Princeton Professor Speaks About The Eurozone Crisis
Published: Thursday, December 6, 2012
Updated: Wednesday, January 9, 2013 20:01
The economic disaster that currently plagues the Eurozone is a result of three interlocking crises relating to sovereign debt, banking, and balance of payments, according to Princeton University professor Hyun Song Shin, who spoke at Boston College Tuesday.
Shin’s lecture, entitled “The Euro Crisis through the Lens of Capital Flow Reversals,” was the seventh of eight in the BC International Economic Policy and Political Economy Seminar series, which has featured speakers from the academic world as well as from policy institutions throughout the fall semester.
The series, sponsored by the BC Institute for the Liberal Arts, focuses on policymaking for the present-day economic climate, emphasizing political and strategic outlooks.
As the Hughes-Rogers Professor of Economics at Princeton, Shin is an Oxford-educated expert in macroeconomics and economic finance, and began his discussion with basic banking concepts and methods in order to more clearly explain the current situation in Europe.
On the liabilities side of a bank’s balance sheet, Shin specified that there are core liabilities, which include those to domestic households and non-financial claim holders; these amount to depositors’ wealth and are very stable. There are also non-core liabilities, those to financial intermediaries and foreign creditors.
It is non-core liabilities, Shin said, that reflect the expansion of lending beyond “normal” levels, indicating that banks must turn to foreign creditors in addition to domestic depositors when they need to borrow more money to then lend to new borrowers.
Where this practice becomes dangerous is when loans financed by non-core liabilities are of lower credit quality than those funded by core liabilities. Shin explained that during an economic boom, new borrowers who may not have had access to credit before are given loans by expanding banks, yet these borrowers have a lower ability to repay their loans, and the loans are subsequently of lower quality, making for the beginnings of a credit crisis.
“The aftermath of a big credit boom is associated with a bad headache,” Shin said.
Turning to the real European crisis, specifically that of Spain, Shin highlighted the fact that, in the period from 1998 to 2008, credit issued to Spanish borrowers increased five-fold.
One may ask where banks obtained so much money to lend, and the answer, Shin said, can be found in foreign creditors. Until the introduction of the Euro in 1998, Spanish banks could raise nearly all of the money they lent domestically, though in 2008, at the dawn of the crisis, half of the 2 trillion Euros they were lending came from abroad.
Countries such as Germany, Finland, and the Netherlands previously funded other European nations directly—however, now they do so indirectly though the European Central Bank. The Eurosystem funds the central banks of individual countries, such as the Bank of Spain, so that they can then fund commercial banks in the absence of abundant foreign creditors, or a “sudden stop” of capital inflows.
With this practice occurring, the ratio of non-core to core liabilities gets higher, indicating a dangerous boom with the potential for low-quality credit. Spanish banks began issuing more long-term covered bonds, many issued only to borrow from the central bank.
“The Euro experiment is unique because it involves cross-border borrowing, cross-border capital flows, but borrowing in [domestic] currency,” Shin said. While it may seem that continuously borrowing from the European Central Bank could be a long-term solution to the Spanish crisis, this can only occur if high-quality loans are being issued. Otherwise, borrowers will eventually default.
Shin utilized the economic crisis suffered by Japan beginning in the 1990s as a parallel for Spain’s crisis, emphasizing that bad loans issued during a bubble phase have to be resolved eventually, despite political hesitations to recognizing losses.
“The politics really push you against recognizing your losses,” Shin said. “[The] temptation is to always kick the can further down the road.”
According to Shin, it took about seven years for Japan to “clean up its balance sheets” through deleveraging, which involves reducing debt in both private and public sectors. Spain has yet to begin this process, though European loans are still following the Japanese trajectory. Hopefully, said Shin, Spain can emulate Japan and get out of its crisis, a situation that sees an estimated 60 million Euros in capital deficit still out there.
The questions remain as to the political process that will achieve a successful cleanup of the Eurozone, and how European governments and financial institutions will cope with, as Shin put it, the “strains of the restructuring process.”