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The euro-area crises: the
next step
Lucrezia Reichlin
London Business School & Now-Casting
Economics Ltd
Presentation at the Italian Parliament
Rome 29th September, 2014
Where are we now in the euro area
crisis?
• The economy is at best stagnating
-- not out of the 2011 recession yet
-- diverging from the US
-- employment flat
• Debt not stabilized
• Financial fragmentation (and relatively high credit risk in the
periphery) not over
 The crisis is not over!
Yet, low volatility … the market does not seem to price this risk …
but the market has been wrong before! … an illusion of
tranquility?
Recent new slowdown
Now-casting Index (NCI) for the US and Euro Area
US
Euro Area
EA vs US since the crisis
Since 2008 the Euro Area had a larger loss of income than the US. Although the initial
income shock was of similar magnitude neither economy is back to trend, but the EA
is further off
Source: Buttiglione et al, 2014
Employment has not recovered and it is still
below the second recession peak everywhere
but Germany
Balance sheets ……
Credit deterioration after the
second recession
The second recession led to a deterioration of the stock of loans especially in
the euro area periphery
Non performing loans / total loans
25
20
15
10
5
0
Q4.2008
Source: OECD
Q3.2012
Financial repression: banks buy
government bonds
Euro Area - Banks' Loans and Gov. Bonds
(% of total assets)
16
6.0
Loans (lhs)
16
5.5
Government Bonds
15
5.0
15
4.5
14
4.0
14
13
3.5
06
07
08
09
10
11
12
13
14
2006Q1
2006Q2
2006Q3
2006Q4
2007Q1
2007Q2
2007Q3
2007Q4
2008Q1
2008Q2
2008Q3
2008Q4
2009Q1
2009Q2
2009Q3
2009Q4
2010Q1
2010Q2
2010Q3
2010Q4
2011Q1
2011Q2
2011Q3
2011Q4
2012Q1
2012Q2
2012Q3
2012Q4
2013Q1
2013Q2
2013Q3
In particular their own
MFIs (excl. ESCB): Government securities/total assets
5%
5%
4%
4%
3%
3%
2%
2%
1%
1%
0%
Source: ECB
CEPR recessions
Extra EA
Other EA
Domestic
Diabolic sovereign-bank loop
Euro-nomics.com
Triggers:
• Bank insolvency
(Ireland, Spain,
Cyprus)
• Public debt and
slow growth
(Greece,
Portugal, Italy)
Debt stabilization only just started –
there is a long way to go
In the euro area debt stabilization just started while it is well
underway in the US
In particular in the public sector
Total Debt as % of GDP
Public Debt as % of GDP
But the market does not seem to
care about debt … eg Italy … until
when?
Italy
General government debt (% of GDP)
Source: IMF, FRED
10 years i.r. (right)
2013
2012
2011
2010
2009
2008
2007
2006
2005
0
2004
0
2003
2
2002
20
2001
4
2000
40
1999
6
1998
60
1997
8
1996
80
1995
10
1994
100
1993
12
1992
120
1991
14
1990
140
Aggregate demand weak
Fiscal stance: Euro area and the US
Source: IMF
General government primary
net lending/borrowing
Source: IMF
5
4
4
2
3
0
2
-2
1
-4
0
-6
GDP YoY
-1
-8
-2
-10
-3
-12
-4
-14
-5
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
United States
Euro area
United States
Euro area
Inflation declining dangerously towards
zero – pushing up real interest rates
HICP - Overall index, YoY
5
4
3
2
1
0
-1
1999Jan 2000Apr 2001Jul 2002Oct 2004Jan 2005Apr 2006Jul 2007Oct 2009Jan 2010Apr 2011Jul 2012Oct 2014Jan
Euro area (changing composition)
Source: ECB
Policies in the seven years of crisis
Limits
• Wrong sequence: no fiscal stimulus in 2009 and emphasis on
fiscal consolidation since, aggressive ECB liquidity policy but
no action on bank solvency until 2012/13
• Uncertainty in central bank policy with respect to the
sovereign – impossible trinity of ‘’no bailout’’, ‘’no default’’,
‘’no exit’’ leading to messy solutions of debt crises: Greece,
Cyprus, contagion …
• De facto contractionary monetary policy since 2013 leading to
declining nominal GDP growth – only recently reversed
Policies in the seven years of crisis
But also …
Not negligible progress:
 Banking Union
 ESM – firewall
 Draghi’s pledge of doing “whatever it takes” to save the euro
(but still untested)
 Recent action on ABS-QE and other measures
 …. and recent ECB communication perhaps leading to a new
grand bargaining involving
(i) conditioning further monetary policy action on commitment
to reform
(ii) framework for coordinating monetary and fiscal policy
Governance: how much progress?
