A review of the European Union and the impact of the 2008 global financial crisis on the Eurozone countries. It discusses the way that the Eurozone managed the banking crisis in 2008 and the subsequent sovereign debt crisis in 2011-12.

1. The European Union and the global
financial crisis
Professor Nigel Healey
Pro-Vice-Chancellor (International)
Nottingham Trent University
10 July 2014
Southwestern University of Finance and Economics

2. Overview
• What is the European Union?
• What is the Eurozone? Who’s in the Eurozone?
• The institutional design of the Eurozone: guaranteed to
avoid inflation and printing money?
• The performance of Eurozone 1999-2014
• The global financial crisis
• Moral hazard, bail-outs and monetisation of debt
• The outlook for the Eurozone
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3. What is the European Union?
• European Union: a political and
economic union of 28 European states
• Population: 0.5bn (China: 1.4bn)
• Land mass: 4.4m km2 (China: 9.6m
km2)
• Gross domestic product: US$18.4tr
(China: $10.0tr)*
• GDP per capita: $36,393 (China:
$7,333)*
• GDP per capita (PPP): $33,084
(China: $10.695)*
3 * IMF World Economic Outlook Database, April 2014

4. What is the Eurozone?
• 18 countries within the European Union
which share:
– European Central Bank
– A common currency (the euro)
– Common monetary policy and short-term
interest rates
Mario Draghi, ECB
President
1November 2011 – 31
October 2019
4
ECB building (Eurotower),
Frankfurt

5. Who’s in the Eurozone?
• France, Germany, Italy, Belgium, Luxembourg, Netherlands,
Ireland, Spain, Portugal, Austria, Finland: January 1999
• Greece: January 2001
• Slovenia: January 2007
• Cyprus and Malta: January 2008
• Slovakia: January 2009
• Estonia: January 2011
• Latvia: January 2014
• = 18 members at July 2014
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6. Objectives of the European Central Bank (1)
• The Maastricht Treaty’s Art. 105.1:
– ‘The primary objective of the ECB shall be to maintain price
stability. Without prejudice to the objective of price stability, the
ECB shall support the general economic policies in the Community
with a view to contributing to the achievement of the objectives of
the Community as laid down in Article 2.’
• Article 2:
– ‘The objectives of European Union are a high level of employment
and sustainable and non-inflationary growth.’
• So:
– fighting inflation is the absolute priority
– supporting growth and employment comes next
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7. Objectives (2)
• Making the inflation objective operational: does the ECB have
a target?
• It has a definition of price stability:
– ‘The ECB has defined price stability as a year-on-year increase in
the Harmonised Index of Consumer Prices (HICP) for the euro
area of below 2%.’
• …and it has an aim:
– ‘In the pursuit of price stability, the ECB aims at maintaining
inflation rates below, but close to, 2% over the medium term.’
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8. Central bank independence
• Current conventional wisdom is that to
ensure price stability, central banks
should be independent:
– most governments cannot resist the
‘printing press’ temptation
– the Bundesbank set the pre-Eurozone
example
• ECB set up to be independent of
national and EU government
• What does “independence” mean?
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9. Independence
• Article 7: Independence
• …neither the ECB, nor a national central bank, nor any member of
their decision-making bodies shall seek or take instructions from
Community institutions or bodies, from any government of a
Member State or from any other body…
• Article 21: Operations with public entities
• …overdrafts or any other type of credit facility with the ECB or with
the national central banks in favour of Community institutions or
bodies, central governments, regional, local or other public
authorities, other bodies governed by public law, or public
undertakings of Member States shall be prohibited, as shall the
purchase directly from them by the ECB or national central banks of
debt instruments
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Politically independent
Financially independent

