SUMMARY MACRO-FINANCE POLICIES IN THE

EMU- EBC 2119

Optimal Currency Areas (OCA) ................................................................................................ 2

European Great Recession ......................................................................................................... 6
Risk-sharing ............................................................................................................................. 14
Banking Union ......................................................................................................................... 18
Capital Markets Union ............................................................................................................. 21
Lecture 2 - Sovereign Debt and Default .................................................................................. 23
7+7 Proposal ............................................................................................................................ 28
European Safe Assets ............................................................................................................... 30

Please, feel free to complete when uncomplete, correct when incorrect and answer when
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 Optimal Currency Areas (OCA)
1. How would you define OCA?

Robert Mundell, an economist who came up with the concept in the 1960s, introduced the idea
of an Optimal Currency Area, or OCA. In order for a single currency and monetary policy to
benefit all countries in the region, the economic conditions must be optimal. To be ideal, the
currency union must have a high level of similarity in economic structure, including free
movement of physical and financial capital, labor migration and emigration, similar
business cycles, and trade of goods and services.
Countries should be hit by similar symmetric shocks.

2. What are the benefits of OCA?

Avoid the uncertainty, international transaction costs and currency risk of a floating exchange
rates, higher price transparency ⇒ More competition. Time inconsistency of MP: Joining the
Eurozone also brought benefits in terms of monetary policy credibility, especially for countries
that had prior problems with high and persistent inflation rates.
1. Lower transaction costs: In an OCA, countries within the region would not need to
worry about currency exchange costs, which can reduce transaction costs and make
trade and investment within the region more efficient.
2. Reduced currency risk: With a single currency, businesses and investors within the
region would not have to worry about fluctuations in exchange rates, which can reduce
currency risk and increase predictability.
3. Improved price transparency: A single currency would lead to greater price
transparency across the region, making it easier for consumers to compare prices and
for businesses to set prices.
4. Greater economic integration: A currency union can foster greater economic
integration between countries, as it eliminates the need for currency hedging and can
facilitate cross-border investment and trade.
5. Greater economic stability: In an OCA, a common central bank would work to
maintain price stability and financial stability across the region, which can lead to
greater economic stability and reduce the risk of financial crises.

3. What are the costs of OCA?

- Loss of monetary policy autonomy: In an OCA, countries would give up their ability to
control their own monetary policy, as it would be set by a common central bank. This can
limit a country's ability to address its specific economic challenges through interest rate
adjustments and other monetary tools. + LOSS OF EXCHANGE RATE POLICY
- Limited fiscal policy autonomy: Similarly, countries within an OCA may have limited
fiscal policy autonomy, as they may be subject to common fiscal rules and constraints.
- Uneven economic shocks: Economic shocks, such as recessions or natural disasters, can
affect different countries within an OCA in different ways, which can make it difficult for
a common central bank to set policy that is beneficial for all countries.
- Diverging economic conditions: Over time, economic conditions within an OCA may
diverge, with some countries experiencing stronger growth and others struggling with high
unemployment or inflation. This can create tensions within the region and limit the
effectiveness of a common monetary policy.

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- Political tensions: An OCA can also create political tensions within the region, as countries
may disagree on the appropriate monetary policy or may feel that they are being unfairly
affected by the policy decisions of the common central bank.

4. What is the difference between asymmetric, symmetric, permanent, and transitory

shocks for the conclusions regarding OCA?

- Asymmetric shocks: Asymmetric shocks are economic shocks that affect different
countries or regions within an OCA in different ways. For example, a natural disaster that
affects one country but not others, or a recession that is more severe in one country than in
others, would be considered an asymmetric shock. Asymmetric shocks can be problematic
for an OCA, as a common monetary policy may not be able to effectively address the
different needs of each affected country.
o Wage flexibility: From (1) 2 ways to restore competitiveness: - depreciator.
1) ↓P and wages⇒ lower price level and higher production ⇒ higher competitiveness
⇒ shift IS right.
2) Labor mobility: Spanish unemployed workers move to Germany. Helps both
countries: lower unemployment in Spain and lower inflation in Germany which
could hamper competitiveness.
- Symmetric shocks: Symmetric shocks are economic shocks that affect all countries within
an OCA in a similar way. For example, a global recession that impacts all countries in the
region would be considered a symmetric shock. Symmetric shocks are generally less
problematic for an OCA, as a common monetary policy would be able to respond to the
needs of all affected countries in a similar way.
- Permanent shocks: Permanent shocks are long-term changes in economic conditions that
affect countries within an OCA. For example, a shift in global demand for a certain product
could permanently reduce the competitiveness of one country's economy relative to others.
Permanent shocks can be problematic for an OCA, as a common monetary policy may not
be able to address the structural differences between affected countries.
- Transitory shocks: Transitory shocks are short-term changes in economic conditions that
affect countries within an OCA. For example, a sudden increase in oil prices could
temporarily impact inflation rates in all countries within the region. Transitory shocks are
generally less problematic for an OCA, as a common monetary policy would be able to
respond to these short-term changes in a similar way for all affected countries.
o Symmetric shocks can be dealt by the ECB.
o Permanent asymmetric shocks require wage flexibility and labor mobility.
o Temporary asymmetric shocks can be dealt with automatic stabilizers.
o Financial markets can have a destabilizing effect on countries withing a monetary
union.

5. What are the consequences for government debt of being in an OCA?

When countries join an OCA and adopt a common currency, they lose the ability to devalue
their currency to reduce the real value of their debt. This means that any existing government
debt will be denominated in the new common currency, and any future borrowing will be
subject to the same currency risk as other countries in the OCA.
Additionally, in an OCA, countries are typically subject to common fiscal rules and constraints,
which can limit their ability to run deficits or borrow to finance spending. This can make
it more difficult for governments to finance their debt or respond to economic shocks through
fiscal policy.

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 6. Is the EU an OCA?

On the one hand, the EU has a high degree of economic integration, with free movement of
goods, services, capital, and labor across member countries. Additionally, there are
similarities in economic structure and business cycles across many EU countries, which can
make it easier for a common monetary policy to be effective.
On the other hand, there are also significant differences in economic conditions across the EU.
For example, some countries have higher levels of unemployment, lower levels of
productivity, and weaker financial systems than others. Additionally, labor mobility
within the EU is not as high as within some other currency unions, which can limit the ability
of workers to move to areas with stronger job opportunities.
Furthermore, the EU does not have a fully integrated fiscal policy, which can limit the
ability of member countries to respond to economic shocks through fiscal policy. In
addition, the EU does not have a common system of bank deposit insurance, which can
create the risk of bank runs in weaker countries.

7. What was the role of OCA in the great recession?

The role of an optimal currency area (OCA) in the Great Recession, which began in 2008, is a
matter of debate. Some economists argue that the eurozone, which is an example of an OCA,
exacerbated the recession by limiting the ability of individual countries to respond to economic
shocks through monetary and fiscal policy.
During the Great Recession, some eurozone countries, such as Greece, Portugal, and Spain,
experienced high levels of unemployment, low economic growth, and financial instability.
However, because these countries share a common currency with other eurozone members,
they could not devalue their currency to make their exports more competitive, which could
have helped to stimulate economic growth. Additionally, they were subject to common
monetary policy decisions made by the European Central Bank (ECB), which may not have
been well-suited to their specific economic conditions.
Furthermore, the fiscal rules and constraints in place within the eurozone limited the ability of
individual countries to respond to the recession through fiscal policy. For example, the Stability
and Growth Pact limited government deficits to 3% of GDP, which made it difficult for
countries to engage in deficit spending to stimulate their economies.
Overall, some economists argue that the OCA structure of the eurozone contributed to the
severity of the Great Recession in some countries, by limiting their ability to respond to
economic shocks through monetary and fiscal policy. However, others argue that the eurozone
was not the primary cause of the recession, and that other factors, such as the housing bubble
in the United States, played a larger role.

