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The Future of the Euro (Brown book 2012)
 

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    The Future of the Euro (Brown book 2012) The Future of the Euro (Brown book 2012) Presentation Transcript

    • BROWN BOOK ANDRÉS DOMINGO AND DOMÉNECH VILARIÑO / XXVIII EDICIÓN DEL LIBRO MARRÓN The Future of the Euro DÍEZ GANGAS / DONGES / GARCÍA ANDRÉS / GROS Y ALCIDI / MARTÍNEZ RICO / REQUEIJO GONZÁLEZ / SÁNCHEZ FUENTES, HAUPTMEIER AND SCHUKNECHT / BROWN EDITION BOOK XXVIII The Future of the Euro El futuro del euroThe Brown Book in 2012 meets his XXVIII edition. Year after year since1984, this flagship publication of the Círculo de Empresarios has offe-red the most varied backgrounds a platform from which to contributetheir ideas and proposals on economic policy that requires ourcountry to its further development. The Brown Book contributes to oneof the founding objectives of the Círculo as the center of the view thatencourages and promotes debate on key issues for the benefit ofSpanish society as a whole. JULIO 2012 CÍRCULO DE EMPRESARIOS C/ MARQUÉS DE VILLAMAGNA, 3, 10ª. 28001 MADRID TEL 915781472. FAX 915774871 www.circulodeempresarios.org July 2012
    • The Future of the EuroBrown BookMadrid, July 2012EDITION SPONSORED BY
    • © 2012, Círculo de EmpresariosC/ Marqués de Villamagna, 3, 28001 MadridThe partial or total reproduction of this publication, or its hand-ling by software, or its transmission under any circumstance orby any means, whether electronic, mechanical, by photocopies,recording or other means, without the express written consentof the copyright holders, is strictly forbidden.The articles reflect the opinions of the contributors, and notnecessarily those held by Círculo de Empresarios.Legal deposit: M-24161-2012Design of collection: Miryam Anllom.anllo@telefonica.netIllustration: María José RuizPublishing: Loft Producción GráficaC/ Martín Machío, 15-1º. 28002 Madrid (Spain)Printed by Atig, S.L.Parque Empresarial Neinor - Henaresedificio 3 - nave 104
    • The Future of the Euro IndexPrologue 71. The future of the Euro after the Great Recession 15 Javier Andrés and Rafael Domenech2. Nature and Causes of the Euro crisis 63 José Carlos Díez3. The European crisis and the challenge of efficient economic governance 97 Juergen B. Donges4. The turbulent adolescence of the euro and its path to maturity 131 Gonzalo García Andrés5. Breaking the common fate of banks and governments 197 Daniel Gros and Cinzia Alcidi 5
    • 6. The fiscal institution in the Economic and Monetary Union: the contribution of Spain 227 Ricardo Martínez Rico7. The European Monetary Union: the Never-Ending Crisis 265 Jaime Requeijo8. Public expenditure policies during the EMU period: Lessons for the future? 289 A. Jesús Sánchez Fuentes, Sebastian Hauptmeier and Ludger Schuknecht6
    • Prologue The crisis in Spain is, to a large extent, the crisis of the Euro. Onthe one hand, the sustainability or otherwise of the monetary inte-gration project hinges on Spain, as the fourth economy in theEurozone. On the other, Spain has no leeway available for fiscal sti-mulus packages, and the success of its adjustments required stabi-lity in the Eurozone. Hence, both crises are the two sides of thesame token. The crisis faced by Euro economies and the adjustments madeand which will be made in the most vulnerable ones, are coming ata high price which has not yielded tangible results to date. Círculode Empresarios believes that the current situation calls for an impro-vement in European institutional architecture, in regard to greaterintegration and, above all, more commitment to reforms in Spain.The natural environment of our country is the Eurozone. Over the last few weeks, citizens are beginning to live with thedifferent rescue modalities, as they had already done with the riskpremiums. Financial aid for troubled economies is quite diverse interms of implications, instrumentation, conditionality and scope ofapplication, therefore requiring detailed analysis for determination.Although each carries its benefits and disadvantages, in the opi- 7
    • nion of Círculo de Empresarios, the greater scope and conditionalityscenarios – known as country-rescue – are not a desirable option.This is why these must be avoided. Indeed, an intervention or rescue, of its own accord, withoutadvancements made in the Eurozone architecture, shall not protectany of its members from future scares. Domestic adjustment maybe less effective if no advancements are made in fiscal and bankingunion, and in the European capacity to provide asymmetrical res-ponses to national situations which are also different. The mostvulnerable countries in the Eurozone must no longer be perceivedas foreign currency debtors and it is imperative that the coordina-tion of economic policies of Member States is improved. Withoutsuch adjustments, a sustained growth path will not be possible toachieve. On the other hand, the crisis in Spain is the result of an accu-mulation of imbalances due to a series of inadequate signals andpolicies. Spain must face up to its responsibilities in terms of fiscalconsolidation and structural reform. All in the interest of recove-ring competitiveness and encouraging a suitable environment toattract growth-contributing investments. In such circumstances, Círculo de Empresarios cannot help buttake part in the debate on the future of the Euro. The XXVIII edi-tion of the Brown Book is dedicated to this matter and gathers avaried number of authors, all with broad experience in the issue8
    • and proven academic and professional records. Therefore, thispublication, with the sponsorship of BBVA as in previous years,maintains its nature as a publication which is open to differentideas and opinions, not necessarily shared by Círculo de Empresarios. As in previous editions, the articles appear in alphabetical orderby the surnames of their authors, although these can be groupedinto three broad categories: the crisis of the sovereign debt inEurope and the future of the Eurozone; the reform of economicgovernance and operations of the institutions in order to solve thesovereign debt crisis in Europe; and the integration into theEurozone, the fiscal coordination mechanisms, Eurobonds and theassignment of sovereignty. In their paper, Javier Andrés and Rafael Doménech analysethe challenges faced by the Eurozone and the proposals to handlethem by improving economic governance. To this end, they beginby reviewing the reasons underlying the accumulation of signifi-cant imbalances in developed economies and among EMU coun-tries, mainly from 2001 until the start of the crisis in 2007, as aresult of an unsustainable growth pattern in many developed eco-nomies. Secondly, the magnitude and implications of such imba-lances and the heterogeneity between EMU countries are closelyexamined. Finally, the authors analyse the challenges involved inthe improvement of economic governance of the EMU on the fis-cal, financial and economic integration fronts, which will determi-ne its short and long term economic future. 9
    • José Carlos Díez analyses the Euro crisis. He reviews the histori-cal background of the European and single currency projects, andthe theory of exchange rates to provide conceptual support to ena-ble an understanding of the nature and the causes of the crisis.According to him, this is an infrequent, but highly destructive, dise-ase found in economics, especially in developed countries, since itcauses devastating damage to the employment and public debt ofthe affected countries. For this reason, he believes it is essential tocome up with the correct diagnosis in order to define the economicpolicy that will put an end to the crisis. The main causes analysedare financial integration, the under-assessment of risk, local imba-lances within the Eurozone and the Great Recession. The aim of Juergen B. Donges is to bring the current debate onthe need for economic governance in the European Union, and par-ticularly in the Eurozone, into the context of political realities. Heanalyses the issue of governance from a historical and current pers-pective, and highlights the significant fact that the Eurozone doesnot constitute an optimal monetary area. He then moves on toanalyse the forms of governance to date and considers new approa-ches to European governance. Finally, he ends his analysis with atone of moderate expectation. If the Governments of the Euro countriesunderstand that the solidity of public finances and the application of struc-tural reforms are their responsibility and act in accordance, no State mustrush to the aid of another due to over-indebtedness and overspending, andthe ECB may stop indirectly funding the States and focus on its own duty,which is to ensure the stability of the price levels within the Eurozone.10
    • Gonzalo García Andrés highlights that, despite having takendecisive steps in national policies and institutional frameworkreform, the Euro crisis has worsened to the point of calling its sur-vival into question; and no definitive solution is yet on the hori-zon. In his article he attempts to offer an interpretation of what hashappened, assuming the extreme complexity both of the startingpoint (with accumulated imbalances and structural deficiencies inseveral countries), as of the outbreak, the contagion and the esca-lation of the crisis. And he does so in the broader context of theglobal financial crisis, which has affected economic and financialdevelopment for five years, in order to determine which specificaspects of the Euro have played a key role. All this with a view toencouraging a reflection on solutions, bringing together the mosturgent and the ones with a longer term effect. Cinzia Alcidi and Daniel Gros point out that the Eurozone cri-sis encompasses different dimensions, from foreign debt andcurrent account balance problems, to the weak situation of the ban-king sector. The document focuses on this last issue, the situationof the banking system, and attempts to show the way in whichcurrent characteristics of the regulatory framework of the financialmarket have influenced the development of the crisis. In addition,they express their concern about the false idea that the recently sig-ned fiscal convention shall become the fundamental ingredient ofthe recipe to overcome the crisis, when the banking sector conti-nues to be heavily indebted and exposed to the vicissitudes of sove-reign States. For this reason, they present a few ideas to break the 11
    • close ties between governments and banks, since these links themin a common fate and constitute a clear impediment to recoveryfrom the crisis in the Eurozone. Ricardo Martínez Rico, throughout his work, analyses the wayin which the sustainability of public finances requires a sold fiscalinstitution and a firm political commitment by European govern-ments. Subsequently, he tackles the close relationship between fis-cal rigour, macroeconomic stability and growth, concluding that, inorder to achieve a positive inter-relation, the establishment of fiscalrules which are simple, transparent, automatically applied and withpreventive control mechanisms for all Public Administrations, isessential. All these items are key when designing a fiscal policywhich contributes to recovering the credibility required by Europealong its route towards greater integration to handle the sovereigndebt crisis. Lastly, he examines the measures taken in Europe andSpain since the start of the sovereign debt crisis, and reflects on thenext steps that should be taken towards a fiscal institution. The work of Jaime Requeijo aims to provide a reasoned expla-nation of the causes of the financial shocks affecting severalEurozone countries, and which endanger the survival of the singlecurrency (the Monetary Union is a poorly built structure becausepolitical urgency has prevailed over economic prudence; the fiscalirresponsibility of many member state governments has translatedinto the appearance of large public debt; such debts generatedoubts as to their holders; and, contributing factors such as the12
    • effects of contagion or of the opinions of the rating agencies andIMF predictions). In the article he also attempts to reply to threequestions on the measures taken, the results thereof, and theimpact of a potential decomposition of the euro. The article endswith a brief final reflection on the solution to be applied in orderto maintain the Monetary Union. A. Jesús Sánchez-Fuentes, Sebastian Hauptmeier and LudgerSchuknecht state in their article that an ambitious fiscal reformwithin a broader programme of reforms would have highly positi-ve effects insofar as it would provide for a safer fiscal position, inline with the requirements of the Stability and Growth Pact (SGP).Expenditure control policies must therefore go hand in hand withstructural reforms, mainly focused on reducing rigidity in thelabour and product markets, on the correction of macroeconomicimbalances, on the improvement of competitiveness and on sus-taining potential growth. This becomes particularly key for themost vulnerable countries in the Eurozone, which no longer havethe option of currency devaluation to increase competitiveness. Finally, and on behalf of Círculo de Empresarios, I wish to thankall the authors for their contributions to this new edition of theBrown Book and I trust that these articles help to shed light on asolution to the European trilemma. Mónica de Oriol President of Círculo de Empresarios 13
    • /JAVIER ANDRES * / RAFAEL DOMENECH**/ The future of the Euro after the Great Recession 1Summary; 1. Introduction; 2. From the Great Moderation to the GreatRecession; 3. The imbalances in Europe and in the EMU; 4. The newEuropean governance and the future of the Euro; 4.1. Changes in fiscalgovernance; 4.2. Financial integration; 4.3. Economic integration; 5.Conclusions.SummaryIn this chapter we shall analyse the challenges the Eurozone is facing andproposals to deal with them via improved economic governance. To do so,* Javier Andrés is professor of Fundamentals of Economic Analysis at the University ofValencia and visiting professor of the University of Glasgow. http://iei.uv.es/javierandres/** Rafael Doménech is Chief Economist of Developed Economies, BBVA Research andProfessor of Fundamentals of Economic Analysis at the University of Valencia.http://iei.uv.es/rdomenec1 The authors thank A. Deligiannido, A. García, M. Jiménez, and E. Prades for their assis-tance and comments on this work, as well as the help from CICYT projects ECO2008-04669 and ECO2011-29050. 15
    • The future of the Euro after the Great Recessionwe shall first examine the reasons behind the accumulation of significantimbalances in the developed economies and among the EMU countries,mainly since 2001 until the crisis in 2007, as a result of a pattern of unsus-tainable growth in many developed economies. Secondly, we shall offer anin-depth analysis of the significance of such imbalances and the heteroge-neity which exists between EMU countries. Lastly, we shall study the cha-llenges presented by the improvement of the economic governance of theEMU from a fiscal, financial and economic integration perspective, whichshall determine its economic future in the short and long term.1. Introduction The international economic crisis which begun in 2007 ishaving an extraordinary impact on the European economy, and forthe coming decades, will leave a deep mark in many of its mem-bers. The crisis has shown that the growth process undergone bet-ween 1994 and 2007, particularly following the creation of theEconomic and Monetary Union (EMU) in 1999, had entered intoan unsustainable dynamics in the long term. The appearance ofimportant macroeconomic imbalances among EMU members wastaking shape within the framework of steady growth, inflationunder control, very low interest rates and a very reduced risk assess-ment (partly as a result of the disappearance of currency risk) in thecontext of a world saving glut. Although the Eurozone as a wholepresents smaller aggregate imbalances in terms of deficit and pri-vate, public and foreign debt than, for instance, the US or theUnited Kingdom, the expectations of economic convergence16
    • The Future of the Euroamong Eurozone countries and the appearance of financial bubbleswith the promise of high yields, led to very significant capital flowsamong its members. This added to a spiralling increase in house-hold debt and businesses in some of the member countries, gene-rating very considerable and longstanding deficits in currentaccount balances. These expectations petered out sharply as of thesubprime crisis of 2007 and, since then, Europe has been experien-cing different surges of financial crises, economic crises and sove-reign debt crises, which have been following on and feeding offeach other over time.2 The result of this complex situation has beenthat, albeit with differences in the intensity and the severity of theproblems (see, for instance, Doménech and Jiménez, 2010), a sig-nificant number of European countries have experienced a situa-tion similar to that of the sudden stops experienced in the past bysome emerging economies, leaving public and private sectors heavilyindebted and, in some cases, extremely high rates of unemployment. The aim of this chapter is to analyse the changes required by theEMU and proposals with which to face such challenges with suc-cess. In order to understand what the problems are and, therefore,their possible solutions, in the second section we analyse the rea-sons why important imbalances accumulated in the developed eco-nomies and among the EMU countries during one of the most sta-ble periods of economic prosperity in the last decades (the GreatModeration), which nevertheless gave way to an unsustainable2 Shambaugh (2012) performs an excellent analysis of the interaction between fiscal,financial and economic crises in the Eurozone. 17
    • The future of the Euro after the Great Recessiongrowth pattern in many economies. In the third section, we offeran in-depth analysis of the magnitude and implications of suchimbalances throughout the crisis, which are well summarised in theExcessive Imbalance Procedure (EIP) recently implemented by theEU, as well as the current heterogeneity among EMU countries. Thefourth section analyses the challenges of improvement of economicgovernance of the EMU from a fiscal, financial and economic inte-gration standpoint, which shall determine its short and long termeconomic future. Lastly, the fifth section presents the main conclu-sions reached in this paper.2. From the Great Moderation to the Great Recession In the period between the mid-1990s and 2007, developed eco-nomies enjoyed one of the greatest economic growth periods,known as the Great Moderation due to the low volatility of growthrates in those years. Graph 1 shows evidence of this for the US andthe EMU in terms of GDP per person of employable age. As can beseen, from the mid-1990s to 2007 there was sustained growth, withlevels well above the historical trend estimated since 1970 for bothgeographical areas. In fact, the growth in GSP per person of emplo-yable age was slightly higher in the EMU than in the US, althoughnot enough to bridge the gap between both economies. The Great Moderation generated the perception that economiccycles would have less volatility, as a result of better managed eco-18
    • The Future of the Euronomic policy (see, for instance, Galí and Gambeti, 2009, or thereferences appearing in this article). In fact, these high growth rateswith low volatility came hand in hand with inflation under con-trol and low interest rates across the board of financial assets, withpractically inexistent risk premiums in many cases as a result of theunderassessment of the risk. In light thereof, some analysts went asfar as to proclaim the disappearance of the economic cycle and thecapacity to avoid significant economic recessions. It was the com-binations of these forces which fed the financial imbalances which,for economists like Rajan (2005) or Borio & White (2005), amongothers, are behind the crisis which began in 2007. There are various economic factors which contributed to genera-te this combination on which the Great Moderation was erected. Inthe first place, the central banks of the developed economies carriedout a low interest rate policy or money glut, as a result of: i) the dropin the inflation of sellable assets following the inrush of exportingcountries in the international economy with a very abundant andcheap workforce and depreciated currencies; ii) the benign neglectpolicy in regard to the high prices of financial and real estate assets(Bordo & Jeane, 2002, or Bean 2004 & 2010); and iii) the attempt toprevent the recession in the US, following the burst of the techno-logical bubble, or in Germany, following the costly process of reu-nification and the burst of its real estate bubble. Secondly a savings glut took place on a worldwide level inChina, Japan, Germany, oil producing countries or the pension 19
    • The future of the Euro after the Great Recessionfunds of developed economies. Thirdly, and as a response the savings glut in some countriesand sectors, a formidable increase took place in the demand of safeassets, moving from the pre-eminence of individual savers to thatof large sovereign funds, investment funds or pension funds whichprioritize safety over yield and which seek to channel savingstowards fixed income rather than towards the acquisition of anyother kind of asset. At the same time that the demand for safefinancial assets (i.e. AAA) increased, there was a relative scarcity ofsuch assets in the case of sovereign debt, due to the fiscal consoli- Chart 1 GDP per person of employable age in the US and in the EMU Source: OEDC (2012) Economic Outlook Database.20
    • The Future of the Eurodation taking place simultaneous in many developed economies asa result of the high growth in GDP. This surplus demand for safeassets created enormous pressure in the financial markets and incertain types of assets, which in turn led to the appearance of bub-bles in certain market segments. The pressure was such that finan-cial deregulation and engineering came to the rescue, enabling theresponse of the financial markets to this scarcity in AAA assets tobe the creation of multiple derivatives and the issue of huge volu-mes of asset backed securities, as shown in Graph 2. In turn, thisgenerated enormous liquidity to fund those assets acting as theunderlying assets (for example, mortgages on homes), thus crea- Chart 2 Issue of Asset backed Securities 1985-2011 Source: SIFMA 21
    • The future of the Euro after the Great Recessionting a circle in which asset demand stimulated supply, which inturn was fed back into the process by boosting demand with thecreation of new assets. As a result of this process, a specialization in asset productiontook place on an international level, leading to enormous hetero-geneity by country, sector and agents. Whereas some countriesgenerated a surplus in net savings, others (US, Spain or Ireland) res-ponded to the very low interest rate incentive by generating thereal investments which served as the underlying assets for finan-cial securities. The US produced assets on a world scale consideredsafe by the markets, thanks to the specialization of its financial ser-vices. Other countries, such as Spain and Ireland, carried out asimilar role, but on a European scale, producing assets backed bysafe collateral (homes) or with no collateral, but issued by financialinstitutions deemed to be safe, which attracted savings funds orlarge European banks. In fourth place, the creation of the EMU meant the disappearan-ce of exchange rate risk among its members. This removed an impor-tant barrier to capital flows within the EMU and encouraged the pre-viously described process. But its effects went even beyond the disap-pearance of currency risk. In the international financial markets, aswell as in the EMU countries, expectations that the greater monetaryand economic integration ensured the economic convergence of itsmembers were generated, which justified the disappearance of anytype of risk premiums (see Ehrmann et al, 2011).22
    • The Future of the Euro Graph 3 clearly shows the almost full disappearance of risk pre-miums for countries becoming part of the EMU. Without doubt,Greece was a paradigmatic example of this process, going from fun-ding at 25% in 1993 to do at the same interest rate as Germany, follo-wing its entry into the Eurozone. Chart 3 10 year public debt interest rates in the EMU, 1995-2011 Source: ECB, Bloomberg The implications of such expectations of economic convergencewere very important in terms of imbalances in the current balance.Under the assumption that a real and economic convergence pro-cess was taking place, well beyond the nominal, it seemed naturalthat capital should flow towards the economies with lower per capi- 23
    • The future of the Euro after the Great Recessionta incomes, as economic theory predicts (see, for example, Barro,Mankiw & Sala-i-Martin, 1995). In fact, as the risk premiums were disappearing, the correlationbetween the savings rated and investment rate were reduced. Aswas already anticipated by Blanchard and Giavazzi (2002), since1999 to the start of the crisis, the Feldstein-Horioka paradox disap-peared completely, as shown in Graph 4. Coinciding with thereduction in the typical deviation of risk premiums, which reached Chart 4 Typical deviation of risk premiums and correlation between the rate of investment and the rate of savings, EMU, 1993-2011 Source: Bloomberg24
    • The Future of the Euroalmost zero as of 1998, the correlation between the national invest-ment rate and the savings rate was observed to have been nil oreven negative, compared to the positive and statistically significantvalues of the beginning of the nineties. In fifth place, a permissive regulation, together with reducedinterest rates and very high competition in the financial sectorgenerated the incentives required for the generation of profit to bedone via transaction volume instead of via price margins (mainlyinterest rates), favouring a very important leveraging of broad seg-ments of the private sector. One of the results of this process wasthe intensification of a new banking business model, based on thegranting of collateral backed loans, the generation of financialassets from such loans and the distribution thereof as asset-backedsecurities in asset packages (originate to distribute) which transfe-rred credit risk in full to the purchasers of these new generatedassets. Compared with the traditional bank business, in whichfinancial institutions that grant the credits keep the risk on theirbalance sheets, this new business model led to greater intercon-nection of the balance sheets among financial institutions all overthe world and a significant increase in contagion risk.3. The imbalances in Europe and the EMU The financial crisis was preceded by a period of economic prospe-rity, measured by conventional indicators of growth, macroecono- 25
    • The future of the Euro after the Great Recessionmic stability and inflation, during which enormous imbalances of afinancial and competitive nature have been created. However, aglance of the macroeconomic picture of the EMU reflects a situationof balance which we do not find in other important economicregions of the world (Table 1). Both the deficit and public debt levelsand the net foreign positions and private indebtedness are generallylower to those recorded in the United States or the United Kingdom. However, the EMU has had other problems hanging over it whichhave led the economy of the region – and that of the whole of theEU by extension – to the situation of stagnation which it is currentlyundergoing. Some of these problems are of a structural nature, andothers are related to the extraordinary disparities between memberstates in their key indicators to which, until very recently, we hadpaid little attention. Among the first are demographic evolution andlow productivity growth which in turn have provoked a limited rateof growth in employment. But the disparities and the heterogeneitywithin the EMU are the most outstanding imbalances, as they callfor a serious amendment in the operation of the Euro, whose mainobjective was to accelerate convergence among countries who adop-ted the single currency along with other common institutions. The European Commission has recently implemented a pro-gramme to monitor a number of indicators to detect and trackmacroeconomic and financial imbalances in countries within theEU (the EIP). One of these indicators summarises, over all others,the nature of the main problem facing the European economy:26
    • The Future of the Eurothe gradual and persistent disparity in the current account of itsmember countries. Although the EMU and the EU are economieswhich can be described as economies which contribute (anddemand) little net savings to (and from) foreign savings, theiraggregate results is the sum of extremely disparate realities. AsLane (2010) points out, in 2010 European countries accounted forapproximately one third of all current account deficits and sur-pluses worldwide. As can be seen in Graph 5, the current accountdeficits and surpluses of the EMU have gradually polarised fromlevels ranging between the [-3%-, +3%] interval, in proportion tothe GDP to position itself outside of this range and even persis-tently above it by 5%. The underlying causes and macroeconomicimplications of this type of imbalance are extremely complex. Table 1 Debts and deficits in the EMU, US and United Kingdom (% GDP) EA17 US UK Budget balance of 2011 -4.4 -9.6 -8.9 public administrations Debt of public 2011 87.6 100.0 84.8 administrations Household debt 2010 67.3 92.1 106.1 Corporate debt 2010 119.1 74.6 123.7 Current account 2011 0.1 -3.1 -2.7 balance Net international 2010 -7.2 -17.0 -13.9 position Sources: AMECO, Haver, IMF, national sources and BBVA Research 27
    • The future of the Euro after the Great Recession It is true that this polarisation is not an exclusively Europeanphenomenon, as it happens in parallel with the so-called “globalimbalances” generated during the recent globalisation process.However, in contrast to what is happening on a world scale and par-ticularly in a series of developed countries (the Anglosphere) andemerging countries (particularly China) in Europe there is a positi-ve correlation between levels of income per capita and sales deficit,so that the capital flows from the more advanced countries to theless developed. This has rendered such imbalances less conspicuous,as they have been associated with the real convergence process. Thetraditional view considered foreign indebtedness as a natural con-sequence of the catching up process during which the countriesundergoing rapid growth required foreign savings to fund strongdomestic investment in commercial goods. Thus, the availability ofsavings and the Euro allowed for the funding of the productivityconvergence without financial and exchange rate strangulation.The international allocation of savings was deemed to be optimal(“consenting adults”, Obstfeld, 2012), and there was no reason forpublic political intervention – what became known as “benignneglect” by Blanchard and Giavazzi (2002) or Edwards (2002). It is not easy to determine an optimal level, or even an adequateone, for the current account deficit which already reflects the gapbetween domestic savings and investment in a country which isassumed to have been optimally determined by consumers and busi-nesses, unless it is associated with high public deficit, in which casewe would be dealing with a fiscal problem. Moreover, a country may28
    • The Future of the Eurohave a deficit current account without having a serious foreignfinancing problem, or may have it despite having a regularisedaccount, in this case because despite a reduced net capital flow, whatmatters in the event of a financial crisis is the size of the gross flows,as nothing guarantees that national savers are willing to funddomestic liabilities should the international markets become una-vailable. However, the evolution of the current account of EMU coun-tries (EU) reflects more deep-rooted problems where the adjustmentrole of the market mechanism has proven insufficient and in whichgross financial flows have grown in a fast and imbalanced way. Chart 5 Current account balance (% GDP) Source: BBVA Research with data from national sources 29
    • The future of the Euro after the Great Recession The deficits have not been linked with productivity convergen-ce, as is evident in the cases of Spain, Portugal and, to a certainextent, Ireland, which accumulated growing deficits despite theslow growth of total productivity of the factors. As can be seen inGraph 6, productivity grew by 1% on average, whereas the currentaccount balance varied between surpluses over 5% (theNetherlands and Germany) and deficits of 10% (as in Portugal andSpain). In fact, it has not only been the lure of investment butmainly the fall in savings in peripheral countries which has causedthe gap in commercial deficit which has exceeded both in volume– percentage of GDP – and in persistence, that observed in manyemerging countries prior to the crisis of the eighties and nineties.Moreover, much of the foreign financing to the receiving countrieshas not been channelled through direct and portfolio investment,but by way of bank bonds, which increases the risk of bank crisesand ‘sudden stops’ (Jaumotte and Sodsriwiboon, 2010; Land,2010). However, the most worrying characteristic of the unequal per-formance of the current account in Europe is its persistence. Farfrom being a transitory phenomenon, the divergence betweencommercial balances has sharpened until 2007 (see Graph 5). Thedesign of the Euro took into account that the absence of owncurrency would hinder the traditional adjustment to which mostcountries resorted in times of crisis in the balance of payments.The impossibility of this recourse to devaluation has not comehand in hand with the strengthening of real devaluation mecha-30
    • The Future of the Euronisms, that is, with a more flexible response by prices and salaries.Between 2000 and 2010, enough time has lapsed to have expectedthat the countries with most foreign debt and strong real apprecia-tions should have begun a process of correction towards a surplusin the commercial balance. Nevertheless, this has not been thecase. The correlation between the commercial deficit and the netforeign position was positive in 2011 and in 2010 (Graph 7) as ithad been in the last decade, indicating that the privatesavings/investment balance does not seem to respond to the cumu-lative net foreign position. Chart 6 Current Account Balance in 2007 (% of GDP) and average productivity growth bet- ween 2000 and 2009. Source: BBVA Research based on AMECO 31
    • The future of the Euro after the Great Recession In 2010 only four EMU countries had a net positive foreign posi-tion – Belgium, Germany, the Netherlands and Finland – and onlyFinland had managed it after correcting a very negative position in2001 (that is, after a decade of foreign rapid growth and surplus).Practically all other EMU countries saw their net indebtednessincrease substantially or, at best, such as in France or Austria, theymanaged a moderate reduction thereof within the first ten years ofthe single currency. Therefore, the performance of the current account is a very use-ful indicator – although naturally not infallible – of the way inwhich a country responds to the commercial and financial globa-lisation process and to the existence of other types of imbalancesassociated with private sector debt, both financial and non-finan-cial. Before reviewing these indicators for the EMU (EU), it is worthasking why the (market) adjustment mechanisms have failed inthis case and what the risk of this situation is happening again inthe future. The conventional current account approach indicates thatfinancial flows are a mere counterpart of commercial flows, so thatsustainability of foreign debt must be guaranteed by the expecta-tion of future current account surpluses or, what is the same, by asignificant proportion of the commercial goods production in theeconomy. Foreign financing is no at risk while foreign investorsconsider the economy to be competitive. The domestic economymust maintain a high productivity growth rate and competitive32
    • The Future of the Eurolabour costs, as the opposite would render the foreign deficitunsustainable, foreign investment would drop, reducing prices andsalaries and improving the foreign balance. In this way, given rea-sonable elasticity in the demand of exports and imports, theperiods of real appreciation and foreign deficit can be reversed wit-hout deep structural changes. However, this market mechanism has not worked in peripheralEurope. Foreign funding has been used to a large extent to fund Chart 7 Current account balance and net international position Source: BBVA Research based on Eurostat 33
    • The future of the Euro after the Great Recessionnon-commercial goods, leading to strong expansion of demand, ofprices and of labour costs (see Graph 8). Despite the loss of com-petitive capacity, the appeal for foreign lenders continues providedthe value of the asset with real guarantees – such as homes – con-tinues, which is perceived as relatively safe. Thus, the worseningcompetitiveness is the effect and not only the cause for the dete-rioration of the current account. But the existence of high com-mercial deficit is not corrected of its own accord nor is it done in asmooth and orderly manner. When the bubble bursts and prices ofthe assets used as guarantees plummet, foreign investors perceivethat the national economy is no longer able to guarantee theirdebt, leading to the well-known processes of flight to quality,increase in the cost of debt and, in extreme cases, to sudden stops. This integration process has led to a number of other imbalan-ces in the European economies. The objective of the EIP is to gobeyond the control of deficit and debt, and to follow a number ofeconomic indicators which enable the detection of inadequatemacroeconomic development in a country and can lead to locali-sed financial crises and even contagion in the future. Such indi-cators come hand in hand with a number of ‘limits’ that are con-sidered to be security measures which, when exceeded by acountry, special tracking must be carried out by the Commission.If an economy is showing imbalance in several of these indicators,it must propose a plan of action for correction thereof which, ifnot suitably applied, might result in some form of political or eco-nomic penalty. The list of indicators is the following (the limits34
    • The Future of the Euroabove which a form of relevant imbalance is detected appear inbrackets): current account balance (% GDP, -4%, 6%); net inter-national position (% GDP, -35%); real effective exchange rate(variation rate, -5%, 5%); export market share (growth rate, -6%);nominal unitary labour cost (growth rate, 9%); cost of housing(growth rate, 6%); credit flow to private sector (% GDP, 15%); pri-vate sector debt (% GDP, 1605); public debt (% GDP, 60%); andunemployment rate (10%). Chart 8 Growth of nominal salaries and real productivity Source: BBVA Research based on Eurostat 35
    • The future of the Euro after the Great Recession The first report issued on the monitoring of these indicators shows that in the third year since the start of the crisis (2010), the imbalances accumulated in recent years are far from being correc- ted, some of them having worsened since 2007 (Table 2). Greece, Portugal, Ireland and Spain are the countries with worse qualitati- ve results. They belong to the Eurozone periphery, where they fail in at least five of the ten criteria.3 It is within the framework of such imbalances that we must interpret the fiscal crisis that has been reflected in the general growth of risk premiums of sovereign debt in Europe, especially in peripheral countries – although not exclusively. The levels of public debt in the EMU are comparable to those in the rest of the develo- ped world, both if we consider the region as a whole or the coun- tries within it separately. As is shown in Graph 6, only in 2008 three EMU countries (Greece, Italy and Belgium) had a public debt above that of the US and in any case much lower than that of Japan. The growth in public debt during the crisis period places EMU countries – with the exception of Greece and Ireland – in the realm of 20%, similar to what had happened in most of the deve- loped countries. Therefore, behind the sovereign debt crisis there are issues related to the economic governance of the EU in general and the Eurozone in particular. But also, deeper reasons which have3 The situation is worse if we take into account that indicators such as the growth rateof housing prices and credit for the private sector are nowadays within the limits accep-ted by the MIP as a result of the extraordinary restriction on credit suffered by most EUeconomies. 36
    • The Future of the Eurobecome evident following the segmentation of the financial mar-kets due to the crisis. On the one hand, we have the demographicand structural characteristics of most of the countries, whichherald for the future a scenario of lesser growth than that beforethe crisis. Graph 9 shows the growth rates up to 2007 and the fore-casts made by the IMF up to 2015 for EMU countries, the UnitedKingdom, Japan, and the US. The aging population and its effects on participation in thelabour market, the low savings rates – with the ensuing difficultiesin funding investments – and the slow rate of productivity growthexplain such expectations, which in turn severely affect the capa-city to absorb the strong increase in public indebtedness. In second place, the economic crisis itself has generated anadditional burden on public finances by way of contingent liabili-ties, the realisation of which shall depend on the performance ofthe private debt and the need to apply measures to assist in thereconversion of the financial sector. As stated by Reinhart & Rogoff(2008 and 2009), one of the main consequences of financial crisesis that a large part of the private sector debt becomes public. Table3 (ECB, 2012) shows the impact on public finances of the twomain contingent-type averages within the EMU: provisions for theEuropean Financial Stability Facility (EFSF) and the guarantees forthe banking sector. The sum of both would mean an additionalimpact on the public debt in the EMU of almost 13% of the GDP.It is true that such contingencies do not necessarily have to mate- 37
    • 38 Table 2 Imbalances at the EMU Source: European Commission (2012): First Alert Mechanism Report (moving averages, 3 or 5 years) The future of the Euro after the Great Recession
    • The Future of the Eurorialise, but it is also true that provisions have proven insufficientand have had to be extended in successive programmes. Chart 9 GDP Growth in 2007 and 2015 Source: IMF (2012) Lastly, the aging of the population gives way to the generationof implicit liabilities which are not considered in public debt figu-res but should be taken into consideration when evaluating thesustainability of public finances (Cecchetti, Mohanty andZampolli, 2010). In 2009 the IMF (IMF, 2009) calculated the sum ofimplicit and contingent liabilities in securities exceed – in presentvalue – 400% of the average GDP of the G20. Of these, those of acontingent nature associated with the crisis account for approxi- 39
    • The future of the Euro after the Great Recessionmately one tenth, whereas that associated with an aging popula-tion – pensions and social security – account for much higherimplicit obligations. As a whole, this type of liability will demanda remarkable effort from public finances in the future. Cecchetti,Mohanty and Zampolli (2010) place the additional permanentfinancing required to meet such obligations at between 5 and 10GDP points assuming a public debt at levels similar to the currentones in developed countries. In summary, some European economies may have reached debtlevels which exceed or are dangerously close to their fiscal limits,defined as the maximum level of debt which a country is able tofund. The fiscal limit depends on the political will of its citizensand the capacity to increase income by means of tax rate rises (Bi,2012 and Leeper & Walker 2011) which makes it specific to eachcountry. This might explain, at least in part, the differences obser-ved in risk premiums between countries with similar levels of debtor even that some countries pay a higher cost of financing thatothers with much higher levels of debt. Moreover, the relationshipbetween the risk premium and the fiscal limit is non-linear, incre-asing rapidly when fiscal performance places debt at such levelsthat the likelihood of reaching the limit is significant (Bi, 2012).That is to say, in order to observe significant risk premiums, it isenough for investors to understand that the fiscal strategy of acountry leads it to a fair likelihood of reaching the maximum levelof debt financed, even if the probability of this taking place in theshort term is very small. This probability in turn grows over the40
    • The Future of the Euroeconomic cycle, which obliges countries with greater volatility ineconomic activity and unemployment to opt for stricter fiscalrules.4 Table 3 Contingent Obligations of the governments 2008-2010 Banking sector EFSF guarantees Belgium 7,3 12,7 Germany 8,22 3 Estonia 12,46 0 Ireland 42,8 Greece 25,8 Spain 8,61 6,2 France 7,97 3,1 Italy 8,78 2,7 Cyprus 8,78 15,7 Luxembourg 4,66 3,2 Malta 10,91 0 The Netherlands 7,32 6,1 Austria 7,19 5,7 Portugal 9 Slovenia 10,23 4,4 Slovakia 11,05 0 Finland 7,34 0 EMU 7,71 5,2 Source: BCE4 When the economies reach this limit, the efficacy of the fiscal and monetary policyis substantially reduced and both instruments no longer have the expected effects oneconomic activity. The fiscal multipliers are reduced and the monetary authority losesthe capacity to control inflation, irrespective of the aggressiveness of its monetarypolicy. 41
    • The future of the Euro after the Great Recession4. The new European governance and the future of the Euro The economic crisis has highlighted the need to carry outimportant changes in European governance. It is obvious thatthere have been failures in coordination in the economic policyand mistakes in the policies adopted by national government,which have generated a sovereign debt crisis and a financial crisis.And it is also obvious that Europe was not first resorting to thesupranational institutions and bodies to prevent the crisis and toprovide a rapid and efficient response once it had begun. The EU,and particularly the EMU, need to improve their economic gover-nance in at least three areas: fiscal, financial and economic inte-gration. Below we shall analyse each of these aspects and the cha-llenges faced in each by the EMU.4.1. Changes in fiscal governance In regard to fiscal integration, over recent months importantinroads have been made, among which are the Stability,Coordination and Governance Treaty and the creation of theEuropean Stability Mechanism (ESM). The new Treaty, which shallcome into force on 1 January 2013, has been signed by all EU coun-tries except for the United Kingdom and the Czech Republic, andaims to make public finances sustainable and prevent the onset ofexcessive public deficits, in order to safeguard the stability of theEurozone as a whole. In fact, this Treaty can be interpreted as asecond version of the Maastricht Treaty of 1992, with the differen-42
    • The Future of the Euroce that whereas the former determined the conditions to enter theEMU, the new treaty can be said to detail the conditions to be metby the members of the EMU to continue to belong to the Eurozone.To this end, the Treaty introduces specific rules (the structural defi-cit may not exceed 0.5% of the GDP, as of a date to be determinedby the European Commission, and a public debt below 60% ofGDP) and automatic mechanisms which enable the adoption ofcorrective actions in the event of deviation from targets. The rules introduced by the Treaty are in general well designed.When establishing an objective in terms of structural fiscal balance itallows for the influence of automatic stabilisers, the minimum beingbetween 0.5% of structural deficit and the deficit limit of 3%.However, a good design does not necessarily guarantee a good imple-mentation, as was the case with the Stability and Growth Pact (SGP).It is true that the new Treaty entails a criterion of “reverse majority”:from now on the adoption of corrective or disciplinary mechanismsproposed by the European Commission must be rejected by a majo-rity, whereas in the SGP the majority needed to be reached in orderto approve such proposals. It is also the experience of the current debtcrisis has led to an accumulation of collective knowledge which shallprove very useful when adopting the right decisions in the future toprevent new crises of this kind. Just as eighty years later the FederalReserve is currently preventing some of the well-known mistakeswhich were made during the Great Depression of the 1930s, theEuropean Commission and the European Council shall endeavour toprevent imbalances similar to those we are currently undergoing. 43
    • The future of the Euro after the Great Recession Available empirical and theoretical literature (see, for instance,Andrés & Doménech, 2006, and the references included in thispaper), indicates that use of fiscal rules has proven useful in thecontainment of public debt and the deficit, without the effective-ness of the automatic stabilisers adversely affecting the effective-ness of the discretionary fiscal policies. Therefore, the fiscal ruleslike those included in the Stability Treaty do not have to be animpediment for the fiscal policy to carry out its duty of stabilisa-tion of economic cycles. Quite the opposite: when the economicagents know, that as a consequence of the existence of such rules,expansive fiscal policies in the short term shall be offset in themedium term by counter-adjustment measures in order to preventthe accumulation of public debt, the effectiveness of these discre-tionary stabilisation policies increases, as has been proven byCorsetti, Meier and Müller (2011). In any event, it shall be very difficult to achieve an optimalimplementation of the Treaty. In the first place, because all govern-ments are often too complacent when allocating probabilities topossible risk scenarios which may render public finances unsustai-nable. Secondly, because it is difficult that sanctions may comeabout from the European Union Court of Justice on the basis of fai-lure to meet the structural deficit targets, which depend of estima-tes of the cyclical position of the economies and the elasticity ofpublic income and expenses to this cyclical position. Nevertheless,what the Stability Treaty does provide is that, prior to reachingsanctions, the Commission may exert much greater pressure on44
    • The Future of the Euronational governments and alert markets about excessive imbalan-ces, so that it is the markets themselves that impose discipline viahigher interest rates. As for the ESM, at the ECOFIN on 30 March the decision wastaken to extend it to 500 thousand million euros, which shall beprovided over two years, and beginning on 1 July 2012. The extentto which this fund will be sufficient is still unknown, in that itshall depend on how it is used and whether it allows for fund leve-raging. Without leveraging, the fund shall only be enough to coverthe financing needs of small or medium sized economies in theEMU, but not of the big four. However, it may prove effective forspecific, selective but highly intensive interventions designed toreduce risk premiums, that is, to replace the ECB in its SecuritiesMarket Programme (SMP). In addition, if the ESM should obtainliquidity from the ECB itself, each of these entities might be able toseparately specialise in the management of a risk: the SMP wouldmanage the ‘solvency risk’ of sovereign debt and the ECB wouldmanaged the ‘liquidity risk’, thus enabling the central bank to resu-me the natural role for which it was created, as it would be creatingan EU fund, with a joint and several guarantee, instead of sove-reign debt with a national guarantee. It is very important that the intervention of the SMP is as effi-cient as possible. To this end, the Commission must be clear aboutwhich countries are solvent, with adoption of any necessary adjust-ment measures and structural reforms, and which countries need 45
    • The future of the Euro after the Great Recessionsome kind of debt restructuring. In the first case, which is clearlyapplicable to countries such as Spain and Italy, SMP interventionon risk premiums should be as intense as necessary until marketdoubt and uncertainty have been obliterated. It would otherwisebe very difficult to convince sovereign, pension or investmentfunds to purchase the public debt of such countries if Europe is notthe first to refrain from doing so. Obviously, a more decisive intervention by the SMP, whichwould lead to a rapid relaxation of the European sovereign debtmarkets, requires the adoption and follow-up of the necessaryadjustments and reforms, but with sufficient time frame so as notto asphyxiate the economic growth of the countries adopting suchpolicies. Specifically, the EU could change the fiscal consolidationstrategy which is currently being demanded from member states.The obsession for nominal deficit targets should be replaced by amore plausible, rigorous multi-annual fiscal policy strategy which,in seeking to prevent a spiralling negative growth, truly contribu-tes towards supporting sustainability in the long term of the publicfinances of all countries. Specifically, the European consolidationstrategy should be based on the following principles:1. Deficit reduction targets should refer to structural deficit inste- ad of nominal deficit, as proposed by the new Stability Treaty. This implies that countries should be asked to take specific and detailed measures to ensure a certain amount ex ante in terms of reduction in expenditure or increase in income in the46
    • The Future of the Euro coming years. If, as a result of such measures, the economic activity should be adversely affect with an impact on nominal deficit (by the mere intervention of the automatic stabilisers), the member states should not be obliged to take new savings measures in that same financial year.2. The pace of structural consolidation should be ambitious enough to ensure sustainability in the medium to long term of public finances, and gradual enough to prevent excessively adverse effects on activity and employment in the short term.3. The long term balance of public finances requires reforms which guarantee the sustainability of public systems of pen- sions and social protection. Blanchard (2011) recently recommended that, in order to return toprudent levels of public debt, it would be advisable to apply the pro-verb of “slow and steady wins the race”. A similar recommendation tothat of De Long and Summers (2012), for whom a fiscal consolidationwhich is too intense and too fast might endanger the very sustainabi-lity of public finances instead of guaranteeing it. In regard to the debate on Eurobonds, although not necessaryor sufficient, these can indeed become a useful tool in the con-text of streamlined national finances. They are not necessary, asthe Eurozone can operate without them, if the Stability Treatyand the mechanism for the prevention and correction of excessi- 47
    • The future of the Euro after the Great Recession ve imbalances work properly. And they are not sufficient to pre- vent debt crises if the fiscal or current account imbalances are not corrected. If growth is imbalanced (private indebtedness, current account balance deficit), they imply a permanent transfer of income from one country to another, which is unsustainable in the long term. But they are convenient as an efficient mechanism to ensure and pool risks in the face of asymmetric shocks and, above all, as an element of political legitimacy of the European project: European citizens must see that there are specific bene- fits to belonging to the EMU. And Eurobonds are one of these benefits, particularly now when many countries need to make considerable sacrifices and carry out adjustments and reforms. In this regard, the Eurobond proposal (blue and red) of Delpla and von Weizsäcker (2010), has the advantage that it would allow countries to benefit from risk pooling and the creation of a more liquid asset (the blue bond) than that of the debt of each of the EMU members, which would strengthen the euro as an internatio- nal reserve currency, but with the benefit of preserving market dis- cipline for national debt issued over and above 60% of GDP (red bonds).5 This proposal consists of the EMU countries pooling their5 Attinasi, Checherita and Nickel (2009) believe that this market discipline is behindthe increase in sovereign spreads between 2007 and 2009, as a result of the increase inrisk aversion and the concern for the sustainability of public finances. However, Faveroand Misale (2012) believe that this market discipline acts in an interrupted fashion overtime and, occasionally, in an exaggerated way, which in fact justifies the issue of euro-bonds. 48
