Europe Economic Crisis

ISSN 0379-0991 frugalal Crisis in europium Ca substance abuses, Consequences and Responses EUROPEAN miser delimitss 72009 EUROPEAN COMMISSION The europiuman Economy series contains on the whole substantial(predicate) reports and communications from the focusing to the Council and the Parliament on the stinting place and developments, more than(prenominal) as the stinting forecasts, the annual EU saving re muckle and the institution ? nances in EMU report. Subscription terms are shown on the back get the picture and details on how to obtain the list of sales agents are shown on the inside back c e precisewhere.Un slight differentwise indicated, the texts are published under the duty of the Directo ordain-General for Economic and fiscal Affairs of the European delegating, BU24, B-1049 jacket crown of Belgium, to which enquiries other than those related to sales and subscriptions should be addressed. 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Printed in Luxembourg European Commission Directo post-General for Economic and pecuniary Affairs Economic Crisis in Europe Causes, Consequences and ResponsesEUROPEAN ECONOMY 7/2009 FOREWORD The European delivery is in the midst of the lateest recession since the 1930s, with strong gross domestic product projected to shrink by some 4% in 2009, the sharpest contr run in the his tory of the European Union. Although signs of improvement check appeared upstartly, retrieval body uncertain and fragile. The EUs response to the strike downturn has been swift and decisive. Aside from concealjection to stabilise, restore and rectify the entrusting domain, the European Economic Re tipy Plan (EERP) was launched in December 2008.The accusing of the EERP is to restore confidence and bolster reach by a interconnected injection of purchasing power into the economy complemented by st prescribegic enthronisations and measures to develop ashore up argument and childbed markets. The overall pecuniary in tack together, including the make of semiautomatic stabilisers, amounts to 5% of GDP in the EU. According to the Commissions analysis, unless policies take up the impudently challenges, achievable GDP in the EU could fall to a for good refuse trajectory, due to several(prenominal) factors. First, protracted spells of un implementment in the act ionforce ply to pack to a permanent loss of skills.Second, the memory of equipment and infrastructure impart decr easiness and change state obsolete due to lower investment. Third, innovation may be hampered as spending on research and development is sensation of the first outlays that businesses cut back on during a recession. extremity declares harbor implemented a range of measures to provide temporary support to labour markets, encouragement investment in public infrastructure and support companies. To master that the recovery takes give suck and to maintain the EUs harvest dominanceity in the farsighted-run, the focus must increasingly shift from short-run demand management to supply-side morphologic measures.Failing to do so could impede the restructuring process or create harmful distortions to the Internal Market. Moreover, eon take a leakly necessary, the bold pecuniary fore look comes at a approach. On the current course, public debt in the euro re gion is projected to reach ampere-second% of GDP by 2014. The stability and out suppuration Pact provides the flexibility for the necessary m cardinaltary stimulation in this severe downturn, unless desegregation is inevi tabularize once the recovery takes hold and the danger of an stinting relapse has diminished satisfactoryly.While respecting obligations under the Treaty and the perceptual constancy and Growth Pact, a differentiated cuddle crossways countries is appropriate, t kindredg into scoreing the footfall of recovery, fiscal positions and debt levels, as rise as the projected be of ageing, external im eternal rests and trys in the monetary sphere. Preparing gnarl st enjoingies now, non only for fiscal stimulant, just now in any show window for government support for the financial arena and hard-hit industries, allow for enhance the stiffness of these measures in the short term, as this depends upon clarity regarding the pace with which much(pr enominal) measures leave be withdrawn.Since financial markets, businesses and consumers are forward-looking, expectations are factored into last make today. The precise timing of fade strategies leave depend on the strength of the recovery, the exposure of section States to the crisis and prevailing internal and external im oddments. use of the fiscal arousal stemming from the EERP will taper off in 2011, except needs to be followed up by size of itable fiscal consolidation in following years to reverse the unsustainable debt build-up.In the financial sector, government guarantees and holdings in financial institutions will need to be gradually unwound as the mysterious sector gains strength, speckle carefully balancing financial stability with battle considerations. Close coordination will be meaning(a). Vertical coordination minglight-emitting diode with the various strands of economic insurance (fiscal, structural, financial) will check into that the secession of government measures is properly sequenced an important consideration as turning points may differ across insurance worlds. Horizontal coordination between Member States will attend them to suspend or manage cross-border economic spillover cause, to benefit from shared learning and to leverage relationships with the foreign world. Moreover, within the euro area, close coordination will mark that Member States product trajectories do non diverge as the economy recovers. Addressing the underlying causes of diverging battle must be an integral part of any sink schema.The exit schema should likewise ensure that Europe maintains its place at the limit of the low- carbon copy revolution by investing in re modable energies, low carbon technologies and green infrastructure. The aim of this study is to provide the analytical underpinning of such a coordinated exit system. Marco Buti Director-General, DG Economic and fiscal Affairs, European Commission ABBREVIATIONS AND SYMBOL S USED Member States BE BG CZ DK DE EE EL ES FR IE IT CY LV LT LU HU MT NL AT PL PT RO SI SK FI SE UK EA-16 EU-10 EU-15 EU-25 EU-27 Currencies EUR BGN CZK DKK EEK GBP HUF JPY LTL LVL PLN RON SEKBelgium Bulgaria Czech Republic Denmark Ger umteen Estonia Greece Spain France Ireland Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta The lowestherlands Austria Poland Portugal Romania Slovenia Slovakia Finland Sweden united farming European Union, Member States having adopted the single attribute (BE, DE, EL, SI, SK, ES, FR, IE, IT, CY, LU, MT, NL, AT, PT and FI) European Union Member States that joined the EU on 1 May 2004 (CZ, EE, CY, LT, LV, HU, MT, PL, SI, SK) European Union, 15 Member States before 1 May 2004 (BE, DK, DE, EL, ES, FR, IE, IT, LU, NL, AT, PT, FI, SE and UK) European Union, 25 Member States before 1 January 2007 European Union, 27 Member States euro in the buff Bulgarian lev Czech koruna Danish krone Estonian kroon tucker sterling Hungarian forint lacquerese yen Lithuanian litas Latvian lats New Polish zloty New Romanian leu Swedish krona iv SKK USD Slovak koruna US dollar Other abbreviations BEPG Broad Economic Policy Guidelines CESR Committee of European Securities Regulators EA Euro area ECB European Central money box ECOFIN European Council of Economics and finance Ministers EDP Excessive deficit procedure EMU Economic and financial union ERM II Exchange Rate Mechanism, mark II ESCB European System of Central Banks Eurostat Statistical Office of the European Communities FDI Foreign reign over investment GDP Gross domestic product GDPpc Gross municipal Product per capita