8. If the EZ is an incomplete Currency area, which areas need improvement?

- Fiscal integration: The EZ lacks a fully integrated fiscal policy, which limits the ability of
individual countries to respond to economic shocks through fiscal policy. While the EZ has
some common fiscal rules and constraints, such as the Stability and Growth Pact, these
have been subject to criticism for being inflexible and not providing sufficient fiscal space
during economic downturns.
- Banking union: The EZ has made progress towards creating a banking union, which would
provide a common framework for bank supervision, resolution, and deposit insurance.
However, this process is not yet complete, and some countries have been reluctant to share
the burden of bank bailouts.

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- Political integration: The EZ lacks a common political union, which can limit the ability
of member countries to coordinate policy responses during crises. Additionally, political
tensions between member countries can make it difficult to reach consensus on policy
decisions.
- Labor mobility: Labor mobility within the EZ is not as high as within some other currency
unions, which can limit the ability of workers to move to areas with stronger job
opportunities. This can exacerbate economic disparities between member countries.

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 European Great Recession
1. Which problems start building up during the 1990’s-2000?

- Economic disparities: There were significant economic disparities between different

countries within the Eurozone. For example, countries like Germany and the Netherlands
had strong export-driven economies, while countries like Greece and Portugal struggled
with high unemployment and low economic growth.
- Fiscal policies: Many Eurozone countries engaged in fiscal policies that were not
sustainable in the long term, such as running high government deficits and accumulating
large levels of debt. This made these countries vulnerable to economic shocks and left
them with limited policy options to respond to crises.
- Financial sector: There were weaknesses in the financial sector, including low levels of
capitalization and high levels of non-performing loans. This made the financial sector
vulnerable to economic shocks and increased the risk of bank failures.
- Housing bubbles: Several countries experienced housing bubbles, which created asset
price bubbles that were not sustainable in the long term. When these bubbles burst, it had
negative effects on the broader economy.
- Lack of policy coordination: There was a lack of coordination in economic policies
across Eurozone countries, which made it difficult to respond to economic shocks in a
coordinated way. Additionally, some countries, such as Greece, engaged in accounting
practices that masked the true state of their finances, which made it difficult to accurately
assess the risks they posed to the broader Eurozone.

2. During 2000-2008

(a) What was the level and path of Government debt among euro Countries?

For example, Greece's government debt increased from 98% of GDP in 2000 to 112% of GDP
in 2008. Italy's government debt stayed constant from 106% of GDP in 2000 to 105% of GDP
in 2008. Portugal's government debt increased from 53% of GDP in 2000 to 71% of GDP in
2008. Spain's government debt decreased from 56% of GDP in 2000 to 40% of GDP in 2008.
Germany's government debt decreased from 61% of GDP in 2000 to 65% of GDP in 2008.
Austria's government debt decreased from 67% of GDP in 2000 to 60% of GDP in 2008.
Overall, the increase in government debt across many Eurozone countries stayed
relatively reasonable which is not the main cause of the following crisis.

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(b) What was the level and path of private debt, lending and external imbalances among euro
countries?

During the period from 2000-2008, there were significant imbalances in private debt, lending,
and external trade among Eurozone countries. Specifically:

- Private debt: Private debt increased significantly in several Eurozone countries,

particularly in the form of household debt. For example, household debt in Spain increased
from 50% of GDP in 2000 to 86% of GDP in 2008. In Ireland, household debt increased
from 44% of GDP in 2000 to 135% of GDP in 2008.
- Lending: There was significant lending between Eurozone countries during this period,
particularly from countries with large current account surpluses (such as Germany) to
countries with large current account deficits (such as Greece and Spain). This created a
system of creditor and debtor countries within the Eurozone.
- External imbalances: There were significant external imbalances between Eurozone
countries, particularly in terms of trade deficits and surpluses. Countries like Germany and
the Netherlands ran large trade surpluses, while countries like Greece and Spain ran large
trade deficits.
Overall, these imbalances created significant vulnerabilities within the Eurozone and
contributed to the difficulties experienced during the Great Recession of 2008-2009. When the
global financial crisis hit, these imbalances were exposed, and the resulting economic shock
had particularly severe impacts on countries with high levels of debt and weak external
positions.

(c) Can current account imbalances be benign?

Current account imbalances can be benign in some cases. A current account surplus, which
represents an excess of exports over imports, can be seen as positive for a country if it is the
result of a strong export sector and reflects the competitiveness of the country's goods and
services. In this case, the surplus can be viewed as a sign of strength in the economy.
Similarly, a current account deficit, which represents an excess of imports over exports, can be
seen as positive for a country if it is the result of strong investment flows, such as foreign direct
investment or portfolio investment, that are financing productive activities within the country.
In this case, the deficit can be viewed as a sign of confidence in the country's economy.

3. Lehman and the Euro Bank crisis of 2007

(a) What was the role of the US Housing Bubble to the Euro crisis?

First, the collapse of Lehman Brothers in September 2008 triggered a global financial crisis
that spread rapidly to Europe. This crisis led to a sharp contraction in credit markets, making it
difficult for European banks to access the funding they needed to support their operations.
Second, the US housing bubble had driven demand for exports from many Eurozone countries,
particularly those in Northern Europe, which had strong export sectors. As the US housing
market collapsed, demand for these exports fell, leading to a decline in economic activity and
job losses in these countries.
Third, many European banks had invested heavily in US mortgage-backed securities, which
were at the heart of the US housing bubble. When these securities lost value, many European
banks suffered significant losses, which further weakened their balance sheets and made it
difficult for them to support economic activity in their home countries.

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(b) What was the role of the banking sector in European crisis?

Excessive lending: Prior to the crisis, many European banks engaged in excessive lending,
particularly to borrowers in countries with weak economic fundamentals. This led to a build-
up of debt in these countries, which ultimately became unsustainable and triggered the crisis.
Exposure to toxic assets: European banks were heavily exposed to toxic assets, such as
mortgage-backed securities, which were at the heart of the US housing bubble. When these
assets lost value, many European banks suffered significant losses, which weakened their
balance sheets and made it difficult for them to support economic activity in their home
countries.
Interconnectedness: The banking sector in Europe was highly interconnected, with many
banks holding large amounts of debt from other banks and from highly indebted countries. This
created a domino effect, where losses in one bank or country could quickly spread to other
banks and countries, leading to a crisis of confidence in the entire European banking system.
Sovereign debt crisis: The European crisis was also triggered by a sovereign debt crisis, as
several countries, including Greece, Portugal, and Spain, struggled to service their debt. Banks
that held significant amounts of sovereign debt from these countries were particularly
vulnerable to losses.

(c) How did we go from a Financial Shock to Sovereign Debt Crisis?

