The role of shocks and institutions in EMU and the US during the crisis

Rafael Doménech

The role of shocks and institutions in EMU and the US during the crisis

July 25, 2013

The role of shocks and institutions in EMU and the US during the crisis July, 2013

Page 2

1.  Introduction

2.  The role of shocks 3.  The role of institutions 4.  Conclusions

Outline


Page 3

Both the USA and EMU suffered an intense recession in 2008 and 2009 …

But EMU has suffered an additional sovereign debt crisis*, with important implications in terms of its

cyclical gap

… caused by a financial crisis with huge effects on international trade

The crisis in EMU and the USA

GDP per working-age population Source: BBVA Research

10.4%

10.5%

10.6%

10.7%

10.8%

10.9%

11.0%

1994% 1996% 1998% 2000% 2002% 2004% 2006% 2008% 2010% 2012%

EMU%

USA%

Average%growth=1.28%

Average%growth=1.33%

GDP%per%WAP%gap%

Cyclical%gap%

(*) See Andrés and Doménech (2012a), Lane (2012) and Shambaugh (2012)


Page 4

The USA has recovered 2/3 of the fall in GDP per working-age population

… such that the current level of GDP per working-age population is slightly lower than in 2009

The sovereign debt crisis in EMU put an end to the recovery of 2010 and 1H2011 …

The crisis in EMU and the USA

GDP per working-age population (2Q2008=100) Source: BBVA Research

88"

90"

92"

94"

96"

98"

100"

102"

mar,00" mar,02" mar,04" mar,06" mar,08" mar,10" mar,12"


Page 5

USA: unemployment rate and the NAIRU Source: BBVA Research

Two different dynamics of the unemployment rate

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

1980 1984 1988 1992 1996 2000 2004 2008 2012

EMU: unemployment rate and the NAIRU Source: BBVA Research

3%

4%

5%

6%

7%

8%

9%

10%

1980 1984 1988 1992 1996 2000 2004 2008 2012


Page 6

2H2008 to 1H2011: (1) negative financial and international trade shocks, (2) fiscal expansion

Monetary policy has been accommodative to cyclical conditions

2H2011 to 1Q2013: (1) negative financial and fiscal shocks (2) positive international trade shock

Structural shocks and their effects in EMU

Decomposition of GDP per working-age population: cyclical component Source: BBVA Research

-6%

-4%

-2%

0%

2%

4%

6%

2006Q1 2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 2013Q1

TRADE FISCAL MONETARY MACRO FINANCIAL GDP pc

(*) See Doménech, García, Méndez-Marcano and Rubio-Ramírez (2013),


Page 7

2H2008 to 1H2011: (1) negative financial and international trade shocks, (2) fiscal expansion

Labour market shocks have contributed to a smaller increase of the unemployment rate

2H2011 to 1Q2013: (1) negative financial and fiscal shocks (2) positive international trade shock

Structural shocks and their effects in EMU

Decomposition of the cyclical component of the unemployment rate Source: BBVA Research

(*) See Doménech, García, Méndez-Marcano and Rubio-Ramírez (2013),

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

2006Q1 2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 2013Q1

TRADE FISCAL MONETARY MACRO FINANCIAL Unemployment rate


Page 8

Differences between the USA and EMU caused by …

… shocks? … their interaction with institutions?

5. Monetary policy

6. Financial integration: banking union

7. Fiscal integration

8. Economic integration

1. Financial shocks

2. International trade

3. Fiscal shocks

4. Supply shocks


Page 9

EMU US UK

Public deficit 2011 -4,4 -9,6 -8,9

Public debt 2011 87,6 100,0 84,8

Households debt 2010 67,3 92,1 106,1

Firms debt 2010 119,1 74,6 123,7

Current account balance 2011 0,1 -3,1 -2,7

Net external debt 2010 -7,2 -17,0 -13,9

EMU had smaller aggregate imbalances than the US …

… in public, private or external sectors ..

… but with a high internal heterogeneity ->

… or aggregate imbalances?

