European monetary policy, fiscal policy and the global financial crisis


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University of Cnnterbury course ECON339: Lecture 4

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European monetary policy, fiscal policy and the global financial crisis

  1. 1. ECON339 EURO339Lecture 4: European monetary policy, fiscal policy and the global financial crisis January 2013
  2. 2. ECON339 / EURO339Overview  The monetary unification of the EU  Monetary and fiscal coordination in the euro zone  Fiscal policy and the Stability and Growth Pact  The performance of EMU 1999-2012  The global financial crisis  Moral hazard, bail-outs and strains within the eurozone  The outlook for European monetary union 2
  3. 3. ECON339 / EURO339The long road to Maastricht and theeuro 2011 Estonia joins 3
  4. 4. ECON339 / EURO339The Maastricht Treaty (1) 4
  5. 5. ECON339 / EURO339The Maastricht Treaty (2) A firm commitment to launch the single currency by January 1999 at the latest A list of five criteria for admission to the monetary union A precise specification of central banking institutions Additional conditions mentioned (the excessive deficit procedure) 5
  6. 6. ECON339 / EURO339The Maastricht convergence criteria Inflation:  not to exceed by more than 1.5 per cent the average of the three lowest rates among EU countries Long-term interest rate:  not to exceed by more than 2 per cent the average interest rate in the three lowest inflation countries ERM membership:  at least two years in ERM (now ERM-2) without being forced to devalue Budget deficit:  deficit less than 3 per cent of GDP Public debt:  debt less than 60 per cent of GDP (or declining satisfactorily) All observed in 1997 for decision in 1998 6
  7. 7. ECON339 / EURO339Interpretation of the convergence criteria:inflation 10.00Straightforwardfear of allowing inunrepentantinflation-pronecountries 5.00 0.00 1991 1992 1993 1994 1995 1996 1997 1998 France Italy Spain Germany Belgium Portugal Greece average of three lowest + 1.5% 7
  8. 8. ECON339 / EURO339Interpretation of the convergence criteria:long-term interest rates  Easy to bring inflation down in 1997 – artificially or not – and then let go again  Long interest rates incorporate bond markets expectations of long term inflation  So criterion requires convincing markets  Problem: self-fulfilling prophecy:  if markets believe admission to euro area, they expect low inflation and long-term interest rate is low, which fulfils the admission criterion  conversely, if they don‟t, all is lost 8
  9. 9. ECON339 / EURO339Interpretation of the convergence criteria:ERM membership  Same logic as the long-term interest rate: need to convince the exchange markets  Same aspect of self-fulfilling prophecy 9
  10. 10. ECON339 / EURO339Interpretation of the convergence criteria:budget deficit and debt Historically, all big inflation episodes born out of runaway public deficits and debts Hence requirement that house is put in order before admission. How are the ceilings chosen?  deficit: the German „golden rule‟  debt: the 1991 EU average Problem No 1:  a few years of budgetary discipline do not guarantee long- term discipline  Need Stability and Growth Pact Problem No 2: artificial ceilings 10
  11. 11. ECON339 / EURO339The deficit and debt criteria in 1997 Maastricht fiscal criteria 1997 120 100 80 Public Debt (%GDP) 60 40 20 0 -3 -2 -1 0 1 2 3 4 5 Deficit (% GDP) 11
  12. 12. ECON339 / EURO339A tour of the acronyms  National Central Banks (NCBs) continue operating but with no monetary policy function  A new central bank at the centre: the European Central Bank (ECB) Jean-Claude  Eurosystem/ECB independent of national Trichet, ECB governments President  The European System of Central Banks (ESCB): the ECB and all EU NCBs  The Eurosystem: the ECB and the NCBs of euro area member countries (N=17) 12
  13. 13. ECON339 / EURO339How does the Eurosystem work?  Objectives:  what is it trying to achieve?  Instruments:  what are the means available?  Strategy:  how is the system formulating its actions? ECB building, Frankfurt 13
  14. 14. ECON339 / EURO339Objectives (1)  The Maastricht Treaty‟s Art. 105.1:  ‘The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB 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 14
  15. 15. ECON339 / EURO339Objectives (2)  Making the inflation objective operational: does the Eurosystem 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.’ 15
  16. 16. ECON339 / EURO339Instruments Main channels of monetary policy:  longer run interest rates  credit  asset prices  exchange rate These are all beyond central bank control Instead it can control the very short-term interest rate: European Over Night Index Average (EONIA) EONIA affects the channels through market expectations 16
  17. 17. ECON339 / EURO339The ‘two-pillar’ strategy  The monthly Eurosystem‟s interest rate decisions (every month) rests on two pillars  Economic analysis:  broad review of economic conditions - growth, employment, exchange rates, economic developments abroad (eg, oil prices)  Monetary analysis:  evolution of monetary aggregates (M3, etc) 17
  18. 18. ECON339 / EURO339Comparison with other strategies  The US Fed:  legally required to achieve both price stability and a high level of employment  does not articulate an explicit strategy  Inflation-targeting central banks (NZ, Czech Republic, Poland, Sweden, UK, etc):  announce a target (eg, 3 per cent in NZ), a margin (eg, 1%) and a horizon (2–3 years)  compare inflation forecast and target, and act accordingly 18