The 2008 financial crisis, which began with the collapse of Lehman Brothers in the US, led to
a sharp contraction in credit markets and a global recession. This financial shock had
significant ripple effects on the European economy, particularly on the banking sector. Many
European banks were heavily exposed to toxic assets, such as mortgage-backed securities,
which lost value during the crisis, leading to significant losses for the banks.
As a result of these losses, European banks became more risk-averse and began to cut back
on lending, particularly to borrowers in countries with weak economic fundamentals. This led
to a credit crunch in many countries, which exacerbated their economic problems.
At the same time, several European countries were grappling with high levels of sovereign
debt. These countries, including Greece, Portugal, and Spain, had taken on large amounts of
debt in the years leading up to the crisis, and were struggling to service this debt as their
economies weakened.
The combination of the banking sector's pullback on lending and the sovereign debt crisis
created a vicious cycle, where weak economic growth and high debt levels in many European
countries led to a loss of confidence in their ability to repay their debts. This, in turn, led to
a further tightening of credit conditions, making it even more difficult for these countries to
grow their way out of the crisis. SELF-FULFILLING PROPHECY
Ultimately, the financial shock of 2008 and the subsequent credit crunch led to a sovereign
debt crisis in many European countries. The banking sector's exposure to toxic assets and the
resulting losses contributed to a decline in lending, which exacerbated economic problems in
many countries. The high levels of sovereign debt in these countries, combined with a loss of
confidence in their ability to repay this debt, led to a prolonged crisis that had significant social
and economic consequences.

(d) What are the risks of Multiple Equilibria when Sovereign Debt is High?

When a country's sovereign debt is high, there is a risk of multiple equilibria, which refers to
the possibility that there could be more than one outcome or equilibrium for the country's
economy. In the context of a high sovereign debt situation, the risks of multiple equilibria arise

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because of the feedback loop between the economy and the market's perception of the country's
ability to service its debt.
If investors perceive that a country's sovereign debt is too high and that there is a risk of default,
they may start to demand higher interest rates to compensate for the perceived risk. This, in
turn, can make it more difficult for the country to service its debt, as higher interest rates
increase the cost of borrowing. If the higher interest rates lead to a decline in economic growth,
this can further weaken the country's ability to service its debt, leading to a self-reinforcing
cycle of rising interest rates, lower economic growth, and increasing debt levels.
In such a situation, there could be two possible equilibria: a good equilibrium where the country
is able to service its debt and interest rates are low, and a bad equilibrium where the country
defaults on its debt and interest rates skyrocket. The risk of multiple equilibria arises because
it is possible for the country to get stuck in the bad equilibrium, even if the underlying economic
fundamentals are not that different from those in the good equilibrium. This can happen if
investors lose confidence in the country's ability to service its debt, leading to higher interest
rates and a self-reinforcing cycle of rising debt and interest rates.
The risks of multiple equilibria are particularly acute in the context of high sovereign debt
levels, as the market's perception of a country's ability to service its debt plays a crucial role in
determining the country's economic outcomes. To avoid the risks of multiple equilibria, it is
important for countries to maintain sound fiscal policies and to build a track record of
responsible debt management. This can help to build confidence in the country's ability to
service its debt, reducing the risk of a self-reinforcing cycle of rising interest rates and debt
levels.

(e) Which policies might encourage the “good” equilibrium?

To encourage the "good" equilibrium in a high sovereign debt situation, policymakers can
implement several policies. Here are some examples:
- Fiscal discipline: One of the most important policies to encourage the good equilibrium is
to maintain fiscal discipline. Governments can do this by implementing a sound fiscal
policy, such as reducing government spending, increasing taxes, or both, to reduce the
budget deficit and slow down the growth of the debt.
- Structural reforms: Implementing structural reforms such as labor market reforms,
financial sector reforms, and product market reforms can increase the economy's
productivity and competitiveness, which can improve economic growth, reduce
unemployment, and enhance the country's ability to service its debt.
- Monetary policy: Central banks can implement an accommodative monetary policy, such
as low-interest rates, to reduce the cost of borrowing, stimulate investment, and boost
economic growth.
- International support: International support can also help countries to overcome the bad
equilibrium. For example, the International Monetary Fund (IMF) can provide financial
assistance to countries in debt distress, conditional on implementing structural reforms, to
restore market confidence and reduce the risk of default.
- Debt restructuring: In some cases, debt restructuring can also help countries to overcome
the bad equilibrium. This involves negotiating with creditors to reduce the debt burden or
extend the repayment period. Debt restructuring can help to reduce the risk of default and
restore market confidence in the country's ability to service its debt.
Overall, policymakers should aim to build a track record of responsible debt management,
which can help to build confidence in the country's ability to service its debt and reduce the
risk of multiple equilibria. By implementing policies that encourage the good equilibrium,

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countries can avoid the self-reinforcing cycle of rising interest rates and debt levels and achieve
sustainable economic growth.

4. 2010: How did the crisis spread to the periphery?

In the Eurozone, the crisis initially affected the peripheral countries, such as Greece, Ireland,
Portugal, and Spain, before spreading to other countries in the region. Here's how the crisis
spread to the periphery:
- Contagion effect: The financial crisis in the US spread to Europe through a contagion
effect. As the US financial system deteriorated, investors became increasingly risk-averse
and began to withdraw their funds from European banks, particularly those with significant
exposure to the US mortgage market.
- Interconnectedness: The interconnectedness of the global financial system meant that the
crisis quickly spread to other European countries. Banks in Europe had extensive cross-
border lending and borrowing relationships, which meant that the problems in one country
could quickly spill over into others.
- Housing market collapse: In some peripheral countries, such as Spain and Ireland, the
crisis was exacerbated by a housing market collapse. The housing market bubble had led
to a surge in construction and investment, but when the bubble burst, it triggered a sharp
contraction in the economy and a rise in unemployment.
- Government debt: Many of the peripheral countries had high levels of government debt,
which made them vulnerable to market volatility and investor concerns about default risk.
This was particularly true in the case of Greece, which had a history of poor fiscal
management and high levels of debt.
- Economic imbalances: Some of the peripheral countries, such as Greece, had significant
economic imbalances, such as a large current account deficit, which meant they were
heavily reliant on foreign borrowing to finance their deficits. This made them vulnerable
to sudden shifts in investor sentiment and capital flows.
Overall, the crisis spread to the periphery due to a combination of interconnectedness,
contagion effects, housing market collapses, high government debt, and economic imbalances.
These factors combined to create a perfect storm that quickly spread from one country to
another, ultimately leading to a wider crisis in the Eurozone.

5. 2011: How did the Contagion spread to the core?

???

6. What were the Policy responses?

- Bailouts: The Eurozone countries and the IMF provided financial assistance to the
peripheral countries in the form of bailouts. These bailouts were aimed at helping these
countries finance their debt and avoid default. The conditions of the bailouts included
implementing austerity measures, structural reforms, and privatization of state assets.
- European Financial Stability Facility (EFSF) and European Stability Mechanism
(ESM): The EFSF and ESM were established as temporary and permanent mechanisms,
respectively, to provide financial assistance to Eurozone countries in need. These
mechanisms had the ability to issue bonds and provide loans to countries in exchange for
economic reforms and austerity measures.

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- Quantitative easing (QE): The European Central Bank (ECB) implemented a series of
QE programs, where it bought government bonds and other securities from banks, to
provide liquidity to the financial system and support economic growth.
- Fiscal consolidation: The peripheral countries implemented austerity measures to reduce
their budget deficits and debt levels. This involved cutting government spending,
increasing taxes, and reforming pensions and social security systems.
- Banking union: The Eurozone countries agreed to establish a banking union to
strengthen the banking sector and prevent future banking crises. This included the
establishment of a single supervisory mechanism and a single resolution mechanism.
- Structural reforms: The peripheral countries implemented structural reforms to improve
their competitiveness and productivity. These reforms included labor market reforms,
product market reforms, and measures to promote entrepreneurship and innovation.

