The Politics of the Euro Area Crisis,Greece and the ECB

Athanasios OrphanidesMIT

Geneva, 17 February 2015

Headlines

“Talks Collapse as Athens Rejects Bailout Extension.”Financial Times.

“Meeting on Greek Debt Produces an Ultimatum.” New YorkTimes.

“Greek Financing Talks Break Down Amid Deep DivisionsOver Bailout.” Wall Street Journal.

“Greek Rescue Talks Collapse in Acrimony.” The Guardian.

Athens: 2015

Athens: 2010

The euro area crisis

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105

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110In

dex

2007

Q4=

100

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

United States Euro Area

Real GDP in US and euro area. Index: 2007Q4 = 100

The narrative of the crisis: Causes or symptoms?

I Sovereign debt crisis?

I Banking crisis?

I Competitiveness crisis?

I Confidence crisis?

Why Europe failed?

I Every crisis generates losses. Key question: Who pays?

I Proper crisis management minimizes total cost andmanages fair distribution.

I The euro tied member states, removed crisis managementtools from individual member states.

I This elevated the importance for cooperation amonggovernments to contain total crisis cost.

I But the necessary political structure to encouragecooperation was absent.

A confidence crisis

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2

4

6

8

0

2

4

6

8Percent

2007 2008 2009 2010 2011 2012 2013 2014 2015

Germany France Italy Spain

Yields on two-year government bonds

A political crisis: Politics over economics

“What we have, in fact, is a crisis of the ability of theEuropean Union’s political bodies to act. This glaringweakness of action is a much greater threat to the future ofEurope than the excessive debt levels of individual euro areacountries.”

Helmut Schmidt, October 19, 2011

The triumph of local politics

I The common currency created opportunities to exploitthe crisis to shift losses from stakeholders in one memberstate to stakeholders in other member states.

I Electoral consideration induced certain governments toleverage the crisis for their own political gain.

I Rather than work towards containing total losses, politicsled governments to focus on shifting losses to others.

I The result was massive destruction in some memberstates and a considerably higher total cost for Europe asa whole.

Who done it? A stroll in Deauville

October 18, 2010: Deauville

I Agreement between French and German government tointroduce the Private Sector Involvement (PSI) doctrine.

I Whenever a euro area member state faced liquiditypressures (not necessarily solvency concerns), theimposition of losses on private creditors would bedemanded before euro area governments agreed to allowany temporary assistance.

I Message to potential investors: Euro area sovereign debtshould no longer be considered a safe asset with theimplicit promise that it would be repaid in full.

I Although it was a blunder for the euro area as a whole,the PSI doctrine proved beneficial to Germany andFrance, widening yield di↵ferentials with periphery.

Examples of shifting losses

I PSI concept introduction. Who benefited and who lost byinjecting credit risk in euro area sovereign debt?

I Greek debt in 2010. Who was exposed? Who wasprotected by postponing a haircut on Greek debt?

I Greek debt in 2012. Who benefited from imposing ahaircut while excluding the ECB after banks in somemember states unloaded their holdings to it?

I Timing and sequencing of decisions had importantdistributional consequences among stakeholders indi↵erent members states.

Winners and losers

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2007

Q4=

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Germany France Italy Spain

Real GDP. Index 2007Q4=100

What about Greece?

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2007

Q4=

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Germany Euro Area Greece

Real GDP. Index 2007Q4=100

What happened in Greece?

I Greek government requested IMF assistance in 2010.

I Program designed with heavy involvement of Germangovernment and European Institutions.

I Severe austerity imposed but program was assessed torestore stability and growth by 2012.

I Greek debt was deemed sustainable without haircuts.

I Independently, ECB started purchases of Greekgovernment debt (SMP).

May 2010 program: Debt to GDP ratio

2010

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rcen

t of G

DP

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

May 2010 program: Deficit to GDP ratio

2010

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-14

-12

-10

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-6

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0

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1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

May 2010 program: Real GDP

2010

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140

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220Bi

llion

2005

eur

o

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

May 2010 program: Unemployment

2010

5

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25

30

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30Percent

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Outcome: Deficit to GDP ratio

2010

2014

-16

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-12

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1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Outcome: Unemployment

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2014

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30

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30Percent

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Outcome: Real GDP

2010

2014

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2005

eur

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1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Outcome: Debt to GDP ratio

2010

2014

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1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

2014 estimate includes e↵ect of 2012 haircut

Ex post evaluation

“There were notable successes ... “

“However, there were also notable failures. Market confidencewas not restored, the banking system lost 30 percent of itsdeposits, and the economy encountered a much-deeper-than-expected recession with exceptionally high unemployment.Public debt remained too high and eventually had to berestructured, with collateral damage for bank balance sheetsthat were also weakened by the recession.”

