Some reflections on governance and financial stability in the … · 2019. 5. 17. · Governance measures taken since 2010 The European Stability Mechanism: Permanent crisis mechanism

Lorenzo CodognoLC Macro Advisors LtdFounder and Chief Economist+44 758 3564410 [email protected]

Visiting Professor in Practice at the London School of Economics [email protected]

Some reflections on governance and financial stability in the EurozonePresentation at the Bank of PortugalLisbon, 14 May 2019

Agenda (Eurozone focus, but equally valid for the EU)

Eurozone at 20: from crisis to crisis, amid growing divergence.

A failure of governance? The fiscal framework and the policy mix.

A failure of governance? Macro-economic imbalances.

Financial stability issues: Risk sharing, mutualisation, fiscal capacity and safe bonds.

The doom loop between the sovereign and the banks: Italy.

A flows of fund approach to sustainability: The Italian case.

Conclusions.

GOVERNANCE AND FINANCIAL STABILITY IN THE EUROZONE

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EU moving from crisis to crisis

2008/09 - The first leg of the crisis, i.e. global contagion and GDP collapse: Sharp drop in export and investment activity, markets turmoil. Economy in free fall until mid-2009.

2010/11 - The second leg, i.e. Greece + banking/debt crisis in Europe: Increase in public debt, widening in government bond spreads, interbank market closure, frantic policy reaction.

2011/12 - The third leg, i.e. Italy: Sharp widening of yield spreads, credit crunch. Eventually, accommodative monetary policy + softer fiscal policy, but also debt overhang and fallouts of the balance sheet recession.

2015 - The fourth leg: Greece again.

2018/19 - A fifth leg: Italy again?

FROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE

Many shocks at once left political scars, i.e. lack of trust

Initial exogenous shock: The trigger was the subprime crisis in the US, hitting through trade and financial markets contagion.

Macroeconomic imbalances: Typical emerging market crisis, just within the Eurozone. Sudden stop of financial flows core/periphery.

Banking crisis: Dis-integration and fragmentation in financial markets; re-nationalisation of the banking industry.

Public debt crisis: Existing weaknesses come to the fore.

A monetary/fiscal policy response failure: Political/legal constraints, mistakes and delays, lack of interpretation model.

Above all, a governance failure? Political/institutional constraints.

FROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE

GDP growth per capita: Divergence since EMUFROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE

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GDP levels per capita: Divergence since EMUFROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE

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Italy: Two lost decades, and still a 5% gap relative to 2008FROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE

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Labour market performances: Big divergence as wellFROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE

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Governance measures taken since 2010

The European Stability Mechanism: Permanent crisis mechanism tool.

Banking Union: Single Supervisory Mechanism (SSM), Single Resolution Mechanism (SRM) and Single Resolution Fund (SRF) and the bail-in rules of the BRRD framework. Yet to be completed.

Macroeconomic Imbalance Procedure (MIP): Detection and correction of macroeconomic vulnerabilities and a way to enforce reform implementation.

Reform of the Stability and Growth Pact and Fiscal Compact:Reinforced fiscal framework, monitoring of expenditure developments, numerical debt benchmark, reverse qualified majority voting.

But how can governance cope with increasingly differing economic performance?

A FAILURE OF GOVERNANCE?

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The ECB view: Draghi’s speech in Helsinki, 27 Nov 2014

MSs “have to be better off inside than they would be outside.”

“The euro is – and has to be – irrevocable in all member states, not just because the Treaties say so, but because without this there cannot be a truly single money” (fungibility of money, redenomination risk).

In the absence of permanent fiscal transfers among MSs: (1) all EA countries need to be able to thrive independently, (2) EA countries need to invest more in other mechanisms to share the cost of shocks, “ensuring that the conditions are in place so that all countries can retain full use of national fiscal policy as a counter-cyclical buffer.”


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IMF (2014): Fiscal rules are too complex and inconsistentA FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX

Reforms of the SGP “have made the system increasingly complicated, creating risks of overlap and inconsistency between rules, as well as difficulties in public communication. […] Staff advised examining the complexity of the framework over the medium term, and looking into the possibility of reducing the number of rules.”

“The SGP may limit the space to finance structural reforms that entail sizeable short-term budgetary costs”.

“A second question is whether the MTO and, to a lesser extent, the 3 percent deficit cap, discourages public investment by limiting the capacity to borrow to fund projects that increase long-term growth potential.”

