Transcript Slide 1

Restructuring the economic
and monetary union
Zsolt Darvas
Bruegel, Corvinus University, IE HAS
IKV Events on the Euro Crisis
24 February 2012, Istanbul
The aggregate fiscal position of the euro area is
better than that of the US – Why is the € in crisis?
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120
100
Euro area
United States
80
60
40
20
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
0
Gereral government balance
(%GDP), 1995-2013
4
2
0
-2
-4
-6
-8
-10
-12
-14
Euro area
United States
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
Gereral government gross
debt (%GDP), 1995-2013
Note: US general gov debt also includes the debt of states and local
governments (IMF and EC data only report federal debt)
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Outline
1. Major reasons behind euro-area problems
2. The EU’s policy response so far
3. What to do?
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1. Major reasons behind Euro-area problems (1)
Pre-crisis - weak governance & incomplete economic integration:
1.The rules-based Stability and Growth Pact failed
 High public debt in Greece and Italy at the outbreak of the
crisis
2.Sole focus on fiscal issues
 Unsustainable credit and housing booms in some countries
(eg Ireland and Spain)
 Structural imbalances (eg current account, wage) developed
3.No proper mechanisms to foster structural adjustment
 Disappointing growth performance in some countries even
before the crisis (eg Italy, Portugal)
4.No crisis resolution mechanism
 Sovereign debt and banking crises came as a surprise
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Paul De Grauwe (2011): EMU is shockingly fragile
Illustrated by comparison between Spain and the UK
United Kingdom
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4
2
0
-2
-4
-6
-8
-10
-12
-14
10 year government yields
(%), Jan 2001-Jan 2012
7
6
5
4
3
Spain
United Kingdom
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1
0
Spain
United Kingdom
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Spain
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
100
90
80
70
60
50
40
30
20
10
0
Gereral government balance
(%GDP), 1995-2013
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
Gereral government gross
debt (%GDP), 1995-2013
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1. Major reasons behind Euro-area problems (2)
The crisis revealed more fundamental problems:
1.Strict no-monetary financing by the ECB/Eurosystem  no lender
of last resort (cf. Spain vs. the UK)
 Sovereign borrowing is like borrowing in a ”foreign” currency
2.National bank resolution regimes & large home bias in banks
government bond holdings
 Lethal correlation of banking and sovereign debt crises
3.Interdependence across countries
 Fall of a ”small” country can create contagion, fall of a ”large”
country leads to meltdown
4.Downward spiral in adjusting countries
 Vicious circle of fiscal austerity and low growth in the
absence of a stand-alone central bank
5.Negative feedback loop between the crisis and growth
 No euro-area level macro policy
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6.Governance crisis: partial, inadequate and belated responses
 Lost policy credibility
2. The EU’s policy response so far
• ECB unlimited liquidity support to banks  very effective, yet the
ECB can turn into a bad bank should the banking crisis escalate
• Strengthened governance, including surveillance & sanctions (6Pack, Fiscal compact, European Semester, assessment of
excessive private sector imbalances)  some helpfuls aspects,
can be useful once the crisis is solved and there is no more
recession, but won’t solve the crisis, and the fiscal compact will
lead to procylical fiscal policy during recessions
• Financial backstop to sovereigns (bilateral loans to Greece, EFSF,
EFSM, ESM)  but limited lending capacity
• ECB purchase of government bonds at the secondary market 
but temporary, limited, and ”only to help monetary transmission”
• New institutions for financial stability (eg ESRB, EBA)  but with
limited powers
• Stress testing of major European banks  discredited almost
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immediately
The EU’s policy response – Overall assessment
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New governance framework addresses only 3 of the 4 precrisis flaws of the euro area
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With a lot of luck – the strategy might work
But the strategy does not address the fundamental problems
revealed by the crisis:
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SGP: focus on debt as well
Excessive Imbalance Procedure (EIP): focus on private sector
vulnerabilities
European Semester: fostering structural adjustment
Not well addressed: no proper way to address sovereign debt and banking
crises
No lender of last resort for sovereigns
Lethal correlation of banking and sovereign debt crises
Interdependence across countries
Downward spiral in adjusting countries
Negative feedback betwen crisis and growth
Governance crisis
Markets may deny funding from Italy (and Belgium and Spain)
and nobody knows what will come afterwards
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3. What to do?
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Address the fundamental problems revealed by the crisis
Restore lender of last resort for sovereigns
 ECB – note: I do not like money printing!
Break the lethal interdependence of banks and sovereigns
 Banking federation (centralised regulation, supervision, resolution,
deposit guarantee)
 Limit bank holdings of government debt
 Eurobond
Address interdependence across countries
 Banking federation
Downward spiral in adjusting countries
 ’Federal’ economic stabilisation/risk-sharing instrument
Negatve feedback loop between crisis and growth
 Euro-area fiscal policy; Banking federation
Governance crisis
 Strengthen centralised decision making instead of inter-governmentalism
Note: a (limited) budget is needed for a banking federation & stabilisation,9
but need not be more redistribution
What fiscal integration?
Sometimes regarded as magic bullet, but what fiscal integration?
• More coordination & survelliance  would not be enough
• Veto power over national budgets, ie partial loss of national
sovereignty  may be necessary
• More redistribution or transfers  no
• Stabilisation instruments (ie when there is a common economic
shock)  yes
• Risk-sharing (ie when there is an asymmetric economic shock)
 yes
• Banking federation, ie centralised bank regulation, supervision,
resolution and deposit insurance  yes
• Central taxing power  yes (but limited, needed for the above
three tasks)
• Eurobonds  yes, but with what governance? Financed by
federal taxes or national contributions? And how to merge
existing debt? I.e.: Should the federal tax rate be the same in
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Estonia (8% debt today) and Italy (120% debt today)?
Conclusions
• The new European economic governance framework: several useful
instruments that will improve the functioning of the EU and the euro
area
• But largely addresses 3 (public debt, private sector vulnerabilities, fostering
adjustment) of the 4 pre-crisis flaws (still no proper crisis resolution
mechanism)
• With a lot of luck, the new governance framework along with other
crisis management instruments might work
• But: does not address the fundamental problems revealed by the
crisis (lender of last resort for sovereigns, interdependence of banks and
sovereigns, interdependence across countries, downward spiral in adjusting
countries, negative feedback between crisis and growth; governance crisis) 
current governance framework is unlikely the ultimate solution
• Limiting national fiscal sovereignty and setting-up ’federal’ functions,
such economic stabilisation, economic risk-sharing and banking
resolution/deposit guarantee
• Limited Eurobond (Bruegel, EC) or Debt Redemption Fund (German
Council of Economic Experts) would improve governance and crisis
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resolution a lot – much better than ECB financing of public debt