The euro crisis: What did we know?

What have we learnt?

Oxonia, 22 February 2012

Jean Pisani-Ferry (Bruegel)

• Extensive research on EMU in the 1990s

• Many advance warnings from academia about euro risks

• In many respects the crisis was foretold

• However not in all

Goal: Find out what could be expected and

what have been genuine surprises Discuss policy lessons

Jonung and Drea’s count of US academic papers on the euro

Outline

1. Non-surprises2. Surprises3. Implications

1. Non-surprises

1. Eurozone not an OCA– Bayoumi-Eichengreen

2. Not an endogeneous OCA– Krugman’s lessons of Massachussets for EMU

3. One-size-fits-all monetary policy destabilising– Walters critique

4. Long-lasting real exchange rate cycles- Blanchard-Muet

5. Sovereign solvency crises more likely in EMU– De Grauwe

6. Inadequate pricing of sovereign risk– Buiter-Sibert

7. Incentives to fiscal indiscipline– Beetsma, Uhlig

8. Design/enforcement problems of SGP– Eichengreen-Wyplosz

9. Weak provisions for coordination of bank supervision/crisis resolution– Lamfalussy, Goodhart

What did policymakers do to address these risks?

Some:• SGP• Surveillance framework

But not much... • Nominal rather than real entry criteria • No real efforts to foster single market integration • Only a few states gave thoughts to ways of controlling divergence,

weak implementation of surveillance provisions • Limited efforts to ensure wage/price flexibility • No appetite for integration of supervisory policies • No crisis management mechanisms

Not only the EU failed to anticipate problems

... also the IMF• Country-by-country approach• “Europe is different” mindset• Institutional mimicry

Why were warnings ignored?

• Predominance of (high) politics• Euro choice• Entry highly politicised choice

• Implementation problems• Hard to define undisputable entry criteria based on OCA

• Adjustment and integration fatigue• No appetite for further reforms • No appetite for surveillance• No appetite for further transfer of competence• Not even for single market enforcement

Hence, complacent reading of the literature• Endogenous price flexibility assumed• Endogenous OCAs taken for likely• Solvency crises not considered a real risk

In the end, incoherence between euro and other dimensions of integration

2. Surprises

1. Current-account crises2. Correlation of banking crises and sovereign crises and the

consequences of not having a LLR for sovereigns

A. Current-account crises

• Evidence of current-account crises within euro area:

• Indirect: sovereign spreads correlated to NFA position

• Direct: Target 2 data

Target balances : North vs. South, €bn

Source: Bruegel

Evidence of Sudden Stops

(Merler and Pisani-Ferry, work in progress)

• Calvo methodology to identify sudden stops episodes• One observation at least with yoy capital inflows 2 standard deviations below mean• Starts: first observation with delta (yoy capital inflows) 1 SD below mean• Ends: first observation with delta (yoy capital inflows) exceeds 1 SD below mean

(reversion)

• Applied to monthly BOP data

• Preliminary results: • Evidence of SS episodes in Southern Europe• First major episode Spring 2010 (before and around first Greek programme)• Second major episode Summer-Autumn 2011

How can current accounts matter?

• Old research: current accounts don’t matter within a country, hence they don’t matter in a MU. See Ingram (1973): “The traditional concept of a deficit or a surplus in a member nation’s balance-of-payments becomes blurred.. With a common currency, no individual country can be exposed to speculative attacks”

• Not seriously challenged by later research. Questions about reasons for CA imbalances (Blanchard-Giavazzi) but general belief that euro was eliminating Feldstein-Horioka

Practical consequences: • EU BOP assistance (Art. 143) reserved to countries outside the euro• No serious attempt to exercise BOP surveillance in the 2000s

Why do they matter? • Mobility? • Banks!

B. Correlation of banking crises and sovereign crises

• Known stylised fact: banking crises and BOP crises are correlated• In the euro area also..

• Was foreseen (Eichengreen Wyplosz 1998)• But was not seen that would be magnified by the absence of a lender of

last resort for sovereigns

• Governments treated financial specialisation like any other specialisation

• State debt was assumed safe

• Results is unexpected “fragility” (De Grauwe 2011)

Correlation of sovereign and banking spreads

Spain Italy

Why? Sovereign exposure to banks is considerable...

Total bank assets to government tax receipts ratio, 2010

Source: Eurostat, ECB, Bruegel calculations

0.005.00

10.0015.0020.0025.0030.0035.0040.0045.0050.00

..and banks exhibit strong home bias in holding of govt bonds

Share of own sovereign’s bonds

in EA government bonds held by banks, 2010

Source: EBA, EUROSTAT, Bruegel calculations

Correlation of sovereign and bank CDSs

US

Source: Bruegel based on Thomson Reuters data

Sovereign CDSs and bank CDSs, 1/2008 to 1/2012

Furthermore banks home bias has increased (even before 3-y LTRO)

Source: Bruegel based on national data

Shares of domestic banks and non-residents in holding of govt bonds, 1998-2011

Source: Merler and Pisani-Ferry (2012)

C. The new impossible trinity

National banking systems

No co-responsibility

over public debt

Strict no-monetary

financing

Financial union

Fisc

al un

ion

Lender of last resort for sovereigns

The no-coresponsibility principle

• Government in the EA are individually responsible for the debt they have issued (No bail-out rule)

Art. 125: “The Union shall not be liable for or assume the commitments of central

governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to

mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central

governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to

mutual financial guarantees for the joint execution of a specific project”

• Markets did not believe it would be enforced. In 2001 Greece was upgraded after joining the euro ”on the belief that Greece was now part of the euro zone and that nobody was ever going to default”

Strict no-monetary financing

Art. 123: Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States

(hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public

authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them

by the European Central Bank or national central banks of debt instruments.

