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The Euro Crisis: Causes and
Solutions
NERI/ETUI Conference: Fixing Europe’s Public Debt
25-26 November 2015
Dr. Tom McDonnell
NERI (Nevin Economic Research Institute)
Dublin
[email protected]
The Euro Crisis: Causes and Solutions
ASYMMETRIC UNION
Lessons from past
currency/monetary unions
Successes
– USA
– UK
Failures
– Latin Monetary Union (LMU)
– Scandinavian Monetary Union (SMU)
– Gold Standard
– Precursors to EMU – i.e. ‘Snake in the Tunnel’, EMS
• Successful unions have been preceded by, or accompanied by, political union
–
•
Is EMU different?
–
•
Domestic objectives/concerns eventually undermine monetary union in absence of political union
Exit costs are much higher
Is EMU an Optimal Currency Area?
–
–
To qualify, a currency union should ideally have labour and capital mobility across the region as well
as a risk-sharing system involving automatic fiscal transfers.
It is also important that members have similar business cycles
• Single interest rate can spawn asymmetric shocks by overheating economies in the good times
and exacerbating recessions in the bad times
The macroeconomic policy
trilemma (domestic perspective)
• Chosen macroeconomic policy regime can include at most two elements
of an ‘inconsistent trinity’ of three policy goals (Obstfeld and Taylor):
A.
B.
C.
Full freedom of cross-border capital movements (part of EU membership);
A fixed exchange rate (important for the functioning of the single market);
An independent monetary policy (interest rates) oriented towards domestic
objectives (e.g. employment, growth)
Gold standard supported ‘A’ and ‘B’ – abandoning ‘C’
•
Governments often forced to adopt pro-cyclical austerian policies (internal devaluation difficult)
Bretton Woods System supported ‘B’ and ‘C’ – abandoning ‘A’
•
Capital controls (currencies pegged to the US dollar); abandoned in 1973 under capital mobility
pressures
Post Bretton Woods Floating Regime de facto entails ‘A’ and ‘C’ – abandoning ‘B’
•
Floating currencies; sharp exchange rate movements seen as problematic for the Single Market
EMU supports ‘A’ and ‘B’ – abandoning ‘C’
•
Single market (free movement of capital) and abolition of national exchange rates; problematic
for crisis response and domestic objectives……
The Euro Crisis: Causes and Solutions
CRISIS BUILD-UP
Crisis origins:
A flawed design?
Fragilities
•
Not an optimal currency area
– No fiscal transfer mechanism for asymmetric shocks
– Euro zone has no automatic stabilisers
– No mechanism for offsetting competitive imbalances
•
Lack of oversight
– A narrow focus on price stability at the expense of other macroeconomic targets (e.g.
current account, house prices)
•
Monetary union without banking union
– No centralised authority was responsible for the supervision, regulation and, if
necessary, resolution of financial institutions
– No FDIC equivalent was installed
•
No conditional Lender of Last Resort
– No circuit breakers against bad equilibriums
– No debt mutualisation
– No protocols for debt write-down
The asymmetric union:
build-up of imbalances and a sudden stop
•
Credit inflows to the periphery
–
–
–
•
Widening of current account imbalances (2000-2007)
–
–
–
•
Wage restrictions in Germany et al
Southern countries maintain traditional wage practices
The widening gap could not be offset by revaluations/devaluations as in the past
2008 credit freeze
–
–
–
•
Homogenous interest rate despite different places on the business cycle
Savings glut in the core; negative real interest rates in the periphery
Failure of supervision and regulation
Credit freeze replaced large credit inflows in context of high private debt
Financial crisis forced bank bailouts (with debt socialisation undertaken at the
national level)
Countries affected asymmetrically (with fixed exchange rates and no transfer
mechanisms)
Negative feedback loop sets in as fiscal balances deteriorated
–
–
–
Greece, Ireland, Portugal, Spain, Italy et al suffer severe recessions
Spiralling interest rates accompanied by deepening austerity
Greece in full blown depression
A balance of payments crisis
not a public debt crisis….
