Theorie und Politik der Europäischen Integration

1. Theorie und Politik der Europäischen Integration • Theory and Politics of European Integration Lecture 8 Fiscal Policy and the Stability Pact The EURO Crisis • Prof. Dr. Herbert Brücker

2. The Last Lecture I Theory and Politics of European Integration Fiscal Policy and Stability Pact Optimum Currency Area (OCA) Theory • What are the trade-offs? • Asymmetric shocks and currency areas • Criteria for an optimal currency area • Labour Mobility • Trade Openness • Diversity of Production • Transfers • Common Values • Common Destiny • Is the EMU an optimal Currency Area?

3. The last lecture II Theory and Politics of European Integration Fiscal Policy and Stability Pact • Fiscal Policy and the Stability Pact • Relevance of fiscal policies in a monetary union • Limitations of fiscal policies • Automatic stabilizers vs. discretionary policy actions • Negative and positive spill-overs: the case for policy coordination • Deficit bias in the EMU • The No-Bailout Clause in the Mastricht Treaty • The Stability and Growth Pact • The 3% and the 60% ceiling and implementation via the Excessive Deficit Procedure • Controversial issues

4. The EURO Crisis Theory and Politics of European Integration Fiscal Policy and Stability Pact

5. The EURO crisis: outline Theory and Politics of European Integration Fiscal Policy and Stability Pact Diagnosis • What is the EURO crisis? What are the questions? • Monetary policies, assymmetric shocks and internal imbalances • Public vs. private debts • Has the ECB monetary policy triggered the real estate bubble? • Why are public debts in a currency union more serious than with national currencies? • Debt financing via the TARGET2 facility of the EURO System Therapy • Banking regulation • ECB: Buying governmental bonds • Creating a Transfer Union • State Bankruptcy within Eurozone • Leaving the Eurozone (“Grexit”)

6. The EURO crisis: what are we talking about? (I/II) Theory and Politics of European Integration Fiscal Policy and Stability Pact • The EURO crisis is nocurrency crisis in traditional sense • No (dramatic) depreciation of EURO • No capital flight out of EURO zone • No balance of payments crisis of EURO zone • No inflation

7. Exchange rate USD/EURO Theory and Politics of European Integration Fiscal Policy and Stability Pact • Source: OECD STAT database, own calculations.

8. Inflation (Consumer price index, change p.a. in %) Theory and Politics of European Integration Fiscal Policy and Stability Pact

9. The EURO crisis: what are we talking about? (II/II) Theory and Politics of European Integration Fiscal Policy and Stability Pact • But: • Burst of real estate bubbles in many Member States • High risks of bank failures in private sector • Sovereign debt crisis of some members of EURO zone (Greece, Ireland, Portugal, Spain, Italy, others?) • High spread of interest rates within EURO zone • Zero growth in the Eurozone and serious recessions in some Member States with high unemployment

10. Real GDP growth rate in %, 2001-2014 Theory and Politics of European Integration Fiscal Policy and Stability Pact

11. Harmonized unemployment rates (ILO norm) in %, 2001-2014 Theory and Politics of European Integration Fiscal Policy and Stability Pact

12. What are the questions? (I/II) Theory and Politics of European Integration Fiscal Policy and Stability Pact • Is the ‘one-fits-all’ monetary policy in the Eurozone the cause of the crisis? What about asymmetric shocks? • Have soft monetary policies of the ECB triggered the financial crisis, e.g. the real estate bubble? • Or is banking regulation the problem, i.e. the Eurozone in the same way affectd as, e.g., the US? • Has the Eurozone created incentives for moral hazard in fiscal policies? Has the Stability and Growth Pact failed?

13. What are the questions? (II/II) Theory and Politics of European Integration Fiscal Policy and Stability Pact • Is the risk of a sovereign debt crisis and capital flight higher in a Currency Union rather than in the case of national currencies? • Creates the EURO System additional opportunities to raise unsustainable debts? TARGET2 debt stocks? • Is state bankruptcy possible in the Eurozone? • Is it better to move to a transfer union? How? • Would it help countries to leave the Eurozone?

