The turbulent adolescence of the euro and its path tomaturity by Gonzalo García Andrés
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The turbulent adolescence of the euro and its path tomaturity by Gonzalo García Andrés The turbulent adolescence of the euro and its path tomaturity by Gonzalo García Andrés Document Transcript

  • /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
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