Fiscal Rules in Europe: Anchor or Straightjacket ? Or Will the Euro Be Stable (After All)?

1. Fiscal Rules in Europe: Anchor orStraightjacket?OrWill the Euro BeStable (After All)? Ansgar Belke University of Duisburg-Essen & DIW Berlin Monetary Experts Panel European Parliament Twenty Years Maastricht Treaty: A Blessing for Europe? Thursday, May 10 Maastricht Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

2. How to proceed … • Macroeconomic background • „Yes, we can“ – Europe can solve its crisis if it is willing to do so • Greek rescue packages, EFSF/EFSM, ESM and ECB • Ten steps towards a „hard“ euro Digression: Liquidity provision and balance-of-payments equilibria in the programme countries • „Doomsday“ for the euro area? • Fiscal rules in Europe: anchor or straightjacket? Digression: Fiscal adjustment and growth versus external adjustment and growth Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

3. Leadership – In search of a definition • The US has two political parties and yet it can barely agree on how to fund the government for weeks at a time. Multiply that by seventeen, the number of countries in the eurozone, many of which are similarly beset by fracturing political systems, and the US understands how the dimensions of the challenge take on a more complex texture. Richard McGregor, The Financial Times, November 2, 2011 • Finally: Does leadership consists of spreading Germany’s ‘stability culture’ throughout Europe? Or: Would a Germany in leadership mode would acknowledge that more German demand would help its troubled neighbours to export their way out of recession? Or: The euro may await a similar fate unless leaders quickly agree on a blueprint for a fiscal union and treasury etc. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

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5. Credit Default Swaps – Insurance against bank default Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

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7. Government debt in the euro area Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

8. Fiscal policies in the euro area Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

9. Monetary policy in the EA versus rest of the world Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

10. Growth in the euro area Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

11. Unemployment in the euro area Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

12. Price developments in the euro area Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

13. Current account balances in the euro area Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

14. Consumer price inflation under Trichet on average 1.97 percentage points– target fulfilled? • Trichet has left Draghi with a demanding legacy. • Projects such as an again stronger orientation of its monetary policy strategy at money and credit growth, … • … the de-coupling of European commercial bank fates from the rating of „their“ economies and the … Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

15. Consumer price inflation under Trichet on average 1.97 percentage points– target fulfilled? • … re-orientation towards a market-oriented pricing of sovereign bonds in the euro area have widely been untouched. • Excessive money creation during Trichet‘s time in office until the financial crisis has led to … • … excessive liquidity, excessive credit growth and a permenantly increasing leveraging of all economic actors in the euro area. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

16. Growth of monetary base compared with M3 growth (euro area) Source: Commerzbank, ECB. The dark line denotes the development of euro area M3, the other one traces the development of the euro area monetary base. Indexed (January 2008 = 100). Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

17. 2. „Yes, we can“ • Macroeconomic key indicators: no problem for the euro area on the whole. • On the contrary: current account roughly on balance.=> Sufficient ressources to solve own problems with public finances! • Euro area fares better than other currency areas … • … such as the US or the UK which record external deficits and are, hence, dependent on foreign capital inflows. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

18. 2. „Yes, we can“ • This is also valid for the area of fiscal policy: euro area average performs relatively “strongly”. • Fiscal deficit much lower than in the US (4 pc of GDP versus nearly 10 pc for theUS). • “Europe’s sluggish growth?”: track record of EA not too bad. • In the last decade, even per capita-growth in the US and in EA were nearly identical. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

19. 2. „Yes, we can“ • „Investor‘s strike“of Northern investors is core of the problem. • Problem is „internal“ allocation of savings and financial investments: • Although EA disposes of sufficient savings to finance the whole EA deficits, … • … there is excess saving in the North. • Savers do not want to finance Italy, Spain and Greece (any more). Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

20. 2. „Yes, we can“ • Unresolved conflict. If the euro finally fails, this is not due to a lack of solutions but to the fact that politics is not doing what is necessary. • Long-term survival of the euro necessitates an appropriate mix of debtor adjustment, haircuts/debt relief (if the former does not prove to be sufficient) and bridge-financing to persuade nervous financial markets that debtors must be granted enough time to let the adjustment programmes take effect. • Ressources are there; political will necessary to use them. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

21. 3. Greek packages, EFSF, ESM and ECB • Greece: basicproblems • The secondGreekrescuepackage: • Will itbesuffcienttostabilizeGreekdebt? • Mainlysupportofcommercialbanks • Drawback: olddebtremainsat EUR 250 bn. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