10. Fiscal complications in a monetary union
• In a monetary union, fiscal policy
– the only macroeconomic instrument left at national level
– government borrows in recession and pays back in good times
– government acts as a buffer in case of a negative shock
• Automatic stabilisers:
– tax receipts decline when the economy slows down
– welfare spending rises when the economy slows down
– rule of thumb: deficit worsens by 0.5% of GDP when GDP
growth declines by 1%
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11. But there are fiscal policy “externalities”
• Borrowing cost externalities:
– Country X’s deficit would boost growth in country X
– But raise interest rate for everyone with wider negative long-
term growth effects
• Most serious is the risk of default in one member country:
– Loss of confidence in other Eurozone members
– Pressure on other governments to help out…
– ..and on the ECB to monetise debt
• Answer to address risk:
– The no monetisation / ‘no-bailout’ clauses in Maastricht Treaty
– Prevention procedure
Alert: moral
hazard!
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12. Maastricht Treaty
• 1.2. Monitoring of budgetary discipline
• The Treaty prohibits the direct financing of public entities’
deficits by national central banks (Art. 101), be it overdraft
facilities, other types of credit facility or the purchase of debt
instruments, except for the purpose of monetary policy. The
Treaty also prohibits public entities' privileged access to
financial institutions (Art. 102).
• Moreover, the “no bail-out” clause in Article 103 stipulates
explicitly that neither the Community nor any Member State
is liable for or can assume the commitments of any other
Member State.
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13. Prevention procedure: pre-GFC attempts to
control government deficits and debt
• The Stability and Growth Pact (SGP)
• The SGP made permanent the 3% GDP deficit and 60%
GDP ceilings
• SGP reformulated in 2005 to make it more flexible:
– negative growth may be exceptional
– take account of ‘all relevant factors’
– no specific definition
•Fines are automatic if approved
•Funds withheld from EU payments to member
state
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14. The record of EMU so far…..
•A “difficult” birth and early teenage years:
– an oil shock in 2000 and again in 2007
– a worldwide slowdown in early 2000s
– September 11, 2001
– the stock market crash in 2002
– Afghanistan, Iraq wars
– the weak US dollar
– the 2008 global financial crisis
– the European (Eurozone) sovereign debt crisis
– Bailouts and austerity
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15. Sources of Eurozone data
Source: http://sdw.ecb.europa.eu/home.do?chart=t1.6
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16. Inflation: missing the objective, a little …until
2008 commodity boom, 2008-14 financial crisis
Source: European Central Bank
Inflation
target
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17. The performance of the euro against US$
Source: European Central Bank
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18. Global financial crisis: the early days
• “ The European Central Bank's main task is to keep inflation down.
But over the past month, it has thrown caution to the wind in trying
to prevent Europe's financial system and integrated economy from
falling apart.
• The ECB has transformed itself into a crisis manager of the sort that
its architects could hardly have imagined when the bank took up its
work 10 years ago. The bank, charged with managing the euro, was
given a single mandate - to keep prices under control.
• Lately, however, the central bank has cast aside worries about
inflation, cutting interest rates once already, with more cuts in the
pipeline. At the same time, it is lending ever more cash to
strapped banks.”
International Herald Tribune
October 16, 2008
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19. Early stages of the recession
• Eurozone entered recession in 2008Q3
• European Council agreed package to avert financial meltdown
in October 2008
• National governments (not ECB) would bail out commercial
banks: ie, buy shares to recapitalise them
• ECB would reduce interest rates and inject liquidity into
banking system
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20. Eurozone short-term interest rate
Source: European Central Bank
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21. GDP growth (% change year-to-year)
“double-dip”
Source: European Central Bank
21

22. GDP (2005 = 100)
Peak
GDP
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23. Eurozone unemployment rate
Source: European Central Bank
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24. Government debt in the Eurozone
• Eurozone governments are effectively borrowing in ‘foreign
currency’
• They cannot borrow from their own central banks,
monetise the debt and inflate away their debts (like US
and UK)
• Financial markets demand ever-higher risk premium from
indebted governments
Source: European Central Bank
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• This increases debt service costs,
the deficit and so the need to
borrow more and eventually the
government will default

25. Eurozone government budget balance (% GDP)
Source: European Central Bank
SGP
Limit
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26. Eurozone government debt (% GDP)
Source: European Central Bank
Never achieved
SPG ceiling
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27. Government debt in key Eurozone countries
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28. Deficits and debt
Source: Eurostat
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29. From financial crisis to sovereign debt crisis
• From 2010, growing concern about sovereign debt levels in Greece,
Spain, Ireland, Portugal and Italy
• Bond yield differentials between this group and France and Germany
widened
• March 2010, European Council agreed on a bailout mechanism for
Greece
• Other countries could apply if needed
• Widely believed bailout violates Maastricht Treaty – “the no bail-out
clause in Article 103 stipulates explicitly that neither the Community
nor any Member State is liable for or can assume the commitments
of any other Member State”
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30. National long-term interest rates
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Source: European Central Bank

31. The bailouts
• In April 2010, bailout mechanism used - €30bn lent to Greece
• In May 2010, EU established a larger fund of €750bn
– €440bn from eurozone states
– €60 billion from European Commission
– €250 billion from the IMF
• European Stability Mechanism, agreed in December 2010:
– issues debt on capital markets, backed by guarantees from the
eurozone states
– lends to indebted eurozone governments once recovery plan (ie,
austerity) agreed
– Combined with a monitoring body
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32. Greece welcomes EU recovery plan
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33. ECB bond purchases
• “The Treaty prohibits the direct financing of public entities’
deficits by …the purchase of debt instruments, except for the
purpose of monetary policy”
• From mid-2011, ECB forced to buy the bonds of weak
governments, especially Italy and Spain, to stop spirally bond
yield differentials
• Could be seen as stabilising the market if yield differentials
fall back…
• …but can be seen as monetising debt of weak governments
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34. ECB market stabilisation operations
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Source: European Central Bank

35. Is the medicine working?
• The ECB "...is ready to do whatever it takes to preserve the
Euro. And believe me, it will be enough” Mario Draghi, July
2012
• A combination of the bailouts and the bond purchases have
sent a strong signal to the markets that the EU is committed
to defending the Eurozone
• EU has given bail-outs to five Eurozone members (G, IRL, P,
E, I) – loans conditional on budget cuts
• Long-term interest rates are coming down
• But indebted states still have poor credit ratings and face
many years of austerity and political unrest
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36. A vote of confidence in the Eurozone from the
financial markets
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Source: European Central Bank

37. Conclusions
• The ECB set up with primary objective of price stability and
independent of national and EU governments – it may not directly
monetise debt
• In EMU, national fiscal policy is the only macroeconomic policy
tool to adjust to negative shocks
• But there are important external effects of budget deficits - EU
has failed to effectively enforce controls on national fiscal policy
• Between 2010-12, EMU was at risk of being destabilised by
sovereign default… but countries in crisis small and the EU has
acted decisively
• Some argue Maastricht Treaty has been breached and ECB has
increased future risk of moral hazard – but deficit countries are
paying a high price for past overspending
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