Problems
Progress
1. Pre-crisis ex ante incentives weak:
combination of common monetary
policy with national fiscal and banking
supervision leading to overborrowing/over-lending (private +
public)
Banking Union and launch of AQR
2. Ex post discipline excessive: no
mechanism for crisis resolution, hence
rules not credible ex ante
None
3. No mechanism for resolving banking
crises, hence diabolic loop between
sovereign and banks
Incomplete: the Banking Union has non
credible resolution fund
4. No lender of last resort mandate for
ECB
Not clear: OMT untested, sovereign QE
controversial
We need a “new bargain”
• Any further progress requires a “new bargain” since needed
new measures have fiscal implications
• Including further ECB action
 Need a mechanism that can enforce credible commitment of
governments to policies aim at repairing balance sheets and
putting the economies on a sustainable path
 For credibility need a mix of rules and market discipline –
tough rules are not credible
Key problems
1. Fiscal policy: need to allow changing fiscal stance overall and
in countries over-burdened by debt overhang
2. Monetary policy: full mandate for sovereign QE
3. Dealing with financial segmentation (tendency to ring-fence
balance sheets along national lines to cope with the risk of a
collapse of the euro)
 What do we need to achieve this goal?
Needed …
• For problem 1 (fiscal):
need a targeted – and sustained – effort to reduce sovereign
debt
The dilemma is how to do so without either pushing the Euro area back into recession
(through a new bout of austerity) or endanger the progress that has been made in
restoring financial stability
• For problem 2 and 3 (QE and financial segmentation):
need to establish incentives for the market to create a euro area
safe/liquid asset
Dealing with the stock of debt
• Need a “stock operation” to reduce sovereign debt, particularly in the
highly indebted peripheral countries

Several proposal on the table all involving partial debt redemption

Prerequisite is to solve a time inconsistency problem via a new
institutional mechanism – new grand bargain
• Essential element is to build a sovereign debt restructuring regime, which:
i.
creates strong market-based incentives that will make it more difficult
for Euro area countries to returning to excessive debt levels in the future
ii.
makes future debt restructuring – should if become necessary – less
painful than is currently the case
[Need market discipline – rules are not enough]
CEPR REPORT IN PROGRESS
Dealing with financial segmentation: the
safe asset problem
• The euro area needs a pan-euro area liquid market for
government bonds
• In its absence what should the ECB buy if it decided to
implement sovereign QE?
• Flight to safety leads to home bias: italian banks hold italian
govy and german banks hold german govy
• Which in turn leads to correlation of banks’ and sovereign risk
• Sovereign bonds unrealistically treated as risk-free in banks
regulation and in the ECB collateral policy
Towards a solution: Garicano-Reichlin
proposal
• Impose as a rule that, for sovereign bonds to have a risk free
weighting, they must be held by banks in certain constant
proportions, for example relative to GDP.
• such proposal would reduce the exposure of banks to their
own sovereigns and therefore help to break the link between
banks and sovereign risk.
• We also anticipate that such a regulatory initiative bias could
help to encourage the emergence of the market driven
creation of a euro area safe asset
• This asset is the natural target for sovereign QE – QE will in
turn encourage a market for such assets
CEPR REPORT IN PROGRESS
Conclusions
• The crisis is not over
• Notwithstanding market tranquility we are at a very
dangerous juncture which find countries profoundly divided
• Need a new bargain based on
 a common narrative of the past (which is lacking)
 a mixed of rules and market discipline to enforce commitment
from all parties involved