Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 8 The EURO Crisis Theory and Politics of European Integration

Theorie und Politik der Europäischen Integration

Prof. Dr. Herbert Brücker

Lecture 8

The EURO Crisis

Theory and Politics of European Integration

Prof. Dr. Herbert BrückerLehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer ArbeitsmärkteUniversität Bamberg | [email protected] | www.uni-bamberg.de/sowi/bruecker

Theory and Politics of European Integration Fiscal Policy and Stability Pact

The Last Lecture (I/II)

Optimum Currency Area (OCA) Theory • What are the trade-offs?• Asymmetric shocks and currency areas• Criteria for an optimal currency area

· Labour Mobility· Trade Openness· Diversity of Production· Transfers· Common Values· Common Destiny

• Is the EMU an optimal Currency Area?



The last lecture II/II

Fiscal Policy and the Stability Pact• Fiscal policy in the monetary union

· More and more important?· Borrowing instead of transfers· Automatic stabilizers and discretionary policy actions

• Fiscal policy externalities· Spillovers and coordination· Cyclical income spillovers· Borrowing cost spillovers· Excessive deficit and the no-bailout clause· Collective discipline



This Lecture

Diagnosis• What is the EURO crisis? What are the questions?• Monetary policies, assymmetric shocks and internal imbalances• Public vs. private debts• Has the ECB monetary policy triggered the real estate bubble?• Why are public debts in a currency union more serious than with

national currencies?• Debt financing via the TARGET2 facility of the EURO System

Therapy• Banking regulation• ECB: Buying governmental bonds • Creating a Transfer Union• State Bankruptcy within Eurozone• Leaving the Eurozone



The EURO crisis: what are we talking about? (I/II)

• The EURO crisis is no currency crisis in traditional sense• No (dramatic) depreciation of EURO

• No capital flight out of EURO zone

• No balance of payments crisis of EURO zone

• No inflation



Exchange rate USD/EURO

Source: OECD STAT database, own calculations.



Inflation (Consumer price index, change p.a. in %)



Inflation (Consumer price index, change p.a. in %)



The EURO crisis: what are we talking about? (II/II)

• But:• Sovereign debt crisis of some members of EURO zone

(Greece, Ireland, Portugal, Spain, Italy?, others?)

• High spread of interest rates within EURO zone

• High risks of bank failures in private sector

• Burst of real estate bubbles in many Member States

• Zero growth in the Eurozone and serious recessions in some Member States



General Government Debt in % of GDP, 2007-2013






Net Government Lending in % of GDP, 2007-2013



Net Government Lending in % of GDP, 2007-2013



Central Bank Interest Rate (3 month rate)



Long-term interest rates (10 years government bonds)






Real GDP growth rate in %, 2007-2012



Real GDP growth rate in %, 2007-2014 (forecast 13-14)



Unemployment rate in %, 2007-2012



Unemployment rate in %, 2007-2014 (forecast 13-14)



What are the questions? (I/II)

• Is the ‘one-fits-all’ monetary policy in the Eurozone the cause of the crisis? What about asymmetric shocks?

• Have soft monetary policies of the ECB triggered the financial crisis, e.g. the real estate bubble?

• Or is banking regulation the problem, i.e. the Eurozone in the same way affectd as, e.g., the US?

• Has the Eurozone created incentives for moral hazard in fiscal policies? Has the Stability and Growth Pact failed?



What are the questions? (II/II)

• Is the risk of a sovereign debt crisis and capital flight higher in a Currency Union rather than in the case of national currencies?

• Creates the EURO System additional opportunities to raise unsustainable debts? TARGET2 debt stocks?

• Is state bankruptcy possible in the Eurozone?

• Is it better to move to a transfer union? How?

• Would it help countries to leave the Eurozone?



