The Future of The Euro (Brown Book 2012)

BROWN BOOK
XXVIII EDICIN DEL LIBRO MARRN
ANDRS DOMINGO AND DOMNECH VILARIO / DEZ GANGAS / DONGES / GARCA ANDRS / GROS Y ALCIDI / MARTNEZ RICO / REQUEIJO GONZLEZ / SNCHEZ FUENTES, HAUPTMEIER AND SCHUKNECHT /
The Future of the Euro

El futuro del euro
July 2012
JULIO 2012

Brown Book Madrid, July 2012
EDITION SPONSORED BY
2012, Crculo de Empresarios C/ Marqus de Villamagna, 3, 28001 Madrid The partial or total reproduction of this publication, or its handling by software, or its transmission under any circumstance or by any means, whether electronic, mechanical, by photocopies, recording or other means, without the express written consent of the copyright holders, is strictly forbidden. The articles reflect the opinions of the contributors, and not necessarily those held by Crculo de Empresarios.
Legal deposit: M-24161-2012 Design of collection: Miryam Anllo m.anllo@telefonica.net Illustration: Mara Jos Ruiz Publishing: Loft Produccin Grfica C/ Martn Macho, 15-1. 28002 Madrid (Spain) Printed by Atig, S.L. Parque Empresarial Neinor - Henares edificio 3 - nave 10
Index
Prologue
1. The future of the Euro after the Great Recession Javier Andrs and Rafael Domenech 15
2. Nature and Causes of the Euro crisis Jos Carlos Dez
63
3. The European crisis and the challenge of efficient economic governance Juergen B. Donges 97
4. The turbulent adolescence of the euro and its path to maturity Gonzalo Garca Andrs 131
5. Breaking the common fate of banks and governments Daniel Gros and Cinzia Alcidi 197
6. The fiscal institution in the Economic and Monetary Union: the contribution of Spain Ricardo Martnez Rico 227
7. The European Monetary Union: the Never-Ending Crisis Jaime Requeijo 265
8. Public expenditure policies during the EMU period: Lessons for the future? A. Jess Snchez Fuentes, Sebastian Hauptmeier and Ludger Schuknecht 289
Prologue
The crisis in Spain is, to a large extent, the crisis of the Euro. On the one hand, the sustainability or otherwise of the monetary integration project hinges on Spain, as the fourth economy in the Eurozone. On the other, Spain has no leeway available for fiscal stimulus packages, and the success of its adjustments required stability in the Eurozone. Hence, both crises are the two sides of the same token.
The crisis faced by Euro economies and the adjustments made and which will be made in the most vulnerable ones, are coming at a high price which has not yielded tangible results to date. Crculo de Empresarios believes that the current situation calls for an improvement in European institutional architecture, in regard to greater integration and, above all, more commitment to reforms in Spain. The natural environment of our country is the Eurozone.
Over the last few weeks, citizens are beginning to live with the different rescue modalities, as they had already done with the risk premiums. Financial aid for troubled economies is quite diverse in terms of implications, instrumentation, conditionality and scope of application, therefore requiring detailed analysis for determination. Although each carries its benefits and disadvantages, in the opi-
nion of Crculo de Empresarios, the greater scope and conditionality scenarios known as country-rescue are not a desirable option. This is why these must be avoided.
Indeed, an intervention or rescue, of its own accord, without advancements made in the Eurozone architecture, shall not protect any of its members from future scares. Domestic adjustment may be less effective if no advancements are made in fiscal and banking union, and in the European capacity to provide asymmetrical responses to national situations which are also different. The most vulnerable countries in the Eurozone must no longer be perceived as foreign currency debtors and it is imperative that the coordination of economic policies of Member States is improved. Without such adjustments, a sustained growth path will not be possible to achieve.
On the other hand, the crisis in Spain is the result of an accumulation of imbalances due to a series of inadequate signals and policies. Spain must face up to its responsibilities in terms of fiscal consolidation and structural reform. All in the interest of recovering competitiveness and encouraging a suitable environment to attract growth-contributing investments.
In such circumstances, Crculo de Empresarios cannot help but take part in the debate on the future of the Euro. The XXVIII edition of the Brown Book is dedicated to this matter and gathers a varied number of authors, all with broad experience in the issue
and proven academic and professional records. Therefore, this publication, with the sponsorship of BBVA as in previous years, maintains its nature as a publication which is open to different ideas and opinions, not necessarily shared by Crculo de Empresarios.
As in previous editions, the articles appear in alphabetical order by the surnames of their authors, although these can be grouped into three broad categories: the crisis of the sovereign debt in Europe and the future of the Eurozone; the reform of economic governance and operations of the institutions in order to solve the sovereign debt crisis in Europe; and the integration into the Eurozone, the fiscal coordination mechanisms, Eurobonds and the assignment of sovereignty.
In their paper, Javier Andrs and Rafael Domnech analyse the challenges faced by the Eurozone and the proposals to handle them by improving economic governance. To this end, they begin by reviewing the reasons underlying the accumulation of significant imbalances in developed economies and among EMU countries, mainly from 2001 until the start of the crisis in 2007, as a result of an unsustainable growth pattern in many developed economies. Secondly, the magnitude and implications of such imbalances and the heterogeneity between EMU countries are closely examined. Finally, the authors analyse the challenges involved in the improvement of economic governance of the EMU on the fiscal, financial and economic integration fronts, which will determine its short and long term economic future.
Jos Carlos Dez analyses the Euro crisis. He reviews the historical background of the European and single currency projects, and the theory of exchange rates to provide conceptual support to enable an understanding of the nature and the causes of the crisis. According to him, this is an infrequent, but highly destructive, disease found in economics, especially in developed countries, since it causes devastating damage to the employment and public debt of the affected countries. For this reason, he believes it is essential to come up with the correct diagnosis in order to define the economic policy that will put an end to the crisis. The main causes analysed are financial integration, the under-assessment of risk, local imbalances within the Eurozone and the Great Recession.
The aim of Juergen B. Donges is to bring the current debate on the need for economic governance in the European Union, and particularly in the Eurozone, into the context of political realities. He analyses the issue of governance from a historical and current perspective, and highlights the significant fact that the Eurozone does not constitute an optimal monetary area. He then moves on to analyse the forms of governance to date and considers new approaches to European governance. Finally, he ends his analysis with a tone of moderate expectation. If the Governments of the Euro countries understand that the solidity of public finances and the application of structural reforms are their responsibility and act in accordance, no State must rush to the aid of another due to over-indebtedness and overspending, and the ECB may stop indirectly funding the States and focus on its own duty, which is to ensure the stability of the price levels within the Eurozone.
10
Gonzalo Garca Andrs highlights that, despite having taken decisive steps in national policies and institutional framework reform, the Euro crisis has worsened to the point of calling its survival into question; and no definitive solution is yet on the horizon. In his article he attempts to offer an interpretation of what has happened, assuming the extreme complexity both of the starting point (with accumulated imbalances and structural deficiencies in several countries), as of the outbreak, the contagion and the escalation of the crisis. And he does so in the broader context of the global financial crisis, which has affected economic and financial development for five years, in order to determine which specific aspects of the Euro have played a key role. All this with a view to encouraging a reflection on solutions, bringing together the most urgent and the ones with a longer term effect.
Cinzia Alcidi and Daniel Gros point out that the Eurozone crisis encompasses different dimensions, from foreign debt and current account balance problems, to the weak situation of the banking sector. The document focuses on this last issue, the situation of the banking system, and attempts to show the way in which current characteristics of the regulatory framework of the financial market have influenced the development of the crisis. In addition, they express their concern about the false idea that the recently signed fiscal convention shall become the fundamental ingredient of the recipe to overcome the crisis, when the banking sector continues to be heavily indebted and exposed to the vicissitudes of sovereign States. For this reason, they present a few ideas to break the
11
close ties between governments and banks, since these links them in a common fate and constitute a clear impediment to recovery from the crisis in the Eurozone.
Ricardo Martnez Rico, throughout his work, analyses the way in which the sustainability of public finances requires a sold fiscal institution and a firm political commitment by European governments. Subsequently, he tackles the close relationship between fiscal rigour, macroeconomic stability and growth, concluding that, in order to achieve a positive inter-relation, the establishment of fiscal rules which are simple, transparent, automatically applied and with preventive control mechanisms for all Public Administrations, is essential. All these items are key when designing a fiscal policy which contributes to recovering the credibility required by Europe along its route towards greater integration to handle the sovereign debt crisis. Lastly, he examines the measures taken in Europe and Spain since the start of the sovereign debt crisis, and reflects on the next steps that should be taken towards a fiscal institution.
The work of Jaime Requeijo aims to provide a reasoned explanation of the causes of the financial shocks affecting several Eurozone countries, and which endanger the survival of the single currency (the Monetary Union is a poorly built structure because political urgency has prevailed over economic prudence; the fiscal irresponsibility of many member state governments has translated into the appearance of large public debt; such debts generate doubts as to their holders; and, contributing factors such as the
12
effects of contagion or of the opinions of the rating agencies and IMF predictions). In the article he also attempts to reply to three questions on the measures taken, the results thereof, and the impact of a potential decomposition of the euro. The article ends with a brief final reflection on the solution to be applied in order to maintain the Monetary Union.
A. Jess Snchez-Fuentes, Sebastian Hauptmeier and Ludger Schuknecht state in their article that an ambitious fiscal reform within a broader programme of reforms would have highly positive effects insofar as it would provide for a safer fiscal position, in line with the requirements of the Stability and Growth Pact (SGP). Expenditure control policies must therefore go hand in hand with structural reforms, mainly focused on reducing rigidity in the labour and product markets, on the correction of macroeconomic imbalances, on the improvement of competitiveness and on sustaining potential growth. This becomes particularly key for the most vulnerable countries in the Eurozone, which no longer have the option of currency devaluation to increase competitiveness.
Finally, and on behalf of Crculo de Empresarios, I wish to thank all the authors for their contributions to this new edition of the Brown Book and I trust that these articles help to shed light on a solution to the European trilemma.
Mnica de Oriol President of Crculo de Empresarios
13
/JAVIER ANDRES * / RAFAEL DOMENECH**/
The future of the Euro after the Great Recession

1
Summary; 1. Introduction; 2. From the Great Moderation to the Great Recession; 3. The imbalances in Europe and in the EMU; 4. The new European governance and the future of the Euro; 4.1. Changes in fiscal governance; 4.2. Financial integration; 4.3. Economic integration; 5. Conclusions.
Summary
In this chapter we shall analyse the challenges the Eurozone is facing and proposals to deal with them via improved economic governance. To do so,
* Javier Andrs is professor of Fundamentals of Economic Analysis at the University of Valencia and visiting professor of the University of Glasgow. http://iei.uv.es/javierandres/ ** Rafael Domnech is Chief Economist of Developed Economies, BBVA Research and Professor of Fundamentals of Economic Analysis at the University of Valencia. http://iei.uv.es/rdomenec 1 The authors thank A. Deligiannido, A. Garca, M. Jimnez, and E. Prades for their assistance and comments on this work, as well as the help from CICYT projects ECO200804669 and ECO2011-29050.
15
we shall first examine the reasons behind the accumulation of significant imbalances in the developed economies and among the EMU countries, mainly since 2001 until the crisis in 2007, as a result of a pattern of unsustainable growth in many developed economies. Secondly, we shall offer an in-depth analysis of the significance of such imbalances and the heterogeneity which exists between EMU countries. Lastly, we shall study the challenges presented by the improvement of the economic governance of the EMU from a fiscal, financial and economic integration perspective, which shall determine its economic future in the short and long term.
1. Introduction
The international economic crisis which begun in 2007 is having an extraordinary impact on the European economy, and for the coming decades, will leave a deep mark in many of its members. The crisis has shown that the growth process undergone between 1994 and 2007, particularly following the creation of the Economic and Monetary Union (EMU) in 1999, had entered into an unsustainable dynamics in the long term. The appearance of important macroeconomic imbalances among EMU members was taking shape within the framework of steady growth, inflation under control, very low interest rates and a very reduced risk assessment (partly as a result of the disappearance of currency risk) in the context of a world saving glut. Although the Eurozone as a whole presents smaller aggregate imbalances in terms of deficit and private, public and foreign debt than, for instance, the US or the United Kingdom, the expectations of economic convergence
16
among Eurozone countries and the appearance of financial bubbles with the promise of high yields, led to very significant capital flows among its members. This added to a spiralling increase in household debt and businesses in some of the member countries, generating very considerable and longstanding deficits in current account balances. These expectations petered out sharply as of the subprime crisis of 2007 and, since then, Europe has been experiencing different surges of financial crises, economic crises and sovereign debt crises, which have been following on and feeding off each other over time.2 The result of this complex situation has been that, albeit with differences in the intensity and the severity of the problems (see, for instance, Domnech and Jimnez, 2010), a significant number of European countries have experienced a situation similar to that of the sudden stops experienced in the past by some emerging economies, leaving public and private sectors heavily indebted and, in some cases, extremely high rates of unemployment.
The aim of this chapter is to analyse the changes required by the EMU and proposals with which to face such challenges with success. In order to understand what the problems are and, therefore, their possible solutions, in the second section we analyse the reasons why important imbalances accumulated in the developed economies and among the EMU countries during one of the most stable periods of economic prosperity in the last decades (the Great Moderation), which nevertheless gave way to an unsustainable
2 Shambaugh (2012) performs an excellent analysis of the interaction between fiscal, financial and economic crises in the Eurozone.
17
growth pattern in many economies. In the third section, we offer an in-depth analysis of the magnitude and implications of such imbalances throughout the crisis, which are well summarised in the Excessive Imbalance Procedure (EIP) recently implemented by the EU, as well as the current heterogeneity among EMU countries. The fourth section analyses the challenges of improvement of economic governance of the EMU from a fiscal, financial and economic integration standpoint, which shall determine its short and long term economic future. Lastly, the fifth section presents the main conclusions reached in this paper.
2. From the Great Moderation to the Great Recession