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Fiscal governance: Recent improvements/still-open issuesA FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX

Structural balances: Well-identified drawbacks mainly due to potential output and output gap measurement, volatility and deep revisions (levels, but not much about changes). Alternatives?

Pro-cyclicality: Fiscal policy has turned pro-cyclical no matter the “true” level of the output gap. Are rules really working?

Flexibility for reforms: Structural reforms increase potential growth and thus lower the structural part of the deficit, often imply either near-term recessionary effects or need to compensate losers.

Public investments: Some flexibility for EU co-financed projects; need to incentivise investment by proper fiscal space.

Bottom line: There are drawbacks, but it is not fair to argue that the framework is wrong. The problem is proper implementation.

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Is fiscal governance based on the output gap a problem?A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX

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Fiscal rules are just part of the storyA FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX

Many other institutional features help strengthening the fiscal framework.

Legislated broad principles that guide the formulation of fiscal policies.

Effective budget mechanisms and procedures designed to minimisedeficit biases.

Strong transparency requirements and public oversight.

The operation of independent fiscal agencies tasked with the monitoring and assessment of fiscal developments.

Last but not least, politics …

A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX

Fiscal policy: The Great Recession led to a change of views

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Before the crisis: Fiscal policy not appropriate for economic stabilisation, no significant effect on output, long time lags, risks of pro-cyclicality, challenging to rein the extra spending back when the cycle turned expansionary. Monetary policy is a more flexible and effective tool for stabilisation.

Zero-lower-bound: Few now question the appropriateness of massive fiscal stimulus to rescue banks, companies and people in 2008-09.

After 2008-09: Can ‘austerity’ or ‘fiscal discipline’ (budgetary policies aimed to reduce the deficit, or increase the surplus, on a structural basis) be counterproductive or self-defeating? Can expansionary policies be self-financing?

Now only mildly accommodative Eurozone fiscal policyA FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX

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Fiscal policy constraints: Would the ECB come to the rescue?

Issuer’s limits: For the reactivation of the APP the ECB would need to first announce some loosening of the issuer limits. Feasable?

Tiering system: Mitigating the costs for banks would likely be a precondition to further extend forward guidance and any lowering of the deposit rate. Would it produce further fragmentation?

T-LTRO III rates decision: It will depend on the state of the economy in June. Rates will likely be closer to the deposit rate, although linked to the MRO.

Changes in the Governing Council: Implementation risk for any accommodative measure.


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Lessons from the past

China 1997-98: PBoC bought impaired assets and accelerated debt-for-equity swaps to clean the balance sheets of the commercial banks and restore their lending capacity (+Malaysia). No moral hazard. The economy stayed on the banks’ balance sheets, and grew.

US 2008: Troubled Asset Relief (TARP): $426.4bn invested. The Treasury bought Preference Shares – bought franchise future, not legacy losses (+AIG bailout $182bn).

GSEs (Fannie Mae, Freddie Mac) nationalised in 2008. Shares delisted in June 2010. By August 2012 they had drawn $190bn in aid.

TARP closed in 2014, $14.3bn profit. AIG closed in 2012: $25.5bn profit. GSEs: profit $80.9bn (2017). 15% return.

2008 UK: Lloyds and RBS. More mixed results.


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Out-of-the-box thoughts

Balance sheets clogged: In the EA, banks were told to hold higher capital and liquidity ratios. Through QE, a proportion of the ‘good economy’ migrated to the balance sheets of the ESCB. Fear of moral hazard and lack of trust blocked purchase of bad assets.

Post crisis regulation has not taken into account bank credit creation, while introducing constraints to the capacity of bank balance sheets through new capital and liquidity regulations.

“The function of a Central Bank should be to regulate the volume and price of bank credit” Macmillan Committee Report, 1931. How to address it? Variable capital ratios and a system leverage target?

The money created by central banks is not a substitute for bank credit.


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5PR: Prevent/correct imbalances before they get out of hand

“It should be not just to detect imbalances but also to encourage structural reforms through the European Semester. Its corrective arm should be used forcefully. It should be triggered as soon as excessive imbalances are identified and be used to monitor reform implementation”.

MIP “should foster adequate reforms in countries accumulating large and sustained current account surpluses if these are driven by, for example, insufficient domestic demand and/or low potential growth, as this is also relevant for ensuring effective rebalancing within EMU.”

