Theorie und Politik der Europäischen Integration Theory ... · Theorie und Politik der...

Theorie und Politik der Europäischen Integration

Prof. Dr. Herbert Brücker

Dr. Ehsan Vallizadeh

Lecture 8

Fiscal Policy and the Stability Pact

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

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

Fiscal Policy and the Stability Pact

• Relevance of fiscal policies in a monetary union

• Limitations of fiscal policies

• Automatic stabilizers vs. discretionary policy actions

• Negative and positive spill-overs: the case for policy coordination

• Deficit bias in the EMU

• The No-Bailout Clause in the Mastricht Treaty

• The Stability and Growth Pact

• The 3% and the 60% ceiling and implementation via the Excessive Deficit Procedure

• Controversial issues



The EURO Crisis



The EURO crisis: outline

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 (“Grexit”)



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 %)



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

• But:

• Burst of real estate bubbles in many Member States

• High risks of bank failures in private sector

• Sovereign debt crisis of some members of EURO zone

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

• High spread of interest rates within EURO zone

• Zero growth in the Eurozone and serious recessions in

some Member States with high unemployment



Real GDP growth rate in %, 2001-2014



Harmonized unemployment rates (ILO norm) in %, 2001-2014



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, a single currency 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)



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 substantially in the

first place. Meanwhile, under the pressure of structural

adjustment, the current account improves there. Still, the

development of the current account is a first hint for

imbalances within the Eurozone.



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



Real wage index (2007 = 100), 2001-2013



Current account balance in % of GDP, 2001-2013



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 before the crisis, 1999-2008



Government debt in % of GDP, 2001-2013

pre –crisis development post –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’



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)



Long-term interest rates (10 year government bonds) before the crisis …



… and after

crisis phase



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 (2007 = 100)



Why are governmental debts different in a CU?

• 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?



General Government Debt in % of GDP, 2001-2013



General Government Debt in % of GDP, 2007-2013



Budget saldo in % of GDP, 2001-2013



10-year goverment bond yields in %, 2001-2014



10-year government bond yields spread in EURO zone

crisis phase




• 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 announced to do in 2012, see below.)




• Thus, the government debts are different in a CU

• 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

• Actually, Target saldos have declines. Equilibrium

might be achieved automatically



Solutions to the EURO crisis

• Abandoning no-bailout policies

• Financial Transfers

• Change of TARGET2 transfers

• Eurobonds

• Leaving the Eurozone («Grexit»)

• Banking regulation



Abandoning the no-bailout policies

• The treaties rule out (i) buying governmental bonds by

the ECB for deficit financing (but allows it in other

cases) and (ii) financial transfers by ECB

• Note that Optimal Currency Area theory suggests that

transfers are needed

• Actually, we see two developments in practice: First,

the ECB announced to buy governmental bonds if

needed (but did not do so until recently) from crisis

countries, and, second, the ESM and ESFM actually

create a transfer union (but is not called so)



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 (or announcing to do so)

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

• ECB President Draghi‘s famous announcement stabilized expectations of financial markets after fiscal transfer committments failed

• Moral hazard problem remains



Long-term interest rates (10 years government bonds)

Draghi‘s

Announcement



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

difficulties and (ii) signals, more importantly, that

EFSF does not belief in success



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 (Grexit)

• Would allow to depreciate currency

• Would not allow solving 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



The Greece crisis summer 2015

• Failure of negotiations between Syriza-led

government and Eurozone finance ministers

• Controversial: macro-economic policies,

privatization, further budget cuts for health

system, pensions, mean-tested benefits, and ….

• Debt default without agreement seemed to be

unavoidable – no chance to issue new government

bonds and reschedule public debts

• Bank-run followed by closure of banks



The Greece crisis summer 2015 (cont.)

• Grexit plan by Schäuble and other Eurozone

finance ministers increased pressure

• Agreement based on similiar conditions as the

originally planned package

• But expected deficit and size of package has

increased

• Questionable whether package works and the

Greek economy will recover. But this is the

precondition for fiscal stabilization



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

Topics

• Microeconomics of Trade

• Preferential Trade Liberalization

• Scale Economies (BECOMP diagram)

• Trade and Competition Policies

• Dynamics of integration

• Capital and labour mobility

• Macroeconomics of monetary integration

• Optimum Currency Area Theory

• European Monetary Union and Eurocrisis (next lecture)

GOOD LUCK!

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