In the period between the mid-1990s and 2007, developed economies enjoyed one of the greatest economic growth periods, known as the Great Moderation due to the low volatility of growth rates in those years. Graph 1 shows evidence of this for the US and the EMU in terms of GDP per person of employable age. As can be seen, from the mid-1990s to 2007 there was sustained growth, with levels well above the historical trend estimated since 1970 for both geographical areas. In fact, the growth in GSP per person of employable age was slightly higher in the EMU than in the US, although not enough to bridge the gap between both economies.
The Great Moderation generated the perception that economic cycles would have less volatility, as a result of better managed eco-
18
nomic policy (see, for instance, Gal and Gambeti, 2009, or the references appearing in this article). In fact, these high growth rates with low volatility came hand in hand with inflation under control and low interest rates across the board of financial assets, with practically inexistent risk premiums in many cases as a result of the underassessment of the risk. In light thereof, some analysts went as far as to proclaim the disappearance of the economic cycle and the capacity to avoid significant economic recessions. It was the combinations of these forces which fed the financial imbalances which, for economists like Rajan (2005) or Borio & White (2005), among others, are behind the crisis which began in 2007.
There are various economic factors which contributed to generate this combination on which the Great Moderation was erected. In the first place, the central banks of the developed economies carried out a low interest rate policy or money glut, as a result of: i) the drop in the inflation of sellable assets following the inrush of exporting countries in the international economy with a very abundant and cheap workforce and depreciated currencies; ii) the benign neglect policy in regard to the high prices of financial and real estate assets (Bordo & Jeane, 2002, or Bean 2004 & 2010); and iii) the attempt to prevent the recession in the US, following the burst of the technological bubble, or in Germany, following the costly process of reunification and the burst of its real estate bubble.
Secondly a savings glut took place on a worldwide level in China, Japan, Germany, oil producing countries or the pension
19
funds of developed economies.
Thirdly, and as a response the savings glut in some countries and sectors, a formidable increase took place in the demand of safe assets, moving from the pre-eminence of individual savers to that of large sovereign funds, investment funds or pension funds which prioritize safety over yield and which seek to channel savings towards fixed income rather than towards the acquisition of any other kind of asset. At the same time that the demand for safe financial assets (i.e. AAA) increased, there was a relative scarcity of such assets in the case of sovereign debt, due to the fiscal consoliChart 1 GDP per person of employable age in the US and in the EMU
Source: OEDC (2012) Economic Outlook Database.
20
dation taking place simultaneous in many developed economies as a result of the high growth in GDP. This surplus demand for safe assets created enormous pressure in the financial markets and in certain types of assets, which in turn led to the appearance of bubbles in certain market segments. The pressure was such that financial deregulation and engineering came to the rescue, enabling the response of the financial markets to this scarcity in AAA assets to be the creation of multiple derivatives and the issue of huge volumes of asset backed securities, as shown in Graph 2. In turn, this generated enormous liquidity to fund those assets acting as the underlying assets (for example, mortgages on homes), thus creaChart 2 Issue of Asset backed Securities 1985-2011
Source: SIFMA
21
ting a circle in which asset demand stimulated supply, which in turn was fed back into the process by boosting demand with the creation of new assets.
As a result of this process, a specialization in asset production took place on an international level, leading to enormous heterogeneity by country, sector and agents. Whereas some countries generated a surplus in net savings, others (US, Spain or Ireland) responded to the very low interest rate incentive by generating the real investments which served as the underlying assets for financial securities. The US produced assets on a world scale considered safe by the markets, thanks to the specialization of its financial services. Other countries, such as Spain and Ireland, carried out a similar role, but on a European scale, producing assets backed by safe collateral (homes) or with no collateral, but issued by financial institutions deemed to be safe, which attracted savings funds or large European banks.
In fourth place, the creation of the EMU meant the disappearance of exchange rate risk among its members. This removed an important barrier to capital flows within the EMU and encouraged the previously described process. But its effects went even beyond the disappearance of currency risk. In the international financial markets, as well as in the EMU countries, expectations that the greater monetary and economic integration ensured the economic convergence of its members were generated, which justified the disappearance of any type of risk premiums (see Ehrmann et al, 2011).
22
Graph 3 clearly shows the almost full disappearance of risk premiums for countries becoming part of the EMU. Without doubt, Greece was a paradigmatic example of this process, going from funding at 25% in 1993 to do at the same interest rate as Germany, following its entry into the Eurozone.
Chart 3 10 year public debt interest rates in the EMU, 1995-2011
Source: ECB, Bloomberg
The implications of such expectations of economic convergence were very important in terms of imbalances in the current balance. Under the assumption that a real and economic convergence process was taking place, well beyond the nominal, it seemed natural that capital should flow towards the economies with lower per capi-
23
ta incomes, as economic theory predicts (see, for example, Barro, Mankiw & Sala-i-Martin, 1995).
In fact, as the risk premiums were disappearing, the correlation between the savings rated and investment rate were reduced. As was already anticipated by Blanchard and Giavazzi (2002), since 1999 to the start of the crisis, the Feldstein-Horioka paradox disappeared completely, as shown in Graph 4. Coinciding with the reduction in the typical deviation of risk premiums, which reached
Chart 4 Typical deviation of risk premiums and correlation between the rate of investment and the rate of savings, EMU, 1993-2011
Source: Bloomberg
24
almost zero as of 1998, the correlation between the national investment rate and the savings rate was observed to have been nil or even negative, compared to the positive and statistically significant values of the beginning of the nineties.
In fifth place, a permissive regulation, together with reduced interest rates and very high competition in the financial sector generated the incentives required for the generation of profit to be done via transaction volume instead of via price margins (mainly interest rates), favouring a very important leveraging of broad segments of the private sector. One of the results of this process was the intensification of a new banking business model, based on the granting of collateral backed loans, the generation of financial assets from such loans and the distribution thereof as asset-backed securities in asset packages (originate to distribute) which transferred credit risk in full to the purchasers of these new generated assets. Compared with the traditional bank business, in which financial institutions that grant the credits keep the risk on their balance sheets, this new business model led to greater interconnection of the balance sheets among financial institutions all over the world and a significant increase in contagion risk.
3. The imbalances in Europe and the EMU

The financial crisis was preceded by a period of economic prosperity, measured by conventional indicators of growth, macroecono-
25
mic stability and inflation, during which enormous imbalances of a financial and competitive nature have been created. However, a glance of the macroeconomic picture of the EMU reflects a situation of balance which we do not find in other important economic regions of the world (Table 1). Both the deficit and public debt levels and the net foreign positions and private indebtedness are generally lower to those recorded in the United States or the United Kingdom.
However, the EMU has had other problems hanging over it which have led the economy of the region and that of the whole of the EU by extension to the situation of stagnation which it is currently undergoing. Some of these problems are of a structural nature, and others are related to the extraordinary disparities between member states in their key indicators to which, until very recently, we had paid little attention. Among the first are demographic evolution and low productivity growth which in turn have provoked a limited rate of growth in employment. But the disparities and the heterogeneity within the EMU are the most outstanding imbalances, as they call for a serious amendment in the operation of the Euro, whose main objective was to accelerate convergence among countries who adopted the single currency along with other common institutions.
The European Commission has recently implemented a programme to monitor a number of indicators to detect and track macroeconomic and financial imbalances in countries within the EU (the EIP). One of these indicators summarises, over all others, the nature of the main problem facing the European economy:
26
the gradual and persistent disparity in the current account of its member countries. Although the EMU and the EU are economies which can be described as economies which contribute (and demand) little net savings to (and from) foreign savings, their aggregate results is the sum of extremely disparate realities. As Lane (2010) points out, in 2010 European countries accounted for approximately one third of all current account deficits and surpluses worldwide. As can be seen in Graph 5, the current account deficits and surpluses of the EMU have gradually polarised from levels ranging between the [-3%-, +3%] interval, in proportion to the GDP to position itself outside of this range and even persistently above it by 5%. The underlying causes and macroeconomic implications of this type of imbalance are extremely complex.
Table 1 Debts and deficits in the EMU, US and United Kingdom (% GDP) EA17 Budget balance of public administrations Debt of public administrations Household debt Corporate debt Current account balance Net international position 2011 2011 2010 2010 2011 2010 -4.4 87.6 67.3 119.1 0.1 -7.2 US -9.6 100.0 92.1 74.6 -3.1 -17.0 UK -8.9 84.8 106.1 123.7 -2.7 -13.9
Sources: AMECO, Haver, IMF, national sources and BBVA Research
27
It is true that this polarisation is not an exclusively European phenomenon, as it happens in parallel with the so-called global imbalances generated during the recent globalisation process. However, in contrast to what is happening on a world scale and particularly in a series of developed countries (the Anglosphere) and emerging countries (particularly China) in Europe there is a positive correlation between levels of income per capita and sales deficit, so that the capital flows from the more advanced countries to the less developed. This has rendered such imbalances less conspicuous, as they have been associated with the real convergence process. The traditional view considered foreign indebtedness as a natural consequence of the catching up process during which the countries undergoing rapid growth required foreign savings to fund strong domestic investment in commercial goods. Thus, the availability of savings and the Euro allowed for the funding of the productivity convergence without financial and exchange rate strangulation. The international allocation of savings was deemed to be optimal (consenting adults, Obstfeld, 2012), and there was no reason for public political intervention what became known as benign neglect by Blanchard and Giavazzi (2002) or Edwards (2002).
It is not easy to determine an optimal level, or even an adequate one, for the current account deficit which already reflects the gap between domestic savings and investment in a country which is assumed to have been optimally determined by consumers and businesses, unless it is associated with high public deficit, in which case we would be dealing with a fiscal problem. Moreover, a country may
28
have a deficit current account without having a serious foreign financing problem, or may have it despite having a regularised account, in this case because despite a reduced net capital flow, what matters in the event of a financial crisis is the size of the gross flows, as nothing guarantees that national savers are willing to fund domestic liabilities should the international markets become unavailable. However, the evolution of the current account of EMU countries (EU) reflects more deep-rooted problems where the adjustment role of the market mechanism has proven insufficient and in which gross financial flows have grown in a fast and imbalanced way.
Chart 5 Current account balance (% GDP)
Source: BBVA Research with data from national sources
29
The deficits have not been linked with productivity convergence, as is evident in the cases of Spain, Portugal and, to a certain extent, Ireland, which accumulated growing deficits despite the slow growth of total productivity of the factors. As can be seen in Graph 6, productivity grew by 1% on average, whereas the current account balance varied between surpluses over 5% (the Netherlands and Germany) and deficits of 10% (as in Portugal and Spain). In fact, it has not only been the lure of investment but mainly the fall in savings in peripheral countries which has caused the gap in commercial deficit which has exceeded both in volume percentage of GDP and in persistence, that observed in many emerging countries prior to the crisis of the eighties and nineties. Moreover, much of the foreign financing to the receiving countries has not been channelled through direct and portfolio investment, but by way of bank bonds, which increases the risk of bank crises and sudden stops (Jaumotte and Sodsriwiboon, 2010; Land, 2010).
However, the most worrying characteristic of the unequal performance of the current account in Europe is its persistence. Far from being a transitory phenomenon, the divergence between commercial balances has sharpened until 2007 (see Graph 5). The design of the Euro took into account that the absence of own currency would hinder the traditional adjustment to which most countries resorted in times of crisis in the balance of payments. The impossibility of this recourse to devaluation has not come hand in hand with the strengthening of real devaluation mecha-
30
nisms, that is, with a more flexible response by prices and salaries. Between 2000 and 2010, enough time has lapsed to have expected that the countries with most foreign debt and strong real appreciations should have begun a process of correction towards a surplus in the commercial balance. Nevertheless, this has not been the case. The correlation between the commercial deficit and the net foreign position was positive in 2011 and in 2010 (Graph 7) as it had been in the last decade, indicating that the private savings/investment balance does not seem to respond to the cumulative net foreign position.
Chart 6 Current Account Balance in 2007 (% of GDP) and average productivity growth between 2000 and 2009.
Source: BBVA Research based on AMECO
31
In 2010 only four EMU countries had a net positive foreign position Belgium, Germany, the Netherlands and Finland and only Finland had managed it after correcting a very negative position in 2001 (that is, after a decade of foreign rapid growth and surplus). Practically all other EMU countries saw their net indebtedness increase substantially or, at best, such as in France or Austria, they managed a moderate reduction thereof within the first ten years of the single currency.
Therefore, the performance of the current account is a very useful indicator although naturally not infallible of the way in which a country responds to the commercial and financial globalisation process and to the existence of other types of imbalances associated with private sector debt, both financial and non-financial. Before reviewing these indicators for the EMU (EU), it is worth asking why the (market) adjustment mechanisms have failed in this case and what the risk of this situation is happening again in the future.
The conventional current account approach indicates that financial flows are a mere counterpart of commercial flows, so that sustainability of foreign debt must be guaranteed by the expectation of future current account surpluses or, what is the same, by a significant proportion of the commercial goods production in the economy. Foreign financing is no at risk while foreign investors consider the economy to be competitive. The domestic economy must maintain a high productivity growth rate and competitive
32
labour costs, as the opposite would render the foreign deficit unsustainable, foreign investment would drop, reducing prices and salaries and improving the foreign balance. In this way, given reasonable elasticity in the demand of exports and imports, the periods of real appreciation and foreign deficit can be reversed without deep structural changes.
However, this market mechanism has not worked in peripheral Europe. Foreign funding has been used to a large extent to fund
Chart 7 Current account balance and net international position
Source: BBVA Research based on Eurostat
33
non-commercial goods, leading to strong expansion of demand, of prices and of labour costs (see Graph 8). Despite the loss of competitive capacity, the appeal for foreign lenders continues provided the value of the asset with real guarantees such as homes continues, which is perceived as relatively safe. Thus, the worsening competitiveness is the effect and not only the cause for the deterioration of the current account. But the existence of high commercial deficit is not corrected of its own accord nor is it done in a smooth and orderly manner. When the bubble bursts and prices of the assets used as guarantees plummet, foreign investors perceive that the national economy is no longer able to guarantee their debt, leading to the well-known processes of flight to quality, increase in the cost of debt and, in extreme cases, to sudden stops.
This integration process has led to a number of other imbalances in the European economies. The objective of the EIP is to go beyond the control of deficit and debt, and to follow a number of economic indicators which enable the detection of inadequate macroeconomic development in a country and can lead to localised financial crises and even contagion in the future. Such indicators come hand in hand with a number of limits that are considered to be security measures which, when exceeded by a country, special tracking must be carried out by the Commission. If an economy is showing imbalance in several of these indicators, it must propose a plan of action for correction thereof which, if not suitably applied, might result in some form of political or economic penalty. The list of indicators is the following (the limits
34
above which a form of relevant imbalance is detected appear in brackets): current account balance (% GDP, -4%, 6%); net international position (% GDP, -35%); real effective exchange rate (variation rate, -5%, 5%); export market share (growth rate, -6%); nominal unitary labour cost (growth rate, 9%); cost of housing (growth rate, 6%); credit flow to private sector (% GDP, 15%); private sector debt (% GDP, 1605); public debt (% GDP, 60%); and unemployment rate (10%).
Chart 8 Growth of nominal salaries and real productivity
Source: BBVA Research based on Eurostat
35
The first report issued on the monitoring of these indicators shows that in the third year since the start of the crisis (2010), the imbalances accumulated in recent years are far from being corrected, some of them having worsened since 2007 (Table 2). Greece, Portugal, Ireland and Spain are the countries with worse qualitative results. They belong to the Eurozone periphery, where they fail in at least five of the ten criteria.3
It is within the framework of such imbalances that we must interpret the fiscal crisis that has been reflected in the general growth of risk premiums of sovereign debt in Europe, especially in peripheral countries although not exclusively. The levels of public debt in the EMU are comparable to those in the rest of the developed world, both if we consider the region as a whole or the countries within it separately. As is shown in Graph 6, only in 2008 three EMU countries (Greece, Italy and Belgium) had a public debt above that of the US and in any case much lower than that of Japan. The growth in public debt during the crisis period places EMU countries with the exception of Greece and Ireland in the realm of 20%, similar to what had happened in most of the developed countries. Therefore, behind the sovereign debt crisis there are issues related to the economic governance of the EU in general and the Eurozone in particular. But also, deeper reasons which have
3 The situation is worse if we take into account that indicators such as the growth rate of housing prices and credit for the private sector are nowadays within the limits accepted by the MIP as a result of the extraordinary restriction on credit suffered by most EU economies.
36
become evident following the segmentation of the financial markets due to the crisis. On the one hand, we have the demographic and structural characteristics of most of the countries, which herald for the future a scenario of lesser growth than that before the crisis. Graph 9 shows the growth rates up to 2007 and the forecasts made by the IMF up to 2015 for EMU countries, the United Kingdom, Japan, and the US.
The aging population and its effects on participation in the labour market, the low savings rates with the ensuing difficulties in funding investments and the slow rate of productivity growth explain such expectations, which in turn severely affect the capacity to absorb the strong increase in public indebtedness.
In second place, the economic crisis itself has generated an additional burden on public finances by way of contingent liabilities, the realisation of which shall depend on the performance of the private debt and the need to apply measures to assist in the reconversion of the financial sector. As stated by Reinhart & Rogoff (2008 and 2009), one of the main consequences of financial crises is that a large part of the private sector debt becomes public. Table 3 (ECB, 2012) shows the impact on public finances of the two main contingent-type averages within the EMU: provisions for the European Financial Stability Facility (EFSF) and the guarantees for the banking sector. The sum of both would mean an additional impact on the public debt in the EMU of almost 13% of the GDP. It is true that such contingencies do not necessarily have to mate-
37
38 The future of the Euro after the Great Recession
Table 2 Imbalances at the EMU
Source: European Commission (2012): First Alert Mechanism Report (moving averages, 3 or 5 years)
rialise, but it is also true that provisions have proven insufficient and have had to be extended in successive programmes.
Chart 9 GDP Growth in 2007 and 2015
Source: IMF (2012)
Lastly, the aging of the population gives way to the generation of implicit liabilities which are not considered in public debt figures but should be taken into consideration when evaluating the sustainability of public finances (Cecchetti, Mohanty and Zampolli, 2010). In 2009 the IMF (IMF, 2009) calculated the sum of implicit and contingent liabilities in securities exceed in present value 400% of the average GDP of the G20. Of these, those of a contingent nature associated with the crisis account for approxi-
39
mately one tenth, whereas that associated with an aging population pensions and social security account for much higher implicit obligations. As a whole, this type of liability will demand a remarkable effort from public finances in the future. Cecchetti, Mohanty and Zampolli (2010) place the additional permanent financing required to meet such obligations at between 5 and 10 GDP points assuming a public debt at levels similar to the current ones in developed countries.
In summary, some European economies may have reached debt levels which exceed or are dangerously close to their fiscal limits, defined as the maximum level of debt which a country is able to fund. The fiscal limit depends on the political will of its citizens and the capacity to increase income by means of tax rate rises (Bi, 2012 and Leeper & Walker 2011) which makes it specific to each country. This might explain, at least in part, the differences observed in risk premiums between countries with similar levels of debt or even that some countries pay a higher cost of financing that others with much higher levels of debt. Moreover, the relationship between the risk premium and the fiscal limit is non-linear, increasing rapidly when fiscal performance places debt at such levels that the likelihood of reaching the limit is significant (Bi, 2012). That is to say, in order to observe significant risk premiums, it is enough for investors to understand that the fiscal strategy of a country leads it to a fair likelihood of reaching the maximum level of debt financed, even if the probability of this taking place in the short term is very small. This probability in turn grows over the
40
economic cycle, which obliges countries with greater volatility in economic activity and unemployment to opt for stricter fiscal rules.4
Table 3 Contingent Obligations of the governments 2008-2010
EFSF Belgium Germany Estonia Ireland Greece Spain France Italy Cyprus Luxembourg Malta The Netherlands Austria Portugal Slovenia Slovakia Finland EMU
Source: BCE
Banking sector guarantees 12,7 3 0 42,8 25,8 6,2 3,1 2,7 15,7 3,2 0 6,1 5,7 9 4,4 0 0 5,2
7,3 8,22 12,46
8,61 7,97 8,78 8,78 4,66 10,91 7,32 7,19 10,23 11,05 7,34 7,71
4 When the economies reach this limit, the efficacy of the fiscal and monetary policy is substantially reduced and both instruments no longer have the expected effects on economic activity. The fiscal multipliers are reduced and the monetary authority loses the capacity to control inflation, irrespective of the aggressiveness of its monetary policy.
41
4. The new European governance and the future of the Euro