Imbalances in EMU and the US before the sovereign crisis (% GDP) Source: AMECO, Haver, IMF, national sources and BBVA Research


Page 10

Bel

gium

Den

mar

k

Ger

man

y

Irel

and

Gre

ece

Spai

n

Fran

ce

Ital

y

Net

herl

ands

Aus

tria

Port

ugal

Finl

and

EMU

Current account -0.6 3.9 5.9 -2.7 -12.1 -6.5 -1.7 -2.8 5.0 3.5 -11.2 2.1 -1.4

Net IIP 77.8 10.3 38.4 -90.9 -92.5 -89.5 -10.0 -23.9 28.0 -9.8 -107.5 9.9 -21.6

Real exchange rate 1.3 1.0 -3.0 -5.0 3.9 0.6 -1.4 -1.0 -1.0 -1.3 -2.4 0.3 -0.7

Export shares -15.4 -15.3 -8.3 -12.8 -20.0 -11.6 -19.4 -19.0 -8.1 -14.8 -8.6 -18.7 -14.3

ULC 8.5 11.0 6.6 -2.3 12.8 3.3 7.2 7.8 7.4 8.9 5.1 12.3 7.4

Housing prices 0.4 0.6 -1.0 -10.5 -6.8 -4.3 3.6 -1.5 -2.9 -1.5 0.1 6.6 -1.4

Private credit 13.1 5.8 3.1 -4.5 -0.7 1.4 2.4 3.6 -0.7 6.4 3.3 6.8 3.3

Private debt 232.8 244.2 128.1 341.3 124.1 227.3 159.8 126.4 223.4 165.7 248.5 177.7 199.9

Public debt 96.2 43.4 83.2 92.5 144.9 61.0 82.3 118.4 62.9 71.8 93.4 48.3 83.2

Unemployment rate 7.7 5.6 7.5 10.6 9.9 16.5 9.0 7.6 3.8 4.3 10.4 7.7 8.4

… but high internal heterogeneity across EMU countries

Macroeconomic imbalances in EMU (Six Pack), 2010 Source: BBVA Research, Eurostat and Haver


Page 11

1.  Introduction

2.  The role of shocks 3.  The role of institutions 4.  Conclusions

Outline


Page 12

BBVA financial tensions index Source: BBVA Research

1. Financial shocks Financial tensions during the crisis

2008-9: Financial shock much more intense in the USA than in EMU

Now EMU has an opportunity window that should be opened up to ensure the economic recovery

2H2011 to 1H2012: sovereign debt crisis in EMU and contagion in the USA

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

USA EMU

Lehman Brothers

1st bail out of Greece

Risk of Euro break up

Sovereign & banking contagion in the EZ


Page 13

1. Financial shocks Financial fragmentation still high

BE

DE

IE

EL

ES

FR

IT CY

LU (290%)

MT

NL AT

PT

SI SK

FI

1.0

10.0

-80% -60% -40% -20% 0% 20% 40%

10-y

gov

ernm

ent b

ond

yiel

ds (l

og. s

cale

)

TARGET2 (in % of GDP)

4.0

30.0

ES

DE

IT IE

PT

FI

NL

BE

LU (230%)

FR

EL

AU

CY

SK

SI

MT

1.0

10.0

-80% -60% -40% -20% 0% 20% 40% 10

-y g

over

nmen

t bon

d yi

elds

(log

. sca

le)

TARGET2 (in % of GDP)

4.0

30.0

Interest rates and TARGET2, June 2012 Source: ECB and BBVA Research, June 2012

Interest rates and TARGET2, June 2013 Source: ECB and BBVA Research, June 2012


Page 14

1. Financial shocks Financial fragmentation still high

Interest rate of new loans to businesses (Up to one million un euros, more than 5 years) Source: ECB