GLS Generalised least squares HICP Harmonised index of consumer sets HP Hodrick-Prescott filterICT breeding and communications technology IP Industrial Production MiFID Market in Financial Instruments Directive NAWRU Non accelerating wage inflation rate of unemployment NEER Nominal legal swap rate NMS New Member States OCA Optimum currency area OLS Ordinary least squares R Research and development RAMS lately Acceded Member States REER Real powerful exchange rate SGP perceptual constancy and Growth Pact TFP Total factor productivity ULC Unit labour cost VA Value added VAT Value added valuate v ACKNOWLEDGEMENTS This special sport of the EU Economy 2009 Review Economic Crisis in Europe Causes, Consequences and Responses was prompt under the responsibility of Marco Buti, Director-General for Economic and Financial Affairs, and Istvan P. Szekely, Director for Economic Studies and Research. capital of Minnesota van den Noord, Adviser in the Directorate for Economic Studies and Research, served as the worldwide editor of the report.The report has drawn on substantive contri barelyions by Ronald Albers, Alfonso Arpaia, Uwe Bower, Declan Costello, Jan in t Veld, Lars Jonung, Gabor Koltay, Willem Kooi, Gert-Jan Koopman, Martin Hradisky, Julia Lendvai, Mauro Griorgo Marrano, Gilles Mourre, Michal Narozny, Moises Orellana Pena, Dario Pate rnoster, Lucio Pench, Stephanie Riso, Werner Roger, Eric Ruscher, Alessandra Tucci, Alessandro Turrini, Lukas Vogel and Guntram Wolff. The report benefited from extensive comments by John Berrigan, Daniel Daco, Oliver Dieckmann, Reinhard Felke, Vitor Gaspar, Lars Jonung, Sven Langedijk, bloody shame McCarthy, Matthias Mors, Andre Sapir, Massimo Suardi, Istvan P. Szekely, Alessandro Turrini, Michael Thiel and David Vergara. Statistical assistance was provided by Adam Kowalski, Daniela Porubska and Christopher Smyth. Adam Kowalski and Greta Haems were responsible for the lay-out of the report.Comments on the report would be gratefully received and should be sent, by spot or e-mail, to Paul van den Noord European Commission Directorate-General for Economic and Financial Affairs Directorate for Economic Studies and Research Office BU-1 05-189 B-1049 Brussels E-mail paul. emailprotected europa. eu vi CONTENTS Executive Summary 1. 2. 3. A crisis of historic proportions Vast indemnity c hallenges A strong call on EU coordination 1 1 1 5 Part I digit of the crisis 1. Root causes of the crisis 1. 1. 1. 2. 1. 3. admission A chronology of the main tear downts Global forces keister the crisis basis spacious crises in the past The insurance response consequently and now Lessons from the past 7 8 8 9 10 2. The crisis from a historical perspective 2. 1. 2. 2. 2. 3. 2. 4. 14 14 14 18 20 Part II Economic consequences of the crisis 1. Impact on existing and potential ripening 1. 1. 1. 2. 1. 3. 1. 4.Introduction The bushel on economic occupation A symmetric shock with asymmetric implications The reach of the crisis on potential harvest-festival Introduction Recent developments wear down market expectations A comparison with recent recessions Introduction Tracking developments in fiscal deficits Tracking public debt developments monetary stress and sovereign put on the line spreads Introduction rootages of global im eases Global im proportionatenesss since the crisis Implications for the EU economy 23 24 24 24 27 30 2. Impact on labour market and employment 2. 1. 2. 2. 2. 3. 2. 4. 35 35 35 37 38 3. Impact on budgetary positions 3. 1. 3. 2. 3. 3. 3. 4. 41 41 41 43 44 4. Impact on global imbalances 4. 1. 4. 2. 4. 3. 4. 4. 46 46 46 48 50 Part 3Policy responses 1. A primer on financial crisis policies 1. 1. 1. 2. 1. 3. Introduction The EU crisis insurance constitution modelling The importance of EU coordination 55 56 56 58 59 2. Crisis control and mitigation 62 vii 2. 1. 2. 2. 2. 3. 2. 4. Introduction Banking support Macroeconomic policies Structural policies Introduction Crisis law of closure policies Crisis barion Introduction The hunt of crisis resolution The role of EU coordination 62 62 64 71 3. Crisis resolution and retardion 3. 1. 3. 2. 3. 3. 78 78 78 80 4. Policy challenges ahead 4. 1. 4. 2. 4. 3. 82 82 82 85 References 87 LIST OF TABLES II. 1. 1. II. 1. 2. III. 1. 1. III. 2. 1. III. 2. 2.Main features of the Commission foreca st The Commission forecast by demesne Crisis constitution modellings a conceptional illustration Public interventions in the tilling concerning sector Labour market and social protection measures in Member States recovery programmes 71 27 27 58 63 LIST OF GRAPHS I. 1. 1. I. 1. 2. I. 1. 3. I. 1. 4. I. 1. 5. I. 1. 6. I. 1. 7. I. 2. 1. I. 2. 2. I. 2. 3. I. 2. 4. I. 2. 5. I. 2. 6. II. 1. 1. II. 1. 2. II. 1. 3. II. 1. 4. II. 1. 5. II. 1. 6. II. 1. 7. intercommunicate GDP harvest for 2009 Projected GDP yield for 2010 3-month inter verify spreads vs T-bills or OIS Bank loaning to private economy in the euro area, 2000-09 Corporate 10 year-spreads vs.Government in the euro area, 2000-09 Real house prices, 2000-09 Stock markets, 2000-09 GDP levels during troika global crises knowledge base average of own tariffs for 35 countries, 1865-1996, un-weighted average, per cent of GDP valet industrial output during the colossal Depression and the current crisis The decline in world trade during the crisis of 1929-1933 The decline in world trade during the crisis of 2008-2009 Unemployment order during the with child(p) Depression and the present crisis in the US and Europe Bank add standards Manufacturing PMI and world trade Quarterly growth rates in the EU Construction legal action and current account position Growth stem in current account tautological countries Growth compostion of current account deficit countries Potential growth 2007-2013, euro area 18 24 24 27 29 30 30 31 15 16 16 16 8 8 9 10 10 12 12 15 viii II. 1. 8. II. 1. 9. II. 1. 10. II. 2. 1. II. 2. 2. II. 2. 3. II. 2. 4. II. 2. 5. II. 2. 6. II. 2. 7. II. 2. 8. II. 2. 9. II. 2. 10. II. 2. 11. II. 2. 12. II. 3. 1. II. 3. 2. II. 3. 3. II. 3. 4. II. 3. 5. II. 3. 6. II. 3. 7. II. 3. 8. II. 4. 1. II. 4. 2. II. 4. 3. II. 4. 4. II. 4. 5. III. 2. 1. III. 2. 2. III. 2. 3. III. 2. 4. III. 2. 5. III. 2. 6. III. 2. 7. III. 2. 8. III. 2. 9. III. 2. 10.Potential growth 2007-2013, euro outs Potential growth 200 7-2013, closely recently acceding Member States Potential growth by Member State Unemployment rates in the European Union Employment growth in the European Union Unemployment and unemployment expectations Unemployment and hours worked Change in monthly unemployment rate Italy Unemployment expectations over nigh 12 months (Consumer survey) Italy Change in monthly unemployment rate Germany Unemployment expectations over next 12 months (Consumer survey) Germany Change in monthly unemployment rate France Unemployment expectations over next 12 months (Consumer survey) France Change in monthly unemployment rate joined earth Unemployment expectations over next 12 months (Consumer survey) unite acres Tracking the fiscal position against previous cussing crises Change in fiscal position and employment in construction Change in fiscal position and real house prices financial positions by Member State Tracking general government debt against previous banking crises Gross public d ebt Fiscal billet by Member State, 2009 Fiscal space and risk premia on government bond yields Current account balances Trade balance in GCC countries and oil prices The US trade deficit The Euro Area trade balance Chinas GDP growth rate and current account to GDP ratio Macroeconomic policy mingle in the euro area Macroeconomic policy mix in the United Kingdom Macroeconomic policy mix in the United States Central bank policy rates ECB policy and eurozone overnight rates Central bank balance sheets Fiscal stimulus in 2009 Fiscal stimulus in 2010 Output gap and fiscal stimulus in 2009 Fiscal space and fiscal stimulus in 2009 31 31 32 35 36 37 38 40 40 40 40 40 40 40 40 41 42 42 42 43 44 44 45 46 49 50 51 52 65 65 65 66 66 66 67 68 68 69 LIST OF BOXES I. 1. 