Euro area governance and the sovereign debt crisis Zsolt Darvas Bruegel

1. Euro area governance and the sovereign debt crisis Zsolt Darvas Bruegel Conference on "Economic Crisis and Governance” IOBE - The Foundation for Economic & Industrial Research, Athens, 16 May 2011

2. Euro area 12 (excl. Greece up to 2000): number of countries missing the Maastricht convergence criteria Source: Author’s calculations using data from Eurostat, ECB and May 2011 forecast of the EC Note: The 2011 data for the interest rate is based only on values up to April.

3. Causes of the sovereign debt crisis Greece: fiscal misbehaviour + structural weaknesses Ireland: unsustainable housing booms and banking sector fragility Portugal: weak economic growth before the crisis, reflecting structural weaknesses Yet it is not impossible to have fast and balanced growth inside the euro area: Finland & Slovakia Question 1: Was the pre-crisis euro-area governance framework (also) responsible? Question 2: Will the new euro-area governance framework resolve the current crisis and avert similar crises in the future? 3

4. Outline Pre-crisis governance framework The new governance framework and its assessment Transition to the new governance system Fiscal and structural adjustments: examples of Greece, Hungary, Iceland, Ireland and Latvia Euro crisis? Summary 4

5. 1. Pre-crisis governance framework Price stability: independent central bank Prevention/correction: Stability and Growth Pact (SGP): Stability and Convergence Programmes (SCPs), Early warning mechanism, Excessive Deficit Procedure (EDP) Macro imbalances: no formal mechanism; only Commission warnings Macro-financial stability: no mechanism Crisis management and resolution: no mechanism (neither for sovereigns, nor for banks;only facility for sovereigns outside the euro area) Structural: Lisbon strategy, National Action Plans (NAPs)/National Reform Programmes (NRPs) Largely failed even before 2008 (apart from overall price stability) 5

6. 2. Sketch of the new governance framework Price stability (no change): independent central bank Prevention/correction: Budgets (more teeth to SGP; national fiscal frameworks) Macro imbalances: EIP – Excessive Imbalance Procedure Macro-financial stability: ESRB – European Systemic Risk Board Crisis management and resolution: Sovereign liquidity assistance (temporary: EU govts, EFSF, EFSM, permanent: ESM) + IMF Sovereign crisis resolution regime: from mid-2013 for newly issued bonds Bank resolution: national frameworks (Euro Pact) ECB: targeted bond purchases, collateral policy, lifeline for banks Structural: EU2020, NRPs, European Semester Unprecedented number of reforms, couple of good initiatives Ability to learn lessons and to reform 6

7. 2. Issues 1. – A general observation Scope of reforms: While ambitious in certain respects, largely fixes current bugs and maintains the decisive role of intergovernmental processes and national frameworks Not a problem for big countries with history of strong national frameworks (eg Germany) and for small countries with good starting positions (eg Finland, Slovakia) But will be difficult to achieve a sustainable status (in terms of fiscal and competitiveness) for countries with bad starting positions (ie corrective arms request fiscal austerity and wage moderation in a falling economy) 7

8. 2. Issues 2. – Some specific observations SGP & EIP: Commission proposes, but largely inter-governmental (even if reverse majority voting rule) Strong emphasis on sanctions Sovereign liquidity provision: Last resort and only if risking ‘euro area financial stability’ Strong conditionality Punitive interest rate (in contrast to non-euro area facility) Do these three features adequately address moral hazard? Inter-governmental (unanimity) Financed/guaranteed by national resources  subject to national interest 8

9. 2. Issues 3. – Some specific observations Sovereign insolvency procedure: ‘contractual approach’ (collective action clauses to all bond issuances from 2013), as opposed to ‘statutory approach’ (international bankruptcy mechanism) Bank resolution: National frameworks, but no EU-wide mechanism Eurobonds (up to a certain % of GDP): Rejected by core countries fearing enforcement in the absence of fiscal integration (a real issue) and interest rate rise (an unlikely issue) Would be better for fiscal discipline, thereby making the euro area more crisis-proof 9

10. 2. Sanctions Is the reliance on sanctions the right solution to compensate for the lack of fiscal/political union? If applied before the crisis: Greece: perhaps Ireland for 25% and Spain 40% pre-crisis debt??? Italy: high debt and slow reduction??? During a crisis: makes no sense For prevention: Even if Commission proposes and reverse majority voting, active politicians decide  fruitless debates and unsettling disputes Unwarranted political message: ‘Brussels fines us and does not understand our situation and social problems’ Amount of EU fine is dwarfed by interest rate premium imposed by markets post-crisis  Name and shame, but let markets do the dirty job 10

11. 3. Transition to the new governance system Resolution of banking crisis, including real stress tests (with stressing the single most important source of stress) Sorting our sovereign insolvency from liquidity Markets will not lend to current programme countries: Will euro area partners ready to finance all debt? Would that be desirable? What if sovereign debt restructuring before 2013? Continuous denial is not a good option. Financial stability risks should be addressed ECB: How to get rid of sovereign bond holdings and bank lifeline, how to normalise collateral policy? Revive growth in Southern Europe (structural reform, single market, EU funds) 11

12. 4. Fiscal and structural adjustments: 5 examples HIIL = Hungary, Iceland, Ireland, Latvia 12

13. 4. Debt and deficit(% GDP), 1990-2012 General government gross debt General government balance 13 Source: May 2011 forecast of the European Commission and EBRD Note: the Irish deficit was 32% in 2010, but for better readability of the right-hand side figure, it has a cut-off at -20%

14. 4. GDP and investment, 1995Q1-2011Q1 GDP (volume, 2007Q4=100) Investment(volume, 2007Q4=100) 14 Source: Eurostat website

15. 4. Consumption, 1995Q1-2010Q4 Private consumption(volume, 2007Q4=100) Public consumption(volume, 2007Q4=100) 15 Source: Eurostat website

16. 4. Trade, 1995Q1-2010Q4 Export (volume, 2007Q4=100) Import (volume, 2007Q4=100) 16 Source: Eurostat website

17. 4. Current account and employment, 1990-2012 Current account (% GDP) Employment (2007=100) 17 Source: May 2011 forecast of the European Commission

18. 4. Some structural indicators The higher the better for all indicators except the ease of doing business rank Sources: Word Economic Forum, Transparency International, World Bank Note: The index of Quality of institutions is composed of public institutions (75%) (property rights, ethics, undue influence, government inefficiency, security) and private institutes (25%) (corporate ethics, accountability) 18

19. 5. Euro crisis? • May 2011: • Greek 5-year CDS have risen to a record of about 1500 basis points, implying a 80% probability of a default (with 50% haircut) • But the euro continues to be very strong

20. 6. Summary • New governance framework: significant steps, but largely fixes current bugs and unlikely the ultimate solution • Sanctions and too much inter-governmentalism carry risks • Lack of Eurobonds: would be a better tool to enforce discipline and make euro area crisis-proof • Transition is very unclear; time and growth (in core euro area) will not solve all issues: banks, solvency, growth, ECB • Greek adjustment: the country has not suffered as much in terms of output, consumption and employment as HIIL, yet export is very weak. Structural indicators are also very weak • Despite sovereign panic: markets do not expect euro area break-up, even in the likely event of a sovereign default • But the currently small political risk to the euro can rise 20