7. 2012: What was the Draghi’s” whatever it takes”? Why was it needed and what was the
outcome?

In July 2012, the Eurozone crisis reached a critical point with rising borrowing costs for Italy
and Spain, two of the largest economies in the Eurozone. European Central Bank (ECB)
President Mario Draghi gave a speech in London, in which he declared that the ECB would do
"whatever it takes" to preserve the euro and promised to use "unlimited" bond purchases
to bring down borrowing costs for struggling countries.
The "whatever it takes" statement was needed because it sent a clear signal to financial markets
that the ECB was willing to take decisive action to prevent the breakup of the Eurozone.
This statement helped to restore confidence in the Eurozone and alleviate the crisis by
reducing the risk of a sovereign debt default.
The outcome of Draghi's statement was significant. It led to a sharp decline in borrowing
costs for Italy and Spain, which had previously been seen as at risk of default. The ECB's
bond-buying program, known as Outright Monetary Transactions (OMT), was launched in
September 2012 and helped to stabilize the Eurozone crisis by providing a backstop to
sovereign debt markets. BUT it was never really used!!!
Overall, Draghi's "whatever it takes" statement was a turning point in the Eurozone crisis. It
helped to ease concerns about the survival of the euro and provided a framework for future
policy actions to address the underlying economic challenges facing the Eurozone.

8. Was fiscal profligacy the main Cause of the crisis?

Fiscal profligacy (the act of spending money or using something in a way that wastes it and is
not wise) was not the main cause of the Eurozone crisis, although it was certainly a
contributing factor.
While fiscal profligacy was not the main cause of the crisis, it did play a role in the buildup of
government debt in some countries, particularly in the periphery. However, it's important to
note that government debt levels were not excessively high in all crisis-hit countries, and
in some cases, they were lower than in other Eurozone countries that were not in crisis.

9. What were the main causes of the crisis?

The crisis had multiple causes, including:

- Banking sector weaknesses: Banks in some countries had invested heavily in real estate
and other risky assets before the crisis, leading to large losses when the housing bubble
burst.

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- Current account imbalances: Some countries, particularly those in the periphery, ran
large current account deficits before the crisis, financed by capital inflows from countries
in the core.
- Flaws in the design of the Eurozone: The Eurozone was an incomplete currency area,
lacking a fiscal union and common deposit insurance, which made it vulnerable to crises.
- Poor economic governance: Some countries in the periphery engaged in fiscal
profligacy and failed to implement structural reforms, exacerbating the crisis.

10. What improvements have been made so far?

In response to the Eurozone crisis, various improvements have been made to strengthen the
resilience of the Eurozone and reduce the likelihood of future crises. Some of these
improvements include:
- Establishment of the European Stability Mechanism (ESM): The ESM is a permanent
crisis resolution mechanism that can provide financial assistance to Eurozone countries in
need. It replaced the temporary European Financial Stability Facility (EFSF) and has a
larger lending capacity.
- Strengthening of fiscal rules: The Fiscal Compact Treaty was signed in 2012, which
enshrined stricter fiscal rules for Eurozone countries, including a requirement to have
balanced budgets and limit public debt.
- Banking Union: The Banking Union was established in 2014 and includes a Single
Supervisory Mechanism (SSM) and a Single Resolution Mechanism (SRM) for banks in
the Eurozone. The SSM oversees and supervises the largest banks in the Eurozone (The
SSM ensures that banks are subject to the same set of rules and supervised on the basis of
common standards. This reduces the risks of spillovers from bank failures to sovereigns
and provides a common framework conducive to further integration in the banking markets,
a process which has been lagging), while the SRM provides a framework for resolving
failing banks in an orderly manner.
- Macroeconomic imbalances procedure: The Macroeconomic Imbalances Procedure
(MIP) was introduced in 2011 to identify and address potential macroeconomic imbalances
within the Eurozone.
- Creation of the European Monetary Fund (EMF): The EMF was proposed in 2017 as a
replacement for the ESM and would provide a permanent source of financial support for
Eurozone countries in crisis.
- Progress towards a banking union: Work is ongoing towards completing the Banking
Union, including the establishment of a European Deposit Insurance Scheme (EDIS) to
protect depositors across the Eurozone. The EDIS would strengthen depositors’ confidence
through an equal level of depositor protection across Member States and therefore promote
financial integration. Ultimately, a fully-fledged EDIS would be strengthened by the
pooling of resources, thus building confidence in the single currency, throughout the
Monetary Union
These improvements have strengthened the resilience of the Eurozone and reduced the
likelihood of future crises. However, challenges still remain, and there is ongoing debate about
the need for further reforms, such as a fiscal union and greater political integration.

11. What are the remaining problems in the Eurozone?

- High levels of public debt: Several Eurozone countries still have high levels of public
debt, which can make them vulnerable to future economic shocks. While the Fiscal

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 Compact Treaty has helped to strengthen fiscal rules, more needs to be done to reduce debt
levels.
- Persistent economic disparities: There are significant economic disparities between
different countries within the Eurozone, with some countries experiencing high levels of
unemployment and low growth. This can create tensions within the Eurozone and make it
difficult to maintain a stable currency union.
- Incomplete banking union: While progress has been made towards a banking union, some
key components, such as a European Deposit Insurance Scheme (EDIS), have yet to be
fully implemented. This can make it difficult to address banking crises within the Eurozone.
- Lack of political integration: The Eurozone remains a currency union without a
corresponding political union. This can make it difficult to make decisions at the European
level and can create tensions between member states.
- Lack of fiscal transfers: The Eurozone does not have a system of fiscal transfers, where
wealthier countries provide financial assistance to poorer countries. This can make it
difficult for countries experiencing economic difficulties to recover.

12. What more is needed to fix the Eurozone?

??? Isn’t the same as question 11?

13. What is the connection between Currency Area theory and the Euro Crisis?

The Euro Crisis can be understood in the context of Currency Area theory, which is a branch
of macroeconomics that seeks to identify the conditions under which a group of countries can
successfully share a common currency. Currency Area theory suggests that successful currency
unions require a high degree of economic convergence, a flexible labor market, a strong
banking system, and a central fiscal authority to manage fiscal transfers and adjust to economic
shocks.
The Euro Crisis highlighted the challenges of maintaining a currency union without these
necessary conditions in place. Despite the efforts to achieve economic convergence through
the Maastricht Treaty, countries within the Eurozone continued to experience diverging
economic conditions and struggled to respond to economic shocks. The lack of a central fiscal
authority and the incomplete banking union made it difficult to coordinate policy responses
and mitigate the impact of the crisis.
The Euro Crisis also highlighted the risks associated with high levels of public and private debt
within a currency union, which can lead to contagion and multiple equilibria. These issues have
led to calls for reforms to strengthen the institutional framework of the Eurozone and promote
greater economic convergence among member states.

