetary policy in order to cool down the overheated economy in
2004. The increase of the interest rate increased the monthly payments for the debtors.
Consequently, many of the borrowers, especially subprime borrowers did not manage to keep
repaying their debts. As a result, the only option left for them was to default.7 Due to the
interconnectedness of the whole financial sector, the individual defaults of borrowers soon
translated into the insolvency of both commercial and investment banks. On September 15, 2008,
one of the most influential investment banks of the US, Lehman Brothers filed for the bankruptcy.8
This was the massive “banking and market earthquake”.9

After the collapse of Lehman Brothers, risks were re-assessed globally and the financial sector was
hit with a massive wave of the distrust. This led to the aggravation of the financial crisis and its
transformation into a business crisis. The distrust and low access to reliable credits temporarily
froze the global trade and eventually declined it. The downturn of the worldwide trade, therefore,
decreased the global demand and shrank the economies worldwide.10

4
Ibid., p. 22.
5
Ibid., p. 28.
6
Ibid., p. 29.
7
Kimberly Amadeo, Subprime Mortgage Crisis, Its Timeline and Effect, Available at :
https://www.thebalance.com/subprime-mortgage-crisis-effect-and-timeline-3305745 (consulted on 25.04.2018).
8
The Guardian, Banking crisis: Lehman Brothers files for bankruptcy protection, Available at:
https://www.theguardian.com/business/2008/sep/15/lehmanbrothers.creditcrunch (consulted on 25.04.2018).
9
Stefan Schultz, What the Lehman Bankruptcy Means for Germany, Available at:
http://www.spiegel.de/international/business/the-return-of-the-finance-crisis-what-the-lehman-bankruptcy-means-
for-germany-a-578493.html (consulted on 25.04.2018).
10
Peter Praet, Speech: The crisis response in the euro area, Available at:
https://www.ecb.europa.eu/press/key/date/2013/html/sp130417.en.html (consulted on 25.04.2018).
Crisis Expansion: Danger to the Eurozone
11
The contagion of the crisis to Europe started in 2009. The first sign of crisis arrival was
showcased by the frozen interbank lending market. The latter automatically resulted in the
significant increase of bond yields for countries like Greece, Portugal and Ireland and to a lesser
extent for Spain and Italy. Thus, above-mentioned countries partially lost access to borrowing
opportunities, on which they heavily relied on. 12

Hence, the EU officials did not manage to fully realise the inevitability of oncoming danger. In a
study published in 2008, the European Commission underlined that the European Monetary Union
was a resounding success and an important “pole of stability”.13 Even though early signs of the
crisis were already visible on the bond markets of Greece in 2009, the narrative was also shared
by the president of the European Central Bank, Jean-Claude Trichet, who proclaimed the EMU as
a shield from the shocks of financial and economic turmoil.14

Not long after, the illusion of resounding success has been shed. In 2009 Greek Prime Minister
Papandreou inculpated the previous government for forging the real data about the Greek Public
deficit which was much larger than publicised.15 Moreover, the 2009 budget deficit turned out to
be more than double of previously announced 6%. 16 Promptly after the announcement, the bond
market reacted. The trust towards Greece’s public finances disappeared and the bond yields
skyrocketed early in 2010 compared to other countries. To simplify, the high bond yield percentage
represents the perception about the credit risk. As the yields surged, Greece finally lost the
opportunity to borrow more and faced the likelihood of default.17

The above-mentioned statistical controversy, which created the narrative of fiscal irresponsibility
as the primary reason for the crisis, however, was only the surface. The real problem was rooted

11
George K. Zestos, op.cit., p. 47.
12
Ibid.
13
European Commission, EMU@10: successes and challenges after 10 years of Economic and Monetary Union,
Available at: http://ec.europa.eu/economy_finance/publications/pages/publication_summary12680_en.htm
(consulted on 25.04.2018).
14
Paul Wallace, The €uro Experiment, Cambridge University Press, Cambridge, 2016, p.1.
15
George K. Zestos, op.cit., p. 47.
16
Philip R. Lane, ‘The European Sovereign Debt Crisis’ in: Journal of Economic Perspectives, Vol. 26, No. 3, 2012,
p. 56.
17
Ibid. pp. 56-58.
deeply in the architecture of the monetary union, divergences between countries and
18
macroeconomic imbalances. These imbalances created a milieu for contagion throughout
Europe. The sovereign debt crisis which took off in Greece hit one country after another and
created the domino effect. Uncertainty caused by Greece affected the government bond yields in
Ireland which already suffered the burst of the housing bubble in 2008. The sequence was
continued in Portugal, Italy and Spain. In addition to this Cyprus became the direct victim of
Greek’s inability to pay back the debt, as Cypriot banks were major creditors of Greek borrowers.19
The investors all around Europe witnessed the financial vulnerability of the Euro Area and this fed
the distrust towards the Eurozone and intensified the fear of a further contagion.20

To summarize, in the timespan of three years, the financial crisis which started on the different
continent, transformed into a business crisis and finally triggered the sovereign debt crisis in the
Eurozone.

