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

The Last Lecture (I/II) 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?

Fiscal Policy and the Stability Pact Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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) 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

Exchange rate USD/EURO Theory and Politics of European Integration Fiscal Policy and Stability Pact Exchange rate USD/EURO Source: OECD STAT database, own calculations.

Inflation (Consumer price index, change p.a. in %) Theory and Politics of European Integration Fiscal Policy and Stability Pact Inflation (Consumer price index, change p.a. in %)

Inflation (Consumer price index, change p.a. in %) Theory and Politics of European Integration Fiscal Policy and Stability Pact Inflation (Consumer price index, change p.a. in %)

The EURO crisis: what are we talking about? (II/II) Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact General Government Debt in % of GDP, 2007-2013

General Government Debt in % of GDP, 2007-2013 Theory and Politics of European Integration Fiscal Policy and Stability Pact General Government Debt in % of GDP, 2007-2013

Net Government Lending in % of GDP, 2007-2013 Theory and Politics of European Integration Fiscal Policy and Stability Pact Net Government Lending in % of GDP, 2007-2013

Net Government Lending in % of GDP, 2007-2013 Theory and Politics of European Integration Fiscal Policy and Stability Pact Net Government Lending in % of GDP, 2007-2013

Central Bank Interest Rate (3 month rate) Theory and Politics of European Integration Fiscal Policy and Stability Pact Central Bank Interest Rate (3 month rate)

Long-term interest rates (10 years government bonds) Theory and Politics of European Integration Fiscal Policy and Stability Pact Long-term interest rates (10 years government bonds)

Long-term interest rates (10 years government bonds) Theory and Politics of European Integration Fiscal Policy and Stability Pact Long-term interest rates (10 years government bonds)

Real GDP growth rate in %, 2007-2012 Theory and Politics of European Integration Fiscal Policy and Stability Pact Real GDP growth rate in %, 2007-2012

Real GDP growth rate in %, 2007-2014 (forecast 13-14) Theory and Politics of European Integration Fiscal Policy and Stability Pact Real GDP growth rate in %, 2007-2014 (forecast 13-14)

Unemployment rate in %, 2007-2012 Theory and Politics of European Integration Fiscal Policy and Stability Pact Unemployment rate in %, 2007-2012

Unemployment rate in %, 2007-2014 (forecast 13-14) Theory and Politics of European Integration Fiscal Policy and Stability Pact Unemployment rate in %, 2007-2014 (forecast 13-14)

What are the questions? (I/II) 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?

What are the questions? (II/II) 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?

Monetary policies and asymmetric shocks 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’ 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 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)

Real Earnings (change in %: 2008 vs. 2000) Theory and Politics of European Integration Fiscal Policy and Stability Pact Real Earnings (change in %: 2008 vs. 2000)

Theory and Politics of European Integration Theory and Politics of European Integration Fiscal Policy and Stability Pact Real wage index (1995 = 100), 1995-2010

Relative unit labour costs (index: 2000 = 100) Theory and Politics of European Integration Fiscal Policy and Stability Pact Relative unit labour costs (index: 2000 = 100)

Current account balance in % of GDP, 2004-2011 Theory and Politics of European Integration Fiscal Policy and Stability Pact Current account balance in % of GDP, 2004-2011

Current account balance in % of GDP, 2004-2011 Theory and Politics of European Integration Fiscal Policy and Stability Pact Current account balance in % of GDP, 2004-2011

Theory and Politics of European Integration 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 persistantly. This is a first hint for imbalances in the Eurozone

Bank debt has increased more than corporate debt 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)

Government and private debt in the Eurozone, 1999-2008 Theory and Politics of European Integration Fiscal Policy and Stability Pact Government and private debt in the Eurozone, 1999-2008

Government debt in % of GDP, 1995-2011 Theory and Politics of European Integration Fiscal Policy and Stability Pact Government debt in % of GDP, 1995-2011 post –crisis development pre –crisis development

Bank liabilities and corporate debt, 1999-2008 Theory and Politics of European Integration Fiscal Policy and Stability Pact Bank liabilities and corporate debt, 1999-2008

Growth of bank loans in the Eurozone, 2003-2009 Theory and Politics of European Integration Fiscal Policy and Stability Pact Growth of bank loans in the Eurozone, 2003-2009

Theory and Politics of European Integration 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

Has ECB monetary policies triggered the financial crisis? 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’

Long-term interest rates (10 year government bonds) Theory and Politics of European Integration Fiscal Policy and Stability Pact Long-term interest rates (10 year government bonds)

Long-term interest rates (10 year government bonds) Theory and Politics of European Integration Fiscal Policy and Stability Pact Long-term interest rates (10 year government bonds)

Long-term interest rates (10-year government bonds) Theory and Politics of European Integration Fiscal Policy and Stability Pact Long-term interest rates (10-year government bonds)

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

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

Do low interest rates explain real estate bubble? 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.

Spain: Real estate prices (EURO per qm) Theory and Politics of European Integration Fiscal Policy and Stability Pact Spain: Real estate prices (EURO per qm)

Ireland: Real estate prices (Index: 2003 = 100) Theory and Politics of European Integration Fiscal Policy and Stability Pact Ireland: Real estate prices (Index: 2003 = 100)

Construction production (Index: 2000 = 100) Theory and Politics of European Integration Fiscal Policy and Stability Pact Construction production (Index: 2000 = 100)

Are governmental debts different in a currency union? Theory and Politics of European Integration Fiscal Policy and Stability Pact 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?

General Government Debt in % of GDP, 2007-2012 Theory and Politics of European Integration Fiscal Policy and Stability Pact General Government Debt in % of GDP, 2007-2012

Theory and Politics of European Integration Theory and Politics of European Integration Fiscal Policy and Stability Pact Net lending in % of GDP, 2007-2012

10-year goverment bond yields in %, 2008-2012 Theory and Politics of European Integration Fiscal Policy and Stability Pact 10-year goverment bond yields in %, 2008-2012

Are governmental debts different in a currency union? Theory and Politics of European Integration Fiscal Policy and Stability Pact Are governmental debts different in a currency union? 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.

Are governmental debts different in a currency union? Theory and Politics of European Integration Fiscal Policy and Stability Pact Are governmental debts different in a currency union? 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.)

Are governmental debts different in a currency union? Theory and Politics of European Integration Fiscal Policy and Stability Pact Are governmental debts different in a currency union? 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 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

How does the TARGET2 system work? 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

What are the implications? 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

Solutions to the EURO crisis Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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 Theory and Politics of European Integration Fiscal Policy and Stability Pact 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)

Theory and Politics of European Integration 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 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) 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 Draghis famous announcement stabilized expectations of financial markets after fiscal transfer committments failed Moral hazard problem remains

Long-term interest rates (10 years government bonds) Theory and Politics of European Integration Fiscal Policy and Stability Pact Long-term interest rates (10 years government bonds) Draghi Announcement

Carrot and stick principles: support and conditionality 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

Theory and Politics of European Integration 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 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

Theory and Politics of European Integration 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

Theory and Politics of European Integration 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)

Government Bankruptcy in Eurozone 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’

Would allow to depreciate currency Theory and Politics of European Integration Fiscal Policy and Stability Pact 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

Higher capital demands for banking sector 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

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.

Preferential trade liberalization Theory and Politics of European Integration Fiscal Policy and Stability Pact 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