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Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 9 Fiscal Policy and the Stability Pact The EURO Crisis Theory and Politics.

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Präsentation zum Thema: "Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 9 Fiscal Policy and the Stability Pact The EURO Crisis Theory and Politics."—  Präsentation transkript:

1 Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 9 Fiscal Policy and the Stability Pact The EURO Crisis Theory and Politics of European Integration

2 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The Last Lecture 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?

3 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

4 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The fiscal policy instrument In a monetary union, the fiscal instrument assumes greater importance ·The only macroeconomic policy instrument left at the national level ·Its effectiveness is increased (a result from the Mundell- Fleming model) ·Heavily used in 2008 financial crisis and subsequent period A subsitute to transfers Yet, many questions arise regarding its effectiveness and use

5 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Limits on effectiveness The crucial role of private expectations ·A deficit today but a debt tomorrow: who will pay? ·A tax cut, but how permanent? Slow implementation ·Agreement within government ·Agreement within parliament ·Spending carried out by bureaucracy ·Taxes not retroactive Result: countercyclical moves can become procyclical actions and in extreme cases create fiscal crisis (default of government bonds)

6 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact A crucial distinction: automatic vs. discretionary Automatic stabilizers ·Tax receipts decline when the economy slows down, and conversely ·Welfare spending rise when the economy slows down, and conversely ·No decision, no lag: nicely countercyclical ·Rule of thumb: deficit worsen by 0.5% of GDP when GDP growth declines by 1%

7 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Public debt and automatic stabilizers in Europe

8 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact A crucial distinction : automatic vs. discretionary Discretionary actions: a voluntary decision to change tax rates or spending Technically: a change in the structural budget balance But no automatic correction of deficits, so a problem of discipline

9 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Should instrument be subject to some form of collective control? Yes, if national fiscal policies are a source of several externalities (Positive) income externalities via trade Important and strengthened by monetary union A case for some coordination Borrowing cost externalities One common interest rate But EURO area integrated in world financial markets Sovereign debt default risk put other EMU members or ECB under bail-out pressure

10 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact What is the problem with the deficit bias? Fiscal indiscipline in parts of the EURO area might concern financial markets and: Raise borrowing costs for all countries: unlikely, markets can distinguish among countries More serious is the risk of sovereign debt default in one member country capital outflows and a weak EURO pressure on other governments to help out pressure on the Eurosystem (European Central Bank) to help out

11 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The answer to default risk: the no-bailout clause 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)

12 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The answer to default risk: the no-bailout clause The no-bailout clause: Question of credibility Ex post the world looks different: See the Draghi- statement of the ECB on debt default Thus, fears remain Informal pressure Impact on EURO Prevention is better, especially given a tradition of indiscipline

13 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact In the end, should fiscal policy independence be limited? The arguments for: Serious externalities A bad track record, anyway The arguments against: The only remaining macroeconomic instrument National governments know better the home scene

14 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The general principles Two general arguments for collective action Externalities Increasing returns Two general arguments against collective action Heterogeneity of preferences Information asymmetries And a caveat Governments may pursue own interests

15 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact How to restrain fiscal policies? Distinction No.1 Micro/structural aspects (tax and spending levels and structure) Macro aspects (the balance between tax revenues and spending) Distinction No.2 Coordination: voluntary and flexible efforts at taking into account each other’s action Binding commitments or rules

16 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The Stability and Growth Pact Formally, the implementation of the Excessive Deficit Procedure (EDP) mandated by the Maastricht Treaty The EDP aims at preventing a relapse into fiscal indiscipline following entry in euro area The EDP makes permanent the 3% deficit and 60% debt ceilings and foresees fines The Pact codifies and formalizes the EDP

17 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact How the Pact works Emphasis on the 3% deficit ceiling Recognition that the budget balance worsens with recessions: Exceptional circumstances when GDP falls by 2% or more: automatic suspension of the EDP When GDP falls by more than 0.75%, country may apply for suspension Precise procedure that goes from warnings to fining

18 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The procedure When the 3% ceiling is not respected The Commission submits a report to ECOFIN ECOFIN decides whether the deficit is excessive If so, ECOFIN issues recommendations with an associated deadline The country must then take corrective action Failure to do so and return the deficit below 3% triggers a recommendation by the Commission ECOFIN decides whether to impose a fine The whole procedure takes about two years

19 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The fine schedule The fine starts at 0.2% of GDP and rises by 0.1% for each 1% of excess deficit

20 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact How is the fine levied The sum is retained from payments from the EU to the country (CAP, Structural and Cohesion Funds) The fine is imposed every year when the deficit exceeds 3% The fine is initially considered as a deposit If the deficit is corrected within two years, the deposit is returned If it is not corrected within two years, the deposit is considered as a fine

