The future of the Euro after the Great Recession by Javier Andrés and Rafel Domenech

The future of the Euroafter the Great Recession 1

* Javier Andrés is professor of Fundamentals of Economic Analysis at the University of

Valencia and visiting professor of the University of Glasgow. http://iei.uv.es/javierandres/

** Rafael Doménech is Chief Economist of Developed Economies, BBVA Research and

Professor of Fundamentals of Economic Analysis at the University of Valencia.

http://iei.uv.es/rdomenec

1 The authors thank A. Deligiannido, A. García, M. Jiménez, and E. Prades for their assis-

tance and comments on this work, as well as the help from CICYT projects ECO2008-

04669 and ECO2011-29050.

Summary

In this chapter we shall analyse the challenges the Eurozone is facing and

proposals to deal with them via improved economic governance. To do so,

15

/JAVIER ANDRES*/ RAFAEL DOMENECH**/

Summary; 1. Introduction; 2. From the Great Moderation to the GreatRecession; 3. The imbalances in Europe and in the EMU; 4. The newEuropean governance and the future of the Euro; 4.1. Changes in fiscalgovernance; 4.2. Financial integration; 4.3. Economic integration; 5.Conclusions.

16

The future of the Euro after the Great Recession

we shall first examine the reasons behind the accumulation of significant

imbalances in the developed economies and among the EMU countries,

mainly since 2001 until the crisis in 2007, as a result of a pattern of unsus-

tainable growth in many developed economies. Secondly, we shall offer an

in-depth analysis of the significance of such imbalances and the heteroge-

neity which exists between EMU countries. Lastly, we shall study the cha-

llenges presented by the improvement of the economic governance of the

EMU from a fiscal, financial and economic integration perspective, which

shall determine its economic future in the short and long term.

1. Introduction

The international economic crisis which begun in 2007 is

having an extraordinary impact on the European economy, and for

the coming decades, will leave a deep mark in many of its mem-

bers. The crisis has shown that the growth process undergone bet-

ween 1994 and 2007, particularly following the creation of the

Economic and Monetary Union (EMU) in 1999, had entered into

an unsustainable dynamics in the long term. The appearance of

important macroeconomic imbalances among EMU members was

taking shape within the framework of steady growth, inflation

under control, very low interest rates and a very reduced risk assess-

ment (partly as a result of the disappearance of currency risk) in the

context of a world saving glut. Although the Eurozone as a whole

presents smaller aggregate imbalances in terms of deficit and pri-

vate, public and foreign debt than, for instance, the US or the

United Kingdom, the expectations of economic convergence

17

The Future of the Euro

among Eurozone countries and the appearance of financial bubbles

with the promise of high yields, led to very significant capital flows

among its members. This added to a spiralling increase in house-

hold debt and businesses in some of the member countries, gene-

rating very considerable and longstanding deficits in current

account balances. These expectations petered out sharply as of the

subprime crisis of 2007 and, since then, Europe has been experien-

cing different surges of financial crises, economic crises and sove-

reign debt crises, which have been following on and feeding off

each other over time.2 The result of this complex situation has been

that, albeit with differences in the intensity and the severity of the

problems (see, for instance, Doménech and Jiménez, 2010), a sig-

nificant number of European countries have experienced a situa-

tion similar to that of the sudden stops experienced in the past by

some emerging economies, leaving public and private sectors heavily

indebted and, in some cases, extremely high rates of unemployment.

The aim of this chapter is to analyse the changes required by the

EMU and proposals with which to face such challenges with suc-

cess. In order to understand what the problems are and, therefore,

their possible solutions, in the second section we analyse the rea-

sons why important imbalances accumulated in the developed eco-

nomies and among the EMU countries during one of the most sta-

ble periods of economic prosperity in the last decades (the Great

Moderation), which nevertheless gave way to an unsustainable

2 Shambaugh (2012) performs an excellent analysis of the interaction between fiscal,

financial and economic crises in the Eurozone.

18


growth pattern in many economies. In the third section, we offer

an in-depth analysis of the magnitude and implications of such

imbalances throughout the crisis, which are well summarised in the

Excessive Imbalance Procedure (EIP) recently implemented by the

EU, as well as the current heterogeneity among EMU countries. The

fourth section analyses the challenges of improvement of economic

governance of the EMU from a fiscal, financial and economic inte-

gration standpoint, which shall determine its short and long term

economic future. Lastly, the fifth section presents the main conclu-

sions reached in this paper.

2. From the Great Moderation to the Great Recession

In the period between the mid-1990s and 2007, developed eco-

nomies enjoyed one of the greatest economic growth periods,

known as the Great Moderation due to the low volatility of growth

rates in those years. Graph 1 shows evidence of this for the US and

the EMU in terms of GDP per person of employable age. As can be

seen, from the mid-1990s to 2007 there was sustained growth, with

levels well above the historical trend estimated since 1970 for both

geographical areas. In fact, the growth in GSP per person of emplo-

yable age was slightly higher in the EMU than in the US, although

not enough to bridge the gap between both economies.

The Great Moderation generated the perception that economic

cycles would have less volatility, as a result of better managed eco-

19


nomic policy (see, for instance, Galí and Gambeti, 2009, or the

references appearing in this article). In fact, these high growth rates

with low volatility came hand in hand with inflation under con-

trol and low interest rates across the board of financial assets, with

practically inexistent risk premiums in many cases as a result of the

underassessment of the risk. In light thereof, some analysts went as

far as to proclaim the disappearance of the economic cycle and the

capacity to avoid significant economic recessions. It was the com-

binations of these forces which fed the financial imbalances which,

for economists like Rajan (2005) or Borio & White (2005), among

others, are behind the crisis which began in 2007.