14. Monetary policies and asymmetric shocks Theory and Politics of European Integration Fiscal Policy and Stability Pact • Recall: Optimal currency area theory focuses on asymmetric shocks • Economic structures between the North and the South might be diverse (manufacturing vs. tourism), but are affected by business cycle shocks in similar way • The ‘Great Recession’ 2008-09 affected therefore countries with strong manufacturing sectors (export demand shock) as least as much as countries with strong tourism

15. Wages and current account imbalances in the Eurozone Theory and Politics of European Integration Fiscal Policy and Stability Pact • If prices and wages are not flexible, different (productivity adjusted) wage developments can create imbalances in current account, which have to be matched by capital inflows • In theory, a single currency would guarantee a balance of payments equilibrium and in long-term also equilibrium in current account • In practice, this need not necessarily be the case, since current account imbalances are financed by public transfers in one way or another (see below)

16. The bottomline Theory and Politics of European Integration Fiscal Policy and Stability Pact • Wage growth has been unbalanced in Eurozone, but (productivity adjusted) real unit labour costs have been much less unbalanced. This suggests that different rates of wage growth reflect different productivity growth patterns • But: current account surplus of Germany tended to increase persistantly and substantially, while current account of Greece, Portugal and Spain deteriorated substantially in the first place. Meanwhile, under the pressure of structural adjustment, the current account improves there. Still, the development of the current account is a first hint for imbalances within the Eurozone.

17. Real Earnings (change in %: 2008 vs. 2000) Theory and Politics of European Integration Fiscal Policy and Stability Pact

18. Real wage index (2007 = 100), 2001-2013 Theory and Politics of European Integration Fiscal Policy and Stability Pact

19. Current account balance in % of GDP, 2001-2013 Theory and Politics of European Integration Fiscal Policy and Stability Pact

20. Current account balance in % of GDP, 2001-2013 Theory and Politics of European Integration Fiscal Policy and Stability Pact

21. Public vs. private debt Theory and Politics of European Integration Fiscal Policy and Stability Pact • Conventional wisdom explains EURO crisis by moral hazard of governments in Eurozone • But: With the notable exception of Greece, (i) public debt has fallen and not increased in Eurozone before the crisis, and (ii) private debt has increased dramatically before the crisis • Bank debt has increased more than corporate debt • Thus, banking regulation and moral hazard in private sector might be more underrated in the debate (DeGrauwe 2010)

22. Government and private debt in the Eurozone before the crisis, 1999-2008 Theory and Politics of European Integration Fiscal Policy and Stability Pact

23. Government debt in % of GDP, 2001-2013 Theory and Politics of European Integration Fiscal Policy and Stability Pact pre –crisisdevelopment post –crisisdevelopment

24. Bank liabilities and corporate debt, 1999-2008 Theory and Politics of European Integration Fiscal Policy and Stability Pact

25. Growth of bank loans in the Eurozone, 2003-2009 Theory and Politics of European Integration Fiscal Policy and Stability Pact

26. The bottomline II Theory and Politics of European Integration Fiscal Policy and Stability Pact • With exception of Greece, the dramatic increase of private debts (real estate loans) are the first cause of financial crisis • The crisis of the banking sector forced govern-ments to take-over private debts to avoid systemic failure of financial sector • This increased dramatically public debts in some countries which had low public debts before • ‘Great Recession’ increased public debt further through automatic stabilizers and fiscal packages

27. Has ECB monetary policies triggered the financial crisis? Theory and Politics of European Integration Fiscal Policy and Stability Pact • Hypothesis: low and ‘one-fits-all’ interest rate policies have triggered financial crisis, i.e. real estate bubble • Interest rates indeed substantially declined in some countries (e.g. Greece, Italy) • But: A deeper analysis suggests that the ECB interest rate policies followed closely what we expect in case of a strict application of ‘Taylor’s rule’

28. Did the ECB violate Taylor‘s rule? (I/III) Theory and Politics of European Integration Fiscal Policy and Stability Pact • Taylor’s Rule: Central Banks policies can be explained by the following simple formula: it = 2 + pt + a(pt – p*) + b(yt –yt*) (1) • where i is the interest rate, pt the current inflation, p* the inflation target (2%), and yt the output gap as a percentage of potential output yt*. • a is the weight assigned by Central bank to price stability, b the weight assigned to economic stability and growth.

29. Did the ECB violate Taylor‘s rule? (II/III) Theory and Politics of European Integration Fiscal Policy and Stability Pact • Taylor’s rule helps to stabilize expectations of market participants. • It explains usually Central Banks monetary policies pretty well.

30. Did the ECB violate Taylor‘s rule? (III/III) Theory and Politics of European Integration Fiscal Policy and Stability Pact • To check whether a Central Bank follows Taylor’s rule is therefore a good indicator whether monetary policies has deviated from standard path under given economic conditions • The answer is, the ECB has not. The interest rate was only slightly below the rate predicted by Taylor’s rule. And less below than the US rate (Dokko et al., 2011)

31. Long-term interest rates (10 year government bonds) before the crisis … Theory and Politics of European Integration Fiscal Policy and Stability Pact

32. … and after Theory and Politics of European Integration Fiscal Policy and Stability Pact crisisphase

33. Do low interest rates explain real estate bubble? Theory and Politics of European Integration Fiscal Policy and Stability Pact • More importantly, we cannot explain the boost in housing prices by national interest rates in most Euro countries empirically (Dokko et al., 2011) • But we can explain the boost by inprudent banking regulation and the subsequent financial packages like subprime mortages. • Thus, the right policy response is to reform banking regulation not monetary policies. • Bottomline: Housing price bubble is a key reason for public debt problem in Eurozone today.