T
Sudden stops and the
‘multiple equilibria’ problem
•
EMU precipitated potentially destabilising credit inflows and outflows
–
•
Persistent mispricing of risk by the market
• An unjustified ‘good equilibrium’ developed (the cost of borrowing was too low) – buildup of (mainly) private debt and current account imbalances;
• Problem: if the borrowed money is not well invested it leaves the debtor exposed to a
sudden stop and reversal of market sentiment
– Debt build-up largely funded increases in consumption and non-productive
investment
• Sudden stop
• Bank/sovereign doom loop
No Lender of Last Resort facility for sovereigns
– Member states effectively ‘Dollarized’, albeit with Euros
• Member states downgraded to emerging country status
– Dollarized Governments can run out of money creating risk of sovereign default
– As fiscal balance deteriorates in a recession the risk premium increases
– This creates a progressively worsening feedback loop
• higher yields are required to justify the increased probability of default thereby
increasing the risk of default – a ‘bad equilibrium’ develops
• eventually this forces external assistance or default
Post 2008 indebtedness crisis
in the periphery
Over indebtedness (Balance sheet recession)
– Public debt
– Private debt
• Business debt
• Household debt
– Weak bank balance sheets
All of the above weigh down on consumption, investment and
employment
Structural imbalances
– Structural deficits
– Misaligned real exchange rates
– Current account imbalances (competitiveness problems)
Three Interlocking Crises
A. Sovereign debt crisis
B. Banking crisis
C. Real economy crisis (growth and employment)
– All three are manifestations of a wider system
crisis
– All three are interlocking
• Negative feedback loops
– Sovereign ↔ Banks
– Banks ↔ Real economy
– Real economy ↔ Sovereign
Comparative Growth and Employment Performance
Source: De Grauwe, 2015
EU10 = non-Euro area EU countries
The Euro Crisis: Causes and Solutions
OFFICIAL RESPONSE
The official response to the crisis
Sovereign debt crisis:
–
–
–
–
Securities Market Programme (SMP) – indirect purchase of government bonds
Special Purpose Vehicles are created: EFSF/EFSM – finally the ESM (Sept, 2012)
•
Funding access conditional on ‘structural reforms’ and fiscal consolidation
Treaty on Stability, Coordination and Governance (TSCG); Euro Plus Pact
Outright Monetary Transactions (OMT)…..”whatever it takes”
Banking crisis:
–
–
–
–
–
Banking recapitalisation at the national level (socialisation of private debt)
Access to cheap liquidity (open market operations/swap lines/required collateral)
Stress tests and increased bank capital ratios
LTROs (infusion of credit into the banking system)
ECB to become a bank supervisor (SSM)….and plans to form a deposit insurance program
Growth and employment crisis:
–
–
–
Austerity and internal devaluation (policies to reduce unit labour costs) to deal with fiscal
and competitiveness imbalances
•
No countervailing measures in the core
Structural ‘reforms’ proposed for programme countries
Loose monetary policy (historically low interest rates) and quantitative easing
The five presidents report…….
Their ‘roadmap’ towards a complete
economic and monetary union
Stage 1 (July 2015 – June 2017)
Economic Union
– Set up a Euro area system of independent competitiveness authorities
– Stronger MIP….more forceful use of the corrective arm
Financial Union
– Completing the banking union (requires single bank supervision/resolution/deposit insurance)
• Setting up a bridge financing mechanism for the Single Resolution Fund (SRF); concrete steps
towards a common backdrop for the SRF – credit line from the ESM?
• Agreeing on a common Deposit Insurance Scheme
• Breaking the sovereign-bank nexus by improving the effectiveness of the instrument for direct
bank recapitalisation in the ESM
– Launch the capital markets union (requires legislative harmonisation in numerous areas)
– Reinforce the European Systemic Risk Board (macro prudential oversight)
Fiscal union
• Set up a new independent advisory European Fiscal Board
“to ensure that the sum of national budget balances leads to an appropriate fiscal stance at
the level of the Euro area as a whole….key to avoiding pro-cyclicality”
Accountability
•
Coordination of economic policy through the European semester (European/national stages)
•
More systematic consultation between Commission and national Parliaments
The Euro Crisis: Causes and Solutions
PROPOSED REFORMS
1st Proposal:
sovereign debt crisis (1)
Goal: Eliminate the multiple equilibria and debt sustainability problem for any
state showing a willingness to pursue a sustainable fiscal path
The current structure of the ESM is inherently fragile (domino effect)
– To date there is no credible institutional framework which would
prevent member state insolvency
– ESM is not an LOLR
– But it is an important reform to deal with acute crises
Medium term solutions?