There are various economic factors which contributed to genera-

te this combination on which the Great Moderation was erected. In

the first place, the central banks of the developed economies carried

out a low interest rate policy or money glut, as a result of: i) the drop

in the inflation of sellable assets following the inrush of exporting

countries in the international economy with a very abundant and

cheap workforce and depreciated currencies; ii) the benign neglect

policy in regard to the high prices of financial and real estate assets

(Bordo & Jeane, 2002, or Bean 2004 & 2010); and iii) the attempt to

prevent the recession in the US, following the burst of the techno-

logical bubble, or in Germany, following the costly process of reu-

nification and the burst of its real estate bubble.

Secondly a savings glut took place on a worldwide level in

China, Japan, Germany, oil producing countries or the pension

funds of developed economies.

Thirdly, and as a response the savings glut in some countries

and sectors, a formidable increase took place in the demand of safe

assets, moving from the pre-eminence of individual savers to that

of large sovereign funds, investment funds or pension funds which

prioritize safety over yield and which seek to channel savings

towards fixed income rather than towards the acquisition of any

other kind of asset. At the same time that the demand for safe

financial assets (i.e. AAA) increased, there was a relative scarcity of

such assets in the case of sovereign debt, due to the fiscal consoli-


20

Chart 1GDP per person of employable age in the US and in the EMU

Source: OEDC (2012) Economic Outlook Database.

dation taking place simultaneous in many developed economies as

a result of the high growth in GDP. This surplus demand for safe

assets created enormous pressure in the financial markets and in

certain types of assets, which in turn led to the appearance of bub-

bles in certain market segments. The pressure was such that finan-

cial deregulation and engineering came to the rescue, enabling the

response of the financial markets to this scarcity in AAA assets to

be the creation of multiple derivatives and the issue of huge volu-

mes of asset backed securities, as shown in Graph 2. In turn, this

generated enormous liquidity to fund those assets acting as the

underlying assets (for example, mortgages on homes), thus crea-


21

Chart 2Issue of Asset backed Securities 1985-2011

Source: SIFMA

ting a circle in which asset demand stimulated supply, which in

turn was fed back into the process by boosting demand with the

creation of new assets.

As a result of this process, a specialization in asset production

took place on an international level, leading to enormous hetero-

geneity by country, sector and agents. Whereas some countries

generated a surplus in net savings, others (US, Spain or Ireland) res-

ponded to the very low interest rate incentive by generating the

real investments which served as the underlying assets for finan-

cial securities. The US produced assets on a world scale considered

safe by the markets, thanks to the specialization of its financial ser-

vices. Other countries, such as Spain and Ireland, carried out a

similar role, but on a European scale, producing assets backed by

safe collateral (homes) or with no collateral, but issued by financial

institutions deemed to be safe, which attracted savings funds or

large European banks.

In fourth place, the creation of the EMU meant the disappearan-

ce of exchange rate risk among its members. This removed an impor-

tant barrier to capital flows within the EMU and encouraged the pre-

viously described process. But its effects went even beyond the disap-

pearance of currency risk. In the international financial markets, as

well as in the EMU countries, expectations that the greater monetary

and economic integration ensured the economic convergence of its

members were generated, which justified the disappearance of any

type of risk premiums (see Ehrmann et al, 2011).


22

Graph 3 clearly shows the almost full disappearance of risk pre-

miums for countries becoming part of the EMU. Without doubt,

Greece was a paradigmatic example of this process, going from fun-

ding at 25% in 1993 to do at the same interest rate as Germany, follo-

wing its entry into the Eurozone.

The implications of such expectations of economic convergence

were very important in terms of imbalances in the current balance.

Under the assumption that a real and economic convergence pro-

cess was taking place, well beyond the nominal, it seemed natural

that capital should flow towards the economies with lower per capi-


23

Chart 310 year public debt interest rates in the EMU, 1995-2011

Source: ECB, Bloomberg

ta incomes, as economic theory predicts (see, for example, Barro,

Mankiw & Sala-i-Martin, 1995).

In fact, as the risk premiums were disappearing, the correlation

between the savings rated and investment rate were reduced. As

was already anticipated by Blanchard and Giavazzi (2002), since

1999 to the start of the crisis, the Feldstein-Horioka paradox disap-

peared completely, as shown in Graph 4. Coinciding with the

reduction in the typical deviation of risk premiums, which reached


24

Chart 4Typical deviation of risk premiums and correlation between the rate of investment andthe rate of savings, EMU, 1993-2011

Source: Bloomberg

almost zero as of 1998, the correlation between the national invest-

ment rate and the savings rate was observed to have been nil or

even negative, compared to the positive and statistically significant

values of the beginning of the nineties.

In fifth place, a permissive regulation, together with reduced

interest rates and very high competition in the financial sector

generated the incentives required for the generation of profit to be

done via transaction volume instead of via price margins (mainly

interest rates), favouring a very important leveraging of broad seg-

ments of the private sector. One of the results of this process was

the intensification of a new banking business model, based on the

granting of collateral backed loans, the generation of financial

assets from such loans and the distribution thereof as asset-backed

securities in asset packages (originate to distribute) which transfe-

rred credit risk in full to the purchasers of these new generated

assets. Compared with the traditional bank business, in which

financial institutions that grant the credits keep the risk on their

balance sheets, this new business model led to greater intercon-

nection of the balance sheets among financial institutions all over

the world and a significant increase in contagion risk.

3. The imbalances in Europe and the EMU

The financial crisis was preceded by a period of economic prospe-

rity, measured by conventional indicators of growth, macroecono-


25

mic stability and inflation, during which enormous imbalances of a

financial and competitive nature have been created. However, a

glance of the macroeconomic picture of the EMU reflects a situation

of balance which we do not find in other important economic

regions of the world (Table 1). Both the deficit and public debt levels

and the net foreign positions and private indebtedness are generally

lower to those recorded in the United States or the United Kingdom.