13
 Risk-sharing
1. How would you define risk-sharing?

Risk-sharing refers to the process by which individuals or groups of individuals share the
financial risks associated with uncertain outcomes. In the context of finance, risk-sharing
involves spreading the risk of potential losses across different parties, such as investors,
lenders, and borrowers. This is typically achieved through various financial instruments, such
as insurance, hedging, diversification, and pooling of resources.
In the context of macroeconomics, risk-sharing refers to the sharing of economic risks across
different regions or countries. For example, in a monetary union, such as the Eurozone, the
idea of risk-sharing implies that the costs and benefits of economic shocks should be shared
equitably among member states. This may involve mechanisms such as fiscal transfers,
common financial instruments, and joint policies to promote economic convergence and
mitigate the impact of economic shocks. The goal of risk-sharing is to promote stability, reduce
uncertainty, and enhance economic welfare.

2. What types of risk-sharing can we have?

- Insurance: This involves paying a premium to transfer the risk of financial losses to an
insurance company. In exchange, the insurance company assumes the risk and pays out
compensation in case of loss.
- Diversification: This involves spreading investments across a range of assets, such as
stocks, bonds, and real estate, to reduce the overall risk of loss.
- Hedging: This involves using financial instruments, such as derivatives or futures
contracts, to protect against potential losses from adverse market movements.
- Fiscal transfers: This involves the redistribution of financial resources from one region or
country to another in order to mitigate the impact of economic shocks.
- Joint policies: This involves coordinating economic policies across different regions or
countries in order to promote stability and mitigate the impact of economic shocks.
- Common financial instruments: This involves creating financial instruments that are
shared across different regions or countries, such as Eurobonds or a common deposit
insurance scheme.
- ALL above is not really applicable to risk sharing for OCA I think… (the following
seems more accurate)
- The first is by de-linking consumption and income at the local level, which happens through
integrated capital markets. If labour income falls during a recession, but the private sector
holds a diversified financial portfolio, people can smooth their consumption with the
financial returns they receive on assets in better performing parts of the union.
- The second way is by de-linking the capital of local banks from the volume of local credit
supply, which happens through retail banking integration. Because local banks are typically
heavily exposed to the local economy, a downturn in their home region will lead to large
losses and prompt them to cut lending to all sectors. But if there are cross-border banks that
operate in all parts of the union, they can offset any losses made in the recession-hit region
with gains in another and can continue to provide credit to sound borrowers.

14
 3. How can we compare risk-sharing between the EMU and the USA?

The European Monetary Union (EMU) and the United States are both currency unions, but
there are some significant differences in the degree of risk-sharing that occurs between them.
Here are a few ways in which risk-sharing in the EMU and the USA can be compared:
- Fiscal transfers: In the United States, there is a significant amount of fiscal transfers
between states, such as the federal government providing aid to states affected by natural
disasters. In the EMU, there is a limited number of fiscal transfers, with only a small portion
of the EU budget allocated to cohesion and structural funds.
- Banking union: The United States has a fully integrated banking system, with a single
regulator (the Federal Reserve) and a common deposit insurance scheme (the Federal
Deposit Insurance Corporation). In the EMU, there is a banking union in place, but it is still
being developed and is not yet fully integrated.
- Capital markets: The United States has a highly integrated capital market, with investors
able to easily move capital between states. In the EMU, capital markets are not yet fully
integrated, with differences in regulations and legal systems making it more difficult for
investors to move capital across borders.
- Labor mobility: Labor mobility is higher in the United States than in the EMU, with
workers able to move relatively easily between states to find employment. In the EMU,
labor mobility is limited by language barriers and differences in social welfare systems.
Overall, the United States has a higher degree of risk-sharing than the EMU, with greater
fiscal transfers, a fully integrated banking system, and a highly integrated capital market. The
EMU is working to increase risk-sharing through the development of a banking union,
greater fiscal integration, and the creation of common financial instruments such as
Eurobonds. However, there are still significant differences between the two currency unions,
and more work is needed to fully integrate the economies and create a truly unified financial
system.

4. Why is risk sharing important, especially in the EMU?

It can help to mitigate the negative effects of economic shocks and improve economic
stability. In the absence of a common fiscal policy and full labor mobility, risk sharing can be
an effective way to redistribute resources and smooth out economic fluctuations between
member states. By sharing risks, shocks that affect one country disproportionately can be
spread across the entire currency area, reducing the impact on any individual member state.
In the EMU, risk sharing is particularly important because of the high level of economic
interdependence between member states. A shock in one member state can quickly spread
to other member states and potentially trigger a broader crisis, as was seen during the Eurozone
crisis. Moreover, the absence of a common fiscal policy means that individual member states
may not have the necessary fiscal resources to respond to shocks on their own, making risk
sharing even more crucial.

5. What steps do we need to take to improve risk-sharing in the EMU?

- Strengthening the banking union: One of the key mechanisms for risk-sharing in the
EMU is through a common banking system. A fully integrated banking union would help
to break the link between banks and sovereigns and enable greater sharing of risk across
the Eurozone. This could be achieved by creating a common deposit insurance scheme,
harmonizing rules for bank resolution, and establishing a centralized fiscal backstop.

15
- Establishing a common fiscal capacity: A common fiscal capacity could be used to
provide automatic stabilizers in the form of unemployment insurance or other forms of
income support during economic downturns. This would help to redistribute resources
across member states and reduce the impact of shocks on individual countries.
- Developing a Eurozone-wide safe asset: A safe asset that is backed by the entire Eurozone
would help to improve risk sharing by providing a low-risk investment option for investors
across the currency area. This would help to reduce the fragmentation of financial markets
and promote greater integration.
- Promoting labor mobility: Labor mobility is an important mechanism for sharing risk
across the currency area. Policies that promote labor mobility, such as reducing barriers to
migration and improving recognition of qualifications, could help to reduce the impact of
regional economic shocks.
- Strengthening the Stability and Growth Pact: The Stability and Growth Pact is designed
to promote fiscal discipline and coordination among member states. Strengthening the Pact
could help to reduce the likelihood of fiscal imbalances and improve risk sharing by
promoting greater fiscal stability across the Eurozone.

6. What was the role of the Euro area financial assistance instruments during the great
recession for shock absorption through risk-sharing?

The European Stability Mechanism (ESM) was created in 2012 to provide financial
assistance to Eurozone countries facing severe economic and financial difficulties. It can
provide loans to member states in need of financial support, subject to conditionality. By
providing financial assistance, the ESM helps to stabilize financial markets and prevent
contagion from spreading to other member states. This helps to improve risk-sharing across the
Eurozone by ensuring that shocks in one country do not lead to broader economic and financial
instability.
In addition to the ESM, the European Financial Stability Facility (EFSF) was established in
2010 as a temporary instrument to provide financial assistance to countries in need. The EFSF
was replaced by the ESM in 2012, but it played an important role in providing financial support
to countries like Greece, Ireland, and Portugal during the early stages of the crisis.
Overall, the Euro area financial assistance instruments helped to improve risk-sharing by
providing financial support to countries facing economic and financial difficulties, thereby
reducing the risk of contagion and spillovers to other member states. However, there are still
ongoing debates about how to improve and reform these instruments to make them more
effective and sustainable in the long run.

7. What is the relationship between private and public risk sharing mechanisms? Are they
substitute complements? Does it depend on the state of the economy?

During normal times, private risk-sharing mechanisms, such as financial markets, are expected
to play a significant role in absorbing shocks. Private risk sharing can be achieved through
capital flows across regions, interregional trade, and migration, among others. However, during
a crisis or a severe economic downturn, private risk-sharing mechanisms may become
inadequate or even dysfunctional, as market participants become more risk-averse and credit-
constrained.
In such circumstances, public risk-sharing mechanisms, such as fiscal transfers or insurance
schemes, become crucial for maintaining economic stability and mitigating the impact of the
crisis. Public risk sharing complements private risk sharing by providing a stable source of
funding and reducing the uncertainty and volatility of private markets.