34. Spain: Real estate prices (EURO per qm) Theory and Politics of European Integration Fiscal Policy and Stability Pact

35. Ireland: Real estate prices (Index: 2003 = 100) Theory and Politics of European Integration Fiscal Policy and Stability Pact

36. Construction production index (2007 = 100) Theory and Politics of European Integration Fiscal Policy and Stability Pact

37. Construction production index (2007 = 100) Theory and Politics of European Integration Fiscal Policy and Stability Pact

38. Why are governmental debts different in a CU? Theory and Politics of European Integration Fiscal Policy and Stability Pact • So far we know that (i) public debts of EURO countries have substantially increased in course of crisis, and (ii) this has started as a debt crisis in the private (financial sector) –- with the notable exception of Greece. • Ok, that happens to other countries as well, e.g. Japan, the US and UK. But these countries are so far not affected by a currency crisis. Why? • And why are the US, UK and Japan with a higher debt-to-GDP ratio than many crisis countries in Eurozone not affected?

39. Theory and Politics of European Integration Fiscal Policy and Stability Pact General GovernmentDebt in % of GDP, 2001-2013

40. Theory and Politics of European Integration Fiscal Policy and Stability Pact General GovernmentDebt in % of GDP, 2007-2013

41. Theory and Politics of European Integration Fiscal Policy and Stability Pact Budget saldo in % of GDP, 2001-2013

42. Theory and Politics of European Integration Fiscal Policy and Stability Pact Budget saldo in % of GDP, 2001-2013

43. Theory and Politics of European Integration Fiscal Policy and Stability Pact 10-year govermentbondyields in %, 2001-2014

44. 10-year government bond yields spread in EURO zone Theory and Politics of European Integration Fiscal Policy and Stability Pact crisisphase

45. Why are governmental debts different in a CU? Theory and Politics of European Integration Fiscal Policy and Stability Pact • Let’s consider two cases. Case 1: Investors fear debt default in country with a national currency: • sells government bonds • sells the currency on exchange market • exchange rate drops • but money stocks remains unchanged • eventually Central Bank buys government bonds • this generates inflation and exchange rate depreciation, but no liquidity risk. Only for countries which cannot issue bonds in national currencies.

46. Why are governmental debts different in a CU? Theory and Politics of European Integration Fiscal Policy and Stability Pact • Case 2: Investors fear debt default of country in Currency Union: • sells e.g. Greek government bonds • buys e.g. German government bonds • EUROs leave Greece, monetary stock contracts there • Government faces liquidity crisis, i.e. cannot lend money at reasonable interest rate • There is no channel to create liquidity • Unless the ECB buys Greek goverment bonds (This is what it announced to do in 2012, see below.)

47. Why are governmental debts different in a CU? Theory and Politics of European Integration Fiscal Policy and Stability Pact • Thus, the government debts are different in a CU • Why? Without a Central Bank you can’t generate liquidity by printing money • The role of expectations about sovereign debt default become increasingly important • Multiple equilbria and self-fullfilling prophecies can emerge (De Grauwe 2011) • This need not to be the case in Greece, but in other countries such as Spain or Italy

48. Another problem: The TARGET2 debts Theory and Politics of European Integration Fiscal Policy and Stability Pact • Theory: In a CU the balance of payments balance is always guanteed by the influx or outflow of money, such that the current account surplus/deficit exactly matches the capital account deficit/surplus • Recall Hume’s price-specie-mechanism • This is not entirely true in EURO System • The «Trans-European-Automatic-Real-time Gross-Settlement Express Transfer» (TARGET2) system allows for balance-of-payments-imbalances

49. How does the TARGET2 system work? Theory and Politics of European Integration Fiscal Policy and Stability Pact • The TARGET2 system allows (theoretcially) short-term debts of Central Banks and private actors at a Central Bank • E.g. real estate credits are accepted as collateral • Debits and credits cancel out exactly • 2012 TARGET2 debts of Greece, Ireland, Spain and Portugal numbered 340 billion Euros, Bundesbank held 326 billion Euros of these (ifo) • Basically, current account deficits of PIGS are largely financed by TARGET2 system

50. What are the implications? Theory and Politics of European Integration Fiscal Policy and Stability Pact • Risk of default is difficult to assess • There might be bad collaterals in portfolio of Bundesbank and other Central Banks • Deficits in current account are no longer financed by capital account surpluses, such that equilibriating forces are distorted • Long-run disequilibria may emerge • Actually, Target saldos have declines. Equilibrium might be achieved automatically