Governance for the Eurozone - Integration or Disintegration

7/29/2019 Governance for the Eurozone - Integration or Disintegration

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GOVERNANCE

FOR THE EUROZONE:

INTEGRATION OR

DISINTEGRATION?

EUROPEAN COMMISSIONEuropean Research Area

Funded under Socio-economic Sciences & Humanities


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GOVERNANCEFOR THE EUROZONE:

INTEGRATION OR

DISINTEGRATION?

EDIED BYFranklin AllenElena Carletti

Saverio Simonelli

With a oreword byJosep Borrell Fontelles

AUHORSLeszek Balcerowicz

Antonio BorgesRussell CooperPaul De GrauweBruno De Witte

Charles GoodhartJanet Kersnar

Friedrich K. KblerBrigid Laan

Wolgang MnchauVictor Ngai

Pier Carlo PadoanRichard PortesFrank Smets

Paul van den NoordGuntram WolJacques Ziller

European University InstituteFlorence, Italy

andWharton Financial Institutions Center

University o Pennsylvania, Philadelphia, USA


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Published by FIC PressWharton Financial Institutions Center2405 Steinberg Hall - Dietrich Hall3620 Locust WalkPhiladelphia, PA 19104-6367USA

First Published 2012

ISBN 978-0-9836469-4-5 (paperback)ISBN 978-0-9836469-5-2 (e-book version)

Cover artwork, design and layout by Christopher rollen


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Contents

Te Contributors ixAcknowledgments xxiii

FOREWORD xxvby Josep Borrell Fontelles

PREFACE xxix by Franklin Allen, Elena Carletti & Saverio Simonelli

1 Te Role o Public FinancialInstitution 1Antonio Borges

2 Te European Central Bank:Lender o Last Resort

in the Government Bond Markets? 17Paul De Grauwe

3 Institutional Aspects o theEurozone Crisis 29

Friedrich Kbler

4 Imbalances In Te Euro Areaand the ECBs Response 41 Frank Smets

5 Governance o the InternationalMonetary System 61

Richard Portes

6 On the Prevention o Crisis in theEurozone 75

Leszek Balcerowicz


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vi Contents

7 Exit rom a Monetary Union 89Russell Coooper

8 Is Austerity Going oo Far?Structural Reorms and Te Debt rap 103Pier Carlo Padoan & Paul van den Noord

9 Te Reorm o the Political andEconomic Architecture o theEurozones GovernanceA Legal Perspective 115Jacques Ziller

10 reaty Games - Law asInstrument and as Constraint inthe Euro Crisis Policy 139Bruno De Witte

11 Te United Kingdom and theEurozone: How to Co-exist 161Charles Goodhart

12 European Union and Eurozone:How to Co-exist? 173Brigid Laan

13 Te Euro Area Crisis andImplications or the RelationBetween Te EU and Te Euro Area 189Guntram B. Wol

14 About Hollande and Holland 199 Wolgang Mnchau


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15 Europes ragedy Nears theEnd o Act One, but the DramaContinues 205Janet Kersnar

AppendixIntroduction to the Stability andGrowth Pact 213Victor Ngai

Conerence Program 229


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The Contributors

Franklin AllenUniversity o PennsylvaniaFranklin Allen is the Nippon Lie Proessor o Finance and Proessoro Economics at the Wharton School o the University o Pennsyl-vania. He has been on the aculty since 1980. He is currently Co-Director o the Wharton Financial Institutions Center. He was or-merly Vice Dean and Director o Wharton Doctoral Programs and

Executive Editor o the Review o Financial Studies, one o the lead-ing academic nance journals. He is a past President o the AmericanFinance Association, the Western Finance Association, the Societyor Financial Studies, and the Financial Intermediation Research So-ciety, and a Fellow o the Econometric Society. He received his doc-torate rom Oxord University. Dr. Allens main areas o interest arecorporate nance, asset pricing, nancial innovation, comparativenancial systems, and nancial crises. He is a co-author with Richard

Brealey and Stewart Myers o the eighth through tenth editions othe textbook Principles o Corporate Finance.

Leszek BalcerowiczWarsaw School o EconomicsLeszek Balcerowicz, born in 1947, graduated with distinction romForeign rade Faculty in Central School o Planning and Statistics in

Warsaw (CSPS), now Warsaw School o Economics (WSE), in 1970.In 1974 he gained an MBA at St. Johns University in New York; in1975 he received his Ph.D. in economics at the CSPS. Since Octo-ber 1992 Leszek Balcerowicz has been a Proessor at WSE, and since1993 a Head o Department o International Comparative Studies.


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Since 2006, he has been a Corresponding Member o the Historyand Philosophy Class o the Polish Academy o Arts and Sciences.Leszek Balcerowicz designed and executed the radical stabilization

and transormation o the Polish economy since the all o com-munism in Poland. In September 1989, Leszek Balcerowicz becameDeputy Prime Minister o Poland and Minister o Finance in therst non-communist government in Poland ater the Second WorldWar. He retained his positions in the government until December1991. From April 1995 to December 2000, he was the president othe Freedom Union, a ree market - oriented party and rom 1997to June 2000 he was Deputy Prime Minister, Minister o Finance.He is a member o the Washington-based nancial advisory body,the Group o Tirty, a board member o Washington, D.C. think-tank, the Peterson Institute or International Economics. LeszekBalcerowicz is a Chairman and a ounder o Civil Development Fo-rum Foundation FOR based in Warsaw. In 2011, he has been ap-pointed a member o the Advisory Scientic Committee providingadvice and assistance on issues relevant to the work o the European

Systemic Risk Board (ESRB).

Antonio BorgesUniversidade Catlica PortuguesaAntnio Borges is Proessor o Economics at Universidade Catli-ca Portuguesa, Lisbon. He was Director o the European Depart-ment o the International Monetary Fund until November 2011.Prior to that, he was the Chairman o ECGI (European CorporateGovernance Institute), a post which he had held since the Institutewas ounded in 2002. In June 2008, he was appointed Chairmano the Hedge Fund Standards Board. Formerly, he was Vice Chair-man o Goldman Sachs International, which he joined in September2000. His responsibilities included investment banking, leadershipdevelopment and strategy. Prior to this he was Dean o INSEADbetween 1993 and 2000. He joined INSEADs aculty in 1980 and

also taught at the University o Lisbon, Portuguese Catholic Uni-versity and Stanord University. Between 1990 and 1993, AntnioBorges was Vice Governor o Banco de Portugal, where he took aleading role in the liberalization o Portugals nancial system. Healso worked at the European level on the project o Economic and


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Monetary Union. He graduated rom the echnical University inLisbon and holds his MA and PhD in Economics rom StanordUniversity. He has been a Board member o several corporations and

oundations.

Josep Borrell FontellesPresident o the European University InstituteJosep Borrell graduated in Aeronautical Engineering in 1969 and ob-tained his PhD in Economic Sciences in 1976. In 1983 he was Pro-essor in Economic Analysis at Complutense University o Madrid.From 1984 to 1991, he was Spanish Secretary o State or Finance,and rom 1991 to 1996 he was Spanish Minister or Public Works,ransport, Environment, Housing and elecommunications. In theperiod 1999 2004 he was President o the European Aairs Com-mittee o the Spanish Parliament (and between 2002 2003 Mem-ber o the European Convention). In 2004, he was elected Presidento the European Parliament, a position which he covered until 2007.From 2007, he was President o the Development Committee o the

European Parliament and in 2010 he began his mandate as Presidento the European University Institute.

Elena CarlettiEuropean University InstituteElena Carletti is Proessor o Economics at the European UniversityInstitute, where she holds a joint chair in the Economics Depart-ment and the Robert Schuman Centre or Advanced Studies. She isalso Research Fellow at CEPR, Extramural Fellow at ILEC, Fellowat the Center or Financial Studies at CesIo, and at the Wharton Finan-cial Institutions Center. Her main areas o interest are nancial inter-mediation, nancial crises, nancial regulation, corporate governance,industrial organization and competition policy. She has publishednumerous articles in leading economic journals, and has recentlycoedited a book with Franklin Allen, Jan Pieter Krahnen and Mar-

cel yrell on Liquidity and Crises. She has worked as consultant orthe OECD and the World Bank and participates regularly in policydebates and roundtables at central banks and international organiza-tions.