Art. 123 prohibits institutionalised fiscal dominance, i.e. explicit agreements between government(s) and central bank(s) similar to the Fed-Treasury accord of 1951…

Where are the problems?

1. ECB has no financial stability mandate • Art. 127-5 very weak

The ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions

and the stability of the financial system• Justification of SMP is to help ensure the proper transmission of monetary policy

decisions

2. ECB does not have the proper governance structure• One governor-one vote not appropriate for decisions with potential distributive

consequences

3. ECB not made to exercise broad policy conditionality• Legitimacy issue

Result: hesitant behaviour

Purchases on secondary market are limited and lack consistency

3. Implications

The strategy: Force RER adjustment in the periphery by enforcing fiscal discipline Eliminate insolvency risk by making states super-safe

The alternative solutions:• Make sovereign risk manageable• Restore the LLR function• Revise the no-coresponsibility principle

A. Super-safe sovereigns

• Safe public debt levels lower than thought• Need to move away from deterministic approach to budgetary

surveillance, take into account implicit liabilities and tail risks• Stress test the sovereigns• But:

• Evaluation of safe debt levels elusive• Goal VERY distant

The (long) way to go…

Gross debt Primary balance CAPB CAPB in 2020–30 Required adjustment between 2010 and 2020

Required adjustment and age-related spending,

2010–30Austria 72.2 -2.5 -1.6 1.8 3.4 7.7Belgium 96.7 -0.9 0.3 3.1 2.8 8.4Estonia 6.6 0.4 4.3 0.4 -3.9 -3.5Finland 48.4 -3.2 -0.7 0.4 1.1 6.8France 82.4 -4.9 -3.1 3.1 6.3 7.9Germany 84.0 -1.2 -0.4 2.0 2.3 4.6Greece 142.8 -4.9 -5.7 9.8 15.5 19.0Ireland 94.9 -28.9 -6.4 5.6 12.0 13.5Italy 119.0 -0.3 1.2 4.3 3.1 4.1Netherlands 63.7 -3.9 -3.1 1.3 4.4 9.7Portugal 92.9 -6.3 -5.3 4.3 9.6 13.8Slovak Republic 41.8 -6.8 -5.8 0.9 6.6 8.5Slovenia 37.3 -4.1 -2.8 1.1 4.0 7.9Spain 60.1 -7.8 -6.3 2.0 8.3 10.4

2010 Illustrative Fiscal Adjustment Strategy to Achieve Debt Target in 2030

Required adjustment to reach 60 per cent debt ratio in 2030

Source: IMF

…and the risk of rushing

• Current adjustments tend to be biased towards immediate revenue-raising measures

• Trade-off speed-quality

B. Make sovereign risk manageable

Much to do in this area

• Limit exposure of banks to their sovereign (prudential policy)• Steps towards banking federation

• Long term: European FDIC• Short term: EFSF backstop to national guarantees (or EFSF direct

recapitalisation of banks – see Greece)

Euro area features not universal

Source: Bruegel calculations

US UK

Netherla

nds

France Ita

ly

Irelan

d

Greec

e

Portuga

l

German

ySpain

05

1015202530

Share of domestic banks in total holdings of government securities, 2011

Note: for Germany and Portugal the measure is measure is general government

debt

Two limitations

• Political economy à la Carmen Reinhart: to limit sovereign access to their own financial institutions in times of fiscal stress is an uphill struggle

• Even with a safer financial system, the default of a medium-sized European state would be a major financial shock.

Qualitatively the same as in the US.. but not quantitatively

IT

FR

DE

ES

GR NL BE

ATPT

IECA NY MASS ILLI NJ PENN FLO TEX MICH CONN0

2

4

6

8

10

12

14

16

18

1 2 3 4 5 6 7 8 9 10

% U

S or

EA

GDP

ranking

Central Government Debt as % of EA GDP versus State Government Debt as % of US GDP

EA

US

Source: Eurostat, US Census, Bruegel calculations

C. Restore LLR role for the ECB

• EFSF leverage proposed by Gros-Mayer (2011)• Advantages

• With appropriate haircut, most of the risk remains with EFSF• EFSF has proper shareholding structure• Distinction fiscal / monetary roles

• But difficulties• EFSF borrowing conditions

• In the end was rejected

D. Fiscal union

• Old discussion on economic pillar of Economic and Monetary Union• Choice was made not to create a federal budget• Now issue back in new clothes• Eurobonds:

• Joint and several liability (so co-responsibility)• Possibly partial (Red /Blue bonds)

• Several proposals• Delpla-Weizsäcker • German Economic Experts• ESBIEs• Hellwig-Philippon

Blue/red bonds: basic mechanism

Principles• Senior blue debt tranche issued

up to [60] per cent of GDP, junior red debt above

• Joint and several responsibility on blue debt

• Red debt not eligible to ECB repo, subject to higher capital requirements

Expected effects• Higher marginal cost of debt,

hence incentive properties• Average cost of debt unaffected

ex ante (abstracting from liquidity premium, incentives)

Policy issues

• Two key issues• Which underlying guarantee structure?

• Joint and several• Guarantee by EU budget – with taxing power

• Responsibility for ex ante control• Parliamentary (implies new body made up of NPs and EP)• Judicial (ECJ)

• Can Germany accept? • No direct benefits• Only with strict conditions

• Can France accept (politically)?• Surrender of budgetary sovereignty• Political integration

Conclusions for research

• Research correctly anticipated many of the problems that developed within euro area

• Key limitations were failure to imagine that BOP crises could occur, failure to anticipate the full consequences of absence of LLR for sovereigns

• Other issue has been selective use of research in policy discussion, bordering to instrumentalisation