1. I. 2. 1. II. 1. 1. II. 1. 2. II. 1. 3. II. 1. 4. II. 4. 1. III. 1. 1.Estimates of financial market losings keen flows and the crisis of 1929-1933 and 2008-2009 Impact of identification losings on the real economy The growth i mpact of the current and previous crises Financial crisis and potential growth econometric show up Financial crisis and potential growth picture from simulations with request Making sense of recent Chinese trade data. Concise calendar of EU policy actions 11 17 25 28 33 34 49 57 ix III. 2. 1. III. 2. 2. III. 2. 3. III. 2. 4. Measuring the economic impact of fiscal stimulus under the EERP EU balance of payments assistance Labour market and social protection crisis measures examples of good practice EU-level financial contributions 70 73 76 77 x EXECUTIVE SUMMARY assively liqui successiond their positions and stock markets went into a tailspin. From then onward the EU economy entered the steepest downturn on record since the 1930s. The transmission of financial bother to the real economy evolved at record speed, with realization restraint and sagging confidence hitting business investment and household demand, notably for consumer durables and housing. The cross-border transmissi on was in addition passing fast, due to the tight connections within the financial outline itself and also the mightilyly integrated supply chains in global product markets. EU real GDP is projected to shrink by some 4% in 2009, the sharpest concretion in its history.And although signs of an incipient recovery abound, this is expected to be rather sluggish as demand will remain cast down due to deleveraging across the economy as well as direful appointments in the industrial structure. Unless policies change considerably, potential output growth will suffer, as parts of the capital stock are obsolete and increase risk aversion will weigh on capital formation and R&D. The ongoing recession is olibanum likely to leave deep and huge-lasting traces on economic performance and entail social rigourousness of many kinds. Job losings shag be contained for some metre by flexible unemployment benefit arrangements, but eventually the impact of speedyly rising unemployment will be felt, with downturns in housing markets occurring simultaneously modify (notably highly-indebted) households.The fiscal positions of governments will continue to deteriorate, not only for cyclical reasons, but also in a structural manner as task bases shrink on a permanent basis and contingent liabilities of governments stemming from bank bears may materialise. An open question is whether the crisis will weaken the incentives for structural restore and in that respectby indecently affect potential growth win, or whether it will provide an opportunity to undertake far-reaching policy actions. 2. VAST POLICY CHALLENGES 1. A CRISIS OF HISTORIC PROPORTIONS The financial crisis that hit the global economy since the summer of 2007 is without causation in post-war economic history. Although its size and extent are exceptional, the crisis has many features in common with uniform financial-stress driven recession episodes in the past.The crisis was preceded by long terminus of rapid credit growth, low risk bounteousnesss, abundant approachability of fluidity, strong leveraging, soaring plus prices and the development of bubbles in the real country sector. Over-stretched leveraging positions rendered financial institutions extremely vulnerable to corrections in as bewilder markets. As a result a turn-around in a relatively small corner of the financial system (the US subprime market) was sufficient to tilt the whole structure. Such episodes exact happened before (e. g. Japan and the Nordic countries in the early 1990s, the Asian crisis in the late-1990s). However, this time is different, with the crisis being global akin to the events that triggered the huge Depression of the 1930s.While it may be appropriate to consider the Great Depression as the best benchmark in terms of its financial triggers, it has also served as a great lesson. At present, governments and telephone exchange banks are well aware of the need to avoid the policy mistakes t hat were common at the time, both in the EU and elsewhere. Large-scale bank runs cause been avoided, monetary policy has been eased high-pressurely, and governments consume released substantial fiscal stimulus. Unlike the live on during the Great Depression, countries in Europe or elsewhere have not resorted to protectionism at the scale of the 1930s. It demonstrates the importance of EU coordination, even if this crisis provides an opportunity for throw out elevate in this regard.In its early stages, the crisis manifested itself as an acute liquidness deficit among financial institutions as they experienced ever stiffer market conditions for rolling over their (typically shortterm) debt. In this phase, concerns over the solvency of financial institutions were increasing, but a general crinkle was deemed unlikely. This scholarship dramatically changed when a study US investment bank (Lehman Brothers) defaulted in family line 2008. Confidence dampd, investors The curre nt crisis has demonstrated the importance of a coordinated manikin for crisis management. It should contain the following building blocks Crisis taproom to prevent a repeat in the future. This should be mapped onto a collective 1 European Commission Economic Crisis in Europe Causes, Consequences and Responses udgment as to what the booster cable causes of the crisis were and how changes in macroeconomic, regulatory and supervisory policy frameworks could admirer prevent their recurrence. Policies to boost potential economic growth and competitiveness could also bolster the resiliency to future crises. Crisis control and mitigation to minimise the damage by preventing general defaults or by containing the output loss and easing the social hardness stemming from recession. Its main objective is thus to stabilise the financial system and the real economy in the short run. It must be coordinated across the EU in order to strike the right balance between home(a) preoccupations and spillover effects affecting other Member States. Crisis resolution to aim crises to a lasting close, and at the lowest possible cost for the taxpayer while containing general risk and securing consumer protection. This requires reversing temporary support measures as well action to restore economies to sustainable growth and fiscal paths. Inter alia, this includes policies to restore banks balance sheets, the restructuring of the sector and an natty policy exit. An orderly exit strategy from expansionary macroeconomic policies is also an prerequisite part of crisis resolution. The beginnings of such a framework are emergent, building on existing institutions and legislation, and complemented by clean initiatives.But of course policy makers in Europe have had no choice but to employ the existing mechanisms and procedures. A framework for financial crisis prevention appeared, with hindsight, to be developing otherwise the crisis would most likely not have happened. The same held authoritative to some extent for the EU framework for crisis control and mitigation, at least at the initial stages of the crisis. Quite naturally, most EU policy efforts to date have been in the pursuit of crisis control and mitigation. But first travel have also been taken to redesign financial regulation and charge both in Europe and elsewhere with a view to crisis prevention. By contrast, the adoption of crisis resolution policies has not begun in earnest yet.This is now proper urgent not least because it should underpin the effectiveness of control policies via its impact on confidence. 