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CHAPTER 6 Financial Crisis in the EU-25 Old and new EU members alike came under severe pressure as the subprime crisis swept over the world in 2008. Economic conditions were very different in the various groups, which were discussed in the previous two chapters, and the divergence persisted throughout the crisis. The major question of this chapter is whether the pre-crisis evaluation of economic performance is tenable following the crisis. Are there any unexpected causalities or successes? If so, how does it affect the argument about the relevance of trust for economic outcomes? In order to answer the above questions, the chapter first provides a brief account of the financial crisis then assesses the costs of the crisis in the various groups examining growth, unemployment, and public debt developments. Through this exercise two major surprises are identified and analyzed in depth—Ireland as an unexpected causality and Poland as an unexpected success story. These cases call attention to the limits of the theory and the need for acknowledging the persistence of fundamental uncertainty even in a seemingly well-functioning institutional environment: overconfidence and complacency caused the collapse in Ireland, while Poland benefited from the prudence understandable in an environment of distrust. These extremes also help to explain the surprising finding from the assessment of performances during the crisis—slow reformers appear to have done better than the pre-crisis star performers. The chapter proceeds as follows. In the next two sections I will provide an overview about the roots of the subprime crisis and its spread in the EU. Then I will discuss the performance of the seven groups of countries during the crisis and contrast the assessment with the predictions of the theory. In the following I will address the cases of Ireland and Poland, the two major surprises of the crisis. I will conclude the chapter with implications to the theory. 148 Institutional Trust and Economic Policy 6.1. The origins of the subprime crisis1 The subprime crisis, which hit the world in 2008, had its origins in the United States subprime mortgage markets but its roots went deeper than particular market segments. Easy monetary conditions are usually identified as the root of most financial crises (Kindelberger 1989, Reinhart and Rogoff 2009) and the subprime crisis is a prime example of this thesis. Following the collapse of the dotcom bubble in 2000, the very low interest rates in the United States, including a 3-year period of negative real rates between August 2002 and August 2005, as well as the substantial dollar savings from Asian countries, created enormous liquidity on the financial markets. As investors were looking for increasing yields, higher risktaking became the norm—implying increased leverage and the expansion of loans to consumers, who were previously denied credit. Advances in risk management, most importantly the securitization of loans, made these investments appear safer since risks could be spread across the financial system.2 The wide availability of credit started a bubble on the housing markets —as demand for housing grew, and supply followed only with a lag, a steady increase of prices took place (Baker 2008). This made real estate an attractive investment leading to further price hikes. However, once supply caught up with demand and prices started to decline, the process took a reverse turn—credit became constrained, leading to a further fall in prices. For those who had low equity in their house, the drop in prices meant that many owed more than the value of their property, and thus it was a better option to leave the key at the bank than continue paying the mortgage. The collapse of the housing market led to the deterioration of the balance sheet of financial institutions, which had a stake in the market. Since securitization implied both a widespread ownership of these papers as well as an ambiguity about the precise extent of exposure, trust in the interbank market collapsed, and interest rates increased sharply—first in August 2007, followed by December 2007 and April 2008. For the wider 1 In the following I present a very brief overview about the major causes of the crisis based on my earlier article (Győrffy 2009). There is already an enormous literature on the issue, see for example Brunnermeier (2009), Rajan (2010), Reinhart and Rogoff (2009), and Stiglitz (2010). 2 For a concise overview of securitization see for example Coval, Jurek, and Stafford (2009) as well as Gorton (2008). [3.143.244.83] Project MUSE (2024...

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