Europe Economic Crisis

ISSN 0379-0991 stinting Crisis in Europe Causes, Consequences and Responses EUROPEAN parsimony 72009 EUROPEAN COMMISSION The European Economy series contains serious reports and communications from the military commission to the Council and the Parliament on the stinting situation and developments, such(prenominal) as the frugalal forecasts, the yearbook EU delivery review and the articulate-supported ? nances in EMU report. Subscription impairment argon shown on the approve c every step to the fore and details on how to obtain the proclivity of sales agents ar shown on the inside spinal column cover.Unless oppositewise indicated, the texts be published infra the responsibility of the Directorate-General for frugal and fiscal Affairs of the European steering, BU24, B-1049 Brussels, to which enquiries former(a) than those related to sales and subscriptions should be addressed. 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Printed in Luxembourg European Commission Directorate-General for Economic and fiscal Affairs Economic Crisis in Europe Causes, Consequences and ResponsesEUROPEAN ECONOMY 7/2009 FOREWORD The European economy is in the midst of the deepest receding since the 1930s, with really gross domestic product communicate to shrink by some 4% in 2009, the sharpest contraction in the history of the European man and wife. Altho ugh signs of expediency grow appeared mod-fashionedly, recuperation re primary(prenominal)s uncertain and fragile. The EUs response to the downturn has been swift and decisive. asunder from intervention to stabilise, restore and am end up the avowing domain, the European Economic Recovery Plan (EERP) was launched in December 2008.The designate of the EERP is to restore confidence and bolster carry by dint of a ordaind injection of purchasing office into the economy complemented by strategic investments and measures to shore up crease and labour food markets. The overall monetary foreplay, including the cause of automatic stabilisers, amounts to 5% of gross domestic product in the EU. According to the Commissions analysis, unless policies take up the newly contends, dominance difference gross domestic product in the EU could fall to a retentive-livedly lower trajectory, receivable to several(prenominal) factors. First, protracted spells of unemployment in the workforce tend to lead to a permanent loss of skills.Second, the breed of equipment and infrastructure leave behind ebb and become obsolete due to lower investment. Third, innovation may be hampered as spending on research and development is one of the first outlays that businesses cut back on during a recession. part States leave implemented a range of measures to provide unstable support to labour markets, boost investment in public infrastructure and support companies. To ensure that the retrieval takes tie down and to maintain the EUs maturement potential in the coherent- phlebotomize, the focus must increasingly shift from short-term demand management to supply-side geomorphological measures.Failing to do so could impede the restructuring process or create harmful distortions to the Internal Market. Moreover, while understandably incumbent, the bold fiscal foreplay comes at a cost. On the current course, public debt in the euro welkin is communicate to reach hundred% of gross domestic product by 2014. The Stability and developing Pact provides the flexibility for the necessary fiscal stimulus in this severe downturn, simply consolidation is inevitable once the recovery takes hold and the assay of an frugal relapse has diminished sufficiently. term respecting obligations under the Treaty and the Stability and Growth Pact, a business office approach crosswise countries is appropriate, taking into account the pace of recovery, fiscal positions and debt trains, as puff up as the projected costs of ageing, external im symmetrys and gambles in the fiscal sphere of influence. Preparing stifle strategies now, not only for fiscal stimulus, except overly for authorities support for the financial sector and hard-hit industries, will enhance the effectiveness of these measures in the short term, as this depends upon clarity regarding the pace with which such measures will be get outn.Since financial markets, businesses and consumer s are forward-looking, expectations are factored into decision reservation today. The precise timing of exit strategies will depend on the strength of the recovery, the exposure of atom States to the crisis and prevailing internal and external imbalances. break away of the fiscal stimulus stemming from the EERP will taper off in 2011, merely privations to be followed up by sizeable fiscal consolidation in following old age 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 private sector gains strength, while carefully balancing financial stability with competitiveness visitations. Close coordination will be cardinal. Vertical coordination amid the various strands of economic insurance (fiscal, structural, financial) will ensure that the detachment of government measures is properly sequenced an important flip overation as turning back breakers may dif fer across insurance constitution airfields. horizontal coordination among out increase States will help them to block or manage cross- couch economic spillover effectuate, to benefit from divided learning and to leverage relationships with the outside world. Moreover, within the euro discipline, close coordination will ensure that Member States maturation trajectories do not diverge as the economy recovers. Addressing the underlying causes of diverging competitiveness must be an total part of any exit strategy.The exit strategy should in addition ensure that Europe maintains its place at the frontier of the low-carbon revolution by investing in renewable energies, low carbon technologies and green infrastructure. The aim of this study is to provide the analytical underpinning of such a coordinated exit strategy. Marco neverthelessi Director-General, DG Economic and financial Affairs, European Commission ABBREVIATIONS AND SYMBOLS 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 Germany Estonia Greece Spain France Ireland Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta The topherlands Austria Poland Portugal Romania Slovenia Slovakia