2. 1. Crisis control and mitigation Aware of the risk of financial and economic meltdown central banks and governments in the European Union embarked on considerable and coordinated policy action. Financial rescue policies have focused on restoring liquidity and capital of banks and the grooming of guarantees so as to get the financial system public presentation again. Deposit gu arantees were raised. Central banks cut policy refer rates to unprecedented lows and gave financial institutions access to lender-of-last-resort facilities.Governments provided liquidity facilities to financial institutions in distress as well, along with plead guarantees on their liabilities, soon followed by capital injections and impaired summation relief. Based on the coordinated European Economy recovery Plan (EERP), a discretionary fiscal stimulus of some 2% of GDP was released of which two-thirds to be implemented in 2009 and the sell in 2010 so as to hold up demand and ease social hardship. These measures for the most part respected agreed principles of being timely and targeted, although there are concerns that in some flakes measures were not of a temporary record and therefore not easily reversed.In addition, the Stability and Growth Pact was utilize in a flexible and supportive manner, so that in most Member States the automatic fiscal stabilisers were allowed to operate unfettered. The dispersion of fiscal stimulus across Member States has been substantial, but this is generally and appropriately in line with differences in terms of their needs and their fiscal room for manoeuvre. In addition, to avoid unnecessary and irreversible destruction of (human and entrepreneurial) capital, support has been provided to hard-hit but viable industries while part-time unemployment claims were allowed on a temporary basis, with the EU taking the lead in developing guidelines on the design of labour market policies during the crisis.The EU has played an important role to provide guidance as to how enounce aid policies including to the financial sector could be shaped so as to pay respect to competition rules. Moreover, the EU has provided balance-of payments assistance jointly with the IMF and World Bank to Member States in Central and Eastern Europe, as these have been exposed to reversals of international capital flows. 2 Executive Summary Fina lly, rail EU support to economic activity was provided through advantageously change magnitude loan support from the European Investment Bank and the accelerated outgo of structural specie. These crisis control policies are gravidly achieving their objectives.Although banks balance sheets are save vulnerable to higher mortgage and credit default risk, there have been no defaults of major(ip) financial institutions in Europe and stock markets have been recovering. With short-term worry rates near the zero mark and non-conventional monetary policies boosting liquidity, stress in interbank credit markets has receded. Fiscal stimulus proves relatively effective owing to the liquidity and credit constraints facing households and businesses in the current environment. Economic contraction has been stemmed and the number of job losses contained relative to the size of the economic contraction. 2. 2. Crisis resolution ontext, the reluctance of many banks to reveal the dependable st ate of their balance sheets or to exploit the extremely favourable earning conditions induced by the policy support to repair their balance sheets is of concern. It is important as well that financial repair be done at the lowest possible long-term cost for the tax payer, not only to win political support, but also to secure the sustainability of public finances and avoid a long-lasting increase in the tax burden. Financial repair is thus prerequisite to secure a satisfactory rate of potential growth not least also because innovation depends on the availability of risk financing. Macroeconomic policies. Macroeconomic stimulus both monetary and fiscal has been utilise extensively.The challenge for central banks and governments now is to continue to provide support to the economy and the financial sector without compromising their stability-oriented objectives in the medium term. While withdrawal of monetary stimulus motionless looks some way off, central banks in the EU are de termined to unwind the supportive stance of monetary policies once inflation drive begins to emerge. At that point a apt exit strategy for fiscal policy must be heavily in place in order to pre-empt pressure on governments to set back or call off the consolidation of public finances. The fiscal exit strategy should spell out the conditions for stimulus withdrawal and must be credible, i. e. ased on pre-committed reforms of entitlements programmes and anchored in national fiscal frameworks. The withdrawal of fiscal stimulus under the EERP will be quasi automatic in 2010-11, but needs to be followed up by very substantial though differentiated across Member States fiscal consolidation to reverse the adverse trends in public debt. An appropriate mix of expenditure restraint and tax increases must be pursued, even if this is challenging in an environment where distributional conflicts are likely to arise. The quality of public finances, including its impact on work incentives and economic efficiency at large, is an overarching concern. Structural policies.Even prior to the financial crisis, potential output growth was expected to roughly halve to as half-size as around 1% by the While there is still major uncertainty surrounding the pace of economic recovery, it is now essential that exit strategies of crisis control policies be designed, and committed to. This is necessary both to ensure that current actions have the desired effects and to secure macroeconomic stability. Having an exit strategy does not involve announcing a fixed calendar for the next moves, but rather defines those moves, including their direction and the conditions that must be satisfied for making them. Exit strategies need to be in place for financial, macroeconomic and structural policies alike Financial policies.An immediate priority is to restore the viability of the banking sector. Otherwise a vicious circle of weak growth, more financial sector distress and ever stiffer credit c onstraints would inhibit economic recovery. Clear commitments to restructure and merge the banking sector should be put in place now if a Japan-like lost decade is to be avoided in Europe. Governments may hope that the financial system will grow out of its problems and that the exit from banking support would be relatively calm. But as long as there remains a lack of transparency as to the value of banks assets and their vulnerability to economic and financial developments, uncertainty remains. In this 3European Commission Economic Crisis in Europe Causes, Consequences and Responses 2020s due to the ageing population. But such low potential growth rates are likely to be recorded already in the years ahead in the wake of the crisis. As noted, it is important to resolutely repair the semipermanent-term viability of the banking sector so as to boost productivity and potential growth. But this will not suffice and efforts are also require in the area of structural policy proper. A sound strategy should include the exit from temporary measures supporting particular sectors and the preservation of jobs, and freeze off the adoption or expansion of schemes to withdraw labour supply.Beyond these defensive objectives, structural policies should include a review of social protection systems with the emphasis on the prevention of persistent unemployment and the promotion of a longer work life. further labour market reform in line with a flexicuritybased approach may also help avoid the experiences of past crises when hysteresis effects led to sustained period of very high unemployment and the permanent exclusion of some from the labour force. Product market reforms in line with the priorities of the Lisbon strategy (implementation of the single market programme especially in the area of services, measures to strangle administrative burden and to promote R and innovation) will also be distinguish to raising productivity and creating new employment opportunities.Th e transition to a low-carbon economy should be pursued through the integration of environmental objectives and instruments in structural policy choices, notably taxation. In all these areas, policies that bind a low budgetary cost should be prioritised. 