Download Default/insolvency of member state

How can the Euro be stabilized?
Günter Franke
May 18, 2016
Kiev National Economic University
Overview
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What endangers the Euro?
ECU-policy for highly indebted countries
Greek Failure
Policy of European Central Bank
How to improve the European Currency
Union?
What endangers the Euro?
Euro: Common currency of 19 member states
of the European Curreny Union (ECU)
Stability of Euro determined by
• financial stability of main actors:
member states, European Union,
European Central bank
• price stability of Euro
What endangers the Euro?
• No member state should borrow heavily and
then default, forcing other member states into
support
• Historical examples of currency unions:
currency unions broke apart whenever one
member state tried heavily to make money at
the cost of other states
What endangers the Euro?
This motivated Maastricht criteria:
For every member state
• Budget deficit ≤ 3% of GDP
• Public debt ≤ 60% of GDP
• In addition: to discourage free riding, bail out
of a member state is prohibited
What endangers the Euro?
• 3% rule violated by France and Germany in
2003
• other member states followed
• but no sanctions
• Financial Crisis 2008: many states violated
Maastricht
Misallocation of money
Investors believed in stability of € until 2009
→ interest rates for government bonds of weak
countries fell dramatically
• Spain: 14 % in 1992
4 % in 2006
• Greece:25 % in 1992
4 % in 2006
Misallocation of money
Effects:
• Spain: Construction boom, e.g. tourist homes
at the Mediterranean coast, funded to a large
extent by Spanish banks
→ large volume of non-performing loans
leading to failure of Spanish banks
Misallocation of money
Greece:
• Strong expansion of government expenditures
• Strong wage increases
• Essential: Additional loans not used for
profitable investments, but for consumption
→ High debt burden, private and public
ECU-policy for highly indebted countries
• May 2010: government heads in Brussels
chose policy:
How handle crisis in ECU-member state?
ECU-policy for highly indebted countries
Option 1: default of member state
→ would strongly hit bond holders:
• European banks
• European insurance companies
• other institutional investors and private
persons
ECU-policy for highly indebted countries
Default/insolvency of member state
→ default of several major European
banks/insurance companies
unless strong public support of these financial
intermediaries
→ threat to Euro??
ECU-policy for highly indebted countries
Option 2:
Difficult to distinguish between insolvency and
illiquidity of country.
Allows to avoid default/insolvency of member
state by claiming illiquidity only.
ECU-policy for highly indebted countries
• European Stability Mechanism ESM and Eur.
Financial Stability Facility EFSF and IMF:
Provide financial assistance (loans) to country
in distress, subject to conditionality (economic
reforms including cutbacks in budget deficit,
economic reforms, privatizations, etc)
• Loans granted at low interest rates and with
long maturity
ECU-policy for highly indebted countries
Effect of option 2 on composition of bond
holders
Main bondholders:
European Currency Union
European Central Bank
IMF
ECU-policy for highly indebted countries
• If anonymous crowd of lenders, these are
never responsible for crisis of borrower.
Only borrower responsible
• If only three major public lenders who impose
conditions for lending, these lenders are made
responsible for crisis, besides of borrower.
→ strengthens position of borrower
continuous fights between borrower and
lender
ECU-policy for highly indebted countries
Austerity policy:
-- major part of conditionality
-- puts heavy burden on citizens
Even if government supports austerity, big
temptation
-- to make main creditors responsible for burden
-- to hide own political mistakes
ECU-policy for highly indebted countries
ESM/EFSF support for
Greece
Ireland
Portugal
Spain
Cyprus
ECU-policy for highly indebted countries
ESM/EFSF support successful in
• Ireland with rather well-functioning economy
• Cyprus: Major burden on international
depositors to local banks by bail-in
ECU-policy for highly indebted countries
ESM/EFSF support partly successful in
• Spain due to weak economic structure and
misallocation of capital
• Portugal due to weak economic structure and
low level of education
Greek Failure
Greece:
• Strong expansion of government expenditures
• Strong wage increases
• Essential: Additional loans not used for
profitable investments, but for consumption
→ High debt burden, private and public
Greek Failure
2009
public debt/GDP 135 %
budget deficit/GDP 15 %
€ 110 bio financial assistance to Greece, subject
to conditionality
New loans with artificially low interest rates
Greek Failure
2011
• European governments forced banks and
insurance companies to accept a debt relief on
their bonds to Greece of about 100 bio €
• ESM, IMF and ECB took no losses
Greek situation today:
• wages came down by 30 % from 2010 until
today
• Strong cuts in pensions
• yet public debt/GDP now 187 %
Greek Failure
• Austerity policy viewed by many Greeks as
strong reason for misery
→ European Currency Union, in particular,
Germany, held responsible
• Clearly, also other internal reasons (strong
need for economic reforms including more
leeway for competition, enforcing tax laws,
reducing corruption)
Greek Failure
Why no further debt relief for Greece?
