How succesful has ECB been?

1. How succesful has ECB been?

2. Market InterestRates Euribor= Euro Interbank OfferedRate

3. ECB interestrate vs. 12-month Euribor

4. Other Central Banks

5. Inflation

6. HICP (Inflation) Source:Eurostat

7. GDP growth in the euro area Source: Eurostat

8. Financial Crisis 2008 • Startedfrom the U.S. • Housingmarket and subprimeloansturned into investmentinstruments • Defaults and decliningpricescausedhugelosses for banks and investors • Problem: trustbetweenbanksdisappeared • Interbank money marketfroze • Banks couldn’tget money sotheycouldnotlendit to firmsorconsumers • No invesments, lowconfidence => recession

9. ECB in the Financial Crisis • ECB tookemergencymeasures • Acting as an intermediary in the interbank money market • Longertermfinancingguaranteed for banks • Decrease in the interestrate • New duties for the ECB: regulation of financialinstitutions, e.g. ”stresstests” for banks • Discussion on moreregulation of the financialmarkets

10. Debt Crisis of 2011: Implications for ECB • Although a problem of national governments, the debtcrisisaffects ECB • Insolvency of onemembercanaffect the credibility of othermembers • Also the credibility of the ECB is at risk: canitmaintainpricestability? • Problems for commercialbanks • Banks usetheir ”lowrisk” investments as collateralwhenborrowingfrom ECB • Whenbanksincurlosses, theirability to gainfinanancing is compromised • Potentialliquidityproblemsimilar to the financialcrisis • ECB hashad to purchasegovernmentbonds to calm the markets • The ECB is notsupposed to purchasegovernmentbonds to maintainitsindependencefrom national governments

11. Today’s Agenda • FiscalPolicy • Goals and tools • National fiscalpolicies in a monetary (currency) union • The Stability and GrowthPact • Content and reasons for the pact • Problemswith the pact • Public debtlevels and annualbudgetdeficits

12. Fiscal Policy = activities controlling the government budget • Government spending • Provision of public goods and services • Investments • Subsidies and income transfers • Government income • Taxes • Returns on investment

13. Goals of fiscal policy • Income redistribution • Provision of public goods • Dealing with externalities • Investments to enable long term economic growth • Dampen business cycle fluctuations

14. National fiscal policies in a monetary union • Good to have flexible national fiscal policies in case of asymmetric shocks… BUT • Large debt = large interest payments • Pressures on central bank to inflate • Lower credit rating  higher interest rate • Crowding out effect of fiscal policy of a small country is diminished in a large union • Incentive to increase budget deficit

15. Crowding out of fiscal policy • Increased government spending to stimulate demand increases money demand (government a major player in the domestic money market) => Md => i  => (C+I) => AD  (!) • When a country enters a monetary union, it becomes a small player => Md increases only little • Less crowding out for one country => incentive to spend more • When all countries do the same thing, interest rates increase a lot • When one country in a union spends more, interest rates increase for everybody!

16. Solution: restrict fiscal policy • Countries should not have public debt over 60% of GDP when entering EMU • Stability and Growth Pact in the EMU • Annual deficit limited to 3% • Council can impose a sanction on a country unless mitigating circumstances (e.g. natural disaster or GDP decreases) • A deposit of max 0.5% of GDP, which turns into a fine if deficit not corrected in two years • Balanced budgets in the medium term (= over the business cycle) • I.e. in the long run no new debt!

17. ”Stupidity Pact”? • The Stability and GrowthPacthasreceivedarguments for and against • Romano Prodi calledit the ”StupidityPact” in 2002 • In groups, try to comeupwitharguments for and against the pact!

18. Arguments for

19. Arguments against

20. Public debt (% of GDP) Source: Eurostat

21. Budgetsurplus (deficit) % of GDP Source: Eurostat

22. Currentdebtcrisis • Slowgrowth and negativegrowth (partlydue to financialcrisis) hasworsened the situation in countireswithlargedebt to beginwith • Financial crisisaffectedbanks and govenrmentsneeded to supportthem • Largerinflation in somecountries (likeGreece) without the possibility of devaluation of currencyhas led to poorcompetitiveness • Also, as capital leaves the country, itdoesnotaffect the exchangerate (as itwouldif the country haditsowncurrency), sothere is no boost for the exportindustry • Ifinvestorsstartquestioning a country’sability to paybackitsdebt, the interestratewillrise (riskpremium), whichincreases the governmentexpenditures and makesitmoredifficult to payback the loans

23. Laborcosts in crisiscountriesincreased

24. Governmentbondrates

25. How to reducedeficit and debt? • When GDP decreasesorincreasesslowly, governmentincomedecreasesorincreasesveryslowly (unlesstaxesareincreased, which in turnreduces GDP growth) • At the sametimegovernmentexpendituresincrease • For example, moreunemployedpeople to support • Manyexpendituresare ”structural” and needshanges in legislation and thereforearedifficult to cut • Governmentcost (salaries, ongoinginvestments, publicserviceslikehealthcare and education) • Benefits and incometransfers (unemploymentbenefits, incomesupport, childbenefits etc.) • Also, when GDP decreases, evenwith no extradebt, ratio of debt to GDP increases

26. Pre-Lecture Assignment 1. Howcan a country join the EU? 2. Howcan a country join the EMU? (Whatare the criteria and procedures of entry into EU or EMU)? 3. Doyouthinkit is difficult to become a member of the EU or EMU? 4. Whenthinkingabout the theoryrelated to tradeareas and the theory of OCA’spresentedduringthiscourse, doyouthinkthat the criteria for enlargementwerechosenwell?