  19. 19. ECON339 / EURO339Taylor Rule interpretation (1)  i = i* + a( - *) + b (y - y*)  i* = equilibrium interest rate   = inflation  * = inflation objective (eg, 2%)  y = GDP growth  y* = trend GDP growth  a = aversion to inflation  b = aversion to cyclical fluctuations 19
  20. 20. ECON339 / EURO339Taylor Rule interpretation (2)  i = i* + a( - *) + b (y - y*)  By Fisher equation,  i* = r* + *  (eg, r* = 2%, then i* = 4%)  and y* = 1.2%  ECNB weights are estimated at:  a = 2.0  B = 0.8 20
  21. 21. ECON339 / EURO339The ECB’s ‘Taylor Rule’? Inflation 3.50 3.00 7 2.50 2.00 6 1.50 1.00 5 0.50 0.00 4 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 Output gap 3 10.5 2 0-0.5 1 -1 EONIA Taylor rule-1.5 0 -2 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1-2.5 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 21
  22. 22. ECON339 / EURO339Independence and accountability  Current conventional wisdom is that central banks ought to be independent:  governments tend not to resist to the „printing press‟ temptation  the Bundesbank has set an example  ECB set up to be independent of national and EU government  What does independence mean?  How does accountability work? 22
  23. 23. ECON339 / EURO339Independence  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 23
  24. 24. ECON339 / EURO339Accountability: redressing thedemocratic deficit  Misbehaving governments are eventually punished by voters  What about central banks? Independence removes them from such pressure - a democratic deficit?  In return for their independence, central banks must be held accountable:  to the public  to elected representatives  The Eurosystem must report to the EU Parliament  The ECB‟s President must appear before the EU Parliament when requested, and does so every quarter 24
  25. 25. ECON339 / EURO339Fiscal policy in a monetary union  In a monetary union, fiscal policy  the only macroeconomic instrument at national level  government borrows in recession and pays back on behalf of citizens in good times  government acts as substitute to inter-country transfers in case of asymmetric shock  Effectiveness depends on private expectations  Slow implementation of fiscal policy  Inside vs outside lags  Result: countercyclical actions can have procyclical effects 25
  26. 26. ECON339 / EURO339Automatic versus discretionary fiscalpolicy  Automatic stabilisers:  tax receipts decline when the economy slows down, and conversely  welfare spending rises when the economy slows down, and conversely  no decision, so no lag: nicely countercyclical  rule of thumb: deficit worsens by 0.5 per cent of GDP when GDP growth declines by 1 per cent 26
  27. 27. ECON339 / EURO339Automatic stabilisers 27
  28. 28. ECON339 / EURO339Actual versus cyclically-adjustedbudget balance  Discretionary actions: a voluntary decision to change tax rates or spending  Cyclically adjusted budget shows what the balance would be if the output gap is zero in a given year  Difference between actual and cyclically adjusted budget = footprint of automatic stabilisers 28
  29. 29. ECON339 / EURO339The Netherlands 6 Output gap Budget balance 4 Cyclically adjusted budget balance 2 0 -2 -4 -6 1991 1993 1995 1997 1999 2001 2003 2005 29
  30. 30. ECON339 / EURO339Fiscal policy externalities  In a monetary union, should fiscal policy be subjected to some form of collective control?  Yes, if national fiscal policies are a source of externalities  Externality #1 - income spillover via trade:  important and strengthened by monetary union  lack of co-ordination means that with a symmetric shock, too much policy action can be used to counteract shock 30
  31. 31. ECON339 / EURO339Other externalities  Borrowing cost externalities:  one country‟s deficit would induce higher interest rate for everyone  long-term growth effects  capital inflows appreciate common currency and affect competitiveness  Most serious is the risk of default in one member country:  capital outflows and a weak euro  pressure on other governments to help out Alert: moral  pressure on the Eurosystem to help out hazard  Answer to address risk:  the „no-bailout‟ clause in Maastricht Treaty  Prevention procedure 31
  32. 32. ECON339 / EURO339Maastricht Treaty  1.2. Monitoring of budgetary discipline  As from Stage 2, 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. 32
  33. 33. ECON339 / EURO339Arguments for/against fiscal policycontrols  The arguments for:  serious externalities  a bad European track record on debt and deficits  The arguments against:  the only remaining macroeconomic instrument  national governments know their domestic economic circumstances best 33
  34. 34. ECON339 / EURO339The Stability and Growth Pact (SGP)  The SGP: meant to avoid excessive deficits upon entry into euro area  Excessive Deficit Procedure (EDP) makes permanent the 3% GDP deficit and 60% GDP ceilings and calls for fines  Final word remains with ECOFIN, and countries avoided fines so far  SGP reformulated in 2005 to avoid rigidity of Pact  negative growth or accumulated loss of output over a period of low growth exceptional  taking account of „all relevant factors‟  no specific definitions  New reform makes fines automatic 34