• Collective action problem means fiscal rules...cannot be ignored
– Eurobonds are problematic
– Unconditional LOLR for sovereigns is inappropriate without full fiscal
federalism
• Moral hazard concerns vs. stability concerns
1st Proposal:
sovereign debt crisis (2)
Proposal – First Element
– Assign Banking Licence to a Special Purpose Vehicle
1. Special Purpose Vehicle (SPV) could be the ESM (but need not be)
2. ECB would be able to lend to it
3. For example, ESM has a paid in working capital of €80 billion and would be
allowed to to engage in purchases of government bonds at future
sovereign debt issuances
4. ESM could then place these bonds as collateral with the ECB in order to
maintain its own capital base
5. The ESM would become a de facto LOLR for sovereigns
• But this basic model has the same old moral hazard risks
– How can we incentivise sovereigns to employ fiscal prudence?
– How can we protect against political interference?
1st Proposal:
sovereign debt crisis (3)
Proposal – Second Element
– Guaranteed but ‘conditional’ lender of last resort
– Moral hazard - Different interest rates for sovereign borrowers with the exact
interest rate offered by the SPV determined by:
• Sovereign policy actions
• Economic context (place in the business cycle)
– Formula would need to be transparent and operate automatically
– The exact interest rate to be offered would be known in advance of
the auction
• This would set a ceiling on the yield demanded
– Political interference? - Precise formula determined annually by the board of
governors (transparent and automatic)
– Accountability:
• Domestic actors would be able to democratically choose their own policy stance
but would also be would be disincentivised to act imprudently
2nd Proposal:
banking crisis (1)
Goals: Breaking the link between sovereigns and banks, protecting taxpayers and
depositors, dealing with capital flight and creating a level playing field for all Euro
zone credit institutions
Proposal - First Element
•
•
•
A centralised deposit insurance scheme is a necessary component of any monetary union characterised
by massive transnational banks
– A centralised deposit insurance system modelled along the lines of the FDIC would end the
differentiation between banks in the periphery and the core and help create a genuine banking
union
– How should such a scheme be implemented and which institution should have responsibility for
managing the scheme?
Short-term
– ECB
Medium-term
– A dedicated and independent European Deposit Insurance Corporation (EDIC) funded by
contributions from the Euro zone’s private credit institutions
– The FDIC receives no congressional appropriations – it is funded by premiums that credit institutions
pay for deposit insurance coverage
– Would a credit line from the ESM be necessary as a back-stop?
2nd Proposal:
banking crisis (2)
Proposal - Second element
•
Centralised banking union
•
Independent centralised supervision and regulation of financial institutions at the Euro zone
level with the authority to close down (resolve) insolvent banks is:
– A necessary quid pro quo for pan Euro zone underwriting of bank deposits
– And desirable in any case (defence against regulatory capture; level playing field for
credit institutions; breaks sovereign/bank doom loop)
All Euro zone banks over a certain size should automatically be covered (genuine banking
union)
– Position of non Euro zone banks is less clear but probably better to keep them separate
•
•
Bank resolution
– No liquidity support for insolvent credit institutions
– Banks should be closed and allowed to fail where shown to be insolvent by mandatory
regular stress tests conducted by the ECB/EDIC itself
– Rules should be clearly defined with transparent protocols.