21 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The Broad Economic Policy Guidelines (BEPG) Emphasis on precautionary measures to avoid warnings and fines The stability programmes are embedded in the wider BEPG, a peer-monitoring process that includes the Lisbon strategy Each year, each country presents its planned budget for the next three years, along with its growth assumptions The Commission evaluates whether the submission is compatible with the Pact

22 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Issues raised by the Pact (1) The BEPG shift the focus to ex ante commitments Led to the Irish warning (2001) Decisions are taken by the ECOFIN, a political grouping France and Germany treated leniently in Imposition of a fine can trigger deep resentment Are fines credible? If not, what is left?

23 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Issues raised by the Pact (2) Does the Pact impose procyclical fiscal policies? Budgets deteriorate during economic slowdowns Reducing the deficit in a slowdown may further deepen the slowdown A fine both worsens the deficit and has a procyclical effect The solution: a budget close to balance or in surplus in normal years

24 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Issues raised by the Pact (3) What room left for fiscal policy? Room left for automatic Room left for discretionary stabilizersfiscal policies

25 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Issues raised by the Pact (3) What room left for fiscal policy? If budget in balance or surplus in normal years, plenty of room left for automatic stabilizers Some limited room left for discretion action In practice, the Pact encourages Aiming at surpluses Giving up discretionary policy At first glance, the early years seems to be hardest Takes time to bring budgets to surplus Today we know, it is even harder after a shock

26 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Further controversies Discipline imposed from outside ·A further erosion of sovereignty? Arbitrary limits ·Why 3%? ·What about the debt celing of 60%? Asymmetry The Pact binds in bad years only A budget forever close to balance or in surplus would drive debt/GDP ratio to 0

27 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact The EURO Crisis

28 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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”)

29 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

30 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Exchange rate USD/EURO Source: OECD STAT database, own calculations.

31 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Inflation (Consumer price index, change p.a. in %)

32 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

33 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Real GDP growth rate in %,

34 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Harmonized unemployment rates (ILO norm) in %,

35 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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?

36 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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?

37 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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’ affected therefore countries with strong manufacturing sectors (export demand shock) as least as much as countries with strong tourism

38 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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)

39 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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.

40 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Real Earnings (change in %: 2008 vs. 2000)

41 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Real wage index (2007 = 100),

42 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Current account balance in % of GDP,

43 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Current account balance in % of GDP,

44 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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)

45 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Government and private debt in the Eurozone before the crisis,

46 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Government debt in % of GDP, pre –crisis developmentpost –crisis development

47 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Bank liabilities and corporate debt,

48 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Growth of bank loans in the Eurozone,

49 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

50 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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’

51 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Long-term interest rates (10 year government bonds) before the crisis …

52 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact … and after crisis phase

53 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Did the ECB violate Taylor‘s rule? (I/III) Taylor’s Rule: Central Banks policies can be explained by the following simple formula: i t = 2 + p t + a(p t – p*) + b(y t –y t *)(1) where i is the interest rate, p t the current inflation, p* the inflation target (2%), and y t the output gap as a percentage of potential output y t *. a is the weight assigned by Central bank to price stability, b the weight assigned to economic stability and growth.

54 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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.

55 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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)

56 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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.

57 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Spain: Real estate prices (EURO per qm)

58 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Ireland: Real estate prices (Index: 2003 = 100)

59 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Construction production index (2007 = 100)

60 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Construction production index (2007 = 100)

61 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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?

62 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact General Government Debt in % of GDP,

63 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact General Government Debt in % of GDP,

64 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Budget saldo in % of GDP,

65 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Budget saldo in % of GDP,

66 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 10-year goverment bond yields in %,

67 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 10-year government bond yields spread in EURO zone crisis phase

68 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Why are governmental debts different in a CU? 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.

69 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Why are governmental debts different in a CU? 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.)

70 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Why are governmental debts different in a CU? 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

71 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

72 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

73 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

74 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Solutions to the EURO crisis Abandoning no-bailout policies Financial Transfers Change of TARGET2 transfers Eurobonds Leaving the Eurozone («Grexit») Banking regulation

75 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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)

76 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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)

77 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

78 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact Long-term interest rates (10 years government bonds) Draghi‘s Announcement

79 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

80 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

81 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

82 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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)

83 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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’

84 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

85 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

86 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

87 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

88 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | 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, 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), 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), 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, 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, 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, Wyplosz, Charles (2007): Debt Sustainability Assessment: The IMF Approach and Alternatives. HEI Working Paper 03/2007, Geneva.

89 Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European Integration Fiscal Policy and Stability Pact 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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