The euro crisis: What did we know? What have we learnt? Oxonia , 22 February 2012

1. The euro crisis: What did we know? What have we learnt? Oxonia, 22 February 2012 Jean Pisani-Ferry (Bruegel)

2. Jonung and Drea’s count of US academic papers on the euro • Extensive research on EMU in the 1990s • Many advance warnings from academia about euro risks • In many respects the crisis was foretold • However not in all • Goal: • Find out what could be expected and what have been genuine surprises • Discuss policy lessons

3. Outline • Non-surprises • Surprises • Implications

4. 1. Non-surprises • Eurozone not an OCA • Bayoumi-Eichengreen • Not an endogeneous OCA • Krugman’s lessons of Massachussets for EMU • One-size-fits-all monetary policy destabilising • Walters critique • Long-lasting real exchange rate cycles • Blanchard-Muet • Sovereign solvency crises more likely in EMU • De Grauwe • Inadequate pricing of sovereign risk • Buiter-Sibert • Incentives to fiscal indiscipline • Beetsma, Uhlig • Design/enforcement problems of SGP • Eichengreen-Wyplosz • Weak provisions for coordination of bank supervision/crisis resolution • Lamfalussy, Goodhart

5. What did policymakers do to address these risks? • Some: • SGP • Surveillance framework • But not much... • Nominal rather than real entry criteria • No real efforts to foster single market integration • Only a few states gave thoughts to ways of controlling divergence, weak implementation of surveillance provisions • Limited efforts to ensure wage/price flexibility • No appetite for integration of supervisory policies • No crisis management mechanisms

6. Not only the EU failed to anticipate problems • ... also the IMF • Country-by-country approach • “Europe is different” mindset • Institutional mimicry

7. Why were warnings ignored? • Predominance of (high) politics • Euro choice • Entry highly politicised choice • Implementation problems • Hard to define undisputable entry criteria based on OCA • Adjustment and integration fatigue • No appetite for further reforms • No appetite for surveillance • No appetite for further transfer of competence • Not even for single market enforcement • Hence, complacent reading of the literature • Endogenous price flexibility assumed • Endogenous OCAs taken for likely • Solvency crises not considered a real risk • In the end, incoherence between euro and other dimensions of integration

8. 2. Surprises • Current-account crises • Correlation of banking crises and sovereign crises and the consequences of not having a LLR for sovereigns

9. A. Current-account crises • Evidence of current-account crises within euro area: • Indirect: sovereign spreads correlated to NFA position • Direct: Target 2 data Target balances : North vs. South, €bn Source: Bruegel

10. Evidence of Sudden Stops • (Merler and Pisani-Ferry, work in progress) • Calvo methodology to identify sudden stops episodes • One observation at least with yoy capital inflows 2 standard deviations below mean • Starts: first observation with delta (yoy capital inflows) 1 SD below mean • Ends: first observation with delta (yoy capital inflows) exceeds 1 SD below mean (reversion) • Applied to monthly BOP data • Preliminary results: • Evidence of SS episodes in Southern Europe • First major episode Spring 2010 (before and around first Greek programme) • Second major episode Summer-Autumn 2011

11. How can current accounts matter? • Old research: current accounts don’t matter within a country, hence they don’t matter in a MU. See Ingram (1973): “The traditional concept of a deficit or a surplus in a member nation’s balance-of-payments becomes blurred.. With a common currency, no individual country can be exposed to speculative attacks” • Not seriously challenged by later research. Questions about reasons for CA imbalances (Blanchard-Giavazzi) but general belief that euro was eliminating Feldstein-Horioka • Practical consequences: • EU BOP assistance (Art. 143) reserved to countries outside the euro • No serious attempt to exercise BOP surveillance in the 2000s • Why do they matter? • Mobility? • Banks!

12. B. Correlation of banking crises and sovereign crises • Known stylised fact: banking crises and BOP crises are correlated • In the euro area also.. • Was foreseen (Eichengreen Wyplosz 1998) • But was not seen that would be magnified by the absence of a lender of last resort for sovereigns • Governments treated financial specialisation like any other specialisation • State debt was assumed safe • Results is unexpected “fragility” (De Grauwe 2011)

13. Correlation of sovereign and banking spreads

14. Why? Sovereign exposure to banks is considerable... Total bank assets to government tax receipts ratio, 2010 Source: Eurostat, ECB, Bruegel calculations

15. ..and banks exhibit strong home bias in holding of govt bonds Share of own sovereign’s bonds in EA government bonds held by banks, 2010 Source: EBA, EUROSTAT, Bruegel calculations