2. 3. Crisis prevention particular in China, into the world economy. This prompted conjunct monetary and fiscal policies. Buoyant financial conditions also had microeconomic roots and these tended to interact with the favourable macroeconomic environment. The list of modify factors is long, including the development of complex but poorly supervised financial products and profuse short-term risk-taking.Crisis prevention policies should tackle these deficiencies in order to avoid repetition in the future. There are again agendas for financial, macroeconomic and structural policies Financial policies. The agenda for regulation and supervision of financial markets in the EU is vast. A number of initiatives have been taken already , while in some areas major efforts are still needed. Action plans have been put forward by the EU to strengthen the regulatory framework in line with the G20 regulatory agenda. With the majority of financial assets held by cross-border banks, an ambitious reform of the European system of supervision, based on the recommendations made by the High- take aim Group chaired by Mr Jacques de Larosiere, is under discussion.Initiatives to achieve better remuneration policies, regulatory coverage of hedge silver and private equity funds are being considered but have yet to be legislated. In many other areas progress is lagging. Regulation to ensure that enough provisions and capital be put aside to cope with difficult times needs to be developed, with history frameworks to evolve in the same direction. A certain degree of third estate and consistency across the rule books in Member States is important and a single regulatory rule book, as soon as feasible, desirable. It is essential that a robust and effective bank stabilisation and resolution framework is developed to govern what happens when supervision fails, including effective deposit protection.Consistency and coherence across the EU in dealing with problems in such institutions is a report requisite of a much improved operational and regulatory framework within the EU. Macroeconomic policies. Governments in many EU Member States ran a relatively A broad consensus is emerging that the ultimate causes of the crisis reside in the public presentation of financial markets as well as macroeconomic developments. in the lead the crisis broke there was a strong belief that macroeconomic asymmetry had been eradicated. Low and stable inflation with sustained economic growth (the Great Moderation) were deemed to be lasting features of the developed economies.It was not sufficiently appreciated that this owed much to the global disinflation associated with the favourable supply conditions stemming from the integrat ion of surplus labour of the emerging economies, in 4 Executive Summary accommodative fiscal policy in the good times that preceded the crisis. Although this plentynot be seen as the main culprit of the crisis, such behaviour limits the fiscal room for manoeuvre to respond to the crisis and can be a factor in producing a future one by undermining the longer-term sustainability of public finances in the face of aging populations. Policy agendas to prevent such behaviour should thus be prominent, and call for a stronger organize role for the EU alongside the adoption of credible national medium-term frameworks.Intra-area adjustment in the Economic and Monetary Union (which constitutes two-thirds of the EU) will need to become smoother in order to prevent imbalances and the associated vulnerabilities from building up. This reinforces earlier calls, such as in the Commissions emailprotected report (European Commission, 2008a), to broaden and deepen the EU control to include intra-are a competitiveness positions. Structural policies. Structural reform is among the most powerful crisis prevention policies in the longer run. By boosting potential growth and productivity it eases the fiscal burden, facilitates deleveraging and balance sheet restructuring, improves the political economy conditions for correcting cross-country imbalances, makes income redistribution writes less onerous and eases the terms of the inflation-output trade-off.Further financial development and integration can help to improve the effectiveness of and the political incentives for structural reform. at the Heads of State Level in the autumn of 2008 for the first time in history also of the Eurogroup to coordinate these moves. The Commissions role at that stage was to provide guidance so as to ensure that financial rescues attain their objectives with minimal competition distortions and shun spillovers. Fiscal stimulus also has cross-border spillover effects, through trade and financial m arkets. Spillover effects are even stronger in the euro area via the transmission of monetary policy responses.The EERP adopted in November 2008, which has defined an effective framework for coordination of fiscal stimulus and crisis control policies at large, was motivated by the recognition of these spillovers. At the crisis resolution stage a coordinated approach is necessary to ensure an orderly exit of crisis control policies across Member States. It would not be envisaged that all Member State governments exit at the same time (as this would be dictated by the national specific circumstances). But it would be important that state aid for financial institutions (or other severely affected industries) not persist for longer than is necessary in view of its mplications for competition and the functioning of the EU Single Market. National strategies for a return to fiscal sustainability should be coordinated as well, for which a framework exists in the form of the Stability and G rowth Pact which was designed to tackle spillover risks from the outset. The rationales for the coordination of structural policies have been spelled out in the Lisbon Strategy and apply also to the exits from temporary intervention in product and labour markets in the face of the crisis. At the crisis prevention stage the rationale for EU coordination is rather straightforward in view of the high degree of financial and economic integration.For example, regulatory reform gear to crisis prevention, if not coordinated, can lead to regulatory arbitrage that will affect location choices of institutions and may change the direction of international capital flows. Moreover, with many financial institutions operating cross border there is a 3. A STRONG CALL ON EU COORDINATION The rationale for EU coordination of policy in the face of the financial crisis is strong at all 3 stages control and mitigation, resolution and prevention At the crisis control and mitigation stage, EU policy ma kers became acutely aware that financial assistance by residence countries of their financial institutions and unilateral extensions of deposit guarantees entail large and potentially disrupting spillover effects. This led to emergency summits of the European Council 5European Commission Economic Crisis in Europe Causes, Consequences and Responses clear