However, the EMU has had other problems hanging over it which

have led the economy of the region – and that of the whole of the

EU by extension – to the situation of stagnation which it is currently

undergoing. Some of these problems are of a structural nature, and

others are related to the extraordinary disparities between member

states in their key indicators to which, until very recently, we had

paid little attention. Among the first are demographic evolution and

low productivity growth which in turn have provoked a limited rate

of growth in employment. But the disparities and the heterogeneity

within the EMU are the most outstanding imbalances, as they call

for a serious amendment in the operation of the Euro, whose main

objective was to accelerate convergence among countries who adop-

ted the single currency along with other common institutions.

The European Commission has recently implemented a pro-

gramme to monitor a number of indicators to detect and track

macroeconomic and financial imbalances in countries within the

EU (the EIP). One of these indicators summarises, over all others,

the nature of the main problem facing the European economy:


26

the gradual and persistent disparity in the current account of its

member countries. Although the EMU and the EU are economies

which can be described as economies which contribute (and

demand) little net savings to (and from) foreign savings, their

aggregate results is the sum of extremely disparate realities. As

Lane (2010) points out, in 2010 European countries accounted for

approximately one third of all current account deficits and sur-

pluses worldwide. As can be seen in Graph 5, the current account

deficits and surpluses of the EMU have gradually polarised from

levels ranging between the [-3%-, +3%] interval, in proportion to

the GDP to position itself outside of this range and even persis-

tently above it by 5%. The underlying causes and macroeconomic

implications of this type of imbalance are extremely complex.


27

EA17 US UK

Budget balance ofpublic administrations 2011 -4.4 -9.6 -8.9

Debt of publicadministrations 2011 87.6 100.0 84.8

Household debt 2010 67.3 92.1 106.1

Corporate debt 2010 119.1 74.6 123.7

Current accountbalance 2011 0.1 -3.1 -2.7

Net internationalposition 2010 -7.2 -17.0 -13.9

Table 1Debts and deficits in the EMU, US and United Kingdom (% GDP)

Sources: AMECO, Haver, IMF, national sources and BBVA Research

It is true that this polarisation is not an exclusively European

phenomenon, as it happens in parallel with the so-called “global

imbalances” generated during the recent globalisation process.

However, in contrast to what is happening on a world scale and par-

ticularly in a series of developed countries (the Anglosphere) and

emerging countries (particularly China) in Europe there is a positi-

ve correlation between levels of income per capita and sales deficit,

so that the capital flows from the more advanced countries to the

less developed. This has rendered such imbalances less conspicuous,

as they have been associated with the real convergence process. The

traditional view considered foreign indebtedness as a natural con-

sequence of the catching up process during which the countries

undergoing rapid growth required foreign savings to fund strong

domestic investment in commercial goods. Thus, the availability of

savings and the Euro allowed for the funding of the productivity

convergence without financial and exchange rate strangulation.

The international allocation of savings was deemed to be optimal

(“consenting adults”, Obstfeld, 2012), and there was no reason for

public political intervention – what became known as “benign

neglect” by Blanchard and Giavazzi (2002) or Edwards (2002).

It is not easy to determine an optimal level, or even an adequate

one, for the current account deficit which already reflects the gap

between domestic savings and investment in a country which is

assumed to have been optimally determined by consumers and busi-

nesses, unless it is associated with high public deficit, in which case

we would be dealing with a fiscal problem. Moreover, a country may


28

have a deficit current account without having a serious foreign

financing problem, or may have it despite having a regularised

account, in this case because despite a reduced net capital flow, what

matters in the event of a financial crisis is the size of the gross flows,

as nothing guarantees that national savers are willing to fund

domestic liabilities should the international markets become una-

vailable. However, the evolution of the current account of EMU coun-

tries (EU) reflects more deep-rooted problems where the adjustment

role of the market mechanism has proven insufficient and in which

gross financial flows have grown in a fast and imbalanced way.


29

Chart 5Current account balance (% GDP)

Source: BBVA Research with data from national sources

The deficits have not been linked with productivity convergen-

ce, as is evident in the cases of Spain, Portugal and, to a certain

extent, Ireland, which accumulated growing deficits despite the

slow growth of total productivity of the factors. As can be seen in

Graph 6, productivity grew by 1% on average, whereas the current

account balance varied between surpluses over 5% (the

Netherlands and Germany) and deficits of 10% (as in Portugal and

Spain). In fact, it has not only been the lure of investment but

mainly the fall in savings in peripheral countries which has caused

the gap in commercial deficit which has exceeded both in volume

– percentage of GDP – and in persistence, that observed in many

emerging countries prior to the crisis of the eighties and nineties.

Moreover, much of the foreign financing to the receiving countries

has not been channelled through direct and portfolio investment,

but by way of bank bonds, which increases the risk of bank crises

and ‘sudden stops’ (Jaumotte and Sodsriwiboon, 2010; Land,

2010).

However, the most worrying characteristic of the unequal per-

formance of the current account in Europe is its persistence. Far

from being a transitory phenomenon, the divergence between

commercial balances has sharpened until 2007 (see Graph 5). The

design of the Euro took into account that the absence of own

currency would hinder the traditional adjustment to which most

countries resorted in times of crisis in the balance of payments.

The impossibility of this recourse to devaluation has not come

hand in hand with the strengthening of real devaluation mecha-


30

nisms, that is, with a more flexible response by prices and salaries.

Between 2000 and 2010, enough time has lapsed to have expected

that the countries with most foreign debt and strong real apprecia-

tions should have begun a process of correction towards a surplus

in the commercial balance. Nevertheless, this has not been the

case. The correlation between the commercial deficit and the net

foreign position was positive in 2011 and in 2010 (Graph 7) as it

had been in the last decade, indicating that the private

savings/investment balance does not seem to respond to the cumu-

lative net foreign position.