“... the baseline macro projections can also be criticized forbeing too optimistic.”

“There are also political economy lessons to be learned.”

(IMF, June 2013)

What was the Troika program about?

“It was about protecting German banks, but especially theFrench banks, from debt write o↵s”

(Karl Otto Pohl, Former Bundesbank President)

Why did the IMF go along in 2010?

“The Dutch, French, and German chairs conveyed to theBoard the commitments of their commercial banks to supportGreece and broadly maintain their exposure.”

(IMF Board meeting, May 9, 2010)

Did the French and German governments honor their part ofthe plan?

Who’s to blame for Greece?

I Greek government policies started the problem.

I Flaws in euro construction made the problem worse.

I Who should bear the cost of the botched Troika program?

I Who should pay for restoring growth if an unworkableprogram was imposed on Greece to protect German andFrench banks from losses in 2010?

I What is the responsibility of other governments?

I What is the responsibility of European Institutions?

A nightmare for the ECB

I Focus on crisis management?

I Focus on monetary policy?

I Respect the mandate or yield to politics?

I Tradeo↵s for survival of the euro area?

Possible descriptions of a new role?

I “The enforcer.” Economist, 7 February 2015

I “Germany’s debt collector.” New York Times op ed byPaul Krugman, 6 February 2015

Fed vs ECB: Inflation

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United States (PCE) Euro area (HICP)

Fed vs ECB: Overnight interest rate

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United States (Federal funds rate) Euro area (Eonia rate)

At the zero bound?

I The stance of monetary policy is no longer wellsummarized by the nominal interest rate.

I Focus shifts on size and composition of balance sheet.

I Size of balance sheet becomes a useful indicator of thestance of monetary policy.

ECB vs Fed policy: Tightening vs easing

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Fed assets ECB assets

ECB policy: inflation and inflation expectations

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2010 2011 2012 2013 2014 2015

HICP Core HICP 5-year forward 5-year swap 2-year SPF forecast

Has the ECB been violating its mandate?

Euro area forecasts as published by ECB

GDP Growth InflationForecast Date 2014 2015 2016 2014 2015 2016Sept. 2013 1.0 1.3Dec. 2013 1.1 1.5 1.1 1.3Mar. 2014 1.2 1.5 1.8 1.0 1.3 1.5June 2014 1.0 1.7 1.8 0.7 1.1 1.4Sept. 2014 0.9 1.6 1.9 0.6 1.1 1.4Dec. 2014 0.8 1.0 1.5 0.5 0.7 1.3

What is the role of the ECB?

I When is it proper NOT to pursue the indicated monetarypolicy that best fulfils the ECB’s mandate according tothe Treaty?

I When should policies be adjusted to appease thegovernment of a specific member state or members ofparliament in any specific member state?

I When should policies be adjusted to appease publicopinion in any specific member state?

ECB QE: Latest decision

I “[The Governing Council] decided to launch an expandedasset purchase programme, encompassing the existingpurchase programmes for asset-backed securities andcovered bonds. Under this expanded programme, thecombined monthly purchases of public and private sectorsecurities will amount to e60 billion.”

I “They are intended to be carried out until end-September2016 and will in any case be conducted until we see asustained adjustment in the path of inflation which isconsistent with our aim of achieving inflation rates below,but close to, 2% over the medium term.”

Joint responsibility for a single monetary policy?

I “With regard to the sharing of hypothetical losses, theGoverning Council decided that purchases of securities ofEuropean institutions (which will be 12% of theadditional asset purchases, and which will be purchasedby NCBs) will be subject to loss sharing. The rest of theNCBs additional asset purchases will not be subject toloss sharing.”

Where do we stand?

I Misdiagnosis of the problem hinders resolution.

I The status quo remains unstable. The euro, in its currentform, is a threat to the European project.

I Once the political nature of the crisis is properlydiagnosed, discussion of remedies can take place.

I A realignment of political power is necessary to moveforward.

I European institutions would contribute better by focusingon fulfilling their mandates.