case for exchange of information and burden sharing in case of defaults. The financial crisis has clearly strengthened the case for economic policy coordination in the EU. By coordinating their crisis policies Member States heighten the credibility of the measures taken, and thus help restore confidence and support the recovery in the short term. Coordination can also be crucial to fend off protectionism and thus serves as a safeguard of the Single Market. Moreover, coordination is necessary to ensure a smooth functioning of the euro area where spillovers of national policies are particularly strong.And coordination provides incenti ves at the national level to implement growth friendly economic policies and to orchestrate a return to fiscal sustainability. Last but not least, coordination of external policies can contribute to a more rapid global solution of the financial crisis and global recovery. EU frameworks for coordination already exist in many areas and could be developed further in some. In several areas the EU has a direct responsibility and thus is the highest authority in its jurisdiction. This is the case for notably monetary policy in the euro area, competition policy and trade negotiations in the framework of the DOHA Round. This is now proving more useful than ever. In other areas, bottom-up EU coordination frameworks have been developed and should be exploited to the full.The pursuit of the regulatory and supervisory agenda implies the set-up of a new EU coordination framework which was long overdue in view of the integration of financial systems. An important framework for coordination of fis cal policies exists under the aegis of the Stability and Growth Pact. The revamped Lisbon strategy should serve as the main framework for coordination of structural policies in the EU. The balance of payment assistance provided by the EU is another area where a coordination framework has been established recently, and which could be exploited also for the coordination of policies in the pursuit of economic convergence. At the global level, finally, the EU can offer a framework for the coordination of positions in e. g. the G20 or the IMF.With the US adopting its own exit strategy, pressure to raise demand elsewhere will be mounting. The adjustment requires that emerging countries such as China reduce their national saving surplus and changed their exchange rate policy. The EU will be more effective if it also considers how policies can contribute to more balanced growth worldwide, by considering bolstering progress with structural reforms so as to raise potential output. In addition , the EU would facilitate the pursuit of this agenda by leveraging the euro and participating on the basis of a single position. 6 Part I Anatomy of the crisis 1. 1. 1. ROOT CAUSES OF THE CRISIS INTRODUCTIONThe depth and breath of the current global financial crisis is unprecedented in post-war economic history. It has several features in common with like financial-stress driven crisis episodes. It was preceded by relatively long period of rapid credit growth, low risk premiums, abundant availability of liquidity, strong leveraging, soaring asset prices and the development of bubbles in the real estate sector. Stretched leveraged positions and maturity mismatches rendered financial institutions very vulnerable to corrections in asset markets, deteriorating loan performance and disturbances in the wholesale funding markets. Such episodes have happened before and the examples are abundant (e. g.Japan and the Nordic countries in the early 1990s, the Asian crisis in the late-1990s). B ut the key difference between these earlier episodes and the current crisis is its global dimension. When the crisis broke in the late summer of 2007, uncertainty among banks rough the creditworthiness of their counterparts evaporated as they had heavily invested in often very complex and opaque and overpriced financial products. As a result, the interbank market virtually closed and risk premiums on interbank loans soared. Banks approach a serious liquidity problem, as they experienced major difficulties to rollover their short-term debt. At that stage, policymakers still perceived the crisis primarily as a liquidity problem.Concerns over the solvency of individual financial institutions also emerged, but systemic collapse was deemed unlikely. It was also astray believed that the European economy, unlike the US economy, would be largely immune to the financial turbulence. This belief was fed by perceptions that the real economy, though slowing, was thriving on strong fundamental s such as rapid export growth and sound financial positions of households and businesses. These perceptions dramatically changed in September 2008, associated with the rescue of Fannie Mae and Freddy Mac, the bankruptcy of Lehman Brothers and fears of the insurance giant AIG (which was eventually bailed out) taking down major US and EU financial institutions in its wake.Panic broke in stock markets, market valuations of financial institutions evaporated, investors rushed for the few safe havens that were seen to be left (e. g. sovereign bonds), and complete meltdown of the financial system became a genuine threat. The crisis thus began to feed onto itself, with banks forced to restrain credit, economic activity plummeting, loan books deteriorating, banks cutting down credit further, and so on. The downturn in asset markets snowballed rapidly across the world. As trade credit became meagre and expensive, world trade plummeted and industrial firms byword their sales drop and invento ries passel up. Confidence of both consumers and businesses fell to unprecedented lows. graph I. 1. Projected GDP growth for 2009 6 4 2 0 -2 -4 Nov-07 CF-NMS EC-NMS Jan-08 May-08 Mar-08 CF-UK EC-UK Jul-08 Sep-08 CF-EA EC-EA Nov-08 Jun-09 Aug-09 Aug-10 % -4. 0 -4. 3 Oct-09 Oct-10 -6 Feb-09 Sources European Commission, Consensus Forecasts chart I. 1. 2 Projected GDP growth for 2010 6 4 2 0 -2 -4 Nov-08 CF-NMS EC-NMS Jan-09 May-09 Mar-09 CF-UK EC-UK Jul-09 Sep-09 CF-EA EC-EA Dec-09 Feb-10 Jun-10 Apr-10 % -6 Sources European Commission, Consensus Forecasts This set chain of events set the scene for the deepest recession in Europe since the 1930s. Projections for economic growth were rewrite downward at a record pace (graphical records I. 1. 1 and I. 1. 2).Although the contraction now seems to have bottomed, GDP is projected to fall in 2009 by the order of 4% in the euro area and the European Union as whole with a modest pick up in activity expected in 2010. 8 Apr-09 Part I Anatomy of the crisis The situation would undoubtedly have been much more serious, had central banks, governments and supra-national authorities, in Europe and elsewhere, not responded forcefully (see Part III of this report). Policy interest rates have been cut sharply, banks have almost unlimited access to lender-oflast-resort facilities with their central banks, whose balance sheets expanded massively, and have been granted new capital or guarantees from their governments.Guarantees for savings deposits have been introduced or raised, and governments provided substantial fiscal stimulus. These actions give, however, rise to new challenges, notably the need to orchestrate a coordinated exit from the policy stimulus in the years ahead, along with the need to establish new EU and global frameworks for the prevention and resolution of financial crises and the management of systemic risk (see Part III). that point most observers were not yet alerted that systemic crisis would be a threat, bu t this began to change in the spring of 2008 with the failures of dribble Stearns in the United States and the European banks Northern Rock and Landesbank Sachsen.About half a year later, the list of (almost) failed banks had grown long enough