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Russell CooperEuropean University InstituteRussell Cooper joined the Institute in September 2009 rom the

University o exas, where he is the Fred Hoheinz Regents Proessoro Economics. He was previously Proessor o Economics at Bos-ton University, Associate Proessor o Economics at the University oIowa and Assistant Proessor at Yale University. He is Fellow o theEconometric Society. He has published in journals such as the Amer-ican Economic Review, the Quarterly Journal o Economics, the Re-view o Economic Studies, and the Journal o Political Economy

Paul De GrauweLondon School o EconomicsPrior to joining LSE, Paul De Grauwe was Proessor o InternationalEconomics at the University o Leuven, Belgium. He was a membero the Belgian parliament rom 1991 to 2003. He is honorary doc-tor o the University o St. Gallen (Switzerland), o the University ourku (Finland), and the University o Genoa. He obtained his PhD

rom the Johns Hopkins University in 1974. He was a visiting pro-essor at various universities - the University o Paris, the Universityo Michigan, the University o Pennsylvania, Humboldt UniversityBerlin, the Universit Libre de Bruxelles, the Universit Catholiquede Louvain, the University o Amsterdam, the University o Milan,ilburg University, and the University o Kiel. He was also a visitingscholar at the IMF, the Board o Governors o the Federal Reserve,the Bank o Japan and the European Central Bank. He was a mem-ber o the Group o Economic Policy Analysis, advising PresidentBarroso. He is also director o the money, macro and internationalnance research network o CESio, University o Munich. He is aresearch ellow at the Centre or European Policy Studies in Brussels.

Bruno De WitteMaastricht University

Bruno de Witte is Proessor o European Union law at MaastrichtUniversity, and part-time proessor at the Robert Schuman Centreo the European University Institute (EUI) in Florence. He is co-di-rector o the Maastricht Centre or European Law. Previously, rom2000 to February 2010, he was proessor o EU law at the EUI, and


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co-director o the Academy o European Law there, and beore that,rom 1989 to 2000, he was proessor at Maastricht University. Hestudied law at the University o Leuven and the College o Europe,

and obtained a doctorate at the European University Institute in1985 on Te Protection o Linguistic Diversity through Fundamen-tal Rights. Bruno De Wittes principal interest is the constitutionallaw o the European Union, with a particular ocus on the relationbetween international, European and national law, the protectiono undamental rights, law-making and treaty revision procedures,internal market law and non-market values. His second main eldo interest is the law o cultural diversity, with a particular ocus onlanguage law, the protection o minorities and the relation betweenmarket integration and cultural diversity in European Union law.Bruno De Witte is also a member o the Ius Commune ResearchSchool. He is a member o the editorial board o the European LawJournal, the European Human Rights Law Review, the Revista Espa-ola de Derecho Europeo, and the Revista de Llengua I Dret. He isa member o the advisory board o the European Journal o Interna-

tional Law, the European Constitutional Law Review, the MaastrichtJournal o European and Comparative Law, the European Journalo Law Reorm, and the Zeitschrit r entliches Recht, and cor-respondent o the Rivista Italiana di Diritto Pubblico Comunitario.He currently teaches the course o Advanced EU law in the Masterprogrammes o Maastricht University. He has supervised some 35doctoral dissertations, partly at the European University Instituteand partly at Maastricht University.

Charles GoodhartLondon School o EconomicsCharles Goodhart (b. 1936: London, UK) was appointed to the new-ly established Norman Sosnow Chair o Banking and Finance at theLondon School o Economics (LSE) in September 1985, which heheld until his retirement in 2002, when he became Emeritus Proes-

sor o Banking and Finance. He has remained at LSE at the Finan-cial Markets Group, initially as Deputy Director, 1987-2005, andnow as member in charge o the research program in nancial regula-tion, 2005-present. He was elected a Fellow o the British Academyin 1990, and awarded the CBE in the New Years Honours List or


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1997, or services to monetary economics. During 1986, he helpedto ound, with Proessor Mervyn King, the Financial Markets Groupat LSE, which began operation at the start o 1987. For the previous

17 years he served as a monetary economist at the Bank o England,becoming a Chie Adviser in 1980. Following his advice on over-coming the nancial crisis in Hong Kong in 1983, and the establish-ment o the link between the HK and the US $, he subsequentlyserved on the HK Exchange Fund Advisory Committee or severalyears until 1997. Later in 1997, he was appointed or three years,until May 2000, as one o the our independent outside memberso the newly-ormed Bank o England Monetary Policy Commit-tee. Between 2002 and 2004, he returned to the Bank o Englandas a (part-time) adviser to the Governor on Financial Stability. Heis a graduate o Cambridge (B.A. 1960) and Harvard (Ph.D. 1963).Ater returning rom Harvard to teach at Cambridge, where he wasa Fellow o rinity College (1963-65), he became an adviser in theDepartment o Economic Aairs (DEA) or a brie period (1965-66), beore returning to academic lie as a Lecturer in Economics at

the LSE (1966-68), rom whence he joined the Bank o England.

Janet KersnarSNL FinancialJanet Kersnar was recently appointed London Bureau Chie or busi-ness intelligence rm SNL Financial, having been Europe Editoro Knowledge@Wharton, the online publication o Te WhartonSchool, since 2009. Prior to K@W, Janet was Editor-in-Chie or11 years o Te Economist Groups CFO Europe, which was parto a global portolio o award-winning magazines or chie nancialocers. Along with various other publishing roles in Berlin, Parisand San Francisco, she has also been an Editor at Te Wall StreetJournal and other Dow Jones International publications. With a BAin political science and German rom the University o Caliornia,Santa Barbara, she also studied at the Georg-August University in

Gttingen, Germany, and the Free University in Berlin.

Friedrich K. KblerJohann-Wolgang-Goethe University & University o PennsylvaniaFriedrich Kbler is an expert on corporations, banking and mass me-dia. He has written or co-written more than 20 books and other in-


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dependent publications and has published more than 100 articles incontract and property law; corporations, banking and securities reg-ulation; and mass media and legal theory, many o them comparing

American with European legal structures. His textbook on Germancorporate law has seen six editions and was recently translated intoSpanish. Last year, he published a textbook on German Mass MediaLaw. He is a member o the American Law Institute and has servedon the boards o the Deutscher Juristentag (the German institutioncorresponding to the American Law Institute) and the German Asso-ciation o Comparative Law. He was a Commissioner o the GermanInterstate Commission or the Regulation o Media Concentrationand served on the board o the Hessian Public Service BroadcastingEntity. He is a member o the European Shadow Financial Regula-tory Committee and o the Frankurt Academy o Sciences.

Brigid LaanUniversity College DublinBrigid Laan PhD took oce as the Principal o the College o

Human Sciences, University College Dublin, in September 2004.In 1991, Proessor Laan was appointed as Jean Monnet Proessoro European Politics in the Department o Politics, UCD. She wasthe ounding Director o the Dublin European Institute UCD in1999. In March 2004, she was elected as a member o the Royal IrishAcademy. She is a member o the Research Council o the EuropeanUniversity Institute (EUI) Florence, the National Economic and So-cial Council (NESC) and the Irish Governments High Level AsiaStrategy Group. Proessor Laan is author o Integration and Co-operation in Europe, 1992, Te Finances o the Union, 1997, andco-author o Europes Experimental Union, 2000. She has publishednumerous articles in the Journal o Common Market Studies andthe European Journal o Public Policy. Proessor Laan co-ordinateda six country cross national research project entitled Organising orEnlargement (2001-2004), nanced by the EU Commissions Fith

Framework Programme, and is part o an integrated research projecton New Governance in Europe.

Wolgang Mnchau

EurointelligenceWolgang Mnchau is an associate editor and European economic


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columnist o the Financial imes. ogether with his wie, the econo-mist Susanne Mundschenk, he runs eurointelligence.com, an inter-net service that provides daily comment and analysis o the Euro area,

targeted at investors, academics and policy makers. Mr. Mnchauwas one o the ounding members o Financial imes Deutschland,the German language business daily, where he served as deputy edi-tor rom 1999 until 2001, and as editor-in-chie rom 2001 until2003. Te business daily is now a rmly established player in theGerman media market with a daily circulation o more than 100,000copies sold. Previous appointments include correspondent posts orthe Financial imes and the imes o London in Washington, Brus-sels and Frankurt. He was awarded the Wincott Young FinancialJournalist o the Year award in 1989. Mr. Mnchau has publishedthree German-language books. His book Vorbeben, on the nancialcrisis, has received the prestigious GetAbstract business book awardin 2008, and is now published by McGraw Hill in the US. He holdsdegrees rom the Universities o Reutlingen and Hagen and an M.A.in international journalism rom City University, London.

Victor NgaiUniversity o PennsylvaniaVictor Ngai graduated summa cum laude in May 2012 rom theHuntsman Program in International Studies and Business at theUniversity o Pennsylvania. He received a Bachelor o Science inEconomics rom the Wharton School with concentrations in Fi-nance and Accounting, and a Bachelor o Arts rom the College oArts o Sciences with a major in International Studies.