    • The Future of the Europublic debt up to 60% of their GDP as senior debt under the jointand several responsibility of all members, whereas the issue ofnational debt beyond such a limit would be junior debt under indi-vidual responsibility. From this perspective, it is easy to concludethat the decision of the European Council reached in December2010 to ensure the solvency of the debt issued until June 2013, butnot that issued as of that date was a mistake, as the decision shouldhave been the opposite: ensure as of a given date all debt issuedunder 60%, which would in effective terms be equal to the creationof the Eurobonds proposed by Delpla and von Weizsäcker (2010).4.2. Financial integration As Pisany-Ferri and Sapir (2010) have pointed out, to date theEMU has worked without a European institution able to rescuetransnational financial entities and without authentic Europeanstress tests for its banking institutions. Oversight duties haveremained with national authorities and coordination problemshave been managed by means of a combination of discretionarycooperation and dependence on rules approved by the EU. One of the lessons to be learned from the current crisis is thatit is difficult to manage a financial crisis on a European scale wit-hout supranational regulators, supervisors and insurance mecha-nisms. A large part of the head start that the US has over Europein terms of crisis management and resolution is precisely due tothe non-existence or the delay in creating such bodies. The US has 49
    • The future of the Euro after the Great Recessionfederal institutions to manage banking crises, whereas Europedoes not, which renders true the saying that banks are internatio-nal when expanding and national upon demise. The problem isthat, for some governments (Ireland is a perfect example of this),banks are too large in relation to their public budgets. Likewise, the US has a federal regulation, whereas Europe hasenormous national dispersion of its regulations, despite theefforts of the European Commission and regulators to homoge-nise and converge towards a common financial regulation.Occasionally, headways made in certain rules give rise to inequa-lities among the agents who intervene in the markets, due toother rules continuing to be different. This was the case, for ins-tance, of the requirement of the European Banking Authoritythat potentially systemic banks must exceed a capital ratio of 9%before 30 June 2012, when the measurement of risk weightedassets is regulated by different rules. Banking oversight in Europe is furthermore carried out vianational supervisors instead of via a single European institution,which introduces heterogeneity in oversight levels of the financialsystem. The result of this financial fragmentation is that one can-not speak of a single market, which generates the possibility ofregulatory arbitrage, different conditions of competency, ineffi-ciencies and, in general, a disadvantage in regard to other worldfinancial areas.50
    • The Future of the Euro In summary, financial integration requires an improvement to bemade in the mechanisms through which information is shared onthe financial systems of each country and the way in which theiractivities are supervised, the harmonisation of the guarantees onbank deposits and of consumer protection regulations, the creationof European bank restructuring and rescue mechanisms, and theadvancement towards a Single Market not with more, but with a bet-ter, European regulation which, instead of adding to and prevailingover national legislation, should simplify and replace it.4.3. Economic integration With greater fiscal and financial integration the Eurozone couldoperate with less tension in the future, without ensuring the economicconvergence among countries. Is convergence of income or welfarelevels in European countries necessary? Probably not, but it is still con-venient, as has been stated earlier, to enable societies to believe thatbeing within an economic and monetary union has advantages wellbeyond those which are provided by monetary stability. One of les-sons to be learned from the Eurozone crisis is precisely that monetaryintegration does not ensure economic convergence, as this requires anadvancement in convergence of the determining factors (economic,social and institutional) of economic growth. Table 4 shows that the differences in medium and long termdeterminants of per capita income are very significant. The relati-ve position of each country has been obtained on the basis of the 51
    • The future of the Euro after the Great RecessionIMF analysis (2010), whereas the allocation of each country to oneof three groups under consideration has been carried out on thebasis of the criteria put forward by Hall and Soskice (2001). On thebasis of a number of criteria, both institutional and based on theworkings of economic relations, Hall and Soskice classify the varie-ties of capitalism into liberal economies (the US being the pro-totype) and coordinated economics (Scandinavian countries arethe paradigm). In both models (either with high or minimumcoordination), the economies can function efficiently. Market eco-nomies which cannot be classified into either group are classifiedas mixed economies. In order to transform the qualitative IMF indicator into a quan-titative one, such as analysing its correlation with per capita inco-me, values of 1 to 3 have been allocated for each of the three levelsconsidered by the IMF, where a higher score suggests a greater needfor implementing structural reforms. This enables the obtention ofan average for each country and for each of the nine indicatorswhich are shown in Table 4. The differences shown in this table arevery marked, not only between developed economies, but also bet-ween European ones. In light of this evidence it is not surprisingthat, except in the case of Ireland, the countries which have accu-mulated the most imbalances and which are suffering more formthe tensions in the debt market are precisely those which showngreater structural weaknesses and the ones which must implementthe most reforms. Countries which in turn have been classified asmixed market economies, presenting more inefficient institutions.52
    • Table 4 Structural capacity of the developed economies Source: BBVA Research (2010) based on IMF (2010) and Hall & Soskice (2010)53 The Future of the Euro
    • The future of the Euro after the Great Recession The changes in the regulations which affect the operation of thelabour, goods and services markets, trade, telecommunicationsmarkets, are easier to implement in the short term, although thechanges thereof are felt in the medium term. An example of thiscan be found in the recent reform of the labour market in Spain,which is bringing its operation in line with that of countries likeGermany (in terms of internal flexibility mechanisms) or to that offree market economies (by prioritising company agreements andopt out clauses for collective bargaining agreements). Makingheadway in these types of reforms (for example, linking salaries toproductivity) is crucial to remove the differences in competitive-ness which exist between EMU countries, particularly bearing inmind that the crisis may have had an effect on the potentialgrowth of these economies (see, for example, the EuropeanCommission analysis, 2009). However, in long term indicators such changes can take a lotlonger and, in some cases, even decades. This is the case withhuman capital. Even in the event that the many younger workersof countries such as Spain, Italy, Greece or Portugal should enterinto the labour market with the same human capital as in betterplaced countries, 25 years would be needed to half the distance forthe whole of the population of employable age.54
    • The Future of the Euro5.Conclusions The economic crisis has highlighted the excessive complacencyof the markets, agents, supranational institutions and governmentswhen interpreting the imbalances which were being generated inthe previous expansion period and the absence of supranationalinstitutions and mechanisms, firstly to prevent the imbalanceswhich led to the crisis and secondly, to provide a fast and efficientresponse once they had happened. Such institutions and mecha-nisms are necessary because the evidence shows that the marketsreact in a discontinuous way, and occasionally in an exaggeratedway, are pro-cyclical and do not generate of their own accord suf-ficient disciplinary mechanisms in the short and medium termwhenever these are needed. Insofar as the current Eurozone crisishas taken place mainly in three areas (debt crisis, banking crisisand crisis in growth and competitiveness, with huge heterogeneitybetween countries), the EU and, particularly the EMU, need toimprove their economic governance in at least three areas: the fis-cal, the financial and that of economic integration. As for the improvement in fiscal governance, the Treaty ofStability, Coordination and Governance needs to be effectivelyapplies in a preventive way and that, during its transition towardsmedium and long term structural deficit targets, this is done withsufficient rigor and the right flexibility to prevent that countriesrequired to make the most efforts in the short term should enterinto a negative growth spiral. In this regard, intervention by the 55
    • The future of the Euro after the Great RecessionESM on risk premiums should be as intense as necessary untilmarket doubts and uncertainty have been removed, so that thecountries which are implementing fiscal adjustments and structu-ral reforms have a sufficiently broad time period to enable suchmeasures to have positive effects on economic growth. As for theEurobonds, although they are not necessary or sufficient to ensu-re the operation of the EMU, they are indeed convenient as anefficient mechanism providing assurance and pooling risk in theface of asymmetrical shocks and, above all, as a political legiti-macy item in the European project: European citizens must disco-ver that there are specific benefits to being part of the EMU.Although it is difficult for such Eurobonds to become a viable ins-trument in the current situation of divergence, they must becomean essential part of the future European Treasury when the mainimbalances are well under way to being corrected through thedecisive application of the reforms in the various countries in theEU. The second area where headway must be made is that of finan-cial integration, in order to prevent future banking crises and tomanage them in a more efficient and rapid way. Europe must havesupranational financial institutions, regulators and supervisors, asthe current financial fragmentation prevents us from speaking of asingle market. An important limitation which gives rise the regu-latory arbitrage, different competency conditions, inefficienciesand, in general, a disadvantage in regard to other world financialareas competing against the European entities.56
    • The Future of the Euro Lastly, although greater fiscal and financial integration may suf-fice to enable the Eurozone to operate with less tension in the futu-re, it is worth establishing the bases for greater economic conver-gence among its members, in order to increase the political legiti-macy of the economic and monetary union project, with benefitswhich go beyond those provided by economic stability. The diffe-rences between the EMU countries in the workings of factor, goodsand services markets are very significant, as well as in long termgrowth determinants. The structural reforms undertaken to enablethe markets to work more efficiently can bring positive effects in arelatively reasonable period of time, enabling competitiveness toimprove and the imbalances accumulated during the expansionand the crisis to disappear more rapidly. In this regard, it is essen-tial to ensure the success of the Excessive Imbalances Procedureand other imbalance monitoring mechanisms, ensuring a moreefficient preventive and corrective action than that provided bythe Stability and Growth Pact. However, in terms of long termgrowth determinants, such changes can take longer and, in somecases, even decades; it shall therefore be necessary for Europe toboost the solidarity mechanisms required to accelerate this conver-gence process in a more effective and efficient way than that donein the past. To simultaneous progress on all these fronts, both at suprana-tional and national levels, is a necessary condition for the Euro toovercome this crisis and for its members to continue to form partof this project in the future. Insofar as the starting point is very 57
    • The future of the Euro after the Great Recessiondifferent in each country, the main challenge now facing theEMU is to combine in a fair way the rigor and the ambition of theadjustments and structural reforms, on the one hand, with anappropriate time frame and solidarity with all other members ofthe Eurozone, on the other. If, on the contrary, the member states should fail to show suchdetermination, any attempt towards European economic gover-nance will be due more an intention than a hard reality. TheEurozone would have an uncertain future. The alternative of aPolitical European Union, in which all necessary economic policiescould be implemented from a community Executive under thecontrol of a European Parliament and with all democratic rights, iscurrently not expected for the time being.Bibliography- Attinasi M. G., C. Checherita y C. Nickel (2009): “What Explainsthe Surge in Eurozone Sovereign Spreads during the Financial Crisisof 2007-09?”, ECB Working Paper no. 1131/2009.- Barro, R. J., N. G. Mankiw y X. Sala-i-Martin (1995): “CapitalMobility in Neoclassical Models of Growth”. The AmericanEconomic Review, 85(1), 103-115.58
    • The Future of the Euro- BBVA Research (2010): Spain Economic Watch. Noviembre.- Bean, Ch. (2004): “Asset Prices, Financial Instability, andMonetary Policy”. The American Economic Review, 94(2), 14-18.- Bean, Ch. (2010): “The Great Moderation, the Great Panic andthe Great Contraction”.- Bi, H. (2012): “Sovereign Default Risk Premia, Fiscal Limits, andFiscal Policy”. European Economic Review, 56 (2012) 389–410.- Blanchard, O. y F. Giavazzi (2002): “Current account deficits inthe euro area: the end of the Feldstein-Horioka puzzle?” BrookingsPapers on Economic Activity, 147-186.- Blanchard, O. (2011): “Blanchard on 2011’s Four Hard Truths”.Vox EU.- Bordo, M. y O. Jeanne (2002): “Monetary Policy and Asset Prices:Does Benign Neglect Make Sense?” International Finance, 5(2), 139-64.- Borio, C. y W. White (2004): “Whiter monetary and financial sta-bility? the implicatios of evolving policy regimes”. BIS WorkingPapers No 147. 59
    • The future of the Euro after the Great Recession- Cecchetti, S., M. Mohanty y F. Zampolli (2010): “The Future ofPublic Debt: Prospects and Implications”. BIS Working Paper No.300.- Comisión Europea (2009): "Impact of the Current Economic andFinancial Crisis on Potential Output". European EconomyOccasional Papers, 49.- Comisión Europea (2012): First Alert Mechanism Report.- Corsetti, G., A. Meier y G. J. Müller (2011): “Fiscal stimulus withspending reversals“. The Review of Economics and Statistics (en prensa).- DeLong, J. B. and L. H. Summers (2012): “Fiscal Policy in aDepressed Economy”. Mimeo.- Delpla, J. y J. von Weizsäcker (2010): “The Blue Bond Proposal”.Bruegel Policy Brief.- Doménech, R. y M. Jiménez (2010): ”La Primera Gran Crisis de laUnión Económica y Monetaria”, Pensamiento Iberoamericano, 6, 49-80.- Edwards, S., 2002. "Does the Current Account Matter?," enSebastian Edwards y Jeffrey A. Frankel, eds, Preventing CurrencyCrises in Emerging Markets, pages 21-76 NBER.60
    • The Future of the Euro- Ehrmann, M., M. Fratzscher, R.S. Gurkaynak y E.T. Swanson(2011). ‘Convergence and Anchoring of the Yield Curves in theEuro Area’, The Review of Economics and Statistics, 93(1), 350–64.- Favero, C. y A. Missale (2012): “Sovereign Spreads in theEurozone: Which Prospects for a Eurobond?” Economic Policy,27(70), 231–273.- FMI (2010), “Regional Economic Outlook. Europe”.- Galí, J. y L. Gambetti (2009): "On the Sources of the GreatModeration." American Economic Journal: Macroeconomics, 1(1):26–57.- Hall, Peter A. y David Soskice, 2001a: An Introduction to Varietiesof Capitalism. In: Peter A. Hall y David Soskice (eds.), Varieties ofCapitalism: The Institutional Foundations of Comparative Advantage.Oxford: Oxford University Press, 1–70.- Florence J. y P. Sodsriwiboon (2010): “Current AccountImbalances in the Southern Euro Area”. WP/10/139. IMF.- Lane, P. (2010): A European Perspective on External Imbalances.Swedish Institue for European Policy Studies. Report nº 5.- Leeper, E. M. y T. B. Walker (2011): “Fiscal Limits in AdvancedEconomies”. Working Paper 16819. NBER. 61
    • The future of the Euro after the Great Recession- Obstfeld, M. (2012): “Does The Current Account Still Matter?”Working Paper 17877. NBER.- Pisani-Ferry, J. y A. Sapir (2010): "Banking crisis management inthe EU: an early assessment". Economic Policy, 341-373.- Rojan, R. (2005): “Has Financial Development Made The WorldRiskier?”. NBER WP 11728.- Reinhart, C. M. y K. Rogoff (2008): “Is the 2007 US Sub-PrimeFinancial Crisis So Different? An International HistoricalComparison”. American Economic Review, 98(2), 339–344.- Reinhart, C. M. y K. Rogoff (2009): This Time is Different: EightCenturies of Financial Folly. Princeton University Press.- Shambaugh, J. C. (2012): “The Euro’s Three Crises”. BrookingsPapers on Economic Activity (de próxima publicación).62
    • /JOSÉ CARLOS DÍEZ * / Nature and Causes of the Euro crisisSummary; 1. Introduction; 2. Historical background of the Euro; 3. Natureof the Euro crisis; 4. Fixed versus flexible exchange rates: a review; 5. Causesof the Euro Crisis; 6. Conclusions; BibliographySummary This work analyses the Euro crisis. It includes a review of its his-torical background and the exchange rate theory to provide con-ceptual arguments to help understand the nature and causes the-reof. It is an infrequent pathology in economics, particularly indeveloped countries, but with an enormous destructive capacity.* José Carlos Díez is an economist who has combined his academic and corporate rolesthroughout his professional career. His academic activity is linked to the University ofAlcalá, where he was an undergraduate and PhD student and now is Professor ofFundamentals of Economic Analysis.He is currently the Chief Economist at Intermoney, a company founded in 1979 andleader in Spain in money market brokerage. He contributes with his forecasts to thepanel of experts of the ECB on European economy and the panel of FUNCAS on theSpanish economy, and advises companies, financial entities and institutions both natio-nal and international. 63
    • Nature and Causes of the Euro crisisFor this reason, it is important to get the right diagnosis when defi-ning the economic policy that will solve the crisis. The main cau-ses analysed herein are financial integration, the under-assessmentof risks, local imbalances within the Eurozone and the GreatRecession.1. Introduction The world financial crisis, whose first symptom was the collap-se of the subprime asset-backed securities market at the start of2007, has been changing. It is currently focused on Europe, and iscalling into question the future viability of the Euro and theEuropean project itself. This work aims to classify the nature of theEuro Crisis and to identify the main causes thereof. Although theobjective is not to analyse potential economic measures designedto solve the crisis, without an accurate diagnosis of the origin anddynamics of the crisis, finding the right solution would be an exer-cise in chance. To this end, section 2 includes the history of the European pro-ject and the single currency. Section 3 describes the nature of thecrisis, which is a seldom seen pathology in economics but whichcauses devastating damage to unemployment and public debt ofaffected countries. In order to provide the conceptual argumentsrequired to analyse the crisis, section 4 contains a review of the lite-rature on exchange rates. Section 5 analyses the main causes of thecrisis, which are: i) financial integration and under-assessment of64
    • The Future of the Eurorisk; ii) local imbalances; and iii) the Great Recession. Finally, sec-tion 6 includes the main conclusions reached in the article andestablishes the requirements to be met by the roadmap in order toput an end to the Euro Crisis.2. Historical Background of the Euro The Euro is the first monetary experiment of the 21st century. Itis not the first in history and shall not be the last, but it affects aneconomy like that of the Eurozone which accounts for 15% of theGDP and for 40% of world exports. The European Union is a poli-tical project designed to prevent a third world war in Europe. Thefirst assignment of sovereignty was control by a supranationalbody of the coal and steel production in France and Germany, basicraw materials to produce weaponry. Europe was not an optimalmonetary area; therefore, if a country suffered from an asymmetri-cal disturbance which did not affect the rest and it saw the effectsthereof on tis unemployment rate, this could not be offset by wor-kers migrating to other countries with lower unemployment rates.The bubble in Spain is a good example of this. Spain created onethird of the jobs in the Eurozone during the boom years, but wor-kers from Germany, where the unemployment rate was reachinghistorical levels, did not come: instead, it was workers from outsi-de the Eurozone who came. When the bubble burst, our unem-ployment rate shot up, but very few Spanish workers have gone towork in Germany. 65
    • Nature and Causes of the Euro crisis The example of an optimal monetary area is always the US.However, we tend to forget that in order to get there; they firsthad to annihilate the original settlers and then have a civil warwhich led to a default on payment of foreign debt. The Europeanproject belongs to the 21st century and when in Asia, America orAfrica integration processes begin, they look to Europe for inspi-ration. Nevertheless, the Euro was a risky headlong rush. Since theend of the Bretton Woods agreement, Europe has tried to avoidthe unfair competition of competitive devaluations within a cus-toms union. Germany, with the strongest currency in the system,has always led the monetary agreements, as its companies suffe-red the industrial delocalisation created by devaluations, mainlythat of the Italian Lira, a country a few hours away by lorry fromBavaria. After the fall of the Berlin Wall, the acceleration of themonetary union was decided so that it would become the strikerof the political union. However, the political union reached stag-nation after the severe German crisis of 2000, and the singlecurrency project began to crack.3. Nature of the Euro Crisis The nature of the crisis which is hitting the European Union isa classical debt deflation crisis (Fischer, 1933). Since the GreatDepression, this type of crisis had mainly taken place in emergingcountries and was associated with countries with financial vulne-rability, with little tradition of macroeconomic stability and insti-66
    • The Future of the Eurotutional fragility. Japan had suffered a crisis of this kind in thenineties and its economy is today trapped under deflation andliquidity, but it was viewed as an exotic case in the Far East. In2008, the Great Recession led to an abrupt disruption of the pathsof growth in developed economies, and the ghost of the GreatDepression began to haunt the world. By contrast, the decisive andcoordinated action of global economic policies prevented anotherGreat Depression (Eichengreen, 2010). Since then, world trade andindustrial production are 10% higher to levels prior to the GreatRecession, although the MSCI world stock index continues to be20% below the levels of spring 2008. Nonetheless, the crash of Lehman Brothers led to the collapse ofworld trade, and all countries and areas entered abruptly into reces-sion, which favoured policy coordination. But the recovery from2009 was asymmetric, and the coordination of world economicpolicies was conspicuously absent. In the Eurozone, from summerof 2008 to spring of 2009, the euphoria in support of an interven-tion to avoid a depression gave way to exit strategies in autumn ofthat same year and to begin implementing these in spring of 2010.The debt crisis affected a country with huge imbalances in thebalance of payments and high level of indebtedness such asGreece, which accounts for 2% of the GDP and population of theEurozone, and has extended first to Ireland, then to Portugal, andnow to Italy and to Spain. One third of the GDP of the area is alre-ady affected, and it has thus become a systemic and global pro-blem. This is a crisis in the balance of payments, but the existence 67
    • Nature and Causes of the Euro crisisof a currency and the high level of indebtedness mean the lack ofany comparable historical precedents, which in turn makes thediagnosis and the search for policies to solve it much harder. Forthis reason, we must carry out a review of classical literature onexchange rates in order to establish the conceptual bases for theexplanation of the crisis, without which the search for a solutionwould become a random wander.4. Fixed exchange rates versus flexible exchange rates: a review An exchange rate is a relative price between two hypotheticalshopping baskets of two countries. However, exchange rates areclosely related to interest rates (Keynes, 1992), and we are therefo-re speaking of a relative price which is essential when explainingeconomic development. Probably for this reason and as a result ofthe advance of globalisation, both commercial and financial sincethe fifties, in recent decades economists have paid special attentionto exchange rates. Exchange rates can be:i. Free floating: the exchange rate is set freely in the market on the basis of supply and demand, without the intervention of the central bank or the government of a country. The Euro and the Dollar are the closest free floating currencies.ii. Dirty or managed float: the government or central bank suppo- sedly does not intervene but there are verbal interventions or68
    • The Future of the Euro changes in monetary policy which attempt to alter the bases of supply and demand in the currency market. At times of maxi- mum volatility both the US government and the European ones verbally intervene in the market. During the Great Recession, the Federal Reserve, without expressly acknowledging this, has applied a monetary policy which has significantly weakened the dollar. The ECB has always followed in the footsteps of the Fed but in 2011 it managed to exceed its action by weakening the Euro, also without express recognition thereof. Japan is without question the best example of dirty flotation. The country sup- posedly enjoys free exchange rates but when there is tension in the markets and the savers repatriate capital, the central bank intervenes massively in the currency market to counteract the pressures of appreciation on its currency, which would have a very negative repercussion on activity and employment.iii. Fluctuation bands: the European Monetary System or EMS, the predecessor of the Euro, was the clearest example of this system. A central parity and fluctuation bands were established. Whilst the exchange rate in the market fluctuated within the bands, the system behaved like a flexible currency rate, but if it reached the bands then the central bank intervened to prevent these being exceeded, therefore becoming a fixed Exchange rate.iv. Fixed on a currency basket: equal to a fixed rate, but instead of fixing the anchor on one single currency it is fixed on a basket. It has been speculated for some time that China wants to apply 69
    • Nature and Causes of the Euro crisis this system. It makes more sense that just fixing it against the dollar, as the basket should replicate the composition of the current account and financial balance and would allow for bet- ter stabilisation of real exchange rates, which are the ones which determine the impact on activity and employment.v. Fixed adjustable: this is a fixed exchange rate which allows for adjustments. These may be discretionary or else subject to rules such as in the Bretton Woods system, or periodically adjustable. The latter were used in emerging countries which had sustained soaring inflation rates in the eighties and nineties during their stabilisation programmes, especially in Latin America.vi. Non-adjustable or true fixed rate: the country fixes a nominal anchor with a fixed rate relative to another currency with no possibility of change. Middle Eastern countries have fixed exchange rates against the dollar, which is justified by income from oil being collected in dollars. China had a fixed exchange rate against the dollar until 2005, when it moved onto daily fluctuation bands which it has recently broadened to +/- 1% daily.vii. Cash conversion: the monetary supply of a country is determi- ned by the level of currency reserves, and thus monetary sove- reignty is subject to capital flows. This was the exchange system in Argentina until 2001.70
    • The Future of the Euroviii.Exchange Union: the countries waive their national sove- reignty and assume a new currency. This may be a dollarization as has been proposed in some Latin American countries, or else a Euroization where the dollar would be adopted but without representation in the central bank. Or else a monetary and exchange union such as the Eurozone, where countries assume the same currency and are represented in the central bank and in monetary and exchange decision making processes. The debate on fixed or floating exchange rates is as old as macroe-conomics. During the happy twenties and then during the GreatDepression, capital movements were accused of being speculative dueto the extreme volatility of exchange (Nurkse 1942). Subsequently,another school of thought argued that the volatility was caused bydestabilising economic policies and that freedom and speculation hadstabilising effects (Friedman 1953). Rudiger Dornsbush opened up anew avenue of research according to which, even with investors withrational expectations, there was volatility in exchange rates. An incre-ase in the money in circulation by the central bank would increaseinflation expectations and lead to a depreciation in the exchange rate.However, for investors to buy once again there should be expectationsof appreciation; the exchange rate should therefore over-react andexceed its level of equilibrium to enable capital flows to return to thecountry. The truth is that neither the theory nor the empirical evidenceare conclusive in this debate. The problem facing the countries is 71
    • Nature and Causes of the Euro crisisthreefold: exchange rate stability, monetary independence andfinancial aperture. Conceptually speaking, flexible exchange ratesare the optimal solution, but for these to be stable the countrymust have monetary credibility. Flexible exchange rates provideleeway to the central bank in terms of fiscal policy, whereas thefixed exchange rate means this is lost and it becomes dependent onthe decisions made by the central bank to which it has anchoredits currency. The problem is that credibility takes a long time toachieve and takes very little time to lose. Moreover, it cannot beimposed; it is the society of the country in question which mustunderstand stability to be a public asset and to accept sacrifices andlimitations in order to preserve it. Countries lacking monetary credibility have hardly any leeway inmonetary policy, and this reduces the costs of accepting a fixedexchange rate. If the country has suffered from hyperinflation or aspiralling inflation, a nominal anchor on a stable currency allows forstabilisation of the prices of imported goods in the shopping basketand, combined with a stabilisation plan, proves to be highly effecti-ve to get the economy out of hyperinflation. This is what happenedin Argentina in 1990, but then the fixed exchange rate allowed imba-lances to go beyond what was sustainable and ended up by explo-ding in mid-air and amplifying the effects of the severe crisis of 2001. During the nineties the debate in Europe prior to the creation ofthe Euro was very intense (Rodríguez Prada, 1994). Most econo-mists did not call into question the fact that Europe was an opti-72
    • The Future of the Euromal monetary area (Meade 1957 and Mundell 1961). Althoughmuch progress has been made in the freedom of movements ofcapital and people, the labour markets continue to be segmented,mainly due to language and cultural differences, and when a regionsuffers an asymmetric disturbance with an increase in unemploy-ment, this is not offset by transferring workers from another regionas they do, for example, in the US. In this scenario, the countryneeds to transfer capital and work to the sector of non-corporategoods to the corporate goods sector and needs to depreciate the realexchange rate. Without the capacity to devaluate the nominalexchange rate, all the adjustment must be made via inflation orproductivity. When the central country has inflation rates close to2% the strategy must be deflationist, which is where the problemsstart, as many economists warned prior to the creation of the Euroand has been proven since the Great Recession (Obstfeld 1998).Nevertheless, the lack of an optimal monetary union is clearly adownside to the creation of the euro, but in the nineties it was thebenefits that were highlighted (De Grauwe 2009). The main bene-fit is that we Europeans already had a customs union and highlevel of commercial integration. Nowadays, approximately 70% ofthe Spanish exports are concentrated in the European Union and60% of what we import comes from our partners. Therefore, natio-nal exchange policies were very destabilising in this scenario, put-ting the European project at risk. 73
    • Nature and Causes of the Euro crisis The main benefits were concentrated in the financial area.Integration would enable the removal of currency risk and risk pre-miums, leading to a drop in real interest rates and therefore incre-asing the potential growth of the Eurozone and of each of thecountries therein, in turn allowing for convergence in income perinhabitant with the US, which experience a sharp boom in pro-ductivity in the nineties. Chart 1 shows how the introduction ofthe euro did not achieve the desired convergence, except in thecase of Spain. Chart 1 Gross Domestic Product per inhabitant Source: Eurostat structural indicators and own work74
    • The Future of the EuroIn the debate of costs and benefits prior to the creation of the Euro,many economists warned of institutional problems in the design ofthe monetary union. The main ones were the absence of a fiscalunion which would offset the asymmetric disturbances that mighttake place in some states and, that in the absence of exchange ratesand monetary policy, the country would be left without economicpolicy leeway to counteract them (Eichengreen 1998). The othermain limitation was the absence of a true lender of last resort whichthe statutes imposed on the ECB (Obstfeld 1998).5. Causes of the Euro Crisis The Euro crisis is extremely complex like all debt deflation cri-ses in history (Díez 2012), which is why we shall now review themain events to enable us to understand the fundamentals of theover-indebtedness without which we shall not be able to come upwith appropriate economic policies to help digest this.5.1. Financial integration and under-assessment of risk When a country adopts a fixed exchange rate and investors con-sider it sustainable in the future, the risk premium drops. A rationalinvestor must choose between an infinite variety of internationalassets in which to invest his savings, but his yield estimates aremade in local currency as the objective of purchasing financialassets is to protect against the impairment of purchasing power 75
    • Nature and Causes of the Euro crisiscaused by inflation during the investment period. If an investorpurchases an asset in another currency that then appreciatesduring the investment period, his yield will increase in the localcurrency, but if it depreciates it will drop, which explains the directrelationship between interest and exchange (Dornbusch 1976). In the case of the Euro we are dealing with the exchange ratewith the largest commitment and greatest exit costs; therefore itsadded credibility is also greater, just as the drop in risk premiums isalso highly intense. Chart 2 shows the intense process of financialintegration which took place in Europe following the creation ofthe single currency. Investment funds and financial institutions inthe Eurozone went from having 20% of assets from other countriesin the region in their portfolios in 1998, to 45% and 40% respecti-vely in 2007. This means a huge transfer of capitals from countrieswith a savings surplus, mainly Germany, to countries with savingsdeficits and especially those with higher risk premiums. This arrival of capital flows, along with the credibility grantedby the investors to the Euro since its inception, help to explain theintense convergence of interest rates between the public debt of thevarious member countries that can be observed in Chart 3.However, as is the case with all bubbles, at the beginning there arefundamentals which justify investor behaviour, but usually, follo-wing such sharp changes in financial flows, there is usually andover-reaction and asset prices move away from the fundamentals.76
    • The Future of the Euro Chart 2 Financial integration Source: European Central Bank Chart 4 shows how not only did convergence take place inpublic debt interest rates, but that the process was more intense inprivate debt. Covered bonds are the assets with the least likelihoodof default following the public debt of a country and it might evenbe the case, in extreme cases, of default on Treasury bonds but noton covered bonds, as has happened in Greece. The covered bond isa bond with a senior guarantee from the financial institution thatissues it, but which also has a second guarantee. The issuing entityselects its highest credit quality mortgages, those for the main resi-dence, with a debt under 80% of appraisal and a monthly instal-ment below 35% of the household income, and these are attachedas bond guarantees. Therefore, in the event of bankruptcy of the 77
    • Nature and Causes of the Euro crisis Chart 3 10 years Public debt spread v. Germany Source: Bloomberg and own dataentity, the buyers of the covered bond would prevail over the restof creditors to collect on such mortgages until recovery of theirinvestment, irrespective of whoever purchases the bankrupt entity.This is what distinguishes them from asset-backed securities wherethe investor assumes the direct default of the mortgages. In thecase of the covered bond, the risk belongs to the entity and, secondto the default of the mortgages, and thus they have a dual guaran-tee and lesser likelihood of default. Moreover, the rating agenciesrequire the over-collateralisation of the issue, so that if an institu-78
    • The Future of the Eurotion issues a covered bond worth 1000 million euros, they wouldbe required to provide between 1300 and 1500 in mortgage portfo-lio as a guarantee. Hence, the entity would first have to be declaredbankrupt and then it should have to have a default in the mortga-ge portfolio of over 50% for the investor not to recover 100% of hisinvestment. This helps one to understand that since 2007 no cove-red bond issued by a European entity has experienced default.These types of assets do not exist in the US, as the Fannie Mae andFreddy Mac played the same role, but evidence has shown that theEuropean system, by maintaining the risk in each institution, wasmore efficient and, in fact, there are legislative proposals under wayto develop a covered bond market in the US. Until 1997, the companies of peripheral countries such as Spainfound it difficult to issue bonds on the international markets. ThePeseta was a currency which had experienced several devaluationsover the last few decades, its financial markets were very narrowand were practically taken over in full by public debt. The entry ofthe Euro enabled Spanish financial entities to access an organisedmarket of covered bonds with a longstanding tradition and depthin Germany, which rapidly spread to all other countries in the area.As we shall explain shortly, this coincided with a deep and complexdebt crisis in Germany, as a result of the excesses of its Unification,which increased the savings rate in a structural way, and thus thesupply of top quality credit assets for its financial institutions, insu-rance companies and pension funds, which in turn boosted therapid growth of this market as well as its (Díez 2012b). 79
    • Nature and Causes of the Euro crisis Chart 4 Spanish covered bonds spreads Source: Bloomberg and own data In Chart 5 we can see how such structural changes in the fun-damentals led to a credit boom in the Spanish economy. The ori-gin of the boom was justified by the fundamentals, but in the endthe only fundamentals were the self-realisable expectations, lea-ding to the bubble. In 1995, when the likelihood assigned by inves-tors that Spain would form part of the founder members of theEuro was very low, practically all of the Spanish bonds in the handsof non-residents were public. Since then, the percentage of publicdebt over GDP had become constant, but when our incorporation80
    • The Future of the Eurointo the single currency was approved in 1998, the internationalissues market opened up for the private sector and grew exponen-tially until it doubled that of public debt in terms of GDP. The hea-ding “other resident sectors” includes the asset-backed securitiesfunds, rendering most of debt as pertaining to banks. Chart 5 Spanish bonds in the hands of non-residents Source: Bank of Spain, INE and own data Covered bonds are purely a bank product, despite carrying asecond mortgage guarantee, and are accounted for as bank debt. Themost developed covered bond market in the world was the German 81
    • Nature and Causes of the Euro crisisone of Pfandbrife but in Chart 6 one can see how in 2006 theSpanish banks issued 70,000 million euros in covered bonds, 30%less than the German banks which had a balance three times aslarge as that of Spanish banks. In summer 2007, before the start ofthe financial crisis, the outstanding balance of covered bonds issuedby Spanish banks exceeded 300,000 million euros, 30% of the GDPand an amount equal to the outstanding balance of Spanish publicdebt. In 2006, the issues of covered bonds and asset-backed securi-ties by Spanish banks comfortably exceeded the current accountdeficit which was approaching 100,000 million and were the mainfinancing instrument of our economic, without which it is not pos-sible to explain the credit and real estate bubble. The dynamics were straightforward. The Spanish banks used theloans granted in retail banking as a guarantee for new issues whichallowed the granting of new credits. The issues of covered bondswere carried out at variable interest rates of Euribor plus 10 basispoints and the mortgages were granted at Euribor plus 50 basispoints. A strong growth in credit, low rate of default and spreadsbetween stable asset and liability rates constituted the basis of thedemand for funds of Spanish banks. What were the fundamentalsof the supply of funds? The key lay in the Shadow Banking System(FSB 2011, European Commission 2012). This consisted mainly ofvehicles created by international banks, based in tax havens andnot consolidated in their balance sheets and thus outside the peri-meter of oversight by the central banks. The vehicles purchasedassets, mainly of high credit quality and were funded by the com-82
    • The Future of the Euro Chart 6 Issues of Covered Bonds Source: International Monetary Fundmercial paper market using those assets as guarantees. Let us assu-me that the vehicle bought a covered bond at Euribor plus 10 basispoints and was funded by Euribor commercial paper. This resultedin a profit of 10 basis points per transaction. If the vehicle only had5% of capital and 95% of debt, this meant a 20-fold leverage, suchthat the yield over equity was Euribor plus 200 basis points. The growth of the shadow banking system was exponential andin 2007 in the US reached 20 billion dollars, whereas the non-sha-dow banking system supervised by the Federal Reserve amounted 83
    • Nature and Causes of the Euro crisisto 16 billion dollars. The asset-based leverage which used mortgageguarantees already granted enabled the banking system to generateliquidity in an endogenous manner without having to resort to thecentral bank, leading to the loss of monopoly by the monetary aut-horities of the issue of money in circulation. When in February2005 Alan Greenspan, then President of the Federal Reserve,announced that there was an enigma in the behaviour of the bondmarket, he was responsible for this for allowing the development ofthe shadow banking system. Until 2009, no statistics were publis-hed on the shadow banking system but, once they became public,it was much easier to understand the causes of the largest global cre- Chart 7 Current account balance Source: International Monetary Fund84
    • The Future of the Eurodit bubble burst since the Great Depression and which was parti-cularly severe in some Eurozone countries, including Spain.5.2. Local imbalances: Over the last few decades, the economic paradigm has analysedthe real economy and the financial economy separately. The GreatRecession has proven the failure of the paradigm and, as we wereshown by Luca Paciolo in the 13th century, when an economy isanalysed, the assets and liabilities cannot be separated. Therefore,although it is evident that the hurricane began in the financialrealm, there are imbalances in the real economy which also helpto explain the crisis. Chart 7 shows the divergence betweencurrent account balances among developed and emerging coun-tries in the last decade. Several causes help explain this phenome-non which the literature has called “global imbalances” (Caballero2009). The main cause was the aftermath of the Asian crisis of 1997.The affected countries had large current account deficits and lowlevels of currency reserves before the crisis, and subsequently theygeared their economic policy towards exports. This led to currentaccount surpluses and high currency reserves, and the ensuingstructural increase of the world savings rate (Bernanke 2005). Theaccumulation of reserves was concentrated on sovereign funds andcentral banks with a conservative approach, which significantlyincreased the demand for fixed income funds of top credit quality, 85
    • Nature and Causes of the Euro crisisknown as AAA. Without understanding the Asian crisis and its con-sequences it is not possible to understand the intense developmentof the shadow banking system and the strong increase in leveragein the world banking system which has been analysed in the pre-vious section (Caballero 2008). Chart 8 shows how the Eurozone was hardly affected by thephenomenon of Global Imbalances, with a current account balan-ce close to equilibrium since the Asian crisis. However, Chart 8shows that there have indeed been huge differences between thecountries within the Euro and, for this reason, the phenomenonhas now been called Local Imbalances. In 2001 Germany suffered adebt crisis similar to the one suffered at present in Spain, althoughit hardly translated into a current account or foreign debt deficit.Germany, as was the case in Japan in the eighties, suffered from aproblem of over-indebtedness of households and businesses, withreal estate bubble, burst and depression all thrown in to the packa-ge. Following the burst of the bubble in 2000, German householdswere reluctant to take on debt and structurally increased theirsavings rate to reduce such a debt. Private consumption plumme-ted and businesses sought the supply that was absent in the domes-tic market in the export market. The fiscal revenue dropped dra-matically and Germany failed to meet the Stability Pact and wat-ched its public debt increase significantly until 2005. The birth of the euro and the credit boom in peripheral coun-tries enabled Germany to overcome the severe recession thanks to86
    • The Future of the Eurothe strength of its exports. Moreover, German savings found aneasy path without assuming exchange rate risk with its partners inthe Eurozone. The causes of the Euro crisis are focused on theanalysis of the imbalances of debtor countries, but it is not possi-ble to understand and explain the crisis without analysing thesaver countries, particularly Germany. Debtor countries are facinga prolonged period of debt reduction, which will ensure a weakinternal demand, and shall be obliged to show a current accountsurplus as was the case in Asia in 1998 and in Germany in 2001.But this will not be possible if the creditor countries reduce theircurrent account surpluses and boost internal demand. Chart 8 Current account balance Source: International Monetary Fund and own data 87
    • Nature and Causes of the Euro crisis5.3. The Great Recession: The European Monetary Union was born with institutional pro-blems but these did not become evident and to put its viability atrisk until 2009. Chart 9 shows how the Great Recession which rava-ged the world and Europe in 2008 has been the worst for seventyyears, although it did not reach the depth and length of the GreatDepression, which it is being called the Great Recession. Withoutan earthquake of this force, it is possible that the institutional flawsof the European project could have endured for longer, but the cri-sis has highlighted them and the Euro is now at a crossroads. In 2007 it was financial disturbances which anticipated therecession. Chart 6 shows how the covered bond market practicallydried up for Spanish banks as well as for all other indebted coun-tries. This brought the credit boom to a halt and acted as the trig-ger for the recession. In 2008 the disorderly collapse of Lehman ledto the worst global run since the Great Depression. The investorsquickly resorted to short term public debt of the internal reservecurrencies, the money markets dried up as did the currency mar-kets, and world trade collapsed in a matter of weeks. The coordi-nated reaction of the G20 with the most expansive monetary, fis-cal and financial policy in history prevented the world from ente-ring into a depression and enabled a V-shaped recovery of worldeconomy and trade in 2009.88
    • The Future of the Euro Chart 9 GDP EU 15 Source: Angus Maddison. University of Groningen Economics is an empirical science but it is difficult to findhomogeneous experiments to compare policies, but this crisis hasprovided one. The Great Recession was synchronized and mostcountries entered into recession at the same time. However, therecovery since 2009 has been disparate and the economic policieshave been very different between the US and the Eurozone, whichenables a comparison of its effects to be drawn. Europe began fis-cal consolidation at the beginning of 2010, despite the boostgiven in 2008 to get out of the recession, whereas the US has con-tinued to renew its fiscal incentive plans. The ECB has been reluc-tant to intervene and has only done so when the markets havebeen on the edge of collapse and it even took the liberty of incre- 89
    • Nature and Causes of the Euro crisisasing the interest rated in July 2011, making the same mistake asin July 2008, anticipating the recession. The Federal Reserve haskept its rates at 0% and has renewed its quantitative policies. After two years of experimenting, what has the result been? Thegrowth in the US has been twice that of Europe, its inflation hasalso doubled and its unemployment rate has reduced to 8.5%,whereas in Europe it has exceeded 10%. In the US, several states,among them California and Florida, burst their real estate bubblesand California defaulted on payments and created its owncurrency, what was known in Argentina as Patacones. Therefore,the Euro crisis is not the cause of the problems in Europe butsimply the result of mistakes made in economic policy in Europesince 2009. Neither is the argument of the greater rigidity ofEuropean labour markets and the mobility problems betweencountries valid. In the US, the unemployment rate increased withequal intensity in states which did not have a real estate bubble,thus confirming that the cause of the growth in unemploymentwas a sharp drop in demand caused by an intense banking crisisand credit restriction. But the most spectacular result of the expe-riment is probably what happened with public finances. The US,without resorting to raising taxes, without great cuts and simply byfreezing public expenditure has managed to increase fiscal revenueby 12% and has reduced the deficit by four percentage points ofGDP. Europe, by raising taxes and cutting costs has managed arevenue increase of 6% and a reduction of the deficit of two pointsof GDP.90
    • The Future of the Euro The emergence of almost ten points of public deficit in a newGovernment in Greece was the spark which ignited the Euro crisiswhich we currently face. The Greek Tragedy spread first to Portugal,then to Ireland, and currently threatens Spain and Italy, thushaving affected one third of the GDP of the Eurozone, (Díez, 2012).Chart 2 shows how the Great Recession began a process of finan-cial disintegration in the Eurozone which was intensified by theGreek Tragedy and the contagion of all other economies. In amonetary union, the outflow of capital is equal to a contractivemonetary policy and, on the contrary, the inflow of capital isexpansive. This helps us to understand why the countries subjectedto financial tension entered once again into deep recession in 2011whereas Germany, the main receiver of capital flows, has continuedto grow.6. Conclusion The European project is a political one and it is born out of theneed to end wars and conflicts which had ravaged Europe in the20th century. The Euro was an attempt to accelerate the politicalunion but has ended up being a headlong flight.· The Euro is the most extreme version of a fixed exchange rate. Indeed, it is reinforced and with high cost of departure, which renders it more credible, but while it lacks a political union there will always be doubts as to whether it will be a single currency. 91
    • Nature and Causes of the Euro crisis· In the nineties the benefits – and there were some which have been clearly demonstrated – of the creation of the euro were overvalued. But at the same time there was an under-assessment of the costs which reality has proven were also there. The two main institutional problems which must be solved are: i) the absence of a fiscal union to complement the monetary union and ii) the absence of a lender of last resort due to the limita- tions imposed on the ECB in its bylaws.· Financial integration and the undervaluation of risk, both glo- bal phenomena, are essential to explain the credit boom and the problem of over-indebtedness which are the origin of the Euro Crisis. The case of the covered bonds is a good example that not only were credit risks undervalued, but liquidity risk was likewi- se under-assessed.· The Local Imbalances, the high current account surplus in Germany and the deficits in Spain and other countries forced the transfer of financial flows and boosted the credit boom and over-indebtedness. Countries subjected to financial tension are implementing sharp reductions in their current accounts, but Germany has hardly reduced its foreign surplus since 2007.· The institutional problems of the Eurozone became apparent at the Great Recession, as a result of the sharp drop in activity and the collapse of the financial markets and credit channels which have rendered many debts unsustainable and unpayable.92