to ring the timidity bells that systemic meltdown was around the corner Lehman Brothers, Fannie May and Freddie Mac, AIG, Washington Mutual, Wachovia, Fortis, the banks of Iceland, Bradford & Bingley, Dexia, ABN-AMRO and hypodermic syringe Real Estate. The damage would have been devastating had it not been for the numerous rescue operations of governments. When in September 2008 Lehman Brothers had filed for bankruptcy the TED spreads jumped to an unprecedented high. This made investors even more wary about the risk in bank portfolios, and it became more difficult for banks to raise capital via deposits and shares. Institutions seen at risk could no longer finance themselves and had to sell assets at fire sale prices and restrict their lend ing.The prices of similar assets fell and this reduced capital and lending further, and so on. An adverse feedback loop set in, whereby the economic downturn increased the credit risk, thus eroding bank capital further. The main response of the major central banks in the United States as well as in Europe (see Chapter III. 1 for further detail) has been to cut official attributed to a common systemic factor (see for evidence Eichengreen et al. 2009). 1. 2. A CHRONOLOGY OF THE MAIN EVENTS The heavy exposure of a number of EU countries to the US subprime problem was clearly revealed in the summer of 2007 when BNP Paribas froze redemptions for three investment funds, citing its inability to value structured products. 1 ) As a result, counterparty risk between banks increased dramatically, as reflected in soaring rates supercharged by banks to each other for short-term loans (as indicated by the spreads see Graph I. 1. 3). ( 2 ) At (1) See Brunnermeier (2009). (2) computer address default swaps, the insurance premium on banks portfolios, soared in concert. The bulk of this rise can be bps 500 400 300 200 100 0 Jan-00 Graph I. 1. 3 3-month interbank spreads vs T-bills or OIS Default of Lehman Brothers BNP Paribas suspends the valuation of two mutual funds Jan-01 Jan-02 EUR Jan-03 Jan-04 USD Jan-05 Jan-06 JPY Jan-07 Jan-08 GBP Jan-09 Sources Reuters EcoWin. 9 European Commission Economic Crisis in Europe Causes, Consequences and Responses interest rates to historical lows so as to contain funding cost of banks.They also provided supernumerary liquidity against collateral in order to ensure that financial institutions do not need to resort to fire sales. These measures, which have resulted in a massive expansion of central banks balance sheets, have been largely successful as three-months interbank spreads came down from their highs in the autumn of 2008. However, bank lending to the non-financial incorporate sector continued to taper off (Graph I. 1. 4). Cre dit stocks have, so far, not contracted, but this may merely reflect that corporate borrowers have been forced to maximise the use of existing bank credit lines as their access to capital markets was virtually cut off (risk spreads on corporate bonds have soared, see Graph I. 1. 5). Graph I. 1. Bank lending to private economy in the euro area, 2000-09 16 14 12 10 8 6 4 2 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source European Central Bank institutions incentives to sell to the government while giving taxpayers a reasonable expectation that they will benefit in the long run. Financial institutions which at the (new) market prices of toxic assets would be insolvent were recapitalised by the government. all in all these measures were aiming at keeping financial institutions afloat and providing them with the necessary breathing space to prevent a disorderly deleveraging. The verdict as to whether these programmes are sufficient is mixed (Chapter III. 1), but the order of asset relief provided seem to be roughly in line with banks needs (see again Box I. 1. ). Graph I. 1. 5 Corporate 10 year-spreads vs. Government in the euro area, 2000-09 450 350 basis points 250 cl 50 -50 Corp AAA rated Corp A rated Corp composite yield Corp AA rated Corp BBB rated y-o-y percentage change house purchases households Non-financial corporations -150 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source European Central Bank. 1. 3. GLOBAL FORCES BEHIND THE CRISIS Governments soon discovered that the provision of liquidity, while essential, was not sufficient to restore a normal functioning of the banking system since there was also a deeper problem of (potential) insolvency associated with undercapitalisation.The write-downs of banks are estimated to be over 300 trillion US dollars in the United Kingdom (over 10% of GDP) and in the range of over EUR 500 to 800 billion (up to 10% of GDP) in the euro area (see Box I. 1. 1). In October 2008, in Washington and Paris, m ajor countries agreed to put in place financial programmes to ensure capital losses of banks would be counteracted. Governments initially proceeded to provide new capital or guarantees on toxic assets. Subsequently the focus shifted to asset relief, with toxic assets interchange for cash or safe assets such as government bonds. The price of the toxic assets was generally fixed between the fire sales price and the price at maturity to giveThe proximate cause of the financial crisis is the bursting of the property bubble in the United States and the ensuing contamination of balance sheets of financial institutions around the world. But this observation does not explain why a property bubble developed in the first place and why its bursting has had such a devastating impact also in Europe. 1 needs to consider the factors that resulted in excessive leveraged positions, both in the United States and in Europe. These comprise both macroeconomic and developments in the functioning of fin ancial markets. ( 3 ) (3) See for instance Blanchard (2009), Bosworth and Flaaen (2009), Furceri and Mourougane (2009), Gaspar and Schinasi (2009) and Haugh et al. (2009). 10 Part I Anatomy of the crisis Box I. 1. 1 Estimates of financial market losses Estimates of financial sector osses are essential to inform policymakers about the severity of financial sector distress and the possible costs of rescue packages. There are several estimates quantifying the impact of the crisis on the financial sector, most recently those by the national Reserve in the framework of its Supervisory Capital Assessment Program, widely referred to as the stress test. Using different methodologies, these estimates generally cover write-downs on loans and debt securities and are usually referred to as estimates of losses. The estimated losses during the past one and a half years or so have shown a steep increase, reflecting the uncertainty regarding the nature and the extent of the crisis.IMF (2008a) and Hatzius (2008) estimated the losses to US banks to about USD 945 in April 2008 and up to USD 868 million in September 2008, respectively. This is at the lower end of predictions by RGE monitor in February the same year which saw losses in the rage of USD 1 to 2 billion. The April 2009 IMF Global Financial Stability Report (IMF 2009a) puts loan and securities losses originated in Europe (euro area and UK) at USD 1193 billion and those originated in the United States at USD 2712 billion. However, the incidence of these losses by region is more relevant in order to try on the necessity and the extent of policy intervention. The IMF estimates write-downs of USD 316 billion for banks in the United Kingdom and USD 1109 billion (EUR 834 billion) for the euro area.The ECBs loss estimate for the euro area at EUR 488 billion is substantially lower than this IMF estimate, with the discrepancy largely due to the different assumptions about banks losses on debt securities. Bank level estimates can be used in stress tests to evaluate capital adequacy of individual institutions and the banking sector at large. For example the Feds Supervisory Capital Assessment Program found that 10 of the 19 banks examined needed to raise capital of USD 75 billion. Loss estimates can also inform policymakers about the effects of losses on bank lending and the magnitude of intervention needed to pre-empt this. Such calculations require additional assumptions about the capital banks can raise or generate through their profits as well as the amount of deleveraging needed.As an illustration the table below presents four scenarios that differ in their hypothetical recapitalisation rate and their deleveraging effects The IMF and ECB estimates of total write-downs for euro area banks are taken as starting points. Net write-downs are calculated, which reflect losses that are not likely to be covered either by raising capital or by tax deductions. Depending on the scenario net losses range between 219 and 406 billion EUR using the IMF estimate, and roughly half of that based on the ECB estimate. Such magnitudes would connote balance sheets decreases amounting to 7. 