The Euro Crisis: Causes and Solutions

Dr. Tom McDonnellNERI (Nevin Economic Research Institute)DublinTom.mcdonnell@nerinstitute.net

NERI/ETUI Conference: Fixing Europe’s Public Debt25-26 November 2015

ASYMMETRIC UNION The Euro Crisis: Causes and Solutions

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– Domestic objectives/concerns eventually undermine monetary union in absence of political union

•Is EMU different?– 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. Full freedom of cross-border capital movements (part of EU membership);B. A fixed exchange rate (important for the functioning of the single market);C. 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……

CRISIS BUILD-UPThe Euro Crisis: Causes and Solutions

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

– 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

• 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– 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) – build-up 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 crisisB. Banking crisisC. 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 PerformanceSource: De Grauwe, 2015

EU10 = non-Euro area EU countries

OFFICIAL RESPONSEThe Euro Crisis: Causes and Solutions

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 unionStage 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

PROPOSED REFORMSThe Euro Crisis: Causes and Solutions

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 it3. 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)

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……..

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

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 framework1.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

LOOKING AHEADThe Euro Crisis: Causes and Solutions

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