16
Therefore, the relationship between private and public risk sharing mechanisms is dynamic and
depends on the state of the economy. In normal times, they can be substitutes, but in times of
crisis, they become complements to ensure sufficient risk-sharing and shock absorption.

!!! Not sure about the explanation from chatGPT above!!!

WORDS TO KNOW:
ESBIES EDIS
ESM SRM
EFSF SSM
OMT DGS
TPI ESA
QE EMF
NEXTGENEU
SURE
MFA

17
 Banking Union
1. Why do we need a banking Union?

To ensure financial stability: A banking union can help prevent financial crises by
establishing a common supervisory framework and a common deposit insurance system that
can absorb the impact of bank failures.
To facilitate cross-border banking: A banking union can remove barriers to cross-border
banking and make it easier for banks to operate across borders. This can help increase
competition, reduce fragmentation, and improve the efficiency of the banking sector.
To break the link between banks and sovereigns: In many European countries, the health of
the banking sector is closely linked to the health of the sovereign. A banking union can help
break this link by establishing a common resolution framework and a common deposit
insurance system that are independent of national governments.
To strengthen the monetary union: A banking union can strengthen the monetary union by
ensuring that the transmission of monetary policy is effective across all member states. This
can help reduce divergence in economic performance and promote convergence.

2. What are the current problems in the banking sector?

- Non-performing loans (NPL’s): Many banks in the Eurozone have high levels of non-
performing loans on their balance sheets, particularly in countries that were hit hardest by
the financial crisis. This makes it difficult for these banks to extend new credit to borrowers
and can constrain economic growth.
- Low profitability: Many banks in the Eurozone are struggling to earn profits due to low
interest rates, increased regulatory costs, and competition from non-bank financial
institutions. This can make it difficult for them to build up sufficient capital buffers to
weather future economic shocks.
- Fragmentation: The banking sector in the Eurozone is highly fragmented, with banks
operating under different regulatory regimes and with different levels of financial stability.
This makes it difficult to create a level playing field and can lead to regulatory arbitrage.
- Home bias: Banks in the Eurozone tend to have a strong bias towards investing in their
home countries, which can lead to a concentration of risk in particular countries or regions.
- Lack of cross-border banking activity: There is currently limited cross-border banking
activity in the Eurozone, which can limit the ability of banks to diversify risk and create
economies of scale.

3. What are the components of the Banking Union?

Single Supervisory Mechanism (SSM): This involves the European Central Bank taking on
a supervisory role over all euro area banks. The ECB has the authority to directly supervise
significant banks, while national authorities supervise less significant banks under the oversight
of the ECB.
Single Resolution Mechanism (SRM): This involves the creation of a centralized authority
responsible for the orderly resolution of failing banks in the euro area. The SRM is responsible
for the development and implementation of resolution plans, as well as the provision of
financial assistance to failing banks.
Deposit Insurance Scheme (DIS): This is a common deposit insurance scheme for the euro
area that provides a minimum level of protection for depositors in the event of bank failure.

18
Common Backstop: This is a reserve fund that serves as a last resort for the SRM in case the
resolution of a failing bank exceeds the available resources of the Single Resolution Fund
(SRF).

4. Will bail-in improve the stability of the banking sector?

Instead of relying on state money for a bailout, the bail-in method enables a failing bank to be
reorganized by inflicting losses on its owners and creditors. The intention is to shift financial
burdens from taxpayers to the bank's shareholders and creditors.
By bringing the interests of bank owners and creditors into line with those of the general public,
bail-in aims to increase the stability of the banking industry. It tries to lessen the moral hazard
connected to bailouts, which may push banks to take excessive risks.
Yet, it is unclear how well bail-in has worked to increase the stability of the banking industry.
Bail-in could bring about a unique set of issues. For example, if bank shareholders and creditors
fear that they may be bailed in, they may demand higher returns on their investments to
compensate for the increased risk. Banks may incur greater funding expenses as a result, which
might lower their profitability and limit their ability to make loans. This can set off a vicious
cycle of falling profits, restricted lending, and growing losses.
Furthermore, if bail-in is not implemented in a coordinated and uniform manner across
jurisdictions, there is a chance that it could have a domino effect and cause systemic risk.
Instead of strengthening financial stability, this might make things worse.

5. Explain the sovereign-bank doom-loop:

The sovereign-bank doom-loop refers to the feedback loop between weak banks and weak
sovereigns, where the problems of one lead to the problems of the other, creating a vicious
cycle:
- Weak banks: Banks in a country may suffer from weak balance sheets due to bad loans,
losses on securities, or other problems. This makes them vulnerable to shocks and increases
the likelihood of bank failures or bailouts.
- Contagion: If a bank fails or is bailed out, it can cause a loss of confidence in other banks
in the same country or in the broader financial system. This can lead to a run on the banks
or the freezing of interbank lending, which can exacerbate the crisis.
- Sovereign debt: If a country must bail out its banks or suffers from a banking crisis, it can
lead to a significant increase in public debt. This can cause a loss of confidence in the
country's ability to repay its debt, leading to higher borrowing costs and the risk of default.
- Bank exposure: Banks in the same country often hold a significant amount of the
government's debt, making them vulnerable to sovereign risk. If the government defaults
on its debt or is downgraded, it can lead to significant losses for the banks, which can further
weaken their balance sheets and increase the risk of failure.
As a result, the sovereign-bank doom-loop can produce a vicious cycle of financial instability,
in which issues in the banking industry trigger issues in the market for national debt, which in
turn weakens the banks even more.

19
 6. How can the Banking Union break the sovereign-bank doom loop?

- Centralized supervision: The establishment of a single supervisory mechanism (SSM)

allows for a more centralized oversight of banks across the Eurozone. This helps to ensure
that banks are properly capitalized, and their risks are effectively managed, reducing the
risk of bank failures.
- Centralized resolution: The establishment of a single resolution mechanism (SRM)
ensures that failing banks can be resolved in a coordinated and effective manner, with a
common set of rules and tools. This reduces the risk of bank failures and helps to prevent
contagion from spreading to other banks and sovereigns.
- Bail-in: The new bail-in rules require shareholders and bondholders of failing banks to take
losses before taxpayers, reducing the burden on the public sector. This makes it less likely
that a bank failure will lead to a sovereign debt crisis, as the losses are absorbed by private
investors rather than taxpayers.
- Deposit insurance: The establishment of a common deposit insurance scheme (EDIS)
provides additional protection to depositors and reduces the risk of bank runs. This helps
to prevent the spread of contagion from one bank to another and reduces the risk of a
systemic crisis.

7. What do you need to complete the Banking Union? Why hasn’t been completed?

????

8. What is the usefulness of the EDIS? Why some Countries oppose?

With the objective of further lowering the danger of bank runs and enhancing financial
stability in the EU, the European Deposit Insurance Scheme (EDIS) is a proposed program
that would offer a common deposit insurance for all depositors in the EU. The EDIS would
protect deposits up to €100,000 and would supplement the current national deposit
guarantee systems (DGS). By eliminating the national bias in deposit insurance and lowering
hurdles for financial institutions doing business internationally, the program is also anticipated
to boost financial integration.
Some EU nations, especially those with more robust banking systems and stable banks, have
rejected the EDIS, nonetheless. One of these nations' main worries is that, because of a shared
deposit insurance scheme, they would be forced to foot the bill for the bank failures of other
nations. They are also worried that the plan may lessen incentives for individual nations to
maintain solid banking and fiscal systems because they may believe that other nations will step
in to save them in times of crises. Several nations are also concerned that the system could put
them at risk for fraud and moral hazard.