3% in the mildest scenario and 30. 8% in the worst case scenario (period between August 2007 and end of 2010). Capital recovery rates and deleveraging play a crucial role in determining the magnitude of the balance sheet effect.Governments capital injections in the euro area have been broadly in line with the magnitude of these illustrative balance sheet effects, committing 226 billion EUR, half of which has been spent (see Chapter III. 1). Table 1 Balance-sheet effects of write-downs in the euro area* Scenario (1) (2) (3) Capital 1760 1760 1760 Assets 31538 31538 31538 Estimated write-downs IMF 834 834 834 ECB 488 488 488 Recapitalisation rate 65% 65% 50% Net write-downs IMF 219 219 313 ECB 128 128 183 minify in balance sheet (leverage constant) IMF -12. 4% -12. 4% -17. 8% ECB -7. 3% -7. 3% -10. 4% Change in lev erage ratio 0% -5% -5% Decrease in balance sheet (with delevraging) IMF -12. 4% -16. 8% -21. % ECB -7. 3% -11. 9% -14. 9% * Billion EUR, EUR/USD exchange rate 1. 33. Source European Commission (4) 1760 31538 834 488 35% 407 238 -23. 1% -13. 5% -10% -30. 8% -22. 2% 11 European Commission Economic Crisis in Europe Causes, Consequences and Responses As noted, most major financial crises in the past were preceded by a sustained period of buoyant credit growth and low risk premiums, and this time is no exception. Rampant optimism was fuelled by a belief that macroeconomic instability was eradicated. The Great Moderation, with low and stable inflation and sustained growth, was conducive to a perception of low risk and high return on capital.In part these developments were underpinned by genuine structural changes in the economic environment, including growing opportunities for international risk sharing, greater stability in policy making and a greater share of (less cyclical) services i n economic activity. Persistent global imbalances also played an important role. The net saving surpluses of China, Japan and the oil producing economies unbroken bond yields low in the United States, whose deep and liquid capital market attracted the associated capital flows. And notwithstanding rising commodity prices, inflation was dumb by favourable supply conditions associated with a strong expansion in labour transferred into the export sector out of rural employment in the emerging market economies (notably China).This enabled US monetary policy to be accommodative amid economic boom conditions. In addition, it may have been kept to a fault loose excessively long in the wake of the dotcom slump, with the federal funds rate persistently below the Taylor rate, i. e. the level consistent with a apathetic monetary policy stance (Taylor 2009). Monetary policy in Japan was also accommodative as it struggled with the aftermath of its late-1980s bubble economy, which entailed so -called carry trades (loans in Japan invested in financial products abroad). This contributed to rapid increases in asset prices, notably of stocks and real estate not only in the United States but also in Europe (Graphs I. 1. 6 and I. 1. 7).A priori it may not be obvious that excess global liquidity would lead to rapid increases in asset prices also in Europe, but in a world with open capital accounts this is unavoidable. To sum up, there are three main transmission channels. First, upward pressure on European exchange rates vis-a-vis the US dollar and currencies with de facto pegs to the US dollar (which includes inter alia the Chinese currency and up to 2004 also the Japanese currency), reduced import inflation and allowed an easier stance of monetary policy. Second, so-called carry trades whereby investors borrow in currencies with low interest rates and invest in higher forsaking currencies while mostly disregarding exchange rate risk, implied the spillover of global liquidit y in European financial markets. 4 ) Third, and perhaps most importantly, large capital flows made possible by the integration of financial markets were turn towards real estate markets in several countries, notably those that saw rapid increases in per capita income from comparatively low initial levels. So it is not affect that money stocks and real estate prices soared in tandem also in Europe, without entailing any upward tendency in inflation of consumer prices to speak of. ( 5 ) Graph I. 1. 6 Real house prices, 2000-09 190 180 clxx 160 150 140 130 120 110 100 90 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Index, 2000 = 100 United States United Kingdom Source OECD euro area euro area excl. Germany 500 400 300 200 100 0 03. 01. 00 12. 10. 00 Graph I. 1. 7 Stock markets, 2000-09 300 200 100 0 27. 07. 01 14. 05. 02 25. 02. 03 05. 12. 03 22. 09. 04 05. 07. 05 12. 04. 06 25. 1. 07 07. 11. 07 22. 08. 08 DJ EURO STOXX (lhs) Source www. stoxx. com DJ Emerging Europe STOXX (rhs ) Aside from the abridge whether US monetary policy in the run up to the crisis was too loose relative to the buoyancy of economic activity, there is a broader issue as to whether monetary policy should lean against asset price growth so as to prevent bubble formation. Monetary policy could be blamed at both sides of the Atlantic for (4) See for empirical evidence confirming these two channels Berger and Hajes (2009). (5) See for empirical evidence Boone and forefront den Noord (2008) and Dreger and Wolters (2009). 12 Part I Anatomy of the crisis cting too narrowly and not reacting sufficiently strongly to indications of growing financial vulnerability. The same holds true for fiscal policy, which may be too narrowly focused on the regular business roll as opposed to the asset cycle (see Chapter III. 1). Stronger emphasis of macroeconomic policy making on macro-financial risk could thus provide stabilisation benefits. This might require explicit concerns for macro-financial stab ility to be included in central banks mandates. Macro-prudential tools could potentially help tackle problems in financial markets and might help limit the need for very aggressive monetary policy reactions. 6 ) Buoyant financial conditions also had microeconomic roots and the list of contributing factors is long. The originate and distribute model, whereby loans were extended and subsequently incase (securitised) and sold in the market, meant that the creditworthiness of the borrower was no longer assessed by the originator of the loan. Moreover, expert change allowed the development of new complex financial products backed by mortgage securities, and credit rating agencies often misjudged the risk associated with these new instruments and attributed unduly triple-A ratings. As a result, risk inherent to these products was underestimated which made them look more attractive for investors than warranted.Credit rating agencies were also susceptible to conflicts of interests as they help developi