    • The Future of the Euro Without such a deep recession, the problems would have taken longer to appear.· The aim of this article was not to discuss solutions, but from the analysis of the nature and causes of the Euro crisis, we can con- clude that the solution must: i) dispel doubts as to the future via- bility of the euro, ii) to do so we must work towards the fiscal union and the creation of Eurobonds would be the precedent for a future single European treasury, iii) we must change the bylaws of the ECB so that it may act as a lender of last resort as the Federal Reserve does in the US, iv) we must halt the process of financial disintegration and ensure the return of part of the capi- tal flows which have exited from peripheral countries, and v) we must urgently reactivate growth in Europe. In order to do so, the monetary policy must opt for quantitative strategies of debt pur- chase, the fiscal policy must be less restrictive and the financial institutions and countries with greater solvency problems must be recapitalized in order to restore the credit channels as soon as possible. 93
    • Nature and Causes of the Euro crisisBibliography- Bernanke, B. (2005). “The Global Saving Glut and the U.S. CurrentAccount Deficit”. Federal Reserve Speech 10 March.- Bernanke, B. (2007). “The Financial Accelerator and the CreditChannel”. Federal Reserve Speech 15 June.- Caballero, Ricardo J., Farhi, Emmanuel and Gourinchas, Pierre-Olivier (2008), "An Equilibrium Model of ‘Global Imbalances and LowInterest Rates," American Economic Review, vol. 98 (1), pp. 358-93.- Caballero, Ricardo J. and Krishnamurthy, Arvind (2009), "GlobalImbalances and Financial Fragility," American Economic Review:Papers & Proceedings, vol. 99 (May), pp. 584-88.- European Commission (2012) “El Sistema Bancario en la Sombra”.Libro verde, Marzo.- De Grauwe, Paul (2009) Economics of Monetary Union 9 ed.Oxford University Press. Oxford.- Díez, José Carlos (2012) “Crisis de la Deuda Europea: crisis de emer-gentes o sumergidos” Papeles de Economía Española 130 January,pag. 150-166.94
    • The Future of the Euro- Díez, José Carlos (2012b) “El Sistema Bancario tras la GranRecesión” Mediterráneo Económico 20 January, pag. 329-345.- Dornbusch, Rudiger. (1976) "Expectations and Exchange RateDynamics." Journal of Political Economy 84: pag. 1161-76.- Eichengreen, Barry, and Wyplosz, Charles (1998) “The StabilityPact: Stabilizing or Destabilizing?” Economic Policy 26 April, pag. 65-113.- Eichengreen, Barry and O’Rourke, Kevin (2010), A tale of twodepressions: What do the new data tell us? February 2010 update,VoxEU.org, 8 March.- European Commission (1998) “Convergence Report 1998”,Bruselas.- European Monetary Institute, Convergence Report, Frankfurt amMain, March 1998.- FSB, Financial Stability Board (2011) Shadow Banking:Strengthening Oversight and Regulation. October.- Friedman, Milton (1953) The Case for Flexible Exchange Rates.Essays in Positive Economics. 95
    • Nature and Causes of the Euro crisis- Chicago: University of Chicago Press, 1953, pp. 157-203. Chicago.- Keynes, John M. (1992) Breve Tratado sobre la Reforma Monetaria.Fondo de Cultura Económica de España. Madrid.- Meade, James (1957) The Balance of Payments Problems of a FreeTrade Area.- Economic Journal, Sept. 67, 379-96.- Mundell, Robert (1961) A Theory of Optimum Currency Areas. TheAmerican Economic Review, Vol. 51, No. 4., pp. 657-665.- Nurkse, Ragnar (1942). International Currency Experience. Lessonsfrom the Inter-War period. League of Nations, p. 188. Genova.- Obstfeld, Maurice (1998) EMU: Ready, or Not? Working Paper.University of California, Berkeley.- Rodríguez Prada, Gonzalo (1994) Teoría y estrategias de la integra-ción económica y monetaria: con aplicaciones a los casos de la UE, elNAFTA y el MERCOSUR. Universidad de Alcalá. Alcalá de Henares.- Torrero, A. (2006) Crisis Financieras: Enseñanzas de Cinco Episodios.Marcial Pons. Madrid.96
    • /JUERGEN B. DONGES * / The European crisis and the challenge of efficient economic governance1. Introduction; 2. The root cause of the problem: too much economic diver-gence; 2.1. A suboptimal monetary area; 3. Attempted governance in anindirect manner; 3.1. Breach of the fiscal rules; 4. Governance as activismagainst the crisis; 4.1. Constituent principles, violated; 4.2. Financial assis-tance, a never-ending story?; 4.3. Political pressure to impose discipline,insufficient so far; 4.4. Financial markets, with capacity to persuade; 5. Newgovernance design: own responsibility as the key; 5.1. The euro Plus Pact, itis not binding on anyone; 5.2. The Fiscal Stability Pact, a test of nine; 5.3.The Macro-economic Governance Pact, with vague parameters; Conclusion* Professor emeritus of economics at the Faculty of Economic and Social Sciences of theUniversity of Cologne (Germany). From 1969 to 1989 he managed several economicanalysis departments at the Kiel Institute for the World Economy, in which he was theVice-chairman for the previous six years until he took the chair in 1989 in Cologne. Heis currently a Senior Fellow of the Cologne Institute for Economic Policy. He was theChairman of the German Council of Economic Experts (the so-called “Five Wise Men”)and the German Commission on Economic Deregulation. He is an economic advisor inseveral academic institutions and foundations in Germany, Spain and in other coun-tries. He is also a member of the Supervisory Board of several multinational companies.He is the author of several books and articles published in academic journals on inter-national economy and public policies in the field of macro and micro economy. 97
    • The European Crisis and the challenge of efficient economic governance1. IntroductionThe purpose of this article is to focus the current discussion on theneed for economic governance in the European Union (EU) and, inparticular, in the euro area, in the context of the political reality.This is not such an easy task, as it may seem; in practice the rela-tions between national governments, on the one hand, and theseand the European Commission and the European Parliament, onthe other, end up being profoundly redefined, with more Europeanpowers and less national sovereignty. This topic is not new; it has been on the table at the mee-tings of the European Council of the Heads of State andGovernment since the formation of the European Single Market 25years ago (1986 Single European Act). We can interpret agreementsleading to a coordination of economic policies, as the initial steptowards “smooth” European economic governance, specifically to(i) promote employment (1997 European Summit of Luxembourg),(ii) apply structural reforms conducive to flexibility in the productand factor markets (1998 Cardiff Summit), and (iii) institutionalisemacro-economic dialogue among the governments, the EuropeanCentral Bank (ECB) and social partners (1999 Cologne Summit).Apart from the above steps we should add (iv) the agreement of theEuropean Council in 2010 to launch a strategy of structural reformsthat would make the EU at the end of that decade the most dyna-mic economic area in the world.98
    • The Future of the Euro These agreements which were then celebrated as a landmark inthe European integration process have not given the desired results.The reason is very simple: over and above the rhetoric, the govern-ments were not willing to co-operate if the alleged or true nationalinterests indicated otherwise. Such governance installed in theEuropean Council, the Ecofin and in other councils of ministersinvolved, lacked any kind of power of management and supervi-sion of the economic and fiscal policies of the member states. At the current debate the great hope is that in the futurenational interests will come second, giving way to the “MoreEurope”, as the new political logo reads. The aim is to reach gre-ater and efficient intra-European co-ordination of the economicpolicy of the member countries. This aim was raised in 2011-2012 in three basic agreements: (i) the Euro Plus Pact (to strengt-hen the competitiveness and growth capacity of the economies),(ii) The Fiscal Stability Pact (Fiscal Compact to guarantee in allthe countries the sustainability of public finances in the mediumand long term) and (iii) the Macro-economic Governance Pact(Economic Governance Six Pack, to ensure economic and fiscalpolicies compatible with the internal and external balance in theeconomies). Now, the declarations of intent are one thing, put-ting them into practice and applying the appropriate economicpolicies, is quite another. Why should what politicians promisetoday be believable, if in the past (and today, as many of themare still around) did not fulfil their commitments? 99
    • The European Crisis and the challenge of efficient economic governance I will now analyse governance in its past and present dimen-sions. The following section emphasises the significant fact thatthe euro area is not an optimal monetary area. In the third andfourth sections the forms of governance relied on until now areanalysed. The fifth section deals with the new approach forEuropean governance. The last section concludes the analysis in atone of moderate hope.2. The root cause of the problem: too much economicdivergence The crisis of the sovereign debt in Europe has shown a seriousfault in the formation of the single currency: trusting that thegovernments of the member countries would apply quality econo-mic policies in accordance with the common interest of all thepartners, as set forth in the EU Treaty (articles 2 and 121), wasnaive. In Germany, I together with many other economists noticedthis fault then, but political leaders took no notice or it was labe-lled as “academic” and, therefore, irrelevant to take great historicaldecisions. The leaders simply invoked the criterion of the so-calledsupremacy of politics over economics, as they do today when theyrun from one summit to the next to rescue certain countries frombankruptcy and try to stabilise the euro area.100
    • The Future of the Euro2.1. A suboptimal monetary area The architects of the euro area, from the 1989 Delors Report,knew that a monetary union would not be feasible in the long runwithout a fiscal union, not to mention political union. The historyof the different monetary unions in Europe in the 19th Centuryhad left an unequivocal message: all of them failed because ofincompatibilities among the budgetary policies of the membercountries. However, during the negotiations of what would becomethe Maastricht Treaty (of 1992) the prerogative of national budge-tary policy was sealed. The then two main characters of theEuropean project, the German Chancellor Helmut Kohl and theFrench President François Mitterrand, fascinated their counterpartswith their vision of the euro as a pacemaker to accelerate and to gointo greater integration. More than one will remember the famousstatement of the French Finance Minister, Jacques Rueff, ‘Europeshall be made through the currency, or it shall not be made’ (1950),and they took it literally. The French statesman could never haveimagined such a deteriorated environment of public finances as wehave today in many European countries. It was also clear that the five convergence criteria set forth in theMaastricht Treaty, even if they could be fulfilled (something thatnot all countries have done), did not guarantee an optimal mone-tary area (in terms of the theory of Robert Mundell and others). InEurope, it would have been essential for the countries to be quitehomogeneous in terms of economic development and functioning 101
    • The European Crisis and the challenge of efficient economic governanceof the institutions or the prices and salaries in the various countriesshould have been flexible enough (especially downwards in coun-tries with weak growth and great structural unemployment), or forEuropean mobility of labour to be high (from backward regionswith high unemployment rates to dynamic regions with shortageof workers). These conditions for an optimal monetary area did nothappen twenty years ago and do not happen today. The differencebetween Europe and the United States in this is significant. Only a group of countries in the euro area (in central and nort-hern Europe) at least met then and meets now the condition ofhomogeneity. The countries in the southern periphery were not,strictu sensu, ready for their accession in 1999 to the monetaryunion and, therefore, to waive a monetary and exchange ratepolicy as adjustment facilities of internal imbalances (inflation)and external imbalances (current account deficit) and to under-take tax regulations that would restrict government deficit andthe level of government debt. It is not a coincidence that thesecountries have had for the past two years a risk of insolvency (notto have the capacity to re-finance the debt in the capital marketunder affordable conditions), as only sovereign countries have, ifthe State may not resort to the Central Bank to secure financingand must get it by issuing bonds in a foreign currency. Greecemay be the most illustrative example of having done what theGerman Council of Economic Experts has classified as an “origi-nal sin”, in other words, having rushed into accessing the mone-tary union in 2001, forced even through deceit (hiding the truth102
    • The Future of the Euroof their fiscal statistics): the country is now at the mercy of theinternational financial markets (rating agencies), after havingrevealed the serious structural deficiencies in the economy andthe public institutions, which has led to a low growth potentialand low levels of productivity and competitiveness clearly insuf-ficient at this time (globalisation of competition).3. Attempted governance in an indirect manner It was conceptually logical that with the creation of the singlecurrency the powers on monetary policy would be transferredfrom the National Central Banks to the new ECB. However, as thebudgetary policy would carry on being a national responsibility,two principles constituting the euro area were established inorder to guarantee the sustainability of the public finances in themember countries and to ensure that the monetary union wouldwork as a price stability union.• The two principles proclaimed in the Maastrich Treaty are the prohibition to bail out insolvent partners, on the one hand, and the prohibition imposed on the ECB to finance govern- ment deficits (no monetisation), on the other hand. These clauses are contained in the most recent version of the Treaty on the European Union (the Treaty of Lisbon of 2007) in arti- cles 125 and 123, respectively. 103
    • The European Crisis and the challenge of efficient economic governance • The two provisions were supplemented with the Stability and Growth Pact (SGP) approved in 1997 at the European Summit in Amsterdam; in it a ceiling for national budget deficits (3% of GDP) and government debt (60% of GDP) were established under the assumption that the growth rate of the nominal GDP in the euro area would be 5% in the medium term.1 With all this, indirect governance elements were created, in other words, formally maintaining national powers in budgetary policy, but controlling the use of the powers that could destroy the feasibility of the euro area. The monetary union was not designed to pay debts jointly and generate financial transfers from certain States to others, as many today think that that is the case, appealing to solidarity among peoples. There was already solidarity, and there still is, in the good sense of the concept: the more developed countries of the EU must help the least developed for these to advance in real convergence; the various European Structural Funds are for this. But it is not compatible with the concept of solidarity; it rather constitutes a “perversion” (Issing) of it, having to rescue a society that underestimates saving, tends to consume ostentatiously, tolerates waste by the public authorities, does not fulfil tax obli-1 For a profound analysis see A. Brunila, M. Buti and D. Franco (ed.), The Stability andGrowth Pact: The architecture of fiscal policy in EMU. Houndsmills/Basingstoke (UnitedKingdom): Palgrave, 2001 – Círculo de Empresarios (ed.), Pacto de Estabilidad yCrecimiento: alternativas e implicaciones. Libro Marrón 2002. Madrid (December). 104
    • The Future of the Eurogations and claims social benefits beyond the means of thecountry, given its own resources.3.1. Breach of the fiscal rulesThe architecture of indirect governance crumbled when it had topass the first real test, in 2002/03. In those days, Germany(Schröder) and France (Chirac) violated the the fiscal rules of thegame. In Germany, government deficit had reached 3.7% of GDPin 2002 and 3.8% in 2003; in France, it was 3.2% and 4.1% respec-tively. In both cases, most part of the deficit was structural. TheEuropean Commission had activated, according to the SGP, thesupervisory mechanism for ‘excessive government deficit’ againstthese two countries. The German Chancellor explicitly rejected theintervention from Brussels, the same as the French President. Theyboth imposed their criterion at the European Council in November2003, which suspended the process (against the votes of Austria,Spain, Finland and Holland). The then President of the EuropeanCommission, Romano Prodi, had described the SGP in an inter-view (on 18/10/02) as “stupido”, which is highly surprising comingfrom the custodian of the European Treaties. At the European Summit held in March 2005, the SGP wasamended, watering it down a great deal: with new exceptions forbreaking the rules, an assessment of the budgetary situation on acase-by-case basis, considering the special circumstances of eachcountry, relaxing the periods to take the necessary adjustment 105
    • The European Crisis and the challenge of efficient economic governance measures, the differentiation among countries as regards the goal of budgetary consolidation in the medium-term and some com- plex and non-transparent supervisory mechanisms.2 We must remember this in order to understand the reason for the current proposals to depoliticise (“automate”) the decisions on sanctions in case of an infringement of the fiscal regulations. With the erosion of the SGP, the factors that determined the cri- sis of the current sovereign debt, put down roots, a crisis which would have happened anyway, if the 2007-09 global financial and economic crisis had not have appeared. If the governments of the two main countries of the euro area are skipping the Treaty of Europe and the SGP, why wouldn’t the rest do the same if this is what is best for them and open the tap of non-productive public expenditure? Structural government deficits increased conside- rably and with this the volume of the government debt. With this precedent, the supervision of national budgetary policies by the European Commission was reduced to merely a rhetorical exercise that did not scare the rulers much. Economic governance in an indirect manner had failed. The ECB, however, fulfilled its role and its first president, Wim Duisenberg, did not allow political leaders to tie his hands, despite their attempts.2 For this purpose, the European Commission adapted the original regulations No1466/97 and 1467/97 of 7/7/1997; see COM (2005) 154 and COM (2005) 155 of20/4/2005. 106
    • The Future of the Euro4. Governance as activism against the crisis The threat of Greece’s suspension of payments two years agoshowed lack of efficient European economic governance. Instead,a rare and disconcerting political activism appeared. The nume-rous measures taken since May 2010 in Europe seem more like anexercise of muddling through than implementation of a consis-tent and long-term strategy.4.1. Constituent principles, violated It all started in the worst possible manner: the Governments eli-minated in one fell swoop the two principles establishing the euroarea mentioned above. The lifting of the non-rescue clause created the problem ofmoral hazard for Governments with a tendency to excessive publicexpenditure and for reckless banks when it comes to buyinggovernment bonds. The Governments could pass the cost of exces-sive indebtedness to taxpayers from other countries (who had noright to speak or vote when the budgets of the State in questionwere drafted). The banks started a tremendous communicationcampaign to warn of the danger of the euro area (systemic risks) ifindebted countries were not rescued, efficiently concealing to thepublic opinion that their true intention was to protect their share-holders. 107
    • The European Crisis and the challenge of efficient economic governance Under the presidency of Trichet, the ECB was under pressure toundertake a new role: the role of being a “repair shop” for thefaults in the fiscal and growth policies. It acquired in the SecuritiesMarkets Programme, big sums of Treasury bonds from countries introuble which nobody wants. Here lies the difference with otherrelevant central banks (the Federal Reserve, the Bank of England,the Bank of Japan), they also buy government securities in the con-text of their non-conventional monetary policies, but these areassets with considerable profitability. Furthermore, the ECBcurrently grants unlimited liquidity to banks for three years, at asymbolic interest rate (1%) and it accepts low quality securities asguarantee. But it is not in its hand to lead banks to proper grantingof credit to companies or households in the country under affor-dable conditions; the ECB must resign itself to banks choosingmore profitable business in the short-term, as purchasing the debtof the State; therefore, there is not much change in the scenario ofcredit restriction in the private sector in several countries, like inSpain. The European monetary entity is not only “a last resort len-der” anymore, which in situations of financial emergency is justi-fiable, but it has also become “a public debt buyer of last resort”,which is more questionable, because it delays the fiscal adjust-ments of the Governments (and it caused in 2011 the resignationof two German senior members of the monetary authority bodies,first the resignation of Axel Weber, President of the Bundesbankand ex officio member of the ECB Governing Council and, subse-quently, the resignation of Jürgen Stark, member of the Board ofthe ECB and its chief economist). The role that the ECB is playing,108
    • The Future of the Eurofor the moment also under its new president (Draghi), may dama-ge its reputation as an institution independent of political powersand commited to price stability, which is what it has been entrus-ted with in the European Treaty. An additional problem is that the same standards of asset qua-lity, which are used as collateral in the re-financing of commercialbanks by the National Central Bank itself (and, as such, part of theEurosystem), do not govern in the whole of the euro area anymo-re. In several countries in trouble, especially with persistent currentaccount deficits which (already) do not finance in a conventionalmanner import of capital or through financial assistance fromabroad, the respective National Central Banks, with permissionfrom the ECB, accept low quality securities as guarantee of loans,more than what is allowed for emergency liquidity assistance. It isas if they were using the money printing press. This somewhatundermines the monopoly of the ECB to create money. What isquestionable from an economic perspective is hidden behind theenormous increase in the amount of these operations in theEurosystem Target 2 in the past years, which has been vehementlywarned by the Ifo Institute of Munich for the last year.3 TheBundesbank has become a gigantic creditor of hundreds of millionsof euros for the National Central Banks of the other countries, wit-3 See H.-W. Sinn and T. Wollmershäuser, “Target Loans, Current Account Balances andCapital Flows: The ECB’s Rescue Facility”, NBER Working Paper, No 17626 (November).CESifo, “The European Balance of Payments Crisis”, CESifo Forum, Special Issue, January2012. 109
    • The European Crisis and the challenge of efficient economic governance hout protection and right to any kind of compensation if there is any significant bankruptcy of banks and savings banks or if the euro area collapses. The Governments of debtor countries have in reserve a powerful argument to manage to get from others, espe- cially from Germany, concessions in the negotiations over finan- cial assistance. 4.2. Financial assistance, a never-ending story? Political leaders believed, and some of them still do, that the creation of a common rescue fund is the solution to the problems of countries in trouble and it eliminates possible spillover effects. The first rescue mechanism was created with the European Financial Stability Facility (EFSF).4 This fund is provisional (three years, until 2013) and at the beginning had a provision of 440,000 million euros in loans guaranteed by the euro countries; as the Fund wanted to place their issues with the highest ranking ‘AAA’ to get attractive profitability, the real lending capacity would be lower than the allocation, about 250,000 million euros. Ireland (87,500 million euros) and Portugal (78,000 million euros) had to resort to this Fund. Subsequently, in July 2011, the European Council decided to increase the real lending capacity of this rescue fund to 440,000 million euros and, in addition, increase their4 EU Council of Ministers (Ecofin), EFSF Framework Agreement, 9/5/10 and 7/6/10.Web page: http://www.efsf.europa.eu (Legal documents). 110
    • The Future of the Europowers and relax the conditions for granting the loans to countriesin trouble. It even received leverage instruments (with a 4 factor)and the so-called ‘special purpose vehicles’ (off-balance); such ins-truments, applied by private banks, were exactly the ones that trig-gered very harmful effects for the global financial crisis to break in2008. In mid-2012, six months in advance to the original schedule, anew permanent rescue fund will come into force, the ‘EuropeanStabilisation Mechanism’ (ESM).5 This fund will have a provisionin nominal terms of 700,000 million euros (with capital contribu-tions from the member countries amounting to 80,000 millioneuros); the real lending capacity of this new Fund is 500,000million euros. Provisionally, the amount of available resources mayamount to about 800,000 million euros, by transferring the unusedEFSF resources. The IMF, the OECD, the United States and China,among others, recommend a higher firewall (up to 1.5 billioneuros). In parallel with these events, a special treatment has been givento Greece. After the initial financial assistance plan approved inMay 2010 (110,000 million euros, of which 30,000 million euroscame from the IMF), of which politicians said that it would enable5 European Council, Treaty Establishing the European Stability Mechanism (ESM), 25/3/11.Internet: http://www.efsf.europa.eu (Legal documents). – European Council, Treaty sig-ned by the 17 euro area Member States, 2/2/12. Internet:http://www.european.council.europa.eu. 111
    • The European Crisis and the challenge of efficient economic governancethe country to return to the capital market in 2013, in Februarythis year a second package was agreed (130,000 million euros,including a contribution from the IMF, to which a further amountof 24,400 million euros of the first package pending payment willbe added). The latest thing is that private creditors will undertake(about 85.8% voluntarily and the rest will be obliged by law) adeduction of 53.5% and will agree for the rest of their securities anexchange for new Greek long-term treasury bonds and of the EFSFFund at a moderate interest rate (which will reduce the Greekpublic debt in about 107,000 million euros of a total of 350,000million euros). Greece’s main public creditor, the ECB, has escapedthis operation and the asset losses derived from it, by means of atrick, quickly exchanging their former Hellenic bonds, whichwould have undergone a reduction, for new exempt bonds underthe same condition. The official aim is to get the public debt to be reduced from thecurrent 160% of GDP to about 120% of GDP in 2020. The Ecofinbelieves that this level is sustainable, which is quite surprising forthree reasons: firstly, this level was what Greece had in 2008/09,already in the increase and considered unsustainable then;secondly, the tax authorities must improve a great deal in order topromote the capacity to collect taxes and stop tax fraud and capi-tal flight; and thirdly the IMF’s estimates of 2-3% economic growthper year from 2014 must be fulfilled, which implies that the neces-sary structural reforms must be quickly implemented and the eco-nomy must reach considerable gains in international competitive-112
    • The Future of the Euroness by substantial salary and price reductions (according to theestimates, about 50%). All of these points are question marks. Themost probable thing is that the announced aim of debt reductionwill not be attained and that the European governments sooner orlater will again have on the negotiating table Greece’s request forfurther financial assistance.4.3. Political pressure to impose discipline, insufficient so far The European form of governance since the sovereign crisis star-ted in Greece has always been “more of the same”: to want to solvea problem of excessive indebtedness with more debt. The criticalpublic opinion, as in Germany, was calmed down by saying that nocash was going to be paid from national budgets and, therefore,from taxpayers (although there will be in the ESM), but that eachgovernment “only” had to provide guarantees (distributed amongthe countries according to the holdings of the national centralbanks in the share capital of the ECB). As if guarantees could not beenforced at the demand of the creditors, in other words, buyers ofthe securities issued by the EFSF/ESM! The expectations to calmdown the markets, restore confidence and stabilise the euro areawere not met. The markets had noticed that, in the countries badlyaffected by the sovereign debt crisis, progress in fiscal consolidationand structural reforms that raise the potential of growth and com-petitiveness, which there are, were too slow and incomplete. 113
    • The European Crisis and the challenge of efficient economic governance This was caused from outside. The aided governments have notforgotten the political messages launched from the beginning ofthe crisis from Brussels/Paris/Berlin. The messages that are least for-gotten and carry on being repeated with slight variations, are thefollowing: (i) “We will rescue the euro, no matter what it costs”(Barroso); (ii) “We will not allow anyone to fall into insolvency”(Sarkozy); (iii) “If the euro fails, Europe fails” (Merkel). There couldbe no better invitation for irresponsible governments to blackmail.That is how a government in trouble is tempted not to consistentlytake pure and hard measures, therefore reducing the cost of loss ofpolitical support, which any severe fiscal adjustment plan (withunnavoidable cuts in salaries and social benefits and necessary riseof taxes) would imply. In Greece it is already normal for the Troika(the European Commission, the ECB and the IMF), each time thatit visits Athens to verify if Greece’s government has implementedits commitments, to confirm that there is lack of forcefulness in thepolicies applied, especially in relation to the structural reforms. Butas the President of the euro group, Juncker, and the Ecofin finallyhave given the green light for new aid tranches to be given, thegovernment (after Papandreou, Papademos) could, after long nego-tiations, according to the demands of his European partners, andonce at home, do half of it. He could even reject the proposals madeby his partners (Germany, the first) to provide administrative advi-ce in situ, for instance, in order to create an efficient tax agency andto design and manage infrastructure investment projects.114
    • The Future of the Euro If with the aid programmes the idea was to buy time to imple-ment structural reforms in the real economy, as the political leadersrepeatedly emphasised, time was not used productively in all thecountries involved, and Spain was no exception during the lastpart of Zapatero’s government, when the crisis was not officiallydenied anymore: fiscal and economic consolidation policies arri-ved late and lacked consistency and force.4.4. Financial markets, with capacity to persuade One way of overcoming the reluctance of the governments toinexorable political and economic changes in their respectivecountries comes from the market, specifically the spreads of therisk premiums included in the interest rates where the Treasurymay place their issues. As mentioned above, the risk premiums of ten-year bonds, withreference to the German bond, “bund”, reached rocket prices inGreece in 2011 and also considerably in the other peripheral coun-tries with debt problems, including Spain, where the interest ratesreached all-time highs of several hundred basis points. The samehappened with the credit default swaps (CDS) premiums. No mat-ter how much the governments criticised financial agents for this,not to mention also the three main rating agencies (Fitch, Moody’s,Standard & Poor’s), we cannot understimate its deterrent effectwhen it is intended to go into greater debt. The increase in price ofthe debt convinced political leaders in the countries in trouble that 115
    • The European Crisis and the challenge of efficient economic governancethe time of spending happily had gone and that they had to beprepared for a future characterised by austerity. The new govern-ment of Spain (Rajoy) is an example of strict action to modifyunsustainable habits in society and restore the economy. In Italythere was a big change of direction since a government of techno-crats (Monti) started in November last year. Ireland had alreadystarted in March 2011, after early parliamentary elections and theformation of the new government (Kenny). Three months afterthat, the same happened in Portugal (Passos Coelho). Therefore, any decision to artificially reduce the interest rates ofgovernment bonds, as it has already been taken within the contextof rescue packages and as some governments claim, is counterpro-ductive. Eliminating the mechanisms of the market that act, wit-hout political interference, in favour of the quality of public finan-ces, is pointless. Mutualisation of the sovereign debt, no matterhow much it is proclaimed by certain political circles (also Spanish,irrespective of ideologies), as well as academic (including German,Keynesian ideas) and financial (especially the most importantbanks which are anxious to operate in capital markets with greatliquidity, comparable to the U.S. market) circles, is also pointless.There is no reason why we should think that issuing eurobondswould improve the quality of the economic policy in the euro area.On the contrary, a reduction in the price of credit in the countriesin trouble, which the eurobond would entail, would deteriorate theestimates of low cost, which all categories of public sector outlaysand any decision by the public authorities on loan finance, would116
    • The Future of the Eurobe subjected to; furthermore, it would be impossible to put pressu-re on a government from outside to control expenditure and opti-mise tax collection; and, in addition, restructuring processes in thereal economy, which are so important to raise the potential ofgrowth, would be postponed. It is far better for the financial mar-kets to deploy their penalising effects and thus complement therelevant mechanisms planned by the SGP and the coming FiscalStability Pact.5. New governance design: own responsibility as the key It seems that European leaders got it into their heads that the euroarea needs another kind of governance different from what we havehad until now. We will have to carry on thinking in the need for official assiss-tance for certain countries, not only for Greece. As regards Greece,maybe we must think of two options: one, exiting the euro, inprinciple on a provisional basis (until the fundamental problemshave been solved) and continue as a EU member; two, exiting theEconomic and Monetary Union, also for a certain time, but kee-ping the euro as dual currency circulation with their own currency. Politicians now understand better than in the past that, for thefeasibility of the monetary union in the long term, we need robustand resilient foundations to prevent external shocks of offer and 117
    • The European Crisis and the challenge of efficient economic governancedemand, both from outside and from inside (which in some way oranother will happen again). It is not enough to have a determinedcommon monetary policy dealt with by a competent European aut-hority with aims of stability and orderly functioning of inter-bankmarket. This is only one of the required conditions. Two further fun-damental conditions are inexorable for the context of national eco-nomic policies:• On the one hand, there must be some rules on behaviour in bud- getary and economic policy compatible with the efficiency crite- ria in the allocation of production factors and with growth and employment aims. The problem of “moral hazard” must be totally eliminated.• On the other hand, there must be unconditional willingness of the governments to observe these rules and act according to them. There must be a clear division of work and responsibility between the governments and the ECB. Indeed, efficient European governance means the transfer of thenational sovereignty to the European Union in budgetary mattersand in areas essential to the real economy. This would entail a qua-litative leap in the process of integration. The three pillars of the new architecture are:• The Euro Plus Pact (approved at the European Summit of 24-25 March 2011, with immediate effect);• The Fiscal Stability Pact (approved at the European Summit on 1st March 2012, with the exception of the United Kingdom and118
    • The Future of the Euro the Czech Republic, and estimated to come into force, after rati- fication by the national parliaments, on 1st January 2013);• The Macro-economic Governance Pact (approved by the European Parliament in September 2011 and ratified by the European Council, which is in force already). The three Pacts complement one another. Without quality ofpublic finances there will be no appropriate economic growth (“dis-trust effect”), but without economic growth it will be impossible tohave organised public accounts (“tax collection weakness effect”),and with no macro-economic balance growth will be slower (“effectof inefficiency in the allocation of production factors”).5.1. The Euro Plus Pact, it is not binding on anyone This Pact is based on right diagnosis: the potention of growth insouthern countries and the capacity to create employment (to a gre-ater or lesser extent) are low owing to the persistence of negativenational factors: non-qualified labour, insufficient technologicalinnovation in companies, over-regulation of the labour market andof various services, inefficient bureaucracy, deplorable tax fraud andcorruption. For this reason, structural reforms in the economy andthe institutions are so necessary. The governments of the countries of the euro area have under-taken to implement it; other six countries of the EU have also 119
    • The European Crisis and the challenge of efficient economic governance undertaken this commitment (for this reason the term “Plus” has been added to the name of the Pact).6 The scope of action that the Pact contemplates affects the labour market, the educational sys- tem, the environment for research, the tax system and a long etce- tera. All this is praiseworthy. But the main problem of the Pact is that it gives full freedom to the governments to take the measures that they deem appropriate and not to take others that would also be necessary from an objec- tive point of view. There is no sanction in case of lack of strictness. Therefore, this pillar of economic governance of the euro area does not offer security. 5.2. The Fiscal Stability Pact, a test of nine Rightly, the inexorable key is the commitment from the govern- ments to maintain orderly and balanced public finances in the future. This is no dogmatic approach (“neoliberal”, as some call it pejo- ratively), but it is the consequence of an economic analysis, sup- ported by theory and empirical experience. Government deficit must be limited, owing to the “Domar condition”, according to which, for reasons of assignative efficiency, long-term interest rates6 European Council, Conclusions 24/25 March 2011, Annex I: The Euro Plus Pact –Stronger Economic Policy Coordination for Competitiveness, Bruselas, 25/3/11 (EUCO 10/11,CO EUR 6, CONCL 3). 120
    • The Future of the Euromust be higher than the economic growth rate. With no ceiling forgovernment deficit sooner or later we reach a point from which thefinancial expenditure of the State (for servicing the debt) increasessubstantially, which progressively reduces the room for manoeuv-re of the government to seek its economic and social aims. Thelevel of public debt must be limited because of the“Reinhart/Rogoff rule”, derived from econometric studies, whichestablish a critical threshold of 90% of GDP, from which the secu-lar economic growth rate may diminish at least half a percentagepoint per year for three reasons: one, because public debt servicingreduces the margin for productive investment of the State (infras-tructures); two, because payment of interest to foreign creditorsreduces available national income and, therefore, the capacity ofconsumption of households; and three, because the need to re-finance sovereign debt makes financing of private companies incapital markets difficult (“expulsion effect”). The Ltmus test is characterised by strictness under which thegovernments deepen in budgetary consolidation. Despite the factthat in different countries of the euro area some measures invol-ving tax adjustment have been taken already, public finances arenot consolidated at all. According to the European Office ofStatistics (Eurostat), government deficit is excessive (more than3% of GDP) in most of the countries, also in Spain (2011: 8.5% ofGDP). Germany (1%) and four small countries (Estonia, Finland,Luxembourg and Malta) are the few exceptions. Most of thegovernment deficits are structural, in other words, not cyclic but 121
    • The European Crisis and the challenge of efficient economic governance permanent, and, therefore, destructive for the good functioning of the economy. The level of public debt is also too high (higher than 60% of GDP) in almost all the countries, including Germany (2011: 81.2%) and France (85.8%) and now also Spain (68.5%), for the first time since 2011, Spain (68%). Where public debt greatly exceeds all acceptable levels according to the “Reinhart/Rogoff rule” is in the three countries that have been rescued (Greece, Ireland and Portugal) and in Italy. For the latter country, however, there is a differentiating factor in its favour, most of the public debt is internal and, thus, its servicing may be managed directly with its own instruments (by increasing fiscal pressure on its citizens). As mentioned above, the rules on sustainability of public finan- ces as set forth in the Treaty of the European Union and in the SGP have not been efficient to impose budgetary discipline. Its applica- tion has been highly politicised. The mechanisms of penalisation have never been implemented. The new Fiscal Pact has been arran- ged in such a manner that it could put the screws, firstly, on the euro countries on which the agreement is binding.7 The most important advances as regards the SGP, for the moment only on paper, are the following three: • Firstly, the seriousness of government deficit is explicitly ack- nowledged when it is structural. The explicit ceiling established7 European Council, Treaty on Stability, Coordination and Governance in the Economic andMonetary Union, 2/3/12, artículos 3-8. Internet: http//:eur-lex.europa.eu. 122
    • The Future of the Euro is 0.5% of GDP, maintaining the threshold of 3% for total defi- cit. There is thus a large margin for the operation of “automatic stabilisers” in the economic cycle and for discretionary govern- mental measures if there is recession.• Secondly, the aim of limiting the level of public debt at 60% of GDP through a procedure which, if the debt exceeds this per- centage, may activate the supervisory mechanism for “excessive government deficit”, even if the deficit is below 3% of GDP. The country in question shall be forced to reduce it at an average rate of one twentieth per year as a benchmark (“1/20 clause”).• Thirdly, the obligation for each member country to define its medium-term budgetary objective (MTO), quantifying an indi- cator for public expenditure evolution and making sure that the estimated expenditure shall be financed by sustainable income (“golden rule” of budgetary balance). If a country does not orga- nise its budgets in a balanced manner it will be required by the European Commission to submit new budgetary plans. If the new rules are important, a mechanism to enforce them isequally important. The most relevant three new elements are thefollowing:• First, continuous supervision of the policies applied in both summits of the euro area has been devised (two per year, at least, called and chaired by the President of the EU, currently Herman Van Rompuy).• Second, there is a change in the decision process on financial sanctions (of up to 0.2% of GDP) in case of breach and non-ful- 123
    • The European Crisis and the challenge of efficient economic governance filment of the specific recommendations to remedy the situa- tion in the sense that a proposal of the European Commission is considered approved if the Council of the Heads of State and Government of the euro area does not vote against it with a qua- lified majority (until now such a majority was required for the European Council to approve the sanction). Therefore, there will be less room for political maneuvre to prevent the fine (as it was normal in the past after the Schröder/Chirac precedent mentio- ned above). The sanctions are not totally automatic as one would like them to be, but they are moving in that direction. Furthermore, they have a broader scope than before, because the manipulation of fiscal statistics shall also be punished.• Third, the obligation for each member country to transpose the fiscal stability rule into its national legislation is established and, therefore, be explicitly responsible for its fulfilment. The Court of Justice of the EU shall ensure its fulfilment. For the States to decide the medium-term budgetary stability(equivalent to the economic cycle), the most credible formula is toconstitutionally estabish a ceiling for structural government deficit.Germany has already done it (0.35% of GDP for the central govern-ment, from 2016, and cero deficit for the federal states, from 2020).Spain is moving in that direction after the reform of article 135 ofthe Constitution at the end of the previous term of office and therecent approval of the Budgetary Stability Law which will requirefrom 2020 cero structural deficit to the public authorities (whichcould be up to 0.4% of GDP in exceptional circumstances). Other124
    • The Future of the Eurocountries are moving in that direction. The advantage of a consti-tutional rule as regards de margin of debt of the government is that,if a country incurs deficit and constitutional breach, it will need bet-ter arguments for its society than if it only needs to be explainedbefore the Community authorities and take there the relevant war-nings; Brussels is “far” and it is “under suspicion” of meddling innational affairs. The Fiscal Pact will only work if the euro area countries arewilling to do without most of its sovereignty in budgetary matters,which will be transferred to Community institutions. Obviously,this affects the main prerogative of national parliaments, which isto shape the budgets of the State and decide how to finance expen-diture. This will meet great opposition, in all the countries. It is nota trivial matter that the Fiscal Pact must be institutionalisedthrough an inter-governmental agreement, that is to say, a levellower than the Treaty of the EU, which reform would have requi-red the unanimous approval of the twenty-seven, which was notreached. This procedure has opened in the legal field a debate todecide if the procedure chosen is compatible with CommunityLaw, specifically in relation to the mechanisms of sanctions forexcessive government deficit as set forth in article 126 of theTreaty. For European leaders to have lowered the quorum requiredfor parliamentary approval of the inter-governmental agreement isnot a trivil matter either, to 12 of the 17 States that form part of theeuro area. Could it be that some partners are not reliable? It is truethat it has been decided that the countries that do not ratify the 125
    • The European Crisis and the challenge of efficient economic governancePact and transpose to their national legislation the ceiling ofgovernment deficit will be excluded from possible financial bai-lout. However, is this credible, especially if the stability of the euroarea is at risk? This being so, it would be better not to be too hope-ful about this Fiscal Pact.5.3. The Macro-economic Governance Pact, with vagueparameters The same caution is advisable with regards to the solemnlyproclaimed Six Pack (so called because its content has been draf-ted through a Community directive and five regulations).Nodoby doubts that, for the feasibility of the euro area, macro-economic stability is a necessary condition (although not enoughif the requirements for an optimal monetary area are not fulfi-lled). Furthermore, it is true that macro-economic stability goesbeyond budgetary balance, as it has been proven with the recentexperience of different countries (inflationary pressure, propertybubble, excessive private sector debt, competitive weakness ofcompanies, current account imbalance, etc.). However, theEuropean Commission, the European Parliament and theEuropean Council seem to have faith in the capacity of economicpolicy to handle crucial factors in the real economy. This ishighly questionable. An alert mechanism scoreboard was created for the appearanceof internal and external imbalances in the countries, which will be126
    • The Future of the Euromanaged by the European Commission based on ten parameters,as follows: 8• Internal imbalance parameters: evolution of unit labour cost, unemployment rate, private sector indebtedness, credit to the private sector, evolution of property prices and government indebtedness.• External imbalance parameters: surplus and deficit of current account balance, net international investment position, change of export market shares and change of the real effective exchange rates of the euro. For these parameters, critical thresholds have been established,from which the alarm would be triggered, and this would start aprocedure to analyse the causes in order to decide from Europe ifcorrective measures need to be taken or not. For instance, for unitlabour costs the threshold is an increase of 9% in three years, forunemployment rates it is 10% of the workforce as a three-year ave-rage or for current account balance the threshold established is 3year backward moving average of the current account balance as aper cent of GDP, with a threshold of +6% of GDP (surplus) and -4%of GDP (deficit). If there is excessive imbalance, the EuropeanCommission will make the relevant recommendations for thegovernment of the country in question to remedy the imbalance; incase of non-fulfilment, a fine may be imposed (up to 0.1% of GDP).8 European Commission, EU Economic governance “Six Pack“ enters into force,MEMO/11/898, 12/12/2011. 127
    • The European Crisis and the challenge of efficient economic governance The thresholds set are not a consequence of a detailed economicand empirical analysis that may indicate for sure when an imba-lance is excessive for a country and negatively affects the euro areaas a whole. The numerical values rather represent the perception ofpoliticians of the recent events; therefore, they are, unavoidably,arbitrary. But the fundamental question is different: How can agovernment act efficiently? We must remember that the EU proposes an open market eco-nomy with free competition (article 119 of the Treaty of the EU). Alleuro countries have this concept of economic system, some becau-se of the Ludwig Erhard tradition (Germany), and others with reser-vation in favour of the government (France). In a market economy,the government lacks the instruments to control the variables con-templated in this Macro-economic Governance Pact. Therefore, thegovernments should activate a series of interventionist measures,with no guarantee of their efficiency and with a high risk of distor-ting efficiency in the allocation of production factors. In a marketeconomy, responsibilities are distributed in a different way: for levelof employment, social partners (unions and employers); for exportdevelopment, private companies (technology); or for grantingloans, commercial banks (based on the appropriate risk estimate).The current account balance, among other things, represents thesaving trend rooted in society and objective conditions for fixedcapital investment (as explained by the “macro-economic equa-tion” and the “Böhm-Bawerk theorem”). Unions will not acceptgovernment interference in the negotiation of collective agree-128
    • The Future of the Euroments and companies will not stop being creative or innovative inorganisational management and product development for whichelasticity-income of international demand is higher than the unit,and banks will not neglect their classical business, which is to pro-vide credit to companies and households. This economic governance project has no clear future. In thebest-case scenario, the new Summits of the euro area would havematters to discuss. The countries in which the economy works wellcould be taken as a benchmark for the others to rectify their struc-tural deficiencies and improve their productive and competitive-ness levels. In the worst-case scenario, the euro area would be expo-sed to continuous political conflicts, which would not promoteeconomic growth with high employment. It is so easy, and espe-cially politically profitable in countries with domestic problems, tolook for the villain abroad, maybe Germany?Conclusion The sovereign debt crisis has had a healthy effect in convincingpoliticians that by providing liquidity to governments and banksthe stability of the euro area will not be attained in the mediumand long term. The quality of the economic policy must improvein the countries, there must be impeccable follow-up by indepen-dent institutions to weigh up the economic and fiscal situation andit must be guaranteed that national accounts and other relevantstatistics are arranged under utmost scientific accuracy at all times. 129
    • The European Crisis and the challenge of efficient economic governance If in all the euro countries the governments understand thatsound public finances and application of structural reforms is theirresponsibility and if they act seriously according to them, no Statewill have to rescue another State because of over-indebtedness andwaste, and the ECB may stop indirectly financing States and focusmore on its task, ensuring stability in price levels in the euro area.The ESM fund would be reserved to emergency situations caused byexternal factors beyond the government’s control. The Fiscal Pactwould have fulfilled its mission and the Euro Plus Pact would befilled with efficient contents. We would not need to resort to mar-ket interventionism as entailed with the Six Pack. If, on the contrary, there is no determination in the membercountries, any attempt of European economic governance wouldresult more from proactive intentions than harsh reality. The euroarea would have an uncertain future. The alternative of a EuropeanPolitical Union, in which all necessary economic policies could beundertaken from a Community Executive under the control of theEuropean Parliament, with all democratic rights, cannot be seen onthe horizon.130