Pier Carlo Padoan

Organisation or Economic Co-operation and Development (OECD)Mr. Pier Carlo Padoan took up his unctions as Deputy Secretary-General o the OECD on 1 June 2007. As o 1 December 2009,he was also appointed Chie Economist while retaining his role as

Deputy Secretary-General. In addition to heading the EconomicsDepartment, Mr. Padoan is the G20 Finance Deputy or the OECDand also leads the Strategic Response, the Green Growth and Inno-vation initiatives o the Organisation and helps build the necessarysynergies between the work o the Economics Department and thato other Directorates. Mr. Padoan is an Italian national and prior


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to joining the OECD was Proessor o Economics at the UniversityLa Sapienza o Rome, and Director o the Fondazione Italianieu-ropei, a policy think-tank ocusing on economic and social issues.

From 2001 to 2005, Mr. Padoan was the Italian Executive Directorat the International Monetary Fund, with responsibility or Greece,Portugal, San Marino, Albania and imor Leste. He served as amember o the Board and chaired a number o Board Committees.During his mandate at the IMF he was also in charge o EuropeanCo-ordination. From 1998 to 2001, Mr. Padoan served as EconomicAdviser to the Italian Prime Ministers, Massimo DAlema and Gi-uliano Amato, in charge o international economic policies. He wasresponsible or co-ordinating the Italian position in the Agenda 2000negotiations or the EU budget, Lisbon Agenda, European Coun-cil, bilateral meetings, and G8 Summits. He has been a consultantto the World Bank, European Commission, and European CentralBank. Mr. Padoan has a degree in Economics rom the University oRome and has held various academic positions in Italian and oreignuniversities, including at the University o Rome, College o Europe

(Bruges and Warsaw), Universit Libre de Bruxelles, University oUrbino, Universidad de la Plata, and University o okyo. He haspublished widely in international academic journals and is the au-thor and editor o several books.

Richard Portes

London Business SchoolRichard Portes is Proessor o Economics at London Business School(since 1995); President o the Centre or Economic Policy Research(which he ounded in 1983); and Directeur dEtudes at the Ecoledes Hautes Etudes en Sciences Sociales in Paris (since 1978). Hewas a Rhodes Scholar and a Fellow o Balliol College, Oxord, andhas also taught at Princeton, Harvard (as a Guggenheim Fellow),and Birkbeck College (University o London). In 1999-2000, he wasthe Distinguished Global Visiting Proessor at the Haas Business

School, University o Caliornia, Berkeley, and in 2003-04 he wasJoel Stern Visiting Proessor o International Finance at ColumbiaBusiness School. Proessor Portes is a Fellow o the Econometric So-ciety and a Fellow o the British Academy. He was Secretary-Generalo the Royal Economic Society 1992-2008. He is Co-Chairman o


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the Board o Economic Policy. He is a member o the Group oEconomic Policy Advisers to the President o the European Commis-sion and o the Bellagio Group on the International Economy. He

has written extensively on sovereign debt, European monetary andnancial issues, international capital fows, centrally planned econo-mies and transition, macroeconomic disequilibrium, and Europeanintegration. His work on collective action clauses in sovereign bondcontracts, on the international role o the Euro, on international -nancial stability and on European bond markets has been directedtowards policy as well as academic publications. Richard Portes wascreated CBE in the Queens New Year Honours List 2003.

Saverio Simonelli

University o NaplesSaverio Simonelli is Assistant Proessor o Economics at the Uni-versity o Naples Federico II. He is also Research Fellow at CSEF,EABCN and Fellow at the European University Institute. He ob-tained his PhD rom the University o Naples Federico II, and a

Master in Economics rom University Pompeu Fabra. His currentresearch ocuses on real business cycle, scal policy and short-termorecasting. Recently he has published in the Review o EconomicDynamics, Scandinavian Journal o Economics, and Journal o Eco-nomic Dynamics and Control.

Frank Smets

European Central BankFrank Smets is Director General o the Directorate General Researcho the European Central Bank. He is proessor o international eco-nomics at the Centre or Economic Studies at the KU Leuven andan honorary proessor in the Duisenberg chair at the Faculty o Eco-nomics and Business o the University o Groningen. He is a Re-search Fellow o the Centre or Economic Policy Research in Londonand CESio in Munich. He has written and published extensively on

monetary, macroeconomic, nancial and international issues mostlyrelated to central banking in top academic journals such as the Jour-nal o the European Economic Association, the American EconomicReview and the Journal o Monetary Economics. He has been man-aging editor o the International Journal o Central Banking rom


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2008 till 2010. Beore joining the European Central Bank in 1998,he was a research economist at the Bank or International Settle-ments in Basel, Switzerland. He holds a PhD in Economics rom

Yale University.

Paul van den Noord

Organisation or Economic Co-operation and Development (OECD)Paul van den Noord, who is Dutch, is Counsellor to the Chie Econ-omist in the Economics Department o the OECD since September2010. He assists the Chie Economist in the Finance Ministers tracko the G-20 and represents the OECD in the Framework WorkingGroup o the G-20. Between March 2007 and September 2010, hewas seconded as adviser to the European Commission in Brussels.Prior to his secondment, Mr. Van den Noord has worked both inthe Country Studies and Policy Studies Branches o the EconomicDepartment o the OECD. In the Country Studies Branch, he hascovered many OECD countries and, between 2000 and 2005, wasHead o the European Union Desk. In the Policy Studies Branch he

has been in charge o the assessment o scal policy and the GeneralAssessment o the Macroeconomic Situation, the leading chapter othe semi-annual OECD Economic Outlook. Mr. Van den Noordhas published extensively on scal policy, economic and monetaryunion and the political economy o structural reorms. He holds aPhD rom the University o Amsterdam (Netherlands), where hewas also a lecturer and research ellow beore joining the OECD in1989.

Guntram Wolf

BruegelGuntram Wol is the Deputy Director o Bruegel. His research o-cuses on the Euro area economy and governance, on scal policy,global nance and Germany. He joined Bruegel rom the EuropeanCommission, where he worked on the macroeconomics o the Euro

area and the reorm o Euro area governance. Prior to joining theCommission, he was an economist at the Deutsche Bundesbank,where he coordinated the research team on scal policy. He alsoworked as an adviser to the International Monetary Fund. He holdsa PhD rom the University o Bonn, studied economics in Bonn,


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oulouse, Pittsburgh and Passau and taught economics at the Uni-versity o Pittsburgh. He has published numerous papers in leadingacademic journals. Guntram is fuent in German, English, French

and has good notions o Bulgarian and Spanish. His columns andpolicy work are published and cited in leading international mediasuch as the Financial imes, the New York imes, Wall Street Jour-nal, El Pais, La Stampa, FAZ, Financial imes Deutschland, BBC,ZDF, WDR, Die Welt, CNBC and others.

Jacques Ziller

University o PaviaBorn in 1951, o French nationality, Proessor o European UnionLaw at the University o Pavia, Faculty o Political Sciences. Stud-ied at Paris II and Paris IV Universities as well as at the Paris Insti-tute o Political Studies (Sciences Po.). Doctors degree in law romParis II University (Doctorat dEtat en droit), post-graduate diplo-mas (Diplmes dEtudes suprieures) in law and political science,the graduate diploma o the Paris Institute o Political Studies, as

well as a graduate diploma (Licence s lettres) in German languageand literature. Has been teaching French public law and compara-tive public law, European community law and international law,as well as public administration as an assistant proessor at Paris IIUniversity (1980-1985), as an associate proessor at ESSEC BusinessSchool (Cergy-Pontoise, 1980-1985) and later as a proessor at theUniversity o French West-Indies and Guyana (Guadeloupe-FWI,1989- 1991) and at Uni. Paris 1, Panthon-Sorbonne (1992-2007 on secondment rom 1/09/1998 to 30/09/2007). Proessor o Com-parative Public Law at the European University Institute, Florencerom September 1st 1998 until 2008. Head o the Law Departmentrom 1 October 1999 to 31 October 2003. Specialized in researchand training or senior civil servants in the elds o comparative pub-lic administration and management and also in the eld o Europeanaairs and regional integration when working as a lecturer and later

an associate proessor at the European Institute o Public Adminis-tration (IEAP/EIPA-Maastricht, Te Netherlands, 1986-1989) andDirector o research and publications at the International Instituteo Public Administration (IIAP, Paris, France, 1992 -1995). ChieEditor o the Revue ranaise dAdministration publique rom Janu-


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ary 1992 to September 1995. Visiting Proessor at the College oEurope (Bruges, Belgium) rom 1993 to 1998, and at the UniversitatAutonoma (Barcelona, Spain) rom 1994 to 1997. Consultant to

OECD (Puma and Sigma programs). Consultant to the EuropeanCommission and to the Committee o the Regions o the EuropeanUnion. He has been a member o the Scientic Advisory Board o theEuropean Center or Development Policy Management (ECDPM-Maastricht); he has also been a member o the Program Commit-tee o the International Association o Schools and Institutes or Ad-ministration (AIEIA/IASIA) and o the Steering Committee o theEuropean Group o Public Administration (EGPA/GEAP) which hechaired in 1995-96. Member o the Scientic Council o the Insti-tute or Research on Public Administration o the German School oHochschule r Verwaltungswissenschaten Speyer) since May 2005.Member o the the Steering Committee o ELSNI-Euro-LatinStudy Network on Integration and rade, o the advisory board othe Institut der Regionen Europas (IRE), Salzburg and o the CentroInterdipartimentale di Ricerca e di Formazione sul Diritto Pubblico

Europeo e comparato (DIPEC), Siena.