Monetary policies and asymmetric shocks

• Recall: Optimal currency area theory focuses on asymmetric shocks

• Economic structures between the North and the South might be diverse (manufacturing vs. tourism), but are affected by business cycle shocks in similar way

• The ‘Great Recession’ 2008-09 affected therefore countries with strong manufacturing sectors (export demand shock) as least as much as countries with strong tourism



Wages and current account imbalances in the Eurozone

• If prices and wages are not flexible, different (productivity adjusted) wage developments can create imbalances in current account, which have to be matched by capital inflows

• In theory, Hume’s mechanism would guarantee a balance of payments equilibrium and in long-term also equilibrium in current account

• In practice, this need not necessarily be the case, since current account imbalances are financed by public transfers in one way or another (see below)



Real Earnings (change in %: 2008 vs. 2000)



Real wage index (1995 = 100), 1995-2010



Relative unit labour costs (index: 2000 = 100)



Current account balance in % of GDP, 2004-2011



Current account balance in % of GDP, 2004-2011



The bottomline

• Wage growth has been unbalanced in Eurozone, but (productivity adjusted) real unit labour costs have been much less unbalanced. This suggests that different rates of wage growth reflect different productivity growth patterns

• But: current account surplus of Germany tended to increase persistantly and substantially, while current account of Greece, Portugal and Spain deteriorated persistantly. This is a first hint for imbalances in the Eurozone



Public vs. private debt

• Conventional wisdom explains EURO crisis by moral hazard of governments in Eurozone

• But: With the notable exception of Greece, (i) public debt has fallen and not increased in Eurozone before the crisis, and (ii) private debt has increased dramatically before the crisis

• Bank debt has increased more than corporate debt

• Thus, banking regulation and moral hazard in private sector might be more underrated in the debate (DeGrauwe 2010)



Government and private debt in the Eurozone, 1999-2008



Government debt in % of GDP, 1995-2011

pre –crisis developmentpost –crisis development



Bank liabilities and corporate debt, 1999-2008



Growth of bank loans in the Eurozone, 2003-2009



The bottomline II

• With exception of Greece, the dramatic increase of private debts (real estate loans) are the first cause of financial crisis

• The crisis of the banking sector forced govern-ments to take-over private debts to avoid systemic failure of financial sector

• This increased dramatically public debts in some countries which had low public debts before

• ‘Great Recession’ increased public debt further through automatic stabilizers and fiscal packages



Has ECB monetary policies triggered the financial crisis?

• Hypothesis: low and ‘one-fits-all’ interest rate policies have triggered financial crisis, i.e. real estate bubble

• Interest rates indeed substantially declined in some countries (e.g. Greece, Italy)

• But: A deeper analysis suggests that the ECB interest rate policies followed closely what we expect in case of a strict application of ‘Taylor’s rule’



Long-term interest rates (10 year government bonds)



Long-term interest rates (10 year government bonds)



Long-term interest rates (10-year government bonds)



Did the ECB violate Taylor‘s rule? (I/III)

• Taylor’s Rule: Central Banks policies can be explained by the following simple formula:

it = 2 + pt + a(pt – p*) + b(yt –yt*) (1)

• where i is the interest rate, pt the current inflation,

p* the inflation target (2%), and yt the output gap

as a percentage of potential output yt*.

• a is the weight assigned by Central bank to price stability, b the weight assigned to economic stability and growth.



Did the ECB violate Taylor‘s rule? (II/III)

• Taylor’s rule helps to stabilize expectations of market participants.

• It explains usually Central Banks monetary policies pretty well.



Did the ECB violate Taylor‘s rule? (III/III)

• To check whether a Central Bank follows Taylor’s rule is therefore a good indicator whether monetary policies has deviated from standard path under given economic conditions

• The answer is, the ECB has not. The interest rate was only slightly below the rate predicted by Taylor’s rule. And less below than the US rate (Dokko et al., 2011)



Do low interest rates explain real estate bubble?

• More importantly, we cannot explain the boost in housing prices by national interest rates in most Euro countries empirically (Dokko et al., 2011)

• But we can explain the boost by inprudent banking regulation and the subsequent financial packages like subprime mortages.

• Thus, the right policy response is to reform banking regulation not monetary policies.

• Bottomline: Housing price bubble is a key reason for public debt problem in Eurozone today.



Spain: Real estate prices (EURO per qm)



Ireland: Real estate prices (Index: 2003 = 100)



Construction production (Index: 2000 = 100)



Are governmental debts different in a currency union?