Finland Sweden unite realm European Union, Member States having adopted the single currency (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 whitethorn 2004 (CZ, EE, CY, LT, LV, HU, MT, PL, SI, SK) European Union, 15 Member States onwards 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 New Bulgarian lev Czech koruna Danish krone Estonian kroon Pound sterling Magyar forint japanese yen Lithuanian litas Latvian lats New Polish zloty New Rom anian leu Swedish krona iv SKK USD Slovak koruna US sawhorse Other abbreviations BEPG Broad Economic insurance insurance Guidelines CESR Committee of European Securities Regulators EA Euro eye socket ECB European Central Bank ECOFIN European Council of Economics and Finance Ministers EDP Excessive deficit mental process EMU Economic and monetary union ERM II Exchange Rate Mechanism, mark II ESCB European System of Central Banks Eurostat Statistical Office of the European Communities FDI Foreign result investment gross domestic product unwashed domestic product GDPpc Gross Domestic mathematical product per capita GLS Generalised least(prenominal) squares HICP Harmonised index of consumer prices HP Hodrick-Prescott filterICT Information and communications technology IP Industrial Production MiFID Market in Financial Instruments leading NAWRU Non accelerating wage lump rate of unemployment NEER Nominal effective exchange rate NMS New Member States oca Optimum currency vault of heaven OLS Ordinary least squares R Research and development RAMS Recently Acceded Member States REER Real effective exchange rate SGP Stability and Growth Pact TFP Total factor productivity ULC Unit labour costs VA Value added VAT Value added valuateation v ACKNOWLEDGEMENTS This special version of the EU Economy 2009 Review Economic Crisis in Europe Causes, Consequences and Responses was prepared under the responsibility of Marco Buti, Director-General for Economic and Financial Affairs, and Istvan P. Szekely, Director for Economic Studies and Research. Paul van den Noord, Adviser in the Directorate for Economic Studies and Research, served as the spherical editor of the report.The report has drawn on substantive contributions 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 Pa ternoster, 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, Mary McCarthy, Matthias Mors, Andre Sapir, Massimo Suardi, Istvan P. Szekely, Alessandro Turrini, Michael Thiel and David Vergara. Statistical service was provided by turn 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 mail 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 insurance challenges A strong cry (out) on EU coordination 1 1 1 5 Part I class of the crisis 1. Root causes of the crisis 1. 1. 1. 2. 1. 3. gateway A chronology of the main take downts globular forces behind the crisis Introduction Great crises in the prehistorical The insurance policy response then 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. impress on actual and potential issue 1. 1. 1. 2. 1. 3. 1. 4.Introduction The push on economic performance A symmetric shock with asymmetric implications The impact of the crisis on potential harvest-feast Introduction Recent developments Labour market expectations A comparison with recent recessions Introduction Tracking developments in fiscal deficits Tracking public debt developments Fiscal stress and sovereign risk spreads Introduction bloodlines of global imbalances Global imbalances 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 IIIPolicy responses 1. A primer on financial crisis policies 1. 1. 1. 2. 1. 3. Introduction The EU crisis policy cloth The importance of EU coordination 55 56 56 58 59 2. Crisis correspond and mitigation 62 vii 2. 1. 2. 2. 2. 3. 2. 4. Introduction Banking support macroeconomic policies geomorphologic policies Introduction Crisis resolution policies Crisis legal community Introduction The pursuit of crisis resolution The business office of EU coordination 62 62 64 71 3. Crisis resolution and streak 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 contestation OF TABLES II. 1. 1. II. 1. 2. III. 1. 1. III. 2. 1. III. 2. 2.Main features of the Commission forecast The Commissio n forecast by country Crisis policy frameworks a conceptional exercise Public interventions in the banking sector Labour market and fond 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. Projected GDP growth for 2009 Projected GDP growth for 2010 3-month interbank spreads vs T-bills or OIS Bank lending to private economy in the euro area, 2000-09 Corporate 10 year-spreads vs.Government in the euro area, 2000-09 Real tolerate prices, 2000-09 Stock markets, 2000-09 GDP levels during three global crises World average of own tariffs for 35 countries, 1865-1996, un-weighted average, per cent of GDP World industrial widening during the Great 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 place during the Great Depression and the look crisis in the US and Europe Bank lending standards Manufacturing PMI and world trade Quarterly growth rank in the EU Construction bodily process and current account position Growth composition in current account surplus 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 2007-2013, virtually recently acceding Member States Potential growth by Member State Unemployment place 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 coterminous 12 months (Consumer survey) Italy Change in monthly unemployment rate Germany Unemployment expectations over future(a) 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 unify Kingdom Unemployment expectations over next 12 months (Consumer survey) United Kingdom Tracking the fiscal position against previous banking crises Change in fiscal position and employment in construction Change in fiscal position and real house prices Fiscal positions by Member State Tracking general government debt against previous banking crises Gross public debt Fiscal space by Member State, 2009 Fiscal space and ri sk premia on government affixation rejoins Current account balances Trade balance in GCC countries and oil prices The US trade deficit The Euro sports stadium trade balance Chinas GDP growth rate and current account to GDP ratio macroeconomic policy mix 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 Out tack 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 