31

Chart 6Current Account Balance in 2007 (% of GDP) and average productivity growth bet-ween 2000 and 2009.

Source: BBVA Research based on AMECO

In 2010 only four EMU countries had a net positive foreign posi-

tion – Belgium, Germany, the Netherlands and Finland – and only

Finland had managed it after correcting a very negative position in

2001 (that is, after a decade of foreign rapid growth and surplus).

Practically all other EMU countries saw their net indebtedness

increase substantially or, at best, such as in France or Austria, they

managed a moderate reduction thereof within the first ten years of

the single currency.

Therefore, the performance of the current account is a very use-

ful indicator – although naturally not infallible – of the way in

which a country responds to the commercial and financial globa-

lisation process and to the existence of other types of imbalances

associated with private sector debt, both financial and non-finan-

cial. Before reviewing these indicators for the EMU (EU), it is worth

asking why the (market) adjustment mechanisms have failed in

this case and what the risk of this situation is happening again in

the future.

The conventional current account approach indicates that

financial flows are a mere counterpart of commercial flows, so that

sustainability of foreign debt must be guaranteed by the expecta-

tion of future current account surpluses or, what is the same, by a

significant proportion of the commercial goods production in the

economy. Foreign financing is no at risk while foreign investors

consider the economy to be competitive. The domestic economy

must maintain a high productivity growth rate and competitive


32

labour costs, as the opposite would render the foreign deficit

unsustainable, foreign investment would drop, reducing prices and

salaries and improving the foreign balance. In this way, given rea-

sonable elasticity in the demand of exports and imports, the

periods of real appreciation and foreign deficit can be reversed wit-

hout deep structural changes.

However, this market mechanism has not worked in peripheral

Europe. Foreign funding has been used to a large extent to fund


33

Chart 7Current account balance and net international position

Source: BBVA Research based on Eurostat

non-commercial goods, leading to strong expansion of demand, of

prices and of labour costs (see Graph 8). Despite the loss of com-

petitive capacity, the appeal for foreign lenders continues provided

the value of the asset with real guarantees – such as homes – con-

tinues, which is perceived as relatively safe. Thus, the worsening

competitiveness is the effect and not only the cause for the dete-

rioration of the current account. But the existence of high com-

mercial deficit is not corrected of its own accord nor is it done in a

smooth and orderly manner. When the bubble bursts and prices of

the assets used as guarantees plummet, foreign investors perceive

that the national economy is no longer able to guarantee their

debt, leading to the well-known processes of flight to quality,

increase in the cost of debt and, in extreme cases, to sudden stops.

This integration process has led to a number of other imbalan-

ces in the European economies. The objective of the EIP is to go

beyond the control of deficit and debt, and to follow a number of

economic indicators which enable the detection of inadequate

macroeconomic development in a country and can lead to locali-

sed financial crises and even contagion in the future. Such indi-

cators come hand in hand with a number of ‘limits’ that are con-

sidered to be security measures which, when exceeded by a

country, special tracking must be carried out by the Commission.

If an economy is showing imbalance in several of these indicators,

it must propose a plan of action for correction thereof which, if

not suitably applied, might result in some form of political or eco-

nomic penalty. The list of indicators is the following (the limits


34


35

above which a form of relevant imbalance is detected appear in

brackets): current account balance (% GDP, -4%, 6%); net inter-

national position (% GDP, -35%); real effective exchange rate

(variation rate, -5%, 5%); export market share (growth rate, -6%);

nominal unitary labour cost (growth rate, 9%); cost of housing

(growth rate, 6%); credit flow to private sector (% GDP, 15%); pri-

vate sector debt (% GDP, 1605); public debt (% GDP, 60%); and

unemployment rate (10%).

Chart 8Growth of nominal salaries and real productivity

Source: BBVA Research based on Eurostat

The first report issued on the monitoring of these indicators

shows that in the third year since the start of the crisis (2010), the

imbalances accumulated in recent years are far from being correc-

ted, some of them having worsened since 2007 (Table 2). Greece,

Portugal, Ireland and Spain are the countries with worse qualitati-

ve results. They belong to the Eurozone periphery, where they fail

in at least five of the ten criteria.3

It is within the framework of such imbalances that we must

interpret the fiscal crisis that has been reflected in the general

growth of risk premiums of sovereign debt in Europe, especially in

peripheral countries – although not exclusively. The levels of public

debt in the EMU are comparable to those in the rest of the develo-

ped world, both if we consider the region as a whole or the coun-

tries within it separately. As is shown in Graph 6, only in 2008

three EMU countries (Greece, Italy and Belgium) had a public debt

above that of the US and in any case much lower than that of

Japan. The growth in public debt during the crisis period places

EMU countries – with the exception of Greece and Ireland – in the

realm of 20%, similar to what had happened in most of the deve-

loped countries. Therefore, behind the sovereign debt crisis there

are issues related to the economic governance of the EU in general

and the Eurozone in particular. But also, deeper reasons which have


36

3 The situation is worse if we take into account that indicators such as the growth rate

of housing prices and credit for the private sector are nowadays within the limits accep-

ted by the MIP as a result of the extraordinary restriction on credit suffered by most EU

economies.


37

become evident following the segmentation of the financial mar-

kets due to the crisis. On the one hand, we have the demographic

and structural characteristics of most of the countries, which

herald for the future a scenario of lesser growth than that before

the crisis. Graph 9 shows the growth rates up to 2007 and the fore-

casts made by the IMF up to 2015 for EMU countries, the United

Kingdom, Japan, and the US.

The aging population and its effects on participation in the

labour market, the low savings rates – with the ensuing difficulties

in funding investments – and the slow rate of productivity growth

explain such expectations, which in turn severely affect the capa-

city to absorb the strong increase in public indebtedness.