9. What is the current status of the political debate in Europe?

Some countries, particularly those in Northern Europe, have expressed concerns about the
potential cost of such measures and have been hesitant to cede too much sovereignty to a
centralized European system. Other countries, particularly those in Southern Europe, have been
more supportive of the Banking Union and EDIS as a way to promote stability and risk-sharing
within the eurozone.

20
 Capital Markets Union
1. How would you define a European capital market?

A financial system known as a "European capital market" allows governments and corporations
to generate money by issuing bonds, stocks, and other financial products, which investors may
then purchase. By putting investors in touch with borrowers and offering a marketplace for
buying and selling securities, it is a mechanism that makes it possible for capital to be allocated
efficiently throughout Europe. A European capital market attempts to establish an unified
market for capital that enables companies and governments to raise money more affordably,
fosters competition, and supports economic expansion and monetary stability throughout the
European Union.

2. How is the European bank and capital markets landscape?

???

3. How capital markets and risk sharing compare with other advanced economies?

???

4. Why is Europe most more bank based compared to other advanced economies?

The organization of the financial sector is one factor in the importance of banks in Europe:
A few numbers of sizable universal banks that offer a broad variety of financial services
dominate the banking industry in Europe. In contrast, the financial sector in the United States
is more fragmented and has specialized financial institutions for various business operations
including investment banking, commercial banking, and insurance. Because of this
fragmentation, it is now simpler for non-bank financial institutions to compete with American
banks.
The regulatory environment has also influenced the banking scene in Europe. In Europe,
banking regulation has historically been more focused on prudential regulation, with regulators
focused on ensuring the stability of the banking system, while in the United States, securities
regulation has traditionally been more focused on protecting investors. This has led to a
different approach to risk management in Europe, with banks relying more heavily on collateral
and balance sheet management, rather than risk transfer mechanisms like securitization.

5. What does economic research say about the optimal finance structure between bank based
and capital markets’ system?

NOT SURE FOR 5 and 6

6. Optimal financial structure - what does the literature tell us?

The literature on the optimal financial structure suggests that there is no one-size-fits-all
approach, and the optimal financial structure may depend on various factors, including the
country's stage of economic development, the size of the economy, the quality of institutions,
the legal and regulatory framework, and the availability of information.

21
 7. What are the economic costs of having a fragmented capital market (and benefits of the
CMU)?

Fragmented Capital Market

- Higher financing costs: Companies in different EU member states have access to different
types of funding and investors, and this fragmentation can lead to higher financing costs
for firms in certain countries. Companies in countries with less developed capital markets
may face difficulties accessing the same types of funding or have to pay higher costs to do
so, compared to firms in countries with more developed capital markets.
- Limited investment opportunities: Fragmentation in the capital markets can also lead to
a lack of investment opportunities, particularly for retail investors who may have limited
access to investment products available in other member states. This can lead to suboptimal
investment decisions and lower returns for investors.
- Hinders cross-border investment: Fragmentation can also hinder cross-border
investment and the free flow of capital, as regulatory differences and lack of harmonization
can create barriers to investment across different member states.
- Reduces economic growth: A fragmented capital market can ultimately reduce economic
growth, as it limits companies' ability to raise funds and invest in growth opportunities,
thereby impacting job creation, innovation, and productivity.

Benefits of CMU

- Increased funding options: By integrating national capital markets, companies would have
access to a wider range of funding options, including equity and debt, and would be able to
tap into a larger pool of investors.
- Improved risk-sharing: A more integrated capital market would also enable better risk-
sharing between member states, reducing the impact of economic shocks on individual
countries.
- Increased competition: Greater integration and competition in the capital markets would
help drive down costs and increase efficiency, benefiting both companies and investors.
- Facilitates cross-border investment: A more integrated capital market would facilitate
cross-border investment, enabling investors to diversify their portfolios and providing
companies with access to capital from across the EU.

8. How can the CMU help complete the Euro area? Is it easier and less controversial? Why?

???

9. The great recession was due to large current account (CA) deficits in some Countries.
Wouldn’t the creation of a CMU foster more capital movement and, thus, create more
imbalances and financial instability?

???

22
 Lecture 2 - Sovereign Debt and Default
1. Concepts: Private vs. sovereign, foreign vs. domestic, time-inconsistency

- Private vs. Sovereign: it refers to the distinction between debts owed by private entities,
such as households and businesses, and those owed by governments, such as national or
local governments. Private debts are generally considered to be the responsibility of the
borrower, while sovereign debts are backed by the full faith and credit of the government
and are therefore considered less risky.
- Foreign vs. Domestic debt: it refers to the distinction between debts owed to creditors
within a country (domestic) and those owed to creditors in other countries (foreign).
Foreign debts can be denominated in foreign currencies and subject to exchange rate risk.
- Time-inconsistency: it refers to the phenomenon where a government may commit to a
particular policy in the present, but then changes course in the future due to changing
circumstances or political pressures. This can create problems in areas such as debt
management, as it can lead to uncertainty among creditors and undermine the credibility of
the government's commitments.

2. Why do investors purchase Sovereign debt?

- Safe-haven asset: Sovereign debt of countries with strong economic and political
institutions, like the United States or Germany, is often considered a safe-haven asset by
investors during times of economic uncertainty or market turmoil.
- Yield: Sovereign debt can offer attractive yields compared to other low-risk investments,
such as cash or short-term bonds.
- Diversification: Sovereign debt can provide diversification benefits to an investor’s
portfolio, as it is often considered to be uncorrelated with other asset classes, such as
equities or corporate bonds.
- Liquidity: Sovereign debt is generally highly liquid, meaning it can be easily bought and
sold on the market, which can be attractive to investors who need to quickly adjust their
portfolios.
- Regulatory requirements: Banks and other financial institutions may be required by
regulators to hold certain amounts of sovereign debt as part of their capital requirements.

3. Why do Governments borrow?

- Consumption Smoothing: ability to spread consumption levels across time. That is,
having similar consumption levels independent of the state of the economy.
- Investment opportunities: the borrower has a good investment opportunity with expected
returns higher than the risk-free rate.
- Consumption front-loading: the government is more in need of resources for tis expenditure
needs than international savers.
- Political reasons: politicians cut taxes and increase spending to increase the
likelihood of being reelected.

23
 4. Why governments default? Ability, willingness, fundamental, self-fulfilling

Governments may default on their debt obligations for a variety of reasons, including their
ability to pay, willingness to pay, fundamental economic factors, and self-fulfilling
expectations.
- Ability to pay refers to the government's ability to generate enough revenue to meet its
debt obligations. If a government's revenue falls short of its debt obligations, it may default.
They can have liquidity problems: when the government has short-term difficulties in
raising funds to honor debt obligations. It can be solved by the intervention of a lender of
last resort such as the ECB or the IMF. They can have solvency problems: when its debt
exceeds the net present value (NPV) of the income it can generate for repayment purposes.
To be solved more complex procedures are needed, like debt renegotiations and
restructurings.
- Willingness to pay (strategic decisions based on cost-benefit analysis) refers to a
government's willingness to meet its debt obligations even if it can pay. A government may
be unwilling to pay if it believes that the costs of servicing its debt are too high, or if it is
politically difficult to do so.
- Fundamental economic factors (default happens due to economic (or political)
underlying country fundamentals such as low GDP, high debt/gdp levels, high current
account deficits) can also contribute to a government defaulting on its debt obligations. For
example, a sharp economic downturn, a sudden drop in commodity prices, or a major
natural disaster could reduce a government's revenue and make it more difficult to service
its debt.
- Self-fulfilling expectations (default happens not due to country’s fundamentals, but due to
coordination problems between creditors) can also lead to a government defaulting. If
investors believe that a government is likely to default, they may start selling its debt, which
could increase borrowing costs and make it more difficult for the government to service its
debt. This, in turn, could lead to a default, even if the government had the ability and
willingness to pay its debt.