    • /GONZALO GARCÍA ANDRÉS * / The turbulent adolescence of the euro and its path to maturity1. Introduction; 2. Anatomy of the crisis: Greece, the contagion and the per-verse dynamics of debt; 2.1. Sovereign credit risk within the euro: from zeroto infinity; 2.2. A fiscal problem, not the fiscal problem; 2.3. Contagion: thefragmentation of the single monetary policy; 2.4 A particular manifestationof the global financial crisis; 3. The Eurosystem at a crossroads; 3.1. Intra-system balances as an expression of the fragmentation of monetary policy;3.2. Quantitative easing for banks only; 4. The definitive solution mustbegin in 2012; 5. Conclusion; Bibliography* Member of the Technical Body of the Spanish Civil Services (Técnico ComercialEconomista del Estado) and Graduate of Economics at Universidad Autónoma deMadrid. He has spent a large part of his professional career in the current General Officeof Treasury and Financial Policy in the Ministry of the Economy and Competitivenessof Spain. He held the office of Deputy Director of Financial and Strategic Analysis, res-ponsible for financial stability and crisis management issues, international financialpolicy (EU, G20) and adviser to the Social Security Reserve Fund. In September 2009 hewas appointed Deputy Director of Funding and Debt Management, where within a fewmonths he was involved in the adaptation of the Treasury funding programme to theinstability generated by the Greek fiscal crisis and its contagion throughout the rest ofthe euro region. From September 2010 to January 2012 he has held the office of DirectorGeneral for International Finance, which has enabled him to form part of the manage-ment boards of the European Investment Bank and of CESCE. He has likewise beenAssociate Professor in Economic Theory at Universidad Rey Juan Carlos and has publis-hed several articles on regulatory, financial and monetary matters in Spanish journals. 131
    • The turbulent adolescence of the euro and its path to maturity 1. Introduction The Monetary Union is a political construction, the boldest and most significant step forward by the European project since the Treaty of Rome. Its conception also had an economic basis, that of completing the consolidation of the economic integration process which was begun in 1985. However, its implementation was a great adventure. The countries that use the euro are far from constituting an optimal monetary zone. In addition to the evident initial diffe- rences in the economic and institutional structure of the countries and in their histories of stability, the euro was forced to make room for disparate economic philosophies. The European leaders elected to create a very light institutional structure, with an independent federal monetary authority, an apparently severe budgetary discipline (the Stability and Growth Pact or SGP) and the rule of no mutual support (in order to rein- force the individual fiscal stability of each State). During its first ten years the euro appeared to be working relati- vely well. Average real growth exceeded 2% and both the level and the volatility of inflation improved in comparison to the previousHe is currently an adviser in the General Deputy Office of Financial and EconomicMatters of the European Union and the Eurozone which is part of the General Office ofthe Treasury and Financial Policy. The opinions expressed in this article pertain to theauthor and under no circumstance may be attributed to the Ministry of the Economyand Competitiveness. 132
    • The Future of the Eurodecade, although the differences in the macro-economic and finan-cial behaviour of the members were quite considerable. Althoughthe Stability and Growth Pact was reformed mid-decade, no signi-ficant alterations were made to the institutional framework and thenumber of members gradually grew. The onset of the financial cri-sis in 2007 initially underlined this perception of the euro as somet-hing imperfect but solid. However, a little after its 11th anniversary, three interconnectedcalamities fell upon the euro. Firstly, one of its members plumme-ted towards insolvency in just three months. Secondly, the politi-cal pact on which the single currency was built began to shakewhen financial assistance within the area became inevitable. Andthirdly, the unity in regard to monetary policy fell apart with thedislocation of the public debt markets. Two years later, and despite having taken decisive steps in natio-nal policies and in institutional framework reform, the crisis of theeuro has deteriorated to the point of calling its survival into ques-tion; and a definitive solution is yet to be glimpsed. With the bene-fit of hindsight, it is worth attempting to interpret was has happe-ned, taking into account the extreme complexity both of the initialsituations (with accumulated imbalances and structural deficien-cies in several countries), as well as the outbreak, contagion andescalation of the crisis. And to do so moreover against the broaderbackdrop of the global financial crisis, which has influenced eco-nomic and financial evolution for five years, in order to identify 133
    • The turbulent adolescence of the euro and its path to maturitywhich specific aspects of the euro have played a vital role. All theabove with the aim of helping come up with solutions, bringingtogether the most urgent ones and those of a longer term basis.2. Anatomy of the crisis: Greece, contagion and the perversedynamics of debt2.1. Sovereign credit risk within the euro: from zero to infinity The natural starting point of the analysis of the crisis is thebehaviour of sovereign debt markets. The creation of the euro gaveway to a number of markets for debt securities issued by sovereignstates but denominated in the same currency. This is an atypicalconfiguration with few precedents, given that sovereign debt secu-rities are usually associated with the bond that exists between theissuer and monetary sovereignty. Until 2007 the markets considered that the very creation of theMonetary Union had reduced sovereign credit risk to a very smalllevel. For example, the spread between the ten year Greek bondand the ten year German bund fell within a range between 10 and30 basis points between 2002 and 2007. In spite of GDP growingat relatively high rates, the level and performance of the fiscal andcurrent account imbalances in Greece had justified a much higherrisk premium.134
    • The Future of the Euro With the outbreak of the global financial crisis, credit risk spre-ads among Eurozone countries widened. But this trend – commonto all of the world financial markets –, was mainly due to risk aver-sion and an increase in the demand of assets deemed to be safer(Barrios et al, 2009). The spreads thus adopted a trend towardsmoderation throughout 2009, all amid a context of low absolutefinancing costs for the sovereign issuers. Towards November 2009, an alteration in the behaviour of sove-reign debt markets took place, which in hindsight can be conside-red as a structural change. The almost perfect convergence sincethe beginning of the Monetary Union1 therefore gave way to acumulative bifurcation, reflecting the binary behaviour of the mar-kets. This is a dynamic system with two main features:• Systematic inefficiency. Bond market prices do not reflect the fundamental information on credit risk determining factors. Until 2009, the spreads had been smaller than would be justified by the main variables (debt stock, deficit, international invest- ment position, real exchange rate); since autumn 2009, the spre- ads have been systematically higher than would be justified by the performance of the fundamental variables. This gap betwe- en market prices and economic fundamentals has been noted in several empirical studies (Aizenman, Hutchison & Jinjarak (2011), De Grauwe & Ji (2012)).1 The average 10 year debt spread in Eurozone countries against Germany was of only18 basis points between 1999 and mid-2007. 135
    • The turbulent adolescence of the euro and its path to maturity• Tendency towards instability. The euro sovereign debt markets have shown themselves to be incapable of adjusting their credit risk assessments in a stable manner. Their capacity for discrimi- nation has been non-existent for years, with a high demand for bonds from countries exposed to vulnerability, which were dee- med to be almost perfect replacements for the German bund. And in these last two years, the trend has been explosive. In micro-economic terms, instability means that given an excess supply of bonds, a drop in price does not bring it back to balan- ce. But furthermore, we must point out that the explosive natu- re of the sovereign debt markets since the beginning of 2010 has become more noticeable than that reflected in market prices. ECB intervention has lessened the trend towards increases which are sharp and not related with new fundamental infor- mation on the likelihood of default by various countries in the region. On the basis of this general outlook of the dynamics of debtmarkets, a distinction must be made between the Greek marketand the rest.2.2 A fiscal problem, not the fiscal problem The Greek situation is special. In October 2009, the new Greekgovernment announced that the public deficit for the year wouldbe somewhat over double that which had been forecast (12.7% ofGDP versus the expected 6%). This setback of Greek public debt136
    • The Future of the Eurowas thus triggered by a fundamental fiscal surprise of considerabledimensions. Greece has systematically managed its public finances poorlysince joining the euro.2 It has taken advantage of the financialbenefits of belonging to the euro to increase expenditure, whilemaintaining a pro-cyclical fiscal orientation during a clearly expan-sive phase. The Hellenic country has thus made real one of theworst fears of the founders of the euro in regard to the risk of free-rider fiscal behaviours. The bad news is that neither the market dis-cipline under the non-mutual guarantee clause nor the Stabilityand Growth Pact have managed to correct this situation, which hasworsened further due to continuous problems regarding reliabilityof public accounts. The Greek public debt market has also followed a pattern ofinefficiency and instability. Gibson, Hall & Tavlas (2011) haveidentified a systematic bias between the credit risk spread adjustedto the main determining variables and the market spread.Nevertheless, the collapse of the market is not difficult to explain.The depth of the fiscal crisis and its structural nature, added to theuncertainty and lack of confidence generated by the handling ofaccounts, spread the perception among investors of inevitableinsolvency with a certain risk of loss of principal.2 In fact, its public deficit has never been below 3% since it joined the monetary union. 137
    • The turbulent adolescence of the euro and its path to maturity What is hard to explain is why the Greek crisis spread to the restof the public debt markets in the area. Firstly, the weight of Greecein the GDP of the Eurozone (around 2.3%) does not justify that itsfiscal crisis should become a systemic problem. Secondly, no otherEurozone member country is anywhere near this level of systema-tic poor management of public funds and continuous breach ofthe rules of the Monetary Union. There are two factors in the Greek collapse during the firstsemester of 2010 which became important for the operation of therest of the Monetary Union. To begin with, the fragility of thedomestic debt markets within the Eurozone became clear.Secondly, the political tension generated by the intra-zone finan-cial aid revealed a considerable institutional weakness. Discussionsprior to the approval of the loan to Greece brought to light that thepolitics of the countries in the zone were about to take on a hardline of fiscal adjustments and onerous conditions in the financialaid defended by creditor countries, in stark contrast with the posi-tion of countries which were beginning to feel the effect of the tur-bulence in Greece as of January. Even so, it seems impossible to explain how the Greek crisisbecame a euro crisis in light of only these two factors. Particularly,following the creation in May 2010 in response to the explosivemarket situation, of the European Financial Stability Facility andthe start of the intervention by the Eurosystem via the SecuritiesMarket Programme.138
    • The Future of the Euro2.3 Contagion: the fragmentation of the single monetary policy The strategy we have chosen to explain the spread from Greecethroughout all of the Monetary Union is a two-phased approach.The first phase attempts to define the morphology of the crisis,which may help, at a second phase, to get to the bottom of itsnature. These are the main morphological characteristics of the crisis:• Systemic for the entire Eurozone. The crisis is often discussed as if it only affects part of the Monetary Union; along the same lines, it is argued that this is not a crisis of the euro, on the grounds of exchange rate levels or price stability. In fact, since the generalised dislocation of the debt markets was sparked off towards the end of April 2010, the crisis has indeed become a euro crisis. It affects all member countries, albeit in opposite way. There has been a flow of capital from the more indebted countries to the creditor countries, which has been reflected in the yields of public debt and other securities. Thus, the impact of the fiscal irresponsibility of one of the members has not resulted in a generalised increase in interest rates as was expec- ted (Dombret (2012)). It has had an asymmetric impact, punis- hing countries with greater financial vulnerability and benefi- ting the stronger ones.• Specific to the Eurozone. The financial bifurcation movement has been limited to the member states, despite having some 139
    • The turbulent adolescence of the euro and its path to maturity effect on the rest of the world.3 There is no sovereign debt glo- bal crisis; on the contrary, public debt yields in the main deve- loped countries have reached historic minimal levels. Thus, the main non Euro indebted countries (United Kingdom, United Sates) have seen an increase in the demand of sovereign debt as a result of the euro crisis. For instance, at the start of 2010, ten year British debt securities traded at levels similar to the Spanish ones. The worsening of the crisis in the Eurozone has meant that the British debt is just a few basis points away from the German debt. The negative contagion has therefore only affected euro members, whereas the positive contagion of public debt has managed to reach other markets. • Its dynamics are financial and autonomous, not defined by fundamental economic variables. This statement calls for an explanation because… doesn’t Ireland have a serious solvency problem in its banking system? Isn’t Portugal undergoing a current unsustainable imbalance? Doesn’t Spain have a high public deficit and an excess of private debt? How will Italy manage to sustain a public debt stock of 120% of the GDP and a GDP growth trend below 1%? … and we could move on to Belgium and then to France. All the euro countries which have suffered the restriction of their external financing terms in the3 The Euro crisis has become the main factor threatening the recovery of the world eco-nomy and the consolidation of the progress made in restoring financial stability afterthe global crisis. However, at this point only direct spreading via debt markets is dis-cussed. 140
    • The Future of the Euro last two years are facing serious problems. But the existence of such problems does not make them causes for the dislocation of the debt markets and the consequences thereof. In fact, in all cases we are dealing with problems with which the markets have been well acquainted for years. There are two ways of illustrating the secondary role played by economic fundamentals in the cri- sis. One is to compare euro countries affected with other non- euro countries with similar fundamentals. Aizenman et al (2011) have done this by matching Spain with South Africa and con- cluding that the greater risk spread in Spain cannot be explained by the worse levels in the variables which have determined cre- dit quality ratings. The other is to verify whether an improve- ment in the fundamentals (including economic policy measures required to achieve this) has had a positive impact on the finan- cing terms. For example, affected countries have considerably reduced their primary deficits adjusted to the cycle, although this has not helped to improve the perception of the fiscal situa- tion. This does not mean that the fundamentals are not impor- tant when determining the vulnerability of a country, or that the economic policies adopted in response to the crisis have not proven vital in halting or slowing down the impact of the crisis. But it is important to stress that the crisis is essentially not a pro- blem of fundamental economic variables.• It has become apparent through the inversion of the capital flow pattern within the euro. For years, the economies with lower rates of savings (such as Greece or Portugal) or higher 141
    • The turbulent adolescence of the euro and its path to maturity investment rates (such as Spain) comfortably financed their large deficits via private flows of capital from countries with hig- her rates of savings and lower investment rates. As of spring 2010, many of these countries have been forced to face an inte- rruption, and in some cases a sudden inversion, of external funds, as shown by the performances of their financial accounts (see Graph 1 for Spain). Part of that capital has been diverted to creditor countries. From this perspective, the crisis can be understood as a series of sudden stops (with their pertaining sudden goes) in capital flows within the Monetary Union. The most acute episodes of the crisis have thus coincided with an intensification of the external financial restriction. In short, it is about a crisis in the balance of payments within the particular framework of the Monetary Union, whose adjustment variable is not the amount of reserves but the net funding of the Eurosystem. By combining these characteristics, the crisis can be defined as a cumulative coordination failure, with a positive feedback.4 The key mechanism underlying this failure is the effect that the dislo-4 The concept of coordination failure arises as part of an alternative interpretation ofKeynes’ analysis to that of the Neoclassical Synthesis, which considers there is a deeperexplanation for unemployment and instability problems than salary rigidity. In a firstformulation, it can be associated with the Macroeconomics of imbalance. Subsequently,within the framework of New Keynesian Economics, this is analysed with differentmodels which have strategic interdependence and multiple balances in common(Cooper and John, 1991). In the context of the financial crisis, the coordination failu-res have played a core role, linked to uncertainty and the effect thereof on expectations. 142
    • The Future of the Euro Graph 1 Net Loan and Financial Account balance of Spain Source: Bank of Spaincation of the operation of the public debt market has over themechanism of monetary transmission and, in the last resort, onthe financing conditions of the non-financial private sector. Indeed, the public debt markets, in addition to procuring statefunding, play a central role in the operation of the monetary andfinancial systems. The yield curve of public debt, considered to bethe risk-free asset, serves as the main price reference for the rest ofthe credit and securities markets, acting as a floor for financingcosts for all other agents. On the other hand, the implementationof monetary policy traditionally uses government securities as assetguarantees. And financial institutions, and credit institutions,UCITs and pension funds in particular, often keep a considerableamount of sovereign bonds in their portfolios. 143
    • The turbulent adolescence of the euro and its path to maturity The dislocation of the public debt markets has had a devastatingeffect on the affected economies. The increase in volatility (seeGraph 2 for the Spanish market) and the upturn in the credit riskspread without any underlying new fundamental informationhave restricted funding for the non-financial sector in variousways. Directly, insofar as market-funded companies must pay morefor issues. And indirectly, and more importantly given the finan-cial structure of the euro economies, it operates via the bankingsystem. Bank access to market funding is restricted in terms ofvolume and prices, whilst the value of both their public debt hol-dings and other market shares continues to fall. The result is a res-triction in funding available to businesses and households. Graph 2 Historical volatility of Spanish debt Source: Bloomberg144
    • The Future of the Euro This situation gives rise a contracting spiral which generates aperverse dynamics in the sustainability of public debt. The first reac-tion from countries suffering from a financial restriction mainly oftheir debt markets is the acceleration of fiscal adjustment which, inprinciple, appears to be a logical and reasonable response. The pro-blem is that a combination of a strong contractive fiscal approachand financial restriction weakens the nominal GDP. This leads toan increase in the nominal fiscal adjustment required to achieve adeficit target in relation to the GDP. Unemployment rises, disposa-ble income falls and the creditworthiness of businesses and house-holds deteriorates. The result is a deterioration of the Debt/GDPratio, with a feedback effect.In summary, the dislocation of public debt markets generated anendogenous monetary restriction, equal to a drastic toughening upof monetary policy in the most affected countries. The transmis-sion mechanism of the policy established by the ECB no longerworks in a fairly uniform manner, upset by the intensity of the pri-vate funding flows and the effect thereof on expectations. Theresult is the breakdown of the single monetary policy.2.4. A particular manifestation of the global financial crisis The symptoms of this disease afflicting the Monetary Unionseem very familiar by now: debt markets which no longer work nor-mally, spreads with an explosive tendency, asset liquidation at dis-counted prices (fire sales), banks in the grip of liability restrictions 145
    • The turbulent adolescence of the euro and its path to maturity and falling asset values, gaps between the financial sector and the real economy. In fact the mechanism is identical to that which led to the subprime mortgage debacle in the systemic crisis of develo- ped economies in 2007-2009. The main difference is that both the source and the means of contagion were in that case the private debt markets, whereas in the Eurozone the dislocation has mainly taken place in public debt markets. But the analogy is valid in analytical terms and can prove quite useful when considering the regulatory implications which will result from the crisis resolution. The effect on monetary policy was similar, although at that time the public debt markets carried on as normal and could continue to be used to tackle the endogenous restriction in the financing con- ditions of the private sector with firm and innovative measures. Several studies on the nature of the global financial crisis have highlighted the importance of the increase in uncertainty when seeking to understand and resolve it. Caballero (2010) considers that the financial crisis, which appears similar to a heart attack, is the product of a combination of uncertainty as defined by Knight and the complexity of the structure of the financial system. These two factors amplify the initial shock effect, with forced sales of assets and liquidity strangulations which drive a wedge between the financial sector and the real economy, preventing the proper operation of the economy and the markets.5 The solution requi-5 This then leads to large scale coordination failure, in the sense mentioned at the endof the previous note. 146
    • The Future of the Eurores the State to become an insurer of last resort, providing insuranceagainst uncertainty to persuade the agents that the less likely nega-tive scenarios will not take place. This enables the coil to snap, thuscoordinating agents at higher comfort levels. This financial crisis model can be applied to the Eurozone. TheGreek fiscal surprise and its rapid decline towards insolvencywould be the initial shock, generating confusion among agents andleading them to reconsider their perception of sovereign risk wit-hin the euro. The complexity of the financial interrelations withinthe area, along with the emergence of political differences, disse-minates lack of confidence to all other markets. And the rapid dis-location of the debt markets increases uncertainty, hits the banksin affected countries and ends up by paralyzing the workings oftheir financial system and depressing the real economy. The inten-sity of self-fulfilling prophecies in the markets increases the uncer-tainty regarding the outlooks for the countries and for theMonetary Union as a whole. Investors fear the possibility that themarket dynamics should cause solvent countries to lose access tonew funding. Definitive uncertainty appears when the disintegration of theMonetary Union, which seemed like a bad joke even at the start of2010, becomes a scenario deemed likely by main investors. In fact,the persistence of such huge spreads between the public debt ofmember countries is an unequivocal indicator that the market istaking the possibility of disintegration very seriously. Investors 147
    • The turbulent adolescence of the euro and its path to maturityaccept negative real returns in the short term and no return in themedium and long term of the German public debt because theybelieve that, given a break-up scenario, these assets are the oneswhich will guarantee the security and continuity of the euro. It is a fact that certain partial insurance mechanisms to dealwith the effects of the crisis have been implemented in theEurozone. On the one hand, the Eurosystem has performed therole of lender of last resort for the banking system with force, adap-ting its role to perceived needs. On the other hand, the creation ofa system of financial aid as a component of the institutional fra-mework of the Monetary Union also constitutes a significantcollective insurance item. But as we pointed out in the introduc-tion, for the time being these instruments, along with the stepstaken at a national level, have not managed to prevent crisis relap-ses. The relapse of summer 2011 was particularly serious, as itunderlined its systemic nature and struck both Italy and Spain,with an ensuing financial strangulation that has led to a new reces-sion in the region.3. The Eurosystem at a crossroads The ECB and the 17 National Central Banks (NCB) comprise themost powerful institution in the Monetary Union. Its legal inde-pendence is greater than that of other central banks in developedcountries and, like them, it has the essential power of unlimited cre-148
    • The Future of the Euroation of money. In contrast with the rest of Monetary Union bodies,the Eurosystem is capable of making decisions and of expedientlyexecuting them. Even so, it is not a central bank like all the others.During its first decade of life, the difficulty entailed in setting a sin-gle monetary policy to be applied to a group of economies with dif-ferent fiscal policies and economic and financial cycles becamepatently clear. But since the Greek crisis, the task has become extra-ordinarily complicated: on the one hand, due to mix of the fiscalorigin of the problem and the financial nature of the contagion;and on the other, as a result of the tension which the solutions con-sidered has produced between the Bundesbank philosophy and thatof the more pragmatic (and closer to Federal Reserve and Bank ofEngland standards) monetary policy of the all the others. The Eurosystem has been in the eye of the storm for the last twoyears and its performance has been the target of criticism from allangles: there are those who resent it not having acted in a suffi-ciently forceful way and there are others who believe that the SMPand the Long-Term Funding Operations are causing it to deviatefrom its mandate and endanger price stability. With our sights set on the search for a definitive solution to thecrisis, let us attempt to better understand the implications of whathas happened for the single monetary policy and the responsegiven by the Eurosystem. 149
    • The turbulent adolescence of the euro and its path to maturity3.1. Intra-system balances as an expression of the fragmentation ofmonetary policy It would have all been simpler if the impact of the Greek fiscaldebacle would have been a generalised increase in public securitiesinterest rates in all other euro members. The Eurosystem wouldhave been able to counteract this effect by adjusting the tone of itsmonetary policy. However, the contagion has driven a wedge wit-hin the euro-debt financial markets, where capital is flowingtowards creditor countries and away from debtor countries. The dislocation of the debt markets has endowed the net fun-ding of the private sector in each country with strongly endoge-nous dynamics, as can be observed in Graph 3. Despite the expan-sive tone of the monetary policy of the ECB, in Ireland, Portugal,Greece and Spain, businesses and households have had to face adrop in the supply of funds, which in recent months has also affec-ted Italy. In countries such as Finland, the net capital inflow hasmagnified the expansive tone of the monetary policy. The Eurosystem has thus had to face the most difficult problemsince its foundation, in that it directly questions the unity of themonetary policy within the area. The alteration in the pattern of financial flows within theregion has substantially modified the geographical distribution ofbalances within the Eurosystem. As we have already mentioned,150
    • The Future of the Eurowithin a monetary union a deficit in the domestic balance of pay-ments is best funded with a greater appeal made by the bankingsystem of the country to the Eurosystem. If we take a close look atthe evolution of the financial account balance of Spain, excludingthe Bank of Spain and the Net Eurosystem Loan granted to theSpanish banking system (Graph 1), we can conclude that deficitsin the balance of payments have been offset by an increase inappeals to funding via monetary policy operations. The result of this is that the counterparts of the monetary base(which can be calculated from the Eurosystem consolidated balan-ce sheet) are now more concentrated in those countries which Graph 3 Interannual Growth rate Bank Funding of the non-financial private sector in Feb 2012 Source: Bank of Spain 151
    • The turbulent adolescence of the euro and its path to maturity have experienced the dislocation of their debt markets and the res- triction of private sector funding. The accounting reflection of these financial dynamics can be found in the sharp increase of the so-called intra-system balances. The monetary policy decided by the Eurosystem is applied in a decentralised fashion, in that it is carried out via national central banks. The net balance of the operations of a given country with all other countries in the area generates a book entry shown as the balance variation between each national central bank (NCB) and the ECB. These intra-system balances, required to ensure the iden- tity between assets and liabilities in the NCBs and an appropriate distribution of seigniorage, disappear when the balances are aggre- gated in the consolidated balance sheet of the Eurosystem, as the sum of positive balances is equal to the sum of the negative ones. The component of these intra-system balances which explains its sharp increase during the crisis is the one that relates to the varia- tions in the net balance of outstanding operations settled via TAR- GET2, whose counterpart entity is the ECB.6 These operations can be either private inter-bank transactions or monetary policy opera-6 The other basic component of intra-system balances is that related with the issue ofeuro banknotes. Both the ECB and the NCBs issue euro banknotes in accordance witha key (8% allocated to ECB and an adjusted allocation by the NCBs). Then the NCBsrelease them based on demand. The difference between the allocated issue of bankno-tes and the release thereof into real circulation generates an intra-system balance,which is required for a fair distribution of seniority associated with banknote issue.Germany has the highest negative balance under this heading. 152
    • The Future of the Eurotions between a NCB and a private counterparty. To a large extent,the sign and amount of the balance depend on the relationship bet-ween the public or private source of the money of commercialbanks in the central bank. When commercial banks increase theirdeposits in the central bank as a result of an increase in private fun-ding received (deposits, loans or security issues), they tend to redu-ce their appeal to central bank funding (as we assume that they seekto limit their reserve surplus). The counterpart of this increase inliabilities and decrease in assets as a result of the net loan is a posi-tive balance held by the central bank with the Eurosystem, accruingat the reference interest rate. On the contrary, a drop in private fun-ding makes the banks increase their appeal to the central bank. Inthis case, the counterpart of the increase in assets is a negativebalance in the liabilities with the Eurosystem. Germany, which had a very moderate positive balance beforethe outbreak of the global financial crisis, has gone on to have overhalf a billion euros of positive balance by the end of February 2012(see Graph 4). The German Banks have reduced their appeals tothe Eurosystem, as they receive funding at very favourable termsfrom the market and have furthermore reduced their asset posi-tions in other euro member countries. On the contrary, Greece, Ireland, Portugal and, more recently,Spain and Italy, have experienced an increase in their negativebalances to very high levels, due to their banks having had to off-set the loss of private funding. 153
    • The turbulent adolescence of the euro and its path to maturity Graph 4 TARGET2 Balanace Source: Whitaker, Central Bank of Ireland, Bank of Spain, Bank of Greece, Bank of Portugal, Deutsche Bundesbank The growing trend of intra-system balances was interpreted by Sinn (2010) as a stealth bailout by Germany of countries with nega- tive balances, going as far as proposing correction measures there- of. Although it found some support among German academic media (see Declaration of Bobenberg, 2011), Sinn’s interpretation was subsequently refuted in several articles which have attempted to shed light on the nature and significance of intra-system balan- ces (Bindseil & König (2011), Jobst (2011), Borhorst & Mody (2012)). The debate saw a later resurgence, to a large extent due to the concern expressed by the Chairman of the Bundesbank in a let- ter addressed to the Chairman of the ECB.7 Sinn (2012) suggests7 Shortly after this letter was made public, the Chairman of the Bundesbank publishedan article in the press which explained the position of his institution in this debate. 154
    • The Future of the Eurothe establishment of a system for annual settlement of intra-systembalances with liquid assets with guarantees from each country (onreal estate assets or on future tax income). In his opinion, it wouldbe a system similar to that which exists in the United States withinthe Federal Reserve System. In order to adequately interpret the evolution of intra-systembalances it is worth remembering the following points:• Balances are the result of the normal execution of monetary policy. These are therefore flows between the Eurosystem and the banking systems (in no case bilateral between central banks), of a monetary nature (these are not real flows of cash or fiscal transfers) and resulting from the use that the Eurosystem counterparts make of monetary policy operations.• Under present conditions, the greater appeal to the Eurosystem Net Loan by the banking system of a country does not reduce the funding available to the banking system of another country.• The risk of loss assumed by the NCB on the assets of the Eurosystem balance is in line with its allocation of the ECB capi- tal and does not depend on the size of its intra-system balance.• Proposals to limit the maximum volume of these balances are equal to calling into question an essential principle of the opera- tion of the Monetary Union, and the adoption thereof would pro- bably lead to the disintegration of the area. It is not appropriate to use the example of the United States, as the Federal Reserve System operates within a fully integrated banking and capital market. 155
    • The turbulent adolescence of the euro and its path to maturity In summary, the accumulation of intra-system balances is the normal result of an asymmetrical crisis in the balance of payments within the area. As is pointed out by Pisany-Ferry (2012), the evo- lution of the intra-system balances is only a symptom of the dise- ase afflicting the Monetary Union: the best expression of the frag- mentation of the monetary policy. As we discussed earlier, access to Eurosystem funding has acted as a security valve to prevent a generalised problem of illiquidity eventually leading to situations of default. However, to date, this insurance mechanism has proven incapable of correcting coordi- nation failure. And on many occasions, the appeal of a country’s banking system to the Eurosystem has been interpreted by the market as a risk factor, so that it has become an additional compo- nent of the self-fulfilling prophecy process. The greater the increase in funding via monetary policy, the greater the restriction on funding from the market. Bear in mind the aberrant nature of this sequen- ce and its lack of sense in an environment other than that of the Monetary Union. During the shutdown of the wholesale financial markets at the end of 2008 and beginning of 2009 nobody thought to judge that a greater appeal to the credit of the Fed or of the Bank of England was an act of weakness.88 Among other reasons because the names of the institutions that most used these faci-lities were not known, and because the geographical distribution of the use (in the caseof the districts of the Federal Reserve system) was not significant 156
    • The Future of the Euro During spring of 2011, it seemed that the combination of theSMP, the maintenance of the full allocation in monetary policyoperations and start of financial aid programmes in the cases dee-med to be more vulnerable (Ireland in November 2010 andPortugal in May 2011) allowed the Eurosystem to take on a less lea-ding role in the crisis resolution. The position of the ECB, as explained by Trichet (2011), wasbased on the diagnosis that this was not a crisis of the euro, but rat-her a problem of poor macro-economic management, linked to aninsufficient budgetary discipline and the persistence of real andfinancial imbalance. The solution could only come about from acombination of fiscal adjustment and structural reforms at a natio-nal level, and the strengthening of the institutional framework ofthe Monetary Union. Much emphasis was placed on the impor-tance of the full activation of the EFSF and the future EuropeanStability Mechanism (ESM). As for monetary policy, this supportedthe principle of separation between the setting of the interest refe-rence rate and the maintenance of unconventional measures todeal with the distortions in the financial markets and the trans-mission mechanisms. As an unequivocal example of application ofthis principle, the Governing Council decided to raise interest rateson two occasions in response to the inflationist risk associated withthe rising price of fuel and raw materials. But the deterioration of the crisis since the end of June 2011once again placed the ECB at a crossroads. The dislocation of the 157
    • The turbulent adolescence of the euro and its path to maturityItalian public debt market, the second largest in the euro region,triggered a new and virulent bifurcation dynamics which severelypunished the banking system. Although the negative balance of itsinternational investment position is moderate, Italy underwent asudden restriction of external funding which led to the liquiditycrisis of its banking system. The value of traded stocks of the banksin the region plummeted and the perception of default risk, reflec-ted in the credit derivative contract premiums, shot up. Duringthose weeks of August and September, the euro crisis reached itsmost dangerous systemic repercussions since its onset. The Eurosystem was forced once again to react in order to con-tain the spiralling instability which threatened to spread the rest ofthe world. It reactivated and expanded the SMP, by purchasingItalian and Spanish public debt for the first time. The bloodbathwas successfully avoided, but throughout the month of October, inthe debates held prior to the European Council and G20 meetings,the need for the ECB to adopt a firmer and more efficient strategyto solve the crisis was the main topic. And the Eurosystem finallytook a new step.3.2. Quantitative easing for banks only The central banks of the main developed economies have had torevolutionise the implementation of monetary policy in order torespond to the financial crisis. At a first phase, they modified theconditions of liquidity provision, both in regard to terms and types158
    • The Future of the Euroof counterparties and guarantees, maintaining a relatively stablebalance. When the crisis became systemic in autumn 2008, it beca-me clear that the cut in the interest reference rate to its minimumlevel (zero or close to zero) would not prove enough to halt the spi-ralling contraction between the financial conditions and the realeconomy. Henceforward, the monetary policy of the Fed, the Bank ofEngland and the ECB was implemented mainly through unconven-tional measures, which was the start of the stage in which we remainto date. Despite the sudden departure from the practice of the lasttwo decades, this was not a totally untraveled path. The Bank ofJapan had spent years trying unconventional measures in an attemptto overcome the persistent deflation generated by the financial crisisat the end of the eighties. And the Japanese experience, not very suc-cessful, brought about a debate on how to implement an efficientmonetary policy in a context of a liquidity trap, distortions in thetransmission mechanism and a banking crisis. The Fed paid special attention to the problems of Japan and theconclusion of its analyses served as the basis for the deflation pre-vention policy of 2002 and 2003. Bernanke & Reinhart (2004) iden-tify three categories of these measures: i) the use of communicationto influence agent expectations ii) quantitative easing via the incre-ase in the size of the balance sheet and iii) the alteration of the com-position of the balance sheet in order to directly affect the prices ofcertain financial assets. Each of the aforementioned central banks 159
    • The turbulent adolescence of the euro and its path to maturityhas applied the unconventional approach in its own way, but allhave coincided in having significantly expanded the balance sheet. Both the Fed and the Bank of England have carried out a three-fold increase of the weight of their balance sheet in regard to theGDP (see Graph 5). And both have done so by the mass acquisitionof financial assets, which traditionally made up the main compo-nent of the assets in their balance sheets. The US monetary autho-rity began by concentrating its purchases on mortgage bonds,having subsequently moved on to Treasury bonds. The Bank ofEngland has mainly purchased significant volumes of short andmedium term public debt securities (around 14% of GDP and 30%of the amount of securities in circulation). The objective in bothcases has been to have a direct influence on the nominal expendi-ture in order to reduce the risk of deflation and help the economyto reabsorb idle resources. Although it is too early to carry out a full evaluation, the evi-dence suggests that the unconventional strategies of the Fed andthe Bank of England have proven successful. Estimates indicate asignificant positive effect on asset prices, both of those assetswhich have been directly purchased and those with higher risk andgreater impact on the funding terms of the non-financial privatesector (See Meaning & Zhu (2011)). The evolution of the nominaldemand has also been positive, although in this case it is harder toestimate the impact of unconventional measures. We must alsohighlight the credibility of the strategy and its contribution to the160
    • The Future of the Euroreduction of uncertainty, given that the forceful and voluminousinterventions and the communication thereof have managed tomodify agent expectation and to coordinate these towards balan-ces equilibria which are at some distance from more catastrophicscenarios. It has not been a magical solution for all problems, butthey have managed to stabilize the operation of the financial sys-tem, to lend strength to the recovery of the economy and to crea-te conditions so that the correction of the structural problems ofpublic and private indebtedness is carried out at a moderate cost. From the start, the Eurosystem elected to concentrate its uncon-ventional measures on the provision of funding to the banking sys-tem, in line with the financial structure of the area, particularly interms of full allotprent and the performance of unusually long termoperations. The purchase of assets has been more modest in relativeterms and has now become sterilised. In December 2011 this stra-tegy was reaffirmed, by deciding to enter into two special financingoperations for a three-year term, along with other credit supportmeasures designed to favour bank lending and the money marketsin the region. The demand for liquidity of both operations was very high, witha very high participation of entities compared to the average num-ber of previous long term financing operations. The total amountgranted was 1.018 trillion euros. The distribution of liquidity follo-wed a concentrated geographical pattern reflecting the effect offunding restrictions on the banking system. The percentages of 161
    • The turbulent adolescence of the euro and its path to maturity Graph 5 Balance fo the Central Banks during the crisis (in % of the GDP) Source: ECB, BoE, FEDSpanish and Italian banks were much higher than their respectiveallocations in the ECB, whereas the banks from creditor countrieswere granted much lower percentages, and further increased theirresources in the Deposit Facility. Following these two operations, the consolidated balance sheetof the Eurosystem reached 32% of the GDP for the region, excee-ding the percentages of the Fed and Bank of England. However, theimpact of the unconventional strategy in the balance sheet of thecentral banks has been somewhat lower in the ECB that in the othertwo, due to the increase in total weight over the GDP, as well ashaving only used assets related to monetary policy, which accountfor a lesser percentage of the balance sheet in the European case.162
    • The Future of the Euro The immediate impact of the three year funding operations wasvery positive. The coverage for a three year period of the liquidityrequirements of the banks considerably reduced the uncertaintywhich had frozen the workings of the banking system. The percep-tion of bank credit risk improved with significant drops in the pre-miums of credit derivatives and increases in the value of capital.The money markets and bank debt markets underwent a revitalisa-tion, with new flows of funds and the return of European andforeign institutional investors. At the same time, the public debtmarket spreads also experienced a significant narrowing down,returning in the case of the Spain and Italy to around 300 basispoints. The disabling of the loop-shaped coordination failure bet-ween sovereign debt and bank risk also had some effect on themonetary and credit performance, as well as on the real economy.Towards the end of the first quarter, both the EuropeanCommission and the ECB stated that the M3 and private sectorloans exhibited positive – albeit very low – expansion rates, where-as activity stabilised after the drop in the last quarter and firstmonths of 2012. Beyond its short term efficacy as an insurance mechanism in theface of the systemic deterioration of the crisis, the full effect of thequantitative easing for banks only in the Eurosystem will only beassessable over time. Nevertheless, the strategy adopted has someweak points, among which we highlight the following:• It emphasises the Eurosystem’s tendency towards geographi- cal concentration of net funding. The net amount and the dis- 163
    • The turbulent adolescence of the euro and its path to maturity persal of the net lending volumes by country and of intra-sys- tem balances have increased substantially. The Eurosystem has thus decided to carry on its clearing role for private funds move- ments, directly avoiding having to deal with the underlying causes of such movements in order to modify them. The side- effect is the increase in the risk volume of the Eurosystem and in its geographical concentration, assumed by member coun- tries in proportion to their share of the capital.• It fails to put an end to the fragility of the public debt markets in the face of dislocation, and might even increase it. According to BIS figures, Spanish Banks have increased their public debt holdings by over 40,000 million between December 2011 and January 2012, whereas the Italians did so at around 15,000 million euros. This evolution, which is due to the entities taking advantage of the possibility of generating margin by borro- wing from the Eurosystem and buying public debt, might end up being counter-productive for two reasons. In first place, because these are not resources geared towards credit for the non-financial private sector (which is the main objective behind it). And secondly, because it might even intensify the means of contagion towards the banking system if the public debt spreads widen once again. A demand has therefore been generated for the more casti- gated public debt securities, but nothing can guarantee that the market evolution will not suffer further dislocation episodes which will increase volatility once again and widen the gap bet- ween market prices and prices based on fundamental variables.• The SMP might be relegated an amortised instrument. It164
    • The Future of the Euro seems logical that the Programme activity was interrupted almost at the time when the positive impact of long term fun- ding operations became evident. The problem is that, within the Governing Council, the opposition to the reactivation of the SMP is likely to increase in the event of a new dislocation of the markets, arguing that both the levels of risk in the balance sheet and degree of geographical concentration are way too high. This eventually would be cause for grave concern, given that the SMP was the instrument which had succeeded in preventing a syste- mic collapse of the euro region both in May 2010 and in August- September 2011. There is an alternative, which the Eurosystem has ruled out,which might prove more effective as a contribution towards a defi-nitive solution to the crisis. It would involve directly tackling thesource of the problem, which is the instability that the dislocationof some public debt markets have brought upon the core of theeconomy’s funding system. The aim would be to ensure that a limitis established on the deviation between the market prices and pri-ces adjusted to fundamental economic variables which must not beexceeded. Although there are various ways of implementing thistype of measure, they all involve direct intervention in the marketin a plausible way. Only the central bank, with its power to createunlimited money, will be able to successfully carry out such a task. A reasonable option would be to publicly commit to ensuringthat the spread between short term sovereign debt in euro countries 165
    • The turbulent adolescence of the euro and its path to maturitydoes not surpass a certain value threshold. Given the arbitrage rela-tionship between the various terms of a country’s public debt yieldcurve, the application of this stability limit on the shorter part of thecurve (bills and bonds up to 2 years) would suffice, for this then tobe applied to longer terms. In fact, the epicentre of the dislocationepisodes in the public debt markets can be found in the shorter partof the curve, where volatility increases and exorbitant probabilitiesof default emerge, which in turn adversely affect the repo market,which is crucial for short term financing of the banking system. The stability limits should be defined for each country on thebasis of its vulnerability and adapted as the case may be to take intoaccount potential default in commitments of fiscal consolidationand structural reform. By way of illustration, for Spain and Italy thestability limits might be around 200 basis points: this level wouldbe clearly above what can be considered a fair value spread. Butwhat is important is not to compress the spreads as much to ensu-re the stability thereof to enable the transmission mechanism of themonetary policy to operate under relative normality. The Eurosystem should purchase public debt when the price rea-ches the stability limit. But if this proposal is viable, the volume ofdebt eventually purchased by the Eurosystem is likely to be more limi-ted than that already in place in the SMP. Moreover, the volume ofpurchase of public debt could be sterilised, as is already done now. Theproblem is less about amount of money, and more about price struc-ture and risk, as well as market operation.166
    • The Future of the Euro This type of initiative would enable to transform the perversedynamics of debt into a virtuous circle. The recovery of monetaryand financial stability in the more adversely affected countrieswould establish the conditions for fiscal consolidation and structu-ral reform measures to have the positive impact that they shouldhave had on the confidence of agents and markets. It is not about the Eurosystem taking on a new role as lender oflast resort to the States, which would be entirely inappropriate.9The idea would be to preserve the good operation of the debt mar-kets as a key component in the transmission mechanism of mone-tary policy and funding of the economy. We are speaking of apublic good of great economic value, the protection of which is anessential (albeit not explicit) task of any central bank. But as werecalled earlier, the Eurosystem is not a central bank like the rest. The rejection by the Governing Council of a plausible interventionin the public debt markets designed to limit the instability seems to berelated to a number of economic and legal objections. It is argued thatthis type of action does not pertain to a central bank and that it carriesinflationist risks in that it would be assuming a quasi-fiscal role,attempting to solve problems of lack of budgetary discipline and/or9 De Grauwe (2011), after performing a thorough analysis of the crisis, uses the notionof lender of last resort for sovereign debt markets. Subsequently, this idea has been usedby others to assimilate a plausible intervention in the debt markets with State fundingvia the central bank. 167
    • The turbulent adolescence of the euro and its path to maturitycompetitiveness by means of creating money. It is also argued that itmay violate section 123 of the Treaty, or at least the spirit thereof. Despite having the seal of respectability granted by theBundesbank, such arguments are questionable. It is true that theEurosystem should not intervene in public debt markets if thewidening of the spreads is due to irresponsible fiscal policies or animpairment of fundamental variables (a drop in the GDP, an incre-ase in the external deficit). For this reason it is highly probable thata mistake was made when in May 2010 the Eurosystem purchasedGreek public debt. But when the market dislocation begins via con-tagion and, furthermore, is endogenous and subject to feedback, ifthe central bank does not act, it is opening the door to monetaryrestriction which would endanger price stability not only of thecountry but of all the region. As for inflation, this type of uncon-ventional measure would carry lesser inflationist risk than theother two long term funding operations unanimously approved bythe Governing Council. The argument to intervene becomes evenstronger when the affected countries have reacted to contagion byaccelerating their fiscal adjustment plans and implementing signi-ficant structural reforms. On the other hand, a more plausible and decisive interventionin debt markets would not only not violate what is set forth in sec-tion 123, but would in fact be fully coherent with the spirit there-of. The text of the section refers to the direct purchase of publicdebt securities in the primary market, excluding from the ban the168