The economic crisis has highlighted the need to carry out important changes in European governance. It is obvious that there have been failures in coordination in the economic policy and mistakes in the policies adopted by national government, which have generated a sovereign debt crisis and a financial crisis. And it is also obvious that Europe was not first resorting to the supranational institutions and bodies to prevent the crisis and to provide a rapid and efficient response once it had begun. The EU, and particularly the EMU, need to improve their economic governance in at least three areas: fiscal, financial and economic integration. Below we shall analyse each of these aspects and the challenges faced in each by the EMU.
4.1. Changes in fiscal governance

In regard to fiscal integration, over recent months important inroads have been made, among which are the Stability, Coordination and Governance Treaty and the creation of the European Stability Mechanism (ESM). The new Treaty, which shall come into force on 1 January 2013, has been signed by all EU countries except for the United Kingdom and the Czech Republic, and aims to make public finances sustainable and prevent the onset of excessive public deficits, in order to safeguard the stability of the Eurozone as a whole. In fact, this Treaty can be interpreted as a second version of the Maastricht Treaty of 1992, with the differen-
42
ce that whereas the former determined the conditions to enter the EMU, the new treaty can be said to detail the conditions to be met by the members of the EMU to continue to belong to the Eurozone. To this end, the Treaty introduces specific rules (the structural deficit may not exceed 0.5% of the GDP, as of a date to be determined by the European Commission, and a public debt below 60% of GDP) and automatic mechanisms which enable the adoption of corrective actions in the event of deviation from targets.
The rules introduced by the Treaty are in general well designed. When establishing an objective in terms of structural fiscal balance it allows for the influence of automatic stabilisers, the minimum being between 0.5% of structural deficit and the deficit limit of 3%. However, a good design does not necessarily guarantee a good implementation, as was the case with the Stability and Growth Pact (SGP). It is true that the new Treaty entails a criterion of reverse majority: from now on the adoption of corrective or disciplinary mechanisms proposed by the European Commission must be rejected by a majority, whereas in the SGP the majority needed to be reached in order to approve such proposals. It is also the experience of the current debt crisis has led to an accumulation of collective knowledge which shall prove very useful when adopting the right decisions in the future to prevent new crises of this kind. Just as eighty years later the Federal Reserve is currently preventing some of the well-known mistakes which were made during the Great Depression of the 1930s, the European Commission and the European Council shall endeavour to prevent imbalances similar to those we are currently undergoing.
43
Available empirical and theoretical literature (see, for instance, Andrs & Domnech, 2006, and the references included in this paper), indicates that use of fiscal rules has proven useful in the containment of public debt and the deficit, without the effectiveness of the automatic stabilisers adversely affecting the effectiveness of the discretionary fiscal policies. Therefore, the fiscal rules like those included in the Stability Treaty do not have to be an impediment for the fiscal policy to carry out its duty of stabilisation of economic cycles. Quite the opposite: when the economic agents know, that as a consequence of the existence of such rules, expansive fiscal policies in the short term shall be offset in the medium term by counter-adjustment measures in order to prevent the accumulation of public debt, the effectiveness of these discretionary stabilisation policies increases, as has been proven by Corsetti, Meier and Mller (2011).
In any event, it shall be very difficult to achieve an optimal implementation of the Treaty. In the first place, because all governments are often too complacent when allocating probabilities to possible risk scenarios which may render public finances unsustainable. Secondly, because it is difficult that sanctions may come about from the European Union Court of Justice on the basis of failure to meet the structural deficit targets, which depend of estimates of the cyclical position of the economies and the elasticity of public income and expenses to this cyclical position. Nevertheless, what the Stability Treaty does provide is that, prior to reaching sanctions, the Commission may exert much greater pressure on
44
national governments and alert markets about excessive imbalances, so that it is the markets themselves that impose discipline via higher interest rates.
As for the ESM, at the ECOFIN on 30 March the decision was taken to extend it to 500 thousand million euros, which shall be provided over two years, and beginning on 1 July 2012. The extent to which this fund will be sufficient is still unknown, in that it shall depend on how it is used and whether it allows for fund leveraging. Without leveraging, the fund shall only be enough to cover the financing needs of small or medium sized economies in the EMU, but not of the big four. However, it may prove effective for specific, selective but highly intensive interventions designed to reduce risk premiums, that is, to replace the ECB in its Securities Market Programme (SMP). In addition, if the ESM should obtain liquidity from the ECB itself, each of these entities might be able to separately specialise in the management of a risk: the SMP would manage the solvency risk of sovereign debt and the ECB would managed the liquidity risk, thus enabling the central bank to resume the natural role for which it was created, as it would be creating an EU fund, with a joint and several guarantee, instead of sovereign debt with a national guarantee.
It is very important that the intervention of the SMP is as efficient as possible. To this end, the Commission must be clear about which countries are solvent, with adoption of any necessary adjustment measures and structural reforms, and which countries need
45
some kind of debt restructuring. In the first case, which is clearly applicable to countries such as Spain and Italy, SMP intervention on risk premiums should be as intense as necessary until market doubt and uncertainty have been obliterated. It would otherwise be very difficult to convince sovereign, pension or investment funds to purchase the public debt of such countries if Europe is not the first to refrain from doing so.
Obviously, a more decisive intervention by the SMP, which would lead to a rapid relaxation of the European sovereign debt markets, requires the adoption and follow-up of the necessary adjustments and reforms, but with sufficient time frame so as not to asphyxiate the economic growth of the countries adopting such policies. Specifically, the EU could change the fiscal consolidation strategy which is currently being demanded from member states. The obsession for nominal deficit targets should be replaced by a more plausible, rigorous multi-annual fiscal policy strategy which, in seeking to prevent a spiralling negative growth, truly contributes towards supporting sustainability in the long term of the public finances of all countries. Specifically, the European consolidation strategy should be based on the following principles:
1. Deficit reduction targets should refer to structural deficit instead of nominal deficit, as proposed by the new Stability Treaty. This implies that countries should be asked to take specific and detailed measures to ensure a certain amount ex ante in terms of reduction in expenditure or increase in income in the
46
coming years. If, as a result of such measures, the economic activity should be adversely affect with an impact on nominal deficit (by the mere intervention of the automatic stabilisers), the member states should not be obliged to take new savings measures in that same financial year.
2. The pace of structural consolidation should be ambitious enough to ensure sustainability in the medium to long term of public finances, and gradual enough to prevent excessively adverse effects on activity and employment in the short term.
3. The long term balance of public finances requires reforms which guarantee the sustainability of public systems of pensions and social protection.
Blanchard (2011) recently recommended that, in order to return to prudent levels of public debt, it would be advisable to apply the proverb of slow and steady wins the race. A similar recommendation to that of De Long and Summers (2012), for whom a fiscal consolidation which is too intense and too fast might endanger the very sustainability of public finances instead of guaranteeing it.
In regard to the debate on Eurobonds, although not necessary or sufficient, these can indeed become a useful tool in the context of streamlined national finances. They are not necessary, as the Eurozone can operate without them, if the Stability Treaty and the mechanism for the prevention and correction of excessi-
47
ve imbalances work properly. And they are not sufficient to prevent debt crises if the fiscal or current account imbalances are not corrected. If growth is imbalanced (private indebtedness, current account balance deficit), they imply a permanent transfer of income from one country to another, which is unsustainable in the long term. But they are convenient as an efficient mechanism to ensure and pool risks in the face of asymmetric shocks and, above all, as an element of political legitimacy of the European project: European citizens must see that there are specific benefits to belonging to the EMU. And Eurobonds are one of these benefits, particularly now when many countries need to make considerable sacrifices and carry out adjustments and reforms.
In this regard, the Eurobond proposal (blue and red) of Delpla and von Weizscker (2010), has the advantage that it would allow countries to benefit from risk pooling and the creation of a more liquid asset (the blue bond) than that of the debt of each of the EMU members, which would strengthen the euro as an international reserve currency, but with the benefit of preserving market discipline for national debt issued over and above 60% of GDP (red bonds).5 This proposal consists of the EMU countries pooling their
5 Attinasi, Checherita and Nickel (2009) believe that this market discipline is behind the increase in sovereign spreads between 2007 and 2009, as a result of the increase in risk aversion and the concern for the sustainability of public finances. However, Favero and Misale (2012) believe that this market discipline acts in an interrupted fashion over time and, occasionally, in an exaggerated way, which in fact justifies the issue of eurobonds.
48
public debt up to 60% of their GDP as senior debt under the joint and several responsibility of all members, whereas the issue of national debt beyond such a limit would be junior debt under individual responsibility. From this perspective, it is easy to conclude that the decision of the European Council reached in December 2010 to ensure the solvency of the debt issued until June 2013, but not that issued as of that date was a mistake, as the decision should have been the opposite: ensure as of a given date all debt issued under 60%, which would in effective terms be equal to the creation of the Eurobonds proposed by Delpla and von Weizscker (2010).
4.2. Financial integration

