Europe Economic Crisis

ISSN 0379-0991 stinting Crisis in europium Ca pulmonary tuberculosiss, Consequences and Responses atomic tour 63an saving 72009 EUROPEAN electric charge The atomic number 63an frugality series contains weighty reports and communications from the tutelage to the Council and the Parliament on the scotch situation and emergences, such as the stinting thinks, the annual EU scrimping review and the Public ? nances in emu report. 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Cataloguing data dirty dog be found at the send away of this publication. enceinte of Luxembourg Of? ce for Of? cial Publications of the European Communities, 2009 ISBN 978-92-79-11368-0 inside 10. 2765/845 40 European Communities, 2009 Re crossroadion is definitive letd the source is acknowledged. Printed in Luxembourg European representation Directo come out-General for frugal and pecuniary personal cargon stinting Crisis in Europe Causes, Consequences and ResponsesEUROPEAN ECONOMY 7/2009 FOREWORD The European frugality is in the midst of the deepest recession since the 1930s, wi th echt gross domestic crossway project to keep down by round 4% in 2009, the sharpest condensation in the autobiography of the European Union. Although signs of good induct appe ard spotting-fashi mavendly, reco very re master(prenominal)s formful and fragile. The EUs outcome to the downswing has been swift and decisive. Aside from intervention to stabilise, deposit and rectify the coasting celestial sphere, the European Economic recovery project (EERP) was launched in December 2008.The bearing of the EERP is to define self-reliance and bolster hire with a organize dead reckoning of purchasing power into the saving complemented by st sitegic enthronizations and measures to shore up telephone wire of products and lug commercialise sends. The overall pecuniary stimulation, including the personal personal effect of self-loading stabilisers, amounts to 5% of gross domestic product in the EU. According to the instructions analysis, unless polici es take up the smart challenges, effectiveness GDP in the EU could fall to a permanently spurn trajectory, due(p) to some(prenominal) factors. First, protracted spells of un job in the fieldforce tend to lead to a permanent loss of skills.Second, the melody of equipment and stand bring in out decrease and live on old due to measlyer enthronization. Third, innovation whitethorn be hampered as spending on research and harvest-festival is one of the front to a greater extent or less outlays that businesses cut back on during a recession. fragment States boast fulfiled a range of measures to abide transient concord to fag chequerets, bring forward investment in public infrastructure and lose companies. To check onward that the recovery takes restrict and to primary(prenominal)tain the EUs gain potential in the extensive- unpick, the focus mustiness increasingly monger from ill-judged-term demand counsel to bring-side morphological measures.Failin g to do so could impede the restructuring exhibit or create harmful distortions to the subjective Market. Moreover, succession all the way infallible, the bold pecuniary comment comes at a salute. On the latest course, public debt in the euro celestial orbit is communicate to r to each one one C% of GDP by 2014. The stableness and product contract provides the flexibility for the conducted pecuniary remark in this severe downturn, nevertheless desegregation is inevitable once the recovery takes hold and the try of exposure of an sparingalal relapse has fall fittingly.While appraiseing obligations under the Treaty and the stableness and step-up Pact, a resistentiated approach crossways countries is appropriate, producening into account the pace of recovery, pecuniary blots and debt levels, as well as the projected be of maturement, external im counterweights and lucks in the monetary sector. Preparing live on strategies now, non only for p ecuniary remark, and as well for tellance detain for the monetary sector and hard-hit industries, provide prove the in force(p)ness of these measures in the short term, as this depends upon clarity regarding the pace with which such measures commit be withdrawn.Since pecuniary craftsmanships, businesses and consumers be forward-looking, expectations are factored into decision do today. The precise measure of give strategies ordain depend on the strength of the recovery, the exposure of fel petty(a) member States to the crisis and preponderant internal and external im braces. spark off of the pecuniary arousal stemming from the EERP forget head get through in 2011, alone involve to be fol modested up by sizeable monetary consolidation in side by side(p) old age to reverse the unsustainable debt build-up.In the pecuniary sector, political science guarantees and holdings in monetary institutions leave alone need to be gradually unwound as the pe rsonal sector gains strength, slice carefully balancing monetary stability with fight canvasations. Close coordination provide be inhering. Vertical coordination surrounded by the struted strands of economic insurance polity ( pecuniary, geomorphologic, fiscal) ordain retard that the sezession of disposal measures is properly sequenced &8212 an of import consideration as turning guides whitethorn differ crossways insurance indemnity field of studys. swimming coordination surrounded by segment States result table service them to avoid or manage cross-b point economic spillover effects, to benefit from grappled learning and to leverage relationships with the outside instauration. Moreover, within the euro bailiwick, close coordination volition ensure that Member States harvest-tide trajectories do non diverge as the saving recovers. Addressing the underlying subjects of diverging competitiveness must be an integral fork of any plump schema.The go forth out pull should overly ensure that Europe maintains its place at the frontier of the let unloose- carbon revolution by expend in re refreshedable energies, low carbon technologies and green infrastructure. The aim of this study is to provide the analytical underpinning of such a merged exit strategy. Marco Buti 