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Financial Crisis

1. Background

When America sneezes …

Europe was caught unawares when the collapse of a little-known segment of the US mortgage market started to dry up credit at home. The ensuing crisis – dubbed the credit-crunch – eventually spread from the financial sector to businesses and households, with devastating effects on the lives of citizens across the continent.

In the US, the market for sub-prime mortgages – loans aimed at low-income households – had been growing at a dizzying pace since the beginning of the decade. These loans, offered at cheap introductory rates, operated on the logic that consumers could later refinance their property if they ran into trouble.

The expansion of the sub-prime phenomenon coincided with a new wave of innovation on the securitisation market, designed to spread out and subsequently reduce risk. Revenue streams from risky sub-prime debt were bundled with other forms of consumer loans into tradable bond-like instruments called asset-backed securities. These were in turn spun off into ever-more complex derivatives that were bought up by banks, insurance companies and pension funds.

Over time, hundreds of billions of dollars worth of sub-prime debt had seeped into the farthest reaches of the global financial system. Institutions were increasingly distanced from the assets underpinning their investments, but while the money flowed everyone was happy. For years, the system went largely unquestioned even by the credit rating agencies that were supposed to assess the riskiness of products.

In 2006, the cracks started to appear. As US interest rates rose and house prices fell, defaults on sub-prime loans rose to record levels. As the money stopped flowing, innumerable chains of investors around the world were affected. Panic welled as it became apparent that nobody knew the source or the value of their investments and banks grew reluctant to lend. A system designed to diversify risk had actually served to disguise the extent and the location of risk.

Financial meltdown

In the European Union, the first real signs of a crisis came in August 2007, when French investment bank BNP Paribas halted withdrawals from its funds on grounds that it was unable to fairly value its holdings. The European Central Bank responded promptly, pumping €95 billion into the banking market to improve liquidity. It was the first of a series of large-scale cash injections aimed at preventing banks from seizing up.

In September 2007, British mortgage lender Northern Rock was forced to seek emergency funds from the Bank of England. The bailout was notable as it sparked a run on the bank, with depositors withdrawing more than ₤2 billion within days. In a bid to quell the panic, the UK government moved to guarantee deposits. (In October 2008, the EU directive on credit guarantee schemes was amended to safeguard all deposits to a minimum of €50,000 with immediate effect in most member states. The minimum limit will be raised to €100,000 at the end of 2010.)

For the rest of 2007 and the first half of 2008, policymakers seemed confident that the EU economy would not sustain much damage. But, the collapse of US investment bank Lehman Brothers in September 2008 took the crisis into an entirely new league. As global confidence plummeted, there followed a string of hasty buyouts and bailouts of banks, mortgage lenders and insurance companies on both sides of the Atlantic. Stocks plunged as the world’s financial system headed into meltdown.

Impact on the real economy

By the end of 2008, the economic outlook for the EU as a whole had darkened considerably. In November 2008, Eurostat figures revealed that the eurozone and the EU had entered recession - defined as two consecutive quarters of economic contraction - in the third quarter of 2008.

In spring 2009, it was clear that the EU faced a long, slow road to recovery as banks struggle to get back on track and businesses recover. In May 2009, the European Commission forecast the bloc will return to year-on-year economic growth in the third quarter of 2010. The eurozone and the EU economy are expected to shrink by 4% in 2009.

Central and Eastern European member states were feeling the most pain, with investor uncertainty on the rise and diminished demand for manufactured goods in credit-starved western markets. Hungary, Latvia and Romania have received loan packages totalling €25.5 billion, €7.5 billion and €20 billion respectively from an EU facility, the International Monetary Fund and the World Bank. Latvia, which has suffered the sharpest downturn of all the bloc’s economies, is buckling under the pressure of meeting stringent criteria for entry to the eurozone in 2012.

Western European countries are also under pressure. EU exports powerhouse Germany has suffered from diminished global demand for goods such as cars and heavy machinery. The UK and Ireland, whose economies were strongly dependent on financial services, have both seen dramatic decline. The latter, along with Italy, Greece and Spain is suffering the consequences of having had its international credit rating downgraded.

As the crisis has taken hold of the real economy, laying waste to businesses and jobs, social unrest has grown. In Latvia, street protests and rioting over the government's economic policy led to its demise in February 2009. In France, there has been a wave of executive kidnappings by workers suffering the effects of cutbacks and job losses. And, in London, rioters at the April 2009 G20 summit stormed the Royal Bank of Scotland in protest at executive bonuses.

Implications for EU policy

The financial crisis has tested the EU’s institutional reflexes to the hilt. Critics, internal and external, charge that the policy response has been overly fragmented and that, as a result, the bloc could trail the US in pulling out of the recession.

The first response of EU finance ministers to the sub-prime wobbles of 2007 was a 'roadmap' setting out plans on improving transparency and risk management on financial markets. Prior to the crisis, they had already begun working on an overhaul of supervisory structures and strategies for dealing with cross-border banking crises. But the debate over how much power should be transferred from national capitals to Brussels had served to slow progress.

The collapse of US investment bank Lehman Brothers in September 2008, however, spurred the bloc into action. In October 2008, in an unprecedented impromptu gathering, eurozone heads of state and government hammered out an emergency action plan to coordinate bank bailout measures and prevent the crisis from spreading into the real economy. That same month, the European Council endorsed the plan for the whole of the EU.

At the end of October 2008, the European Commission drafted a detailed framework entitled 'From financial crisis to recovery: A European framework for action' that would form the backbone of the EU's response to the crisis. The framework set the scene for an overhaul of the bloc's financial infrastructure, the co-ordination of stimulus efforts and the orchestration of international action.

The depth and scale of the recession has reignited ideological debate over Europe's economic future, shining a harsh light on the so-called Anglo-Saxon model of laissez-faire capitalism. Big questions are now being asked about issues such as the role of the state, job markets and welfare systems. The political wind would now appear to be blowing in favour of the social market economy model espoused by countries such as Germany and France.

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