    • The Future of the Europurchase of bonds on the secondary market. The ban on monetaryfunding seeks to ensure the independence of monetary policy inregard to the needs imposed by the fiscal policy. The public indeb-tedness requirements (arising from treasury deficits, net asset varia-tion and the refinancing of debt maturities) must be covered byappealing to the market, without resorting to the expansion of themonetary base, which ends up generating an inflationist bias.However, compliance with this healthy principle requires the exis-tence and proper operation of a liquid and deep public debt mar-ket. A lack of action in the face of the dislocation of public debtmarkets means accepting the gradual destruction of one of thebasic foundation stones of the separation between fiscal policy andmonetary policy.10 In our opinion, the reason why the Eurosystem has not chosenthis solution, more in line with the practice of other comparablecentral banks, is not economic but political. This is difficult to belie-ve, in that it is a fiercely independent institution managed by qua-lified professionals. But as was pointed out in the first sentence, theMonetary Union is a political construction; and the euro crisiscarries, as is natural, a very influential political dimension. Thegovernments and central bank authorities of Germany and all other10 Within the monetary union, the loss of access to the market as a result of contagiondoes not mean resorting to monetary funding of public debt, but the use of official fun-ding on a temporary basis. However, this situation quickly leads to some to request toexit the euro and the recovery of monetary sovereignty as a means of escaping the per-verse dynamics of debt. 169
    • The turbulent adolescence of the euro and its path to maturitycountries benefiting from the positive contagion of the Greek crisis,have viewed the crisis as a vindication of their economic philosop-hies and an opportunity to reconsolidate the Monetary Union inaccordance with their principles. And as part of this process, theyunderstand that market pressure is an efficient discipline that mustnot be neutralised. In their opinion, the markets may exaggerate,but in the end they reflect the fundamental economic problems. In summary, the Eurosystem has proven to be essential in con-taining the crisis at the times of greater systemic danger, but it hasnot done what any national central bank would have done to tac-kle the perverse dynamics of debt which threaten the survival ofthe euro. In a way, it cannot be blamed. It has acted in accordancewith its nature.4. The definitive solution must begin in 2012 After the bad omens with which 2011 came to an end, the firstfew months of 2012 have seen the danger of a systemic collapse ofthe euro fade into the distance, and it even seems that certain sig-nificant steps have been taken towards a definitive solution to thecrisis. The insurance provided by the Eurosystem has broughtabout time and tranquillity. But the situation is still critical, if we look beyond the financialtension gauges and we measure the situation of the real economy170
    • The Future of the Euroand political cohesion within the area. The deterioration of the cri-sis in the second half of 2011 has come at a very high cost in termsof a fall into recession for Spain and Italy and other member coun-tries, as well as the worsening outlook for countries with a pro-gramme. To the rise in unemployment we must add new fiscaladjustment measures, required to meet the targets in a context oflesser growth of tax bases and higher cyclical expenditure. At thesame time, the detachment towards the Monetary Union is on theincrease, both in countries punished by financial pressure as wellas in creditor countries. Given such conditions, the definitive solution to the crisis, thisbeing understood as the one allowing recovery of sustainedgrowth throughout the region and a reduction and stabilisation ofthe credit risk spreads, cannot take as long as the refund of themoney by the banks to the ECB. It is urgent and the effect ofEurosystem long term funding operations should be harnessed inorder to implement it. In our opinion, the definitive solution is made up of 4 compo-nents. Two of them are already well on track. The third is the key:the one requiring greater effort due to its political and technicalcomplexity. And the last is fundamental to prevent future crises andto encourage the stable operation of the Monetary Union; but thiscan be taken more slowly, as it is not a pressing need and will even-tually happen when the time is right. 171
    • The turbulent adolescence of the euro and its path to maturity A SUITABLE HANDLING OF THE INSOLVENCY PROBLEM IN GREECE. Immediately after the approval by the States in the euro region of the Loan to Greece which gave rise to the first adjust- ment programme carried out jointly with the IMF in April 2010, the prevailing opinion in the financial markets was that Greece had a solvency problem which required debt restructuring. However, among the European authorities, including the ECB, the overriding idea was that any measure generating losses for inves- tors had to be avoided at all costs. It was believed that this appro- ach might exacerbate contagion to other public debt markets. But the delay in recognising this problem undoubtedly was very onerous. In the Deauville Declaration of October 2010, the leaders of France and Germany, guided by the healthy aim of involving private investors in the assumption of losses as a result of their decisions, extended the potential risk beyond Greece, moreover projecting it to the future. And in spring 2011, it became clear that the first Greek programme was not in line with the assumption of return to the market expected for 2012.11 Finally, the Heads of State and Government of the Eurozone countries decided in October 2011 that the restructuring of Greek debt had to allow suf- ficient reduction of its stock and that this solution was meant exclusively for the exceptional case of Greece.11 The alarm bell was sounded by the IMF, given that the approval of program disbur-sements requires a reasonable guarantee that the financing needs of the country are 172
    • The Future of the Euro A year and a half after the outbreak of the crisis, one of the mostdecisive conclusions was thus reached: the problem of Greece isspecial and requires special handling. And a series of questionabledecisions that had amalgamated, consciously or unconsciously, theGreek situation with that of other vulnerable countries in theregion, was thus left behind. Greece has continued to be a source of uncertainty which hasaffected the crisis dynamics. Its economic depression (a 13% dropin real GDP between 2009 and 2011, a 30% drop in deposits in thebanking system during the same period) and the proof of its insti-tutional frailty have led to a situation of clear unsustainability ofits public debt,12 calling into question the viability of its perma-nence in the euro. And the risk of Greece’s departure is a very dis-turbing scenario, as this is not contemplated in the Treaties and itis difficult to imagine the consequences it may lead to. The Private Sector Involvement (PSI) Operation in the reductionof debt, a prior condition for the approval of the second program-me by the Eurogroup and the IMF, was quite successfully executedthroughout the month of March. The operation is a sophisticatedmet for the following year; and given the market situation, the IMF considered thatGreece could not be expected to return to the market in 2012 as expected.12 The deterioration of the sustainability analyses of the Troika since the start of theprogramme has been overwhelming. At the start of the program the public debt vs.GDP was expected to reach its peak in 2012 with 158% of GDP and no reduction. Inautumn 2011, this peak was changed to 186%; finally, the sustainability analysis carriedout after the PSI operation suggests a peak of 164% of the GDP. 173
    • The turbulent adolescence of the euro and its path to maturity and European version of the Brady Plan,13 which has used bonds issued by the European Financial Stability Facility (EFSF) to soften the drop in present value of over 50% in exchange for new ultra long term bonds. The credible threat of a disordered bankruptcy and the retroactive introduction of Collective Action Clauses in the issues subject to Greek legislation managed to achieve a per- centage participation in the exchange above 95%. The operation has succeeded in reducing the debt load and Greek state’s refinan- cing needs very substantially. From a liquidity approach and at punitive rates at the start of 2010, reality has taken over through an operation in which priva- te investors rightly take on a part of the cost of bankruptcy pre- vention14 and Eurozone countries assume greater risks, for longer periods and in exchange for lower interest rates. Despite the magnitude of the debt reduction (100,000 million euros, which would allow it to reach a ratio over GDP of 116.5% in 2020, according to the sustainability analysis of the Troika), the13 Name of the Plan used at the end of the 1980s to solve the foreign debt crisis of deve-loping countries, mainly Latin American. It consisted in exchanging outstanding bondsfor new bonds with a lower present value and longer terms, guaranteed by US Treasuryissued securities.14 The policy of loss avoidance for investors led to a perverse dynamics whereby priva-te investors reduced their exposure, in many cases with substantial gains, thanks to theever increasing involvement of official creditors. Taken to the extreme, this logic wouldhave led to a process whereby private investors would not suffer any losses whereas theofficial lenders were left funding the entire Greek debt. 174
    • The Future of the Europrevailing opinion seems to emphasise the main risks facing thesecond Greek programme.15 After the last two years, any glimpseof a positive assessment in regard to what is going on in Greeceseems completely off the wall. It is true that the sharp drop in theGDP, the fiscal adjustment and the reforms carried out have notachieved sufficient reduction in the primary budgetary balance orin the current deficit (which is still around 10% of GDP). However,in our opinion, the PSI operation and the approval of the new pro-gramme, which supports devaluation via the reduction of labourcosts, the gradual continuation of the fiscal adjustment and the50,000 million euros to ensure the solvency of the banking system,will be able to restore certain stability to the Greek economy.Taking into account the reduction in uncertainty, the moderatedeflation of costs and the effort invested in structural reforms,there is a very clear potential for economic recovery. This stabiliza-tion would exert a positive impact on expectations, leading in turnto a virtuous circle. All this depends on the country being able tomaintain a stable political leadership which is committed to com-pliance with the second programme. In any event, the value of the PSI operation and the second pro-gramme for the definitive solution of the euro crisis arises from thereduction in uncertainty. Despite the need to continue to adoptpolicies which require sacrifices on the part of the citizenship for15 See for instance the IMF report on the request for a new program, which emphasizesthe risk of new accidents and the importance of Euro members undertaking to continueto finance Greece in concessional terms whilst the appropriate policies are implemented. 175
    • The turbulent adolescence of the euro and its path to maturitysome time, the reduction of the debt and the funding of the longterm needs of the State render the option of staying in the euromuch more attractive than the option of departure (although thelatter will continue to have its supporters both in and outside ofGreece). A FISCAL PACT TO STRENGTHEN POLITICAL CONFIDENCE.The Greek experience clearly justifies a reinforcement of the fiscalregulations of the euro, so that these are more efficient during theexpansive stages of the cycle, therefore obliging member states tointernalise the external cost of unbalanced public finances. The European Union already approved in 2011 a substantialtoughening of the Stability Pact and Growth, as part of the reformof the macro-economic governance known as Six Pack, which alsobroadens the multilateral supervision of macro-economic imbalan-ces of a non-fiscal nature. The preventive section includes the quan-titative definition of what is understood to be a substantial deviationfrom the Medium Term Objective of structural budgetary balance orfrom the path established to achieve it. The corrective section bringsabout the Excessive Deficit Procedure due to the non-fulfilment ofthe public debt criterion and introduces the reverse qualified majo-rity rule for decision-making, which will make it harder for memberstates to put a stop to a Commission proposal. Minimum require-ments are also established for the budgetary frameworks of the coun-tries, in terms of coverage of all administrations, multiannual natu-re and quality of the public accounting systems.176
    • The Future of the Euro This exhaustive reform of the fiscal rules culminated with thesignature on 2 March 2012 of the Treaty on Stability, Coordinationand Governance. This new Treaty:• Has been signed by 25 of the 27 EU member countries, alt- hough it will only be legally binding for euro members.• It shall come into force on 1 January 2013, provided it has been ratified by 12 euro member states, thus avoiding the uncer- tainty associated with the ratification process of a modification of EU Treaties. Even so, its content is expected to be added to community legislation within five years.• It introduces the rule of budget balancing. This will be unders- tood to be met when the structural deficit reaches its Medium Term Objective (MTO) with a maximum deficit of 0.5% (which can reach 1% if the debt is significantly below 60% and the sus- tainability risks are low).• Any significant deviation from MTO or from the path of adjust- ment towards the MTO that is observed will trigger an automa- tic correction mechanism, defined in the national legislation but inspired by the principles established by the Commission. The foregoing shall be of application unless in the event of exceptional circumstances.16• Both the rule and the correction mechanism must be added to the national legislative systems, preferably at a constitutional level, within the year subsequent to the entry in force of the16 This refers to i) An unusual event outside of the control of the country which has alarge impact on the financial position of the public administrations or to ii) periods of 177
    • The turbulent adolescence of the euro and its path to maturity Treaty. And the transposition shall be subject to verification by the EU Court of Justice, which shall be empowered to take dis- ciplinary action in the event of infringement. • The euro countries undertake to support Commission propo- sals within the framework of the excessive deficit procedure concerning any of them, except in the event of a qualified majority thereof against it. The new Treaty is consistent with the system of fiscal regula- tions established in the revised SGP and actually uses its basic com- ponents (the MTO, the significant deviation and the exceptional circumstances). What it does is to toughen these rules and increa- se the legal rank thereof within the internal legal system. The two most important items are the rule of budget balance and the auto- matic correction mechanism. In technical terms, the new framework of fiscal rules for the euro is reasonable from a medium to long term perspective, inso- far as: • It reinforces the discipline mechanism during the expansive phases of the cycle, which will oblige budgets to be kept in balance or with surplus.serious economic contraction as this is defined in the revised Stability and Growth Pactand, in both cases, provided the temporary deviation does not endanger medium termfiscal sustainability. 178
    • The Future of the Euro• It increases control at a European level on the quality of the public accounts as a basis for multilateral supervision of the fis- cal policies.• It increases the credibility of the prevention and sanctioning mechanisms, assisting in non-discretional decision-making and toughening sanctions.• It obliges national legal systems to fully incorporate both the fiscal rules and the minimum requirements of quality and coor- dination of budgetary frameworks. In the medium to long term, the application of such rules, assu-ming a trend nominal growth of 3% per annum, would lead to apublic debt stock of 17% of GDP (Whelan, 2012). The key for suchrules to generate anti-cyclical fiscal policies is that they are able toimpose tough discipline during the expansive phases, that thereliability of the fiscal information is assured and that the sanc-tions are applied in rigorous and equitable way for all. The use of a non-observable variable such as the structuralbalance in order to assess compliance with the deficit rule makessense, but it complicates the practical application thereof due touncertainty in regard to the correct estimate of potential GDP. Thecase of Spain during the phase prior to the crisis is paradigmatic:during the period 2005-2007, the Commission estimated the struc-tural budgetary balance to be very close to the nominal balance,given that the growth estimate for potential GDP was around 3%.The subsequent performance of the economy and of the public 179
    • The turbulent adolescence of the euro and its path to maturityincome and expenditure has shown that in the years previous tothe crisis, Spain was growing over and above its potential and thatthe structural balance was much worse than that indicated by thenominal surplus. In reality, the value of the Treaty on Stability, Coordination andGovernance is above all political, as it helps to bring about onceagain a new political understanding among the euro membercountries. Several countries have interpreted the financial aid as abreach, at least in spirit, of the non-mutual guarantee clause in theTreaty. It was hard for Germany and other countries in the D-markarea to bring their monetary sovereignty in line with that of coun-tries with a lesser tradition of stability. And the non-guaranteeclause was one of the essential conditions to do so. Part of the atti-tude of governments and central bank authorities in these coun-tries in the last two years could be explained by this feeling thatrules have been broken. The new Treaty, with its reflection in the Constitutions of severalcountries, is one more step for countries in the north and centre tobelieve that the countries which are currently more vulnerable areadopting a longstanding commitment to fiscal discipline, beyondthe adjustment forced upon them by the markets. And this confi-dence is essential to the creation of political conditions which willenable decisions to be taken with a view to solving the crisis. TheFiscal Pact is therefore a necessary condition, but in no way is itenough to make 2012 the year of the start of the end of the crisis.180
    • The Future of the Euro The Treaty will strengthen the policy of firm advancement in fis-cal consolidation in the most vulnerable countries, which has beenapplied for the last two years. But we are already aware that the per-verse dynamics can make a steadfast programme of fiscal adjustmentwhich lacks a complement to help restore growth fail in its objecti-ve of stabilising public debt. Without nominal growth and financialstability, the efforts made in regard to deficit reduction not only failto reduce the debt/GDP ratio, but actually increase it. THE GRADUAL AND FLEXIBLE CONSTRUCTION OF A SIN-GLE PUBLIC DEBT MARKET. The key to doing away with the per-verse dynamics of debt is to restore the good working order of thepublic debt markets, so that the spreads are more in line with eco-nomic fundamentals and more stable. This is an essential conditionfor relaxing financial terms in vulnerable countries and for allowinggrowth to benefit from the positive effects of the reforms adopted. We have already pointed out that there is no confidence that theEurosystem will adopt the strategy required to achieve this objecti-ve. A second alternative on the table is the EFSF/ESM. In theory, theEFSF/ESM, with the set of intervention instruments which itcurrently contains, has the effective capacity to stabilise the publicdebt markets. However, in our opinion, financial aid is not an effi-cacious solution to the perverse dynamics of debt. Under currentconditions, the preventive funding facilities would soon becomeordinary adjustment programmes; the result would be the exten-sion of the loss of access to market funding and the escalation of the 181
    • The turbulent adolescence of the euro and its path to maturitypolitical tension arising from the concentration of funding in thearea from only a few contributor countries. On the other hand, thedesign of the secondary market intervention instruments has toomany political and operational limitations to even appear plausible. In our opinion, the most suitable way is the creation of a newpublic debt market with jointly and severally guaranteed securities.This is a very important and delicate political decision, as it involvesthe pooling together of sovereign risk, which is an essential part offiscal sovereignty. Countries with higher credit rating have been hit-herto reluctant to share the issue of debt with those of a lower cre-dit quality. This attitude is fair and understandable; to ask Finland,Holland or Germany to pool together all the debt issued with moreindebted and vulnerable countries is politically unrealistic. But given the current crossroads of the Monetary Union, thisstep must be taken, and the way to do it is to design it in such away that it is politically feasible. This design should abide by thefollowing principles:• The construction of a single public debt market in euros must be done gradually. The first stone must be solid but of a mode- rate size. The next stones shall be placed little by little and on the basis of experience.• At the first stage, the percentage of public debt pooled together must be limited. This requirement should be in line with the doctrine of the German Constitutional Court, which requires bonds issued by the State to have a clear quantitative limit.182
    • The Future of the Euro• The pooled debt must be senior to the national debt, in order to reduce the risk of the joint and several guarantee.• Incentives restricting moral hazard must be introduced, taking in account the strengthened governance framework of the Monetary Union. In the Eurobond debate, several specific formulae have beenconsidered which are compatible with such principles. The pione-er was the blue bond/red bond proposal (Delpla & Weizsäcker,2009), which suggested pooling together up to 60% of the publicdebt over the GDP (blue debt), leaving the rest as subordinatenational debt (red debt). The Commission published a Green Papercontaining various different options of Stability Bonds whichaimed at feeding the debate. Lastly, the proposal of a EuropeanDebt Redemption Fund from the Group of German EconomicExperts (2011), which advises the Federal Government, is also ofgreat interest, in that it considers the pooling together of the sur-plus of the 60% of debt over GDP in exchange for real guaranteesin order to overcome the crisis. 17 In our opinion, the most attractive alternative would be theEurobills proposal made by Hellwig & Phillippon (2011) whichwould consist of:• The issue with a joint and several guarantee of all public debt securities with initial maturities of up to 1 year (Eurobills).17 The formula of the surplus over and above the 60% does not seem fair, as it rewardsthe more indebted countries. 183
    • The turbulent adolescence of the euro and its path to maturity • The participation of each member country would be limited to 10% of the GDP. The Eurobill market would therefore have a maximum size, based on the GDP for 2011, of 1 billion euros. • The Eurobills would be senior to all other longer term debt, as the short term debt is already de facto senior to medium and long term debt. • The loss of access to the Eurobills could be considered discipli- nary action within the framework of multilateral supervision of fiscal policies and macro-economic imbalances. The Eurobills are a simple formula with many advantages: • Efficacy. As we have already mentioned, the core of the dislo- cation in economy funding mechanisms lies with the shorter part of the debt markets and its connection to the money mar- kets. The Eurobills would manage to directly tackle the failure and the effect would be foreseeably transmitted throughout the yield curve. They would thus represent an alternative to stability limits. • Political feasibility. The high level of political and legal com- mitment to fiscal stability brought by the new Treaty should allow for the more solvent countries to accept the Eurobills. Given their term, the risk is limited; and in terms of cost if issue, the loss would be small or non-existent.18 • Operating facility. The EFSF/ESM already issues bills, so it could easily assumed the issue of Eurobills. A system would have to18 The bills issued by the EFSF with proportional guarantees from euro member coun-tries have a small spread compared to German bills. Taking as a reference the issue of 184
    • The Future of the Euro be established to consolidate the treasury needs for each State, as Bills play a certain role as treasury management instruments.• Additional benefits. Eurobills could be used to meet Basel III liquidity requirements and would attract a strong demand from institutional investors in and outside of the region. The construction of a single public debt market in euros will bea long and complicated process, likely to take decades. It is a basicingredient in the path of the euro towards institutional maturity,which shall have to develop alongside advancements made in fis-cal integration. But it must commence now, as it is the key to over-come the crisis once and for all. THE FEDERALISATION OF BANKING SUPERVISION IN THEEUROSYSTEM AND THE CREATION OF A EUROPEAN DEPOSITGUARANTEE FUND. In hindsight, one of the most serious flaws ofthe institutional framework of the first decade of the euro has to dowith banking supervision and crisis management. In order to reacha definitive solution, this flaw must be corrected. Despite having harmonised prudential legislation from thestart, the euro region has worked with banking systems which havecontinued to be governed by an essentially national approach. OnMarch 6 month bills, the spread compared to the German bills is lower than 20 basispoints. The cost of issue of the Eurobills would naturally be lower than that of the EFSFbills, thanks to the joint and several guarantees, closer to the levels at which bills arecurrently issued by Germany and by other countries with a higher credit rating. 185
    • The turbulent adolescence of the euro and its path to maturitythe other hand, despite the efforts begun following the BrouwerReport (2001) to build a crisis management plan within the EU,when the crisis was broke out weak in deposit guarantee and prac-tically non-existent in the intervention and liquidation of creditinstitutions. One of the most illustrative indicators of this persistence of thenational approach in the realm of banking is that the integrationhas advanced more between euro countries and non-euro coun-tries than within the euro region itself. Among the problems asso-ciated with this situation, we shall highlight two: The absence of global overview of the funding structure ofthe area and its relation with monetary policy. The creation ofthe euro led to a strong expansion of gross and net flows withinthe area. In a way, this was the reallocation of capital towards thosecountries where it was scarce and could obtain better returns. Butin some countries this process ended up by creating bubbles in thereal estate sector, which reached hitherto unknown peaks partlydue to belonging to the Monetary Union (low interest rates, veryelastic supply of external funds). In light of the high short termeconomic benefits in terms of extraction of income, employment,fiscal activity and collection, the economic policy renders very dif-ficult, as we have seen, the adoption of domestic measures to burstthe bubble. At the same time, given that monetary policy is exo-genous to the authorities of a country, the effect thereof is notinternalised in regard to the creating or blowing up a bubble furt-her. But it is not only about bubbles. The global crisis showed up186
    • The Future of the Euroother weaknesses in the funding structure of the banks in the euroregion, such as its dependence on the liquidity of the US moneymarkets. The possibility that a banking crisis might bring down acountry. National supervision goes hand in hand with the natio-nal responsibility for covering costs in the event of a crisis. As wehave seen in Ireland, the bank solvency problems can overwhelmthe fiscal capacity of the country. Moreover, and continuing withthe Irish example, the potential effects of contagion within theMonetary Union limit the capacity of the affected country to solvethe crisis by the assumption of losses by private creditors. Since the start of the crisis, considerable progress has been madein terms of coordination of bank supervision and crisis manage-ment in Europe. Nevertheless, the maturity of the Monetary Unionstill has a way to go. The essential public policies on the bankingsystem must be common within the euro area, in accordance witha plan with two main cornerstones:• Federal banking supervision within the Eurosystem. The time has come to make use of a provision of the Treaty on the fede- ralization of banking supervision within the euro area. Given that only in 5 euro countries the banking supervisor is separate from the central bank, and that the ECB is the most powerful euro institution, the most natural approach to achieve this is by awarding competencies to the Eurosystem. And the competen- cies assumed must include micro-prudential regulation, macro- 187
    • The turbulent adolescence of the euro and its path to maturity prudential regulation and part of the crisis prevention and management function.• A European Deposit Guarantee Fund (EDGF). The crisis has proven that the deposit guarantee systems are basic instruments in the prevention and management of banking crises. During the global crisis, the risk of having systems with insufficient coverage (eg. Northern Rock) or the chaos generated by unilate- ral decisions on levels of coverage within the euro (movements of deposits between countries at the end of 2008) became patently clear. With the generalized increase in coverage of deposits up to 100,000 euros (which increases the cost of the liquidation of the institutions), the guarantee funds, in princi- ple, assume a crucial responsibility. However, the models of deposit guarantee systems within the area as still quite different from one another. For this reason an obligatory adhesion fund should be created to assume the guarantee of all deposits in the banks of the euro area and their branches in the EU. The fund should be made up of the contributions from entities, determi- ned on the basis of credit and liquidity risk and have a system of governance similar to that of the Spanish guarantee funds, presided over by the ECB and with broad representation of the private sector in its Board of Governance. The functions of this EDGF should include the resolution of banking crises, assisting the mandate of the Eurosystem in early intervention and crisis resolution at the lowest cost for the public treasury. As an addi- tional and exceptional mechanism of funding, a system could be established whereby the ESM could lend funds to the EDGF.188
    • The Future of the Euro The improvement in the operation of the Monetary Union as aresult of the federalisation of banking supervision and crisis mana-gement would be considerable in the medium and long term. Thefollowing are among the possible positive changes associated withthis reform:• The monetary transmission mechanism would become more robust against national fiscal evolutions and the fluctuations of the financial markets.• A boost to cross-border integration and consolidation. The pro- tection of domestic industry would become more difficult, which would lead to benefits of risk diversification and econo- mies of scale. And competition would gradually become more intense, which is essential after the re-nationalisation of the banking markets and the strong public support provided to cri- sis- affected entities.• Support for incentives to implement measures to prevent the creation of speculative bubbles.• The internalisation of external effects and public service provi- sion problems associated with financial stability within the area. This would allow for the creation of a structure where the central bank and the Ministries (Eurogroup) work much more efficiently towards preserving financial stability.• It would support the introduction of measures to achieve grea- ter involvement of the private sector in the solution of future crises. 189
    • The turbulent adolescence of the euro and its path to maturity5. Conclusion The adolescent crisis of the euro is extremely serious. Europeanand national authorities have taken courageous and significantdecisions in recent months, in many cases having learned fromprevious mistakes. The restructuring of the debt and the newadjustment programme are an intelligent and well executed res-ponse to the serious solvency problem in Greece. Ireland andPortugal are applying their programmes with excellent assessmentsmade by the troika. And an institutional framework is under way,which will render the generation of a crisis in the future a lot lesslikely. Much political and social capital has been spent on implemen-ting such measures. It is clear that the euro member countries arewilling to make great sacrifices in order to preserve the project. Butthe truth is that the crisis has not yet been overcome, because theroot causes of the uncertainty and the instability generated by thedislocation of the public debt markets have not been attacked. The economy within the euro area will foreseeably face a secondrecession three years after the sharp blow of 2009. Ireland andPortugal are watching their expectations of recovery fade as aresult of lower foreign demand and maintenance of financial pres-sure. And there are questions as to the likelihood of its return tothe markets within the timeframes set and even in regard to theGreece and no more commitment. Spain and Italy are implementing190
    • The Future of the Eurostrong fiscal adjustments and deep structural reforms in an envi-ronment of recession and financial vulnerability. The euro cannot afford to undergo another episode like the onein August-September 2011. It is imperative that a measure is takento protect us against that risk and removes, once and for all, thedevastating coordination failure of the global crisis of 2009. Havingassumed that the stabilisation of the debt markets cannot be pro-vided by the central bank as in other countries, we have to choosea new market. Eurobills are an efficient and balanced solution;2012 should be their birth year. They will help reunify monetarypolicy, by first restoring stability and establishing the foundationsfor a solid economic recovery. These conditions are essential for theprogrammes to work, for the debt to stabilize and for the consoli-dation and reform policies to be effective and have continuity.There is no future without stability and growth. It is not necessary to search for great constructions or to comeup with solutions for all the problems. The Eurozone shall never bean optimal monetary region. It does not need to be. For the timebeing, we must concentrate on a series of efficient and plausible fis-cal regulations, a single monetary policy based on debt marketswhich are operating fairly and a stable banking system capable offunding the economy. And to continue to learn and build an incre-asingly closer union. The countries that are currently suffering willlearn from their mistake; one cannot prosper within the euro withthe same institutional framework that one had out of the euro: 191
    • The turbulent adolescence of the euro and its path to maturityforeign finances continue to be a restriction, the real exchange rateand the flexibility in real salaries and mark-ups are important, cre-dit excesses cost dearly… but we must allow some time for the les-sons learned to be put into practice and produce good results.192
    • The Future of the EuroBibliography- Aizenman, J., Hutchison, M. and Jinjarak, Y. (2011) “What is therisk of European sovereign debt defaults? Fiscal Space, CDS Spreads andMarket pricing of Risk”. NBER Working Paper 17407.- Barrios, S., Iversen, P., Lewandowska, M. and Setzer, R. (2009)“Determinants of intra-euro area government bond spreads during thefinancial crisis” Economic Papers 388. European Commission.- Bernanke, B. and Reinhart, V. (2004) “Conducting Monetary Policyat Very Low Short-Term Interest Rates” American Economic Review,94(2): 85-90.- Bernanke, B., Reinhart, V. and Sack, B. (2004) “Monetary PolicyAlternatives at the Zero Bound: An Empirical Assessment” Staff Paper.US Federal Reserve- Bindseil, U. and König, J. (2011) “The Economics of TARGET2 balan-ces” SFB 649 Discussion Paper, Universidad Humboldt de Berlín.- Bornhorst, F. and Mody, A. (2012) “TARGET imbalances: Financingthe capital-account reversal in Europe” VoxEU.org, 7 March.- Caballero, R. (2010) “Sudden Financial Arrest” Mundell-FlemingLecture prepared for the IMF 10th Jacques Polack Annual ResearchConference. IMF Economic Review, July 20, 2010. 193
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    • The Future of the Euro- Hellwig, T. and Philippon, T. (2011) “Eurobills, not Eurobonds”,VoxEU.org, 2 December 2011.- Jobst, C. (2011) “A balance sheet view on TARGET-and why restric-tions on TARGET would have hit Germany first” Vox 19 July 2011.- Joyce, M., Tong, M. and Woods, R. (2011) "The United Kingdom’squantitative easing policy: design, operation and impact” QuarterlyBulletin 2011 Q3. Bank of England.- Meaning, J. and Zhu, F. (2011) “The impact of recent central bankasset purchase programmes” BIS Quarterly Review, December 2011.- Pisani Ferry, J. (2012) “The Euro crisis and the new impossible trinity”Bruegel Policy Contribution January 2012.- Pisany-Ferry, J. (2012) “Debate on Target 2: Don´t confuse symptomand disease!” Blog de Bruegel, 2 de marzo de 2012.- Sinn, H.W. (2011) “The ECB Stealth Bailout” VoxEU.org, 1 June.- Sinn, H.W. (2012) “Fed versus ECB: how Target debts can be repaid”VoxEU.org 10 March 2012.- Trichet, J.C. (2011) “The monetary policy of the ECB during the finan-cial crisis” Speech by the President of the ECB, Montreal, 6 June2011. 195
    • The turbulent adolescence of the euro and its path to maturity- Weidmann, J. (2012) “What is the origin and meaning of the Target2balances?” Carta del Presidente del Bundesbank publicada en elFrankfurter Allgemeine Zeitung y el Het Financieele Dagblad el 13de marzo de 2012.- Whelan, K. (2011) “Fiscal Rules: Stocks, Flows and All That” TheIrish Economy Blog, December 9th, 2011.- Whitaker, J. (2011) “Intra-eurosystem debts” Monetary Research,Lancaster University Management School. 30 March 2011.- Whitaker, J. (2011) “Eurosystem debts, Greece and the role of bank-notes”. Monetary Research, Lancaster University ManagementSchool. 14 November 2011.196
    • /DANIEL GROS * / CINZIA ALCIDI**/ Breaking the common fate of banks and governments1. Introducción; 2. Recent eurozone history: From bad to worse; 2.1. Recallingthe building blocks of the EMU construction; 3. A false solution to the crisis: thefiscal compact; 4. Fiscal indiscipline versus financial regulation inconsistency;5. A proposal for a new regulatory treatment of sovereign debt securities in theeuro area; 6. Conclusions; Bibliography* Dr. Daniel Gros is the Director of the Centre for European Policy Studies (CEPS) since2000. Among other current activities, he serves as adviser to the European Parliamentand is a member of the Advisory Scientific Committee of the European Systemic RiskBoard (ESRB), the Bank Stakeholder Group (BSG) of the European Banking Authority(EBA) and the Euro 50 Group of eminent economists. He also acts as editor of EconomieInternationale and International Finance. In the past, Daniel Gros worked at the IMF(1984-86), at the European Commission (1989-91), has been a member of high-leveladvisory bodies and provided strategic advice to numerous governments and centralbanks. Gros holds a PhD. in economics from the University of Chicago, has taught atprestigious universities throughout Europe and is the author of several books and nume-rous contributions to scientific journals and newspapers. Since 2005, he has been Vice-President of Eurizon Capital Asset Management.** Dr. Cinzia Alcidi holds a Ph.D. degree in International Economics from the GraduateInstitute of International and Development Studies, Geneva (Switzerland). She is 197
    • Breaking the common fate of banks and governments 1. Introduction Since 2010 the news about Europe has gone from bad to worse. In early 2012, it still cannot be claimed that the eurozone crisis is solved, thought markets within the euro area seems to return (maybe only temporarily) to more normal conditions. Interestingly enough, the average of the fundamentals of the euro area looks actually relatively good: compared to the US, the eurozone as whole has a much lower fiscal deficit (4% of GDP in 2011 against almost 10% for the US) and unlike the US, it has no external deficit. Its current account is close to balance, which means that enough savings exist within the monetary union to finance the public deficits of all its member states. This implies, in turn, that potentially enough, domestic, euro zone’s resources exist to solve the debt problem, without recurring to external lenders. Whether these resources will be invested to finance eurozone governments is a different question.currently LUISS Research Fellow at Centre for European Policy Studies (CEPS) inBrussels where she is part of the Economic Policy Unit dealing mainly with issues rela-ted to monetary and fiscal policy in the European Union. Before joining CEPS in early2009, she taught undergraduate courses at University of Perugia (Italy) and worked atInternational Labour Office in Geneva. Her research interest focuses on internationaleconomics and economic policy. Since her arrival at CEPS, she has worked extensivelywith Daniel Gros on the macroeconomic and financial aspects of crisis in Europe andat global level, as well on the policy response to it. She has published several articles onthe topic and participates regularly in international conferences. 198
    • The Future of the Euro In spite of this relative strength, eurozone policy-makers seemincapable to solve the debt crisis. Meeting after meeting, heads ofstate and Government or finance ministers have failed to convincemarkets of the validity of their strategy, which has focused almostexclusively on fiscal discipline and has repeatedly advocated theneed of financial help from outside investors, e.g. IMF and Asianinvestors, regardless of whether resources exist within the eurozo-ne. This approach has been both misguided and unconvincing. Against this background, the paper emphasizes that while thepolitical agenda is almost obsessively focused on fiscal issues, theeuro zone crisis does not have a mere fiscal nature neither a simplefiscal solution. It involves different dimensions running fromcurrent account and external debt problems to the weak state of thebanking sector, which is still largely undercapitalized. This paperwill focus on the last element, the state of the banking system andattempts at highlighting how features of the existing financial mar-ket regulation framework which are inconsistent with main buil-ding blocks of the monetary union have affected the course of thecrisis. We will argue that this inconsistency has crucially contribu-ted to eurozone crisis and still remains unaddressed. The paper alsoexpresses concern about the misleading, prevailing view that thejust signed fiscal compact will work as crucial ingredient in the reci-pe to overcome the eurozone crisis, while the banking sectorremains highly leveraged and exposed to the fortune and misfortu-ne of sovereign governments. On this ground, the paper puts for-ward some ideas about how to break the tight linkage between 199
    • Breaking the common fate of banks and governmentsgovernments and banks. This is at the root of their common fateand represents a decisive obstacle to overcome the eurozone crisis.2. Recent eurozone history: From bad to worse To understand why the euro crisis has gone from bad to worse,one needs to develop a better understanding of the inconsistenciesin the setup of European Monetary Union (EMU) that caused theproblem in the first place. The official reading is that this is not acrisis of the euro, but of the public debt of some profligate euroarea member countries. Therefore, tackling the causes of this crisisand averting future ones requires only a new, tighter framework forfiscal policy – which will be delivered by the new ‘fiscal compact’. Yet, financial markets do not seem much impressed by a furtherstrengthening of fiscal rules: Portugal and other countries still haveto pay high risk premia while Greece has defaulted on its debt andstill teeters on the brink of a total collapse. This suggests that theofficial approach captures only part of the problem and still missesthe full picture. It is not only fiscal indiscipline in the periphery which turnedthe public debt problems of a small country like Greece into a cri-sis of the entire euro area banking system. The euro zone crisis isthe result of a constellation of vulnerabilities within the eurozone.They include balance of payments problems, foreign debt, sudden-200
    • The Future of the Eurostops of crosser-border financing running from North to Southcombined with a generalized undercapitalization of the bankingsystem. This financial fragility has been the result of inconsistencies inthe setup of the EMU as well as a fundamental inconsistency infinancial market regulation that has yet to be addressed.2.1. Recalling the building blocks of the EMU construction The original design of EMU, as established by the MaastrichtTreaty in 1992, contained three key elements:i) An independent central bank, the ECB, devoted only to price stability.ii) Limits on fiscal deficits enforced via the excessive deficit pro- cedure (Treaty based) and the Stability and Growth Pact (SGP, essentially an intergovernmental agreement, although still within the EU’s legal framework).iii) The ‘no bail-out’, or rather ‘no co-responsibility’ clause (art. 125 of the TFEU). The treaty also contained other elements of economic gover-nance,1 but this remained mostly declamatory as in reality1 For instance, Article 121 of the TFEU contains the provision that member statesshould regard economic policies as a matter of common concern and shall coordinatethem within the Council. 201
    • Breaking the common fate of banks and governments Member States did not see any need to coordinate economic poli- cies; at least, not before the crisis. The first key element of the Maastricht Treaty, i.e. the very strong independence of the ECB, was based on a large consensus among both economists and policy makers that the task of a cen- tral bank should mainly be to maintain price stability. The con- sensus was based on a common reading of the experience of the previous decades that higher inflation did not buy more growth and independent central banks (with the Bundesbank as the most prominent example) are best placed to achieve and maintain price stability.2 Some academic economists and some observers at international financial institutions worried already in the 1990s about financial instability and advocate a clear role of the EBC in safeguarding financial stability.3 Some also emphasized that a common currency area also requires a common system of supervision of financial markets.4 But the issue of financial stability did not attract the attention of policy makers mainly for two main reasons. The first one is theoretical: most prominent economic models before 2007 suggested that price stability delivers financial stability as by-pro-2 A prominent paper of the period when plans for EMU were taking shape encapsula-ted this insight in the title ‘The advantage of tying one’s hands’ (see Giavazzi andPagano (1988).3 See for instance Garber (1992).4 Among others Tommaso Padoa Schioppa (1994). 202
    • The Future of the Euroduct, with no need to add another tool to achieve it. The secondone is much less sophisticated and relates to the fact that the twokey member states driving EMU, France and Germany, had notexperienced a systemic financial crisis for decades. The second element of the Maastricht Treaty, namely the limitson fiscal policy, did not enjoy the same consensus in the academicprofession (nor among policy makers) as central bank indepen-dence. During the 1990s a wide ranging debate took place aboutthe sense or non-sense of the Maastricht ‘reference’ values of 3% ofGDP for the deficit and 60% for the debt level. Apparently theadvantage of tying one’s hands was much less recognized in the fieldof fiscal policy. However, this debate did not need to be resolved aslong as benign financial market conditions prevailed and even thecore countries conspired to weaken the limits on deficits set by theSGP in 2003. The third element was only in the background and remaineduntested until recently. Contrary to a widespread misconception,Article 125 of the TFEU does not prohibit bail outs. It merelyasserts that the EU does not guarantee the debt of its member sta-tes and that member states do not guarantee each other’s obliga-tions. Germany had insisted on the no bail-out clause when theMaastricht Treaty was negotiated about 20 years ago. Today, it isclear that this clause does not provide the kind of protection thatwas sought and widespread financial market turbulences threatento engulf Germany to agree to huge bail-out packages which would 203
    • Breaking the common fate of banks and governmentshave been unthinkable only recently. However, instead of workingon averting the repeat of this situation in the future, Germanpolicy makers are focusing exclusively on the need to ensure lowerfiscal deficits. This is the purpose of the Treaty on Stability, Coordinationand Governance in the Economic and Monetary Union also called the‘fiscal compact’ under which euro area member countries agree toadopt strict rules, ‘at the constitutional or equivalent level’, limi-ting the cyclically adjusted deficit of the government to less than0.5% of GDP. Will this fiscal compact work where the Stability Pactfailed? The ‘original’ SGP already contained the engagement by mem-ber states to balance their budget over the cycle. If implementedsince the onset of the monetary union, the rule would have led toa continuous reduction of the debt-to-GDP ratio towards the 60%target. But this did not happen. The promise or rather exhortationcontained in the SGP to balance budgets over the cycle was widelyignored, given that the rule was not binding and financial marketsremained in a ‘permissive’ mood. All of the larger euro area mem-bers ran budget deficits in excess of 3% of GDP threshold for thefirst 4-5 years of the euro’s existence. Even Germany ran deficitsabove 3% of GDP from 2001 to 2005. In 2003 a proposal put for-ward by the Commission to ratchet up the excessive deficit proce-dure to the point where fines might have been imposed on Franceand Germany was defeated in the Council (of finance ministers,ECOFIN). In the crucial vote the large countries (most of whichhad excessive deficits, except Spain) colluded to water down the204
    • The Future of the Europroposal and won the opposition of the smaller countries. The’band of three large sinners’ (Germany, France and Italy) evenmanaged to put together a qualified majority to ‘hold the proce-dure in abeyance’.5 This narrative is interesting in the light of the new ‘fiscal com-pact’ which is supposed to radically strengthen the enforcement ofthe fiscal rules by the application of the ‘reverse qualified majo-rity’. Under this principle, an excessive deficit procedure launchedby the Commission is taken to be approved unless it is opposed bya qualified majority. As past experience shows, despite the new sys-tem makes the opposition harder, it does not ensure enforcement. In 2005, following the 2003 episode, the SGP was changed. Theofficial justification was the need to improve its economic rationaland thus ownership,6 but it clear that it was necessary to avoid therepeat of the embarrassing situation in which a literal applicationof the rules would have led to sanctions for Germany and Franceamong others. The reaction in academia and among policy makerswas mixed: the SGP was ‘softened’ according to some, but ‘impro-ved’ according to others. The very fact that professional opinionon the merits of ’binding rules for fiscal policy’ was divided fromthe start certainly facilitated the change in the SGP when it beca-me politically opportune.5 See Gros et al. (2004). 3 See for instance Garber (1992).6 Annex to the 2005 Council conclusions(http://register.consilium.europa.eu/pdf/en/05/st07/st07619-re01.en05.pdf). 205
    • Breaking the common fate of banks and governments As matter of facts, shortly after the SGP was made less stringent,the upturn of the business cycle allowed most governments toreduce their deficits to below 3% seemingly vindicating the officialposition that the ‘improved’ Stability Pact had led to a more res-ponsible fiscal policy. But structural deficits (i.e. adjusted for thecycle) actually improved very little even at time the boom reachedthe peak in 2006-7 and, when the crisis hit, any remaining cautionwas thrown overboard as deficits were allowed to increase again. The euro area countries thus never lived up to the rules they gavethemselves. But even so, on average they remained relatively con-servative in fiscal terms. In 2009, the average deficit peaked at 6.5%of GDP, its highest level, whereas both the UK and the US wentabove 11% during that year. Moreover, while the eurozone deficithas brought back to 4% of GDP in 2011, it has remained at doubledigits levels in both the UK and the US. In this limited sense, onecould argue that the Maastricht provisions against ‘excessive’ defi-cits did have some influence after all, at least on average. While the average deficits for the euro area appear today‘modest’ by the standard of other large developed countries, oneeuro area country, Greece, clearly violated all rules for years. Butmounting evidence that the Greek fiscal numbers did not add upwas never acted upon until it was too late. As long as financial mar-kets provided financing at favorable rates any action was politicallyinconvenient and was avoided.206
    • The Future of the Euro When the euro debt crisis started in early 2010 following thediscovery that Greece was running a deficit of 15% of GDP (andthat previous deficits had been misreported), some policymakers,German in particular, started to call for tighter fiscal rules as essen-tial to the survival of the euro.Despite Greece was an extreme case,the case of Italy is widely seen as providing another justificationfor tighter fiscal rules. However, the country seems to stand forcomplacency rather than fiscal profligacy. Over the last ten yearsthe deficits of Italy have on average been lower than those forFrance and even today its deficit is below the euro area average(and declining rapidly).Yet, the incapacity of the country to redu-ce its very high debt-to-GDP ratio has made it vulnerable to a lossof investor’s confidence.3. A false solution to the crisis: the fiscal compact The new Treaty that was agreed upon in March 2012 has a longtitle, Treaty on Stability, Coordination and Governance in the Economicand Monetary Union, but upon closer examination it is long ongood intentions and rather short on substance in terms of bindingprovisions. The core of the new ‘fiscal compact’ is an obligation to enshrine innational constitutions the commitment not to allow cyclically adjus-ted deficits to exceed about ½ of 1% of GDP, which is roughly equi-valent to balancing the budget over the cycle as in the original SGP. 207