A FAILURE OF GOVERNANCE? MACROECONOMIC IMBALANCES

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Why the MIP? Any ambiguity on the MIP objectives?

A way to spot the next crisis? Intra-EU/EA or vs ROW?

A way to identify risky macroeconomic imbalances that jeopardise the functioning of the EMU, i.e. force countries to do what is best to protect the rest of the EU/EA from a fall-out?

A way to make Europe 2020 more binding and strengthen the European semester, i.e. force MSs to do what is best for them?

A way to put forward broad policy objectives – a Christmas tree approach?

A way to address phenomena but not their underlying causes? Need for an holistic and non-mechanical approach?


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Draghi’s speech: joint sovereignty on reforms

“EA countries cannot be agnostic about whether and how others address their reform challenges. Their own prosperity ultimately depends on each country putting itself in a position to thrive within the Union. For this reason, there is a strong case for sovereignty over relevant economic policies to be exercised jointly. That means above all structural reforms.”

Deepening Economic Union: (1) Using more effectively the rules and procedures we already have, (2) acknowledging the community of interest and the reality of spillovers in the form of a real sharing of sovereignty in the governance of structural reforms. That is shifting from coordination to common decision-making, and from rules to institutions.


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Political legitimacy versus unelected technocratic bodies?

Suspicion towards the ‘expects’ may be a stumbling block in the implementation of the European semester.

How can we make reforms and adjustments socially and politically sustainable? Bring sovereignty back means looking of what is good for the country first and over the short term, at the expense of the European dimension.

Can European rules/procedures go beyond what already achievedwithout further political integration?


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Is enforcement a paper tiger?

Again, 5PR: MIP = “a tool to prevent and correct imbalances before they get out of hand”. Can misguided policies be corrected once approved in parliament and with the blessing of a democratic process? Or is it better to prevent?

Diversity, experimentation, and country-specific solutions are a value for a large diversified area as the EU. Still, can the EU allow for completely divergent policies? What is the limit?

What is the role of European institutions? Can the European Commission enter the political debate on macro imbalances and structural reforms? Ownership of reforms? National Productivity Boards (13 out of 28 already in)?


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Is the whole governance a bureaucratic tiger?

Numerous ‘packs’, ‘pacts’ and ‘procedures’ and additional reporting requirements, periodic reporting, regular peer reviews, ‘comply or explain’ approaches. Has complexity blurred the rationale and effectiveness of rules?

Populists’ suspicion towards the ‘expects’ may be a stumbling block in the implementation of the European semester.

How can governance make reforms and adjustments socially and politically sustainable? Bring sovereignty back means looking of what is good for the country first and over the short term, at the expense of the European dimension.

Can European rules/procedures go beyond what already achievedwithout further political integration?


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The ECB view: need for risk sharing

“Sharing monetary policy and in particular an exchange rate deprives national economies of some adjustment tools in the face of local shocks”. To ensure that countries are better off being in the Union when a shock hits than they would be outside, “we need other ways to help spread [short term adjustment costs] … those channels have to be at least as effective as if countries were not part of monetary union.

Sovereign debt needs to act as a safe haven in times of economic stress (strong fiscal governance; backstop). “It would be natural to reflect further on whether we have done enough in the euro area to preserve at all times the ability to use fiscal policy counter-cyclically. But it is also clear that this could only take place in the context of a decisive step towards closer Fiscal Union”.

FINANCIAL STABILITY ISSUES, A SAFE ASSET AND FISCAL CAPACITY

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Draghi’s speech: is private risk sharing a solution?

“The less public risk-sharing we want, the more private risk-sharing we need.”

“Private risk-sharing chiefly comes through a well-integrated financial system.” Diversified portfolios make balance sheets more resilient to local shocks and allow the effects of those shocks to be dispersed across countries. Financial union (inter-temporal/country income smoothing) instead of financial fragmentation (interbank liabilities vs. retail concentration).

This discussion led to the introduction of the BRRD, Capital Market Union, and the debate about risk sharing/risk reduction. Probably, it may contribute over the long run, but it is not a solution for the near term.


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The prevailing view before the crisis

Monetary policy cannot absorb asymmetric shocks (‘one size cannot fit all’) and fiscal policy is constrained by fiscal rules. ‘Alternative adjustment mechanisms’ were underdeveloped.