In second place, the economic crisis itself has generated an

additional burden on public finances by way of contingent liabili-

ties, the realisation of which shall depend on the performance of

the private debt and the need to apply measures to assist in the

reconversion of the financial sector. As stated by Reinhart & Rogoff

(2008 and 2009), one of the main consequences of financial crises

is that a large part of the private sector debt becomes public. Table

3 (ECB, 2012) shows the impact on public finances of the two

main contingent-type averages within the EMU: provisions for the

European Financial Stability Facility (EFSF) and the guarantees for

the banking sector. The sum of both would mean an additional

impact on the public debt in the EMU of almost 13% of the GDP.

It is true that such contingencies do not necessarily have to mate-


38

Table2

Imbalances

attheEM

U

Source:EuropeanCommission

(2012):FirstA

lertMechanism

Report(movingaverages,3

or5years)

rialise, but it is also true that provisions have proven insufficient

and have had to be extended in successive programmes.

Lastly, the aging of the population gives way to the generation

of implicit liabilities which are not considered in public debt figu-

res but should be taken into consideration when evaluating the

sustainability of public finances (Cecchetti, Mohanty and

Zampolli, 2010). In 2009 the IMF (IMF, 2009) calculated the sum of

implicit and contingent liabilities in securities exceed – in present

value – 400% of the average GDP of the G20. Of these, those of a

contingent nature associated with the crisis account for approxi-


39

Chart 9GDP Growth in 2007 and 2015

Source: IMF (2012)

mately one tenth, whereas that associated with an aging popula-

tion – pensions and social security – account for much higher

implicit obligations. As a whole, this type of liability will demand

a remarkable effort from public finances in the future. Cecchetti,

Mohanty and Zampolli (2010) place the additional permanent

financing required to meet such obligations at between 5 and 10

GDP points assuming a public debt at levels similar to the current

ones in developed countries.

In summary, some European economies may have reached debt

levels which exceed or are dangerously close to their fiscal limits,

defined as the maximum level of debt which a country is able to

fund. The fiscal limit depends on the political will of its citizens

and the capacity to increase income by means of tax rate rises (Bi,

2012 and Leeper & Walker 2011) which makes it specific to each

country. This might explain, at least in part, the differences obser-

ved in risk premiums between countries with similar levels of debt

or even that some countries pay a higher cost of financing that

others with much higher levels of debt. Moreover, the relationship

between the risk premium and the fiscal limit is non-linear, incre-

asing rapidly when fiscal performance places debt at such levels

that the likelihood of reaching the limit is significant (Bi, 2012).

That is to say, in order to observe significant risk premiums, it is

enough for investors to understand that the fiscal strategy of a

country leads it to a fair likelihood of reaching the maximum level

of debt financed, even if the probability of this taking place in the

short term is very small. This probability in turn grows over the


40

economic cycle, which obliges countries with greater volatility in

economic activity and unemployment to opt for stricter fiscal

rules.4


41

4 When the economies reach this limit, the efficacy of the fiscal and monetary policy

is substantially reduced and both instruments no longer have the expected effects on

economic activity. The fiscal multipliers are reduced and the monetary authority loses

the capacity to control inflation, irrespective of the aggressiveness of its monetary

policy.

EFSF Banking sectorguarantees

Belgium 7,3 12,7Germany 8,22 3Estonia 12,46 0Ireland 42,8Greece 25,8Spain 8,61 6,2France 7,97 3,1Italy 8,78 2,7Cyprus 8,78 15,7Luxembourg 4,66 3,2Malta 10,91 0The Netherlands 7,32 6,1Austria 7,19 5,7Portugal 9Slovenia 10,23 4,4Slovakia 11,05 0Finland 7,34 0

EMU 7,71 5,2

Table 3Contingent Obligations of the governments 2008-2010

Source: BCE

4. The new European governance and the future of the Euro

The economic crisis has highlighted the need to carry out

important changes in European governance. It is obvious that

there have been failures in coordination in the economic policy

and mistakes in the policies adopted by national government,

which have generated a sovereign debt crisis and a financial crisis.

And it is also obvious that Europe was not first resorting to the

supranational institutions and bodies to prevent the crisis and to

provide a rapid and efficient response once it had begun. The EU,

and particularly the EMU, need to improve their economic gover-

nance in at least three areas: fiscal, financial and economic inte-

gration. Below we shall analyse each of these aspects and the cha-

llenges faced in each by the EMU.

4.1. Changes in fiscal governance

In regard to fiscal integration, over recent months important

inroads have been made, among which are the Stability,

Coordination and Governance Treaty and the creation of the

European Stability Mechanism (ESM). The new Treaty, which shall

come into force on 1 January 2013, has been signed by all EU coun-

tries except for the United Kingdom and the Czech Republic, and

aims to make public finances sustainable and prevent the onset of

excessive public deficits, in order to safeguard the stability of the

Eurozone as a whole. In fact, this Treaty can be interpreted as a

second version of the Maastricht Treaty of 1992, with the differen-


42

ce that whereas the former determined the conditions to enter the

EMU, the new treaty can be said to detail the conditions to be met

by the members of the EMU to continue to belong to the Eurozone.

To this end, the Treaty introduces specific rules (the structural defi-

cit may not exceed 0.5% of the GDP, as of a date to be determined

by the European Commission, and a public debt below 60% of

GDP) and automatic mechanisms which enable the adoption of

corrective actions in the event of deviation from targets.

The rules introduced by the Treaty are in general well designed.

When establishing an objective in terms of structural fiscal balance it

allows for the influence of automatic stabilisers, the minimum being

between 0.5% of structural deficit and the deficit limit of 3%.

However, a good design does not necessarily guarantee a good imple-

mentation, as was the case with the Stability and Growth Pact (SGP).

