The ECB to the rescue? Filling the Lacunae in Euro Area Governance

1. The ECB to the rescue? Filling the Lacunae in Euro Area Governance Gabriel Glöckler * European Central Bank Edinburgh, 1 June 2012 * The views expressed are those of the author and do not necessarily reflect the position of the ECB.

2. Conceptual Framework Designing EMU The response to the crisis Filling the ‘gaps’ in economic governance Toward economic and financial union? 2

3. Fiscal and financial dominance? • Classic notion of fiscal vs. monetary dominance(see Sargent and Wallace: 1981, Jeanne: 2012) • Morgan Stanley, Oct 2011: “The name of the game: fiscal dominance […] the inability or unwillingness of governments to rein in debts and deficits becomes a binding constraint on monetary policy and may well collide with the objective of price stability.” • See also ECB Monthly Bulletin July 2012 (forthcoming)

4. Conceptual Framework Designing EMU The response to the crisis Filling the ‘gaps’ in economic governance Toward economic and financial union? 4

5. Designing EMU • Economic basis • ‘Sound money sound finances consensus’ (McNamara: 1998) “ [A single currency] would imply a common monetary policy and require a high degree of compatibility of economic policies…, in particular in the fiscal field”; “In particular, uncoordinated and divergent national budgetary policies would undermine monetary stability….” (Delors report 1989) • Legal basis (Maastricht Treaty) • Art. 101 monetary financing prohibition • Art. 102 prohibited privileged access to governments • Art. 103 (1) no bailout clause • Art. 104c, 109j and protocol annexed in the Treaty outlined the ‘Maastricht criteria’

6. ECB’s institutional context EMU rests on four fundamental constitutional pillars EMU Price stability orientation of the central bank Independence of the central bank Monetary financing prohibition ‘No bail-out’ clause

7. Designing EMU: positive feedback mechanisms Source: Yiangou, Glöckler, O’Keefe (forthcoming)

8. What went wrong (I)? – despite early warnings Unit labour costs in selected euro area countries, nominal (index 1998 Q4 = 100, relative to Germany, based on sa data) Euro area Germany France Italy Spain Netherlands Belgium Austria Greece Ireland Finland Slovakia Luxembourg Portugal Slovenia Cyprus Malta 145 145 140 140 135 135 130 130 125 125 120 120 115 115 110 110 105 105 100 100 95 95 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 • Weak implementation of fiscal rules • Insufficient monitoring of imbalances “..[T]he access to a large capital market may for some time even facilitate the financing of economic imbalances.”(Delors report, 1989) • Low pricing of sovereign risk 8

9. What went wrong (II) ? – despite early warnings • Missing elements • “…Rather than leading to a gradual adaptation of borrowing costs, market views about the creditworthiness of official borrowers tend to change abruptly and result in closure of access to market financing. The constraints imposed by market forces might either be too slow and weak or too sudden and disruptive.” (Delors report) • No crisis resolution mechanism • No responsibility for financial stability at euro area level • Contagion channels not adequately understood Risk of fiscal dominance 9

10. What went wrong?: ‘Gaps’ in the financial governance framework • Two trilemmas: • Financial trilemma (2) The new impossible trinity Source: Schoenmaker (2011) Source: Pisani-Ferry (2012) • Increasing financial fragmentation due to bank sovereign nexus: also a risk of financial dominance Financial integration Sovereign-bank interdependence Financial stability National supervision No monetary financing National fiscal policies

11. Conceptual Framework Designing EMU The response to the crisis Filling the ‘gaps’ in economic governance Toward economic and financial union? 11

12. Financial sector debt transferred to public sector Short-term fiscal impact of crisis- general government debt Source: Commission Services 12

13. Sovereign spreads on the rise Spreads compared to 10 yr German Bund, in basis points Source: Bloomberg

14. But do markets get it right? Source: Bloomberg 14

15. Bluntness of debt markets as disciplining devicesObserved payout distribution of debt and equity contracts http://ineteconomics.org/sites/inet.civicactions.net/files/turner-frankfurt-slides.pdf

16. The fiscal-financial nexus in the euro area… …. has been strong since the beginning of 2010 Euro area US Source: Thomson Reuters and ECB calculation. Latest observation: 31 Dec 11. Note: Sovereign CDS euro area average calculated as country CDS weighted by ECB capital key. Banks CDS euro area average is calculated taking the largest bank of each available country and aggregating using ECB capital key. Each dot represents the pair (av. sovereign CDS, av. bank CDS) at a certain day in the respective quarter.