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Acknowledgments

As last year, we would like to thank all the people and institutions

that have helped to make the conerence and the book possible. Ourspecial thanks go to ina Horowitz, Christopher rollen, Julia Valerioand the Presidential Oce at the European University Institute. Tisbook is produced as part o the project Politics, Economics andGlobal Governance: Te European Dimension (PEGGED) undedby the European Commission under its Seventh Framework Pro-gramme or Research (Collaborative Project), Contract no. 217559.

We would also like to thank the Wharton Financial InstitutionsCenter or nancial support.


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xxv

FOREWORD

It is with great pleasure that I write the oreword to this e-book Gov-ernance or the Eurozone: Integration or Disintegration? above allbecause it is the second publication in this series, ollowing last yearsLie in the Eurozone: With or Without Deault?.

In the oreword to last years publication, I reerred to the sovereigndebt crisis and its implications as not only a severe economic prob-lem, but also a major challenge to European society that has starkimpacts on the broader European integration process. Furthermore,I put into question the claim that European political leaders haveobtained a successul grand bargain and I hinted to the act thatnumerous commentators have instead accused the decision-makerso only dangerously muddling through and kicking the can downthe road. Unortunately, these accusations still hold true, and oneyear ater the workshop Lie in the Eurozone: With or Without De-ault?, which was held at the European University Institute (EUI) inApril 2011, we are still ar rom having ound a substantial solutionto the crisis.

Te 2012 edition o the workshop and this e-book very appropri-

ately raise the question Governance or the Eurozone: Integrationor Disintegration? Te survival o the Eurozone in its current ormis as much at stake as it was a year ago and the publication o thise-book comes at a very timely moment. Once again, the individualchapters cover topics that dominate the political, economic and aca-


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demic discussion in and on Europe and I think this e-book has thepotential to make a signicant contribution to the current debates as much as last years e-book did, which was a great success.

While many important changes in the economic governance o theEuro and regarding bail-out mechanisms have been made in thelast two years (such as the European semester, the European Finan-cial Stability Facility, the European Stability Mechanism, the EuroPlus Pact and lately the Fiscal pact), we still seem ar away romreaching a proper and sustainable solution. Te markets were notto be convinced, and while the heavy interventions o the EuropeanCentral Bank were able to calm the markets or a short while, thecrisis is now back in ull orce. And as much as the markets are notconvinced, European citizens and politicians are increasingly uncer-tain about the benets the common currency brings and about howar they are willing to reach or a proper design o the Eurozone thattackles the current crisis and prevents uture crises. From an eco-nomic and political point o view, it seems clear to me that the only

way out o this severe crisis is through proper economic governancewith a proper scal union, but member states seem unable or unwill-ing to make the needed steps towards this direction.

Tis e-book describes how such steps and proper economic gover-nance o the Eurozone and its institutions could look. In three sec-tions, the individual chapters consider the role o public nancialinstitutions in dealing with the crisis and discuss the possibilities andlimits o scal policy support. Furthermore, the various authors re-fect on the reorm o the political and economic architecture andon the crucial question o how to reorm the growth and stabilitypact and how to construct sound mechanisms or providing liquidityto governments and nancial institutions. Finally, the contributionsanalyse how the European Union and the EU can coexist, whetherEurope is developing towards a two-speed Europe and what the con-

sequence o such a development would entail or the governance othe Eurozone. Overall, I think the chapters and their topics con-centrate on some o the most crucial elements o the sovereign debtcrisis, the uture o the Euro and the Union.


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xxviiFOREWORD

At the time o writing this oreword, the uture looks rather grimand the probability o disintegration seems to be growing. Unableto orm a government ater the Parliamentary elections in May, the

Greeks are being called to the polling stations again and the prospectso a dramatic exit rom the Eurozone are openly discussed. AlthoughGermany and France have repeated - at the rst meeting between thenew President Hollande and Chancellor Merkel - their willingnessto keep Greece in the Euro, words and armations are no longerenough and convincing action is needed. At the same time, the suc-cessive increases o the public decit, the ever-growing banking crisisand the rising spreads in Spain, make it increasingly probable that aEuropean intervention will be required to at least recapitalise parts othe Spanish banking system. Tese events and other problematic on-going developments make it very dicult to imagine what the situa-tion will be when this e-book is published. However, this publicationwill certainly provide a very important intellectual contribution tothe problems we are acing and to the analysis o the crisis implica-tions and the dierent ways out o the Eurozone crisis.

o conclude, I would like to thank and congratulate the editors othis e-book. Te workshop that Proessors Elena Carletti, FranklinAllen and Saverio Simonelli organised, and on which this e-book isbased, was a huge success in several regards and I can speak or allparticipants when I say that it was a pleasure to attend this event.Te workshop, which was held in the ramework o the PEGGED

project (Politics, Economics and Global Governance: Te EuropeanDimensions) and which was co-organised with the Wharton Finan-cial Institutions Center, brought together leading academics romvarious disciplines and policymakers and I am very satised that theworkshops presentations and results are being published in this e-book.

Finally, as much as I hope the sovereign debt crisis in the Eurozone

will be contained soon, I think the tradition o this workshop shouldbe continued to annually discuss the state and the challenges o theEurozone. Te EUI is certainly the right place to hold such an event.Te Institute was created to study the problems o European societ-ies and the construction o Europe at the highest intellectual level.


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xxviii FOREWORD

And without any doubt, the current Eurozone crisis is one o thebiggest problems that Europe and its societies are acing today. Tismeans that these past and uture workshops contribute to one o the

EUIs core missions by being an excellent example or the Europeanocus o the Institutes research activities.

May 2012

Josep Borrell Fontelles

President o the European University Institute


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xxix

PREFACE

Te European University Institute (EUI) and the Wharton FinancialInstitutions Center (FIC) organized a conerence entitled Gover-nance or the Eurozone: Integration or Disintegration? Te event,which was held at the EUI in Florence, Italy, on 26 April 2012, wasnanced by the PEGGED project (Politics, Economics and Global

Governance: Te European Dimension). Te conerence broughttogether leading economists, lawyers, political scientists and policy-makers to discuss the current situation in the Eurozone with particu-lar emphasis on its governance. Te goal was to have an open andmultidisciplinary discussion on this important topic to understandbetter where the Eurozone is going and what is needed to preserve it.

Te President o the European University Institute, Josep BorrellFontelles, opened the event, which consisted o three panels, a key-note speech and a dinner speech.

Te rst panel considered the role o public nancial institutions.Antonio Borges (Catolica-Lisbon School o Business and Econom-ics) discussed the various responses o the European Central Bank(ECB) and the International Monetary Fund (IMF) in dealing with

the European sovereign debt crisis; and the structure o the Euro-pean Financial Stability Facility (EFSF) and the European FinancialStability Mechanism (EFSM). Paul De Grauwe (London School oEconomics) discussed the role o the European Central Bank (ECB)during the crisis, and argued in avor o the ECB acting as the lender


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xxx PREFACE

o last resort also in the government bond market. Friedrich Kbler(Johann-Wolgang-Goethe University & University o Pennsylvania)discussed dierent scenarios o integration/disintegration or the

Eurozone, stressing the responsibility o the public institutions de-signed to provide additional nancial support or needy Euro Mem-ber States. Frank Smets (European Central Bank) ocused on the roleo the ECB as market maker o last resort to alleviate the risk thatunding problems translate into a deep credit crunch and a systemiccollapse.

In the keynote address, Richard Portes (London Business School) o-cused on the choice o the international reserve currency in the inter-national monetary system. He stressed that markets normally choosethe dominant currency, except or the Bretton Woods exchange-ratesystem in the period 1944-1971, and had to adjust to the creationo the Euro as a major new international currency. Te role o theEuro may change now in light o the recent crisis and ollowing theemergence o China with its currency RMB as a powerul nation.

Te second panel discussed the reorm o the political and economicarchitecture. Leszek Balcerowicz (Warsaw School o Economics)pointed out the importance o structural reorms to manage and pre-vent the Euro crisis. Russell Cooper (EUI) analyzed the exit roma monetary union as a punishment or an unsuccessul reorm andthus as incentive mechanism or the reorm to be implemented.Pietro Carlo Padoan (OECD) discussed the contribution o struc-tural reorms to solving the Euro area crisis together with the need toprogress in scal consolidation. Jacques Ziller (University o Pavia)presented a legal perspective on the most recent reorms o the Eu-rozone architecture.