Asymmetric shocks lead to temporary economic divergence, which become persistent once ‘hysteresis’ kicks in.

Policy prescriptions:

1. EU ‘Internal Market’ integration for labour and capital for alternative adjustment mechanisms.

2. Product and labour market reforms to rein in hysteresis.

3. Fiscal consolidation to create ‘fiscal space’ and allow the operation of automatic stabilisers.


Since the crisis the view has changed

The ‘doom loop’ between sovereigns and banks:

1. Higher risk of sovereign default due to insolvencies of the domestic banking system;

2. Liquidity and solvency problems of banks also due to sovereign debt in their balance sheets.

ESM rules and restructuring risk may become in itself a source of financial instability.

Monetary policy continues to edge at the brink of a de facto zero-lower-bound (ZLB), i.e. ‘one size fits nobody’.

Need for an asset to serve as collateral for interbank loans and repos and ECB funding and break the banks-sovereign doom loop, while preserving market discipline.


Need for a safe asset and fiscal capacity

Financial and fiscal integration is experiencing another setback due to the surge of populism and the desire to bring sovereignty back.

Unity of liability and control remains the guiding principle, but there is still a need for a smooth transition that avoids unnecessary strains to macro economic and financial stability, while preserving market discipline and avoiding moral hazard.

Need for lightening the burden of stabilisation from national sovereigns (legacy debt) and the ECB (zero-lower-bound), and strengthening the transmission of monetary and fiscal policy.

Therefore, need for an analytical framework: “The rationale for a safe asset and fiscal capacity in the Eurozone” Lorenzo Codogno and Paul van den Noord (2019).


Safe assets proposals

ESBies (and others): Issued at the centre and used to purchase national sovereign bonds in the secondary market according to the ‘capital key’. Reduced risk due to pooling & tranching, and diversification.

E-Bonds: Issued by a triple-A entity and used to issue ‘soft loans’ to national sovereigns to replace sovereign debt as it matures. No tranching. Long transition period.

ESBies & E-Bonds: Usually capped at 60% of national GDP (risk premium and market discipline above 60%), with ‘regulatory encouragement’ by exempting ESBies/E-Bonds from risk-weighting.


Fiscal capacity

Fiscal capacity: It directly affects the fiscal stance, at the national or Eurozone level or both (not with safe bonds).

Loans from the centre: Loans to member states in recession, subject to conditionality (lower borrowing costs).

Public works at the centre and top-down grants: Entity that can raise its own taxes and capital through bonds issued against future proceeds. Redistribution, fiscal stimulus or restrain.

Horizontal transfers: Spending on welfare and other ‘cyclical needs’, i.e. unemployment insurance. Risks: fiscal dominance, lack of democratic legitimacy.


No fiscal capacity, safe assets or ECB backstop, then what?FINANCIAL STABILITY ISSUES, A SAFE ASSET AND FISCAL CAPACITY

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Shock Symmetric Asymmetric

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y*

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r*-r

Baseline

Fiscal Capacity 2

Safe Asset + Fiscal Capacity 2

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Baseline

Fiscal Capacity 2

Safe Asset + Fiscal Capacity 2

Lorenzo Codogno and Paul van den Noord, “The rationale for a safe asset and a fiscal capacity for the Eurozone”, LEQS, May 2019, www.lse.ac.uk/european-institute/Assets/Documents/LEQS-Discussion-Papers/LEQSPaper144.pdf

http://www.lse.ac.uk/european-institute/Assets/Documents/LEQS-Discussion-Papers/LEQSPaper144.pdf

Main results of the paperFINANCIAL STABILITY ISSUES, A SAFE ASSET AND FISCAL CAPACITY

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The introduction of the safe asset removes the doom loop (impulse responses of both countries become perfectly symmetric, while the yield spread disappears), reduces the output loss and improves stabilisation in both economies, and creates some space for the periphery to expand its fiscal policy.

The introduction of fiscal capacity aimed at macro stabilisationprovides fiscal space, and a powerful stabilisation mechanism.

When fiscal capacity aims at minimising cyclical divergence, it helps minimising output losses in both countries in case of asymmetric demand shocks, but it also implies cross-country fiscal transfers.

In general, fiscal capacity is of little help in case of supply shocks.


Is there evidence of multiple equilibria?