Financial Crisis in the US

2008

Global Business Crisis

2009

Sovereign Debt Crisis in the EU

2010

Figure 1. The Sequence of the Crisis Events21

assistance in May 2010

18
Ibid.
19
Joanna Pagones, ‘The European Union’s Response to the Sovereign Debt Crisis: Its Effect on Labor Relations in
Greece’ in: Fordham International Law Journal, Vol. 36, No. 5, 2013, p. 1533.
20
Ibid.
21
Lieven Tack, Lecture Material: European Economic Integration, Available at:
https://www.coleurope.eu/system/files/uploads/intranet-page/lieven_tack_-_european_economic_integration_-
_2017-2018_-_slides_classroom.pdf, (consulted on 26.04.2018).
Fixing the Sovereign Debt Crisis

Bail-out dilemma

In the midst of the crisis, the euro-zone leaders encountered a dilemma of rescuing insolvent
countries or staying loyal to the no-bailout clause laid down by the Treaty on the Functioning of
the European Union. 22 According to the Article 125 TFEU, neither member states nor the union
should assume the responsibility for the commitments of others.23 Hence, abiding by this inviolable
rule, carried an enormous risk not only for Greece but even French and German banks, the whole
24
Eurozone and the future of the single currency. The Greek default would eventually mean the
exit of Greece from the Monetary Union, as it would have no other way “to restore access to its
central bank for both the government and the banks”25 This exit, on the other hand, would augment
already existing problems in other vulnerable member states.26

The possible adverse outcome of following the rule, was coupled with an external influence from
the US administration which was fostering the recovery of the country and was disturbed by the
possibility of further escalations in the euro area, as it would hit back on the American economy.
27
Therefore, the IMF pressured the officials in Brussels, to lift the ban from the bail-outs. As a
result of this pressure, in May of 2010, the president of the ECB and the Member States finally
decided to introduce fiscal rescue funds. In addition to this, the EU took the approach of the IMF
28
for bailing out member states and used austerity programs as a conditionality. In other words,
bailout beneficiaries had to decrease the government spending and increase taxes in order to
decrease their public deficits and debts. This method was heavily supported by Germany. 29

22
Paul Wallace op.cit., p. 91.
23
Official Journal of the European Union, Consolidated Version of the Treaty on the Functioning of the European
Union, Article 125.
24
Paul Wallace op.cit., p. 91.
25
Ibid.
26
Ibid.
27
Paul Wallace op.cit., p. 92.
28
George K. Zestos, op.cit., p. 74.
29
Ibid.
Meanwhile, the Troika, consisting of the ECB, the European Commission and the IMF, became
the guardian of the austerity conditions. 30

The first €110 Billion rescue programme for Greece was launched on the 2nd of May 2010. In the
time-span of several days, this bailout fund was to be followed by two additional ad hoc rescue
instruments that had to rescue not only Greece but other vulnerable states as well. First, it was the
private company EFSF set up in Luxembourg with a capacity of €440 Billion, which was intended
to issue bonds and provide loans for the countries in need. Apart from this, member state
governments committed themselves to the creation of the European Financial Stabilisation
Mechanism (EFSM) with a limited capacity of €60 Billion. The latter was set in place by the
31
enforcement of the Article 122 TFEU. According to this article, the Union may provide the
financial assistance to the countries in the case of “natural disasters or exceptional occurrences
beyond its control.”32 However, justification of the creation of this mechanism through Article 122
was legally uncertain.

