The lead up to the EU crisis

Mishkin (1992) defines a financial crisis in terms of asymmetric information “A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities.  As a result, a financial crisis can drive the economy away from an equilibrium with high output in which financial markets perform well to one in which output declines sharply. … It indicates that financial crisis have effects over and above those resulting from bank panics and therefore provides a rationale for an extended lender-of-last-resort role for the central bank in which the central bank uses the discount window to provide liquidity…”

This definition by Mishkin, although rather long, gives a good overview in to the most recent financial crisis and those which have come before it.  Hall (2010) argues that the worst crisis to hit the US and most other countries struck in 1929 and was followed by the Great Depression.  He refers the current crisis, from 2007 onwards ,as being the second worst in history aligning it to the 1929 crisis by calling it the ‘Great Recession’.  It is to this global crisis we must look to begin to unfold why Europe is in such a mess today.

The European Commission in 2009 published a document which aimed to get to the root of the global crisis and outlined it main causes.  The findings showed that the crisis in 2007 started in a similar manner to any past financial crisis; it was preceded by a long period of rapid credit growth (shown most obviously by mortgages given for over 100% of house value), abundant availability of liquidity, high leverage, increasing asset prices and the development of bubbles in the real estate industry.  

The high levels of leverage preceding the crisis left the markets massively exposed to any changes. One such change was that of the subprime mortgage market in the US, and when that fell it was sufficient to “topple the whole structure”, European Commission (2009).  And so the crisis was born due to the liquidity shortage of financial institutions as they expected ever tougher market conditions for rolling over their short term debt.  Even though the was a growing concern over the solvency of financial institutions, a systemic collapse remained unlikely, that was until the fall of Lehman Brothers in 2008 when perceptions changed.  Investors were now largely liquidating their positions and the stock markets ‘nose-dived’ sending the global economy and the EU into the deepest downturn since the 1930’s.