Thursday, 16 February 2012
The Eurozone Financial Crisis
The depth and breath of the current global financial crisis is unprecedented in post-war
economic history. It has several features incommon with similar 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).
But 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 about 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 faced 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 widely 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 fundamentals 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 it
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 scarce and expensive, world trade
plummeted and industrial firms saw their sales drop and inventories pile up. Confidence of both
consumers and businesses fell to unprecedented low
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