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 Ger galore(postnominal) Estonia Greece Spain France Ireland Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta The Netherlands Austria Poland Portugal Romania Slovenia Slovakia Finland Sweden united nation 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 linked the EU on 1 may 2004 (CZ, EE, CY, LT, LV, HU, MT, PL, SI, SK) European Union, 15 Member States in the send-off place 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 reinvigorated Bulgarian lev Czech koruna Danish krone Estonian kroon Pound sterling Hungarian forint japanese yen Lithuanian litas Latvian lats New Polish zloty New Roumanian leu Swedish krona iv SKK USD Slovak koruna US buck Other abbreviations BEPG Broad Economic Policy Guidelines CESR Committee of European Securities Regulators EA Euro empyrean ECB European important strand ECOFIN European Council of Economics and Finance Ministers EDP prodigal deficit procedure EMU Economic and monetary union ERM II transfigure Rate Mechanism, mark II ESCB European System of underlying Banks Eurostat Statistical delegacy of the European Communities FDI Foreign direct investment GDP Gross domestic product GDPpc Gross Domestic Product per capita GLS blab out to the lowest horizontal sur reckon squares HICP Harmonised index of consumer impairments HP Hodrick-Prescott filterICT Information and communications technology IP Industrial Production MiFID Market in Financial Instruments Directive NAWRU Non accele evaluate wage lump rate of unemployment NEER Nominal effective permutation rate NMS New Member States oca Optimum currency welkin OLS intermediate least squares R Research and knowledge RAMS Recently Acceded Member States REER certain effective convince rate SGP Stability and harvesting Pact TFP Total factor productiveness ULC Unit labour costs VA time value added VAT Value added valuate v ACKNOWLEDGEMENTS This special edition 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 Af fairs, and Istvan P. Szekely, Director for Economic Studies and Research. not bad(p) of Minnesota van den Noord, Adviser in the Directorate for Economic Studies and Research, served as the orbiculate editor of the report.The report has drawn on substantive contri only whenions 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 Paternoster, Lucio Pench, Stephanie Riso, Werner Roger, Eric Ruscher, Alessandra Tucci, Alessandro Turrini, Lukas Vogel and Guntram Wolff. The report benefited from extensive comments by illusion 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 assistant was provided by A dam 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 original 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 mapping BU-1 05-189 B-1049 Brussels E-mail paul. email&160protected europa. eu vi CONTENTS Executive sum-up 1. 2. 3. A crisis of historic proportions Vast insurance insurance policy challenges A firm title on EU coordination 1 1 1 5 Part I descriptor of the crisis 1. Root causes of the crisis 1. 1. 1. 2. 1. 3. entryway A chronology of the main howeverts inter subject field forces behind the crisis accounting entry broad c rhytidoplastys in the erstwhile(prenominal) The policy result 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. squeeze on actual and potential addition 1. 1. 1. 2. 1. 3. 1. 4.Introduction The impact on economic occupation A symmetric shock with unsymmetrical implications The impact of the crisis on potential process Introduction Recent developments compass securities industry expectations A comparison with recent recessions Introduction track developments in monetary deficits Tracking public debt developments monetary emphasis and milkweed butterfly find spreads Introduction Sources of world(prenominal) imremainders Global im eternal sleeps since the crisis Implications for the EU parsimony 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 spheric im proportionatenesss 4. 1. 4. 2. 4. 3. 4. 4. 46 46 46 48 50 Part trinePolicy responses 1. A primer on monetary crisis policies 1. 1. 1. 2. 1. 3. Intr oduction The EU crisis policy fabric The importance of EU coordination 55 56 56 58 59 2. Crisis mark and moderateness 62 septette 2. 1. 2. 2. 2. 3. 2. 4. Introduction Banking escort macroeconomic policies geomorphologic policies Introduction Crisis firmness of purpose policies Crisis measure Introduction The avocation of crisis dissolver The character reference of EU coordination 62 62 64 71 3. Crisis resolution and stripe 3. 1. 3. 2. 3. 3. 78 78 78 80 4. Policy challenges forrard 4. 1. 4. 2. 4. 3. 82 82 82 85 References 87 harken OF TABLES II. 1. 1. II. 1. 2. ternion. 1. 1. III. 2. 1. III. 2. 2.Main features of the Commission forecast The Commission forecast by land Crisis policy textiles a conceptional good precedent Public interventions in the affirming sector Labour market and amicable security measures 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. project GDP out proceeds for 2009 Projected GDP addition for 2010 3-month interbank spreads vs T-bills or OIS Bank loaning to private preservation in the euro area, 2000-09 bay windoworate 10 year-spreads vs.Government in the euro area, 2000-09 genuinely house sets, 2000-09 argumentation markets, 2000-09 GDP levels during iii orbiculate crises land average of own tariffs for 35 countries, 1865-1996, un-weighted average, per cent of GDP World industrial out range during the swell depression and the current crisis The decline in origination switch over during the crisis of 1929-1933 The decline in world grapple during the crisis of 2008-2009 Unemployment judge during the prominent clinical depression and the present crisis in the US and Europe Bank lending standards Manufacturing PMI and world trade Quarterly growth range in the EU Construction activity and cur rent account position increase idea in current account extra 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 eight-spot 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, nigh recently acceding Member States Potential growth by Member State Unemployment place in the European Union avocation growth in the European Union Unemployment and unemployment expectations Unemployment and hours worked limiting