It is true that the new Treaty entails a criterion of “reverse majority”:

from now on the adoption of corrective or disciplinary mechanisms

proposed by the European Commission must be rejected by a majo-

rity, whereas in the SGP the majority needed to be reached in order

to approve such proposals. It is also the experience of the current debt

crisis has led to an accumulation of collective knowledge which shall

prove very useful when adopting the right decisions in the future to

prevent new crises of this kind. Just as eighty years later the Federal

Reserve is currently preventing some of the well-known mistakes

which were made during the Great Depression of the 1930s, the

European Commission and the European Council shall endeavour to

prevent imbalances similar to those we are currently undergoing.


43

Available empirical and theoretical literature (see, for instance,

Andrés & Doménech, 2006, and the references included in this

paper), indicates that use of fiscal rules has proven useful in the

containment of public debt and the deficit, without the effective-

ness of the automatic stabilisers adversely affecting the effective-

ness of the discretionary fiscal policies. Therefore, the fiscal rules

like those included in the Stability Treaty do not have to be an

impediment for the fiscal policy to carry out its duty of stabilisa-

tion of economic cycles. Quite the opposite: when the economic

agents know, that as a consequence of the existence of such rules,

expansive fiscal policies in the short term shall be offset in the

medium term by counter-adjustment measures in order to prevent

the accumulation of public debt, the effectiveness of these discre-

tionary stabilisation policies increases, as has been proven by

Corsetti, Meier and Müller (2011).

In any event, it shall be very difficult to achieve an optimal

implementation of the Treaty. In the first place, because all govern-

ments are often too complacent when allocating probabilities to

possible risk scenarios which may render public finances unsustai-

nable. Secondly, because it is difficult that sanctions may come

about from the European Union Court of Justice on the basis of fai-

lure to meet the structural deficit targets, which depend of estima-

tes of the cyclical position of the economies and the elasticity of

public income and expenses to this cyclical position. Nevertheless,

what the Stability Treaty does provide is that, prior to reaching

sanctions, the Commission may exert much greater pressure on


44

national governments and alert markets about excessive imbalan-

ces, so that it is the markets themselves that impose discipline via

higher interest rates.

As for the ESM, at the ECOFIN on 30 March the decision was

taken to extend it to 500 thousand million euros, which shall be

provided over two years, and beginning on 1 July 2012. The extent

to which this fund will be sufficient is still unknown, in that it

shall depend on how it is used and whether it allows for fund leve-

raging. Without leveraging, the fund shall only be enough to cover

the financing needs of small or medium sized economies in the

EMU, but not of the big four. However, it may prove effective for

specific, selective but highly intensive interventions designed to

reduce risk premiums, that is, to replace the ECB in its Securities

Market Programme (SMP). In addition, if the ESM should obtain

liquidity from the ECB itself, each of these entities might be able to

separately specialise in the management of a risk: the SMP would

manage the ‘solvency risk’ of sovereign debt and the ECB would

managed the ‘liquidity risk’, thus enabling the central bank to resu-

me the natural role for which it was created, as it would be creating

an EU fund, with a joint and several guarantee, instead of sove-

reign debt with a national guarantee.

It is very important that the intervention of the SMP is as effi-

cient as possible. To this end, the Commission must be clear about

which countries are solvent, with adoption of any necessary adjust-

ment measures and structural reforms, and which countries need


45

some kind of debt restructuring. In the first case, which is clearly

applicable to countries such as Spain and Italy, SMP intervention

on risk premiums should be as intense as necessary until market

doubt and uncertainty have been obliterated. It would otherwise

be very difficult to convince sovereign, pension or investment

funds to purchase the public debt of such countries if Europe is not

the first to refrain from doing so.

Obviously, a more decisive intervention by the SMP, which

would lead to a rapid relaxation of the European sovereign debt

markets, requires the adoption and follow-up of the necessary

adjustments and reforms, but with sufficient time frame so as not

to asphyxiate the economic growth of the countries adopting such

policies. Specifically, the EU could change the fiscal consolidation

strategy which is currently being demanded from member states.

The obsession for nominal deficit targets should be replaced by a

more plausible, rigorous multi-annual fiscal policy strategy which,

in seeking to prevent a spiralling negative growth, truly contribu-

tes towards supporting sustainability in the long term of the public

finances of all countries. Specifically, the European consolidation

strategy should be based on the following principles:

1. Deficit reduction targets should refer to structural deficit inste-

ad of nominal deficit, as proposed by the new Stability Treaty.

This implies that countries should be asked to take specific and

detailed measures to ensure a certain amount ex ante in terms

of reduction in expenditure or increase in income in the


46

coming years. If, as a result of such measures, the economic

activity should be adversely affect with an impact on nominal

deficit (by the mere intervention of the automatic stabilisers),

the member states should not be obliged to take new savings

measures in that same financial year.

2. The pace of structural consolidation should be ambitious

enough to ensure sustainability in the medium to long term of

public finances, and gradual enough to prevent excessively

adverse effects on activity and employment in the short term.

3. The long term balance of public finances requires reforms

which guarantee the sustainability of public systems of pen-

sions and social protection.

Blanchard (2011) recently recommended that, in order to return to

prudent levels of public debt, it would be advisable to apply the pro-

verb of “slow and steady wins the race”. A similar recommendation to

that of De Long and Summers (2012), for whom a fiscal consolidation

which is too intense and too fast might endanger the very sustainabi-

lity of public finances instead of guaranteeing it.