losses Capital flows and the crisis of 1929-1933 and 2008-2009 Impact of assurance losses on the real economy The growth impact of the current and previous crises Finan cial crisis and potential growth econometric register Financial crisis and potential growth evidence from simulations with QUEST Making sense of recent Chinese trade data. compendious 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 illustrations of good practice EU-level financial contributions 70 73 76 77 x EXECUTIVE SUMMARY assively liquidated their positions and fall markets went into a tailspin. From then onward the EU economy entered the steepest downturn on indicate since the 1930s. The transmission of financial distress to the real economy learnd at record speed, with credit restraint and sagging confidence hitting business investment and household demand, notably for consumer durables and living accommodations. The cross-border transmission was besides highly rapid, d ue to the tight connections within the financial trunk itself and likewise the strongly integrated supply chains in global product markets. EU real GDP is projected to shrink by some 4% in 2009, the sharpest contraction in its history.And although signs of an incipient recovery abound, this is expected to be rather sluggish as demand will remain depressed due to de supplement across the economy as comfortably as painful adjustments in the industrial structure. Unless policies change considerably, potential output growth will suffer, as parts of the smashing stock are obsolete and increase risk aversion will weigh on keen formation and R&D. The ongoing recession is thus likely to leave deep and long-lasting traces on economic performance and entail social hardship of many kinds. Job losses can be contained for some time by tensile unemployment benefit arrangements, but at last the impact of rapidly rising unemployment will be felt, with downturns in housing markets occurring s imultaneously affecting (notably highly-indebted) households.The fiscal positions of governments will continue to deteriorate, not only for cyclical reasons, but in addition in a structural manner as tax bases shrink on a permanent basis and contingent liabilities of governments stemming from bank rescues may materialise. An open question is whether the crisis will weaken the incentives for structural clear and thereby untowardly affect potential growth elevate, or whether it will provide an opportunity to acquire 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 precedent in post-war economic history. Although its size and extent are exceptional, the crisis has many features in common with interchangeable financial-stress driven recession episodes in the past.The crisis was preceded by long period of rapid credit growth, low risk premiums, abundant av ailability of fluidness, strong lever maturation, soaring plus prices and the development of blethers in the real e maintain sector. Over-stretched leveraging positions rendered financial institutions extremely vulnerable to corrections in asset markets. As a result a turn-around in a relatively small corner of the financial remains (the US subprime market) was sufficient to tap the whole structure. Such episodes oblige 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 Great 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 central banks are well aware of the need to countermand the policy mistakes that were common at the time, both in the EU and elsewhere. Larg e-scale bank runs pick up been avoided, monetary policy has been eased aggressively, and governments have released substantial fiscal stimulus. Unlike the experience 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 further progress in this regard.In its early stages, the crisis manifested itself as an acute liquidity shortage among financial institutions as they experience 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 collapse was deemed unlikely. This perception dramatically changed when a major US investment bank (Lehman Brothers) defaulted in kinfolk 2008. Confidence collapsed, investors The current crisis has demonstrated the importance of a coordinated framework for cris is management. It should contain the following twist blocks Crisis prevention 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 principal causes of the crisis were and how changes in macroeconomic, restrictive and supervisory policy frameworks could help prevent their recurrence. Policies to boost potential economic growth and competitiveness could also bolster the resilience to future crises. Crisis surmount and mitigation to minimise the damage by preventing systemic defaults or by containing the output loss and easing the social hardship 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 plate preoccupations and spillover effects affecting other Member States. Crisis resolution to bring cr ises to a lasting close, and at the lowest possible cost for the taxpayer while containing systemic 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 complicates policies to restore banks balance sheets, the restructuring of the sector and an orderly policy exit. An orderly exit strategy from expansionary macroeconomic policies is also an indispensable part of crisis resolution. The beginnings of such a framework are uphill, building on brisk institutions and legislation, and complemented by new 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 underdeveloped otherwise the crisis would most likely not have happened. The homogeneous held true to some extent for the EU framework for crisis control and m itigation, 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 steps have also been taken to design financial regulation and control both in Europe and elsewhere with a view to crisis prevention. By contrast, the adoption of crisis resolution policies has not begun in earnest barely.This is now becoming 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 massive and coordinated policy action. Financial rescue policies have focused on restoring liquidity and capital of banks and the provision of guarantees so as to get the financial system execution again. Deposit guarantees were raised. Central banks cut policy interest rates to rare lows and gave financial institutions vex to lender-of-last-resort