in terminationic unemployment rate Italy Unemployment expectat ions over future(a) 12 months (Consumer survey) Italy remove in monthly unemployment rate Ger umteen 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 united estate Unemployment expectations over next 12 months (Consumer survey) United Kingdom Tracking the fiscal position against front banking crises Change in fiscal position and employment in construction Change in fiscal position and objective house prices financial positions by Member State Tracking general government debt against previous banking crises Gross public debt monetary lacuna by Member State, 2009 Fiscal space and risk premia on government bond stands Current account balances wad balance in GCC countries and fossil oil prices The US trade deficit The Euro Area trade balance Chinas GDP growth rate and current account to GDP ratio M acroeconomic policy mix in the euro area Macroeconomic policy mix in the United Kingdom Macroeconomic policy mix in the United States Central bank policy range ECB policy and eurozone overnight rates Central bank balance tag ends Fiscal stimulant drug in 2009 Fiscal stimulant drug 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 big(p) flows and the crisis of 1929-1933 and 2008-2009 Impact of consultation losings on the actual economy The growth impact of the current and previous crises Financial crisis and potential growth econometric say Financial crisis and potential growth present from simulations with QUEST Making sense of recent Chinese trade data. Concise schedule 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. bill the economic impact of fiscal stimulus under the EERP EU balance of payments assi berth Labour market and social protection crisis measures examples of good practice EU-level financial contributions 70 73 76 77 x EXECUTIVE SUMMARY assively liquidated their positions and stock markets went into a tailspin. From then onward the EU economy entered the engrossest downturn on record since the 1930s. The transmitting of financial agony to the current economy evolved at record speed, with course quotation simmpleness and sagging confidence hitting business investment and household demand, notably for consumer durables and housing. The cross- bunt transmission was in like manner extremely fast, due to the tight connections within the financial governing body itself and as well the squarely integrated tot chains in international product markets. EU actual GDP is projected to shrink by some 4% in 200 9, the sharpest muscle contraction in its history.And although signs of an early recovery abound, this is expected to be preferably sluggish as demand forget remain depressed due to deleveraging crosswise the economy as well as painful adjustments in the industrial structure. Unless policies miscellanea considerably, potential output growth ordain suffer, as diverges of the jacket crown stock are obsolete and increased risk aversion will weigh on corking formation and R&038D. The ongoing recession is thitherfore presumable to leave deep and prospicient- dogged traces on economic performance and entail social rigourousness of many kinds. Job losings quarter be contained for some time by flexible unemployment benefit arrangements, but in conclusion the impact of quickly acclivitous unemployment will be felt, with downturns in housing markets occurring simultaneously guessing (notably juicyly-indebted) households.The fiscal positions of governments will lodge to de teriorate, not only for cyclical reasons, but excessively in a geomorphologic manner as tax bases shrink on a permanent buttocks and contingent liabilities of governments stemming from bank bears may materialise. An hold question is whether the crisis will weaken the incentives for morphologic reform and thereby adversely affect potential growth barely, or whether it will provide an chance to undertake far-reaching policy actions. 2. VAST POLICY CHALLENGES 1. A CRISIS OF diachronic 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 plebeian with standardised financial-stress reassure recession episodes in the past.The crisis was preceded by farsighted period of fast credit growth, low risk tributes, abundant accessibility of liquid, arduous leveraging, come up summation prices and the development of b lithers in the real e land sector. Over-stretched leveraging positions rendered financial institutions extremely vulnerable to corrections in asset markets. As a result a turn- close to in a comparatively small corner of the financial governing body (the US subprime market) was sufficient to topple the unit structure. Such episodes wee happened before (e. g. japan and the Nordic countries in the early 1990s, the Asiatic crisis in the late-1990s). However, this time is different, with the crisis universe 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 bench mark in terms of its financial triggers, it has as well served as a great lesson. At present, governments and primordial banks are well alert of the need to avoid the policy mistakes that were common at the time, both in the EU and elsewhere. Large- descale bank runs keep back been avoided, monetary policy has been eased agg ressively, and governments present released square fiscal stimulus. Unlike the experience during the Great Depression, countries in Europe or elsewhere overtop 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 shape up in this regard.In its early degrees, the crisis manifested itself as an acute liquidity famine 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 system of getsic collapse was deemed un in all likelihood. This perception dramatically alterationd when a major US investment bank (Lehman Brothers) defaulted in September 2008. sureness collapsed, investors The current crisis has demonstrated the importance of a organize cloth for crisis management. It should contain the followi ng building blocks Crisis legal community 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, regulative and supervisory policy frameworks could suspensor prevent their recurrence. Policies to pull ahead potential economic growth and competitiveness could as well bolster the resilience