    • Breaking the common fate of banks and governments This should be done ‘preferable at the constitutional level’. TheEuropean Court of Justice (of the EU) can be asked to pass a judg-ment on these national rules, but the maximum fine that could beassessed is capped at 0.1% of GDP – hardly a strong deterrent byitself. This Treaty concerns only the framework for fiscal policy, i.e.the rules setting up national ‘debt brakes’, not their implementa-tion. This Treaty thus does not give any new powers to the Courtof Justice (neither to the Commission) to interfere with the actualconduct of national fiscal policy. None of the provisions on eco-nomic policy coordination are binding. Essentially they reiteratethe already often repeated statements of good intentions on struc-tural reforms. Among the provisions, the specification on governance institu-tes regular meetings, at least twice a year, of the heads of state andgovernment of the euro area. However, since these meetings willremain informal, in truth, there was no need for an internationaltreaty to establish them. As far as the non-euro EU member states who signed the Treatyare concerned, there is no obligation for them to do anything, butthe signature constitutes a political statement which gives them apartial ‘seat at the table’ of the eurozone meetings, allowing themto participate in most of the euro area summits. From a purely legal point of view, this Treaty contains an inhe-rent contradiction: it implies that its signatory countries agree on208
    • The Future of the Eurobinding constraints for their constitutional order via an ordinaryinternational treaty. In most countries the national constitution isof a higher in legal hierarchy than international treaties. Thismeans that even the provisions on the ‘fiscal compact’ constituteessentially a political statement, unless the treaty is ratified with aconstitutional majority, as will be done in Germany. The main value of this political statement coming from all euroarea member states is of course that it provides political cover forthe German government in its efforts to sell the euro rescue ope-rations to a sceptical domestic audience. However, it is doubtfulthat the ‘fiscal compact’ was really needed for this purpose. Dataon German support of the euro show that public opinion remainsmuch more constructive on the euro than widely assumed (seeGros and Roth, 2011). Moreover even before the fiscal compactexisted, all votes in the Bundestag have resulted in very large majo-rities in favour of the euro area rescue operations, even when theycontained large fiscal risks for Germany. In judging the value of this Treaty one should also keep in mindthat, of the four large euro area countries, three have already natio-nal debt brakes at the constitutional level: in Germany it is alreadyoperational, in Spain has been adopted recently and in Italy is incourse of adoption. In the fourth country, France, it is already clearthat the Treaty will be implemented, if at all given the negativeattitude of the current opposition, via a so-called ‘loi organique’ andthat the French constitution will not be changed. 209
    • Breaking the common fate of banks and governments All in all, the fiscal compact is probably useful in the long runand may contribute to avert a future crisis. It forces Member Statesto adopt stronger national fiscal frameworks at home. Some, per-haps most, would have done so anyway under the pressure of themarkets, but it is unlikely that the new Treaty will make a signifi-cant difference. The main danger is that that it has been oversold. It is likely that the ratification process (e.g. the referendum inIreland) and then the implementation process in some difficultcountries (e.g. France) will receive a lot of attention and create adistorted impression of the importance of the Fiscal Compact. However, the initial excitement will be over once the nationalfiscal rules have been put into place and this Treaty will quietly beforgotten. Its only remaining impact will consist in the meetings ofthe euro area heads of state which are likely to produce the regularconclusions that ‘Member States commit’ to everything desirable(structural reforms, etc.). Conclusions which become irrelevantonce the heads of state return to their capitals and their domesticpolitical realities. The experience with the SGP suggests that how this new ‘fiscalcompact’ will be applied in future will depend on the degree of con-sensus on the need to balance the budget over the cycle. If anything,political will to follow this balanced budget rule will be even moreimportant for the new ‘fiscal compact’ since it will take the form ofan intergovernmental Treaty outside the legal framework of the EU.210
    • The Future of the Euro Today the consensus that only balancing budgets can solve thiscrisis and allow the euro to survive seems strong and the positionof the German government seems particularly tough. This is cer-tainly desirable to prevent future public debt problems but itneglects the crucial role financial market fragility has played in thiscrisis. The case of Greece is emblematic in this sense: despiteGreece accounts for less than 3% of the euro area’s GDP, the pros-pect of the Greek government becoming bankrupt caused Europe’sfinancial markets to go into a tailspin. The reason behind it wasthe fragility of banks due to their undercapitalization and theirlarge holdings of government debt. In this perspective, while for a creditor country like Germany itmight be important that other member states are forced to copy itsbalanced budget rules, it should be even more important to ensu-re that financial regulation helps to provide additional incentivesfor good fiscal policy and that financial markets become morerobust and able to withstand a sovereign insolvency. This is whatwould reduce the need for future bail outs by the German govern-ment. German savers have over the last decade of current accountsurpluses accumulated about one trillion euro worth of claims onother euro area countries. Safeguarding the value of these claims(which amount to about 50% of GDP) and ensuring the futureGerman savings surpluses are invested with minimal risk shouldthus be a key policy goal for German policy makers. 211
    • Breaking the common fate of banks and governments 4. Fiscal indiscipline versus financial regulation inconsistency The key insight that has been overlooked in the official circles dominating EU policy making today is that today’s crisis is largely due to an inconsistency in the original design of EMU, not in the area of fiscal policy, but in the area of financial market regulation. Even after the start of the EMU, financial regulation in general, and banking regulation in particular, continued to be based on the assumption that in the euro area all government debt is riskless. This was from the start logically incompatible with the no-bail out clause in the Maastricht Treaty, which implies that a euro area member country can become insolvent, and the institution of an independent central bank which cannot monetize government debt. But it was adopted anyway, maybe because of the perception, expressed recently in a spectacularly mis-timed paper from the IMF, which proclaimed: “Default in Todays Advanced Economies: Unnecessary, Undesirable, and Unlikely”.7 In the much more forgiving environment of the turn of the cen- tury, it was quite natural for policy makers to ignore the logical inconsistency between the no bail-out clause and maintaining the assumption that government was really risk less. Yet this contra- diction had two important consequences. First, banks did not (and still do not) have to hold any capital against their sovereign expo-7 Cottarelli, C., L. Forni, J. Gottschalk, and P. Mauro (2010) Staff Position Note No.2010/12. 212
    • The Future of the Eurosure. Second, it was also deemed unnecessary to impose any con-centration limit on the claims any bank can hold on any one sove-reign. This lack of a concentration limit for sovereign debt is inclear contrast to the general rule that banks must keep their expo-sure to any single name below 25% of their capital. This exceptionwould make sense only if government debt is really totally riskless. The main result of this special treatment reserved to govern-ment debt securities on banks’ balance sheets has been that aboutone third of all public debt of the eurozone is held by eurozonefinancial institutions, which also tend to privilege the financing oftheir own government. The fate of governments and banks is thustightly linked. To the inconsistency of financial market regulation it must beadded that the ECB failed to apply differentiated haircuts togovernment debt it accepted as collateral. Debt securities issued byeuro area governments ware accepted in indiscriminate fashionprovided that the country was rated at investment grade. This wasthe case for all euro area member countries, of Greece as Germany.When the Stability Pact was weakened by Germany and France in2005, the ECB took member countries to court, but it did notchange its collateral policy. By doing so it would have given a con-crete signal that it was worried about the long run sustainability offiscal policy and its consequences for the future of the singlecurrency. Alas, it did not do so, not even during the crisis, after itwas clear that it was changing its policy stance. Only now, the ECB 213
    • Breaking the common fate of banks and governmentsapplies a sliding scale of graduated haircuts which makes it lessattractive for banks to hold lower rated government debt. The idea that governments provide the only safe assets even ina monetary union where a no bail-out clause exists was also themain reason for another omission: a common euro area (or EU)deposit insurance scheme was never seriously considered. At EUlevel, deposit insurance is regulated by the 1994 Directive on depo-sit guarantee schemes, but the minimum harmonization approachadopted at that time has proven largely insufficient and the ulti-mate back up for all national schemes remains the national govern-ment. A common European deposit insurance modeled on the USapproach of a fund financed ex-ante by risk based contributionsfrom banks like the Federal Deposit Insurance Company – FDIC-would have had obvious advantages in terms of risk diversification.But the preference for national solutions (based on the fear that aEuropean equivalent to the FDIC would lead to large transfersacross countries) and the bureaucratic interests of the existingnational deposit guarantee schemes ensured that such ideas do notget a hearing even today. The experience with Greece should have served to rest the ideathat government debt in the euro area is riskless. But so far no cri-sis summit has drawn the conclusion from this experience for ban-king regulation. Of course, it is true that once the crisis has hit it isno longer possible to tighten the rules on government debt becau-se this is pro-cyclical as the mayhem which followed the only214
    • The Future of the Euroattempt to shore up the banking system in the context of therecent EBA stress tests on government debt has shown. However in order to illustrate the importance of thinking aboutthe larger benefits from a different kind of banking regulation it isstill worthwhile speculating what would have been different ifbanking regulation had been ‘Maastricht’ conform, i.e. if it hadrecognized that belonging to the European Monetary Unionimplies that national government debt is no longer riskless. One could thus consider how the crisis would have played outif the following rules had applied since 1999:i) Forcing banks to have capital against their holdings of euro area government debt.ii) Applying the normal concentration limits also to government exposure.iii) A different collateral policy of the ECB, for example with a sli- ding scale of increasing haircuts on government debt in func- tion of the country’s deficit and debt and its position in the excessive deficit procedure. One can only speculate what would have been different if thiskind of regulation had been in place during the boom years. But afew conclusions seem certain. 215
    • Breaking the common fate of banks and governments Greece would certainly have encountered much more difficul-ties selling its bonds to banks which would have had to hold capi-tal against it would be less able to use them to access ECB funds.The same applies to Italy, whose rating went already in 2006 belowthe threshold at which under normal banking rules higher capitalrequirements kick in. Both these countries would thus have seengradually increasing market signals, which would have most pro-bably led to a more prudent fiscal policy. Moreover, their problems would today have been much easierto deal with because banks would have more capital and the con-centration limit would have prevented Greek banks to accumulateGreek government debt worth several times their capital. Theresources necessary to prevent the collapse of the Greek bankingsystem has increased considerably (by about 40 to 50 billion euro)the size of the financial support Greece needed so far. The negative feedback loop between the drop in the value ofbanks and in the yields on government bonds which destabilized theentire European banking system so much during the summer and fallof 2011 would also have been very much mitigated if the concentra-tion limit had been observed. Italian banks would have accumulatedless Italian debt and would have been able to offset some of the markto market losses on the Italian debt with their gains on German debtholdings which they would have had to hold as well.216
    • The Future of the Euro Common euro area wide deposit insurance would have contri-buted in several ways to deal with the financial crisis from thebeginning. First of all, in 2008 it would have obviated the percei-ved need for the competitive rush to provide national guaranteesfor bank deposits. The Irish government would thus probably nothave had felt the need to provide the blanket guarantee for all lia-bilities of its local banks which proved fatal once the extent of thelosses was revealed. Ireland would still have suffered from a massive real estate bustwith all the consequences in terms of unemployment, but the Irishgovernment would not have been bankrupted by its own banks.Paul Krugman has drawn attention to the parallels in terms of eco-nomic fundamentals between Nevada and Ireland8 arguing thatexplicit fiscal transfers and higher labour mobility within the USconstitute the main differences. However, Ireland has actuallyexperienced a degree of labour mobility which is quite similar tothat among US states like Nevada. During the boom it had immi-gration running at over 1% of its population, which after the bustturned into emigration of a similar order of magnitude. The wides-pread held opinion that the euro could never work because there isnot enough labour mobility in Europe is not entirely correct. In the case of Ireland the key issue was not one of a lack of labormobility, but of the absence of a common safety net for banks. A8 See http://krugman.blogs.nytimes.com/2010/12/29/ireland-nevada/. 217
    • Breaking the common fate of banks and governmentsEuropean deposit insurance would have provided stability to thedeposit base. It is also likely that the European Deposit insurancewould have been less complacent and less beholden to the inte-rests of Irish banks and would thus have started to increase its riskpremium when the signs of a local real estate bubble were clear toalmost everybody outside the country. Greece, where the national deposit guarantee scheme is nowpractically worthless because it is backed up only by the Greekgovernment, which has just defaulted on its debt, provides anot-her example of the potential importance of stabilizing the bankingsystem. With a European deposit guarantee scheme there wouldhave been no deposit flight, which has amounted so far to about50 billion, or over 25% of GDP. There would have thus been muchless need for the ECB to refinance the Greek banking system, lowe-ring again the cost of the Greek bail out. The next crisis will be different from the current crisis, but it isclear that different rules for the banking system could bring twoadvantages: they would provide graduated market based signalsagainst excessive deficits and debts. Moreover, a better capitalizedbanking system with less concentrated risks would be much betterable to absorb a sovereign insolvency, thus reducing the need forfuture bail outs. Acting on this front seems a much more promi-sing route to reduce the likelihood for future crises and minimizethe cost should they occur anyway.218
    • The Future of the Euro Perceptions matter. Europe’s policy makers seem to be driven bythe perception that this crisis was caused by excessively lax fiscalpolicy in some countries. In reality, however, the public debt pro-blems of some countries have become a systemic, area wide, finan-cial crisis because of the fragility of the European banking system.The ‘euro’ crisis is likely to fester until this fundamental problemhas been tackled decisively.5. A proposal for a new regulatory treatment of sovereigndebt securities in the euro area The purpose of this section is to sketch a simple proposal for anew regulatory treatment of sovereign debt securities in the euroarea which follows the arguments illustrated in the previous sec-tions.1. Any risk weights to be introduced after the crisis might better be based on ‘objective’ criteria, rather than ratings.2. Diversification of banks’ exposure; this is even more important than risk weighting for sovereign exposure. A simple way to attach a risk weight on government debt secu-rities of a given country would be to make the weight function ofobjective factors like the debt and deficit of the country. For exam-ple, one could imagine that the risk weight could remain at zero ifboth government debt and fiscal deficit relative to GDP remainbelow 60% and 3% respectively. If the deficit and/or the debt ratio 219
    • Breaking the common fate of banks and governmentsexceed the ‘reference’ values of the Treaty, the risk weight wouldincrease by certain percentage points in a proportional or progres-sive fashion. In addition the risk weights should be linked to thestages of the excessive deficit procedure (EDP). When the procedu-re is launched, the risk weight is increased and at each additionalstage of the EDP the risk weighting would be increased further. Thiswould provide the EDP with real incentives even without the needto impose fines. Introducing positive risk weights for government debt will notbe enough to prevent crisis because of the ‘lumpiness’ of sovereignrisk. Experience has shown that sovereign defaults are rare events;but the losses are typically very large (above 50%) when defaultdoes materialize. Even with a risk weight of 100% banks wouldhave capital only to cover losses of 8%. Risk weights would thushave to become extremely high before they could protect banksagainst realistic loss given default scenarios. This suggests that themore important aspect is diversification. All regulated investors, i.e. banks, insurance companies, invest-ment funds, pension funds, have rules which limit their exposurevis-à-vis a given counterpart to a fraction of their total investmentor capital (for banks). However, this limit does not apply to sove-reign debt, especially within the eurozone for banks. The result ofthis lack of exposure limits has been that, in the periphery, bankshave too much debt of their own government on their balancesheet which has led to the deadly feedback loop between sovereign220
    • The Future of the Euroand banks. In Northern Europe, investors, such as investmentfunds and life insurance companies, which typically cannot avoidgovernment debt have also concentrated their holdings nationally.This has led to a significant fall and in some cases even to negati-ve value of government bond yields, not only in Germany butthroughout Northern Europe. From the point of view of coreEurope investors, today this might appear as being a prudent stra-tegy, but this concentration increases the vulnerability of the sys-tem to any reversal of fortunes. Moreover, if Northern investorswere required to diversify their holdings there would be a naturaldemand for Southern European bonds, which would bring someoxygen to those governments which have experienced a dramaticsurge in their borrowing cost. Introducing exposure limits during a crisis period would bemuch less pro-cyclical than introducing capital requirements. Inpractical terms, the simplest approach would be to grandfather theexisting stocks, but apply exposure limits to new investments.6. Conclusions This paper has emphasized that while the political agenda hasbeen obsessively focusing on fiscal issues since the early onset ofthe euro zone crisis; this crisis has neither a mere fiscal nature noran exclusively fiscal solution. Despite the Greek episode seemed topoint only to fiscal indiscipline, the reasons why the crisis did not 221
    • Breaking the common fate of banks and governmentsconfined itself to Greece but spread out to the entire euro area assu-ming a systemic nature should be sought in the state of the euroarea banking sector. European banks were, and still are, largelyundercapitalized and too tightly linked to the fortune and the mis-fortune of governments. The paper spots three contradictory building blocks of the EMUconstruction: the no bail-out rule in the Stability and Growth Pact,the independence of the European central bank and the provisionin the financial market regulation framework that governmentbonds are considered as risk free assets. The combination of the no-bail clause with the institution of an independent central bankimplies that fiscally undisciplined countries may have to facedefault as no other country, nor the EU can take on its debt and thecentral bank cannot monetize it. This definitely collides with theprinciple that banks are not required to hold any capital againstgovernment debt securities as it assumed that they do not carryany default risk. In fact, Greece has proved this assumption wrong. This contradiction was completely overlooked during the goodyears in the turn of the new century and the politically more con-venient approach suggested by financial regulation became thedominant. The ‘risk free treatment’ of public debt securities has clearlyworked as incentive for banks to finance profitable governmentspending and accumulate large amounts of government bonds.222
    • The Future of the Euro This is at the root of the common fate of euro area banks andgovernments. Alas, the crisis has made that fate an evil one. Though these contradictory elements have now emerged clearly,the issue has not been addressed and the regulator treatment of thegovernment bonds has not changed yet. On this ground, the paper puts forward some concrete ideasabout how to break the tight linkage between governments andbanks, which represents a decisive obstacle to overcome of theeuro zone crisis. We argue that positive risk weights for government debt securi-ties must be introduced in the banks’ balance sheet, but alone thismeasure will not be enough to prevent a new crisis. A clear pres-cription to reduce concentration of the risk and impose diversifi-cation is at least equally important and complementary to the riskweighting. While developing the arguments for the regulatory changes, thepaper expresses skepticism about the official, widespread view thatthe just signed fiscal compact will have a crucial role in overco-ming the eurozone crisis. As far as the banking sector remains weakand highly exposed to governments, and the common fate ofgovernment and banks is not broken, the crisis will be hard to die. 223
    • Breaking the common fate of banks and governmentsBibliography- Cottarelli C., L. Forni, J. Gottschalk and P. Mauro (2010), “Defaultin Todays Advanced Economies: Unnecessary, Undesirable, andUnlikely”, IMF Staff Position Note No. 2010/12.- Graber M. And D. Folkerts-Landa (1992) The European CentralBank: A bank of a Monetary Policy Rule, NBER Working PaperN.4016.- Giavazzi, F. and M. Pagano (1988), “The advantage of tying oneshands: EMS discipline and Central Bank credibility”, EuropeanEconomic Review, Vol. 32, No. 5, June, pp 1055-1075(http://www.sciencedirect.com/science/article/pii/0014292188900657).- Gros, D., T. Mayer and A. Ubide (2004), The Nine Lives of theStability Pact, Special Report of the CEPS Macroeconomic PolicyGroup, CEPS, Brussels, February (http://www.ceps.eu/book/nine-lives-stability-pact).- Gros D. and F. Roth (2011) Do Germans support the euro? CEPSWorking Paper Document No. 359, December 2011.- Gros D. (2012), The misdiagnosed debt crisis, Current History,Vol.111, Issue 773 p.83.224
    • The Future of the Euro- Gros D. (2012), The Treaty on Stability, Coordination andGovernance in the Economic and Monetary Union (aka FiscalCompact), CEPS Commentary, March 2012.- Padoa Schipppa T. (1994), The Road to the Monetary Union: TheEmperor, the King and Genies, Clarendon Press. Place ofPublication: Oxford. 225
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    • /RICARDO MARTÍNEZ RICO * / The fiscal institution in the Economic and Monetary Union: the contribution of Spain1. Introduction; 2. Evolution of the fiscal policies in Europe and Spain;3. Analysis of the relationship between fiscal rigour, macroeconomic sta-bility and growth; 4. Next steps in the Fiscal Institution of the Economicand Monetary Union: the necessary contribution of Spain; 5. Conclusion1. Introduction The current financial crisis in the European Union (EU) hashighlighted the importance of establishing a common framework* Public Sector economist, on leave, and Founding Partner, President and CEO of EquipoEconómico, S.L. He has held office as Deputy Finance Minister Working inside the teamof the Deputy Prime Minister, Rodrigo Rato, and Finance Minister, Cristóbal Montoro.Graduate cum laude in Business Administration at the University of Zaragoza, he stu-dies in the Deutsche Schule of Bilbao and Valencia. He has attended postgraduate cour-ses at the London School of Economics, Kennedy School at Harvard University andWharton Business School. 227
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spainwhich enables the economic agents to act in a macroeconomic sce-nario of stability and confidence in the coming years. In this crisis situation, once again the discussion has sparkedthe debate in Europe of whether the necessary fiscal stability,which will demand the rationalisation of public spending in themember states, will be achieved at the expense of prolonging thecrisis and limiting economic growth possibilities. However, thereshould be no dilemma between sustainability of public accountsand medium term economic growth. The crisis of the Europeansovereign debt is a consequence of overspending and debt whichthe markets are not prepared to fund. In this regard, the onlyrecourse is a fiscal policy designed to mitigate the harsh effects ofthe crisis and boost economic growth within the framework ofmacroeconomic stability, continuous supervision over the sustai-nability of public sector accounts and economic reforms. Spain must cease to be a burden for Europe and once againbecome a driver of growth. Compliance with a route of plausiblecuts in public spending in all Public Administrations is a necessarycondition to do so, though not the only. As previously shown, inthe case of the Spanish economy, stability and reforms make up theformula required to revitalize investment, consumption and jobcreation. Thus, economic reforms and budgetary discipline areequally important.228
    • The Future of the Euro The Spanish case is a clear example of a solid and plausible bud-getary institution, where the principle of subsidiarity enables eachgovernment with sound finances to tackle its internal decisions inaccordance with its economic and social reality (not only becauseof its significance from a regulatory perspective but also because ofthe parallels between the European scenario relative to the coun-tries and the Spanish scenario relative to the AutonomousCommunities). At the same time, those who are forced to ask forhelp must abide by the ensuing conditionality. In Europe, likewise, the need for greater economic and mone-tary integration must take us along the path of clear fiscal rules. Butit must also do so to encouraging income transmission mechanismsbetween countries and regions, availability of financial resourcesand support by way of providing the necessary liquidity to faceemergency situations and the pooling of risks, always in exchangefor strong sets of conditions to prevent moral hazard. Moreover,within the monetary and economic union the imbalances must beaddressed, not only of highly indebted countries, but also thosewith surplus balances. In some way, it must be recovered an incen-tive system to ensure political commitment and compliance withgoals set. Nowadays, the fiscal institution1 is a basic component ofEuropean and Spanish economic policy.1 González Páramo defines it as "the rules which govern the preparation of the budgets, theirdebate and approval in parliament, execution and subsequent control”. "Costs and benefits of fis-cal discipline: the Law of Fiscal Stability in perspective” (Costes y beneficios de la disciplina fis-cal: la Ley de Estabilidad presupuestaria en perspectiva), J.M. González-Páramo, 2001. 229
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spain Throughout this work we shall examine, in first place, how thesustainability of the public finances requires a solid fiscal institu-tion and a firm political commitment by the different Europeangovernments. Only on the basis of the conviction of the benefits ofthis statement can one contribute towards the construction of astronger Europe. Then we shall go on to examine the close relationship betweenfiscal rigour, macroeconomic stability and growth, arriving at theconclusion that the establishment of simple, transparent, automati-cally applied rules with preventive control mechanisms for allPublic Administrations is essential for this ‘positive’ interrelation.All these components are basic for the design of a fiscal policywhich helps to recover the credibility that Europe needs in its pathtowards greater integration to face the sovereign debt crisis. In the last chapter we shall examine the measures taken in Europeand in Spain since the start of the sovereign debt crisis, and we shallreflect on the following steps to be taken in support of the budgetaryinstitution. Then close with the appropriate conclusions.2. Evolution of fiscal policy in Europe and Spain The European political integration project came about in thepost World War years, as an extension of the economic integrationprocess. This was envisaged by one of the founding fathers of the230
    • The Future of the Eurocurrent Union, Jean Monnet. In 1950, he proposed the creation ofa space of peace and prosperity for Europe, via the formation of theEuropean Coal and Steel Community, which became a reality ayear later. His way of conceiving the European construction as aproject made up of very specific steps – beginning with the eco-nomy – is the way to understand many of the milestones thatEurope has achieved in the last sixty years. Examples of this havebeen the creation of the European Economic Communities, thelaunch of the European Monetary System, the creation of the sin-gle European market and the firm commitment that has led to theEconomic and Monetary Union (EMU). During the first decades of the European unification project,Spain was but a mere observer, although fully embraced the inte-gration process along the same lines and endorsed the way of tra-velling the path towards a united Europe. Thus, in the mid-1980s,Spain understood that the current EU offered a chance to take adecisive step in its integration into an international market whichwould bring gains in efficiency, reinforce macroeconomic stabilityand contribute to the increase of wealth and per capita income.That would lead to the development and modernisation of thecountry. And, indeed, this was the case in the first years, where eco-nomic growth rate of Spain was positive over that of the EU, by amaximum of 3pp in 1987 (see Chart 1). However, as of this time,macroeconomic instability driven by an expansive fiscal policy,became a burden for economic growth and job creation, and gene-rated a fast and continuous rise in public debt. The importance of 231
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spainhaving a solid fiscal institution in the economic development ofthe Spanish economy became patently clear. Chart 1 Year-on-year growth in real GDP in Spain and in the European Union Source: Prepared by Equipo Económico with data from the International Monetary Fund After the repeated failures of the European Monetary System star-ted up in 1979, and the progress of the approval of the SingleEuropean Act (1986) in favour of an internal market, the EU mem-ber states took an additional step in Maastricht. EU member statessupport, via the adoption of the Treaty on the European Union(TEU) (1992), the creation of an Economic and Monetary Union,whose third phase would entail the launch of the single currency,the Euro. Title VIII of the Maastricht Treaty set three main axesaround which the design of the EMU should be built around: sin-232
    • The Future of the Eurogle monetary policy, fiscal policies subject to common rules andcoordination mechanisms for the remaining economic policies. Aclear view of establishing nominal convergence mechanisms basedon the fiscal institution was already existent at that stage, foundedon the following common rules: absolute ban on monetary fundingof public deficits, no liability held by the EU or by any other Statein regard to debts acquired by another member state, and the set-ting of limits on deficit (3%) and public debt (60%). As of 1997, theStability and Growth Pact (SGP) introduce stricter rules with a defi-cit target of balance or surplus, supported by an early alert systemand a disciplinary penalty structure designed to correct deviations. For Spain the commitment to meet the convergence criteria esta-blished in the TEU for eligibility for the third phase of the EMUdemanded a radical change to be made in our fiscal policy. Europethen began to act as an anchor in Spanish budgetary policy.However, even when the worst of the recession was over for Spain,governments continued to face enormous difficulties in balancingthe budget in the pursuit of macroeconomic stability. It would not be until the political change of 1996, and with thereference and encouragement arising from the creation of the sin-gle currency, when the necessary fiscal consolidation was finallytackled, that macroeconomic stability was achieved and the basesfor a new economic growth phase were put in place. The startingpoint was poor, in 1995 with a deficit around 7% of the GDP and agrowing public indebtedness which reached 67% in 1996. 233
    • The fiscal institution in the Economic and Monetary Union: the contribution of SpainAlthough the level of indebtedness was lower than the average forthe EU, in the case of Spain the combination of the primary defi-cit, the high cost of financing of the debt and the recession hadrendered unsustainable the growing public debt. As of that timethere was a change in fiscal policy, which took on a markedly coun-ter-cyclical approach. As shown in chart 2, an ambitious fiscal con-solidation programme was implemented which allowed the annualbudgets to close with primary surpluses from 1996 until the end ofthe period and to slow down the growth trend in public debtwhich, after peaking in 1996, dropped by more than 20pp of GDPuntil 2004. Chart 2 Evolution of income and expenditure of Public Administrations and of their budget balances Source: Prepared by Equipo Económico with data from the Ministry of Finance and Public Administrations234
    • The Future of the Euro During the period, the fiscal consolidation drive contributedtowards a strong growth in GDP (average rate of 3.6 between 1996and 2004), which helped reducing debt stock via the positive spre-ad between the economic growth rates and interest rates. The suc-cess in the change of direction in fiscal policy was due to a firmpolitical commitment, a well-designed fiscal consolidation pro-gramme and a substantial reform of the fiscal institution.2 For countries that, like Spain, managed to take part in its foun-dation and for others which joined subsequently – such as the caseof Greece which, with the support of Germany and despite notmeeting at the time the requirements established by the MaastrichtTreaty, became part of the Eurozone two years later – the incorpo-ration to the euro meant the relinquishment of monetary policy infavour of the European Central Bank (ECB). And this total integra-tion in the establishment of monetary policy has fostered greaterprice stability during these years. On the other hand, this relin-quishment made budgetary policy, along with economic liberalisa-tion policies, into the main economic policy instruments in each ofthe Eurozone member countries. We must highlight that, once the objective of forming part ofthe euro was met in full, Spain took an additional step beyond whatwas required in Maastricht. And, in line with the principles agreed2 “The Spanish fiscal institution: from the Stability Pact to the rules of fiscal stability” (Lainstitución presupuestaria española: del Pacto de Estabilidad a las reglas de estabilidadpre¬supuestaria), R. Martínez Rico (2005). 235
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spainin the SGP, it rounded off the fiscal consolidation effort with a deepreform of the fiscal institution. As a result thereof, the approval ofthe fiscal stability laws (the General Law on Fiscal Stability and theOrganic Law additional thereto) brought about a change in thebudgeting process. This mainly consisted of: the definition of a fis-cal stability target (fiscal balance) in the medium term for all PublicAdministrations; for the State, a non-financial expenditure limit,the so-called expenditure ceiling, was applied following parliamen-tary approval during the first half of the year; as a novelty, theContingency Fund was added into the State budget, as a flexibilitycomponent during the life of the budget which removes the needfor making fiscal adjustments, equal to 2% of the non-financialexpenditure ceiling approved by Parliament. The approval of theFiscal Stability Laws was further completed with a new GeneralFiscal Law and a new General Subsidies Law. Specifically, theGeneral Fiscal Law aimed at achieving greater rationalisation of thefiscal process, whereas the General Subsidies Law, on its part, aimedat transferring the governing principles of Fiscal Stability Laws (effi-ciency, transparency and multi-annual framework) to the expendi-ture on subsidies (which would mean 20% of expenditure budget). However, in 2005, the European process of integration andreform came to a halt. The solution provided to the reiterated vio-lations of the 3% limit on public deficit established at Maastricht –and following the pressure exerted by Germany and France in thisregard, backed by the European Commission – was none otherthan the SGP, introducing greater discretionary power and taking a236
    • The Future of the Eurostep back in the capacity of the fiscal institution to contribute togrowth. Along the same lines, with a comfortable fiscal position andwith the same philosophy as that of the reform of the SGP, Spain in2006 approved a reform to render the fiscal and TerritorialAdministration funding processes more flexible, which is the sour-ce of our current fiscal crisis. The relaxation of fiscal stability led toa loss of transparency in its application as a result of the flexiblenew rules. With the outbreak of the international financial crisis as of 2008,the primary surplus of the first years of the period quickly ran out.Discretionary expenditure decisions, the impact of automatic sta-bilisers and the major errors in revenue estimates led to a deficitbalance, which worsened over two years (from 2007 to 2009) by13pp of GDP. This deterioration, which had also taken place in therest of EU members, was more notable in Spain due to its speed andmagnitude (see Chart 3), with few comparable examples within thescope of the OECD (except for the cases of Iceland or Ireland). Thedeficit fiscal position generated a fast increase in public debt, lea-ding to doubts about sustainability thereof, and translating intosignificant rises in the risk premium of the country. At the start of 2010, given the lack of confidence displayed byinternational markets, and in light of the fast deterioration ofpublic finances, the previous Government was forced to implement 237
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spain Chart 3 Budget balance in 2006 and change in budget balance in 2007-2009 Source: Prepared by Equipo Económico with OECD dataa radical change in its fiscal policy and announce a fiscal consoli-dation programme. The sovereign debt crisis, which especially affects several of the“peripheral” member states of the Eurozone (but which has alsoaffect countries such as France and Austria), has highlighted theneed to reinforce the budgetary coordination mechanisms withinthe EMU. In the face of the problems arising from the sovereign238
    • The Future of the Eurodebt crisis and as a result of the fluctuations in the risk premiumsof the Eurozone member states, a double reinforcement movementof the budgetary crisis has taken place from Brussels since the onsetof the crisis. On the one hand, that implemented by the EuropeanCommission, the result of which is, for instance, the legislative pac-kage comprising five regulations and one directive designed to rein-force the preventive part and the disciplinary part of EC mecha-nisms. On the other, that of the member states which, via theEuropean Council, have brought about agreements such as theFiscal Pact, which seeks to guarantee that all countries will committo fiscal stability under the highest level of regulation. The reformenacted last year of the Spanish Constitution must be understoodwithin the framework of this new drive from Europe in support ofthe fiscal institution. The reform, as we shall discuss further in thispaper, guarantees the principle of fiscal stability via the highest ran-king law. Despite efforts invested, and despite the positive effect of theliquidity injections made by the ECB, the current economic scena-rio in Europe continues to be marked by the risk premiums of EUperipheral countries, which continue to be too high. The questionsas to the capacity of such countries to meet their debt commit-ments have burdened economic European Union results over thelast two years. This has led the Commission to forecast a drop inGDP for all of the EU of -0.5% for this year, which sets it back interms of the growth of the world economy. Although it must besaid, that all countries are not behaving in the same way. Germany, 239
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spainfor instance, closed last year with 3% growth, expecting to do sothis year at 0.6%, whereas Italy will experience a drop of around -1.3% of GDP. From a growth perspective, there is an important dif-ference between northern and southern European countries arisingfrom the financial crisis. However, it is worth remembering thestrong interdependence between all member states, includingGermany (second country in the world in terms of export volume,of which 60% are directed to the EU). On its part, the Spanish economy is clearly included in the “slo-wer” group, at an extremely difficult time. In recent months, thereturn to recession, which accumulates after four years of crisis, theadverse effect on employment and on businesses, has led to a 24%unemployment rate. At the same time, there is high external debt,exceeding 160% of the GDP, with a high accumulation of public andprivate debt maturities this year. All these factors have led to a riskpremium of around 340 basis points in the last few months and, morerecently, well above 450 basis points, and to be closely watched by themarkets, that is to say, our creditors. Given this scenario, in 2012, theSpanish economy faces challenges associated with its macroeconomicimbalances yet to be corrected, as well as the potential problems ari-sing from a new challenge from international financial markets. Inthis framework, we expect a drop in GDP during the first quarters,and although its performance will improve towards the end of theyear, it will result in an overall drop in GDP of around -1.5% this year.Meanwhile, the reality experienced by the rest of the world is diffe-rent, with a world economy growth rate of around 3.5% of GDP.240
    • The Future of the Euro Undoubtedly, the unemployment rate is our main negative dif-ferentiating factor compared to all other EU members and the mainconcern for Spanish society. As a result of the economic crisis, nocountry in the OECD has experienced a downturn in the joblessrate as negative as ours. Our rate of unemployment has gone from8.3% of active population in 2007 to almost 24% at the end of2011. The crisis has highlighted the problem with our employmentmodel, as our economy is adjusted by means of redundancies ins-tead of by adding greater flexibility to employment conditions. Despite the gradual correction of the external imbalance (thecurrent account deficit has been reduced from 10% of GDP recor-ded for 2007 to less than 4% in 2011), Spain continues to be signi-ficantly reliant on foreign funding (around 40,000M€ per annum).The need for funds shown by the current account deficit, cannot infact be met by attracting foreign investment to our country.Indeed, the opposite is the case, with recent years witnessing adivestment process, particularly of portfolio assets. The forecastdrop in the GDP combined with the high level of debt, puts thesustainability of our funding at risk. Given such conditions, the cri-sis is requiring a must faster deleveraging process than that initiallyexpected. Since the common denominator of the European sovereign debtcrisis is insufficient GDP growth, only by articulating the reformsin Europe and in Spain in an expedient and firm manner can thecurrent increasing loss of confidence by financial markets be sta- 241
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spainlled. In the case of the Spanish economy, this is a path which wetravelled successfully in the second half of the nineties, whenSpain took part in the foundation of the euro and then went on tolead the fiscal consolidation process in Europe. The new govern-ment seems to have understood this, having begun reforms inthree main areas: sustainability of the public finances and moder-nisation of the public sector, the restructuring and reorganizationof the financial sector and the reform of the labour market. In thecoming years, political commitment to fiscal rigour, macroecono-mic stability and growth must go hand in hand in Spain andEurope, and happen in parallel.3. Analysis of the relationship between fiscal rigour, macroe-conomic stability and growth In the context described in the previous section, fiscal consolida-tion within the EMU is a fundamental tool for recovering macroeco-nomic stability, the confidence of economic players and the path togrowth, leading in turn to job creation. Moreover, the balance in public finances provides the econo-mies participating in the monetary union, which therefore cannotresort to instruments such as currency rates, with greater leeway todeal with external shocks, enabling the implementation of anti-cyclical policies and of automatic stabilisers.242
    • The Future of the Euro At the same time, as has been amply studied in the literature,3fiscal balance fosters a macroeconomic stability scenario which pro-vides a more efficient framework for the development of economicactivity. The reduction in the deficit increases the confidence ofsavers and investors. This translates into a stimulus for investmentand job creation, as well as allowing households and businesses toplan the purchase of durable goods in the long term, thus leading tosustained consumption, which is a key factor of economic growth. One of the most relevant aspects is the stronger credibility of theeconomic policy and the improvement in the funding terms of theeconomies in the international markets, thanks to the reduction ofthe risk premium, which in turn leads to a drop in financial costs,as shown in Chart 4 in the case of Spain as of 1996. The subjectionof European monetary and fiscal policies to certain rules, and theassumption thereof by Spain as a participant in the foundation ofthe Euro, helped to provide additional credibility to the govern-ment’s fiscal consolidation strategy. This strategy was strengthenedby the regulatory reforms introduced by said government as we dis-cussed in the previous section. This positive impact4 on the expec-tations and on the confidence of economic agents explains thesharp drop in long term interest rates, compared to the 10 yearGerman bond. The spread in the Spanish risk premium was actuallyzeroed as of 2003.3 “Fiscal policy and long-run growth”, V. Tanzi and H. Zee, 1997.4 “The Spanish economic model 1996-2004” (El modelo económico español 1996-2004), L.Bernaldo de Quirós and R. Martínez Rico, 2005. 243
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spain However, since 2008, with the arrival of the international finan- cial crisis, the macroeconomic imbalances accumulated by the Spanish economy led to the opposite effect. Furthermore, as a result of the degradation of Spanish public finances between 2003 and 2009, as shown in the aforementioned graph 3, and the doubts in regard to the sustainability of the Spanish public debt, the risk premium increased once again in a significant way as of 2010, now reaching the 450 base point mark. The significance of fiscal consolidation as a tool for the recovery of stability and long term growth has also been proven in practice in many successful fiscal adjustment processes implemented in the last decades in certain European countries, such as Spain (1996- 2004), Ireland (1982-1989) or Sweden and Finland (1993-2000), some of which have been studied in depth in the literature.5 The most successful process was the one implemented in Finland between 1993 and 2000, which managed to reduce pri- mary expenditure by 14pp of GDP. This was mainly based on per- sonnel cost containment, reduction in transfers from the Central Administration to Local Corporations and the pursuit of efficiency in social expenditure, particularly in health services, education and pensions. Moreover, the fiscal institution underwent a reform with the introduction of expenditure ceilings, which proved to be a key5 "Fiscal expansions and adjustments in OECD countries", A. Alesina y R. Perotti, 1995. “AnEmpirical Analysis of Fiscal Adjustments", C. McDermott & R. Wescott, 1996. 244
    • The Future of the Eurotool for cost containment. At the same time, the pension system,the labour market and the financial system underwent a structuralreform. The only expenditure programme that was deliberatelymaintained, thus keeping its 1% share of the GDP, was that ofResearch and Development. The Swedish experience between 1993 and 2000 obtained similarresults in terms of a reduction in primary expenditure (14% GDP),which led to the attainment of fiscal balance in 1997, having closedfinancial year 1993 with a deficit of 12.9%. In contrast with Finland, Chart 4 Evolution of risk premium Source: Financial Times 245
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spainin Sweden the fiscal consolidation took place due to both the cut inexpenditure and the increase in revenue through a tax rise, whilealso implementing simultaneous structural reforms such as the pri-vatisation of public corporations and the liberalisation of the labourmarket. Public spending was reduced by 16pp of GDP over a sevenyear period, mainly through a reduction of the expenses in transfersand benefits (including unemployment benefits) and a reduction inpersonnel and current costs of all public administrations. The intro-duction of three-year expenditure ceilings and annual productivitytargets must be added to such measures. The starting point of all the above was the strict cut in primaryexpenditure, as the basis for the adjustment process, mainly cen-tred on personnel costs, transfers and health services.Undoubtedly, a key factor in all such measures is that they weredone hand in hand with important structural reforms, particularlythose implemented in the labour market, the fiscal system and theprivatisations. Those allowed the adjustment process consolidationand the increase in potential growth, on the basis of a firm politi-cal commitment. Furthermore, it helped proved that fiscal consoli-dation strategies based on spending cuts are more enduring andpromote a better economic performance than those based on reve-nue increase. Experience has likewise proven that fiscal consolidation cannotbe maintained in the medium term without a proper fiscal institu-tion articulation. As shown in the previous section, from the start,246
    • The Future of the Eurothe construction of Europe has been evolving towards a greaterrelinquishment of national policies in favour of European ones. Itis a slow and complicated process in which political divergencesoften prevail over the overall view of what this process means. Thisrelinquishment has meant the need for greater autonomy in theestablishment of rules and objectives, as has been the case, for ins-tance, with monetary policy. Aside from the current supervisionproblems, it is clear that the role of the ECB in regard to price con-trol has been a success. This example should be transferred to thefiscal policy as a source of inspiration to maintain the necessarypolitical commitment and thus achieve effective fiscal coordina-tion in the Eurozone. We live in an open economy, where freedom of movement ofpersons, goods, capital, information and technology are necessaryconditions for improvement of competitiveness and economicdevelopment. A globalised market, with a high level of competi-tion, but also great opportunities, requires a disciplined, foreseea-ble and transparent behaviour by the countries, designed to gene-rate confidence among economic agents. The EMU was born out ofthis perspective although there have been mechanisms, or evenrelevant design components, which have failed. In general, The European construction has been preceded by theestablishment of rules seeking to limit the risks of integration. Theproblem has arisen from the lack of rigour in compliance with suchrules, probably as result of the insufficient clarity of the rules and 247
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spain of political leadership committed to integration. When this hap- pens, it is easier to interpret the situation in one’s own favour, par- ticularly when high political power is held. Therefore, it is impor- tant to have clear and simple rules, in order to reduce the possibili- ties of interpretation and to help control subsequent compliance. At the same time, the establishment of preventing rules to ena- ble the anticipation of sharp increases in public deficit, should be articulated via a greater participation by the EU in the preparation of national budgets, in line with the latest legislative proposals of the European Commission on the matter. Preliminary control is a guarantee of compliance and greater co-responsibility with Brussels, which should in turn lead to better access to European funding. According to economic literature,6 those countries exerting con- siderable effort to achieve fiscal consolidation amid a context of economic uncertainty, should design and announce the establish- ment of a fiscal rule within a reasonable period of time designed to improve credibility. In the case of Spain, this step has been taken by way of the reform of section 135 of the Constitution, a historical event of special political relevance. In our case, constitutional reform has managed to raise to the level of fundamental Law – a relevant issue in our highly decentra- lised State – the commitment of all the Administrations to fiscal6 “Fiscal Rules – anchoring expectations for sustainable public finances”, FMI, 2009. 248