As Pisany-Ferri and Sapir (2010) have pointed out, to date the EMU has worked without a European institution able to rescue transnational financial entities and without authentic European stress tests for its banking institutions. Oversight duties have remained with national authorities and coordination problems have been managed by means of a combination of discretionary cooperation and dependence on rules approved by the EU.
One of the lessons to be learned from the current crisis is that it is difficult to manage a financial crisis on a European scale without supranational regulators, supervisors and insurance mechanisms. A large part of the head start that the US has over Europe in terms of crisis management and resolution is precisely due to the non-existence or the delay in creating such bodies. The US has
49
federal institutions to manage banking crises, whereas Europe does not, which renders true the saying that banks are international when expanding and national upon demise. The problem is that, for some governments (Ireland is a perfect example of this), banks are too large in relation to their public budgets.
Likewise, the US has a federal regulation, whereas Europe has enormous national dispersion of its regulations, despite the efforts of the European Commission and regulators to homogenise and converge towards a common financial regulation. Occasionally, headways made in certain rules give rise to inequalities among the agents who intervene in the markets, due to other rules continuing to be different. This was the case, for instance, of the requirement of the European Banking Authority that potentially systemic banks must exceed a capital ratio of 9% before 30 June 2012, when the measurement of risk weighted assets is regulated by different rules.
Banking oversight in Europe is furthermore carried out via national supervisors instead of via a single European institution, which introduces heterogeneity in oversight levels of the financial system. The result of this financial fragmentation is that one cannot speak of a single market, which generates the possibility of regulatory arbitrage, different conditions of competency, inefficiencies and, in general, a disadvantage in regard to other world financial areas.
50
In summary, financial integration requires an improvement to be made in the mechanisms through which information is shared on the financial systems of each country and the way in which their activities are supervised, the harmonisation of the guarantees on bank deposits and of consumer protection regulations, the creation of European bank restructuring and rescue mechanisms, and the advancement towards a Single Market not with more, but with a better, European regulation which, instead of adding to and prevailing over national legislation, should simplify and replace it.
4.3. Economic integration

With greater fiscal and financial integration the Eurozone could operate with less tension in the future, without ensuring the economic convergence among countries. Is convergence of income or welfare levels in European countries necessary? Probably not, but it is still convenient, as has been stated earlier, to enable societies to believe that being within an economic and monetary union has advantages well beyond those which are provided by monetary stability. One of lessons to be learned from the Eurozone crisis is precisely that monetary integration does not ensure economic convergence, as this requires an advancement in convergence of the determining factors (economic, social and institutional) of economic growth.
Table 4 shows that the differences in medium and long term determinants of per capita income are very significant. The relative position of each country has been obtained on the basis of the
51
IMF analysis (2010), whereas the allocation of each country to one of three groups under consideration has been carried out on the basis of the criteria put forward by Hall and Soskice (2001). On the basis of a number of criteria, both institutional and based on the workings of economic relations, Hall and Soskice classify the varieties of capitalism into liberal economies (the US being the prototype) and coordinated economics (Scandinavian countries are the paradigm). In both models (either with high or minimum coordination), the economies can function efficiently. Market economies which cannot be classified into either group are classified as mixed economies.
In order to transform the qualitative IMF indicator into a quantitative one, such as analysing its correlation with per capita income, values of 1 to 3 have been allocated for each of the three levels considered by the IMF, where a higher score suggests a greater need for implementing structural reforms. This enables the obtention of an average for each country and for each of the nine indicators which are shown in Table 4. The differences shown in this table are very marked, not only between developed economies, but also between European ones. In light of this evidence it is not surprising that, except in the case of Ireland, the countries which have accumulated the most imbalances and which are suffering more form the tensions in the debt market are precisely those which shown greater structural weaknesses and the ones which must implement the most reforms. Countries which in turn have been classified as mixed market economies, presenting more inefficient institutions.
52
Table 4 Structural capacity of the developed economies
Source: BBVA Research (2010) based on IMF (2010) and Hall & Soskice (2010)
53
The changes in the regulations which affect the operation of the labour, goods and services markets, trade, telecommunications markets, are easier to implement in the short term, although the changes thereof are felt in the medium term. An example of this can be found in the recent reform of the labour market in Spain, which is bringing its operation in line with that of countries like Germany (in terms of internal flexibility mechanisms) or to that of free market economies (by prioritising company agreements and opt out clauses for collective bargaining agreements). Making headway in these types of reforms (for example, linking salaries to productivity) is crucial to remove the differences in competitiveness which exist between EMU countries, particularly bearing in mind that the crisis may have had an effect on the potential growth of these economies (see, for example, the European Commission analysis, 2009).
However, in long term indicators such changes can take a lot longer and, in some cases, even decades. This is the case with human capital. Even in the event that the many younger workers of countries such as Spain, Italy, Greece or Portugal should enter into the labour market with the same human capital as in better placed countries, 25 years would be needed to half the distance for the whole of the population of employable age.
54
5.Conclusions
The economic crisis has highlighted the excessive complacency of the markets, agents, supranational institutions and governments when interpreting the imbalances which were being generated in the previous expansion period and the absence of supranational institutions and mechanisms, firstly to prevent the imbalances which led to the crisis and secondly, to provide a fast and efficient response once they had happened. Such institutions and mechanisms are necessary because the evidence shows that the markets react in a discontinuous way, and occasionally in an exaggerated way, are pro-cyclical and do not generate of their own accord sufficient disciplinary mechanisms in the short and medium term whenever these are needed. Insofar as the current Eurozone crisis has taken place mainly in three areas (debt crisis, banking crisis and crisis in growth and competitiveness, with huge heterogeneity between countries), the EU and, particularly the EMU, need to improve their economic governance in at least three areas: the fiscal, the financial and that of economic integration.
As for the improvement in fiscal governance, the Treaty of Stability, Coordination and Governance needs to be effectively applies in a preventive way and that, during its transition towards medium and long term structural deficit targets, this is done with sufficient rigor and the right flexibility to prevent that countries required to make the most efforts in the short term should enter into a negative growth spiral. In this regard, intervention by the
55
ESM on risk premiums should be as intense as necessary until market doubts and uncertainty have been removed, so that the countries which are implementing fiscal adjustments and structural reforms have a sufficiently broad time period to enable such measures to have positive effects on economic growth. As for the Eurobonds, although they are not necessary or sufficient to ensure the operation of the EMU, they are indeed convenient as an efficient mechanism providing assurance and pooling risk in the face of asymmetrical shocks and, above all, as a political legitimacy item in the European project: European citizens must discover that there are specific benefits to being part of the EMU. Although it is difficult for such Eurobonds to become a viable instrument in the current situation of divergence, they must become an essential part of the future European Treasury when the main imbalances are well under way to being corrected through the decisive application of the reforms in the various countries in the EU.
The second area where headway must be made is that of financial integration, in order to prevent future banking crises and to manage them in a more efficient and rapid way. Europe must have supranational financial institutions, regulators and supervisors, as the current financial fragmentation prevents us from speaking of a single market. An important limitation which gives rise the regulatory arbitrage, different competency conditions, inefficiencies and, in general, a disadvantage in regard to other world financial areas competing against the European entities.
56
Lastly, although greater fiscal and financial integration may suffice to enable the Eurozone to operate with less tension in the future, it is worth establishing the bases for greater economic convergence among its members, in order to increase the political legitimacy of the economic and monetary union project, with benefits which go beyond those provided by economic stability. The differences between the EMU countries in the workings of factor, goods and services markets are very significant, as well as in long term growth determinants. The structural reforms undertaken to enable the markets to work more efficiently can bring positive effects in a relatively reasonable period of time, enabling competitiveness to improve and the imbalances accumulated during the expansion and the crisis to disappear more rapidly. In this regard, it is essential to ensure the success of the Excessive Imbalances Procedure and other imbalance monitoring mechanisms, ensuring a more efficient preventive and corrective action than that provided by the Stability and Growth Pact. However, in terms of long term growth determinants, such changes can take longer and, in some cases, even decades; it shall therefore be necessary for Europe to boost the solidarity mechanisms required to accelerate this convergence process in a more effective and efficient way than that done in the past.
To simultaneous progress on all these fronts, both at supranational and national levels, is a necessary condition for the Euro to overcome this crisis and for its members to continue to form part of this project in the future. Insofar as the starting point is very
57
different in each country, the main challenge now facing the EMU is to combine in a fair way the rigor and the ambition of the adjustments and structural reforms, on the one hand, with an appropriate time frame and solidarity with all other members of the Eurozone, on the other.
If, on the contrary, the member states should fail to show such determination, any attempt towards European economic governance will be due more an intention than a hard reality. The Eurozone would have an uncertain future. The alternative of a Political European Union, in which all necessary economic policies could be implemented from a community Executive under the control of a European Parliament and with all democratic rights, is currently not expected for the time being.
Bibliography
- Attinasi M. G., C. Checherita y C. Nickel (2009): What Explains the Surge in Eurozone Sovereign Spreads during the Financial Crisis of 2007-09?, ECB Working Paper no. 1131/2009.
- Barro, R. J., N. G. Mankiw y X. Sala-i-Martin (1995): Capital Mobility in Neoclassical Models of Growth. The American Economic Review, 85(1), 103-115.
58
- BBVA Research (2010): Spain Economic Watch. Noviembre.
Bean, Ch. (2004): Asset Prices, Financial Instability, and
Monetary Policy. The American Economic Review, 94(2), 14-18.
- Bean, Ch. (2010): The Great Moderation, the Great Panic and the Great Contraction.
- Bi, H. (2012): Sovereign Default Risk Premia, Fiscal Limits, and Fiscal Policy. European Economic Review, 56 (2012) 389410.
- Blanchard, O. y F. Giavazzi (2002): Current account deficits in the euro area: the end of the Feldstein-Horioka puzzle? Brookings Papers on Economic Activity, 147-186.
- Blanchard, O. (2011): Blanchard on 2011s Four Hard Truths. Vox EU.
- Bordo, M. y O. Jeanne (2002): Monetary Policy and Asset Prices: Does 'Benign Neglect' Make Sense? International Finance, 5(2), 13964.
- Borio, C. y W. White (2004): Whiter monetary and financial stability? the implicatios of evolving policy regimes. BIS Working Papers No 147.
59
- Cecchetti, S., M. Mohanty y F. Zampolli (2010): The Future of Public Debt: Prospects and Implications. BIS Working Paper No. 300.
- Comisin Europea (2009): "Impact of the Current Economic and Financial Crisis on Potential Output". European Economy Occasional Papers, 49.
- Comisin Europea (2012): First Alert Mechanism Report.
- Corsetti, G., A. Meier y G. J. Mller (2011): Fiscal stimulus with spending reversals. The Review of Economics and Statistics (en prensa). - DeLong, J. B. and L. H. Summers (2012): Fiscal Policy in a Depressed Economy. Mimeo.
- Delpla, J. y J. von Weizscker (2010): The Blue Bond Proposal. Bruegel Policy Brief.
- Domnech, R. y M. Jimnez (2010): La Primera Gran Crisis de la Unin Econmica y Monetaria, Pensamiento Iberoamericano, 6, 4980.
Edwards, S., 2002. "Does the Current Account Matter?," en
Sebastian Edwards y Jeffrey A. Frankel, eds, Preventing Currency Crises in Emerging Markets, pages 21-76 NBER.
60
Ehrmann, M., M. Fratzscher, R.S. Gurkaynak y E.T. Swanson
(2011). Convergence and Anchoring of the Yield Curves in the Euro Area, The Review of Economics and Statistics, 93(1), 35064.
Favero, C. y A. Missale (2012): Sovereign Spreads in the
Eurozone: Which Prospects for a Eurobond? Economic Policy, 27(70), 231273.
- FMI (2010), Regional Economic Outlook. Europe.
Gal, J. y L. Gambetti (2009): "On the Sources of the Great
Moderation." American Economic Journal: Macroeconomics, 1(1): 2657. - Hall, Peter A. y David Soskice, 2001a: An Introduction to Varieties of Capitalism. In: Peter A. Hall y David Soskice (eds.), Varieties of Capitalism: The Institutional Foundations of Comparative Advantage. Oxford: Oxford University Press, 170.
Florence J. y P. Sodsriwiboon (2010): Current Account
Imbalances in the Southern Euro Area. WP/10/139. IMF.
- Lane, P. (2010): A European Perspective on External Imbalances. Swedish Institue for European Policy Studies. Report n 5.
- Leeper, E. M. y T. B. Walker (2011): Fiscal Limits in Advanced Economies. Working Paper 16819. NBER.
61
- Obstfeld, M. (2012): Does The Current Account Still Matter? Working Paper 17877. NBER.
- Pisani-Ferry, J. y A. Sapir (2010): "Banking crisis management in the EU: an early assessment". Economic Policy, 341-373.
- Rojan, R. (2005): Has Financial Development Made The World Riskier?. NBER WP 11728.
- Reinhart, C. M. y K. Rogoff (2008): Is the 2007 US Sub-Prime Financial Crisis So Different? An International Historical Comparison. American Economic Review, 98(2), 339344.
- Reinhart, C. M. y K. Rogoff (2009): This Time is Different: Eight Centuries of Financial Folly. Princeton University Press.
- Shambaugh, J. C. (2012): The Euros Three Crises. Brookings Papers on Economic Activity (de prxima publicacin).
62
/JOS CARLOS DEZ * /
Nature and Causes of the Euro crisis
Summary; 1. Introduction; 2. Historical background of the Euro; 3. Nature of the Euro crisis; 4. Fixed versus flexible exchange rates: a review; 5. Causes of the Euro Crisis; 6. Conclusions; Bibliography
Summary
This work analyses the Euro crisis. It includes a review of its historical background and the exchange rate theory to provide conceptual arguments to help understand the nature and causes thereof. It is an infrequent pathology in economics, particularly in developed countries, but with an enormous destructive capacity.
* Jos Carlos Dez is an economist who has combined his academic and corporate roles throughout his professional career. His academic activity is linked to the University of Alcal, where he was an undergraduate and PhD student and now is Professor of Fundamentals of Economic Analysis. He is currently the Chief Economist at Intermoney, a company founded in 1979 and leader in Spain in money market brokerage. He contributes with his forecasts to the panel of experts of the ECB on European economy and the panel of FUNCAS on the Spanish economy, and advises companies, financial entities and institutions both national and international.
63
For this reason, it is important to get the right diagnosis when defining the economic policy that will solve the crisis. The main causes analysed herein are financial integration, the under-assessment of risks, local imbalances within the Eurozone and the Great Recession.
1. Introduction
The world financial crisis, whose first symptom was the collapse of the subprime asset-backed securities market at the start of 2007, has been changing. It is currently focused on Europe, and is calling into question the future viability of the Euro and the European project itself. This work aims to classify the nature of the Euro Crisis and to identify the main causes thereof. Although the objective is not to analyse potential economic measures designed to solve the crisis, without an accurate diagnosis of the origin and dynamics of the crisis, finding the right solution would be an exercise in chance.
To this end, section 2 includes the history of the European project and the single currency. Section 3 describes the nature of the crisis, which is a seldom seen pathology in economics but which causes devastating damage to unemployment and public debt of affected countries. In order to provide the conceptual arguments required to analyse the crisis, section 4 contains a review of the literature on exchange rates. Section 5 analyses the main causes of the crisis, which are: i) financial integration and under-assessment of
64
risk; ii) local imbalances; and iii) the Great Recession. Finally, section 6 includes the main conclusions reached in the article and establishes the requirements to be met by the roadmap in order to put an end to the Euro Crisis.
2. Historical Background of the Euro