– EDIC decisions should be independent of national governments
3rd Proposal:
real economy crisis (1)
Goal: Escaping the ‘trilemma’ and enabling a macroeconomic policy mix that
favours growth, avoids deflationary bias and macroeconomic imbalances
The problem:
• Giving up full freedom of cross-border capital movements is inconsistent
with EU membership
• Giving up a fixed exchange rate is inconsistent with Euro zone membership
But…
• At the level of the Euro zone itself we don't have the trilemma problem
because the Euro floats against other currencies
• At the Euro zone level we can align monetary and fiscal policies to the
goals of employment and growth
3rd Proposal:
real economy (2)
Target for peripheral
regions
(weight = 1)
Target for non-peripheral
regions
(weight = 2)
Overall Target
Inflation (%)
0
3
2
Inflation (%)
1
4
3
Inflation (%)
2
5
4
Proposal – First Element
– Balance of payments and competitiveness crisis:
• Competitiveness is a relative concept not an absolute concept
• Is there an alternative to Internal Devaluation (ID)? ID can be counterproductive
with high levels of debt and generates a deflationary bias
• Differentiated inflation targeting
– Temporarily or permanently increasing the overall target
• Fiscal and wage expansion in the more competitive economies
• Closer coordination of policy – e.g. through a Euro zone Productivity,
Competitiveness and Fiscal Council (PCFC) mandated to balance
deflationary/inflationary pressures at a Euro zone level (could have radically
different recommendations from country to country – but there needs to be an
incentive structure to encourage compliance……..
3rd Proposal:
real economy (3)
Proposal – Second Element
– How do we address the problem of asymmetric shocks within a currency
union and the need to replace lost policy levers
• Does not imply the need for full fiscal union
Broad framework
1.
Intergovernmental coordination of policies to prevent competitiveness imbalances from
growing too large and to promote policies to Increase productivity (human capital/R&D
ratio/investment ratio/efficiency)
2.
Centralised Insurance Fund (CIF):
• Counter cyclical policy lever at the Euro zone level
• Funded through a pan Euro zone tax – the tax would be hypothecated for and paid
directly to the centralised insurance fund
– This could be a consumption tax or a wealth tax or both
• CIF would be mandated to run a surplus over the economic cycle and funds allocated to
capital projects (productive infrastructure) within a member state whose economy is
operating at x% below its potential (tapered funding) – an ‘automatic stabiliser’
• There could be a partial and tapered refund available to countries adhering sufficiently
closely to the recommendations of the PCFC
– Discourages pro cyclicality but decision making remains with domestic
authorities
4th Proposal:
economic and social justice
– What kind of EMU do we want to be part of and to save?
Proposal
• Supplementing the Fiscal Compact (TSCG) with a Social
Compact
• Macroeconomic imbalance procedure
– Expanding the list of indicators
– Greater emphasis on
employment/inequality/poverty/deprivation/environment
/investment rate/R&D rate
– Countries should be obliged to explain why they are failing
to hit targets and this should inform the deliberations of
the PCFC
The Euro Crisis: Causes and Solutions
LOOKING AHEAD
A flawed union
•
We know that EMU as constructed was fragile, incomplete, and highly flawed:
– There was no centralised authority responsible for the supervision,
regulation and, if necessary, resolution, of financial institutions
– There was no fiscal transfer mechanism to deal with asymmetric shocks; no
‘automatic stabilisers’ at Euro area level to replace those lost at the domestic
level; and no mechanism for offsetting competitive imbalances or for
preventing them in the first place
– There was no Lender of Last Resort for member states and therefore no
‘circuit breaker’ to protect against negative feedback loops of spiralling
borrowing costs. Member states were at the whim of massive and
destabilising credit inflows and outflows
– It is often forgotten that the historical rationale for a central bank was not to
stabilise prices by controlling inflation, but to stabilise the entire economic
system itself by providing backstop or ‘last resort’ liquidity to banks and to
sovereigns.
Design flaws must be fixed
The monetary union can fail or stagnate…performance to date has been poor
compared to other advanced Western economies
• But if the correct policies are adopted the Euro zone can be made viable
• The overall effect of the policy response has been ‘deflationary’ (i.e. it has
caused economies to contract rather than grow)
Lessons of history and economic theory:
1. Monetary unions must be supplemented by banking unions including
trans-national deposit insurance
2. Monetary union also requires a guaranteed lender of last resort with
safeguards against moral hazard
3. An offsetting centralised fiscal apparatus to combat regional
recessions and asymmetric shocks is an important component of
successful monetary union
4. Long-term viability requires domestic buy-in and flexibility to
accommodate domestic realities and concerns