    • The Future of the Eurosustainability. The approval of this reform has meant the recogni-tion of the benefits of fiscal discipline, having assumed the flaws inthe relaxation of the Stability Laws in 2006 as well as the need toprovide a new common legal framework for all of the public sector.Except for force majeure cases (natural disasters or emergencysituations), compliance with the limits on public debt and fiscalbalance set by the EU are guaranteed. Likewise, priority is given toservicing the debt in the budget, a condition which helps build thenecessary confidence in lenders, and is an appropriate antidote forpreventing the loss of confidence in Eurozone countries. The reform also established the need for articulation in a neworganic Law, designed, on the one hand, to regulate the distribu-tion of deficit and debt limits between the variousAdministrations, the exceptional cases of surpluses therein, andthe means and terms for correction of any deviations in one or theother that might take place. On the other hand, it had to establishthe methodology and procedure for calculation of structural defi-cit. It is important that the calculation methodology respects theprocedure used in the EU, to provide discipline and transparencyto the fiscal process and help in the statement of accounts. The cal-culation rule must be clear, and serve to consolidate fiscal discipli-ne, as a permanent long term commitment. Lastly, it must esta-blish the responsibility of the Administrations in the event of fai-lure to achieve fiscal stability targets. In this regard, the credibilityof the reform will depend on the existence of efficient systemswhich encourage the Administrations to meet the fiscal targets. As 249
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spainwe shall mention in the next section, such principles have beenincluded in the Law on Fiscal Stability and Financial Sustainabilityof Public Administrations.4. Next steps in the Fiscal Institution of the Economic andMonetary Union: the necessary contribution of Spain The European debate on sustainability of public finances andthe future of the Euro is set at a time in which, following the con-version of the international crisis into the crisis of the sovereigndebt of several Eurozone countries, we have witnessed myriadEuropean summits, each of which seeming to be the last chance totackle the doubts of the markets in relation to the viability of thedebt, in the first place, of Greece, Portugal and Ireland, and morerecently, of Italy and Spain. It is true that the crisis is far from being resolved. The EU has notalways shown a capacity to react with the speed required by econo-mic relations nowadays – until the tensions reached non peripheraleconomies such as Austria or France, the pace in reaching consen-sus had been much slower than necessary. Moreover, during the cri-sis, it has become obvious that the institutional design of theMonetary Union was incomplete and, above all, as we have men-tioned in this paper, that there has been insufficient political com-mitment to the application of the existing mechanisms of fiscalcoordination. But it is also true that in the last four years, a consi-250
    • The Future of the Euroderable path has been travelled towards European construction,towards an improvement in economic governance, so that in addi-tion to a single monetary policy, Europe is also able to benefit fromgreater integration of fiscal policies. As such, it is worth highlighting the agreements reached, eithervia the community procedure or via inter-governmental agree-ments, in terms of strengthening coordination, supervision andpolicing mechanisms of fiscal and macroeconomic policies. In the first place, the European Semester establishes a new sche-dule whereby, on the basis of the macroeconomic situation of eachmember state and its growth forecast, the budgets and economicpolicies required to meet the commitments undertaken in the EuroPlus Pact and the 2020 Growth Strategy are discussed during thefirst six months of the year in a coordinated fashion and in accor-dance with common rules. In the second place, the adoption of the so-called Six-pack (onedirective and five regulations) constitutes the greatest reform of theSGP and of economic Governance since the Maastricht Treatywhich created the EMU. As of the adoption of the new legislation,the European Commission may establish automatic penalties (ofup 0.2% of GDP) for those countries with excessive deficits whichdo not follow the recommendations for correction. At the sametime, the public debt control mechanism and the required reduc-tion are reinforced in the event of exceeding the 60% GDP level 251
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spain assumed. It also introduces a mechanism designed to prevent excessive imbalances such as unsustainable current account defi- cits, loss of competitiveness and other macroeconomic imbalances. Lastly, the signature of the new Treaty on Stability, Coordination and Growth (by all member states of the EU except for the United Kingdom and the Czech Republic) brings changes at the highest legislative level to fiscal stability regulation. This must be translated in each country in that the structural deficit of the public sector may not exceed 0.5 GDP per annum, subject to auto- matic penalties. These steps will be followed in the months to come by impro- vements seeking to fine-tune the mechanisms of economic con- vergence, via two legislative proposals7 of the European Commission, by establishing a clearer and more demanding sche- dule for fiscal coordination in Europe and implementing fiscal control and monitoring mechanisms in countries facing serious difficulties in regard to their financial stability within the Eurozone. All these measures help towards the consolidation of economic governance, and establish the bases to enable progress to be made7 "Proposal for a regulation of the European Parliament and of the Council on commonprovi¬sions for monitoring and assessing draft budgetary plans and ensuring the correction ofexces¬sive deficit of the Member States in the euro area" and "Proposal for a regulation of theEuropean Parliament and of the Council on the strengthening of economic and budgetary sur- 252
    • The Future of the Eurovia other instruments, in order to provide funding and liquidity tohandle emergency situations, to the extent of including euro-bonds, if necessary, as well as helping the ECB to have greater lee-way when acting in the markets in pursuit of economic stability.Without doubt, greater fiscal coordination broadens the fundingmargin of these countries. But we must be clear that access to fun-ding requires preliminary fiscal control, and not the reverse.Conditionality in all these mechanisms is an essential requirementwhen seeking to limit risk. Any funding requires certain minimumguarantees of repayment of the loan, and this translates intoadjustments and reforms. This is nothing new, but something thathas cropped up on many occasions in IMF interventions.Eurobonds might get to play a key role, but cannot be the onlyitem to support the fiscal union, which will drive the Eurozonetowards optimum monetary union, and for which to date there isno more than a highly experimental road map. Within this working programme so badly needed in Europe, andsupported by conditionality, greater mechanisms for EU incometransmission should be created to help countries facing serious pro-blems – such as that of the sovereign debt crisis – in order to imple-ment the structural reforms required by their economies, with thesupport of Europe in driving growth. This can be done via theencouragement of youth employment and entrepreneur program-veillance of Member States experiencing or threatened with serious difficulties with respect totheir finan¬cial stability in the euro area", European Commission, November 2011 253
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spainmes, the reinforcement of resources available, among other uses,for structural funds or for the activity of the European InvestmentBank. On their part, the Eurozone member states can and must con-tribute to guarantee the future of the single currency, and to thegeneration of the economic growth required to clear any doubts asto the sustainability of sovereign debt, either via their contribu-tions towards the establishment of common rules so that the EMUbecomes an optimum monetary zone, or via the reforms on anational scale which constitute an example for all the others. There is also a high degree of parallelism between the rulesrequired and which must be institutionalized in the MonetaryUnion at a European level, and the process which must be follo-wed in Spain in regard to responsibility, conditionality and subsi-diarity of regional and local Public Administrations. In both cases,the need for a political will capable of applying clear and straight-forward rules, with prevention mechanisms, supported by coordi-nation, monitoring and automatic sanction systems for those whofail to comply with the targets undertaken, has become clearly evi-dent. In this sense, the fact that the new fiscal pact at a Europeanlevel and the recent legislative changes in Spain seem to be goingin the same direction is a positive factor. The case of Spain, where we have a very high degree of decentra-lisation and where the Autonomous Communities and Local254
    • The Future of the EuroCorporations manage approximately 50% of the public expenditure,is a clear example of the need for coordination of fiscal policies toensure that the right signals are sent to markets and investors inregard to the orientation of the fiscal policy. The consolidation effortsmade by some countries and regions are useless if there are otherswhich do not honour their commitments and destabilise the zone,region or country. Europe and, of course, Spain have their own iden-tity, and this applies to act as a unique body in order to establish theaims. The scope of action of each government to achieve fiscal targetsundertaken, via the instruments deemed appropriate, is a differentthing altogether. The principle of subsidiarity must be respected pro-vided that the principle of fiscal balance is observed. Each countrymust have autonomy to define and design its fiscal structure solong as the limits set for deficit, debt and growth in expenditure arerespected. Fiscal competition allows for improvement in revenuecollection efficiency and greater rigour in expenditure control, andthus the greater fiscal coordination in Europe must not be envisagedas a single fiscal policy. However, one of the main instruments at thedisposal of the governments when coordinating fiscal policies is con-ditionality. In any regional funding system there are income transmis-sion mechanisms and penalties aiming to fulfil the set fiscal targets.Therefore, in the event that fiscal stability criteria are not met, be it ata national level within the Eurozone or at a regional level withinSpain, the aid provided, as the case may be via special liquidity facili-ties and even, if necessary, by way of eurobonds or hispanobonds, orby way of larger revenue transmissions at a European level, cannottake place without the acceptance of the conditionality it carries. 255
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spain Spain has understood the need to contribute to the stability inEurope and is leading, for the second time, a solid process ofreforms towards fiscal balance. Following the general elections ofNovember 2011, the new government and a reinforced politicalcapital constitute the main assets to bring about the necessaryreforms. The proof thereof is evident in the fiscal reforms: theRoyal Decree of non-availability, the reform of the Law onStability, the new system for payment to suppliers, the new bill onTransparency or the bill of General State Budgets for 2012 (whichestablishes an adjustment of 27,300 million euros to be made bet-ween cost control and revenue increase). The modification of section 135 of the Spanish Constitutionassumed its inclusion in a subsequent organic Law (the Law ofBudgetary Stability and Financial Sustainability of the PublicAdministrations, recently presented), which specifies changes inthe preparation, execution and control of the Spanish fiscal insti-tution. The recent approval of this bill means a return to the com-mitment to the control of public finances and, more importantly,it adds all of the Public Administrations to its scope of application,which the previous Stability Law failed to do. The three main objectives of this bill are to guarantee the fiscalsustainability of all Public Administrations, to strengthen econo-mic confidence and to reinforce the commits of Spain with theEuropean Union.256
    • The Future of the Euro All Public Administrations must present a balance or a surpluscalculated according to EAS terms and none may incur in structuraldeficit. However, there are two exceptions in the case of structuralreforms with long term fiscal effects (a structural deficit of 0.4% ofthe GDP may be achieved) and in the event of natural disasters, eco-nomic recession and extraordinary economic emergency. In establishing the objectives of stability and public debt, therecommendations of the EU in regard to the Stability Programmemust be taken into account, and all Public Administrations mustapprove an expenditure ceiling in line with the stability target andthe expenditure rule. One of the most important aspects, in accor-dance with European regulations, restricts the growth in expendi-ture by the Public Administrations, as this may not exceed the GDPgrowth rate. Failure to comply with the targets shall require the presenta-tion of an economic and financial plan to allow the correction ofthe deviation for a period of one year. This plan must explain thecauses underlying the deviation and the measures which willbring it back within the limit. In the event of non-compliancewith the plan, the responsible Administration must automaticallyapprove the non-availability of loans to guarantee compliancewith the set target and the meeting of the targets shall be takeninto account when authorising debt issues, granting subsidies andsigning agreements. 257
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spain The Law, on the other hand, strengthens the preventive andmonitoring systems of stability and debt objectives. Therefore, adebt threshold of a preventive nature is established, beyond whichthe only debt operations allowed will be cash transactions. In order to render all Public Administrations jointly responsible,the penalties imposed in Spain in matters of stability shall be assu-med by the responsible administration. In the event of failure toproduce an economic-financial plan, the administration in breachmust put of a deposit of 0.2% of its nominal GDP, which after sixmonths may be converted into a penalty in the event that the vio-lations should continue. After nine months, the Ministry ofFinance and Public Administrations may send a delegation toassess the economic and budgetary situation of the delinquentAdministration. In order to strengthen the principle of transparency, eachPublic Administration must establish the equivalence betweenthe budget and the national accounts. Prior to approval, eachPublic Administration must provide information on its mainbudget guidelines, in order to comply with European regulatoryrequirements. As was set forth in the new draft of section 135 of theConstitution, the Law establishes a temporary period until 2020for gradual compliance, until public debt is 60% of GDP. In orderto ensure compliance with this scenario, public debt must be redu-258
    • The Future of the Euroced whenever the economy experiences positive real growth. Uponreaching a growth rate of 2% or net yearly employment is genera-ted, the debt ratio shall be reduced each year at least by two GDPpoints. On its part, the global structural deficit must be reduced by0.8% of the annual average GDP. Beyond the institutional importance of the reform, it is worthconsidering the political capital that is allowing the deficit problemto be addressed in an integral way and with long term vision. Doubtsas to possible deficit deviations in the current and following finan-cial years should not lead us to lose perspective of the importance ofthe reform. This reform set a trend designed to transform public bud-gets into a reliable institution, with a simple structure, with no roomfor interpretation, equal for all and with an automatic applicationwhich allows it to be protected from temptations from other govern-ments. In this regard, we also view the provisions included in the Billfor the Transparency Law, which, undoubtedly, shall contributetowards generating better knowledge of public finances. The fiscal systems being approved in Spain matched with theEuropean model. There is a strong parallelism between the two,and the construction errors of the European design and of the fis-cal institution in Spain must be corrected by means of a coordina-tion of fiscal policies in which the principles of regulatory equity,subsidiarity, conditionality and sustainability should prevail aboveall others. 259
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spain Without doubt, the future of the euro requires more Europe.The construction of Europe needs rules, adjustments and reforms.Without growth the European model is doomed for failure. Thecurrent crisis is but a result of the structural deficiencies of our eco-nomy, of our excess indebtedness, of our lack of flexibility and ourlack of competitiveness in some aspects. Once again, Spain, on its part, must become a role model of thefiscal institution in Europe, and of the benefits which macroeco-nomic stability brings to the economies, in terms of higher growth,more wealth and greater employment. This is unquestionably thebest way to redistribute income. This is the only way we will mana-ge to get Europe and Spain out of the sovereign debt crisis theyface, ensuring a solid future for the process of European construc-tion, which is the greatest milestone in the search for peace andprosperity in Europe.5. Conclusion Following the same pattern set since the inception of theEuropean integration project after the World War, the EMU cameabout in 1999 as a result of the political aspiration of increasingintegration and as a European response to the globalisation pro-cess. In reality, the integration via the monetary union whichmakes up the Eurozone was not an objective in and of itself, butrather a means to improve competitiveness and efficiency among260
    • The Future of the Euromember countries. The ultimate goal, therefore, was growth, jobcreation and the improvement of social welfare, while at the sametime making inroads in terms of political integration. At that time the countries were aware of the need to set fiscal dis-cipline targets as stability factors for Europe. However, those impor-tant advances in the European construction process became dilutedover the years with the introduction of components carrying greaterflexibility and discretionality in the fiscal institution. The best exam-ple is that the solution provided in 2005 to the violation of the SGPby Germany and France was none other than the reform thereofwhich included greater ambiguity in the search for fiscal stability, forwhich they gained the support of the European Commission. Thediminishing political commitment with the fiscal institution and itsfragility in the face of the vicissitudes of the different governmentsand ideologies became clear at that time. Therefore, with an institu-tional design which was incomplete, and gradually declining overthe years, the EMU was far from representing an optimal monetaryarea, and therefore the imbalances of the Eurozone economies incre-ased, instead of decreasing, placing Europe in a difficult situation inthe face of the global financial crisis. In this context, the current European debt crisis has highlightedthe urgent need for better coordination of the fiscal policies inEurope. At the same time and particularly during the crisis, theexperience since the foundation of the euro has shown the impor-tance of political commitment with the fiscal institution and the 261
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spainneed for preventive rules instead of penalties which are difficult toapply. It is essential to ensure that the accumulation of excessivedeficits does not lead to unsustainable situations which call intoquestion traditional European security and seriously complicatethe capacity for funding growth and job creation. Rules are anecessary condition to ensure compliance with fiscal targets. Butthese rules must be of straightforward and automatic application. Despite the difficulties, the present economic time obligesEurope and Spain to make fast and efficient decisions in order tostraighten out the situation. It is important to take advantage ofcurrent circumstances to tackle ambitious reforms designed tocorrect some of the structural flaws of the Eurozone and of our eco-nomy. It is important to face the current problems from a longterm outlook and to establish the rules of a fiscal institution whichensure the viability of the European project. The future and survival of the euro rests on all member statesbeing able to implement domestic reforms seriously, thus genera-ting a sign of confidence for international investors and whichshall also serve, again in our case, as a calling card for our busines-ses abroad. In Spain, one of the countries which has sustained themost damage from the sharp budgetary deviations of recent years,regional configuration shows evident parallelisms with Europe,both in terms of the need to establish common objectives, and interms of the control systems or the transmission and penaltymechanisms.262
    • The Future of the Euro Spain, as a country which has already proven its ability to takeon this role at the end of the 1990s in the foundation of the Euro,once again has an important role to play. In this regard, it is worthmentioning that, thanks to the latest reforms implemented in sup-port of the fiscal institution, Spain is once again contributing tothe European debate in pursuit of macroeconomic stability in theEurozone and its recovery. The challenge to be addressed, by meansof a change in the economic policy, is to recover confidence andcredibility of our economy, to enable businesses and consumers toconcentrate efforts in business, labour or consumer decisions, andthat macroeconomic issues, such as the risk premium, cease to because for concern. Only in this way may Spain avoid laggingbehind like a second rate club, to which we have already said no afew years back. In order to move forward in building a fiscal union in Europe,which succeeds in turning the EMU into an optimal monetary areaand ensures the good health of the euro and of the European eco-nomy, the necessary mechanisms of income transmission, ensurethe availability of financial resources and required liquidity, to theextent, if necessary, of creating risk pooling instruments, such aseurobonds and, in parallel, the hispanobonds in the case of Spain.These require, however, the establishment of prerequisites, that is,economic adjustments and reforms to be implemented by thecountries facing the most difficulties. The rules are very important,but without reforms it is impossible to grow, and without growth,budgets become unsustainable. A different issue is, provided agre- 263
    • The fiscal institution in the Economic and Monetary Union: the contribution of Spained commitments are met, the respect for the autonomy of eachcountry to decide on its income and expenditure structure.Subsidiarity must govern in Europe for those who are taking thenecessary steps, as is being done in Spain, in order to adapt thebudgets to the economic and social reality of each country. The European construction has taken important steps since thestart of the crisis, but it needs to continue to progress via an incen-tive system to ensure the political commitment with the fiscal ins-titution in the medium and long term. The objectives of peace andprosperity established by the founding fathers of the Europeanconstruction, on a long term horizon, once again depend on ourcapacity to recover the growth and competitiveness of the eco-nomy, and hence employment and the European welfare model.264
    • /JAIME REQUEIJO * / The European Monetary Union: the Never-Ending Crisis1. Introduction; 2. The Euro: a Badly Constructed Building; 3. The fiscalSpillover; 4. The Consequences of the Doubtful Debt; 5. ContributingFactors; 6. Main Measures Adopted to Solve the Monetary Union Crisis; 7.Outcome of the Measures Adopted so far; 8. Consequences of the Breakupof the Euro; 9. The Missing Link* Ph.D in Economics, BA in Law, Former Civil Servant attached to the Ministry ofCommerce, Emeritus Professor of Applied Economics (UNED and IEB).Former positionsinclude : General Director for Imports and Tariff Policy at the Ministry of Commerce,Chief Executive Officer of Caja Postal de Ahorros, Member of the Board of BancoZaragozano, Director of the School of Financial Studies (UCM) and Member of theBoard of Banco de España.His fields of research focus on monetary and financial matters, international economicsand the Spanish economy. He has written seven books and published more thenseventy papers in Spanish economic reviews.. 265
    • The European Monetary Union: the Never-Ending Crisis1. Introduction The constant financial trepidation afflicting different countriesof the Eurozone, and which threatens the survival of the singlecurrency, is not the result of random events. In our view, they canbe put down to four fundamental reasons. First, the MonetaryUnion is a badly constructed building as political urgency prevai-led over economic prudence. Second, there is the fiscal irresponsi-bility of many member state governments, an irresponsibility thathas materialized as hefty public debts. Thirdly, the doubts beinggenerated among the debt holders, mainly institutional investorsand banks, and which has led to significant fluctuations in theinterest rates of those assets and, in general, to a cost hike for theissuers. Four, what we could call the contributing aspects: the spi-llover and contagion effects that batter the financial markets,effects linked to the opinions of the rating agencies and, on occa-sions, to the worst-case scenarios of the International MonetaryFund regarding the medium-term performance of the EuropeanUnion economies and, particularly important, those of theMonetary Union. Faced with that panorama, and given the absence of clear solu-tions, there are three questions raised by many observers of the cri-sis. The first question is what the measures are that have beenadopted so far to try and avoid the recurring disruption. Thesecond question is whether those measures, or further onescurrently under debate, will be sufficient to solve the problem or,266
    • The Future of the Euroon the other hand, will the fate of the Monetary Union be to totallyor partially break up? The third question is if the Monetary Unionproves to be totally unviable and the national currencies have to bere-introduced, what will the consequences be of the failure of theeuro? This paper seeks to provide a reasoned explanation of the cau-ses underpinning the current major upheaval and it also aims toanswer the aforementioned three questions regarding the measu-res, their outcome and impact of a possible breakup of the euro.The paper ends with a short section considering the solution thatshould be adopted to keep the Monetary Union in place.2. The Euro: a Badly Constructed Building Even though the dream of the single currency had been alwayspresent since the Treaty of Rome, the definitive decision, containedin the Maastricht Treaty, is the outcome of the political desires ofFrance and Germany. Of France as French governments believedthat having a single European currency would avoid the constantpressures on the franc, pressures that usually led to the devaluationof its currency. Of Germany as accepting the single currency meanthighlighting the European vocation of the most importantEuropean economy after reunification in 1990, a process that ope-ned up many raw wounds – particularly in France. Driven by thosedual interests, the currency unification project prospered, not wit- 267
    • The European Monetary Union: the Never-Ending Crisis hout significant frictions, until it became reality in 1999, the year when eleven countries, including Spain, ceded their monetary autonomy to the European System of Central Banks; Greece would join in 2001, followed by other countries until it reached the current seventeen members.1 Joining the Eurozone required the countries to meet the so- called Maastricht convergence criteria, those rules aimed at ensu- ring that the different economies had a certain nominal similarity. During the year prior to the Compatibility Test, the inflation rate could not be more than 1.5 points over the average of the three most stable candidate countries; as the end of that year, the public sector deficit could not exceed 3% of the Gross Domestic Product or the debt be greater than 60% of that figure; the candidate country had to have been part of the European Monetary System during the two years prior to the test and without its currency having experienced significant fluctuations; and, during the pre- vious year, the long-term nominal interest rate had not exceeded the average of the three most stable countries by more than 2 points.2 After the failure of the European Monetary System in 1993, only the other three criteria were required to determine which countries could join the euro, and those criteria have conti-1 Note that the countries that initially joined the Monetary Union were Germany,Austria, Belgium, Spain, Finland, France, the Netherlands, Italy, Luxembourg andPortugal. Greece joined later and, successively, followed by Slovenia, Cyprus, Malta,Slovakia and Estonia.2 Article 121 of the 1992 Maastricht Treaty. 268
    • The Future of the Euronued to be applied to accept the application for entry of the suc-cessive candidates. Please note that those criteria were only required at the time of joi-ning. The subsequent restrictions were laid down by the 1997Stability and Growth Pact, aimed at maintaining budgetary stabilitywithin the Union. Thus, the country could not exceed the annuallimit of the deficit and the debt: 3% and 60% of the GDP respectively.Exceeding those limits meant that the European Commission wouldimplement the excessive deficit procedure, which would result in thecountry in question having to face certain penalties. Subsequently, in2005, the rules were reformed so that the deficits tested were not thenominal but rather the structural ones. Therefore, not only thecurrent deficit, but also the sustainability of the long-term public debtwas taken into account in the supervision and monitoring processentrusted to the European Commission.3 In short, and right from theoutset, the nominal similarities that a series of economies with clearreal differences had to offer were what seemed to matter to Europeanleaders. And, proof of that difference could be seen when, in 2002 –Greece had already joined – the typical deviation of labour producti-vity per hour worked, calculated as CWA was 29.46;4 which clearlyshowed the different competitive capacity of the different countries,right from the start. Those differences were a hint of the future sym-3 See “The Stability and Growth Pact: Public Finances in the Euro Zone” of the Sub-Directorate General for Financial and Economic Affairs of the European Union, SCIEconomic Gazette No. 2906, 16-28 October 2007.4 Prepared using the Eurostat data for the twelve member countries. 269
    • The European Monetary Union: the Never-Ending Crisis metric upheavals to come in the zone, and that group of countries, for different reasons, did not constitute – or constitutes – an optimum monetary zone. And thus, the European Monetary Union was built on quicksand, quicksand that would begin to overwhelm it as soon as the fiscal irresponsibility of some of the governments made a sig- nificant dent in the building overall. 3. The Fiscal Spillover Can governments of countries with weak currencies issue debt in their currency and ensure that attracts foreign investors? The like- lihood is minimum as the potential investor will think that, at some point, the currency will depreciate substantially, leading to a loss. Can countries with a strong currency do so? They can because the investors will not fear the losses following on from devalua- tion. And proof of this is that institutional or private investors, resi- dent in a wide variety of countries, have traditionally kept debts in dollars, marks, Swiss francs or yens in their portfolios. The euro sought to be a strong currency right from the outset. This strength was based on the monetary policy of the European Central Bank, whose primary objective would be to keep prices sta- ble.5 And which, furthermore, represented a series of important5 Art. 2 of the Statues of the European System of Central Banks and the EuropeanCentral Banks. 270
    • The Future of the Euroeconomies, with Germany at the head. Moreover, the exchangerate risk disappeared for member countries and it therefore facilita-ted the setting up of a large financial market in euro. The appearance of the euro, therefore, meant the disappearanceof the original sin experienced by countries with weak currencies:the difficultly of leverage in other currencies, which meant thatthey were at huge risk of financial fragility.6 The way was thereforeleft clear for governments of euro countries that had found it diffi-cult to finance themselves in other currencies prior to joining thesingle currency, to easily raise leverage in the powerful financialmarket of the euro. The only thing missing was the imperative needto do so. And that imperative need arrived with the economic crisis,which began in 2007, and with the general downturn in the ratesof growth, a fall that is reflected in the following table. It should be noted that even through the downturn in growthwas widespread, the countries with the sharpest recession wereIreland, Italy, Portugal and Spain within the initial group of twelvecountries. When the growth rate shrank, which was greatest in those caseswith the sharpest change in cycle, the budgetary revenue fell and6 See Eichengreen, B. & Haussmann, R. “Exchange Rates and Financial Fragility”, NBERWP 7418, 1999. 271
    • The European Monetary Union: the Never-Ending Crisis Table No. 1. Average Growth of the Eurozone (17 countries) Average Average Country 2004-2006 2 0 0 7 -2 0 1 1 Germany 1.87 1.20 Austria 2.90 1.30 Belgium 2.57 1.12 Cyprus 4.07 1.68 Slovenia 4.73 0.74 Slovakia 6.70 3.80 Spain 3.67 0.26 Estonia 8.43 -0.14 Finland 3.70 0.80 France 2.20 0.52 Greece 4.07 -1.90 The Netherlands 2.53 1.14 Ireland 5.03 -0.82 Italy 1.27 0.52 Luxembourg 4.93 1.28 Malta 2.33 2.20 Portugal 1.27 -0.20 Source: Own preparation, using Eurostat data (Europe in figures, 2012)the deficits appeared or increased and grew even further if the bud-gets included automatic stabilisers, by virtue of which the fiscalpolicy became expansive in periods of recession, and even moreexpansive if the governments relied on additional fiscal stimulus toovercome the economic crisis. All of these are reasons have been given to explain the rapidincrease in the public sector debt, as can be seen in Table No. 2. Given that panorama of slow growth, or decline, and of growingpublic debts, it comes of no surprise that debt holders would soonhave greater misgivings – misgivings that particularly affected those272
    • The Future of the Euro Table No. 2. Evolution of the public debt of the eurozone (% GDP) Country 2007 2011 Growth Germany 65.2 81.8 25% Austria 60.2 72.2 20% Belgium 84.1 97.2 16% Cyprus 58.8 64.9 10% Slovenia 23.1 45.5 97% Slovakia 29.6 44.5 50% Spain 36.2 69.6 92% Estonia 3.7 5.8 57% Finland 35.2 49.1 38% France 64.2 85.4 33% Greece 107.4 162.8 52% The Netherlands 45.3 64.3 42% Ireland 24.9 108.1 334% Italy 103.1 120.5 17% Luxembourg 6.7 19.5 191% Malta 62.4 69.6 12% Portugal 68.3 101.6 49% Eurozone 66.3 88 33% Source: Own preparation, with data from the Statistical Annex of European Economy, autumn 2011. The data refer to the gross debt as they are the liabilities that the govern- ment must face.countries where the recession was combined with spiralling debt andthe few prospects for recovery. It was, therefore, foreseeable that anyevent that affected the debt of a country would lead to a chain reac-tion that would challenge the financial stability of the Eurozone. That event was Greece going into virtual receivership on 23 April2010: on that date the Greek government asked the InternationalMonetary Fund and the European Union for a 45,000 million euroloan to meet their financial obligations, four months after Fitch, therating agency, had downgraded its debt. 273
    • The European Monetary Union: the Never-Ending Crisis4. The Consequences of the Doubtful Debt From then onwards, there were constant indications of concernin different channels about the sovereign debts with a questionmark over them. First of all, the increase of the risk premiums ofcertain securities; secondly, the increase in the cost of the creditinsurance for the same securities; third, the greater occasional costof the new issues by the countries under suspicion, the so-calledperipheral countries: Greece, Portugal, Ireland, Italy and Spain. The three aforementioned reactions clearly moved in the samedirection. As is known, hikes in risk premiums on the secondary mar-kets consist of discounts on the value of the securities, discounts thatare equivalent to an increase in the relevant interests and which arecompared to the interests of the benchmark debt, the German one,for the same market. In its simplest version, credit insurance (CreditDefault Swaps) are contracts by virtue of which, and by means ofpaying a premium, the bondholder is guaranteed the collection ofthe nominal amount. And in increase of the risk premiums and theprice of the swaps affect, by definition, the cost of the new issues: themore expensive the premiums and swaps become, the higher theinterest that the new issues should offer and the greater the cost forthe relevant governments. All of which tends to worsen the financialsituation of the governments, a situation that will enter a downwardspiral if the average interest rate of the outstanding debt is greaterthan the growth rate of its economy.274
    • The Future of the Euro5. Contributing Factors Current financial markets are markets of news and rumourmills.7 The first report on how the turbulence develop and reflect veri-fiable facts: the initial request for help by the Greek government;the successive austerity measures demanded by the European aut-horities and the International Monetary Fund for the bailout to begranted; the social response to the austerity plans in differentcountries or the downgrading of the sovereign debts of differentcountries of the Eurozone, including France. All of the events showthe constant severity of an ongoing crisis. The second are, in general, interpretations, opinions that areusually transmitted through the different media, whether they arejournals, the daily press, television and radio programmes or newsspread online. Some are reasonably based opinions that are tryingto consider the difficult situation of the Monetary Union and tooffer some type of solution.8 Others are purely and simply seekingto be alarmist, to the point of suggesting to their readers that they7 An extensive study into the subject of rumours is by Mark Schindler: “Rumors inFinancial Markets”, Wiley&Sons, UK, 2007.8 Examples of opinions of this type are “Beware of fallen masonry”, The Economist,26/11/2011, and those expressed by K. Rogoff in the interview published by Spiegel on27/2/2012, entitled “Germany Has Been the Winner in the Globalization Process”. 275
    • The European Monetary Union: the Never-Ending Crisis should stock up on food to survive the chaos that will reign, on the world scale, when the euro implodes and triggers a financial tsu- nami that will spread over the five continents.9 Furthermore, there are the constant threats of downgrading the sovereign debt by the three major US agencies – Standard & Poors, Moody’s and Fitch –, the three who were so optimistic when it came to US mortgage junk bonds,10 and the doubts expressed, from time to time, by the International Monetary Fund regarding the future of the euro zone. There is also the risk that the whole set of views, from the most founded to the most alarmist, will awaken many fears and the prophecy will become self-fulfilling: the disaster will occur because the avalanche of negative opinions will set it in motion. 6. Main Measures Adopted to solve the Monetary Union Crisis At the time of writing (April 2012), these measures have invol- ved setting up general bailout funds, the approval of a Greek Loan9 Read “Will Greek Sovereign Debt Default on March 23” by Patrik Heller, Coinweck,22/2/2012 (online).10 In the opinion of John Kiff, from the International Monetary Fund, the opinion ofthe agencies increases the uncertainties on the sovereign debt markets, due to theimportance that the participants on those markets seem to attribute to them. See hisarticle “Reducing Role of Credit Ratings Would Aid Markets” IMF Survey Magazine,29/9/2010. Also Arezki et al: “Sovereign Rating News and Financial MarketsSpillovers”, IMF, WP/11/68. 276
    • The Future of the EuroFacility, the interventions of the European Central Bank and thefine tuning of a new Treaty on Stability, Coordination andGovernance of the Monetary and Economic Union. In 2010, the European Financial Stability Fund was set up,whose aim is to facilitate resources to euro countries in financialdifficulties. It is a company whose headquarters are in Luxembourgand its loan capacity is to the tune of 440,000 million euros.11 Togrant a loan to a Euro country, the government of the country hasto request it and sign an austerity programme. Part of the loans toIreland and Portugal were arranged through that Fund. In 2011, the European Financial Stabilisation Mechanism wascreated for a similar purpose. It is an institution, supervised by theEuropean Commission, which obtains its resources from the capi-tal markets by means of issuing bonds underwritten by theEuropean Union budget. It may provide aid to members of theEuropean Union, whether or not they are members of theEurozone, is compatible with aid provided by other channels andalso requires the prior approval of an austerity package. Loanshave also been granted through this programme to Ireland andPortugal. The two aforementioned funds would duly be subsumed in theEuropean Stability Mechanism), agreed by the Eurozone countries11 All the data referring to the bailout fund and to the Greek Loan Facility are takenfrom European Commission official documents. 277
    • The European Monetary Union: the Never-Ending Crisisin February 2012 and which should begin to function in July ofthat year. Its aid will not be limited to granting loans, but it willlikewise be able to acquire bonds issued by the member countries,either on the primary or on the secondary markets, and facilitateresources aimed at recapitalising financial institutions. In princi-ple, it would have 80,000 million euros of capital and an initial cre-dit capacity of 500,000 million euros. In May 2010, the membersof the Eurozone bilaterally decided to lend Greece 80,000 millioneuros that, in addition to the 30,000 million from theInternational Monetary Fund, meant that the first Greek bailouttotalled 110,000 million euros. At the end of 2011, and 73,000million euros had been paid out from that fund, a payment thatrequired an austerity undertaking. On 14 March 2012, a new bai-lout programme was approved, with substantial write offs for thecreditors and austerity obligations for the Greek Government, tothe tune of 130,000 million euros, an amount which includes theInternational Monetary Fund contribution of 28,000 millioneuros. The purpose of that financial support, which will last until2014, is to bring the Greek public deficit under the 117% of itsGross Domestic Product by 2020. Part of that bailout will be chan-nelled through the European Financial Stability Fund. A crisis intervention of particular importance is by theEuropean Central Bank, an intervention channelled in two lines.In a non-recurrent way, the Bank acquires debt on the secondarymarket, which reduces the risk premium and means that the issuesof new securities are at a lower cost. On the other hand, it lends278
    • The Future of the Euroresources at a very low interest rate to financial brokers – its basicrate has remained at 1% for some time – which means that thebanks of the worst hit countries acquire part of the new issues.They, therefore, facilitate the placement of securities, securities thatare profitable for the financial institutions and less costly for theissuers. On 2 March 2012 and after many debates in the EuropeanCouncil, the representatives of twenty-five countries of theEuropean Union – as neither the United Kingdom nor in theCzech Republic wanted to sign up – signed the Treaty on Stability,Coordination and Governance in the Economic and MonetaryUnion. Even though the new Treaty was signed by members of theEuropean Union that are not part of the Monetary Union, its fun-damental proposal is to force the euro countries to ensure thattheir public finances are balanced. Further proof of that purpose isthat the Treaty will come into force when it has been ratified by atleast twelve euro countries. A key aspect of the agreement is the so-called BudgetaryAgreement that forces those countries to tighten their budgetarydiscipline and which introduces the balanced budget rule, a rulethat must be included in national legislation and, preferentially, inthe Constitution. The structural deficit must not exceed a specificlimit and cycle deficits are accepted, resulting from substantialdownturns in the economic activity, provided that they do notalter the balanced budget rule in the medium term. And, in the 279
    • The European Monetary Union: the Never-Ending Crisis case that the deficit exceeds the permitted limit, a series of auto- matic penalties are envisaged.12 7. Outcome of the Measures Adopted so far Judging by the data that appeared in early April 2012, recovery from the downturn has not yet started, in particular, as far as the peripheral countries are concerned: volatility remains high both on the sovereign debt markets and on the variable income ones – in the case of the latter, the downward trend is reflected by the drop in share prices of the most exposed banks to the sovereign debt of those countries – and the doubts persist regarding the capa- city of several of them to meet their obligations. Which is not at all strange for several reasons. The required restructuring to bring the debt back to more bea- rable levels would hinder, in the short term, the growth capacity of the five countries, as economic recovery would be further compli- cated by the shrink in their tax revenue. And all of this would occur in a climate of recession and economic stagnation that appe- ars to have taken hold of the European Union, over all, and the Monetary Union, in particular.1312 The full text of the Treaty can be seen at the European Council website.13 The forecasts can be seen at the European Economic Forecast, Autumn 2011 (online). 280
    • The Future of the Euro The situation of Greece is at the forefront of all the economicanalysis of the euro zone as very few believe so far that the recentlyapproved second bailout will result in the country solving pro-blems and many believe that a third bailout will soon be on thecards. And those doubts regarding the future of the Greek economyare spreading to the rest of the peripheral countries and, to a greatextent, to the very future of the Monetary Union. Despite the measures approved so far, the decision processes havedragged on as an agreement needs to be reached by country repre-sentatives, who are very aware of the opinion of their citizens, andby representatives of community institutions. Long processes, wheremultiple opinions, sometimes discrepancies, are mixed, that increa-se the uncertainties regarding the future of the euro, even thoughthe disappearance of the single currency could raise much morewide-ranging problems than the current ones trying to be solved.8. Consequences of the Breakup of the Euro The breakup of the Monetary Union could occur should one ormore member states decided to leave the single currency and rein-troduce their own currency. That split could either be due to thedeparture of one or more weak-economies or to one or morestrong-economies breaking. In either of the two cases, the Unionwould be broken. 281
    • The European Monetary Union: the Never-Ending Crisis From the legal perspective, such a possibility does not currently exist as the Maastricht Treaty does not include any clause that opens up the way; only the 200714 Lisbon Treaty accepts the voluntary withdrawal of a member state from the European Union, but says nothing about the Monetary Union. This may be because the architects of the common currency always thought that, given that the single currency was an extremely important step in the political and economic construction of Europe, the decision of each country should be irrevocable. Yet, leaving the legal aspect on one side, despite its importance, the collapse of the Eurozone would lead to a series of disastrous con- sequences for the country or countries that had left the euro, for the Eurozone overall and for the world economy. Let us first consider the departure of a weak economy. The mere presumption by its citizens of leaving would result in a large-scale transference of deposits from its banks towards other banks located outside the country, given that nobody would want to see their euro assets converted into balances in the devalued currency; the Government in question would be forced to impose, as a preventive measure and prior to the decision to abandon the euro, a limit on withdrawing deposits and a strict exchange rate control. As it is to be supposed that part of the private debt of the country would be held by foreign institutions, individuals and companies would find them- selves in the worrying situation of having to face such debts with a14 Art. 50 of the Treaty regarding the voluntary withdrawal for a member country. 282
    • The Future of the Euronational currency of a lower value. With respect to the sovereigndebt, the problem would be the same: the Government would becompelled to honour it at a higher cost. And the internal economicadjustments would be of such a magnitude that the main purposesought by returning to the national currency – regaining the exchan-ge rate policy and, thus, making the exportable goods more compe-titive – would take many years to occur. Without even going into thesocial and legal conflicts that would occur, in that country, as a seve-re recession for an unforeseeable length would occur. If the country decided to abandon the euro were a very strongeconomy, would there be more advantages than disadvantages? It isnot easy to answer that question, for two reasons. First of all, becau-se the foreseeable outcome is that its currency would appreciate,which, even though it would mean an initial advantage, would alsoraise problems. For example, and from that moment onwards, itsbanks would have deposits in the new currency, but it is to be sup-posed that part of its assets would be for operations with residentsin the euro zone and, therefore, the financial brokers would have toface losses through that channel, and would moreover have to faceits fiscal obligations in the new currency. Second, and this is themore important aspect, the appreciation of its currency would affectits competitiveness in the remaining euro countries – the main mar-ket of all the countries of the Monetary Union – which, undoub-tedly, would hit its growth capacity for many years to come.1515 On these aspects, see “Euro break-up: the consequences” of UBS InvestmentResearch, 6/9/2011 (online). Also the opinions of Eric Dior: “Leaving the euro zone: a 283
    • The European Monetary Union: the Never-Ending Crisis The departure from the Eurozone of any country, or several countries, would break up the Monetary Union in both political and economic terms. In economic terms, because the growing dis- trust of all its citizens would lead to substantial capital flights and, probably, to the collapse of different financial systems, which would cloud the very limited economic perspectives of the zone and would lead to a long recession. In political terms as its inter- national clout would be considerably reduced, based on a situa- tion, the current one, which is not particularly brilliant: its lack of political unity and its indecisiveness, which characterises it as a soft power area clearly reduce the international presence of a zone that, we should not forget, is, taken overall, the second economy and the second market of the world.16 Its breakup and the ensuing recession would cloud the international presence of that group of countries to unimaginable limits. And without taking into account the likely decline of the European Union. It is interesting to observe the distancing that many non- European analysts show when considering the spasms of the Monetary Union. Which is the equivalent, in many cases, to con- sidering them as a local problem: the Eurozone is having to bear great tensions, arising from the sovereign debt crisis, and there is a question mark over its survival. And they go no further. They forget that, in a world of fully integrated financial markets, theuser’s guide”. IESEG School of Management (Lille Catholic University), October 2011(online).16 With World Bank and World Trade Organisation data for 2010. 284
    • The Future of the EuroEurozone crisis would have a global impact. For two reasons. Firstof all, because a good part of the sovereign debt is in bank port-folios; secondly, because the credit insurances (CDS) are, pos-sibly, held by financial institutions around the world. In December 2011, 513,000 million euros of public debt of thefive peripheral countries (Greece, Ireland, Italy, Portugal and Spain)appeared in the portfolios of European banks.17 If we take intoaccount that the financial institutions around the world are linkedby a series of international transactions, it is not difficult to con-clude that the breakup of the euro would have global repercussions. In the March 2011, the CDS linked to European sovereign debtstood at 145,000 million dollars.18 Neither of these two figures arehigh but they are sufficiently important for the upheavals of the eurozone, following on from the breakup of the currency, to be transferredto other regions of the world with substantial multiplying effects. It therefore can be supposed that the Monetary Union willmanage to overcome this crisis. Yet, from our point of view, thecurrent firewalls – the bailout funds, however they are called – andthe budgetary obligations, included in the Treaty on Stability,Coordination and Governance, will not be enough to overcome17 Jenkins, P. y Stabe, M: “EU banks slash sovereign holdings”. With European BankAssociation data (online).18 ISDA: “The Impact of Derivative Collateral Policies of European Sovereigns andResulting Basel III Capital Issues”, 19/12/2011 (online). 285
    • The European Monetary Union: the Never-Ending Crisisthe current problems and ensure that the Monetary Union is thethreshold to what, when all said and done, has been what theywanted to achieve through the single currency: a certain degree ofPolitical Union. An additional link is therefore now needed.9. The Missing Link The endeavours aimed at solving the crisis have so far been alongtwo paths: creating financial instruments to avoid the bankruptcy ofsome governments – the most worrying case is Greece – and strengthe-ning the obligation of member countries to reach and maintain a rea-sonable budgetary balance. Important steps, but which have not mana-ged to eliminate the continuous tension that has been observed in thefinancial markets, tension that the interventions of the EuropeanCentral Bank have only managed to soften. Soften, not eliminate. Note that all the actions undertaken so far – bailout and rules –do not imply any joint liability. It involves combining financial aidand remembering that fiscal policy in a single currency arena mustbe very similar and very prudent in all member countries. The lia-bility therefore falls on the Government of each country. Yet these measures will not be sufficient if the aim is to shore upthe badly constructed building of the Eurozone. It would be neces-sary to show that the members of the Monetary Union are capableof jointly and severally assuming liability of the problems of all its286