• So far we know that (i) public debts of EURO countries have substantially increased in course of crisis, and (ii) this has started as a debt crisis in the private (financial sector) –- with the notable exception of Greece.

• Ok, that happens to other countries as well, e.g. Japan, the US and UK. But these countries are so far not affected by a currency crisis. Why?

• And why are the US, UK and Japan with a higher debt-to-GDP ratio than many crisis countries in Eurozone not affected?






Net lending in % of GDP, 2007-2012



10-year goverment bond yields in %, 2008-2012




• Let’s consider two cases. Case 1: Investors fear debt default in country with a national currency:

• sells government bonds

• sells the currency on exchange market

• exchange rate drops

• but money stocks remains unchanged

• eventually Central Bank buys government bonds

• this generates inflation and exchange rate depreciation, but no liquidity risk. Only for countries which cannot issue bonds in national currencies.




• Case 2: Investors fear debt default of country in Currency Union:

• sells e.g. Greek government bonds

• buys e.g. German government bonds

• EUROs leave Greece, monetary stock contracts there

• Government faces liquidity crisis, i.e. cannot lend money at reasonable interest rate

• There is no channel to create liquidity

• Unless the ECB buys Greek goverment bonds (This is what it started to do in 2012, see below.)




• Thus, the answer is yes. Why? Without a Central Bank you can’t generate liquidity by printing money

• The role of expectations about sovereign debt default become increasingly important

• Multiple equilbria and self-fullfilling prophecies can emerge (De Grauwe 2011)

• This need not to be the case in Greece, but in other countries such as Spain or Italy



Another problem: The TARGET2 debts

• Theory: In a CU the balance of payments balance is always guanteed by the influx or outflow of money, such that the current account surplus/deficit exactly matches the capital account deficit/surplus

• Recall Hume’s price-specie-mechanism

• This is not entirely true in EURO System

• The «Trans-European-Automatic-Real-time Gross-Settlement Express Transfer» (TARGET2) system allows for balance-of-payments-imbalances



How does the TARGET2 system work?

• The TARGET2 system allows (theoretcially) short-term debts of Central Banks and private actors at a Central Bank

• E.g. real estate credits are accepted as collateral

• Debits and credits cancel out exactly

• 2012 TARGET2 debts of Greece, Ireland, Spain and Portugal numbered 340 billion Euros, Bundesbank held 326 billion Euros of these (ifo)

• Basically, current account deficits of PIGS are largely financed by TARGET2 system



What are the implications?

• Risk of default is difficult to assess

• There might be bad collaterals in portfolio of Bundesbank and other Central Banks

• Deficits in current account are no longer financed by capital account surpluses, such that equilibriating forces are distorted

• Long-run disequilibria may emerge



Solutions to the EURO crisis

• Abondining no-bailout policies

• Financial Transfers

• Change of TARGET2 transfers

• Eurobonds

• Leaving the Eurozone

• Banking regulation



Abondoning the no-bailout policies

• The treaties rule out (i) buying governmental bonds by the ECB and (ii) financial transfers

• Note that Optimal Currency Area theory suggests that transfers are needed

• Actually, European policy makers have abondoned both principles in practice: First, the ECB buys governmental bonds from crisis countries, and, second, the ESM and ESFM create a transfer union



Recall principle one: no bail-out by the ECB

• The no-bailout clause:Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments. (Art. 101)



Bail-out by ECB (I/II)

• We have seen, that expectations of debt default

can generate vicious circle which result in liquidity

crisis and eventually debt default

• Buying governmental bonds can break this

expectations similar to national Central Bank

policies• Two problems: Moral hazard of governments and

credibility of Central Bank• Solution: difficult, since conditionality can be

hardly imposed by ECB (time limits)



Bail-out by ECB (II/II)

• Announcing that Central Bank buys government is

a strong commitment, since they can print money

• Fast to implement• Draghis famous announcement stabilized

expectations of financial markets after fiscal transfer committments failed

• Moral hazard problem remains




DraghiAnnouncement



Transfer Union

• The European Financial Stability Funds (EFSF) and

the later European Stabilization Mechanism (ESM)

create a transfer union de facto

• Carrot and stick principles: support and

conditionality

• Zero structural debt ceiling (« Schuldenbremse »)