2

3

4

5

6

7

8

May

-08

Nov-

08

May

-09

Nov-

09

May

-10

Nov-

10

May

-11

Nov-

11

May

-12

Nov-

12

May

-13

Euro Area Germany France Spain Italy

Financial tensions have declined significantly from August 2012 …

… creating very heterogeneous financial conditions for the recovery

… but financial fragmentation is still high across countries …


Page 15

2. External shocks International trade has recovered above pre-crisis levels

The external shock in 2H2008 was huge: a fall of 15-20% in exports levels

The contribution of exports to GDP are three times larger in EMU than in the USA

The recovery of exports has been quite similar in EMU and the USA

USA and EMU: Exports levels (2Q2008=100) Source: BBVA Research

75#

80#

85#

90#

95#

100#

105#

110#

mar+06# mar+07# mar+08# mar+09# mar+10# mar+11# mar+12# mar+13#

USA (14% of GDP)

EMU (45% of GDP)


Page 16

3. Fiscal shocks Similar patterns of public consumption and investment …

Despite the conventional wisdom, the patterns of public consumption and investment per working-age

population have been quite similar …

Both in EMU and the USA current levels are similar to those observed in 1Q2007

… first during the fiscal expansion and later during the fiscal consolidation (-8 pp)

USA and EMU: Public consumption and investment per working-age population (2Q2008=100) Source: BBVA Research

USA

EMU


Page 17

3. Fiscal shocks … with a great heterogeneity across EMU countries

The response of real public consumption and investment has been very heterogeneous in EMU …

… whereas others, with high growth of public expenditures from 1999 to 2008, have been implementing a contractionary fiscal policy

… with some countries applying expansionary fiscal policies …

EMU: real public consumption and investment per working-age population in 1999 and 2013 (2008=100) Source: AMECO and BBVA Research

USA EMU

BEL

DEU

EST

IRL

GRC

ESP

FRA

ITA

CYP

LUX MLT

NLD AUT

PRT

SVN

SVK

FIN

50

60

70

80

90

100

110

120

40 60 80 100

20

13

1999

Expansionary fiscal policy since 2008

Contractionary fiscal policy since 2008


Page 18

jan$99&

jul$08&

jul$09&

jul$11&

apr$13&

jul$09&

jul$11&

apr$13&

$2&

$1&

0&

1&

2&

3&

4&

5&

6&

3& 4& 5& 6& 7& 8& 9& 10& 11& 12& 13&

CPI&(%&y/y)&

Unemployment&rate&(%)&

4. Supply shocks Different unemployment and inflation dynamics

New empirical evidence on the Phillips curve suggests that is flatter today than in the past (IMF, 2013)

Inflation and unemployment dynamics from 2011 are consistent with a negative demand shock in EMU

and a positive supply shock in the USA

Although headline inflation is at similar levels in the USA and EMU, unemployment dynamics are different

USA and EMU: Phillips curves Source: BBVA Research

USA

EMU


Page 19

Preliminary conclusions about the role of shocks

1. Financial shocks: more intense in the USA than in EMU in 2008 and 1H2009

2. Similar international trade shocks

3. Similar fiscal shocks

4. Some evidence of positive supply shocks in the USA


Page 20

1.  Introduction

2.  The role of shocks

3.  The role of institutions 4.  Conclusions

Outline


Page 21

Central bank balance sheet as % of GDP Source: Bloomberg and BBVA Research

5. Monetary policy

Differences in size and timing, …

Both the Fed and the ECB have increased their balance sheets in response to the crisis, but with

some significant differences:

2. Timing: the Fed was more aggressive in 2008-9 whereas the ECB was more aggressive in response

to the sovereign debt crisis

1. Size: the size in terms of GDP has increased by 4x in the Fed and 2x in the ECB

5%

10%

15%

20%

25%

30%

35%

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Fed

ECB


Page 22

Composition of central banks balance sheets by type of asset Source: Bloomberg and BBVA Research

5. Monetary policy

… differences in the composition of assets and maturities, …

3. The composition of central banks balance sheets is quite different:

The Fed has been much more active buying public debt and affecting the slope of the yield curve

