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.
The Research paper on The Euro Crisis- A Case Study
The economic and political success of the United States of America, since the end of the Second World War had prompted their cousins across the Atlantic to dream of an entity that could be called the United States of Europe. But between this vision and its implementation lies a plethora of political, linguistic, financial and nationalist borders that cut up and divide Europe into small nation ...
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 holder who lent their money to EU member states, and the agents are the government. Debt holder cannot determine whether the government has the ability to repay the promised amount of money within the maturity date, therefore, debt holder has to monitor government to make sure the government has put the best effort to ensure their repay. In conclusion, adverse selection causes higher interest rate, a large decline in assets, and an increase in sovereign debt. However, moral hazard problem slows the pace of financial recovery.