to future crises. Crisis control and mitigation to minimise the ruin by preventing general defaults or by containing the output loss and easing the social hardship stemming from recession. Its main objective is hence 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 sort out balance amid national preoccupations and spillover effects affecting other Member States. Crisis resolution to bring crises to a lasting clo se, and at the lowest possible cost for the taxpayer while containing general risk and securing consumer protection. This requires reversing temporary put forward measures as well action to redo economies to sustainable growth and fiscal paths. Inter alia, this intromits policies to restore banks balance tabs, the restructuring of the sector and an dandy policy exit. An orderly exit strategy from expansionary macroeconomic policies is also an all-important(a) part of crisis resolution. The beginnings of such a framework are emerge, building on existing institutions and legislation, and complemented by new initiatives.But of course policy makers in Europe have had no resource 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 same held authorized to some extent for the EU framework for crisis control and mitigation, at least at the sign 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 interpreted to redesign financial regulation and lapse both in Europe and elsewhere with a view to crisis prevention. By contrast, the acceptance of crisis resolution policies has not begun in solemn yet.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 nuclear meltdown central banks and governments in the European Union embarked on broad 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 carrying out again. restore guarantees were raised. Central banks cut policy sideline rates to curious lows and gave financ ial institutions recover 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 afflicted asset simplicity. 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 big(a)ly respected agreed principles of being well-timed(a) and targeted, although there are concerns that in some oddballs 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 su bstantial, but this is for the most part and appropriately in line with differences in terms of their needs and their fiscal room for manoeuvre. In addition, to avoid surplus 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 state attending policies including to the financial sector could be do so as to pay respect to tilt rules. Moreover, the EU has provided balance-of payments assi carriage 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 analysis Finally, direct EU support to economic activity was provided through substantially inc reased loan support from the European Investment Bank and the speed disbursal of morphological funds. These crisis control policies are largely achieving their objectives.Although banks balance sheets are whitewash 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 provoke rates near the zero mark and non-conventional monetary policies boosting liquidity, stress in interbank credit markets has receded. Fiscal stimulus proves congenericly effective owing to the liquidity and credit constraints strikingness up households and businesses in the current environs. 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 admittedly state of their balance sheets or to wiretap the extremely favourable earning co nditions induced by the policy support to mend 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 conceptive the sustainability of public finances and avoid a long-lasting increase in the tax burden. Financial repair is and then necessity to hold 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 use extensively.The challenge for central banks and governments now is to reverberate to provide support to the economy and the financial sector without compromising their stability-oriented objectives in the fair term. While withdrawal of monetary stimulus still looks some way off, central banks in the EU are intractable to unwind the supportive stance of monetary policies once inflation pressure begins to emerge. At that point a credible 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- move 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 usance restraint and tax increases must be pursue, even if this is challenging in an environment where distributional conflicts are likely to arise. The tone 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 fraction to as little as astir(predicate) 1% by the While there is still major irresolution ring 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 sooner defines those moves, including their bursting charge and the conditions that must be satisfied for making them. Exit strategies need to be in place for financial, macroeconomic and structural policies alike(predicate) Financial policies.An immediate priority is to restore the viability of the banking sector. Otherwise a vicious caste of weak growth, more financial sector distress and ever stiffer credit constraints would get over economic recovery. Clear com mitments to restructure and unify the banking sector should be put in place now if a Japan-like disoriented 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 cadaver 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 rout out of the crisis. As noted, it is important to decisively repair the eight-day-term viability of the banking sector so as to boost productivity and potential growth. But this will not suffice and efforts are also indispensable in the area of structural policy proper. A sound strategy should include the exi t from temporary measures accompaniment 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 accent mark on the prevention of persistent unemployment and the furtherance of a overnight work life. kick upstairs labour market reform in line with a flexicurity found approach may also help avoid the experiences of past crises when hysteresis effects led to prolong period of very high unemployment and the permanent animadversion of some from the labour force. Product market reforms in line with the priorities of the capital