22. Sovereign bond purchases of the ECB (€ bn) Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

23. Balance sheet total and equity capital of the ECB (€ mn) Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

24. LTRO size Source:http://www.ecb.int/mopo/implement/omo/html/top_history.en.html. LTRO = Long Term Refinancing Operations. The ECB actually conducts these operations with a monthly frequency. They typically mature in three months. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

25. The euro area deposit facility and the two 3Y LTROs Source: ECB Statistical Data Warehouse. Red bars mark the dates of the two 3Y LTROs in week 51 of 2011 and week 9 of 2012, respectively. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

26. Euro area dependence on ECB funds Source: Oxford Economics/Haver Analytics. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

27. Financial and political independence of the ECB? • (Formerly) Unambiguous role of the ECB watered down today and more difficult to interpret: close symbiosis of governments and ECB, „quasi-fiscal“ tasks of monetary policy. • Unlimited sovereign bond purchases and a potential „Fiscal Backing“ by the EA member states: ECB is caught in a role model which might contradict its financial and political independence and its given mandate (Northern versus Southern lawyers, European Court). Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

28. Financial and political independence of the ECB? • Even more in the focus since the most recent EU summits and French elections. • A self-commitment by the ECB to guarantee „caps“ (upper limits) to sovereign bond yields does not make sense economically. • Better to put main focus on liquidity provision to banks in confidence crisis (unconventional monetary policies). Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

29. European Stability Mechanism (ESM) starting onJuly 1st, 2012(antedated) Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

30. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries • Link betweenexternalfinancingthrough Eurosystem and EU-IMF andthebalanceofpayments. Threeobservations. • Liquidityprovisionbythe Eurosystem and EU-IMF prevented a further sharp adjustment in thecurrentaccountofcrisis countries. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

31. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries • In all three programme countries, Eurosystem support particularly strong in the early stages of the capital flight and was then gradually replaced by EU-IMF programme financing. • Recent sharp turnaround in private capital flows to Italy which was covered by Eurosystem liquidity provision. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

32. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries • Case for extraordinary liquidity provision by the Eurosystem and financing by the EU-IMF is based not only on impaired capital market access in the short term, but also to enable a smoothening of the adjustment process in the long term. • As in any current account crisis: how much adjustment should be mitigated through official financing and how fast or to what extent should the crisis-affected economy adjust? Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

33. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries Official financingandthebalanceofpayment • Eurosystem and EU-IMF financing can have similar implications on the balance of payment. • Greece, Ireland and Portugal were faced with large private capital outflows during the crisis. (Graphs 3-5) • If the countries were not part of the euro area, the capital outflows would have resulted in a sharp adjustment in the current account. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

34. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries • Funding through central bank money and by EU-IMF prevented a sharp adjustment in the current account, while also financing substantial outflows of external private funding. • The Eurosystemsupporthasbeenparticularly strong in theearlystagesofthecapitalflightand was thenpartiallyreplacedby EU-IMF programmefinancing. • Balance of payment data also illustrate a large bank run in Italy. (Graph 6) Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

35. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

36. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

37. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries • Conclusions • Access to central bank money as well as EU-IMF loans have,apart from covering withdrawal of external private funding, allowed to finance peripheral economies' consumption and investment that would not have existed otherwise. • The Eurosystem canreactfasterandmore flexible tothe private capitaloutflowsofperipheraleconomiesthanofficialfinancialassistanceby EU-IMF. • Policy conditionality is important to ensure that official financing does not permanently replace the adjustment process! Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

38. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries Euroland’s hidden balance-of-payments crisis => conclusions: • Below the surface of the euro area’s public debt and banking crisis: balance-of-payments crisis caused by misalignment of internal real exchange rates. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

39. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries • With outright and permanent budgetary transfers from the creditor to the debtor countries unlikely and … • the debtor countries also probably unable to achieve internal real depreciation through deflation of goods, services and asset prices, … • … the path of least resistance is an appreciation in creditor countries through the inflation of goods, services and asset prices. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

40. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries • Representatives of debtor countries hold a majority of votes in the ECB’s Governing Council, hence … • … a policy of easy money and (real) exchange rate depreciation that leads to overheating in the creditor countries seems most likely. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

41. Digression: Liquidity provision and Balance-of-Payments equilibria im Programme countries • Tom Mayer (Deutsche Bank): “The authorities in creditor countries could insure their population against inflation and a soft currency policy by offering them index-linked securities that would convert into a new currency should these governments eventually decide to abandon the euro”. • Most probable scenario: combination of intra-EMU transfers, deflation in the debtor countries and inflation in creditor countries … • … such that the economic pain felt in each country group is shared between them in a way that leaves it below the level triggering a break-up of EMU. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