16. Correlation of sovereign and bank CDSs Sovereign CDSs and bank CDSs, 1/2008 to 1/2012 US Source: Bruegel based on Thomson Reuters data

17. Furthermore banks home bias has increased (even before 3-y LTRO) Shares of domestic banks and non-residents in holding of govt bonds, 1998-2011 Source: Bruegel based on national data Source: Merler and Pisani-Ferry (2012)

18. C. The new impossible trinity National banking systems Lender of last resort for sovereigns Fiscal union Strict no-monetary financing No co-responsibility over public debt Financial union

19. The no-coresponsibility principle • Government in the EA are individually responsible for the debt they have issued (No bail-out rule) • Art. 125: “The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project” • Markets did not believe it would be enforced. In 2001 Greece was upgraded after joining the euro ”on the belief that Greece was now part of the euro zone and that nobody was ever going to default”

20. Strict no-monetary financing • Art. 123: Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bankor national central banks of debt instruments. • Art. 123 prohibits institutionalised fiscal dominance, i.e. explicit agreements between government(s) and central bank(s) similar to the Fed-Treasury accord of 1951…

21. Where are the problems? • ECB has no financial stability mandate • Art. 127-5 very weak • The ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system • Justification of SMP is to help ensure the proper transmission of monetary policy decisions • ECB does not have the proper governance structure • One governor-one vote not appropriate for decisions with potential distributive consequences • ECB not made to exercise broad policy conditionality • Legitimacy issue

22. Result: hesitant behaviour Purchases on secondary market are limited and lack consistency

23. 3. Implications • The strategy: • Force RER adjustment in the periphery by enforcing fiscal discipline • Eliminate insolvency risk by making states super-safe • The alternative solutions: • Make sovereign risk manageable • Restore the LLR function • Revise the no-coresponsibility principle

24. A. Super-safe sovereigns • Safe public debt levels lower than thought • Need to move away from deterministic approach to budgetary surveillance, take into account implicit liabilities and tail risks • Stress test the sovereigns • But: • Evaluation of safe debt levels elusive • Goal VERY distant

25. The (long) way to go… Required adjustment to reach 60 per cent debt ratio in 2030 Source: IMF

26. …and the risk of rushing • Current adjustments tend to be biased towards immediate revenue-raising measures • Trade-off speed-quality

27. B. Make sovereign risk manageable • Much to do in this area • Limit exposure of banks to their sovereign (prudential policy) • Steps towards banking federation • Long term: European FDIC • Short term: EFSF backstop to national guarantees (or EFSF direct recapitalisation of banks – see Greece)

28. Euro area features not universal Note: for Germany and Portugal the measure is measure is general government debt Source: Bruegel calculations

29. Two limitations • Political economy à la Carmen Reinhart: to limit sovereign access to their own financial institutions in times of fiscal stress is an uphill struggle • Even with a safer financial system, the default of a medium-sized European state would be a major financial shock.

30. Qualitatively the same as in the US.. but not quantitatively Source: Eurostat, US Census, Bruegel calculations

31. C. Restore LLR role for the ECB • EFSF leverage proposed by Gros-Mayer (2011) • Advantages • With appropriate haircut, most of the risk remains with EFSF • EFSF has proper shareholding structure • Distinction fiscal / monetary roles • But difficulties • EFSF borrowing conditions • In the end was rejected

32. D. Fiscal union • Old discussion on economic pillar of Economic and Monetary Union • Choice was made not to create a federal budget • Now issue back in new clothes • Eurobonds: • Joint and several liability (so co-responsibility) • Possibly partial (Red /Blue bonds) • Several proposals • Delpla-Weizsäcker • German Economic Experts • ESBIEs • Hellwig-Philippon

33. Blue/red bonds: basic mechanism • Principles • Senior blue debt tranche issued up to [60] per cent of GDP, junior red debt above • Joint and several responsibility on blue debt • Red debt not eligible to ECB repo, subject to higher capital requirements • Expected effects • Higher marginal cost of debt, hence incentive properties • Average cost of debt unaffected ex ante (abstracting from liquidity premium, incentives)

34. Policy issues • Two key issues • Which underlying guarantee structure? • Joint and several • Guarantee by EU budget – with taxing power • Responsibility for ex ante control • Parliamentary (implies new body made up of NPs and EP) • Judicial (ECJ) • Can Germany accept? • No direct benefits • Only with strict conditions • Can France accept (politically)? • Surrender of budgetary sovereignty • Political integration

35. Conclusions for research • Research correctly anticipated many of the problems that developed within euro area • Key limitations were failure to imagine that BOP crises could occur, failure to anticipate the full consequences of absence of LLR for sovereigns • Other issue has been selective use of research in policy discussion, bordering to instrumentalisation