Te third panel analyzed whether the Eurozone is diverging into twogroups and the potential consequence o a two tier Europe or the

governance o the Eurozone. Bruno De Witte (Maastricht Univer-sity) ocused on the unction o treaties as an attempt o the EU insti-tutions and governments to deal with the sovereign debt crisis duringthe past two years. Charles Goodhart (London School o Econom-ics) discussed the role o the UK under three possible scenarios or


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xxxiPREFACE

the uture o the Eurozone: (i) more political, scal and nancialcentralisation; (ii) Eurozone break-up; (iii) Eurozone and the EUcollapse. Brigid Laan (University College Dublin) discussed the im-

plications o the policy responses to the Euro crisis or the dynamicso European integration. Guntram Wol (Bruegel) pointed out thatsolving the Euro area crisis would require more integration steps, inparticular in the nancial and banking eld.

At dinner, Wolgang Mnchau (Eurointelligence) presented his viewon the German approach o ghting the crisis through a combina-tion o scal discipline and structural reorms. He suggested that thisapproach is fawed because it does not take into account the interac-tion between austerity and growth. He argued that the likely suc-cess o Francois Hollande will change the crisis narratives, in thateurobonds or bank resolution regimes, or example, may no longerbe a taboo subject.

Te book ends with a postscript entitled Europes ragedy Nears

the End o Act One, but the Drama Continues, written by JanetKersnar as an article or Knowledge@Wharton. Tis summarizes thevarious views expressed at the conerence.

Te book contains also an appendix including a piece written byVictor Ngai (University o Pennsylvania) on the history o the Stabil-ity and Growth Pact and the conerence program.

Te conerence ollows last years event entitled Lie in the EurozoneWith or Without Sovereign Deault? As on the previous occasion,the debate at the conerence was very lively and many dierent viewson the need o urther reorms were presented. Again, we preer notto take a stance but rather present all o them in this book and let thereaders draw their own conclusions.

A color e-book is available or ree download at the ollowing links:http://www.eui.eu/Personal/Carletti/http://www.eui.eu/DepartmentsAndCentres/Economics/Seminar-sEvents/Conerences/GovernanceortheEurozoneIntegrationorDis-integration.aspxhttp://nance.wharton.upenn.edu/FIC/FICPress/goveuro.pd


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xxxii PREFACE

Last years e-book is available or ree download at the ollowing links:http://www.eui.eu/Personal/Carletti/http://www.eui.eu/DepartmentsAndCentres/Economics/Re-

searcheaching/Conerences/Lieinthe Eurozone/Index.aspxhttp://nance.wharton.upenn.edu/FIC/FICPress/eurozone.pd

Franklin Allen, Elena Carletti and Saverio Simonelli


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1

1The Role of Public FinancialInstitutions

Antonio Borges

1. Foundations o Monetary Union

When the project o European monetary union was conceived andagreed to, there was little dissent with respect to its model: Europe-ans agreed to the German approach to monetary and nancial stabil-ity. We were all going to behave like the Germans, adopt price stabil-ity as a undamental pillar o prosperity and put in place a centralbank that would be single-mindedly ocused on that goal. For thispurpose, the central bank had to be ully independent rom politi-

cians, have a clear cut mandate with only one objective in mind andnever engage in monetary nancing o governments, let alone bailout any country.

It is most likely that, in the absence o agreement along these lines,the Germans would not have considered abandoning their belovedDeutschmark. But that was not the real issue: Europeans or at leastthose who opted to join were ully convinced o the merits o theGerman model o monetary policy, and embraced it without hesita-tion. And indeed it is a act that the countries o the Eurozone startedbehaving more like the Germans, in the sense that they eliminatedtheir propensity to let infation fare up, and quickly converged onthe German denition o price stability across the Eurozone.


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2 Te Role o Public Financial Institutions

Apart rom the ocus on price stability, this model was extremelyspecic about the separation between scal and monetary policy:governments would never be allowed to use central bank unding

monetary nancing irrespective o any crisis or emergencies theymight ace; urthermore, anything that might look like a bailout oa government by the monetary authorities was specically ruled out,in a orm that could be enorced by the courts.

Te model also included a strict denition o the modus operandio the central bank: unding to the banks within the union had tobe based on sound collateral; banks should not be too dependent onthe central bank or their unding needs; and any excessive growtho monetary aggregates should be a source o concern, to be oughtwith all the weapons o the central monetary authority.

oday, these conditions might be considered too rigid. Tere aremany appeals to change the mandate o the European Central Bank,many demands that these restrictions be relaxed. Under the current

emergency, many nd it hard to believe that the central bank hasto limit its action because o some rules devised at a time when noemergency existed or was oreseen. Furthermore, many well-knownand highly reputed economists deend the view that Europe, and es-pecially Germany, should accept a relatively high rate o infation, asthe simplest way to sort out the Eurozone crisis. Tis is, o course, incomplete contradiction with the whole spirit under which monetaryunion was created and is certainly contrary to Germanys tradition oprice stability as a undamental pillar o prosperity.

Tis is a more serious problem than most commentators tend toadmit. First, the single-minded ocus on price stability is enshrinedin the Maastricht reaty, which was ratied by all member states andcannot be overlooked. Not only a deviation rom the reaty may bechallenged in the courts, but, more importantly, the political legiti-

macy o such a break would be seriously questioned. It is not dicultto argue that the various countries agreed to a project o monetaryunion which was well dened and subject to political ratication; amaterial change in the rules o the game would be a rather dramaticviolation o democratic principles.


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3Antonio Borges

Secondly, this is not simply a matter o disagreement among econo-mists. In Germany and to a certain extent in other neighboringcountries - the principles o monetary stability, scal rectitude and

robust nancial policies are regarded as absolutely undamental.Given their post-war experience, the Germans consider that theireconomic and nancial success is due to the adherence to those prin-ciples and will not easily tolerate substantial deviations rom them.Tereore, a change o policy, away rom the principles enshrined inthe reaty, is not something that the German political leadership canaccommodate as a matter o expediency. Tey would most likely acea real backlash rom German public opinion. In this sense, it is airto predict that the project o monetary union however importantor Germany may very well not survive a demand or a change inthe mandate o the European Central Bank.

2. Te Need or Coherent Policies

Te current crisis brings to broad daylight the consequences o inco-

herent economic policies across the Eurozone. From the beginning,it was clear that monetary union required some degree o restrainton the part o the member states, because o serious externalities inthe conduct o their economic policies. But this restraint was ini-tially limited to scal discipline. Te stability and growth pact wasdesigned to prevent what was perceived as ree-riding temptation:the incentive to adopt lax scal policies because the cost would be

diluted across the union, since interest rates would not rise nearly asmuch as i monetary policy remained a domestic aair.

What the current crisis showed is that the externalities went ar be-yond what was initially expected. Since the ramework did not al-low or any kind o bailout o countries with nancial diculties,governments were expected to adopt responsible scal policies. Butnot enough attention was paid to other perverse eects o incon-

sistent policies, beyond scal recklessness. In act, without bailouts,debt sustainability was bound to become a central concern, simplybecause, i a government ever became insolvent, it might have nooption but to leave the union and return to its own currency. Debtsustainability is not only a question o scal decits, but also o inter-


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est rates and growth rates. Tis became only too apparent went theGreek crisis exploded in early 2010, proving that doubts about debtsustainability called into question the integrity o the Eurozone.

Te rst decade o monetary union went too well. Monetary integra-tion proceeded at a ast pace, credit began fowing in larger and largeramounts across borders, interest rates converged almost perectly andit seemed that the Eurozone had become like the United States oAmerica: monetary conditions were pretty much the same, creditwent to where it was in demand, exchange rate risk was eliminated,and the uture looked very bright.

With large credit infows, some countries on the periphery o theEurozone seemed to be booming. Access to very cheap credit led to aspectacular increase in spending, both private and public. Te mostimportant consequence o this was a dramatic reduction in savingsrates. Tese countries Greece, Portugal, Spain and even Ireland moved towards large current account decits, unded through credit

infows, and refecting a level o domestic demand ar in excess oGDP. For a while, this looked like a new phase o prosperity, entirelyjustied by the need to catch up, relative to other members o theEurozone. Tere were even some positive elements to this process:Spain had budget surpluses or quite a ew years, Greece had sig-nicant productivity increases, and Ireland kept expanding its ex-port base. But the negative components became dominant: most othe growth in spending beneted essentially the non-tradable sector,whose prices kept rising steadily, relative to tradables. Tis is exactlyequivalent to real exchange rate appreciation and made these coun-tries less and less competitive. Teir current account decits becamenot just a matter o excessive spending, but a more structural andpermanent reality.