Member states, especially Germany, challenged the applicability of this article because the existing
situation was neither a natural disaster nor the occurrence beyond the control of governments. On
the contrary, the governments of troubled member states contributed to the creation of the
problem.33 Furthermore, in October 2010, member states agreed on the need of creating
“permanent crisis mechanism to safeguard the financial stability of the euro”.34 In March of the
following year, the European Council amended the Article 136 TFEU by adding a special
provision enabling the use of stability mechanisms (under a strict conditionality) in case of its
indispensability for ensuring the stability of the monetary union.35 After the revision, in 2012,

30
Eurofond, Troika, Available at : https://www.eurofound.europa.eu/observatories/eurwork/industrial-relations-
dictionary/troika (consulted on 27.04.2018)
31
Hans-Werner Sinn, The Euro Trap, Oxford University Press, Oxford, 2014, p.267.
32
Official Journal of the European Union, Consolidated Version of the Treaty on the Functioning of the European
Union, Article 122.
33
Bruno de Witte, ‘The European Treaty Amendment for the Creation of a Financial Stability Mechanism’, in:
European Policy Analysis, Issue 2011, pp. 5-6.
34
Official Journal of the European Union, establishing a permanent crisis mechanism to safeguard the financial
stability of the euro area, 2012/C 169 E/12.
35
Treaty Establishing the European Stability Mechanism, T/ESM 2012-LT/en 1.
intergovernmental European Stability Mechanism (ESM) was established with a limit of €500
billion. 36

Table 1. Rescue Funds 37and Amounts of Received Bailouts.38

The EU Reforms

In addition to the ad hoc crisis resolution mechanisms, the EU’s response to the crisis also included
reinforcing the economic governance. First of all, the Union was concentrated on improving the
fiscal governance. Due to the fact that previously existing Stability and Growth Pact (SGP) lacked
the binding power, it was revised through the group of six regulations, Six-Pack (2011) which
39
increased the credibility of the possible sanction threat in the case of violation. The
innovativeness of this change mainly underlies in the introduction of reversed qualified-majority
voting during the enforcement of sanctions under the Excessive Deficit Procedure. Also, Six-Pack

36
Paul Wallace, op.cit., p. 98.
37
Hans-Werner Sinn, op.cit., p. 267-270.
38
ESM, Financial Assistance, Available at : https://www.esm.europa.eu/financial-assistance (consulted on :
30.04.2018)
39
Peter Praet, op. cit.
established the macroeconomic imbalance procedure, however, the binding nature of the latter is
still questionable. 40

After the entry of the six-pack into force, Member States commenced the talks about the Treaty
41
on Stability, Coordination, and Governance. The intergovernmental Treaty also known as the
Fiscal Compact entered into force in 2013. It obliges the signatory states to have a budget balance
(or surplus) while also laying down the obligation for them to transpose the treaty provisions into
the national legislation. Moreover, the definition of a balanced budget envisaged in the Fiscal
Compact, involves a certain requirements regarding not only a general budget deficit, but the
structural deficit as well. 42

Finally, in order to improve the fiscal surveillance of the EU, the European Semester was
established in 2011. It requires member states to submit their national budget plans to the
Commission and the Council before they are adopted by the national parliament. Later in 2013,
the European Semester was complemented by yet another reform, namely by the Two-Pack. This
reform “codifies further changes to the EU fiscal surveillance calendar and provides for enhanced
surveillance of member states experiencing financial difficulties or risk thereof.”43

Apart from the fiscal governance reforms, the significant change was initiated in 2012 when the
Commission proposed to create a Banking Union. two pillars were set up: Single Supervisory
Mechanism (SSM) and Single Resolution Mechanism (SRM). However, they became fully
operational only in 2014 and 2016 respectively. The first one gives the ECB the power to monitor
financial institutions of the Euro Area, while the second one is used for rescuing the failing banks.
Hence, the banking union still lacks a European Deposit Insurance Scheme. 44

Monetary Policy

40
Paul Wallace op.cit., p. 187.
41
Ibid.
42
Peter Praet, op. cit.
43
Paul Wallace op.cit., p. 187.
44
European Parliament, Main Institutional Elements of the Banking Union, Available at :
http://www.europarl.europa.eu/RegData/etudes/divers/join/2014/497748/IPOL-ECON_DV(2014)497748_EN.pdf
(consulted on 30.04.2018).
The major step towards overcoming the crisis however, was taken only when the previous
president of the ECB, Jean-Claude Trichet, was replaced by Mario Draghi, who undertook a
“whatever it takes to save the euro” approach. 45
Even before Draghi, the ECB commenced the
expansionary monetary policy in 2008. However, the ECB interest rate (REPO) was consistently
higher than the US federal funds rate. The situation changed in November 2011. As soon as Draghi
was appointed, he made a decision to decrease the REPO rate by 0.25%. Moreover, with an
introduction of long-term refinancing operations with a maturity of three years, the liquidity
supplies to financial institutions increased. The increased liquidity relieved the situation of
commercial banks in the distressed countries. Hence this policy change did not manage to
46
incentivise the production as banks hesitated to finance businesses and consumers. In order to
improve the situation, the ECB went even further and announced the program of Outright
Monetary Transactions. This announcement, even though it was never realised, (as a result of
German resistance) finally had a positive impact on investors and it created an impetus for
investments and economic growth. 47