The Euro is the first monetary experiment of the 21st century. It is not the first in history and shall not be the last, but it affects an economy like that of the Eurozone which accounts for 15% of the GDP and for 40% of world exports. The European Union is a political project designed to prevent a third world war in Europe. The first assignment of sovereignty was control by a supranational body of the coal and steel production in France and Germany, basic raw materials to produce weaponry. Europe was not an optimal monetary area; therefore, if a country suffered from an asymmetrical disturbance which did not affect the rest and it saw the effects thereof on tis unemployment rate, this could not be offset by workers migrating to other countries with lower unemployment rates. The bubble in Spain is a good example of this. Spain created one third of the jobs in the Eurozone during the boom years, but workers from Germany, where the unemployment rate was reaching historical levels, did not come: instead, it was workers from outside the Eurozone who came. When the bubble burst, our unemployment rate shot up, but very few Spanish workers have gone to work in Germany.
65
The example of an optimal monetary area is always the US. However, we tend to forget that in order to get there; they first had to annihilate the original settlers and then have a civil war which led to a default on payment of foreign debt. The European project belongs to the 21st century and when in Asia, America or Africa integration processes begin, they look to Europe for inspiration. Nevertheless, the Euro was a risky headlong rush. Since the end of the Bretton Woods agreement, Europe has tried to avoid the unfair competition of competitive devaluations within a customs union. Germany, with the strongest currency in the system, has always led the monetary agreements, as its companies suffered the industrial delocalisation created by devaluations, mainly that of the Italian Lira, a country a few hours away by lorry from Bavaria. After the fall of the Berlin Wall, the acceleration of the monetary union was decided so that it would become the striker of the political union. However, the political union reached stagnation after the severe German crisis of 2000, and the single currency project began to crack.
3. Nature of the Euro Crisis

The nature of the crisis which is hitting the European Union is a classical debt deflation crisis (Fischer, 1933). Since the Great Depression, this type of crisis had mainly taken place in emerging countries and was associated with countries with financial vulnerability, with little tradition of macroeconomic stability and insti-
66
tutional fragility. Japan had suffered a crisis of this kind in the nineties and its economy is today trapped under deflation and liquidity, but it was viewed as an exotic case in the Far East. In 2008, the Great Recession led to an abrupt disruption of the paths of growth in developed economies, and the ghost of the Great Depression began to haunt the world. By contrast, the decisive and coordinated action of global economic policies prevented another Great Depression (Eichengreen, 2010). Since then, world trade and industrial production are 10% higher to levels prior to the Great Recession, although the MSCI world stock index continues to be 20% below the levels of spring 2008.
Nonetheless, the crash of Lehman Brothers led to the collapse of world trade, and all countries and areas entered abruptly into recession, which favoured policy coordination. But the recovery from 2009 was asymmetric, and the coordination of world economic policies was conspicuously absent. In the Eurozone, from summer of 2008 to spring of 2009, the euphoria in support of an intervention to avoid a depression gave way to exit strategies in autumn of that same year and to begin implementing these in spring of 2010. The debt crisis affected a country with huge imbalances in the balance of payments and high level of indebtedness such as Greece, which accounts for 2% of the GDP and population of the Eurozone, and has extended first to Ireland, then to Portugal, and now to Italy and to Spain. One third of the GDP of the area is already affected, and it has thus become a systemic and global problem. This is a crisis in the balance of payments, but the existence
67
of a currency and the high level of indebtedness mean the lack of any comparable historical precedents, which in turn makes the diagnosis and the search for policies to solve it much harder. For this reason, we must carry out a review of classical literature on exchange rates in order to establish the conceptual bases for the explanation of the crisis, without which the search for a solution would become a random wander.
4. Fixed exchange rates versus flexible exchange rates: a review

An exchange rate is a relative price between two hypothetical shopping baskets of two countries. However, exchange rates are closely related to interest rates (Keynes, 1992), and we are therefore speaking of a relative price which is essential when explaining economic development. Probably for this reason and as a result of the advance of globalisation, both commercial and financial since the fifties, in recent decades economists have paid special attention to exchange rates. Exchange rates can be:
i. Free floating: the exchange rate is set freely in the market on the basis of supply and demand, without the intervention of the central bank or the government of a country. The Euro and the Dollar are the closest free floating currencies.
ii. Dirty or managed float: the government or central bank supposedly does not intervene but there are verbal interventions or
68
changes in monetary policy which attempt to alter the bases of supply and demand in the currency market. At times of maximum volatility both the US government and the European ones verbally intervene in the market. During the Great Recession, the Federal Reserve, without expressly acknowledging this, has applied a monetary policy which has significantly weakened the dollar. The ECB has always followed in the footsteps of the Fed but in 2011 it managed to exceed its action by weakening the Euro, also without express recognition thereof. Japan is without question the best example of dirty flotation. The country supposedly enjoys free exchange rates but when there is tension in the markets and the savers repatriate capital, the central bank intervenes massively in the currency market to counteract the pressures of appreciation on its currency, which would have a very negative repercussion on activity and employment.
iii. Fluctuation bands: the European Monetary System or EMS, the predecessor of the Euro, was the clearest example of this system. A central parity and fluctuation bands were established. Whilst the exchange rate in the market fluctuated within the bands, the system behaved like a flexible currency rate, but if it reached the bands then the central bank intervened to prevent these being exceeded, therefore becoming a fixed Exchange rate.
iv. Fixed on a currency basket: equal to a fixed rate, but instead of fixing the anchor on one single currency it is fixed on a basket. It has been speculated for some time that China wants to apply
69
this system. It makes more sense that just fixing it against the dollar, as the basket should replicate the composition of the current account and financial balance and would allow for better stabilisation of real exchange rates, which are the ones which determine the impact on activity and employment.
v. Fixed adjustable: this is a fixed exchange rate which allows for adjustments. These may be discretionary or else subject to rules such as in the Bretton Woods system, or periodically adjustable. The latter were used in emerging countries which had sustained soaring inflation rates in the eighties and nineties during their stabilisation programmes, especially in Latin America.
vi. Non-adjustable or true fixed rate: the country fixes a nominal anchor with a fixed rate relative to another currency with no possibility of change. Middle Eastern countries have fixed exchange rates against the dollar, which is justified by income from oil being collected in dollars. China had a fixed exchange rate against the dollar until 2005, when it moved onto daily fluctuation bands which it has recently broadened to +/- 1% daily.
vii. Cash conversion: the monetary supply of a country is determined by the level of currency reserves, and thus monetary sovereignty is subject to capital flows. This was the exchange system in Argentina until 2001.
70
viii.Exchange Union: the countries waive their national sovereignty and assume a new currency. This may be a dollarization as has been proposed in some Latin American countries, or else a Euroization where the dollar would be adopted but without representation in the central bank. Or else a monetary and exchange union such as the Eurozone, where countries assume the same currency and are represented in the central bank and in monetary and exchange decision making processes.
The debate on fixed or floating exchange rates is as old as macroeconomics. During the happy twenties and then during the Great Depression, capital movements were accused of being speculative due to the extreme volatility of exchange (Nurkse 1942). Subsequently, another school of thought argued that the volatility was caused by destabilising economic policies and that freedom and speculation had stabilising effects (Friedman 1953). Rudiger Dornsbush opened up a new avenue of research according to which, even with investors with rational expectations, there was volatility in exchange rates. An increase in the money in circulation by the central bank would increase inflation expectations and lead to a depreciation in the exchange rate. However, for investors to buy once again there should be expectations of appreciation; the exchange rate should therefore over-react and exceed its level of equilibrium to enable capital flows to return to the country.
The truth is that neither the theory nor the empirical evidence are conclusive in this debate. The problem facing the countries is
71
threefold: exchange rate stability, monetary independence and financial aperture. Conceptually speaking, flexible exchange rates are the optimal solution, but for these to be stable the country must have monetary credibility. Flexible exchange rates provide leeway to the central bank in terms of fiscal policy, whereas the fixed exchange rate means this is lost and it becomes dependent on the decisions made by the central bank to which it has anchored its currency. The problem is that credibility takes a long time to achieve and takes very little time to lose. Moreover, it cannot be imposed; it is the society of the country in question which must understand stability to be a public asset and to accept sacrifices and limitations in order to preserve it.
Countries lacking monetary credibility have hardly any leeway in monetary policy, and this reduces the costs of accepting a fixed exchange rate. If the country has suffered from hyperinflation or a spiralling inflation, a nominal anchor on a stable currency allows for stabilisation of the prices of imported goods in the shopping basket and, combined with a stabilisation plan, proves to be highly effective to get the economy out of hyperinflation. This is what happened in Argentina in 1990, but then the fixed exchange rate allowed imbalances to go beyond what was sustainable and ended up by exploding in mid-air and amplifying the effects of the severe crisis of 2001.
During the nineties the debate in Europe prior to the creation of the Euro was very intense (Rodrguez Prada, 1994). Most economists did not call into question the fact that Europe was an opti-
72
mal monetary area (Meade 1957 and Mundell 1961). Although much progress has been made in the freedom of movements of capital and people, the labour markets continue to be segmented, mainly due to language and cultural differences, and when a region suffers an asymmetric disturbance with an increase in unemployment, this is not offset by transferring workers from another region as they do, for example, in the US. In this scenario, the country needs to transfer capital and work to the sector of non-corporate goods to the corporate goods sector and needs to depreciate the real exchange rate. Without the capacity to devaluate the nominal exchange rate, all the adjustment must be made via inflation or productivity. When the central country has inflation rates close to 2% the strategy must be deflationist, which is where the problems start, as many economists warned prior to the creation of the Euro and has been proven since the Great Recession (Obstfeld 1998).
Nevertheless, the lack of an optimal monetary union is clearly a downside to the creation of the euro, but in the nineties it was the benefits that were highlighted (De Grauwe 2009). The main benefit is that we Europeans already had a customs union and high level of commercial integration. Nowadays, approximately 70% of the Spanish exports are concentrated in the European Union and 60% of what we import comes from our partners. Therefore, national exchange policies were very destabilising in this scenario, putting the European project at risk.
73
The main benefits were concentrated in the financial area. Integration would enable the removal of currency risk and risk premiums, leading to a drop in real interest rates and therefore increasing the potential growth of the Eurozone and of each of the countries therein, in turn allowing for convergence in income per inhabitant with the US, which experience a sharp boom in productivity in the nineties. Chart 1 shows how the introduction of the euro did not achieve the desired convergence, except in the case of Spain.
Chart 1 Gross Domestic Product per inhabitant
Source: Eurostat structural indicators and own work
74
In the debate of costs and benefits prior to the creation of the Euro, many economists warned of institutional problems in the design of the monetary union. The main ones were the absence of a fiscal union which would offset the asymmetric disturbances that might take place in some states and, that in the absence of exchange rates and monetary policy, the country would be left without economic policy leeway to counteract them (Eichengreen 1998). The other main limitation was the absence of a true lender of last resort which the statutes imposed on the ECB (Obstfeld 1998).
5. Causes of the Euro Crisis

The Euro crisis is extremely complex like all debt deflation crises in history (Dez 2012), which is why we shall now review the main events to enable us to understand the fundamentals of the over-indebtedness without which we shall not be able to come up with appropriate economic policies to help digest this.
5.1. Financial integration and under-assessment of risk