The ECB has solved the liquidity problems of financial institutions

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Jan-0

7

Jun-1

3

Jan-0

7

Jun-1

3

Fed ECB

Government Securities Non-governement securities

Lending to financial institutions Other assets


Page 23

5. Monetary policy

… and differences in the forward guidance

The dual mandate (inflation and activity) of the Fed makes forward guidance potentially more successful than in the case of the ECB

Despite its previous non-commitment policy, the ECB introduced a softer version of forward guidance in July, 2013:

low interest rates for an extended period of time

The Fed introduced two thresholds for forward guidance: inflation below 2.5% and unemployment rate above 6.5%

Although it would be very informative, the ECB cannot introduce a threshold in terms of the unemployment rate


Page 24

•  Unlimited purchases of sovereign in secondary markets;

•  1-3 year bonds; •  Possibility of ESM to buy in primary market

OMT program of sovereign bond

purchases:

a sizeable “announcement effect”

•  ESM renounces to preference status

•  Only after official request of support to ESM •  Conditionality required

•  Designed to avoid countries losing market access

5. Monetary policy

The ECB as a bridge towards a more genuine EMU


Page 25

Despite its limitations (objectives and no mutualizaton of public and private debt), the ECB has been the most efficient European institution, avoiding

the break up of euro and the collapse of some peripheral economies

Downward bias on interest rates, including the possibility of negative deposit rate

Rate cuts to 0.5% and extension of full allotment until mid-2014. The economic impact of the rate cut is presumably limited

Coordinated action with EIB and EC to support credit to SMEs and new collateral discounts for ABS to ease lending in EMU periphery

5. Monetary policy



Page 26

The solution has benefits but also costs

Problem 1: How to distribute the solution costs in the short term between the members?

Problem 2: How to design a time-consistent solution and the conditions to carry it out?*

5. Monetary policy


EFSF & ECB +

Six Pack ESM

European Treasury Eurobonds

Very short run Short to medium run

Long run

ESM ->Gov’ts +

SSM

ESM .> Banks +

SRM

European banking union

Short run

Short to medium run

Long run

See Andrés and Doménech (2012b)

Fiscal union

Banking union

(*) See Andrés and Doménech (2012b), Buti and Carnot (2012), Henning and Kessler (2012) or Sargent (2012)


Page 27

Single Supervisory Mechanism (SSM) reduces banking fragmentation and restores interbank market

The Single Resolution Mechanism (SRM) with participation of the private sector increases incentives to mutualize part of resolution funds

Convergence of financing costs and evolution towards trans-european banks

Banking union helps breaking the loop between banking and sovereign risk

6. Financial integration

Banking union (I): the benefits


Page 28

2013 2013-14 2018? ?


Banking union (II): the initial agenda

•  AQR in late 2013

•  ECB direct supervision of ≈ 137 significant banks since May-June 2014

•  ECB may decide to intervene any credit institution

•  CRDIV: Approved by EP, pending of Council adoption

•  BRRD: EC June 2013 and Parliament in October

•  No details

•  ESM Recapitalization (operational framework): June 2013

•  COM proposal of a SRM: June 2013

•  DE two-step proposal: (i) Network of national RAs + ESM as backstop; ii) Changing treaties and SRM

Single Rulebook (EU 27)

Single Supervisory Mechanism (EZ)

Single Resolution Mechanism (EZ)

Single DGS (EZ)

Pillar I

Pillar II Pillar III

Pillar IV


Page 29


Banking union (III): the state of the play

The legal basis is weak. Eventually, a reform of the Treaty may be needed

The Assets Quality Review should restore confidence on the European banking system, but this may require a sufficiently big backstop

The roadmap shows that the process advances towards a Banking Union, but other changes are needed to decoupling sovereign and banking risks

The problem lies in the transition: single supervision with national resolution funds


Page 30

At the December summit, all focus on banking union. Progress towards a fiscal union has been delayed

The key would be an agreement between Germany (accept eurobonds) and France (accept additional EU control of national budgets)