In Ireland and Spain, the wave o excessive credit and spending turned

into a massive real estate bubble, with huge implications or theirbanking sectors. In Portugal and Greece, where the real estate prob-lem was ar less severe, the excessive level o indebtedness, coupledwith a bloated non-tradable sector, also put the banks in a vulnerableposition. As a result, when the process nally came to an end that


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5Antonio Borges

is, when credit stopped fowing to these countries, as the nancialworld realized that ater all they were not as nancially sound as Ger-many it became clear that the situation was unsustainable. Saddled

with too much oreign debt, having lost competitiveness and nowacing a deadly serious banking situation, these countries becamevery problematic, because the sustainability o their public debt wasno longer convincing. Te particular situation o each country wasnot exactly the same; but all o them ound it very dicult to attractinvestor interest, because the structural problems that had developedraised very serious questions about growth prospects, which made itimpossible to convince investors that they would ever be able to payback.

Tus, the real cause o the Eurozone crisis became not so much anissue o scal profigacy, but rather a much more serious issue ocompetitiveness and growth. Fiscal decits can be cut rather quickly;restoring growth is much more dicult i the obstacles to growth arestructural, that is, are caused by a misallocation o resources, with

excessive growth in the non-tradable sector, an overvalued real ex-change rate and a very ragile situation in the banking sector.

As investors became more and more aware o the dimension o theproblem and o its long term implications, policymakers also real-ized that the challenge they aced was huge. Adjustment programs,unded by the European countries and the IMF became inevitable;but those programs could not simply adopt the typical IMF recipeo restoring scal discipline and regaining competitiveness throughdevaluation. Under xed exchange rates, rebalancing the economyby transerring resources rom non-tradables to tradables was muchmore dicult to do. Serious resistance rom all those vested interestswhich had beneted rom the previous policy was going to provequite strong, and the nancial sector was not in a position to nancein attractive conditions the investments necessary to restore the trad-

able sector back to a healthier and more competitive situation.

Policymakers realized that monetary union required much morethan scal discipline. It became clear that systematic losses o com-petitiveness, massive oreign borrowing to nance consumer spend-


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ing and real estate investment, and illusory growth based on non-tradables were all elements o an incoherent policy stance, whichcreated very deeply entrenched obstacles to growth, justied serious

doubts about debt sustainability and spooked investors who movedaway rom these countries. It dawned on all o them that monetaryunion would only be sustainable i policies were brought back inline, not only in scal terms, but also in regard to what concernedcompetitiveness, openness and potential growth.

3. Financial Support and Policy Conditionality

o avoid catastrophic outcomes that would put monetary unionat risk, nancial support became crucial. aking Greece, Irelandand Portugal out o the markets, in order to provide them with thebreathing space necessary to put their economies back on track, wasinevitable. But the programs had, above all, to restore credibility; inother words, it was undamental that investors recovered their con-dence in the prospects o these countries, so that they would be ready

to nance them again, when the programs were over.

Financial support may be needed even when the policies a country isollowing are not out o line in terms o long term debt sustainability.I an acute crisis o condence raises ears about the prospects o aparticular country, investors will demand a premium to hold thatcountrys debt. I the premium is high enough, that may be sucientto make the situation unsustainable. In other words, even a coun-try where debt would normally be sustainable may nd itsel in asituation o insolvency, because a decline in investor condence maymake its debt too expensive. Tis is what is called a bad equilibrium,generated by a kind o sel-ullling prophecy: i markets think debtis unsustainable, then debt will become unsustainable, irrespectiveo what would otherwise be relatively benign conditions in terms othe scal situation.

Tus, nancial assistance has to restore condence in the prospectso a country to regain debt sustainability, which most o the timerequires condence that economic growth will return. And thereore,the policy conditionality associated with assistance programs has to


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7Antonio Borges

emphasize structural reorms and nancial strengthening, in order tocreate the conditions to make growth possible. Much o the debateabout the success or ailure o these adjustment programs refects

controversy around the issue o growth. Since there is a need or scalconsolidation, given the inability to keep on borrowing in the mar-kets, many economists believe that these programs will only generateeconomic decline. But the undamental goal o the programs has tobe economic recovery, so that debt can be paid back and investorscome back to the market or these countries debt.

Te last two years show that an obsessive ocus on scal accountsis clearly not sucient. Te authorities have sometimes put toomuch emphasis on the immediate achievement o the standards othe Stability and Growth Pact, in particular through ront loadedcorrections o budget imbalances. Restoring the credibility o publicnances is a requirement to recover investor condence; but it isnot sucient. I there are no prospects or economic growth, debtwill most likely never be sustainable again. And the programs ail in

their ultimate goal o restoring credibility. Since growth requires theremoval o deeply entrenched obstacles to growth, their nature has tobe quite dierent rom previous programs o adjustment, and theirpolitical component also becomes ar more decisive.

Tis situation also creates a dicult dilemma: i the right policiesare not adopted, the programs will ail. I there is a perception thatprograms ail, then nancial assistance makes no sense. Not only willpolitical opposition increase both rom taxpayers in Europe, butalso at the IMF but also countries at risk may resist asking or aprogram. Tis is now the case in Spain and Italy, where any kind oassistance rom outside is seen as counterproductive because it is per-ceived as a step down a path o no return, with limited or no impacton market credibility.

4. Cooperation Between EFSF, ESM and IMF

Te adjustment programs negotiated with the so-called roika theEuropean Commission, the European Central Bank and the IMF require a convergence o approaches and an understanding o the role


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o each o these institutions, which is hard to put in place. Te threeinstitutions have dierent perspectives and priorities: the EuropeanCommission attaches enormous priority to the scal adjustment

process, with a ocus on the Maastricht criteria; it preers rontloadedadjustment and monitors closely budget execution, on the assump-tion that, i the scal problem is solved, everything else will all inplace. Te European Central Bank also insists on rontloaded scaladjustment but adds to it a concern with the health o the bankingsector. Beyond scal austerity, the ECB typically requires substan-tial deleveraging o the banking system, higher capital ratios and nolosses imposed on holders o bank debt. Te IMF is traditionally lessocused on speedy scal consolidation and puts more emphasis onstructural policies, designed to restore economic growth; but, giventhe Funds previous ocus on more straightorward stabilization pro-grams, its experience in the area o structural reorms in advancedeconomies is rather limited.

Where the IMF plays a crucial role, which actually makes it indis-

pensable, is in the credibility it has acquired over decades with re-spect to its ability to negotiate with the countries involved, and alsoto monitor rigorously the execution o the programs, their undingrequirements and their impact on debt sustainability. European gov-ernments have repeatedly toyed with the idea that they could runthe whole process themselves, relying only on the Commission andthe ECB. But this has proven politically impossible. All governmentshave ound that their tax-payers have serious doubts about the ap-proach o throwing more money at the countries in trouble; and so,even the most hard line o them have realized that the support o theIMF had become crucial, not because o the amounts o money theFund could contribute which were always going to be small, rela-tive to the total but because they could convince their tax-payersthat the money was going to be well spent, thanks to the kind oconditionality which the Fund could impose better than anyone else.

As the Greek program unolded and began running into problems during roughly the rst hal o 2011 the position o the IMFbecame more and more uncomortable. Since the program was notbeing properly executed, the whole credibility eect was losing its


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9Antonio Borges

value, with considerable implications or the rest o the IMFs ac-tivity. But many throughout Europe were not prepared to acceptthe natural consequence o these developments, which was that the

program should be terminated and no urther disbursements shouldbe authorized. Greek politicians skillully exploited this divergence,by always promising to correct their slippage in program execution;and, with the nancing guarantees provided by the European gov-ernments, it was possible to keep the program running and to main-tain the myth that Greek debt was sustainable.

Another very dicult area or cooperation within the roika relatedto debt restructuring. Based on their long experience with less devel-oped economies, many at the IMF started early in 2011 proposingsome kind o debt restructuring, certainly or Greece, perhaps alsoor Ireland and Portugal. Tis was strongly resisted by the EuropeanCommission and the ECB, who eared that the precedent wouldprove devastating or the cohesion o the Eurozone. Te ECB, in par-ticular, always argued that debt restructuring would place the coun-

tries in deault, which prevented the Central Bank rom continuinglending to banks in those countries and lead to a collapse o theirbanking sectors. As these discussions went on, the Greek Govern-ment obviously ollowed them with great interest, which led it to putmuch less emphasis on program execution.

Te debate around debt restructuring eventually led to the concepto Private Sector Involvement, or PSI, which was essentially politi-cally driven. Many countries, starting with but not limited to Ger-many, ound it impossible to admit to their tax-payers that they werepouring money into Greece only to see private sector investors bailedout. Given that the program was proving to be less likely to succeed,it looked like the only benet rom oreign assistance was capturedby private sector investors. Keeping them involved became a politicalnecessity, so much so that the European Commission and especially

the ECB, had to swallow their reservations and accept the idea, al-though dressing it up under the pretense o a voluntary negotiation,which was to have only a minor and temporary impact on ratings.