When a country adopts a fixed exchange rate and investors consider it sustainable in the future, the risk premium drops. A rational investor must choose between an infinite variety of international assets in which to invest his savings, but his yield estimates are made in local currency as the objective of purchasing financial assets is to protect against the impairment of purchasing power
75
caused by inflation during the investment period. If an investor purchases an asset in another currency that then appreciates during the investment period, his yield will increase in the local currency, but if it depreciates it will drop, which explains the direct relationship between interest and exchange (Dornbusch 1976).
In the case of the Euro we are dealing with the exchange rate with the largest commitment and greatest exit costs; therefore its added credibility is also greater, just as the drop in risk premiums is also highly intense. Chart 2 shows the intense process of financial integration which took place in Europe following the creation of the single currency. Investment funds and financial institutions in the Eurozone went from having 20% of assets from other countries in the region in their portfolios in 1998, to 45% and 40% respectively in 2007. This means a huge transfer of capitals from countries with a savings surplus, mainly Germany, to countries with savings deficits and especially those with higher risk premiums.
This arrival of capital flows, along with the credibility granted by the investors to the Euro since its inception, help to explain the intense convergence of interest rates between the public debt of the various member countries that can be observed in Chart 3. However, as is the case with all bubbles, at the beginning there are fundamentals which justify investor behaviour, but usually, following such sharp changes in financial flows, there is usually and over-reaction and asset prices move away from the fundamentals.
76
Chart 2 Financial integration
Source: European Central Bank
Chart 4 shows how not only did convergence take place in public debt interest rates, but that the process was more intense in private debt. Covered bonds are the assets with the least likelihood of default following the public debt of a country and it might even be the case, in extreme cases, of default on Treasury bonds but not on covered bonds, as has happened in Greece. The covered bond is a bond with a senior guarantee from the financial institution that issues it, but which also has a second guarantee. The issuing entity selects its highest credit quality mortgages, those for the main residence, with a debt under 80% of appraisal and a monthly instalment below 35% of the household income, and these are attached as bond guarantees. Therefore, in the event of bankruptcy of the
77
Chart 3 10 years Public debt spread v. Germany
Source: Bloomberg and own data
entity, the buyers of the covered bond would prevail over the rest of creditors to collect on such mortgages until recovery of their investment, irrespective of whoever purchases the bankrupt entity. This is what distinguishes them from asset-backed securities where the investor assumes the direct default of the mortgages. In the case of the covered bond, the risk belongs to the entity and, second to the default of the mortgages, and thus they have a dual guarantee and lesser likelihood of default. Moreover, the rating agencies require the over-collateralisation of the issue, so that if an institu-
78
tion issues a covered bond worth 1000 million euros, they would be required to provide between 1300 and 1500 in mortgage portfolio as a guarantee. Hence, the entity would first have to be declared bankrupt and then it should have to have a default in the mortgage portfolio of over 50% for the investor not to recover 100% of his investment. This helps one to understand that since 2007 no covered bond issued by a European entity has experienced default. These types of assets do not exist in the US, as the Fannie Mae and Freddy Mac played the same role, but evidence has shown that the European system, by maintaining the risk in each institution, was more efficient and, in fact, there are legislative proposals under way to develop a covered bond market in the US.
Until 1997, the companies of peripheral countries such as Spain found it difficult to issue bonds on the international markets. The Peseta was a currency which had experienced several devaluations over the last few decades, its financial markets were very narrow and were practically taken over in full by public debt. The entry of the Euro enabled Spanish financial entities to access an organised market of covered bonds with a longstanding tradition and depth in Germany, which rapidly spread to all other countries in the area. As we shall explain shortly, this coincided with a deep and complex debt crisis in Germany, as a result of the excesses of its Unification, which increased the savings rate in a structural way, and thus the supply of top quality credit assets for its financial institutions, insurance companies and pension funds, which in turn boosted the rapid growth of this market as well as its (Dez 2012b).
79
Chart 4 Spanish covered bonds spreads
Source: Bloomberg and own data
In Chart 5 we can see how such structural changes in the fundamentals led to a credit boom in the Spanish economy. The origin of the boom was justified by the fundamentals, but in the end the only fundamentals were the self-realisable expectations, leading to the bubble. In 1995, when the likelihood assigned by investors that Spain would form part of the founder members of the Euro was very low, practically all of the Spanish bonds in the hands of non-residents were public. Since then, the percentage of public debt over GDP had become constant, but when our incorporation
80
into the single currency was approved in 1998, the international issues market opened up for the private sector and grew exponentially until it doubled that of public debt in terms of GDP. The heading other resident sectors includes the asset-backed securities funds, rendering most of debt as pertaining to banks.
Chart 5 Spanish bonds in the hands of non-residents
Source: Bank of Spain, INE and own data
Covered bonds are purely a bank product, despite carrying a second mortgage guarantee, and are accounted for as bank debt. The most developed covered bond market in the world was the German
81
one of Pfandbrife but in Chart 6 one can see how in 2006 the Spanish banks issued 70,000 million euros in covered bonds, 30% less than the German banks which had a balance three times as large as that of Spanish banks. In summer 2007, before the start of the financial crisis, the outstanding balance of covered bonds issued by Spanish banks exceeded 300,000 million euros, 30% of the GDP and an amount equal to the outstanding balance of Spanish public debt. In 2006, the issues of covered bonds and asset-backed securities by Spanish banks comfortably exceeded the current account deficit which was approaching 100,000 million and were the main financing instrument of our economic, without which it is not possible to explain the credit and real estate bubble.
The dynamics were straightforward. The Spanish banks used the loans granted in retail banking as a guarantee for new issues which allowed the granting of new credits. The issues of covered bonds were carried out at variable interest rates of Euribor plus 10 basis points and the mortgages were granted at Euribor plus 50 basis points. A strong growth in credit, low rate of default and spreads between stable asset and liability rates constituted the basis of the demand for funds of Spanish banks. What were the fundamentals of the supply of funds? The key lay in the Shadow Banking System (FSB 2011, European Commission 2012). This consisted mainly of vehicles created by international banks, based in tax havens and not consolidated in their balance sheets and thus outside the perimeter of oversight by the central banks. The vehicles purchased assets, mainly of high credit quality and were funded by the com-
82
Chart 6 Issues of Covered Bonds
Source: International Monetary Fund
mercial paper market using those assets as guarantees. Let us assume that the vehicle bought a covered bond at Euribor plus 10 basis points and was funded by Euribor commercial paper. This resulted in a profit of 10 basis points per transaction. If the vehicle only had 5% of capital and 95% of debt, this meant a 20-fold leverage, such that the yield over equity was Euribor plus 200 basis points.
The growth of the shadow banking system was exponential and in 2007 in the US reached 20 billion dollars, whereas the non-shadow banking system supervised by the Federal Reserve amounted
83
to 16 billion dollars. The asset-based leverage which used mortgage guarantees already granted enabled the banking system to generate liquidity in an endogenous manner without having to resort to the central bank, leading to the loss of monopoly by the monetary authorities of the issue of money in circulation. When in February 2005 Alan Greenspan, then President of the Federal Reserve, announced that there was an enigma in the behaviour of the bond market, he was responsible for this for allowing the development of the shadow banking system. Until 2009, no statistics were published on the shadow banking system but, once they became public, it was much easier to understand the causes of the largest global cre-
Chart 7 Current account balance
Source: International Monetary Fund
84
dit bubble burst since the Great Depression and which was particularly severe in some Eurozone countries, including Spain.
5.2. Local imbalances:

Over the last few decades, the economic paradigm has analysed the real economy and the financial economy separately. The Great Recession has proven the failure of the paradigm and, as we were shown by Luca Paciolo in the 13th century, when an economy is analysed, the assets and liabilities cannot be separated. Therefore, although it is evident that the hurricane began in the financial realm, there are imbalances in the real economy which also help to explain the crisis. Chart 7 shows the divergence between current account balances among developed and emerging countries in the last decade. Several causes help explain this phenomenon which the literature has called global imbalances (Caballero 2009).
The main cause was the aftermath of the Asian crisis of 1997. The affected countries had large current account deficits and low levels of currency reserves before the crisis, and subsequently they geared their economic policy towards exports. This led to current account surpluses and high currency reserves, and the ensuing structural increase of the world savings rate (Bernanke 2005). The accumulation of reserves was concentrated on sovereign funds and central banks with a conservative approach, which significantly increased the demand for fixed income funds of top credit quality,
85
known as AAA. Without understanding the Asian crisis and its consequences it is not possible to understand the intense development of the shadow banking system and the strong increase in leverage in the world banking system which has been analysed in the previous section (Caballero 2008).
Chart 8 shows how the Eurozone was hardly affected by the phenomenon of Global Imbalances, with a current account balance close to equilibrium since the Asian crisis. However, Chart 8 shows that there have indeed been huge differences between the countries within the Euro and, for this reason, the phenomenon has now been called Local Imbalances. In 2001 Germany suffered a debt crisis similar to the one suffered at present in Spain, although it hardly translated into a current account or foreign debt deficit. Germany, as was the case in Japan in the eighties, suffered from a problem of over-indebtedness of households and businesses, with real estate bubble, burst and depression all thrown in to the package. Following the burst of the bubble in 2000, German households were reluctant to take on debt and structurally increased their savings rate to reduce such a debt. Private consumption plummeted and businesses sought the supply that was absent in the domestic market in the export market. The fiscal revenue dropped dramatically and Germany failed to meet the Stability Pact and watched its public debt increase significantly until 2005.
The birth of the euro and the credit boom in peripheral countries enabled Germany to overcome the severe recession thanks to
86
the strength of its exports. Moreover, German savings found an easy path without assuming exchange rate risk with its partners in the Eurozone. The causes of the Euro crisis are focused on the analysis of the imbalances of debtor countries, but it is not possible to understand and explain the crisis without analysing the saver countries, particularly Germany. Debtor countries are facing a prolonged period of debt reduction, which will ensure a weak internal demand, and shall be obliged to show a current account surplus as was the case in Asia in 1998 and in Germany in 2001. But this will not be possible if the creditor countries reduce their current account surpluses and boost internal demand.
Chart 8 Current account balance
Source: International Monetary Fund and own data
87
5.3. The Great Recession:

The European Monetary Union was born with institutional problems but these did not become evident and to put its viability at risk until 2009. Chart 9 shows how the Great Recession which ravaged the world and Europe in 2008 has been the worst for seventy years, although it did not reach the depth and length of the Great Depression, which it is being called the Great Recession. Without an earthquake of this force, it is possible that the institutional flaws of the European project could have endured for longer, but the crisis has highlighted them and the Euro is now at a crossroads.
In 2007 it was financial disturbances which anticipated the recession. Chart 6 shows how the covered bond market practically dried up for Spanish banks as well as for all other indebted countries. This brought the credit boom to a halt and acted as the trigger for the recession. In 2008 the disorderly collapse of Lehman led to the worst global run since the Great Depression. The investors quickly resorted to short term public debt of the internal reserve currencies, the money markets dried up as did the currency markets, and world trade collapsed in a matter of weeks. The coordinated reaction of the G20 with the most expansive monetary, fiscal and financial policy in history prevented the world from entering into a depression and enabled a V-shaped recovery of world economy and trade in 2009.
88
Chart 9 GDP EU 15
Source: Angus Maddison. University of Groningen
Economics is an empirical science but it is difficult to find homogeneous experiments to compare policies, but this crisis has provided one. The Great Recession was synchronized and most countries entered into recession at the same time. However, the recovery since 2009 has been disparate and the economic policies have been very different between the US and the Eurozone, which enables a comparison of its effects to be drawn. Europe began fiscal consolidation at the beginning of 2010, despite the boost given in 2008 to get out of the recession, whereas the US has continued to renew its fiscal incentive plans. The ECB has been reluctant to intervene and has only done so when the markets have been on the edge of collapse and it even took the liberty of incre-
89
asing the interest rated in July 2011, making the same mistake as in July 2008, anticipating the recession. The Federal Reserve has kept its rates at 0% and has renewed its quantitative policies.
After two years of experimenting, what has the result been? The growth in the US has been twice that of Europe, its inflation has also doubled and its unemployment rate has reduced to 8.5%, whereas in Europe it has exceeded 10%. In the US, several states, among them California and Florida, burst their real estate bubbles and California defaulted on payments and created its own currency, what was known in Argentina as Patacones. Therefore, the Euro crisis is not the cause of the problems in Europe but simply the result of mistakes made in economic policy in Europe since 2009. Neither is the argument of the greater rigidity of European labour markets and the mobility problems between countries valid. In the US, the unemployment rate increased with equal intensity in states which did not have a real estate bubble, thus confirming that the cause of the growth in unemployment was a sharp drop in demand caused by an intense banking crisis and credit restriction. But the most spectacular result of the experiment is probably what happened with public finances. The US, without resorting to raising taxes, without great cuts and simply by freezing public expenditure has managed to increase fiscal revenue by 12% and has reduced the deficit by four percentage points of GDP. Europe, by raising taxes and cutting costs has managed a revenue increase of 6% and a reduction of the deficit of two points of GDP.
90
The emergence of almost ten points of public deficit in a new Government in Greece was the spark which ignited the Euro crisis which we currently face. The Greek Tragedy spread first to Portugal, then to Ireland, and currently threatens Spain and Italy, thus having affected one third of the GDP of the Eurozone, (Dez, 2012). Chart 2 shows how the Great Recession began a process of financial disintegration in the Eurozone which was intensified by the Greek Tragedy and the contagion of all other economies. In a monetary union, the outflow of capital is equal to a contractive monetary policy and, on the contrary, the inflow of capital is expansive. This helps us to understand why the countries subjected to financial tension entered once again into deep recession in 2011 whereas Germany, the main receiver of capital flows, has continued to grow.
6. Conclusion
The European project is a political one and it is born out of the need to end wars and conflicts which had ravaged Europe in the 20th century. The Euro was an attempt to accelerate the political union but has ended up being a headlong flight.
The Euro is the most extreme version of a fixed exchange rate. Indeed, it is reinforced and with high cost of departure, which renders it more credible, but while it lacks a political union there will always be doubts as to whether it will be a single currency.
91
In the nineties the benefits and there were some which have been clearly demonstrated of the creation of the euro were overvalued. But at the same time there was an under-assessment of the costs which reality has proven were also there. The two main institutional problems which must be solved are: i) the absence of a fiscal union to complement the monetary union and ii) the absence of a lender of last resort due to the limitations imposed on the ECB in its bylaws.
Financial integration and the undervaluation of risk, both global phenomena, are essential to explain the credit boom and the problem of over-indebtedness which are the origin of the Euro Crisis. The case of the covered bonds is a good example that not only were credit risks undervalued, but liquidity risk was likewise under-assessed.
The Local Imbalances, the high current account surplus in Germany and the deficits in Spain and other countries forced the transfer of financial flows and boosted the credit boom and over-indebtedness. Countries subjected to financial tension are implementing sharp reductions in their current accounts, but Germany has hardly reduced its foreign surplus since 2007.
The institutional problems of the Eurozone became apparent at the Great Recession, as a result of the sharp drop in activity and the collapse of the financial markets and credit channels which have rendered many debts unsustainable and unpayable.
92
Without such a deep recession, the problems would have taken longer to appear.
The aim of this article was not to discuss solutions, but from the analysis of the nature and causes of the Euro crisis, we can conclude that the solution must: i) dispel doubts as to the future viability of the euro, ii) to do so we must work towards the fiscal union and the creation of Eurobonds would be the precedent for a future single European treasury, iii) we must change the bylaws of the ECB so that it may act as a lender of last resort as the Federal Reserve does in the US, iv) we must halt the process of financial disintegration and ensure the return of part of the capital flows which have exited from peripheral countries, and v) we must urgently reactivate growth in Europe. In order to do so, the monetary policy must opt for quantitative strategies of debt purchase, the fiscal policy must be less restrictive and the financial institutions and countries with greater solvency problems must be recapitalized in order to restore the credit channels as soon as possible.
93
Bibliography
- Bernanke, B. (2005). The Global Saving Glut and the U.S. Current Account Deficit. Federal Reserve Speech 10 March.
Bernanke, B. (2007). The Financial Accelerator and the Credit
Channel. Federal Reserve Speech 15 June.
Caballero, Ricardo J., Farhi, Emmanuel and Gourinchas, Pierre-
Olivier (2008), "An Equilibrium Model of Global Imbalances' and Low Interest Rates," American Economic Review, vol. 98 (1), pp. 358-93.
- Caballero, Ricardo J. and Krishnamurthy, Arvind (2009), "Global Imbalances and Financial Fragility," American Economic Review: Papers & Proceedings, vol. 99 (May), pp. 584-88.
- European Commission (2012) El Sistema Bancario en la Sombra. Libro verde, Marzo.
- De Grauwe, Paul (2009) Economics of Monetary Union 9 ed. Oxford University Press. Oxford.
- Dez, Jos Carlos (2012) Crisis de la Deuda Europea: crisis de emergentes o sumergidos Papeles de Economa Espaola 130 January, pag. 150-166.
94
Dez, Jos Carlos (2012b) El Sistema Bancario tras la Gran
Recesin Mediterrneo Econmico 20 January, pag. 329-345.
Dornbusch, Rudiger. (1976) "Expectations and Exchange Rate
Dynamics." Journal of Political Economy 84: pag. 1161-76.
- Eichengreen, Barry, and Wyplosz, Charles (1998) The Stability Pact: Stabilizing or Destabilizing? Economic Policy 26 April, pag. 65113.
- Eichengreen, Barry and ORourke, Kevin (2010), A tale of two depressions: What do the new data tell us? February 2010 update, VoxEU.org, 8 March.
European Commission (1998) Convergence Report 1998,
Bruselas.
- European Monetary Institute, Convergence Report, Frankfurt am Main, March 1998.
FSB, Financial Stability Board (2011) Shadow Banking:
Strengthening Oversight and Regulation. October.
Friedman, Milton (1953) The Case for Flexible Exchange Rates.
Essays in Positive Economics.
95
- Chicago: University of Chicago Press, 1953, pp. 157-203. Chicago.
- Keynes, John M. (1992) Breve Tratado sobre la Reforma Monetaria. Fondo de Cultura Econmica de Espaa. Madrid.
- Meade, James (1957) The Balance of Payments Problems of a Free Trade Area.
- Economic Journal, Sept. 67, 379-96.
- Mundell, Robert (1961) A Theory of Optimum Currency Areas. The American Economic Review, Vol. 51, No. 4., pp. 657-665.
- Nurkse, Ragnar (1942). International Currency Experience. Lessons from the Inter-War period. League of Nations, p. 188. Genova.
- Obstfeld, Maurice (1998) EMU: Ready, or Not? Working Paper. University of California, Berkeley.
- Rodrguez Prada, Gonzalo (1994) Teora y estrategias de la integracin econmica y monetaria: con aplicaciones a los casos de la UE, el NAFTA y el MERCOSUR. Universidad de Alcal. Alcal de Henares.
- Torrero, A. (2006) Crisis Financieras: Enseanzas de Cinco Episodios. Marcial Pons. Madrid.
96
/JUERGEN B. DONGES * /
The European crisis and the challenge of efficient economic governance
1. Introduction; 2. The root cause of the problem: too much economic divergence; 2.1. A suboptimal monetary area; 3. Attempted governance in an indirect manner; 3.1. Breach of the fiscal rules; 4. Governance as activism against the crisis; 4.1. Constituent principles, violated; 4.2. Financial assistance, a never-ending story?; 4.3. Political pressure to impose discipline, insufficient so far; 4.4. Financial markets, with capacity to persuade; 5. New governance design: own responsibility as the key; 5.1. The euro Plus Pact, it is not binding on anyone; 5.2. The Fiscal Stability Pact, a test of nine; 5.3. The Macro-economic Governance Pact, with vague parameters; Conclusion
* Professor emeritus of economics at the Faculty of Economic and Social Sciences of the University of Cologne (Germany). From 1969 to 1989 he managed several economic analysis departments at the Kiel Institute for the World Economy, in which he was the Vice-chairman for the previous six years until he took the chair in 1989 in Cologne. He is currently a Senior Fellow of the Cologne Institute for Economic Policy. He was the Chairman of the German Council of Economic Experts (the so-called Five Wise Men) and the German Commission on Economic Deregulation. He is an economic advisor in several academic institutions and foundations in Germany, Spain and in other countries. He is also a member of the Supervisory Board of several multinational companies. He is the author of several books and articles published in academic journals on international economy and public policies in the field of macro and micro economy.
97
The European Crisis and the challenge of efficient economic governance
1. Introduction
The purpose of this article is to focus the current discussion on the need for economic governance in the European Union (EU) and, in particular, in the euro area, in the context of the political reality. This is not such an easy task, as it may seem; in practice the relations between national governments, on the one hand, and these and the European Commission and the European Parliament, on the other, end up being profoundly redefined, with more European powers and less national sovereignty.
This topic is not new; it has been on the table at the meetings of the European Council of the Heads of State and Government since the formation of the European Single Market 25 years ago (1986 Single European Act). We can interpret agreements leading to a coordination of economic policies, as the initial step towards smooth European economic governance, specifically to (i) promote employment (1997 European Summit of Luxembourg), (ii) apply structural reforms conducive to flexibility in the product and factor markets (1998 Cardiff Summit), and (iii) institutionalise macro-economic dialogue among the governments, the European Central Bank (ECB) and social partners (1999 Cologne Summit). Apart from the above steps we should add (iv) the agreement of the European Council in 2010 to launch a strategy of structural reforms that would make the EU at the end of that decade the most dynamic economic area in the world.
98
These agreements which were then celebrated as a landmark in the European integration process have not given the desired results. The reason is very simple: over and above the rhetoric, the governments were not willing to co-operate if the alleged or true national interests indicated otherwise. Such governance installed in the European Council, the Ecofin and in other councils of ministers involved, lacked any kind of power of management and supervision of the economic and fiscal policies of the member states.
At the current debate the great hope is that in the future national interests will come second, giving way to the More Europe, as the new political logo reads. The aim is to reach greater and efficient intra-European co-ordination of the economic policy of the member countries. This aim was raised in 20112012 in three basic agreements: (i) the Euro Plus Pact (to strengthen the competitiveness and growth capacity of the economies), (ii) The Fiscal Stability Pact (Fiscal Compact to guarantee in all the countries the sustainability of public finances in the medium and long term) and (iii) the Macro-economic Governance Pact (Economic Governance Six Pack, to ensure economic and fiscal policies compatible with the internal and external balance in the economies). Now, the declarations of intent are one thing, putting them into practice and applying the appropriate economic policies, is quite another. Why should what politicians promise today be believable, if in the past (and today, as many of them are still around) did not fulfil their commitments?
99
I will now analyse governance in its past and present dimensions. The following section emphasises the significant fact that the euro area is not an optimal monetary area. In the third and fourth sections the forms of governance relied on until now are analysed. The fifth section deals with the new approach for European governance. The last section concludes the analysis in a tone of moderate hope.
2. The root cause of the problem: too much economic divergence

The crisis of the sovereign debt in Europe has shown a serious fault in the formation of the single currency: trusting that the governments of the member countries would apply quality economic policies in accordance with the common interest of all the partners, as set forth in the EU Treaty (articles 2 and 121), was naive. In Germany, I together with many other economists noticed this fault then, but political leaders took no notice or it was labelled as academic and, therefore, irrelevant to take great historical decisions. The leaders simply invoked the criterion of the so-called supremacy of politics over economics, as they do today when they run from one summit to the next to rescue certain countries from bankruptcy and try to stabilise the euro area.
100
2.1. A suboptimal monetary area

The architects of the euro area, from the 1989 Delors Report, knew that a monetary union would not be feasible in the long run without a fiscal union, not to mention political union. The history of the different monetary unions in Europe in the 19th Century had left an unequivocal message: all of them failed because of incompatibilities among the budgetary policies of the member countries. However, during the negotiations of what would become the Maastricht Treaty (of 1992) the prerogative of national budgetary policy was sealed. The then two main characters of the European project, the German Chancellor Helmut Kohl and the French President Franois Mitterrand, fascinated their counterparts with their vision of the euro as a pacemaker to accelerate and to go into greater integration. More than one will remember the famous statement of the French Finance Minister, Jacques Rueff, Europe shall be made through the currency, or it shall not be made (1950), and they took it literally. The French statesman could never have imagined such a deteriorated environment of public finances as we have today in many European countries.
It was also clear that the five convergence criteria set forth in the Maastricht Treaty, even if they could be fulfilled (something that not all countries have done), did not guarantee an optimal monetary area (in terms of the theory of Robert Mundell and others). In Europe, it would have been essential for the countries to be quite homogeneous in terms of economic development and functioning
101
of the institutions or the prices and salaries in the various countries should have been flexible enough (especially downwards in countries with weak growth and great structural unemployment), or for European mobility of labour to be high (from backward regions with high unemployment rates to dynamic regions with shortage of workers). These conditions for an optimal monetary area did not happen twenty years ago and do not happen today. The difference between Europe and the United States in this is significant.
Only a group of countries in the euro area (in central and northern Europe) at least met then and meets now the condition of homogeneity. The countries in the southern periphery were not, strictu sensu, ready for their accession in 1999 to the monetary union and, therefore, to waive a monetary and exchange rate policy as adjustment facilities of internal imbalances (inflation) and external imbalances (current account deficit) and to undertake tax regulations that would restrict government deficit and the level of government debt. It is not a coincidence that these countries have had for the past two years a risk of insolvency (not to have the capacity to re-finance the debt in the capital market under affordable conditions), as only sovereign countries have, if the State may not resort to the Central Bank to secure financing and must get it by issuing bonds in a foreign currency. Greece may be the most illustrative example of having done what the German Council of Economic Experts has classified as an original sin, in other words, having rushed into accessing the monetary union in 2001, forced even through deceit (hiding the truth
102
of their fiscal statistics): the country is now at the mercy of the international financial markets (rating agencies), after having revealed the serious structural deficiencies in the economy and the public institutions, which has led to a low growth potential and low levels of productivity and competitiveness clearly insufficient at this time (globalisation of competition).
3. Attempted governance in an indirect manner

It was conceptually logical that with the creation of the single currency the powers on monetary policy would be transferred from the National Central Banks to the new ECB. However, as the budgetary policy would carry on being a national responsibility, two principles constituting the euro area were established in order to guarantee the sustainability of the public finances in the member countries and to ensure that the monetary union would work as a price stability union.
The two principles proclaimed in the Maastrich Treaty are the prohibition to bail out insolvent partners, on the one hand, and the prohibition imposed on the ECB to finance government deficits (no monetisation), on the other hand. These clauses are contained in the most recent version of the Treaty on the European Union (the Treaty of Lisbon of 2007) in articles 125 and 123, respectively.
103
The two provisions were supplemented with the Stability and Growth Pact (SGP) approved in 1997 at the European Summit in Amsterdam; in it a ceiling for national budget deficits (3% of GDP) and government debt (60% of GDP) were established under the assumption that the growth rate of the nominal GDP in the euro area would be 5% in the medium term.1
With all this, indirect governance elements were created, in other words, formally maintaining national powers in budgetary policy, but controlling the use of the powers that could destroy the feasibility of the euro area.
The monetary union was not designed to pay debts jointly and generate financial transfers from certain States to others, as many today think that that is the case, appealing to solidarity among peoples. There was already solidarity, and there still is, in the good sense of the concept: the more developed countries of the EU must help the least developed for these to advance in real convergence; the various European Structural Funds are for this. But it is not compatible with the concept of solidarity; it rather constitutes a perversion (Issing) of it, having to rescue a society that underestimates saving, tends to consume ostentatiously, tolerates waste by the public authorities, does not fulfil tax obli1 For a profound analysis see A. Brunila, M. Buti and D. Franco (ed.), The Stability and Growth Pact: The architecture of fiscal policy in EMU. Houndsmills/Basingstoke (United Kingdom): Palgrave, 2001 Crculo de Empresarios (ed.), Pacto de Estabilidad y Crecimiento: alternativas e implicaciones. Libro Marrn 2002. Madrid (December).
104
gations and claims social benefits beyond the means of the country, given its own resources.
3.1. Breach of the fiscal rules