Costs of refusing to repay debt obligation:

- Reputation costs: when a country default it will be (temporarily) excluded from
international markets. Country may be willing to pay its creditors to ensure access to
international capital markets.
- Economic sanctions: trade embargos and loss in foreign direct investment (FDI)

24
5. Know how to solve the 2-period sovereign debt model and to draw the conclusions about
debt and default.

25
 6. Solutions to sovereign debt problems

- Fiscal consolidation: This involves reducing government spending and increasing revenue
to bring down the budget deficit and stabilize the government's debt-to-GDP ratio.
- Debt restructuring: This involves renegotiating the terms of existing debt, such as
extending the maturity of the debt or reducing the interest rate, to make it more sustainable.
- Debt forgiveness: This involves canceling a portion of the debt owed by the government
to its creditors, usually in exchange for certain economic or policy reforms.
- International financial assistance: This involves providing loans or grants to a country in
financial distress, usually by international organizations such as the International Monetary
Fund or other bilateral lenders.
- Economic growth: By promoting economic growth and job creation, a government can
increase tax revenue and reduce the debt-to-GDP ratio over time.
- Default: This involves a government simply choosing to stop paying its debts, which can
have serious consequences for its economy and its reputation in the global financial
markets.

26
27
 7+7 Proposal
1. What are the main problems in the EZ found by this proposal?

The main problems identified in the 7+7 proposal are the lack of fiscal union, insufficient
risk-sharing mechanisms, incomplete Banking Union, and limited progress on completing
the Capital Markets Union. These factors have contributed to a fragile economic environment
in the Eurozone, making it more vulnerable to shocks and crises. The proposal argues that
addressing these issues is crucial for the long-term stability and prosperity of the Eurozone.

2. Why risk-sharing and risk reduction can be complements?

Because they address different aspects of financial stability:

- Risk-sharing mechanisms, such as a common deposit insurance scheme or a European
Safe Asset, aim to absorb and distribute risks across the Eurozone, reducing the likelihood
of bank runs and financial instability.
- Risk reduction measures, such as stricter bank regulations and supervision, aim to reduce
the likelihood of risks materializing in the first place. By reducing the likelihood of risks
and improving the absorption and distribution of those that do materialize, risk reduction
and risk-sharing can work together to strengthen financial stability.

3. What are the proposals to solve the NPL problem and breaking the doom-loop?

???

4. What are the risk reduction proposals to reform the fiscal architecture of the EZ?

- Establishing a common backstop for the Single Resolution Fund (SRF): This would
ensure that there is adequate funding available to handle the resolution of any failing banks
in the EZ, thereby reducing the potential costs for taxpayers.
- Harmonizing insolvency laws: The proposal recommends harmonizing insolvency laws
across the EZ to ensure a more efficient and transparent process for resolving insolvencies,
reducing legal uncertainty and the cost of restructuring.
- Developing a European Safe Asset (ESA): The proposal suggests creating a new type of
sovereign bond backed by a diversified pool of EZ government debt, which would serve as
a safe asset and help to reduce the sovereign-bank doom loop.
- Creating a European Unemployment Benefit Scheme (EUBS): The proposal
recommends establishing a centralized EUBS to provide financial support to workers who
have lost their jobs due to economic shocks, thereby reducing the social costs of
unemployment and providing a degree of risk-sharing across the EZ.
- Improving the governance of the Stability and Growth Pact (SGP): it suggests
strengthening the enforcement mechanisms of the SGP and introducing a more flexible
approach to fiscal rules, taking into account national circumstances.
- Completing the Banking Union: completing the Banking Union, including the
establishment of a European Deposit Insurance Scheme (EDIS), which would further
reduce the risk of bank runs and strengthen the resilience of the banking sector.
- Introducing a macroeconomic stabilization function: it suggests introducing a
centralized fiscal stabilization function to help mitigate the impact of economic shocks on
member states and promote risk-sharing across the EZ. This would involve the

28
 establishment of a European Fiscal Capacity (EFC) that could provide loans or grants to
member states facing severe economic downturns.

5. What are the risk-sharing proposals to reform the fiscal architecture of the EZ? What
problems do they solve?

- Eurozone-wide unemployment insurance: it would involve creating a common

unemployment insurance scheme for all Eurozone countries. This would allow for a more
efficient allocation of resources during downturns, as countries experiencing high
unemployment could receive financial assistance from other countries.
- European Safe Bonds (ESBies): it involves the creation of a new financial instrument that
combines the sovereign bonds of multiple Eurozone countries. These bonds would be
considered safe because they would be backed by a diversified pool of government debt.
- Fiscal capacity: it involves creating a common fiscal capacity for the Eurozone, which
would be used to fund stabilization policies during recessions. This could take the form of
a common budget or a common unemployment insurance scheme.
- European Monetary Fund (EMF): it involves transforming the existing European
Stability Mechanism (ESM) into a European Monetary Fund (EMF). The EMF would have
a wider range of powers and could provide financial assistance to member states during
times of crisis.

6. What are Paul De Grauwe’s critiques to using junior debt as a fiscal discipline device?

7. What are Paul De Grauwe’s critiques to sovereign debt restructuring?

8. What are Paul De Grauwe’s critiques to the safe asset proposal?

9. What is Tabellini’s critique on sovereign concentration charges?

10. What is Tabellini’s critique on Debt restructuring and the ESM?

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 European Safe Assets
1. What are the properties of European safe assets?

2. Why do we need these types of assets?

First, it could help reduce the excessive home bias in banks’ sovereign exposures, which
exacerbates the feedback loop between banks and sovereigns. Reforms to the resolution regime
have tackled the issue from one direction, from banks to the sovereign. However, at present,
there is no clear solution for tackling it in the other direction, from the sovereign to the banks.
The creation of a euro area-wide safe asset, composed of a pool of sovereign bonds, would lead
to a reduction in the home bias of banks’ portfolios by facilitating de-risking and
diversification.
Second, a euro area safe asset would be crucial for the financial integration and the capital
markets union. In fact, it is necessary for the creation of an integrated, deep and liquid European
bond market as a central piece of CMU. A single term structure of risk-free interest rates could
serve as a euro area pricing benchmark for the valuation of bonds, equities and other assets.
The safe asset could also be used as collateral, for example for repo and derivatives transactions
across the euro area.

3. How can they help with the sovereign-bank doom-loop?

SEE ABOVE

4. What is the German-block and French-block position about them?

5. What is the connection between SURE and NexGenEU?

6. What is the timeline of conventional and unconventional monetary tools used by the ECB?
How do European safe assets enter this timeline?

7. Do financial markets consider European common debt a safe asset?

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