  35. 35. ECON339 / EURO339How the SGP works  A limit on acceptable deficits: 3% of GDP  A preventative arm  Aims at avoiding reaching the limit in bad years  Calls for surpluses in good years  A corrective arm  „early warning‟ when deficit is believed to breach limit + recommendations  EDP procedure for excessive deficit: recommendations, to be followed by corrective measures, and ultimately sanctions 35
  36. 36. ECON339 / EURO339The SGP fine schedule The sum is retained from payments from the EU to the country(CAP, Structural and Cohesion Funds) The fine is imposed every year when the deficit exceeds 3 percent. The fine is initially considered as a deposit:  if the deficit is corrected within two years, the deposit is returned  if it is not corrected within two years, the deposit is considered as a fine 36
  37. 37. ECON339 / EURO339Issues raised by the SGP  It could make fiscal policies procyclical:  budgets deteriorate during economic slowdowns  reducing the deficit in a slowdown may further deepen the slowdown  a fine both worsens the deficit and has a procyclical effect  In practice, the Pact encourages countries to:  aim at surpluses (so public debts will disappear) in normal times, to give them scope to use fiscal policy in a downturn  reduce reliance on discretionary policy and just use automatic stabilisers 37
  38. 38. ECON339 / EURO339The record of EMU so far…..  A difficult period:  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 38
  39. 39. ECON339 / EURO339Inflation: missing the objective, a little …until2008 commodity boom, 2008-12 financial crisis 39 Source: European Central Bank
  40. 40. ECON339 / EURO339The performance of the euro againstUS$ 40 Source: European Central Bank
  41. 41. ECON339 / EURO339Current financial crisis  “ The European Central Banks main task is to keep inflation down. But over the past month, it has thrown caution to the wind in trying to prevent Europes 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 41
  42. 42. ECON339 / EURO339Early 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  ECB would reduce interest rates and inject liquidity into banking system 42
  43. 43. ECON339 / EURO339Eurozone GDP growth 43 Source: European Central Bank
  44. 44. ECON339 / EURO339Eurozone unemployment 44 Source: European Central Bank
  45. 45. ECON339 / EURO339Eurozone one-year interbank rate 45 Source: European Central Bank
  46. 46. ECON339 / EURO339Remember from Lecture 1:government debt and the euro  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  This increases debt service costs, the deficit and so the need to borrow more and eventually the government will default 46
  47. 47. ECON339 / EURO339From financial crisis to sovereigndebt 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 EU treaties – note: bailout is by EU national governments, not ECB, which cannot directly monetise debt 47
  48. 48. ECON339 / EURO339Eurozone budget balance (% GDP) 48 Source: European Central Bank
  49. 49. ECON339 / EURO339Eurozone government debt (% GDP) Ratio has never been below 60% GDP 49 Source: European Central Bank
  50. 50. ECON339 / EURO339Government debt in key Eurozonecountries 50
  51. 51. ECON339 / EURO339Deficits and debt 51 Source: Eurostat
  52. 52. ECON339 / EURO339National long-term interest rates 52
  53. 53. ECON339 / EURO339The bailouts In April 2010, bailout mechanism used - €30bn lent to Greece In May 2010, EU established a full fund of €750bn  €440bn from eurozone states  €60 billion from European Commission  €250 billion from the IMF European Financial Stability Facility (EFSF) established  issues debt on capital markets, backed by guarantees from the eurozone states  lends to indebted eurozone governments once recovery plan agreed Long-term solution is the European Stability Mechanism, agreed in December 2010  Replaces the EFSF and similar legal instruments  Combined with a monitoring body 53
  54. 54. ECON339 / EURO339Greece debates budget cuts 54
  55. 55. ECON339 / EURO339Trying to make the SGP work  In June 2010, the Council agreed that national governments would present their budget plans to the Council and Commission six months before budget time  Governments would have to justify deficits  Tougher scrutiny for deficits if debt > 60% GDP  Sanctions still unclear – possibly having voting rights in the Council suspended 55
  56. 56. ECON339 / EURO339Is the medicine working?  The EU has given bail-outs to five Eurozone members:  G, IRL, P, E, I  Loans have been conditional on budgetary cuts and return to sustainable debt levels  In some countries (Greece), budget cuts have deepened the recession  Long-term interest rates are coming down  But indebted states still have poor credit ratings and face many years of austerity and political unrest 56
  57. 57. ECON339 / EURO339Conclusions  The ECB set up with primary objective of price stability and independent of national and EU governments  May not directly monetise debt  In EMU, national fiscal policy more effective, only macroeconomic policy tool to adjust to asymmetric shocks  But there are important external effects of fiscal policy  EU has so far failed to design and enforce controls on national fiscal policy  EMU presently at risk of being destabilised by sovereign default… but countries in crisis small and the EU has acted decisively so far 57