    • The Future of the Euromembers. And what is necessary, to affirm that joint liability, is toissue the so-called Eurobonds or Stability Bonds; in other words,bonds jointly issued that will replace, totally or partly, the currentsovereign debt. That measure, that would be a highly importantstep forward in the construction of the common building that isbased on the single currency, would result in three far-reachingconsequences: the sovereign debt crisis of some countries wouldbe rapidly alleviated; the cost of future issues would be reduce as aconsequence of the overall solvency; and the financial system ofthe Eurozone would be more resistant to any future upheaval, andthe overall financial stability would therefore be strengthened.This decision necessarily implies the setting up of a common trea-sury and likewise the application of a fiscal policy. Clearly, that decision would entail many economic difficultiesand highly complex political problems, as the citizens of the mostprosperous and stable countries of the Union will be not verywilling to accept that type of shared liability which they would seeas the financial problems of others being placed on their shoul-ders. Yet we should not forget that that possibility has already beenraised by the European Commission itself, precisely to attain thoseobjectives.19 And we should not forget, above all, that, as I haveattempted to explain in this paper, the end of the Monetary Unionis not a zero-sum game, where there are winners and losers; it is anegative sum game, where everyone loses.19 See European Commission: “Green Paper on the feasibility of introducing StabilityBonds”, 23/11/2011.COM (2011) 818 final (online). 287
    • The European Monetary Union: the Never-Ending Crisis288
    • A. JESÚS SÁNCHEZ FUENTES * /SEBASTIAN HAUPTMEIER ** / /LUDGER SCHUKNECHT *** / Public expenditure policies during the EMU period: Lessons for the future?11. Introduction; 2. Long-term public expenditure in industrialised coun-tries; 3. The first decade of EMU period: a missed opportunity?; 3.1. Adisaggregated assessment of past expenditure policies; 3.2. Determinantsof the expenditure stance; 3.3. Implications for public debt; 4. Lookingbackward to the past, lessons for the future? an episodes based approach;5. The need for prudent expenditure rules; 6. Concluding remarks;Bibliography*He currently works as Ph. D Assistant professor at Complutense University of Madrid.Before he worked as external consultant at European Central Bank, as (Ph. D) Assistantprofessor at Pablo de Olavide University (Seville, Spain) and as research assistant atFoundation centrA. He holds a Ph.D in Economics from Pablo de Olavide University(with distinctions) and a Bachelor in Mathematics from University of Seville. His rese-arch areas are mainly public economics and computational economics.** He currently works as an Economist at the German Ministry of Finance. He was alsoan Economist in the Fiscal Policies Division of the European Central Bank and workedas a research assistant at the Centre for European Economic Research (ZEW). He holdsa Ph.D. in Economics from Munich University (LMU). His research focuses on empiri-cal public finance and fiscal policy.***Is heading the Directorate General Fiscal Policy and International Financial andMonetary Policy at the German Ministry of Finance. Previously, he worked at theEuropean Central Bank, the World Trade Organisation and the International MonetaryFund. His recent research mainly focuses on public expenditure policies and reform andthe analysis of economic boom-bust episodes. 289
    • Public expenditure policies during the EMU period: Lessons for the future? 1. Introduction The outlook for public finances in the advanced economies for the second decade of the 21st century is extremely challenging, not least due to the substantial fiscal expansion that took place in the context of the financial and economic crisis. Public deficits in 2010 averaged around 6% of GDP in the euro area and exceeded 10% of GDP in the US and the UK (Chart 1, panels a, and b). At the same time, public debt in advanced economies has increased signifi- cantly between 2007 and 2010: by some 20pp of GDP to around 86% in the euro area and so far by 30pp or more in the UK (to 80%) and in the US (to over 90% of GDP). When including Japan, public debt in the G7 countries already averaged over 100% of GDP in 2010. A closer look suggests that most of the deficit increase since the start of the crisis in 2007 was due to an increase in public expendi- ture ratios which have reached or approached historical highs. By contrast, revenue ratio declines have been rather limited (panels c and d). It is, therefore, logical to look at public expenditure when striving to correct fiscal imbalances in industrialised countries. This approach is in fact pursued already by a number of countries with fiscal difficulties. It was also the approach used—successfully—by1 The views expressed are the authors’ and do not necessarily reflect those of the authors’employers. Correspondence to: A. Jesús Sánchez-Fuentes. Universidad Complutense deMadrid. Campus de Somosaguas, 28223, Madrid (Spain). Tel: +34 913942542, Fax: +34913942431. Email: antoniojesus.sanchez@ccee.ucm.es. 290
    • The Future of the Euro Chart 1. Developments in public finances, 1990-2011 a) Fiscal balanceb) Public debtSource: Ameco. 291
    • Public expenditure policies during the EMU period: Lessons for the future? Chart 1. (cont.) Developments in public finances, 1990-2011 c) Total public expenditure d) Total revenue Source: Ameco.292
    • The Future of the Euromany advanced economies in the 1980s to return to sound publicfinances and at the same time reinvigorate the economy. The case of the euro area is of special relevance for a number ofreasons. While the crisis-related deterioration of public finances inthe euro area as a whole has not been as pronounced as for examplein the US or Japan (see Chart 1), heterogeneity at the Member Statelevel is substantial. A number of countries, in particular Greece,Ireland and Portugal, recorded double-digit deficit ratios and expe-rienced significant increases in government debt as a ratio to GDP.Unsustainable fiscal positions coupled with structural economicweaknesses and competitiveness deficiencies, in turn, fuelled markettensions which - due to strong financial interlinkages – underminefinancial stability in the monetary union as a whole. Therefore, atthe time of writing, there is a particular urgency for euro area coun-tries to regain market confidence through a swift return to soundpublic finances. At the same time, euro area membership tends toexacerbate adjustment efforts since the exchange rate mechanism isnot available, preventing an external devaluation. Therefore, fiscalconsolidation and the restoration of external competitiveness needto strongly rely on internal adjustment processes. Against the background, this study assesses expected publicexpenditure developments of selected euro area countries for thecoming years. Based on the experience with expenditure reform inthe 1980s and 1990s, we argue that ambitious and high qualityexpenditure reform as part of comprehensive economic reform pro- 293
    • Public expenditure policies during the EMU period: Lessons for the future? grammes have the best chance of success. Furthermore, the role of a prudent expenditure rule and the relevance of having a suitable institutional framework are discussed. Section 2 reviews public expenditure trends over the past 30 years. Section 3 reports on the main findings of earlier studies on public expenditure policies during the first decade of EMU. Section 4 looks backward to the past to extract important conclusions on the successful strategy exit of current crisis. Section 5 provides an illustration on the preventive role of prudent expenditure rules before section 6 concludes and draws some policy lessons. 2. Long-term public expenditure in industrialised countries With a view to assessing recent developments in a broader his- toric perspective, it is worth briefly taking stock of trends in public expenditure and the size of the state over the past 30 years (Table 1).2 After a strong increase in the size of government in industria- lised countries in the 1960s and 1970s, the average total public expenditure ratio across OECD, G7 or euro area was broadly unchanged in 2007 -just before the financial crisis- from 2000, 1990 and 1980. The average spending ratio for the euro area remained around 45% of GDP and that of OECD and G7 around 40%.2 See also Tanzi and Schuknecht (2000) for more details on historic expenditure deve-lopments. 294
    • The Future of the Euro Table1. Total expenditure developments Maximum Change value 1980 maxi-% of GDP 1990 2000 2007 2010 or nearest mum Year Ratio to 2010Austria 50,0 51,5 52,3 48,6 52,5 1995 56,4 -3,9Belgium 54,9 52,3 49,1 48,3 52,9 1983 62,2 -9,2Finland 40,1 48,1 48,3 47,2 55,1 1993 64,7 -9,6France 46,0 49,6 51,7 52,6 56,6 2010 56,7 -0,1Germany 47,4 44,2 47,6 43,5 48,1 1995 54,8 -6,7Greece 27,0 45,2 47,1 47,6 50,2 2009 53,8 -3,6Ireland 50,1 42,8 31,2 36,6 46,8 1982 54,2 -7,3Italy 40,8 52,9 47,0 47,6 50,3 1993 56,3 -6,0Luxembourg 48,4 37,7 37,6 36,3 42,5 1981 51,7 -9,2Netherlands 55,2 54,9 44,8 45,3 51,2 1983 59,1 -7,9Portugal 32,4 38,5 41,4 44,4 51,3 2010 51,3 0,0Spain 31,1 42,1 39,3 39,2 45,6 1993 47,1 -1,4Euro area (15) 4 5 ,4 4 7 ,9 4 6 ,2 4 6 ,0 51,0 1 9 9 5 5 3 ,1 - 2 ,1Australia 32,5 35,4 35,5 33,4 38,5 1985 38,5 0,0Canada 41,6 48,8 41,1 39,4 44,1 1992 53,3 -9,2Denmark 52,7 55,4 53,7 50,8 58,5 1993 60,2 -1,7Japan 33,0 31,6 39,0 35,9 41,1 1998 42,5 -1,4Sweden 62,9 61,3 55,1 51,0 52,9 1993 71,7 -18,8Switzerland 32,8 30,3 35,1 32,3 34,2 2003 36,4 -2,2United 47,6 41,1 36,8 43,9 50,6 2009 51,5 -0,9KingdomUnited States 34,2 37,2 33,9 36,8 42,5 2010 42,7 -0,2G7 3 8 ,3 3 9 ,8 3 8 ,5 3 9 ,9 45,0 2 0 0 9 4 5 ,5 - 0 ,5OECD 3 9 ,1 4 0 ,2 3 8 ,8 3 9 ,8 44,6 2 0 0 9 4 5 ,2 - 0 ,6 Source: Ameco, OECD. 295
    • Public expenditure policies during the EMU period: Lessons for the future? However, this masks significant differences across countries. The countries that undertook ambitious reforms in the 1980s and 1990s typically had much lower spending ratios in 2007 than in 1980 or at least than at their peak. A few countries, however, inclu- ding many of those that we will refer to in the next sections (US, Italy, Spain, Portugal, Greece, Ireland, UK) had significantly incre- ased the size of government between 1980 and 2007 or least in the 2000-2007 period.3 This occurred notwithstanding an extended economic boom in most of these when expenditure ratios should have gone down. With the start of the financial crisis, public expenditure ratios went up everywhere by on average 5pp of GDP. This brought the total expenditure ratio to about 50% in the euro area and 45% in the OECD/G7 in 2010. For the euro area, the increase still consti- tutes a decline in overall spending since the previous peak in 1995 but this was due to a lower interest bill. On the whole and for many countries, public expenditure ratios are now at or near his- torical peaks. This includes the European crisis countries, Portugal and Greece and the UK and US. These developments show that the challenge of containing the size of the state is more present than ever. And together with deficit and debt figures, the close link between rising public spending, defi-3 See also Hauptmeier et al, 2011 for an assessment of the expenditure stance in euroarea countries since the start of EMU. 296
    • The Future of the Eurocit and debt figures is also obvious. But a number of countries mas-tered the challenge of very large expenditure ratios with ambitiousreform programmes in the 1980s and 1990s. This experience will bere-called in the next sections. These countries were typically not thesame that face such challenges now—except Ireland and the UK.3. The first decade of EMU period: a missed opportunity? In this section, we examine expenditure developments and plansof a number of euro area economies, notably Greece, Ireland andPortugal (programme countries), Germany, France, Italy and Spain(large euro area countries) in comparison to the UK and US. Thecommon feature of most of these countries (except Germany andItaly) for the period up to 2007 was a drawn out economic boomcharacterised by significantly positive output gaps. In principle, thisshould have allowed bringing down public expenditure ratios signi-ficantly, firstly, due to the impact of automatic stabilisers and,secondly, in some cases also due to lower interest spending thanksto the euro. However, this is not what happened. All countries pursued anexpansionary expenditure stance, of the order of 1-5pp of GDPexcept for Germany (Hauptmeier et al, 2011).4 This basically “ate4 One of analysing the expenditure stance of a country is to compare it with the expen-diture levels that should have occurred if a country had followed certain fiscal rules. 297
    • Public expenditure policies during the EMU period: Lessons for the future? up” the interest savings from introducing the euro. As a conse- quence, total public expenditure only went down significantly in Germany and even increased strongly in the three crisis countries and the UK between 1999 and 2007 (Table 2). In the US, total spen- ding grew by around 2pp of GDP between 2001 and 2006 but the ratio remained well below 40% of GDP. Together with the US, Ireland and Spain maintained the lowest spending ratios (below 40% of GDP), France’s public expenditure was the highest, at 52.4% in 2007. The increase in public expenditure becomes even more pronounced when looking at primary spending. For the crisis coun- tries and the UK this went up by 3 to almost 6% of GDP between 1999 and 2007. As a result, most of the sample countries still had significant deficits in 2007 while the debt ratio had hardly declined or even increased between 1999 and 2007 (Schuknecht, 2009). Expansionary expenditure policies during good times left most of the countries “unprepared” when the crisis hit. As a consequen- ce of the output fall and further expansionary programmes, public expenditure ratios increased strongly between 2007 and 2009/2010. Increases ranged from around 4pp of GDP in Italy and Germany, to 6-7½ pp in the UK and US to over 10pp in Ireland. The expenditu- re increase was particularly strong in the countries where a credit- fed real estate and financial sector boom had “artificially” inflatedSuch an exercise was conducted by us last year (Hauptmeier et al, 2011). The studyfound that most euro area countries had pursued expenditure policies that were moreexpansionary than a reasonable expenditure rule would have proposed. 298
    • The Future of the EuroTable 2: Recent total expenditure developments % of G DP 1999 2007 2009 2010 Change Memoradum: deficit 1999-2007 2007-2010 2007 2010Programme countriesGreece 44,8 47,6 53,8 50,2 2,8 2,6 -6,8 -10,8Ireland 33,9 36,6 48,9 46,8 2,7 10,2 0,1 -11,3Portugal 41,0 44,4 49,9 51,3 3,4 7,0 -3,2 -9,8Large euro area countriesGermany 48,2 43,5 48,1 48,1 -4,7 4,5 0,2 -4,1France 52,6 52,6 56,7 56,6 0,0 4,0 -2,8 -7,1Italy 48,1 47,6 51,6 50,3 -0,5 2,6 -1,6 -4,5Spain 39,9 39,2 46,3 45,6 -0,7 6,4 1,9 -9,3Large non-euro area countriesUnited States 34,2 36,8 42,7 42,5 2,7 5,6 -2,8 -10,6United Kingdom 38,9 43,9 51,5 50,6 5,0 6,7 -2,7 -10,3Table 2: Recent expenditure developments for selected countries % of GDP 1999 2007 2009 2010 Change 1999-2007 2007-2010Programme countriesGreece 37,3 42,8 48,7 44,4 5,5 1,6Ireland 31,5 35,6 46,9 43,7 4,1 8,1Portugal 38,1 41,4 47,0 48,3 3,3 7,0Large euro area countriesGermany 45,1 40,7 45,4 45,4 -4,4 4,7France 49,6 49,9 54,3 54,2 0,3 4,3Italy 41,5 42,7 47,1 45,9 1,2 3,2Spain 36,4 37,6 44,5 43,7 1,2 6,1Large non-euro areacountriesUnited States 30,4 34,0 40,2 39,8 3,5 5,9United Kingdom 36,0 41,7 49,6 47,7 5,6 6,0Source: Ameco 299
    • Public expenditure policies during the EMU period: Lessons for the future?Table 2: Recent cyclically adjusted primary expenditure developments % of GDP 1999 2007 2009 2010 Change 1999-2007 2007-2010Programme countriesGreece 37,3 42,9 48,6 44,4 5,5 1,5Ireland 31,7 35,8 46,6 43,5 4,0 7,7Portugal 38,2 41,4 46,9 48,3 3,2 6,9Large euro area countriesGermany 45,1 40,9 45,0 45,2 -4,1 4,3France 49,7 50,1 54,1 54,0 0,4 4,0Italy 41,5 42,7 47,0 45,8 1,2 3,1Spain 36,5 37,7 44,3 43,4 1,2 5,7Large non-euro area countriesUnited States 0,0 0,0 0,0 0,0 0,0 0,0United Kingdom 36,1 41,7 49,5 47,6 5,7 5,9Source: AmecoGDP. When this reversed over the crisis, both higher spending andlower GDP drove up the expenditure ratio. Virtually all of theexpenditure ratio increase was on public consumption and transfersand subsidies; public investment went up only slightly in a fewcountries. Greece, Ireland and Spain also reported higher interestexpenditure as the rapidly rising debt ratio and higher interest ratesstarted to affect public budgets. Where did countries stand in the third year of the crisis, 2010?None of our sample countries still featured a relatively small public300
    • The Future of the Eurosector of below 40% of GDP (as defined by Tanzi and Schuknecht,2000). Even the US, at 41.3% of GDP, featured a public sector thatwas not much smaller than the euro area average before the crisis.Greece, Portugal, France, Italy and the UK reported public spendingratios of around to significantly above 50%. It has been argued that the increase in expenditure ratios is notvery relevant as it presumably reflects almost solely the crisis andshould, thus, reverse itself over time as the economy normalises.This reasoning implicitly assumes that output levels and growthrates will more or less return to pre-crisis levels. As a large output gapwould be closed, public commitments should decline relative toGDP. However, if the pre-crisis GDP was artificially inflated by boo-ming sectors which have to shrink then both GDP level and growthrates may be significantly lower post-crises. If the 2010 output gapwas only small, 2010 deficits and expenditure ratios would in factrepresent structural features of the examined economies. In anycase, significant fiscal adjustment is needed which in some casesexceeds 10 pp of GDP in the coming years (IMF, 2011).3.1. A disaggregated assessment of past expenditure policies To assess in more detail what drove expenditure developmentssince the start of EMU, this section provides an analysis the publicexpenditure stance across the three main expenditure componentsthat governments can influence in the short term: governmentconsumption, transfers and subsidies and public investment. We 301
    • Public expenditure policies during the EMU period: Lessons for the future? apply the same methodology as in Hauptmeier et al (2011): given the existing levels at the start of the EMU (1999), actual public expenditure developments are assessed against an expenditure path that should have been taken if countries had followed a neu- tral expenditure stance, i.e. if governments had aligned expenditu- re growth to that of potential GDP. The latter is measured on the basis of two expenditure rules: (a) nominal potential GDP growth (NPG rule) and (b) real potential GDP growth plus the growth rate of the GDP deflator capped at the ECB’s price stability objective of below but close to 2% (RPECB) based either on real time or ex post data. This counter factual analysis provides four measures of the expenditure stance.5 Deviations are analysed by looking at margi- nal (annual) and/or cumulative (total period) deviations (expressed as percentage of GDP). According to this procedure, on the one hand, marginal deviations help to identify the year(s) in which expansionary/restrictive policies were implemented. On the other hand, cumulative deviations measure the degree of expansio- nary/restrictive policies in percentage points (pp) of GDP accumu- lated over the period (1999-2010). Firstly, to provide a general perspective, we focus on cumulati- ve effects for the aggregate euro area (Chart 2), comparing actual and rule-based expenditure developments (expressed as percentage of GDP).5 The earlier study applied six measures but the two additional ones did not providemuch additional insights. 302
    • The Future of the EuroChart 2: Euro Area (12). Expenditures ratios as implied by a neutral expenditurestance, across rules.Primary expendituresPublic consumption 303
    • Public expenditure policies during the EMU period: Lessons for the future? Chart 2: (cont.) Euro Area (12). Expenditures ratios as implied by a neutral expen- diture stance, across rules. Public investment304
    • The Future of the Euro Looking at the primary expenditures stance - panel a - suggestsa co-movement with the NPG rules which indicates the absence ofa prudence margin to operate when difficulties appear. Looking atthe disaggregated developments, i.e. the main expenditure compo-nents, gives a different picture: First, the results for public con-sumption show an expansionary expenditure stance on this cate-gory adding up to 0.5-2pp of GDP, depending on the respectiveexpenditure rule. Second, for the transfers and subsidies compo-nent, a strong counter-cyclical behaviour is observed, as one wouldexpect. However, the decreases in economic good times were muchless significant than the increases during the crisis. Finally, the pat-tern for public investment is clearly pro-cyclical. At the same time,the adjustments carried out by some countries during 2010 can bealready observed (returning to 2004 levels). To complement this general view, we briefly describe thecountry pattern for the main expenditure components.6 As inHauptmeier et al. (2011), for primary expenditures, we observe arestrictive expenditure stance for Germany whereas all other coun-tries show an expansionary policy stance over the 1999-2010periods, notably as regards public consumption as well as transfersand subsidies. However, the degree of expansion is different amongcomponents. On the one hand, in the case of public consumption,the magnitude of cumulative expansion ranged from near zero for6 For the sake of brevity, related country-specific results are not included in the maintext. They are available from the authors upon request. 305
    • Public expenditure policies during the EMU period: Lessons for the future?France to up to 5pp of GDP for Ireland. On the other hand, fortransfers and subsidies, Germany is highly restrictive by 2-3 pp,and the rest is expansionary by 1-7pp depending on the rule andcountry. Finally, for public investment, the development of the cumula-tive expenditure stance is quite interesting: restrictive for Germanyand Portugal, neutral for Italy and expansionary for all other coun-tries with a tendency of neutralisation in 2010. However, overallmagnitudes are small. In a second step, we repeat this same exercise component bycomponent, in order to decompose the cumulative deviationobserved. This analysis provides a view of the respective stance ofeach expenditure component. The list of indicators included is inline with those presented so far; i.e. (i) public consumption, (ii)transfers and subsidies, (iii) public investment, and (iv) otherexpenditures. Moreover, we split our sample period into sub-periods to show the role of (i)-(iv) before (1999-2007) and duringthe crisis (2008 – 2009, 2009-2010). First, looking at the expenditures stance, Chart 3 presents thedecomposition of cumulative effects observed for ex-post and real-time rules. When compared real-time and ex-post rules behaviourboth similarities and differences are found. While on the one handthe dynamics are very similar, quantitative differences emergeespecially during sub-period (II), i.e. 2007-2009.306
    • The Future of the Euro Chart 3: Decomposition of cumulative changes to public primary spending ratios compared to a neutral expenditure stance for selected periods (I) Real-time NPG rule. 1999-2007%GDP (II) Ex-post NPG rule. 1999-2007%GDP 307
    • Public expenditure policies during the EMU period: Lessons for the future? Chart 3. (cont.) Decomposition of cumulative changes to public primary spending ratios compared to a neutral expenditure stance for selected periods (I) Real-time NPG rule. 2007-2009 %GDP (II) Ex-post NPG rule. 2007-2009%GDP308
    • The Future of the Euro Chart 3. (cont.) Decomposition of cumulative changes to public primary spending ratios compared to a neutral expenditure stance for selected periods (I) Real-time NPG rule. 2009-2010%GDP (II) Ex-post NPG rule. 2009-2010%GDP 309
    • Public expenditure policies during the EMU period: Lessons for the future? An alternative way to look at these figures is going through thedifferent sub-periods. First, deviations in the pre-crisis period areclearly dominated by public consumption. Moreover, if we leaveout Germany as the only restrictive country over this period, twodifferent country patterns can be observed: major deviations fromtrend as regards public consumption in Italy, Spain and Irelandwhile Greece and Portugal show strongly expansionary trends intransfers and subsidies. Second, deviations from trend in transfersbecome relatively more important with the start of the financialand economic crisis.3.2. Determinants of the expenditure stance An empirical analysis of factors that influence countries’ expen-diture stances can provide further information on the determinantsof expansionary expenditure policies in the past. Hauptmeier et al.(2011) therefore applied standard fixed-effects panel estimationtechniques on a sample of 12 euro area countries for the 2000-2009period using the measure for the expenditure stance describedabove, i.e. the (marginal) deviations of actual spending growth fromrule-based or neutral spending (under the NPG and the RPECB rulein ex-post terms), as the dependent variable. The aim of this empirical exercise was to explain the govern-ments’ expenditure stance on the basis of fiscal and macroecono-mic factors, relevant institutional characteristics as well as political310
    • The Future of the Euroeconomy variables. The results of the analysis are presented inTable 3. As one would expect, the macroeconomic environment measu-red by the output gap (in % of potential GDP) constitutes animportant determinant of the expenditure stance. We find robustsupport for a positive correlation between the output gap and theexpenditure stance across rules and estimations, suggesting a pro-cyclical spending behaviour. As regards fiscal factors, surprisingly the level of public indeb-tedness does not seem to significantly affect our measure of theexpenditure stance. We also do not find robust evidence for aneffect of revenue windfalls that arguably could increase spendingprofligacy. We capture such windfalls by including the excess reve-nue growth in a given year relative to previous year’s Autumn fore-cast by the European Commission. However, while we see theexpected positive sign the effect is not significant. We find empirical support for the importance of political eco-nomy factors. In particular, parliamentary elections at the nationallevel (Electoral cycle 1) tend to significantly increase the deviationof actual from rule-based primary spending. The opposite holds truefor a second election-related variable (Electoral cycle 2) which cap-tures the years left in the current election term. The negative sign onthis variable suggests that the incentives for fiscal discipline can beexpected to be higher at the beginning of the legislative period. We 311
    • Public expenditure policies during the EMU period: Lessons for the future?Table 3: Determinants of expenditure stanceDependent variable: Deviation of primary spending growth from rule-based growth ratePanel A: Ex-post Nominal Potential GDP (NPG) rule (I) (II) (III) (IV) (V ) (VI) (VII)Output gap (based on Potential GDP) 0,525 0,476 0,401 0,463 0,274 0,374 0,476 [3.78]*** [3.01]** [2.50]** [3.04]** [1.65] [2.22]* [3.00]**Public debt ratio (t-1) 0,054 0,056 0,035 0,071 0,042 0,033 0,057 [0.96] [1.04] [0.62] [1.20] [0.83] [0.67] [1.03]Crisis dummy 3,946 3,649 4,028 3,138 2,241 2,34 3,341 [2.17]* [1.74] [1.64] [1.75] [1.08] [1.13] [1.22]Strenght of expenditure framework *Output Gap -0,262 -0,262 [2.09]* [2.08]*Surprises in Revenues growth 0,09 [0.46]Strenght of expenditure framework *Surprises in revenues growth -0,08 [0.86]Electoral cycle 1 2,204 [3.64]***Electoral cycle 2 -0,812 [3.66]***Government Stability -2,699 [3.26]***EDP 0,308 [0.16]Constant -2,941 -2,998 -1,47 -4,148 -0,006 -0,512 -3,079 [0.72] [0.77] [0.39] [0.97] [0.00] [0.13] [0.78]Observations 108 108 108 108 90 90 108Number of countries 12 12 12 12 10 10 12R-squared 0,1 0,11 0,11 0,14 0,13 0,11 0,11corr u_i and Xb -0,76 -0,76 -0,57 -0,79 -0,52 -0,47 -0,77adjusted R-squared 0 0,01 -0,01 0,05 0,01 -0,02 0R-squared overall model 0,02 0,02 0,05 0,03 0,07 0,06 0,02R-squared within model 0,1 0,11 0,11 0,14 0,13 0,11 0,11R-squared between model 0,56 0,53 0,58 0,57 0,49 0,38 0,53standard deviation of epsilon_it 4,52 4,51 4,54 4,42 4,15 4,2 4,53panel-level standard deviation 2 2,13 1,43 2,55 1,24 1,05 2,17fraction of variance due to u_i 0,16 0,18 0,09 0,25 0,08 0,06 0,19312
    • The Future of the EuroTable 3. (cont)Panel B: Ex-Post Real Potential GDP +ECB price stability objective (RPECB) rule (I) (II) (III) (IV) (V) (VI) (VII)Output gap (based on Potential GDP) 0,469 0,429 0,299 0,419 0,277 0,377 0,429 [3.92]*** [2.74]** [2.39]** [3.20]*** [1.94]* [2.58]** [2.72]**Public debt ratio (t-1) 0,057 0,059 0,031 0,071 0,053 0,044 0,058 [1.19] [1.33] [0.64] [1.40] [1.18] [0.98] [1.33]Crisis dummy 2,882 2,634 3,267 2,223 1,685 1,793 2,654 [1.56] [1.26] [1.26] [1.22] [0.74] [0.78] [0.90]Strenght of expenditure framework *Output Gap -0,219 -0,219 [1.75] [1.74]Surprises in Revenues growth 0,172 [0.91]Strenght of expenditure framework *Surprises in revenues growth -0,044 [0.59]Electoral cycle 1 1,798 [3.40]***Electoral cycle 2 -0,798 [4.17]***Government Stability -2,544 [3.48]***EDP -0,02 [0.01]Constant -2,808 -2,855 -0,747 -3,792 -0,392 -0,879 -2,85 [0.75] [0.82] [0.22] [0.97] [0.10] [0.23] [0.83]Observations 108 108 108 108 90 90 108Number of countries 12 12 12 12 10 10 12R-squared 0,08 0,09 0,09 0,11 0,14 0,11 0,09corr u_i and Xb -0,82 -0,82 -0,55 -0,83 -0,61 -0,58 -0,82adjusted R-squared -0,02 -0,02 -0,02 0,01 0,01 -0,01 -0,03R-squared overall model 0,01 0,01 0,04 0,01 0,07 0,06 0,01R-squared within model 0,08 0,09 0,09 0,11 0,14 0,11 0,09R-squared between model 0,61 0,61 0,58 0,62 0,4 0,37 0,61standard deviation of epsilon_it 4,34 4,34 4,35 4,28 4,09 4,15 4,36panel-level standard deviation 2,04 2,16 1,24 2,49 1,36 1,18 2,16fraction of variance due to u_i 0,18 0,2 0,07 0,25 0,1 0,07 0,2Notes: Baseline (I), Baseline + Institutional framework (II and III), Baseline + electoralcycle and government stability , (IV - VI) and Baseline + European Institutions(VII).Source: Hauptmeier, S., Sánchez-Fuentes, A.J. & Schuknecht, L. (2011) 313
    • Public expenditure policies during the EMU period: Lessons for the future? also control for government stability as measured by the respective index of the World Bank and find that the policy stance on the spen- ding side is less expansionary if a government scores a higher value. Most interestingly from a policy perspective, our results suggest that the country-specific institutional framework exerts a significant effect on the expenditure stance. In particular, we control for the extent to which national expenditure policy faces domestic institu- tional constraints using the expenditure rules index as developed by Debrun et al. (2008).7 We interact this index with the output gap to analyse to what extent strong institutions reduce spending profli- gacy and find that, indeed, the strength of the national institutional framework on the expenditure side significantly reduces the pro- cyclicality of the expenditure stance. This finding is along the lines of Holm-Hadulla et al (2010), Turini (2008) and Wierts (2008). At the same time, the EDP dummy which is included to capture whether a country is facing an excessive deficit procedure (EDP) due to deficits above the 3% of GDP reference value of the Stability and Growth Pact, does not turn up significantly in our regressions. The results on the impact of fiscal institutions may be put into the perspective of the recent efforts to strengthen the European fis- cal framework. One of the lessons from past fiscal developments in7 For a definition and a detailed description of the computation of this index seeEuropean Commission (2006) and Debrun et al. (2008). The index takes into accountthe share of public spending covered by the rule and qualitative features such as thetype of enforcement mechanisms and media visibility. 314
    • The Future of the Euroeuro area countries is that the implementation of the Stability andGrowth Pact has not been effective in delivering sound and sustai-nable fiscal positions in Member States. While one has to be care-ful when interpreting the non-significance of the effect of the EDPprocedure dummy, the result is in line with this perception.Moreover, the empirical analysis suggests that national budgetaryrules if well-designed can help to effectively reduce spending pro-fligacy and therefore serve as important tools to promote soundand sustainable public finances in line with the European fiscal fra-mework. This reinforces the need for enhancing national fiscalrules and frameworks as had been proposed by the EuropeanCommission in the autumn of 2010.3.3. Implications for public debt Based on the analysis presented in Section 3.1, it is possible tocompute to what extent deviations of expenditure growth fromtrend led to increases in government debt. Chart 4 shows alterna-tive debt paths for the sample economies and across expenditurerules. Consistent with the previous results, real time rules typicallylead to higher debt paths than ex-post rules. In the case of France,for example, following a neutral expenditure path since 2000would have resulted in a significantly lower debt ratio in 2010, i.e.between 70% and 75% of GDP. If Italy had followed a neutral spen-ding path, public debt would now stand roughly between 80% and100% of GDP in 2010, rather than at around 120% of GDP. 315
    • Public expenditure policies during the EMU period: Lessons for the future? For a second group of countries (Spain, Greece, Ireland andPortugal), the difference becomes even more drastic. Neutral spen-ding policies in Portugal would have led to debt ratios of 40-60% ofGDP in 2010 rather than over 80% of GDP in reality. Spanish debtwould have been at a trough of 10-40% in 2007-08 and would haveremained well below the reference value in 2009 under all rules.Ireland would have just about eliminated all its debt in good timesand thus created significant room for the subsequent rise. Under allrules, debt would have remained below 60% of GDP in 2010.Finally, Greek public debt would have fallen to 60-80% of GDP (rat-her than remain broadly constant around 100% of GDP until thestart of the crisis) and increased much more slowly in the crisis. All in all, public debt positions in the euro area would havebeen much sounder at the start of the crisis and in 2010, if euroarea countries had pursued at least a neutral expenditure stance onaverage during EMU. Public debt could have been well around orbelow the reference value in the euro area in most of its membersby 2010 and nowhere above 100% of GDP.4. Looking backward to the past, lessons for the future? anepisodes based approach In an earlier study, Hauptmeier, Heipertz and Schuknecht(2007) looked at the experience with public expenditure reform inthe 1980s and 1990s. They found that there were basically two316
    • The Future of the EuroChart 4: Public debt ratios - actual vs. rule-basedEuro area (12)Germany 317
    • Public expenditure policies during the EMU period: Lessons for the future? Chart 4: (cont.) Public debt ratios - actual vs. rule-based France Italy318
    • The Future of the EuroChart 4. (cont.) Public debt ratios - actual vs. rule-basedSpainGreece 319
    • Public expenditure policies during the EMU period: Lessons for the future? Chart 4: (cont.) Public debt ratios - actual vs. rule-based Ireland Portugal320
    • The Future of the Euroreform waves in industrialised countries. Moreover, they foundthat there were three groups of countries: (i) ambitious, (ii) timidand (iii) non-reformers. Ambitious reformers were those thatmanaged to reduce public primary (non interest) expenditure bymore than 5pp of GDP from their peak within 7 years. Timid refor-mers were those that cut primary spending between 0 and 5pp andnon-reformers never undertook much of a cut at all. These coun-tries and country groups, the time and size of the maximum expen-diture ratio and the change in the expenditure ratio within years(T7) as reported in Hauptmeier et al. (2007) are depicted in Table 4. The study argued that conceptually, reforms needed to be ambi-tious in order to make a significant difference for the resultingpublic deficits and adverse debt dynamics. The more ambitious theywere the more they would even allow tax cuts. Already in the 1980s,Ireland, Belgium, the UK, Luxembourg and the Netherlands had sig-nificantly reduced their public expenditure ratio. The UK, Irelandand the Netherlands did so again in the 1990s plus a number ofother countries: Finland, Sweden, Canada and Spain. Four countriesreduced public primary expenditure by more than 10% of GDP.During this period, 10 countries undertook timid expenditurereforms (amongst them the US, France, Germany and Italy at whichwe will look again later). The three non-reformers includedAustralia, which had always maintained a rather small governmentsector, and Portugal and Greece. 321
    • Public expenditure policies during the EMU period: Lessons for the future?Table 4: Expenditure reform phases 1980s and 1990s Max. primary expenditure Change maximum in year to T7Ambitious reformersFinland 1993 -14,0Sweden 1993 -14,0Ireland (Phase 1) 1982 -12,4Belgium (Phase 1) 1983 -12,3Canada 1992 -9,5United Kingdom (Phase 1) 1981 -8,2Netherlands (Phase 2) 1993 -7,5United Kingdom (Phase 2) 1992 -7,2Spain 1993 -6,4Ireland (Phase 2) 1992 -6,2Luxembourg 1981 -5,7Netherlands (Phase 1) 1983 -5,1Timid reformersAustria 1993 -4,3Denmark 1993 -3,9New Zealand 1985 -3,8United States 1992 -3,4Italy 1993 -3,0Japan 1998 -2,7Belgium (Phase 2) 1993 -2,1Germany 1996 -0,6France 1996 -0,5Switzerland 1998 -0,3Non reformersPortugal 2004 0,0Greece 2000 0,4Australia 1985 0,4 It is, however, not just the magnitude of spending and reformthat is important but also the composition. The literature (e.g.,Alesina and Perotti, 1995 and 1997) argues that reductions inpublic consumption/wages and transfers and subsidies are particu-larly “high quality”. They increase the chance of success of reformby providing a strong signal of “willingness” and cuts tend to focuson unproductive expenditure.322
    • The Future of the Euro Table 5 illustrates that much of the expenditure cuts ofambitious reformers came from transfers and subsidies and alsofrom government consumption. About two-thirds of the reduc-tion in the total expenditure ratio and over 80 per cent of thedecline in the primary expenditure ratio occurred in these twocategories. Nine out of 11 reform episodes reported a decline inpublic consumption by more than 2 per cent of GDP and eightout of 11 featured a fall in transfers and subsidies by over 3 percent of GDP. At the same time, in most cases, governmentinvestment and public education expenditure did not declinedisproportionately or in some cases even increased as a share ofGDP. Timid reformers did not report much of a decrease inpublic transfers and subsidies and focussed on public invest-ment in some cases and on public consumption including edu-cation in others. The study by Hauptmeier et al. (2007) also argued that publicexpenditure reform needed to be part of a comprehensive overallstructural reform strategy. It was argued on the basis of the litera-ture that this would allow the improvement in public finances notonly via less spending but also via better growth prospects. Anoverview of the reforms undertaken by ambitious countries isreported in Table 6. Most of the ambitious reformers undertookmajor reforms that were complementary to expenditure retrench-ment. Most countries strengthened their national fiscal institu-tions. This not only facilitated fiscal retrenchment but also tended 323
    • 324 Table 5: Composition of expenditure reform Transfers Total Interest Primary Government Government Change T0-T7 and Health Education Pensions expenditure Spending expenditure consumption investment Subsidies Ambitious reformers Finland -15,7 -1,6 -14,0 -3,8 -0,3 -9,4 -1,3 -1,8 -1,5 Sweden -15,7 -1,8 -14,0 -2,8 -0,9 -8,0 -0,4 0,2 -1,7 Ireland (Phase 1) -13,3 -1,0 -12,4 -5,2 -3,2 -2,2 -1,7 -0,9 -0,7 Belgium (Phase 1) -10,9 -4,8 -6,2 -3,9 1,0 -4,7 -0,5 -0,9 -1,6 Canada -11,4 -1,7 -9,5 -5,3 -0,5 -3,3 -1,1 -1,9 -0,2 United Kingdom (Phase 1) -10,5 -2,3 -8,2 -2,5 -0,3 -2,0 -0,3 -0,8 -0,5 Netherlands (Phase 2) -9,8 -2,3 -7,5 -1,9 0,1 -6,5 -0,8 -0,4 -1,2 United Kingdom (Phase 2) -7,1 0,1 -7,2 -2,7 -1,1 -2,6 -0,1 -0,8 -0,4 Spain -8,2 -1,8 -6,4 -1,5 -1,0 -4,1 -0,4 0,0 0,2 Ireland (Phase 2) -10,9 -4,8 -6,2 -3,9 1,0 -4,7 -0,5 -0,9 -1,6 Luxembourg -5,9 -0,4 -5,7 -1,4 -2,1 0,0 0,1 -1,6 -0,8 Netherlands (Phase 1) -5,0 0,2 -5,1 -2,0 -0,2 -2,2 -0,1 -1,1 0,4 Public expenditure policies during the EMU period: Lessons for the future?
    • The Future of the Euroto make future budgetary control and thus the avoidance of fiscalproblems more likely.8 A number of countries devalued theircurrencies. All ambitious reformers initiated significant labourmarket reforms that improved work incentives. All but onecountry reformed the tax system. And most countries reduced theTable 6: Summary findings for ambitious reform episodes Expenditure reform Structural reform Institutional Other macroeco- Labour Public Transfers & reform nomic reform market consumption Taxation Privatisation subsidies 1/ incenti- 1/ vesIreland 1 XX XX X X X X XIreland 2 X XX X X X XSweden X XX X X X X XCanada XX XX X X X XFinland XX XX X X X X XBelgium XX XX X XNetherlands 1 X X X X X XNetherlands 2 ~ XX X X X XSpain ~ XX X X X XUK 1 X X X X X X XUK 2 X X X X XAll 9 11 10 6 11 10 88 For the importance of fiscal rules and institutions, see, e.g., Poterba and Von Hagen(1999). Debrun et al. (2008) and Holm-Hadulla et al (2011) focus on the numerical fis-cal rules in EU countries. 325
    • Public expenditure policies during the EMU period: Lessons for the future?role of the state in the economy via privatisation. Based on the fact that the reforming countries fulfilled the con-jectures of ambition, high quality and comprehensive reforms it isnot surprising that the impact on public finances and the economywere quite positive, compared to timid reformers (Chart 5). Panela) shows that ambitious reformers (here differentiating early andlate reformers) brought the public expenditure ratio down signifi-cantly to levels similar or lower than those of timid reformers. Thiswas mainly achieved through cuts in public consumption andtransfers and subsidies while public investment did not changemuch, at least for late ambitious reformers (see panels b)-d)). Panele) illustrates that public deficits were brought down very substan-tially by ambitious reformers. The group of late reformers even rea-ched sizable surpluses. As regards public debt developments (panelf)), timid reformers did not achieve any significant reversal in debtdynamics. Ambitious reformers, by contrast, managed to bringdebt down once fiscal balances had been sound enough. Contrary to the concerns of vocal special interests and politi-cians, ambitious expenditure reforms had very little (if any) adver-se growth impact even in the very short run while the medium tolong term impact was very positive. Ambitious reformers experien-ced a significant increase in trend growth by 1-2 percentage points(panel g). By contrast, timid reformers experienced no such incre-ase. Real private consumption started to recover as of the first yearof public expenditure reduction and accelerated more stronglywhere ambitious reforms were undertaken (panel g). Private invest-326
    • The Future of the EuroChart 5: Ambitious vs. timid reforms, 1980s and 1990s.a) Total public expendituresb) Public consumption 327
    • Public expenditure policies during the EMU period: Lessons for the future? Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. c) Transfers and subsidies d) Public investment328
    • The Future of the EuroChart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.e) Fiscal balancef) Public debt 329
    • Public expenditure policies during the EMU period: Lessons for the future? Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. g) Trend growth h) Real private consumption330
    • The Future of the Euro Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. i) Private investment Source: Hauptmeier, S., Heipertz, M. & Schuknecht, L. (2007)ment initially declined or was flat and showed a relatively lessfavourable trend than for timid reformers but this reversed in themedium term. In the seventh reform year, the private investmentratio of timid reformers had increased by 1pp of GDP while that ofambitious reformers had increased by 2-3pp (panel i). In a next step we assess recent and projected fiscal develop-ments for 2012 and 2013 in selected euro area countries as well asthe UK and the US in the light of the evidence from past expendi-ture reform periods described above. We do this on the basis of thelatest European Commission forecast (Autumn 2011) (see Table 7).For the US we consider the latest IMF World Economic Outlook 331
    • Public expenditure policies during the EMU period: Lessons for the future?projections. For all sample countries, the projections point to sig-nificant primary expenditure reductions for the period up to 2013(with the exception of France). This ranges from about 3-4pp ofGDP for Germany, Italy and the US to over 5pp in the UK andSpain and to 7 to 10pp in the EU/IMF programme countries.Expenditure reductions show a more or less linear pattern in mostcountries. In the case of the US, the primary expenditure ratiowent down quite strongly in 2010. However, it is expected to decli-ne only by another 1pp of GDP over 2011-13. Table 7: Expenditure plans % of GDP Primary expenditure Actual Forecast 2009 2010 2011 2012 2013 2013 to max(0910)Programme countriesGreece 48,7 44,4 43,6 42,4 41,7 -6,9Ireland 46,9 43,7 42,1 39,6 37,0 -9,9Portugal 46,9 48,3 44,9 42,0 39,9 -8,4Large euro area countriesGermany 45,4 45,4 43,3 43,2 42,8 -2,6France 53,8 54,2 54,0 54,3 53,9 -0,3Italy 47,1 45,9 44,8 43,8 43,0 -4,1Spain 44,5 43,7 40,8 39,8 39,3 -5,2Large non-euro area countriesUnited States 42,1 39,3 39,6 39,0 38,5 -3,7UK 49,6 47,7 46,8 45,3 43,9 -5,6 Sources: Actual and forecasts: EU Commission (Ameco), IMF for the US.332
    • The Future of the Euro If projected spending developments materialise, primary expen-diture ratios would decline to around 40% of GDP in most coun-tries. The main exception is France where the ratio would remainsignificantly above 50%. Projected spending developments should also be assessed froma longer term perspective. When comparing the 2013 figures to the1999 primary expenditure ratios it is noteworthy that spendingwould still be 1-7pp of GDP higher in 2013 than in 1999 for 8 outof 9 countries. This relative increase would be particularly sizeablefor Ireland, the US and the UK and appears unwarranted in view ofthe expected ageing-related increases in social security outlays inthe medium and long-term. Only Germany would post a signifi-cantly lower primary expenditure ratio than at the start of EMU. Coming back to the adjustment effort in countries’ expenditureplans, it is noteworthy that five countries (Ireland, Greece,Portugal, Spain and the UK) would meet the criteria of ambitiousreformers as applied in the earlier study by Hauptmeier et al. (2007)whereas a second group of countries could be classified as “timid”reformers (Germany, USA, and Italy).5.The need for prudent expenditure rules The evidence presented in this study supports the view thatpublic spending has been a major determinant of unsound public 333
    • Public expenditure policies during the EMU period: Lessons for the future?finance developments in the past. Looking forward, it thereforeseems plausible to address this fact through the implementation ofprudent expenditure rules. Indeed, empirical studies suggest thatwell-designed expenditure rules tend to limit the pro-cyclicality ofpublic spending (see, e.g. Holm-Hadulla et al (2010)). Recent policyaction in Europe goes in this direction. Notably, the EU fiscal sur-veillance framework has been extended by a so called “expenditu-re benchmark” which restricts the growth rate of public spendingnet of discretionary tax measures to that of potential growth.However, this new rule does not take into account some of the pro-blems we identified in Section 3.1. Most notably, an effective rule-based restriction of spending policies in real-time requires themaintenance of a margin of prudence. This is necessary to accountfor the tendency of overestimating potential GDP growth in real-time. Given the past experience of systematic and persistent down-ward revisions in potential growth, a margin of prudence of ½ ppin expenditure growth per annum appears warranted. In addition,excessive price developments should not automatically feed intohigher expenditure growth as expansionary fiscal policies mayaccelerate an economic overheating. Therefore, the nominal com-ponent of an effective expenditure growth rule should be capped,e.g. at the ECB’s price stability objective (“close to but below 2%”). Chart 6 shows that the application of such prudent expenditu-re growth rules during EMU would have resulted in much safer fis-cal positions. Primary expenditure ratios would have reachedmuch lower levels in 2009. As a result, also public debt ratios in334
    • The Future of the EuroChart 6: Actual ratios versus neutral expenditure policies-based ratios (based onNPG – ½ pp and RPECB – ½ pp rules), 2009Panel A: Primary expenditure ratiosPanel B: Public Debt ratiosNote: Includes GDP multiplier and compound interest effects. 335
    • Public expenditure policies during the EMU period: Lessons for the future?2009 would have generally been much closer to 60% of GDP withthe highest ratio of around 90% in Italy. It is important to note,however, that the proposed expenditure rules are intended to pro-vide guidance for an appropriate, i.e. neutral, policy stance in theabsence of fiscal imbalances. Any fiscal adjustment, e.g. to regainsound fiscal positions in the aftermath of the crisis, would of cour-se require a restrictive policy stance, i.e. spending growth ratesbelow potential GDP growth.6. Concluding remarks What are the main findings of this study and what policy lessonscan be drawn? Public finances in advanced economies are at a cross-roads. In the fifth year of the crisis, fiscal deficits remain high andpublic debt has reached unprecedented peace-time levels in mostindustrialised countries. Public primary expenditure stands at ornear historical peaks in many countries and therefore constitutes animportant determinant of the fiscal imbalances. It therefore seemsstraight forward to focus on expenditure restraint when striving toregain sound fiscal positions in the aftermath of the crisis. In the 1980s and 1990s a number of countries undertook ambi-tious expenditure reforms. Their experience, which was brieflyreviewed here, has been very positive. Within a few years from thestart of expenditure reform, public expenditure ratios went downsignificantly, fiscal deficits largely or fully disappeared, public debt336
    • The Future of the Eurowas brought on a downward path, and economic growth and pri-vate consumption resumed swiftly. We argue that this was becauseambitious expenditure reform was conducted in a growth-friendlymanner as part of comprehensive adjustment programmes. Our study emphasises the key role of expenditure policies inexplaining fiscal developments during EMU in the euro area. It findsthat, almost all euro area countries (with the notable exception ofGermany) applied expansionary expenditure policies already beforethe crisis. This resulted in much higher expenditure and debt pathscompared to a counterfactual neutral expenditure stance. Rules-based spending policies could have led to much safer fiscal positionsmuch more in line with the EU’s Stability and Growth Pact (SGP). The policy recommendations from these findings are obvious:countries should focus on reducing public spending in the contextof ambitious reform programmes. Spending based consolidationefforts need to be complemented by structural reforms, notablywith a view to removing rigidities in national labour and productmarkets, to reduce macroeconomic imbalances, improve competi-tiveness and support potential growth. This will be particularlyimportant for the vulnerable countries in the euro area which donot have available the exchange rate mechanism to improve exter-nal competitiveness. Latest projections suggest that governments’consolidation plans in a number of countries indeed put a focus onreducing government expenditure as a ratio to GDP in the comingyears. However, the benefits of reforms are only going to materia- 337
    • Public expenditure policies during the EMU period: Lessons for the future?lise under one condition, namely that all these plans are fully andadequately implemented. This is their main challenge. In addition, the empirical evidence on the determinants of euroarea countries’ expenditure stance provide a number of policyimplications. First, strong national budgetary institutions seem tolimit expansionary spending biases. Second, the European institu-tional framework needs to feature prominently expenditure moni-toring and control. The incorporation of an expenditure bench-mark in the preventive arm of the Stability and Growth Pact in thecontext of the recent “Six-Pack” reform therefore constitutes a stepin the right direction. An effective enforcement of this rule shouldhelp to limit overly expansionary spending policies in the future. Furthermore, this chapter argues that a potential growth rulewith an extra ½ percentage point deduction from the resultingannual expenditure growth targets would be a sufficiently prudentand, thus, advisable expenditure rule for euro area countries. Aseconomic (e.g., population aging) and political economy reasonssuggest that overestimating potential growth could also occur inthe future, such a rule could provide a reasonably prudent bench-mark for a neutral expenditure stance looking forward. How does the debate on the overhaul of European economic gover-nance fare against these conclusions? At the time of completing thisstudy (March 2012), EU member states have set up new EU economicgovernance principles with a view to ensuring a tighter and more338
    • The Future of the Euroeffective surveillance of economic and fiscal policies at the Europeanlevel. At the same time, policy makers have agreed - in the context ofthe new fiscal pact - to strengthen national fiscal frameworks. All in all, a stringent implementation and enforcement of thefiscal surveillance at European level could well ensure the necessarybreak with past expenditure trends and thus also secure sustainabledeficits and debt dynamics in the future. However, it remains to beseen whether the main obstacle of the “old framework”—lack ofincentives and enforcement—is really sufficiently remedied.Bibliography- Alesina, A. and R. Perotti (1995) Fiscal expansions and adjustments inOECD countries, Economic Policy, vol. 10, pp. 205–48.- Alesina, A. and R. Perotti (1997) Fiscal adjustments in OECD countries:Composition and macroeconomic effects, IMF Staff Papers, vol. 44, pp. 210–48.- Brück, T. and R. Zwiener (2006) Fiscal policy rules for stabilisation andgrowth: A simulation analysis of deficit and expenditure targets in a mone-tary union, Journal of Policy Modeling, 28, 357–369.- Cimadomo, J. (2008) Fiscal policy in real time, Working Paper 919,European Central Bank. 339
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