Over time, the PSI project became closer and closer to ull blowndebt restructuring. But, all things considered, it actually has only a


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very limited impact on Greek debt sustainability. It provides some li-quidity relie, since the cash payments to investors were substantiallydelayed. But debt sustainability still depends crucially on the ability

to get some degree o economic growth in Greece. Without it, thelosses imposed on private investors will be only a down-payment orwhat is to come.

As everyone became more and more worried about the absence oprogress in the Greek program, and as ears began spreading to Italy,the position o the IMF also changed and the dierences o opinion

with the European authorities became more pronounced. Te Fundbegan putting more emphasis on decisive action to put an end to thecatastrophic risk o a Eurozone collapse. In this new approach, theFund began deending a change in the stance o the ECB, a moregeneralized adoption o debt restructuring and the creation o a hugerewall, designed to scare markets and restore a good equilibrium.Tis was bound to create tensions with the European authorities, orwith those within Europe who had undamental reservations about

this plan. Te level o tension increased steadily, leading the Fundto adopt a more reserved position with respect to support or theEurozone. In the second Greek program, the Fund reduced its levelo nancial commitment to a minimum, in a gesture that many in-terpreted as an indication that the Fund was not happy to see itspositions rejected.

In the end, the European authorities moved partially in the directiono what the Fund wanted. Te ECB adopted a policy o large scaleliquidity injections into the European banking system, designed toacilitate the purchase o sovereign debt by European banks, whilealso trying to eliminate liquidity risks across the European economy.Te European governments agreed to provide additional unding tothe IMF, to help shore up the nancial resources required by a re-wall. But the adoption o more radical measures such as changing

the EFSF or the ESM so that they could lend to banks, or asking theECB to impose a ceiling on the yields o Italian debt were rmlyresisted.

Apart rom the issue o undamental dierences o views on themodel o monetary union, as described above, there is also a techni-


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11Antonio Borges

cal reason or the European resistance to the concept o a huge re-wall. Te European experience o 1992, at the time o the great cur-rency crisis which almost destroyed the European Monetary System,

shows that markets will always beat the authorities, i the issue is whocan mobilize more money. Te attempt to win a battle on a positionwhich the market believes is untenable simply by displaying a largewar chest will usually ail. Te resources the authorities can mobilizeor a rewall, no matter how large, will always be limited. And thereis general consensus that they will never be sucient to take Italy orSpain out o the markets. Tereore, i the issue becomes whether therewall is large enough to deter the markets, the answer will alwaysbe negative, since markets can mobilize or all practical purposes anunlimited amount o unds. In other words, in the case o Italy andSpain, either the credibility battle is won, or a rewall, no matterhow large, will never solve the problem. In act, it can be argued thata large rewall is actually destabilizing, because it only makes the betlarger this is exactly how George Soros and others looked at the UKdeense o the Pound Sterling in the all o 1992.

O course, the proponents o a large rewall will always argue that itcan be made all powerul i it is nanced by the ECB. But this wouldrequire quite a change in the role and mandate o the ECB, which,as argued above, is not very likely.

5. Te Limited Role o the ECB

Te act that the ECB has substantial constraints in its action doesnot mean that it has no possible contribution to helping to solvethe Eurozone crisis. Te Central Bank has been experimenting withseveral types o initiatives, with mixed results. A certain consensusseems to be emerging, even though this is a rather controversial area.

Te key concern relates to the act that every type o intervention

has to have a certain degree o policy conditionality. Every expres-sion o support must be based on the conviction that the country inquestion is moving in the right direction. And i that movement isnot serious, whatever support is provided must be stopped. Tis is asimple principle, but very dicult to enorce by the ECB.


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First, the very act that the ECB has unlimited weaponry reduces thecredibility o conditionality. Te IMF may say that, i programs arenot executed, the Fund must interrupt them, because otherwise it

risks very large losses, since its money is at stake and a ailed programmakes repayment very unlikely. In the case o the ECB, it is easy toargue that, i the program is not working well, more money rom theCentral Bank will always allow the country to gain time and provideit with the means to overcome short term diculties and get back ontrack. Since the ECB, unlike the IMF, can create unlimited amountso money, it is easy to give credence to this argument, which obvi-ously undermines the whole idea o conditionality.

Put more simply, when the ECB was intervening in Italian debt mar-kets in the all o 2011, Silvio Berlusconi could always argue that alittle more money rom the ECB would be enough to deal with mar-ket pressures; and i the ECB had accepted the argument, Berlusconiwould still be Prime Minister o Italy, independently o the policieshe would or would not put in place.

A second problem has to do with the kind o intervention the ECBcan conduct and the way it is infuenced by the attempt to imposeconditionality. Te same episode o intervention in Italian debt mar-kets illustrates this point. Te ECB was trying to limit the yieldsin Italian sovereign bonds, restore condence, and bring investorsback into the market. As the discussions with the Italian govern-

ment became more and more dicult, the ECB ound it necessaryto condition its purchases o Italian bonds on the willingness o theGovernment to adopt the right policies. Given the Italian hesitationsand requent reversals o agreed policies, the ECB ound itsel in theuncomortable position o intervening intermittently in the market.Tis created huge uncertainty and very high volatility, in act scaringinvestors away, instead o bringing them back to the market. TeECB must have ound this episode extremely rustrating.

Tis does not mean that there are no circumstances under whichECB intervention would be helpul and stabilizing. Te SecuritiesMarket Program remains in the armory o the ECB and can andshould have a role in stabilizing monetary conditions across the


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13Antonio Borges

Eurozone. Tere are occasions when erratic events or acute crises leadto very destabilizing eects in the markets or government bonds. Itis quite appropriate that the SMP be used to control those situations

and provide a degree o stability that leads investors to consider themarkets or government bonds as stable, mature and reliable, some-thing o enormous importance in every economy. But keeping thiskind o intervention separate and distinct rom a bail-out or a ormo monetary nancing is not always simple. Te stabilizing role othe ECB in moments o crisis depends very much on its ability towork around this dilemma.

6. Financial Regulation, Incomplete Monetary Union and thePrisoners Dilemma

wo more issues deserve a great deal o attention, when discussingthe role o nancial institutions in the unolding o the Eurozonecrisis. One is the act that monetary union is still a work in progressacross Europe. Te other one deals with the incongruence o trying

to put in place monetary union and maintaining a nationally regu-lated banking sector.

When compared with a proper monetary union, as in the case o theUnited States o America, the European project shows how incom-plete it is. In Europe, the only orm o capital that fows reely acrossborders is credit. Monetary integration has led to very large even

excessive fows o credit across borders, but other orms o capitalare not so easy to invest in other countries. Tis is particularly thecase with equity, when it involves changes o control. In reality, inspite o monetary union and o several decades o reedom o capitalfows, many European countries still resist the idea that oreign capi-tal can buy their assets and can gain control o their large corpora-tions. Tis is especially acute in the case o banks.

Te main consequence o this restriction, which is essentially politi-cal, is that one o the most important mechanisms o sel-correctiono problems within the union is eliminated. In a proper monetaryunion, i, because o reckless policies in certain parts o the union,resulting in high levels o indebtedness, assets are discounted, then


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investors rom other parts o the union will quickly step in and takeadvantage o the arbitrage opportunities to grab those assets. Tisallows conversion o debt into equity, with considerable mitigation

o the excessive indebtedness problem. I cross-border mergers andacquisitions are not allowed, monetary union will be unbalanced,because credit fows cannot be compensated by equity fows whennecessary. As long as corporate control remains protected and changeo control is not allowed or seriously discouraged, excessive creditfows will be more destabilizing than otherwise.

A similar, but even more serious argument can be made with re-spect to the imprudence o trying to run monetary union without acentral approach to banking regulation. As banking systems remainregulated at the national level, with resolution schemes and nan-cial backstops also national, whenever a large scale banking problememerges, monetary union becomes very unstable. Tis was evidentlythe problem in Ireland, but potentially could still happen in manyother countries in the Eurozone. First, banks are typically very sub-

stantial investors in sovereign debt, so they become the rst victimso any impairments related to the credibility o sovereign debt. But iin trouble, they can only turn to their own government or support.Tis creates the inamous vicious circle o excessive sovereign debt,which leads to solvency problems in the banking system, which inturn drives the public sector urther into bankruptcy.

Furthermore, when these developments take place, monetary uniontends to unravel. Regulators will insist that the banks they are re-sponsible or must abandon exposure to the countries in diculty,which only makes the problems o these countries worse. As the cri-sis advances, banking systems become more and more ocused ondomestic markets, and monetary conditions diverge more and moreacross Europe.