Response to the crisis

Even though, the European authorities undertook various measures for tackling the crisis, the
recovery turned out to be slow and unsteady. Despite, the fact that the crisis originated from the
US, the recession in the EU was much stronger. In addition to this, the US recovery was much
more stable, while the Euro Area GDP took the so-called double dip, before slowly recovering.

45
Paul Wallace op.cit., p. 3.
46
George K. Zestos, op.cit., p. 80.
47
George K. Zestos, op.cit., pp. 82-83.
 4
3
2
1
0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-1
-2
-3
-4
-5

United States Euro area

Figure 1. GDP Growth Rate (%) in the EU and US.48

There are number of reasons, which halted the process of overcoming the recession in the EU. One
of the main reasons argued in the scholarly debate concerns the imposed austerity measures.
Germany portrayed austerity as an only way of overcoming the crisis. Hence, after several years,
even the economist of the IMF, Olivier Blanchard admits that this type of procyclical fiscal
behaviour can do more damage than good. The decrease of the spending and increase of taxes
further demotivates production in already struggling country and leads to crippling economic
growth which might increase the deficit even more.49 Indeed, up till today Greece has not managed
to come out of recession and is suffering from the highest unemployment rate in the EU.50

Additionally, it is important to underline that the EU was slow and hesitant to come up with a
solution “as the EU structures are less suitable for speedy decision”. 51 Therefore, the decisions on
52
the first stage of the crisis were dominated by the member state unilaterally. A bright example

48
The World Bank, op. cit.
49
Brad Plumer, IMF: Austerity is much worse for the economy than we though, Available at:
https://www.washingtonpost.com/news/wonk/wp/2012/10/12/imf-austerity-is-much-worse-for-the-economy-than-
we-thought/?noredirect=on&utm_term=.d75223ef2db5 (consulted on 30.04.2018).
50
The World Bank, World Development Indicators, Available at: https://data.worldbank.org/products/wdi (consulted
on 30.04.2018).
51
Amy Verdun, ‘A historical institutionalist explanation of the EU's responses to the euro area financial crisis’, in:
Journal of European Public Policy, Vol. 22, No. 2, 2015, p. 231. .
52
Ibid.
for this is Germany which impeded almost every proposal that would potentially “create inflation,
raise the interest rate for Germany, or result in a burden to its taxpayers.”53

Finally, there also doubts about the sequencing of the events. As Mario Draghi has underlined, the
first step for tackling the crisis should have been the creation of solid backstop for both
governments and banks. According to him, this should have been followed by the recapitalisation
of banks and finally by the creation of excessive debt framework so that recapitalised banks would
absorb potential losses. He further argued that the sequence of the events in case of the Euro crisis
was almost reversed and “As a consequence, instead of acting as a shock absorber, both banks and
governments began to act pro-cyclically”,54making the situation even harder.

Conclusion

The EU has partially managed to overcome the negative consequences of a global financial crisis.
This achievement can mainly be attributed to the ECB, which employed monetary expansion
policy and re-established the market confidence. Even though the process of assisting the indebted
Member States took off in a chaotic manner, the institutional design was advanced by the creation
of permanent ESM. Hence, throughout the process, the EU policy was mostly concentrated on the
balanced budget and a stricter fiscal consolidation through austerity. Unfortunately, the austerity
measures attached to bailouts added extra pressure on countries in recession and resulted in various
negative consequences including the high unemployment, increased debt/GDP ratio and low
economic growth. Overall, the institutional response was partially effective to assist the troubled
countries. Meanwhile, the Banking Union and also new packages for fiscal disciple have more
enforcement tools and thus can guarantee better convergence.

53
George K. Zestos, op.cit., p. 88.
54
Mario Draghi, Lecture : A consistent strategy for a sustained recovery, Available at:
https://www.ecb.europa.eu/press/key/date/2014/html/sp140325.en.html (consulted on 30.04.2018)
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