facilities.Governments provided liquidity facilities to financial institutions in distress as well, along with state guarantees on their liabilities, soon followed by capital injections and impaired asset 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 remainder in 2010 so as to hold up demand and ease social hardship. These measures largely respected agreed principles of being timely and targeted, although there are concerns that in some cases measures were not of a temporary nature and therefore not easily reversed.In addition, the Stability and Growth Pact was applied 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 mostly speaking 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 character reference to provide guidance as to how state aid policies including to the financial sector could be shaped so as to pay respect to argument 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 expel to reversals of international capital flows. 2 Executive Summary Finally, direct EU support to economic activity was provided through substantially increased loan support from the European Investment Bank and the accelerated outlay of structural funds. These crisis control policies are largely achieving their objectives.Although banks balance sheets are still vulnerable to higher mortgage and credit default risk, there have been no defaults of major financial institutions in Europe and stock markets have been recovering. With short-term interest 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 add together 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 true state 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 stop the sustainability of public finances and avoid a long-lasting increase in the tax burden. Financial repair is thus essential 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 employed 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 still looks some way off, central banks in the EU are determined to unwind the supportive stance of monetary policies once inflation insisting begins to emerge. At that point a cred ible exit strategy for fiscal policy must be firmly in place in order to pre-empt pressure on governments to postpone 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, potenti al output growth was expected to roughly halve to as little 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 than financial sector distress and ever stiffer credit constraints would inhibit economic recovery. Clear commitments to restructure and consolidate 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 smooth. 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 decisively repair the womb-to-tomb-term viability of the banking sector so as to boost productivity and potential growth. But this will not suffice and efforts are also needed 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 resist 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 flexicurity ground approach may also help avoid the experiences of past crises when hysteresis effects led to carry on 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 reduce administrative burden and to promote R and innovation) will also be key out to raising productivity and creating new employment opportunities.The 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 carry a low budgetary cost should be prioritised. 2. 3. Crisis prevention particular in China, into the world economy. This prompted accommodative monetary and fiscal policies. Buoyant financial conditions also had microeconomic roots and these tended to interact with the favourable macroeconomic environment. The proclivity of contributing factors is long, including the development of complex but poorly supervised financial products and excessive 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 strength en 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 make by the High-Level Group chaired by Mr Jacques de Larosiere, is under discussion.Initiatives to achieve better remuneration policies, regulatory coverage of hedge funds 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 accounting frameworks to evolve in the analogous direction. A certain degree of commonality 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 key requisite of a untold 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 last-ditch causes of the crisis reside in the functioning of financial markets as well as macroeconomic developments. Before the crisis stony-broke there was a strong belief that macroeconomic instability 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 integration of surplus labour of the emerging economies, in 4 Executive Summary accommodative fiscal policy in the good tim es that preceded the crisis. Although this cannot be seen as the main perpetrator of the crisis, such behaviour traps 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 coordinating agency 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 surveillance to include intra-area competitiveness positions. Structural policies. Structural reform is among the most powerful crisis p revention policies in the longer run. By boosting potential growth and productivity it eases the fiscal burden, helps deleveraging and balance sheet restructuring, improves the political economy conditions for correcting cross-country imbalances, makes income redistribution issues 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 enter upon their objectives with minimal competition distortions and negative spillovers. Fiscal stimulus also has cross-border spillover effects, through trade and financial markets. Spillover effects are even stronger in the euro area via the transmission of monetary policy r esponses.The EERP adopted in November 2008, which has delimit 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 Growth Pact which was designed to tackle spillover risks from the outset. The precepts for the coordi nation 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 geared to crisis prevention, if not coordinated, can lead to regulatory arbitrage that will affect situation 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 three stages control and mitigation, resolution and prevention At the crisis control and mitigation stage, EU policy makers became acutely aware that financial assistance by home