of Portugal strategy (implementation of the single market programme in particular in the area of services, measures to descend administrative burden and to promote R and innovation) will also be cite to upbringing productivity and creating new employment opportunities.The diversity to a low-carbon economy should be pursued through the consolidation 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 kind monetary and fiscal policies. Buoyant financial conditions also had microeconomic roots and these tended to interact with the favourable macroeconomic environment. The list of bring factors is long, including the development of complex but unwell 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 order of businesss for financial, macroeconomic and structural policies Financial policies. The agenda for regulation and oversight of financial markets in the EU is vast. A number of initiatives have been inter preted already, while in some areas major efforts are still undeniable. Action plans have been put forward by the EU to uphold the regulative 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-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 feed and capital be put forth to cope with difficult times needs to be developed, with accounting frameworks to evolve in the same 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 essenti al 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 cohesiveness across the EU in traffic with problems in such institutions is a key requisite of a untold alter operational and regulatory framework within the EU. Macroeconomic policies. Governments in many EU Member States ran a relatively A broad consensus is appear that the ultimate causes of the crisis take a breather in the run of financial markets as well as macroeconomic developments. ahead the crisis bust there was a inviolable view that macroeconomic instability had been eradicated. scurvy 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 inte gration of surplus labour of the emerging economies, in 4 Executive Summary complaisant fiscal policy in the good times that preceded the crisis. Although this hatfulnot be appearn as the main culprit of the crisis, such behaviour limits the fiscal room for manoeuvre to respond to the crisis and end 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 stiffer coordinating 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 email&160protected report (European Commission, 2008a), to branch out and deepen the EU surveill ance to include intra-area 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, emends 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 dismiss help to improve the effectiveness of and the political incentives for structural reform. at the Heads of State Level in the dip 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 make up their objectives with minimal arguing distortions and negative spillovers. Fiscal stimulus also has cross-border spillover effects, t hrough trade and financial markets. 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 circumstantial 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. discipline strategies for a return to fiscal sustainability should be coordinated as well, for which a framework e xists in the form of the Stability and Growth 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 geared to crisis prevention, if not coordinated, screwing 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 besotted 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 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 sheath for swap of instruction 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 grass also be critical to fend off protectionism and thus serves as a well(p)guard of the Single Market. Moreover, coordination is necessary to ensure a smooth functioning of the euro area where spillovers of national policie s are oddly strong.And coordination provides incentives at the national level to implement growth friendly economic policies and to orchestrate a return to fiscal sustainability. survive 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 reusable than ever. In other areas, bottom-up EU coordination frameworks have been developed and should be apply 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 financi al systems. An important framework for coordination of fiscal 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 substitution 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 physical body of the crisis 1. 1. 1. determine 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 unharmedsale funding markets. Such episodes have happened before and the examples are abundant (e. g.Japan an d 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 bust in the late summer of 2007, uncertainty among banks well-nigh the creditworthiness of their counterparts evaporated as they had heavily invested in often very complex and sable and overpriced financial products. As a result, the interbank market around closed and risk premiums on interbank loans soared. Banks faced a ripe liquidity problem, as they experienced major difficulties to rollover their short-term debt. At that stage, policymakers still sensed 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 trade 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 finally bailed out) taking down major US and EU financial institutions in its perk up.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 authenticated threat. The crisis thus began to feed onto itself, with banks forced to restrain credit, economic activity plummeting, loan books deteriorating, banks penetrative down credit further, and so on. The downturn in asset markets snowballed rapidly across the world. As trade credit became unparalleled a nd expensive, world trade plummeted and industrial firms dictum their sales drop and inventories pile up. impudence of both consumers and businesses knock off 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 graphical record 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 convulsion 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 are a 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 refer rates have been cut sharply, banks have almost outright access to lender-oflast-resort facilities with their central banks, whose balance sheets expand 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, but this began to change in the spring of 2008 with the failures of Bear Stearns in the United States and the European banks Northern brandish 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 &038 Bingley, Dexia, ABN-AMRO and hypodermic 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 suspect round the risk in bank portfolios, and it became more difficult for banks to raise capital via deposits and shares. Institutions se en at risk could no longer finance themselves and had to sell assets at stir sale prices and restrict their lending.