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Not just debt-to-GDP

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Core is from Mars, periphery is from Venus

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THE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

One hell of a journey: from AAA to close-to-junk in 3 decades

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High risks for debt sustainability

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Primary surplus should be brought back to 3.0-3.5% of GDP

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Since May 2018, yield spreads have remained wideTHE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Doom loop: alive and wellTHE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Credit to the economy: much quicker reaction than in 2011THE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Credit has not yet recovered since 2011THE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Credit not flowing: demand or supply?THE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Stock of EA govies in the portfolio of banks rising somewhereTHE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Stock of EA govies: Italian banks remain the problem THE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Massive issuance of MREL bail-in-able bonds? Retail buying? THE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Banks have reduced bad debt forcefully, but it is not enoughTHE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Quality of credit (NPL flows) has improved substantiallyTHE DOOM LOOP BETWEEN THE SOVEREIGN AND THE BANKS: ITALY

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Foreign holdings of govies steadily decliningA FLOWS OF FUNDS APPROACH TO SUSTAINABILITY: THE ITALIAN CASE

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A FLOWS OF FUNDS APPROACH TO SUSTAINABILITY: THE ITALIAN CASE

The ESCB can no longer be the only buyer of net issues

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Foreign investors are the marginal buyers who sets the priceA FLOWS OF FUNDS APPROACH TO SUSTAINABILITY: THE ITALIAN CASE

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Risks of an investors’ strike?A FLOWS OF FUNDS APPROACH TO SUSTAINABILITY: THE ITALIAN CASE

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A balance of payment approach to sustainabilityA FLOWS OF FUNDS APPROACH TO SUSTAINABILITY: THE ITALIAN CASE

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In a BoP framework, flows can only be absorbed by Target2 A FLOWS OF FUNDS APPROACH TO SUSTAINABILITY: THE ITALIAN CASE

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Creeping capital outflows?A FLOWS OF FUNDS APPROACH TO SUSTAINABILITY: THE ITALIAN CASE

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5PR: Some innovative principles that remained on paperCONCLUSIONS

“Absorbing the impact of shocks also through risk-sharing within EMU”: integrated financial and capital markets (private risk-sharing) combined with the necessary common backstop, i.e. a last resort financial safety net to the Banking Union. Public risk-sharing should be enhanced through a mechanism of fiscal stabilisation.

Progress needed on four fronts: (1) Genuine Economic Union, (2) Financial Union, (3) Fiscal Union, (4) Political Union.

Principle: Need to shift from a system of rules and guidelines for national economic policy to sovereignty-sharing within common institutions.

Timing: first steps (‘deepening by doing’), clear orientation for the longer-term measures (‘completing EMU’). A gradual approach.

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Draghi’s speech: sharing a single currency is political union

“A common misconception about the European Union – and the euro area – is that they are economic unions without underlying political union. This reflects a deep misunderstanding of what economic union means: it is by nature political”.

“Fiat money is a political construct and monetary union could not operate without adequate political structures”.

But political commitment is not enough: “Until we have completed EMU, which means achieving the minimum requirements in all areas for our union to be truly sustainable, doubts about its future will never entirely fade away. And this is true no matter how much political commitment is voiced.”

CONCLUSIONS

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However, the political dimension is still missing

Ways to smooth economic cycle over the medium term: unemployment insurance or other macroeconomic stabilisation tools? Technically difficult and challenging; politically toxic.

Any form of Eurobond/ESB? Again politically toxic. It does not address the underlying issues: unity of liability and control.

Need for an irrevocable roadmap, backed by unlimited firing power and with mutualisation together with political control?

Sudden stops and liquidity crisis, that can push countries into bad equilibrium: must be avoided. Destabilising capital flows within the Eurozone must be stopped. Risk sharing through financial markets is not very effective during financial crisis.

CONCLUSIONS

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How the EU/Eurozone will retool for the future?

Legacy debt and transition period are critical. Will the second stage of the 5PR ever take off?

Is Europe politically prepared for fiscal/political union? Schumpeterian political leadership?

“A consistent framework to satisfy the unity of liability and control”: (1) “More Europe”, i.e. transfer of fiscal and economic sovereignty to European level and assume joint liability, or (2) national sovereignty over fiscal and economic policy without joint liabilityfor government debt, a credible no-bail out clause with debt restructuring mechanism to re-establish market discipline?

Finally, can the European integration process withstand another crisis?

CONCLUSIONS

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