The Treaty on Stability and the Six Pack appear to be sufficient for now

State of the play

Options for eurobonds

Neither necessary nor sufficient, but convenient as insurance mechanism

1.  Blue/red bonds (Delpla and Von Weizsäcker, 2011 )

2.  Eurobills (mutualize only part of short-term debt)

3.  Debt Redemption Fund (Schmidt and Weigert, 2013): Temporary insurance of debt over 60% of GDP

7. Fiscal integration Fiscal union has been delayed


Page 31

Application

Other macroeconomic imbalances

Fiscal side: Strengthening the SGP

•  Approved in December 2011 •  Applies to EU27, with some specifics for eurozone on sanctions

Reinforcing the Excessive Deficit Procedure (EDP):

•  It defines what is a “significant deviation” of budget balance from medium-term objective or its adjustment towards it

•  Launches an EDP when debt ratio does not diminish towards 60% at a satisfactory pace (not only when deficit is above 3% as was the case so far)

•  Sanctions by the Commission adopted by the Council unless a qualified majority (QM) of countries are against it. Until now a QM was needed to approve sanctions

•  Macroeconomic Imbalance Procedure: Extends surveillance to other imbalances of the private sector and the external accounts

•  European Semester: The aim is to identify imbalances earlier on (roughly from January to June) to end up with recommendations on budget and structural reforms to be incorporated in budgetary process in the fall

7. Fiscal integration Six Pack: reinforcing the SGP with macro surveillance


Page 32

External imbalances

Current account balance (% GDP, 3-year moving avg)

Competitiveness

-4% to +6%

Net international investment position (% GDP) > -35%

Export market shares (5 year % change) >-6%

Nominal unit labour cost in value (3 year % change) <9%

Real effective exchange rate, CPI based (3 year % change) +/- 5%

Private sector imbalances

Private sector debt (% GDP) <160%

Private sector credit flow (% GDP) <15%

Other

Real house prices, consumption deflator based (growth) <6%

General government sector debt (% GDP) <60%

Unemployment rate (3 year moving average) <10%

7. Fiscal integration Six Pack: reinforcing the SGP with macro surveillance


Page 33

Fiscal adjustment focus on the structural deficit, instead of the nominal deficit

Hence, no further measures to offset fiscal slippages due to cyclical factors

Lower fiscal adjustment in the eurozone in 2013 (0,6% GDP after 1.3% in 2012)

Deficit revision and fiscal consolidation Source: BBVA Research

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Previous Revised 2012 2013

Deficit 2013 Fiscal Consolidation

France Italy Spain Portugal

7. Fiscal integration In the meantime, fiscal consolidation at a slower pace


Page 34

8. Economic integration Heterogeneity of structural determinants of growth …

Structural factors in developed economies, 2010 Source: IMF and BBVA Research

Liberal Market Economies Coordinated Market Economies Mixed market Economies

Avge. Medium Term UK USA IRL GER FRA NLD BEL AUT FIN DEN SWE JAP SPA ITA POR GRE Labour market 1 1 1 2 3 2 2 2 1 1 2 1 3 3 3 3 1.9 Corporate regulations 1 1 1 2 2 1 3 2 2 1 1 2 3 2 2 3 1.8 Network regulations 1 1 3 1 2 1 1 1 2 1 1 2 1 2 2 3 1.6 Retail regulations 1 1 1 1 2 1 3 3 2 2 1 1 2 2 2 3 1.8 Professional services reg. 1 1 1 3 2 1 2 2 1 1 1 1 2 3 2 3 1.7

Long term Institutions and contracts 1 2 2 1 2 1 2 1 1 1 2 2 2 3 3 3 1.8 Human capital 2 2 1 2 2 1 1 2 1 1 1 1 3 3 3 3 1.8 Infraestructure 1 1 3 1 1 1 2 2 2 1 1 1 1 3 2 3 1.6 Innovation 1 1 2 1 1 1 1 2 2 1 1 1 3 2 3 3 1.6