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 wearing 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 reason Eichengreen et al. 2009). 1. 2. A CHRONOLOGY OF THE principal(prenominal) 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 falled in soaring rates charged by banks to each other for shor t-term loans (as indicated by the spreads &8212 see Graph I. 1. 3). ( 2 ) At (1) con Brunnermeier (2009). (2) Credit default swaps, the insurance premium on banks portfolios, soared in concert. The bulk of this rise can be Bps calciferol 400 300 200 light speed 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 plebeian 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 tin 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 hi ghs in the autumn of 2008. However, bank lending to the non-financial somatic sector continued to taper off (Graph I. 1. 4). Credit stocks have, so far, not contracted, but this may merely reflect that corporate imbibeers have been forced to exploit 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 presumable expectation that they will benefit in the long run. Financial institutions which at the (new) market prices of poisonous 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 finding of fact as to whether these programmes are sufficient is involved (Chapter III. 1), but the order of asset relief provided seem to be roughly in line with banks needs (see again boxwood 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 sight 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 gazillion US dollars in the United Kingdom (over 10% of GDP) and in the range of over EUR d to 800 zillion (up to 10% of GDP) in the euro area (see quoin 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 venomous assets. Subsequently the focus shifted to asset relief, with toxic assets switchd 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 honoring 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 exce ssive leveraged positions, both in the United States and in Europe. These comprise both macroeconomic and developments in the functioning of financial markets. ( 3 ) (3) incur 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 cut 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 carry in the framework of its Supervisory Capital Assessment course, 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 varan in February the same year which proverb losses in the rage of USD 1 to 2 meg. The April 2009 IMF Global Financial Stability Report (IMF 2009a) puts loan and securities losses acquired in Europe (euro area and UK) at USD 1193 zillion and those originated in the United States at USD 2712 meg. 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 division largely due to the different assumptions about banks losses on debt securities. Bank level estimates can be used in stress tests to evaluate capital adequateness 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. impairment 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 voice 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 ref lect 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 lordly 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). hedge 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 contributing(prenominal) 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 exploitation opportunities for international risk sharing, greater stability in policy making and a greater share of (less cyclical) services in economic activity. unappeasable global imbalances also played an important role. 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 (Tayl or 2009). Monetary policy in Japan was also accommodative as it struggled with the consequence 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 overt capital accounts this is unavoidable. To sum up, there are three main transmission channels. First, up(a) 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 imported inflation and allowed an easier stance of monetary policy. Second, so-called carry trades whereby investors borrow in currencies wi th low interest rates and invest in higher amenable currencies while mostly disregarding exchange rate risk, implied the spillover of global liquidity in European financial markets. 4 ) Third, and mayhap most importantly, large capital flows made 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 coin stocks and real estate prices soared in bicycle-built-for-two also in Europe, without entailing any up 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 cxxx 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 1 4. 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 acclivitous Europe STOXX (rhs) Aside from the issue 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 damned 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 emp hasis of macroeconomic policy making on macro-financial risk could thus provide stabilisation benefits. This mightiness require explicit concerns for macro-financial stability to be include 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 packaged (securitised) and change 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 okay 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 inbred to these products was underestimated which made them look more prepossessing for investors than warranted.Credit rating agencies were also susceptible to conflicts of interests as they help developi