17. Market segmentation and the fiscal-financial nexus Increased risk aversion and retrenchment behind national borders

18. The risk of re-fragmentation of markets Cross-border holdings of EU MFIs (% of total holdings) Share of cross border collateral used in Eurosystem credit operations Quelle: ECB Financial Integration Report, April 2012

19. Could the ECB break that feedback loop? • In the absence of common supervision, resolution or fiscal backstop: • Deploy “bazooka” via the ECB operations? • Unlimited commitments? Yield targets? • Major problems: • Legal prohibition • Incentives • Accountability and democracy

20. The SMP in a comparative context

21. 3 year LTRO as ‘the Big Bertha’ Two 3-year operations (1) € 489 bn, 523 counterparties; (2) € 529 bn, 800 counterparties Exceptionally serious situation in late 2011 • panic and complete drying-up of inter-bank markets; • Dangers of a credit crunch; • perceptions of the “inevitability” of a catastrophe • 21

22. Impact on money markets Reduced tensions in money markets Reduced credit risk • Euro area money market spread and volatility • CDS for financial and non-financial corporations • Note: The vertical green line denotes the announcement on 8 December 2011 of the two three-year LTROs. The two vertical red lines mark the allotment of the two LTROs on 21 December 2011 and 29 February 2012 respectively. Source: ECB Monthly Bulletin, march 2012

23. First impact on credit provision Quelle: ECB Bank Lending Survey April 2012

24. Addressing the criticisms No real help for real economy? • 800 banks – of which 500 German (i.e. many of those which are closest to SMEs) Excessive risks for the Eurosystem balance sheet? • strikt und differentiated risk management framework • loss only through double default • dynamic balance sheet as part of normal central bank functions (i.e. when intermediation breaks down)

25. The ‘breathing’ Eurosystem balance sheet Quelle: ECB, Letzte Daten: 26..März 2012

26. Sowing the seeds of future inflation? Market-based inflation indicators euro area (%.) • Different concepts of liquidity • Till now no significant increase in monetary aggregates(M3 +3.2% March 2012) • Inflation expectations securely anchored • Eurosystem can re-absorb liquidity (e.g. via minimum reserve requirements) Sources: Bloomberg, BoE, Fed staff calculations, Reuters, Euro MTS, and ECB. Note: market-based inflation expectations (break-even inflation rates). Latest observation: 30 August 2011.

27. Conceptual Framework Designing EMU The response to the crisis Filling the ‘gaps’ in economic governance Toward economic and financial union? 27

28. 2. A robust rescue mechanism European Stability Mechanism Supportive Funding Primary Market Purchases Secondary Market Purchases EFSF Basiert auf Eurogruppe, EIB, ECB, … Vorsorge-Kreditlinien Funds to recapitalize banks Other uses – genuine EMF? Precautionary Facilities ESM “...a ‘European Monetary Fund’ in all but name?” (Sarkozy) 28

29. 3. Progress in financial supervision and resolution • New supervisory framework (since Jan 2011) • EBA, gradual progress towards single rulebook –main role still played by national supervisors • EU Bank Recovery & Resolution Directive (COM proposal) • Harmonised powers for early interventions, new resolution tools, framework for cross-border cooperation • Deposit Guarantee Schemes Directive (text in trialogue) • Harmonisation of levels (at EUR 100,000) Enough to secure monetary dominance ? What now?

30. Further governance reform is needed • “…to operate smoothly and to be more resilient to crises, the Economic and Monetary Union has to become a true financial union.” B Coeure, March 2012 • “Increasingly, it seems that it is not too bold to consider a European finance ministry, but rather too bold not to consider creating such an institution” J.C. Trichet, October 2011 • “Financial market union”, “fiscal union”, and “political union” J. Asmussen, May 2012

31. Toward financial/banking union? • Strengthened micro and macro prudential regulation of risk • Strengthened EBA? • New Authority with mandate for cross border supervision? • Harmonised deposit guarantee scheme • Recapitalisation of financial institutions • Direct recapitalisation of banks by the ESM • Resolution • Network of resolution funds? Common fund financed by the industry?

32. Thank you For further questions Email: gabriel.glockler@ecb.europa.eu Or visit: www.ecb.europa.eu