Average 1.1 1.3 1.7 1.6 1.9 1.1 1.9 1.9 1.6 1.1 1.2 1.3 2.2 2.6 2.4 3.0 1.7


Page 35

Differences in structural determinants not only result in different GDP per capita …

… but also in huge differences in unemployment rates across EMU countries …

The benefits of EMU should go beyond banking and fiscal union: economic convergence

Regional variation in unemployment rates Source: M. Wynne and J. Koech (2012)

8. Economic integration … and heterogeneity in unemployment rates


Page 36

1.  Introduction

2.  The role of shocks

3.  The role of institutions

4.  Conclusions

Outline


Page 37

Conclusions

•  Aggregate imbalances and shocks were slightly better in EMU and the USA in 2008 and 2009

•  The sovereign debt crisis in EMU was an endogenous shock resulting from European institutions that were not well designed to deal with very heterogeneous internal imbalances and their effects on growth and employment

•  Sooner better than later, decoupling sovereign and banking risks requires some sort of debt mutualization (e.g., public debt redemption fund) and a complete banking union

•  Structural reforms are needed (1) as an exchange for debt mutualization and (2) to promote economic convergence

•  It is crucial to take advantage of the current window of opportunity to ensure economic growth and employment creation, through the implementation of appropriate structural reforms and the improvement of European institutions


Page 38

References Andrés, J. and R. Doménech (2012a): “El Futuro del Euro tras la Gran Recesión”. Libro Marrón, Círculo de Empresarios.

http://www.circulodeempresarios.org/es/publicaciones/libro-marron/el-futuro-del-euro-libro-marron-2012 Andrés, J. and R. Doménech (2012b): “A Solution to the Euro Debt Crisis: Back From the Future” Vox EU, June 26.

http://www.voxeu.org/article/back-future-solution-eurozone-crisis Buti, M. and Carnot, N. (2012): “The EMU Debt Crisis: Early Lessons and Reforms”. Journal of Common Market Studies, 50: 899–911.

doi: 10.1111/j.1468-5965.2012.02288.x Delpla, J., and J. Von Weizsäcker (2011) “Eurobonds: The Blue Bond Concept and Its Implications.” Bruegel Policy Contribution. 2011/02. Doménech, R. A. García, R. Méndez-Marcano and J. Rubio-Ramírez (2013): "Banks, Fiscal Policy and the Great Recession in EMU". Mimeo. BBVA Research. Henning, C. R., and M. Kessler (2012): ““Fiscal Federalism: US History for Architects of Europe’s Fiscal Union.” Bruegel Essays and Lectures Series. IMF (2013; World Economic Outlook Hopes, Realities, Risks. Chapter 3, 79-96. Lane, P. (2012): “The European Sovereign Debt Crisis”. Journal of Economic Perspectives, 26(3), 49-68. Reinhart, C., and K. Rogoff (2009): This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, Princeton University Press. Sargent, T. (2012): “United States Then, Europe Now”. Journal of Political Economy, Vol. 120, No. 1 (February 2012), 1-40.

http://www.wcfia.harvard.edu/sites/default/files/Sargent_Sweden_final.pdf Schmidt, C. M., and B. Weigert (2013): "Weathering the Crisis and Beyond: perspectives for the Euro Area". CEPR Discussion Paper No. 9414. Shambaugh, J. (2012): “The Euro’s Three Crises.” Brookings Papers on Economic Activity. Spring, 157-211.

http://www.brookings.edu/~/media/Projects/BPEA/Spring%202012/2012a_Shambaugh.pdf Wynne, M. and J. Koech (2012): “One-Size-Fits-All Monetary Policy: Europe and the U.S.” Dallas Fed Economic Letter, 7(9).

http://www.dallasfed.org/assets/documents/research/eclett/2012/el1209.pdf

Rafael Doménech

The role of shocks and institutions in EMU and the US during the crisis

July 25, 2013

Business

The role of shocks and institutions in EMU and the US during the crisis