Tis then develops into a typical prisoners dilemma. Under uncer-tain conditions or sovereign debt sustainability and bank solvency,every national regulator and every large bank will only think o solv-ing its own problem. In the process they generate a nal outcomewhich is a collective disaster. Only a cooperative solution creates the


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15Antonio Borges

conditions to overcome the dilemma, and yet European institutions national regulators as well as the Commission, the ECB, andeven the IMF will not be prepared to lead such a cooperative process,

because it is outside o their traditional mandate.

Te problem o retrenchment on the part o European banks, as areaction to the inability o the European authorities and the IMFto nd a solution to this prisoners dilemma, is one o the biggestobstacles to economic recovery in Europe, since credit is not fow-ing and monetary conditions are extremely onerous in the countrieswhich most need more relaxed access to credit. And yet, no solutionseems to be in sight or is even being studied.


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17

2The European Central Bank:Lender of Last Resort

in the Government BondMarkets?*

Paul De Grauwe

Introduction

In October 2008, the ECB discovered that there is more to centralbanking than price stability. Tis discovery occurred when the ECBwas orced to massively increase liquidity to save the banking system.Te ECB did not hesitate to exert its unction o lender o last resort

to the banking system, setting aside all ears o moral hazard andinfation, and concerns about the scal implications o its lending.

Tings were very dierent when the sovereign debt crisis eruptedin 2010. Ten the ECB was gripped by hesitation. A stop-and-gopolicy ensued in which it provided liquidity in the government bondmarkets at some moments only to withdraw it at other times. Whenthe crisis hit Spain and Italy in July 2011, the ECB was compelledagain to provide liquidity in the government bond markets.

Is there a role or the ECB as a lender o last resort in the governmentbond market? Tis is the question I want to analyze in this paper.

* Paper prepared for the conference Governance for the Eurozone. Integration orDisintegration? organized at the European University Institute, 26 April, 2012.I am grateful for the many comments formulated by the participants at the confer-

ence, and more particularly by Frank Smets.


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18 Te European Central Bank: Lender o Last Resort in the Government Bond Markets

Fragility o a monetary union

It is useul to start by describing the weakness o government bond

markets in a monetary union. National governments in a monetaryunion issue debt in a oreign currency, i.e., one over which theyhave no control. As a result, they cannot guarantee to the bondhold-ers that they will always have the necessary liquidity to pay out thebond at maturity. Tis contrasts with stand-alone countries thatissue sovereign bonds in their own currencies. Tis eature allowsthese countries to guarantee that the cash will always be available topay out the bondholders. Tus, in a stand-alone country there is animplicit guarantee that the central bank is a lender o last resort inthe government bond market.

Te absence o such a guarantee makes the sovereign bond marketsin a monetary union prone to liquidity crises and orces o conta-gion, very much like banking systems that lack a lender o last resort.In such banking systems, solvency problems in one bank may lead

deposit holders o other banks to withdraw their deposits. When ev-erybody does this at the same time, the banks will not have enoughcash. Tis sets in motion a liquidity crisis in many sound banks, anddegenerates into a solvency crisis as banks try to cash in their as-sets, thereby pulling down their prices. As asset prices collapse, manybanks nd out that they are insolvent. Tis banking system instabil-ity was solved by mandating the central bank to be a lender o lastresort and the neat thing about this solution is that, when depositholders are condent that it exists, it rarely has to be used.

Te government bond markets in a monetary union have the samestructure as the banking system. When solvency problems arise inone country (Greece), bondholders, earing the worst, sell bondsin other bond markets. Tis triggers a liquidity crisis in these othermarkets, only because there is a ear that cash may not be available

to pay out to bondholders. But this selling activity leads to an in-crease in government bond rates and turns the liquidity crisis into asolvency crisis. Tere is an interest rate high enough that will makeany country insolvent. Te characteristic eature o these dynamicsis that distrust can push a country in a sel-ullling way into a bad


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19Paul De Grauwe

equilibrium.1 Te latter is characterized by high interest rates, re-cessionary orces, increasing budgetary problems, and an increasedprobability o insolvency. In a bad equilibrium, it is also likely that

domestic banks will experience unding problems that can degener-ate into solvency problems.

Te single most important argument or mandating the ECB to bea lender o last resort in the government bond markets is to preventcountries rom being pushed into a bad equilibrium. In a way, it canbe said that the sel-ullling nature o expectations creates a coordi-nation ailure, i.e., the ear o insucient liquidity pushes countriesinto a situation in which there will be insucient liquidity or boththe government and the banking sector. Te central bank can solvethis coordination ailure by providing lending o last resort.

Failure to provide lending o last resort in the government bond mar-kets o the monetary union carries the risk o orcing the central bankinto providing lending o last resort to the banks o the countries hit

by a sovereign debt crisis. In act, this happened in December 2011and February 2012 when the ECB was orced to pour a total o onetrillion Euros into the banking system that had become inected bythe sovereign debt crises. And this lending o last resort is almostcertainly more expensive. Te reason is that most oten the liabilitieso the banking sector o a country are many times larger than theliabilities o the national government. Tis is shown in Figure 1. We

observe that the bank liabilities in the Eurozone represented about250% o GDP in 2008. Tis compares to a government debt toGDP ratio in the Eurozone o approximately 80% in the same year.

1 See De Grauwe (2011) where this point is elaborated urther. See also Kop(2011). For ormal theoretical models see Calvo (1988) and Gros (2011). Tisproblem also exists with emerging countries that issue debt in a oreign currency.See Eichengreen, et al. (2005). Te problem is also similar to sel-ullling oreignexchange crises (Obsteld(1994)).


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Figure 1: Bank liabilities as percent GDP (2008)

While the argument or mandating the ECB to be a lender o last re-sort in the government bond markets is a strong one, the opposition

to giving the ECB this mandate is equally intense. Let me review themain arguments that have been ormulated against giving a lender olast resort role to the ECB.

Risk o ination

A popular argument against an active role o the ECB as a lender olast resort in the sovereign bond market is that this would lead toinfation. By buying government bonds, it is said, the ECB increasesthe money stock thereby leading to a risk o infation. Does an in-crease in the money stock not always lead to more infation as MiltonFriedman taught us? wo points should be made here.

First, a distinction should be introduced between the money base andthe money stock. When the central bank buys government bonds (or

other assets), it increases the money base (currency in circulationand banks deposits at the central bank). Tis does not mean thatthe money stock increases. In act, during periods o nancial crises,both monetary aggregates tend to become disconnected. An exampleo this is shown in Figure 2. One observes that, prior to the banking

Source: IMF, Global Financial Stability Report 2008


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21Paul De Grauwe

crisis o October 2008, both aggregates were very much connected.From October 2008 on, however, the disconnect became quite spec-tacular. In order to save the banking system, the ECB massively piled

up assets on its balance sheets, the counterpart o which was a verylarge increase in the money base. Tis had no eect on the moneystock (M3) (see Figure 2). In act, the latter declined until the endo 2009. Te reason why this happened is that banks piled up theliquidity provided by the ECB without using it to extend credit tothe non-banking sector. A similar phenomenon has been observedin the US and the UK.

Another way to understand this phenomenon is to note that when anancial crisis erupts, agents want to hold cash or saety reasons. Ithe central bank decides not to supply the cash, it turns the nancialcrisis into an economic recession and possibly a depression, as agentssell assets in their scramble or cash. When instead the central bankexerts its unction o lender o last resort and supplies more moneybase, it stops this defationary process. Tat does not allow us to con-

clude that the central bank is likely to create infation.

All this was very well understood by Milton Friedman, the ather omonetarism, who cannot be suspected o avoring infationary poli-cies. In his classic book co-authored with Anna Schwartz, A Mon-etary History o the United States, he argued that the Great Depres-sion was so intense because the Federal Reserve ailed to perormits role o lender o last resort, and did not increase the US moneybase suciently (see Friedman and Schwartz (1961). In act, on page333, Friedman and Schwartz produce a gure that is very similar toFigure 2, showing how, during the period 1929-33, the US moneystock declined, while the money base (high powered money) in-creased. Friedman and Schwartz argued orceully that the moneybase should have increased much more and that the way to achievethis was by buying government securities. Much to the chagrin o

Friedman and Schwartz, the Federal Reserve ailed to do so. Tosewho today ear the infationary risks o lender o last resort opera-tions should do well to read Friedman and Schwartz (1961).

Tis unounded ear o infationary consequences o lender o lastresort activity continues to aect policymaking. For example, when


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the ECB recently decided to start buying Spanish and Italian gov-ernment bonds, it announced that it would sterilize the eect thesepurchases have on the money base by withdrawing liquidity rom

the market. Tis was an unortunate decision. Tere was absolutelyno need to do so. Since the start o the banking crisis in

Documents

Governance for the Eurozone - Integration or Disintegration