In regard to the debate on Eurobonds, although not necessary

or sufficient, these can indeed become a useful tool in the con-

text of streamlined national finances. They are not necessary, as

the Eurozone can operate without them, if the Stability Treaty

and the mechanism for the prevention and correction of excessi-


47

ve imbalances work properly. And they are not sufficient to pre-

vent debt crises if the fiscal or current account imbalances are not

corrected. If growth is imbalanced (private indebtedness, current

account balance deficit), they imply a permanent transfer of

income from one country to another, which is unsustainable in

the long term. But they are convenient as an efficient mechanism

to ensure and pool risks in the face of asymmetric shocks and,

above all, as an element of political legitimacy of the European

project: European citizens must see that there are specific bene-

fits to belonging to the EMU. And Eurobonds are one of these

benefits, particularly now when many countries need to make

considerable sacrifices and carry out adjustments and reforms.

In this regard, the Eurobond proposal (blue and red) of Delpla

and von Weizsäcker (2010), has the advantage that it would allow

countries to benefit from risk pooling and the creation of a more

liquid asset (the blue bond) than that of the debt of each of the

EMU members, which would strengthen the euro as an internatio-

nal reserve currency, but with the benefit of preserving market dis-

cipline for national debt issued over and above 60% of GDP (red

bonds).5 This proposal consists of the EMU countries pooling their


48

5 Attinasi, Checherita and Nickel (2009) believe that this market discipline is behind

the increase in sovereign spreads between 2007 and 2009, as a result of the increase in

risk aversion and the concern for the sustainability of public finances. However, Favero

and Misale (2012) believe that this market discipline acts in an interrupted fashion over

time and, occasionally, in an exaggerated way, which in fact justifies the issue of euro-

bonds.

public debt up to 60% of their GDP as senior debt under the joint

and several responsibility of all members, whereas the issue of

national debt beyond such a limit would be junior debt under indi-

vidual responsibility. From this perspective, it is easy to conclude

that the decision of the European Council reached in December

2010 to ensure the solvency of the debt issued until June 2013, but

not that issued as of that date was a mistake, as the decision should

have been the opposite: ensure as of a given date all debt issued

under 60%, which would in effective terms be equal to the creation

of the Eurobonds proposed by Delpla and von Weizsäcker (2010).

4.2. Financial integration

As Pisany-Ferri and Sapir (2010) have pointed out, to date the

EMU has worked without a European institution able to rescue

transnational financial entities and without authentic European

stress tests for its banking institutions. Oversight duties have

remained with national authorities and coordination problems

have been managed by means of a combination of discretionary

cooperation and dependence on rules approved by the EU.

One of the lessons to be learned from the current crisis is that

it is difficult to manage a financial crisis on a European scale wit-

hout supranational regulators, supervisors and insurance mecha-

nisms. A large part of the head start that the US has over Europe

in terms of crisis management and resolution is precisely due to

the non-existence or the delay in creating such bodies. The US has


49

federal institutions to manage banking crises, whereas Europe

does not, which renders true the saying that banks are internatio-

nal when expanding and national upon demise. The problem is

that, for some governments (Ireland is a perfect example of this),

banks are too large in relation to their public budgets.

Likewise, the US has a federal regulation, whereas Europe has

enormous national dispersion of its regulations, despite the

efforts of the European Commission and regulators to homoge-

nise and converge towards a common financial regulation.

Occasionally, headways made in certain rules give rise to inequa-

lities among the agents who intervene in the markets, due to

other rules continuing to be different. This was the case, for ins-

tance, of the requirement of the European Banking Authority

that potentially systemic banks must exceed a capital ratio of 9%

before 30 June 2012, when the measurement of risk weighted

assets is regulated by different rules.

Banking oversight in Europe is furthermore carried out via

national supervisors instead of via a single European institution,

which introduces heterogeneity in oversight levels of the financial

system. The result of this financial fragmentation is that one can-

not speak of a single market, which generates the possibility of

regulatory arbitrage, different conditions of competency, ineffi-

ciencies and, in general, a disadvantage in regard to other world

financial areas.


50

In summary, financial integration requires an improvement to be

made in the mechanisms through which information is shared on

the financial systems of each country and the way in which their

activities are supervised, the harmonisation of the guarantees on

bank deposits and of consumer protection regulations, the creation

of European bank restructuring and rescue mechanisms, and the

advancement towards a Single Market not with more, but with a bet-

ter, European regulation which, instead of adding to and prevailing

over national legislation, should simplify and replace it.

4.3. Economic integration

With greater fiscal and financial integration the Eurozone could

operate with less tension in the future, without ensuring the economic

convergence among countries. Is convergence of income or welfare

levels in European countries necessary? Probably not, but it is still con-

venient, as has been stated earlier, to enable societies to believe that

being within an economic and monetary union has advantages well

beyond those which are provided by monetary stability. One of les-

sons to be learned from the Eurozone crisis is precisely that monetary

integration does not ensure economic convergence, as this requires an

advancement in convergence of the determining factors (economic,

social and institutional) of economic growth.

Table 4 shows that the differences in medium and long term

determinants of per capita income are very significant. The relati-

ve position of each country has been obtained on the basis of the


51

IMF analysis (2010), whereas the allocation of each country to one

of three groups under consideration has been carried out on the

basis of the criteria put forward by Hall and Soskice (2001). On the

basis of a number of criteria, both institutional and based on the

workings of economic relations, Hall and Soskice classify the varie-

ties of capitalism into liberal economies (the US being the pro-

totype) and coordinated economics (Scandinavian countries are

the paradigm). In both models (either with high or minimum

coordination), the economies can function efficiently. Market eco-

nomies which cannot be classified into either group are classified

as mixed economies.

In order to transform the qualitative IMF indicator into a quan-

titative one, such as analysing its correlation with per capita inco-

me, values of 1 to 3 have been allocated for each of the three levels

considered by the IMF, where a higher score suggests a greater need

for implementing structural reforms. This enables the obtention of

an average for each country and for each of the nine indicators

which are shown in Table 4. The differences shown in this table are

very marked, not only between developed economies, but also bet-

ween European ones. In light of this evidence it is not surprising

that, except in the case of Ireland, the countries which have accu-

mulated the most imbalances and which are suffering more form

the tensions in the debt market are precisely those which shown

greater structural weaknesses and the ones which must implement

the most reforms. Countries which in turn have been classified as

mixed market economies, presenting more inefficient institutions.