• Would imply bail-out by ECU, ECB and IMF
• Other highly indebted countries might insist on
debt relief
→ would undermine budget discipline even
more and endanger Euro-stability
Greek Failure
3 requirements for Greek recovery
• Massive reduction of
-- budget deficit
-- bureaucracy ( and corruption)
• Massive debt relief (might only be feasible
with Grexit)
ECB
Role of ECB
Monetary policy
for price stability
Banking
supervision
ECB
ECB policy of cheap money
• depresses yields on government bonds
• stimulates lending to firms and households
• stimulates stock and real estate price increases
ECB
ECB policy of cheap money
• lowers budget deficits of many countries
strongly
Example: Italian deficit 2015 2.7 % of GDP
Given public debt/GDP of 130 %, cheap
money policy of ECB lowers budget deficit by
~ 3 % of GDP
→ otherwise massive violation of Maastricht
criteria
ECB
Puzzling role of ECB:
• without active ECB policy, €-crisis
• with active ECB policy: budget deficits much
lower
→ necessary economic reforms in ECUcountries postponed
Hence € fragile
How to improve the European Currency Union?
How to stabilise Euro?
• Option 1: enforce much stronger political and
economic integration together with fiscal
discipline of ECU countries
Presumably little support in most ECU
countries
evidenced by removement to nationalistic
policies (refugee crisis)
How to improve the European Currency Union?
Strong cultural differences among ECU
countries: very difficult to agree on
economic policies including
• competition policy,
• labour market legislation,
• government interventions in markets,
• fiscal policy
How to improve the European Currency Union?
• Currently no sign of convergence between
different national cultures
• In the long run convergence ?
How to improve the European Currency Union?
Option2:
Strengthen economic independence and
responsibility of ECU- countries
Each country borrows in financial markets, not
from ECU, ECB and IMF
How to improve the European Currency Union?
• Each country responsible for its financial
health
Unhealthy countries pay high interest rates
→ constrains borrowing
• Each country has more freedom in designing
its economic policy
How to improve the European Currency Union?
→ clear cut responsibility of each country
instead of confusion of responsibility between
country and ECU
cultural differences may persist
How to improve the European Currency Union?
Would such a model work?
Example USA.
50 member states + some territories use $ as
single currency.
Every state has its own strict rules for admissible
budget deficits and borrows in financial
markets.
How to improve the European Currency Union?
How many states defaulted?
• Some states defaulted at end of 18th century,
due to high expenses in independence war.
US-congress helped these states.
How to improve the European Currency Union?
• Some states defaulted between 1830 and 1842,
due to strong investments in infra-structure
projects. US-congress denied help.
• Later on: no US states defaults except for Civil
War and now Puerto Rico (US-territory).
How to improve the European Currency Union?
• No financial support of Washington for Puerto Rico.
U.S. Congress would never help Puerto Rico
repaying its debt.
• Automatic stabilisers:
-- given bad economic performance of some state,
then less transfer of state-tax revenues to federal
government.
• Federal government may help state to fund expenses
for health care and pensions.
How to improve the European Currency Union?
Model
• might also work for Euro
• would reduce conflicts between ECU and its member
states
• ECU would provide indirect help in case of problems
and demonstrate solidarity.
• should weaken nationalist tendencies in ECU and
promote the great idea of European unionisation