countries of their financial instit utions 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 overlap 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 incentives at the national level to implement growth friendly economic policies and to mastermind 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 fiscal policies exists under the aegis of the Stability and Growth Pact. The revamped Lisbon strategy s hould serve as the main framework for coordination of structural policies in the EU. The balance of payment assistance provided by the EU is other 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 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 near 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 merchandise growth and sound financial positions of households and businesses. These perc eptions 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 unquestionable 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 range and inventories pile up. Confidence of both consumers and businesses fell to unprecedented lows. graphical record 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 Graph 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 depiction for the deepest recession in Europe since the 1930s. Projections for economic growth were revised downward at a record pace (Graphs 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 low-pitched 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 ba nks, 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 unfathomable 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 nest egg 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, but this began to change in the springiness of 2008 with the failures of Bear 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 alarm 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 Hypo Real Estate. The damage would have been devastating had it not been for the numerous rescue trading 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 lending.The prices of similar assets fell and this reduced capital and lending further, and so o n. An adverse feedback loop set in, whereby the economic downturn increased the credit risk, thus wear away 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 ricocheted 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) adopt Brunnermeier (2009). (2) Credit default swaps, the insurance premium on banks portfolios, soared in concert. The bulk of this r ise 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 additional 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 corporate sector continued to taper off (Graph I. 1. 4). Credit 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 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 disaster I. 1. ). Graph I. 1. 5 C orporate 10 year-spreads vs. Government in the euro area, 2000-09 450 350 basis points 250 150 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 piece of ass 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 meg US dollars in the United Kingdom (over 10% of GDP) and in the range of over EUR 500 to 800 one thousand thousand (up to 10% of GDP) in the euro area (see Box I. 1. 1). In October 2008, in Washington and Paris, major 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 exchanged for specie or safe assets such as government bonds. The price of the toxic assets was for the most part fixed between the fire sales price and the price at maturity to giveThe proximate cause of the financial crisis is the bursting of the plaza bubble in the United States and the ensuing contamination of balance sheets of financial institutions around the world. But this thoughtfulness 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. One 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 financial markets. ( 3 ) (3) See for instance Blanchard (2009), Bosworth and F laaen (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 Federal 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 200 8 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 judge 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 divergency 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 institut ions 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 imply 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). plank 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 Decrease in balance sheet (leverage constant) IMF -12. 4% -12. 4% -17. 8% ECB -7. 3% -7. 3% -10. 4% Change in leverage 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 contributive 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 in economic activity. Persistent global imbalances also played an important r ole. The net saving surpluses of China, Japan and the oil producing economies kept 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 muted 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 too loose too 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 neutral 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 rapi d 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 unmistakable 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 trade 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 yielding currencies while mostly disregarding exchange rate risk, implied the spillover of global liquidity in European financial markets. 4 ) Third, and perhaps most importantly, large capital flows mad e possible by the integration of financial markets were diverted 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 surprising that bullion 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 one hundred seventy 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 issue whether US monetary policy in the run up to the cri sis 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 Van 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 cycle 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 stability to be include in central banks mandates. Macro-prudential tools could potenti ally 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 packaged (securitised) and sold in the market, meant that the creditworthiness of the borrower was no longer assessed by the originator of the loan. Moreover, technological change allowed the development of new complex financial products approve 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