52


53

Table4

Structuralcapacityofthedevelopedeconom

ies

Source:BBV

AResearch

(2010)basedon

IMF(2010)andHall&Soskice(2010)

The changes in the regulations which affect the operation of the

labour, goods and services markets, trade, telecommunications

markets, are easier to implement in the short term, although the

changes thereof are felt in the medium term. An example of this

can be found in the recent reform of the labour market in Spain,

which is bringing its operation in line with that of countries like

Germany (in terms of internal flexibility mechanisms) or to that of

free market economies (by prioritising company agreements and

opt out clauses for collective bargaining agreements). Making

headway in these types of reforms (for example, linking salaries to

productivity) is crucial to remove the differences in competitive-

ness which exist between EMU countries, particularly bearing in

mind that the crisis may have had an effect on the potential

growth of these economies (see, for example, the European

Commission analysis, 2009).

However, in long term indicators such changes can take a lot

longer and, in some cases, even decades. This is the case with

human capital. Even in the event that the many younger workers

of countries such as Spain, Italy, Greece or Portugal should enter

into the labour market with the same human capital as in better

placed countries, 25 years would be needed to half the distance for

the whole of the population of employable age.


54

5.Conclusions

The economic crisis has highlighted the excessive complacency

of the markets, agents, supranational institutions and governments

when interpreting the imbalances which were being generated in

the previous expansion period and the absence of supranational

institutions and mechanisms, firstly to prevent the imbalances

which led to the crisis and secondly, to provide a fast and efficient

response once they had happened. Such institutions and mecha-

nisms are necessary because the evidence shows that the markets

react in a discontinuous way, and occasionally in an exaggerated

way, are pro-cyclical and do not generate of their own accord suf-

ficient disciplinary mechanisms in the short and medium term

whenever these are needed. Insofar as the current Eurozone crisis

has taken place mainly in three areas (debt crisis, banking crisis

and crisis in growth and competitiveness, with huge heterogeneity

between countries), the EU and, particularly the EMU, need to

improve their economic governance in at least three areas: the fis-

cal, the financial and that of economic integration.

As for the improvement in fiscal governance, the Treaty of

Stability, Coordination and Governance needs to be effectively

applies in a preventive way and that, during its transition towards

medium and long term structural deficit targets, this is done with

sufficient rigor and the right flexibility to prevent that countries

required to make the most efforts in the short term should enter

into a negative growth spiral. In this regard, intervention by the


55

ESM on risk premiums should be as intense as necessary until

market doubts and uncertainty have been removed, so that the

countries which are implementing fiscal adjustments and structu-

ral reforms have a sufficiently broad time period to enable such

measures to have positive effects on economic growth. As for the

Eurobonds, although they are not necessary or sufficient to ensu-

re the operation of the EMU, they are indeed convenient as an

efficient mechanism providing assurance and pooling risk in the

face of asymmetrical shocks and, above all, as a political legiti-

macy item in the European project: European citizens must disco-

ver that there are specific benefits to being part of the EMU.

Although it is difficult for such Eurobonds to become a viable ins-

trument in the current situation of divergence, they must become

an essential part of the future European Treasury when the main

imbalances are well under way to being corrected through the

decisive application of the reforms in the various countries in the

EU.

The second area where headway must be made is that of finan-

cial integration, in order to prevent future banking crises and to

manage them in a more efficient and rapid way. Europe must have

supranational financial institutions, regulators and supervisors, as

the current financial fragmentation prevents us from speaking of a

single market. An important limitation which gives rise the regu-

latory arbitrage, different competency conditions, inefficiencies

and, in general, a disadvantage in regard to other world financial

areas competing against the European entities.


56

Lastly, although greater fiscal and financial integration may suf-

fice to enable the Eurozone to operate with less tension in the futu-

re, it is worth establishing the bases for greater economic conver-

gence among its members, in order to increase the political legiti-

macy of the economic and monetary union project, with benefits

which go beyond those provided by economic stability. The diffe-

rences between the EMU countries in the workings of factor, goods

and services markets are very significant, as well as in long term

growth determinants. The structural reforms undertaken to enable

the markets to work more efficiently can bring positive effects in a

relatively reasonable period of time, enabling competitiveness to

improve and the imbalances accumulated during the expansion

and the crisis to disappear more rapidly. In this regard, it is essen-

tial to ensure the success of the Excessive Imbalances Procedure

and other imbalance monitoring mechanisms, ensuring a more

efficient preventive and corrective action than that provided by

the Stability and Growth Pact. However, in terms of long term

growth determinants, such changes can take longer and, in some

cases, even decades; it shall therefore be necessary for Europe to

boost the solidarity mechanisms required to accelerate this conver-

gence process in a more effective and efficient way than that done

in the past.

To simultaneous progress on all these fronts, both at suprana-

tional and national levels, is a necessary condition for the Euro to

overcome this crisis and for its members to continue to form part

of this project in the future. Insofar as the starting point is very


57

different in each country, the main challenge now facing the

EMU is to combine in a fair way the rigor and the ambition of the

adjustments and structural reforms, on the one hand, with an

appropriate time frame and solidarity with all other members of

the Eurozone, on the other.

If, on the contrary, the member states should fail to show such

determination, any attempt towards European economic gover-

nance will be due more an intention than a hard reality. The

Eurozone would have an uncertain future. The alternative of a

Political European Union, in which all necessary economic policies

could be implemented from a community Executive under the

control of a European Parliament and with all democratic rights, is

currently not expected for the time being.

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Education

The future of the Euro after the Great Recession by Javier Andrés and Rafel Domenech