42. 5. „Doomsday“ for the euro area? • Theory/modelling Theory of optimum currency areas: optimal degree of integration at which efficiency gains and stabilisation losses are the same. • Entry and exit thresholds different, due to „sunk“ entry costs and high exit costs. • Band of inactivity (comparable to „play“ when steering a car => physics) has to be passed in order to have a nonlinear reaction (i.e., euro-area breakup)! Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

43. 5. „Doomsday“ for the euro area? • „Breakup“ and „Doomsday“ – the scenarios The „probable“ case: a „weak“ country leaves the euro area (GR) The „populist“ case: a „strong“ country enacts secession (D) Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

44. Is a unified macroeconomic policy necessarily better for a common currency area? • It is widely assumed that a common currency makes it desirable to have also a common fiscal policy. • However, if fiscal policy is a source of shocks, independent national fiscal policies are generally preferable because they allow risk diversification. • “The variance of a sum of shocks is the lower the lower the covariance among the individual components”. • Otherwise, leadership problem: one weak or bad leader can suffice to hole the euro project below the waterline. See Belke and Gros (2009): European Journal of Political Economy 25, 98–101. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

45. Expansionary fiscal contractions? • Non-Keynesian effects (Giavazzi & Pagano, 1990, 1996, Alesina, Perotti, 1995, Blanchard and co-authors): fiscal adjustments could affect positively demand through confidence and wealth effects and offset the usual Keynesian effects. • Improved long-term refinancing conditions and crowding-in of private investment. • Increase of public expenditure as observed in financial crisis casts doubts on sustainability of debt-to-GDP ratio: Uncertainty leads to option value of waiting with consumption decisions. • Good example: Italy versus Spain - fiscal rules beneficial for lower interest rates and growth. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

46. Expansionary fiscal contractions? II • Existence of non-Keynesian effects depends on size and persistence of fiscal adjustment. • Non-Keynesian effects if large budget deficit or a very high-debt-to-GDP ratio (demographics!) and number of credit-constrained consumers is low. • But importance of swift real EXR depreciations for economies caught up in a situation with large fiscal deficits, low output growth and an appreciated real exchange rate (Sweden, 90s!). • Without them, tax increases and public expenditure cuts bound to reduce aggregate demand/output. => Tax revenue will fall and fiscal consolidation will be slow. • Good example: Ireland versus Greece (closed economy with low saving rates) – different multipliers! Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

47. Public debt and growth • Large debts discourage capital accumulation + reduce growth. • Occurs through higher long-term interest rates, higher future distortionary taxation, higher (expected) inflation, greater uncertainty about prospects/policies, macroeconomic volatility (since it limits potential for counter-cyclical policies, hampers future growth further) … • … fueling accumulation of other macroeconomic (CA) imbalances. • Higher interest expenditure implies higher taxes or constraints on other government spending items promoting higher growth. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

48. Public debt and growth II • If growth is indeed reduced, fiscal sustainability issues are likely to be exacerbated, with further adverse consequences (debt hysteresis). • Link between growth and debt is weak at “normal” debt levels, but: median/mean growth rates for countries with public debt > 90 p.c. of GDP more than 1 p.c. lower than otherwise. • Seldomdo countries “grow”their way out of debts. • Impact of external debt on economic growth (“debt overhang” - a situation where a country’s debt service burden is so heavy that a large portion of output accrues to foreign lenders and consequently creates disincentives to invest. See Reinhart and Rogoff (2010) and Kumar and Woo (2010). Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

49. There is massive monetary accomodation … • Two-handed approach: bazooka-like 3yr monetary stimulus in order to cope with confidence crisis and to make cutback of debt possible. • Monetary stimulus may lower incentives for reform (Italy?). • Lars Calmfors: Double dividend hypothesis. Reforms to avoid inflationary bias (expectations of sustainable non-inflationary growth). = long-run corollary to short-run EXR depreciation (Sweden!). • In absence of fiscal rules: inflation as the only reasonable way out of the debt problem? Fiscal dominance (Sims, Sargent)? Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen

50. There is massive monetary accomodation … II • Rating agencies’ argument: malus for euro area member countries because they are individually too far away from the ECB in order to inflate their debt away. But this also implies: leeway for debt is lower within the euro area than outside! • Fiscal compact in order to avoid credibility and reputation loss of ECB, the most important pillar of EU governance during the crisis up to now (“flexibility in the short run, but rules in the long run”). • ECB President’s leadership: Trichet versus Draghi • ECB leadership: voting power in the ECB council =>One area in which Germany will not enact leadership is monetary policy. Fachbereich Wirtschaftswissenschaften Universität Duisburg-Essen