• The problems lie in the details



Transfer Union (II)

• The (EFSF) requests higher interest rates above the

market rate (e.g. 6% for Ireland)

• This high risk premium (i) creates further financial

difficualties and (ii) signals, more importantly, that

EFSF does not belief in success

• The ESM took over debts from ESF, but request that

private actors participate in debt restructuring



Transfer Union (III)

• The ESM took over debts from ESF, but requested

that private actors participate in debt restructuring

• This seems to be a good idea at first glance, but

markets will anticipate this and require additional

risk premium in first instance

• Volume: 750 billion EUROs

• Establishment was not sufficient to calm down

markets. Complementary measures from ECB were

needed



Eurobonds

• Would ease refinancing for governments, but

creates (i) moral hazard problem and (ii) higher

interest rates for ‘good’ countries

• BRUEGEL model: blue and red bonds: Blue Bonds

up to debt of 60% of GDP, Red Bonds for remaining

debts. This would create higher interest rates for

high debt countries, and low ones for low debt

countries (Delpha/von Weizsäcker, 2010)

• Combining this models with different fees for Blue

Bonds (De Grauwe/Moesen, 2009)



Government Bankruptcy in Eurozone

• In principle, there is no reason why goverments of

Euro members could not go bankrupt. Similar to

private actors

• Risks: Contagion to other countries by forming

vicious circle of bad expectations

• Systemic risk by breakdown of banking sector, at

least in affected country

• Moderate version: the so-called ‘hair-cut’



Leaving the Eurozone

• Would allow to depreciate currency

• Would not allow solvoing debt problem by printing

money, since debts are issued in EUROs

• Debt default is unavoidable. Risk of systemic

failure of financial system and of contagion

• High risk of new default, since it is likely that new

debts are not accepted in new currency

• Note that currency depreciation cannot solve long-

run structural problems



Banking regulation

• It is largely uncontroversial that the regulation of banks has to be reformed

• But not much is done

• Higher capital demands for banking sector

• Better regulation of derivatives

• ECB branch is in charge of regulation. This is conroversial

• Is complex and beyond this lecture


Literature

Baldwin, Richard und Daniel Gros (2010): The euro in crisis - What to do? In: Baldwin, Richard, Daniel Gros und Luc Laeven (Hrsg.): Completing the Eurozone Rescue: What more needs to be done? London, VoxEU, 1-24.

Corden, W. Max (1972): Monetary Integration. Essays in International Finance. (93).Clarida, Richard, Jordi Gali und Mark Gertler (2002): A Simple Framework for International

Monetary Policy Analysis. Journal of Monetary Economics. 49 (5), 879-904.Ingram, J. (1969): Comment : The Optimum Currency Problem. In: Mundell, Robert und A

Swoboda (Hrsg.): Monetary Problems of the International Economy. Chicago and London.Ishiyama, Yoshihide (1975): The Theory of Optimum Currency Areas: A Survey. International

Monetary Fund Staff Papers. 22 (2), 344-383.Mayer, Thomas (2010): What more do European governments need to do to save the

Eurozone in the medium run? In: Baldwin, Richard, Daniel Gros und Luc Laeven (Hrsg.): Completing the Eurozone Rescue: What more needs to be done? London, VoxEU, 1-24.

Persaud, Avinash D. (2010): The european bicycle must accelerate. In: Baldwin, Richard, Daniel Gros und Luc Laeven (Hrsg.): Completing the Eurozone Rescue: What more needs to be done? London, VoxEU, 1-24.

Kenen, Peter B. (1969): The Theory of Optimum Currency Areas: An Eclectic View. In: Mundell, Robert und A Swoboda (Hrsg.): Monetary Problems of the International Economy. Chicago, London, 41-59.

Wyplosz, Charles (2007): Debt Sustainability Assessment: The IMF Approach and Alternatives. HEI Working Paper 03/2007, Geneva.



Exam

• Trade and trade policy• Preferential trade liberalization• Integration and increasing returns to scale

(BECOMP)• Trade and competition policies• Dynamic effects of integration• Factor mobility• Optimum currency areas• Euro and the crisis

Documents

Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 8 The EURO Crisis Theory and Politics of European Integration