Euro Crisis 2009
2. Outline the adverse selection and moral hazard problems that existed in the Euro crisis of 2009. (approx. 2 double spaced pages; 10 marks)
Due to imperfect information of borrower makes and the lender cannot be able to distinguish between good and bad borrowers, the issue of adverse selection has been arisen and become the major reason of Euro Crisis in 2009. Firstly, adverse selection causes a increase in the interest rate, those borrowers who is with a good credit record may withdraw their asset from the market and decrease the average quality of the borrower and makes the interest rate become even higher which lead to a large reduction of lending. Secondly, maturity mismatch such as financial institution finance long- term investment with short-term debt causes a huge amount of short-term liabilities and a large decline in asset prices. Thirdly, deterioration in the balance sheets causes the bank to liquidate the assets and makes the assets even less valuable. Furthermore, in Euro Crisis 2009, because of adverse selection, poorer countries become the major member of single currency zone such as Greece, Portugal, Spain and so on. The larger government debt of those poorer countries makes the sovereign debt crisis becomes more intense and the political balance of euro zone fiscal union is more toward to them. Therefore, richer countries in Euro-Zone have to transfer their financial resource to those poorer countries to cover the sovereign debt. With the continuous rising of sovereign debt in Euro zone, Euro Crisis becomes a global financial crisis.
In Moral Hazard model, a principal- agent principal conflict occurs when the agent has more information about his or her actions than the principal does, and the principal cannot be able to monitor the agent’s actions effectively and gives the agent an opportunity to act in a manner that would adversely affect the principal’s interest. Applying this model into Euro Crisis, the principal is a euro-debt
Due to imperfect information of borrower makes and the lender cannot be able to distinguish between good and bad borrowers, the issue of adverse selection has been arisen and become the major reason of Euro Crisis in 2009. Firstly, adverse selection causes a increase in the interest rate, those borrowers who is with a good credit record may withdraw their asset from the market and decrease the average quality of the borrower and makes the interest rate become even higher which lead to a large reduction of lending. Secondly, maturity mismatch such as financial institution finance long- term investment with short-term debt causes a huge amount of short-term liabilities and a large decline in asset prices. Thirdly, deterioration in the balance sheets causes the bank to liquidate the assets and makes the assets even less valuable. Furthermore, in Euro Crisis 2009, because of adverse selection, poorer countries become the major member of single currency zone such as Greece, Portugal, Spain and so on. The larger government debt of those poorer countries makes the sovereign debt crisis becomes more intense and the political balance of euro zone fiscal union is more toward to them. Therefore, richer countries in Euro-Zone have to transfer their financial resource to those poorer countries to cover the sovereign debt. With the continuous rising of sovereign debt in Euro zone, Euro Crisis becomes a global financial crisis.
In Moral Hazard model, a principal- agent principal conflict occurs when the agent has more information about his or her actions than the principal does, and the principal cannot be able to monitor the agent’s actions effectively and gives the agent an opportunity to act in a manner that would adversely affect the principal’s interest. Applying this model into Euro Crisis, the principal is a euro-debt