The architecture of indirect governance crumbled when it had to pass the first real test, in 2002/03. In those days, Germany (Schrder) and France (Chirac) violated the the fiscal rules of the game. In Germany, government deficit had reached 3.7% of GDP in 2002 and 3.8% in 2003; in France, it was 3.2% and 4.1% respectively. In both cases, most part of the deficit was structural. The European Commission had activated, according to the SGP, the supervisory mechanism for excessive government deficit against these two countries. The German Chancellor explicitly rejected the intervention from Brussels, the same as the French President. They both imposed their criterion at the European Council in November 2003, which suspended the process (against the votes of Austria, Spain, Finland and Holland). The then President of the European Commission, Romano Prodi, had described the SGP in an interview (on 18/10/02) as stupido, which is highly surprising coming from the custodian of the European Treaties.
At the European Summit held in March 2005, the SGP was amended, watering it down a great deal: with new exceptions for breaking the rules, an assessment of the budgetary situation on a case-by-case basis, considering the special circumstances of each country, relaxing the periods to take the necessary adjustment
105
measures, the differentiation among countries as regards the goal of budgetary consolidation in the medium-term and some complex and non-transparent supervisory mechanisms.2 We must remember this in order to understand the reason for the current proposals to depoliticise (automate) the decisions on sanctions in case of an infringement of the fiscal regulations.
With the erosion of the SGP, the factors that determined the crisis of the current sovereign debt, put down roots, a crisis which would have happened anyway, if the 2007-09 global financial and economic crisis had not have appeared. If the governments of the two main countries of the euro area are skipping the Treaty of Europe and the SGP, why wouldnt the rest do the same if this is what is best for them and open the tap of non-productive public expenditure? Structural government deficits increased considerably and with this the volume of the government debt. With this precedent, the supervision of national budgetary policies by the European Commission was reduced to merely a rhetorical exercise that did not scare the rulers much. Economic governance in an indirect manner had failed. The ECB, however, fulfilled its role and its first president, Wim Duisenberg, did not allow political leaders to tie his hands, despite their attempts.
2 For this purpose, the European Commission adapted the original regulations No 1466/97 and 1467/97 of 7/7/1997; see COM (2005) 154 and COM (2005) 155 of 20/4/2005.
106
4. Governance as activism against the crisis

The threat of Greeces suspension of payments two years ago showed lack of efficient European economic governance. Instead, a rare and disconcerting political activism appeared. The numerous measures taken since May 2010 in Europe seem more like an exercise of muddling through than implementation of a consistent and long-term strategy.
4.1. Constituent principles, violated

It all started in the worst possible manner: the Governments eliminated in one fell swoop the two principles establishing the euro area mentioned above.
The lifting of the non-rescue clause created the problem of moral hazard for Governments with a tendency to excessive public expenditure and for reckless banks when it comes to buying government bonds. The Governments could pass the cost of excessive indebtedness to taxpayers from other countries (who had no right to speak or vote when the budgets of the State in question were drafted). The banks started a tremendous communication campaign to warn of the danger of the euro area (systemic risks) if indebted countries were not rescued, efficiently concealing to the public opinion that their true intention was to protect their shareholders.
107
Under the presidency of Trichet, the ECB was under pressure to undertake a new role: the role of being a repair shop for the faults in the fiscal and growth policies. It acquired in the Securities Markets Programme, big sums of Treasury bonds from countries in trouble which nobody wants. Here lies the difference with other relevant central banks (the Federal Reserve, the Bank of England, the Bank of Japan), they also buy government securities in the context of their non-conventional monetary policies, but these are assets with considerable profitability. Furthermore, the ECB currently grants unlimited liquidity to banks for three years, at a symbolic interest rate (1%) and it accepts low quality securities as guarantee. But it is not in its hand to lead banks to proper granting of credit to companies or households in the country under affordable conditions; the ECB must resign itself to banks choosing more profitable business in the short-term, as purchasing the debt of the State; therefore, there is not much change in the scenario of credit restriction in the private sector in several countries, like in Spain. The European monetary entity is not only a last resort lender anymore, which in situations of financial emergency is justifiable, but it has also become a public debt buyer of last resort, which is more questionable, because it delays the fiscal adjustments of the Governments (and it caused in 2011 the resignation of two German senior members of the monetary authority bodies, first the resignation of Axel Weber, President of the Bundesbank and ex officio member of the ECB Governing Council and, subsequently, the resignation of Jrgen Stark, member of the Board of the ECB and its chief economist). The role that the ECB is playing,
108
for the moment also under its new president (Draghi), may damage its reputation as an institution independent of political powers and commited to price stability, which is what it has been entrusted with in the European Treaty.
An additional problem is that the same standards of asset quality, which are used as collateral in the re-financing of commercial banks by the National Central Bank itself (and, as such, part of the Eurosystem), do not govern in the whole of the euro area anymore. In several countries in trouble, especially with persistent current account deficits which (already) do not finance in a conventional manner import of capital or through financial assistance from abroad, the respective National Central Banks, with permission from the ECB, accept low quality securities as guarantee of loans, more than what is allowed for emergency liquidity assistance. It is as if they were using the money printing press. This somewhat undermines the monopoly of the ECB to create money. What is questionable from an economic perspective is hidden behind the enormous increase in the amount of these operations in the Eurosystem Target 2 in the past years, which has been vehemently warned by the Ifo Institute of Munich for the last year.3 The Bundesbank has become a gigantic creditor of hundreds of millions of euros for the National Central Banks of the other countries, wit3 See H.-W. Sinn and T. Wollmershuser, Target Loans, Current Account Balances and Capital Flows: The ECBs Rescue Facility, NBER Working Paper, No 17626 (November). CESifo, The European Balance of Payments Crisis, CESifo Forum, Special Issue, January 2012.
109
hout protection and right to any kind of compensation if there is any significant bankruptcy of banks and savings banks or if the euro area collapses. The Governments of debtor countries have in reserve a powerful argument to manage to get from others, especially from Germany, concessions in the negotiations over financial assistance.
4.2. Financial assistance, a never-ending story?

Political leaders believed, and some of them still do, that the creation of a common rescue fund is the solution to the problems of countries in trouble and it eliminates possible spillover effects.
The first rescue mechanism was created with the European Financial Stability Facility (EFSF).4 This fund is provisional (three years, until 2013) and at the beginning had a provision of 440,000 million euros in loans guaranteed by the euro countries; as the Fund wanted to place their issues with the highest ranking AAA to get attractive profitability, the real lending capacity would be lower than the allocation, about 250,000 million euros. Ireland (87,500 million euros) and Portugal (78,000 million euros) had to resort to this Fund. Subsequently, in July 2011, the European Council decided to increase the real lending capacity of this rescue fund to 440,000 million euros and, in addition, increase their
4 EU Council of Ministers (Ecofin), EFSF Framework Agreement, 9/5/10 and 7/6/10. Web page: http://www.efsf.europa.eu (Legal documents).
110
powers and relax the conditions for granting the loans to countries in trouble. It even received leverage instruments (with a 4 factor) and the so-called special purpose vehicles (off-balance); such instruments, applied by private banks, were exactly the ones that triggered very harmful effects for the global financial crisis to break in 2008.
In mid-2012, six months in advance to the original schedule, a new permanent rescue fund will come into force, the European Stabilisation Mechanism (ESM).5 This fund will have a provision in nominal terms of 700,000 million euros (with capital contributions from the member countries amounting to 80,000 million euros); the real lending capacity of this new Fund is 500,000 million euros. Provisionally, the amount of available resources may amount to about 800,000 million euros, by transferring the unused EFSF resources. The IMF, the OECD, the United States and China, among others, recommend a higher firewall (up to 1.5 billion euros).
In parallel with these events, a special treatment has been given to Greece. After the initial financial assistance plan approved in May 2010 (110,000 million euros, of which 30,000 million euros came from the IMF), of which politicians said that it would enable
5 European Council, Treaty Establishing the European Stability Mechanism (ESM), 25/3/11. Internet: http://www.efsf.europa.eu (Legal documents). European Council, Treaty signed by the 17 euro area Member States, 2/2/12. Internet: http://www.european.council.europa.eu.
111
the country to return to the capital market in 2013, in February this year a second package was agreed (130,000 million euros, including a contribution from the IMF, to which a further amount of 24,400 million euros of the first package pending payment will be added). The latest thing is that private creditors will undertake (about 85.8% voluntarily and the rest will be obliged by law) a deduction of 53.5% and will agree for the rest of their securities an exchange for new Greek long-term treasury bonds and of the EFSF Fund at a moderate interest rate (which will reduce the Greek public debt in about 107,000 million euros of a total of 350,000 million euros). Greeces main public creditor, the ECB, has escaped this operation and the asset losses derived from it, by means of a trick, quickly exchanging their former Hellenic bonds, which would have undergone a reduction, for new exempt bonds under the same condition.
The official aim is to get the public debt to be reduced from the current 160% of GDP to about 120% of GDP in 2020. The Ecofin believes that this level is sustainable, which is quite surprising for three reasons: firstly, this level was what Greece had in 2008/09, already in the increase and considered unsustainable then; secondly, the tax authorities must improve a great deal in order to promote the capacity to collect taxes and stop tax fraud and capital flight; and thirdly the IMFs estimates of 2-3% economic growth per year from 2014 must be fulfilled, which implies that the necessary structural reforms must be quickly implemented and the economy must reach considerable gains in international competitive112
ness by substantial salary and price reductions (according to the estimates, about 50%). All of these points are question marks. The most probable thing is that the announced aim of debt reduction will not be attained and that the European governments sooner or later will again have on the negotiating table Greeces request for further financial assistance.
4.3. Political pressure to impose discipline, insufficient so far

The European form of governance since the sovereign crisis started in Greece has always been more of the same: to want to solve a problem of excessive indebtedness with more debt. The critical public opinion, as in Germany, was calmed down by saying that no cash was going to be paid from national budgets and, therefore, from taxpayers (although there will be in the ESM), but that each government only had to provide guarantees (distributed among the countries according to the holdings of the national central banks in the share capital of the ECB). As if guarantees could not be enforced at the demand of the creditors, in other words, buyers of the securities issued by the EFSF/ESM! The expectations to calm down the markets, restore confidence and stabilise the euro area were not met. The markets had noticed that, in the countries badly affected by the sovereign debt crisis, progress in fiscal consolidation and structural reforms that raise the potential of growth and competitiveness, which there are, were too slow and incomplete.
113
This was caused from outside. The aided governments have not forgotten the political messages launched from the beginning of the crisis from Brussels/Paris/Berlin. The messages that are least forgotten and carry on being repeated with slight variations, are the following: (i) We will rescue the euro, no matter what it costs (Barroso); (ii) We will not allow anyone to fall into insolvency (Sarkozy); (iii) If the euro fails, Europe fails (Merkel). There could be no better invitation for irresponsible governments to blackmail. That is how a government in trouble is tempted not to consistently take pure and hard measures, therefore reducing the cost of loss of political support, which any severe fiscal adjustment plan (with unnavoidable cuts in salaries and social benefits and necessary rise of taxes) would imply. In Greece it is already normal for the Troika (the European Commission, the ECB and the IMF), each time that it visits Athens to verify if Greeces government has implemented its commitments, to confirm that there is lack of forcefulness in the policies applied, especially in relation to the structural reforms. But as the President of the euro group, Juncker, and the Ecofin finally have given the green light for new aid tranches to be given, the government (after Papandreou, Papademos) could, after long negotiations, according to the demands of his European partners, and once at home, do half of it. He could even reject the proposals made by his partners (Germany, the first) to provide administrative advice in situ, for instance, in order to create an efficient tax agency and to design and manage infrastructure investment projects.
114
If with the aid programmes the idea was to buy time to implement structural reforms in the real economy, as the political leaders repeatedly emphasised, time was not used productively in all the countries involved, and Spain was no exception during the last part of Zapateros government, when the crisis was not officially denied anymore: fiscal and economic consolidation policies arrived late and lacked consistency and force.
4.4. Financial markets, with capacity to persuade

One way of overcoming the reluctance of the governments to inexorable political and economic changes in their respective countries comes from the market, specifically the spreads of the risk premiums included in the interest rates where the Treasury may place their issues.
As mentioned above, the risk premiums of ten-year bonds, with reference to the German bond, bund, reached rocket prices in Greece in 2011 and also considerably in the other peripheral countries with debt problems, including Spain, where the interest rates reached all-time highs of several hundred basis points. The same happened with the credit default swaps (CDS) premiums. No matter how much the governments criticised financial agents for this, not to mention also the three main rating agencies (Fitch, Moodys, Standard & Poors), we cannot understimate its deterrent effect when it is intended to go into greater debt. The increase in price of the debt convinced political leaders in the countries in trouble that
115
the time of spending happily had gone and that they had to be prepared for a future characterised by austerity. The new government of Spain (Rajoy) is an example of strict action to modify unsustainable habits in society and restore the economy. In Italy there was a big change of direction since a government of technocrats (Monti) started in November last year. Ireland had already started in March 2011, after early parliamentary elections and the formation of the new government (Kenny). Three months after that, the same happened in Portugal (Passos Coelho).
Therefore, any decision to artificially reduce the interest rates of government bonds, as it has already been taken within the context of rescue packages and as some governments claim, is counterproductive. Eliminating the mechanisms of the market that act, without political interference, in favour of the quality of public finances, is pointless. Mutualisation of the sovereign debt, no matter how much it is proclaimed by certain political circles (also Spanish, irrespective of ideologies), as well as academic (including German, Keynesian ideas) and financial (especially the most important banks which are anxious to operate in capital markets with great liquidity, comparable to the U.S. market) circles, is also pointless. There is no reason why we should think that issuing eurobonds would improve the quality of the economic policy in the euro area. On the contrary, a reduction in the price of credit in the countries in trouble, which the eurobond would entail, would deteriorate the estimates of low cost, which all categories of public sector outlays and any decision by the public authorities on loan finance, would
116
be subjected to; furthermore, it would be impossible to put pressure on a government from outside to control expenditure and optimise tax collection; and, in addition, restructuring processes in the real economy, which are so important to raise the potential of growth, would be postponed. It is far better for the financial markets to deploy their penalising effects and thus complement the relevant mechanisms planned by the SGP and the coming Fiscal Stability Pact.
5. New governance design: own responsibility as the key

It seems that European leaders got it into their heads that the euro area needs another kind of governance different from what we have had until now.
We will have to carry on thinking in the need for official assisstance for certain countries, not only for Greece. As regards Greece, maybe we must think of two options: one, exiting the euro, in principle on a provisional basis (until the fundamental problems have been solved) and continue as a EU member; two, exiting the Economic and Monetary Union, also for a certain time, but keeping the euro as dual currency circulation with their own currency.
Politicians now understand better than in the past that, for the feasibility of the monetary union in the long term, we need robust and resilient foundations to prevent external shocks of offer and
117
demand, both from outside and from inside (which in some way or another will happen again). It is not enough to have a determined common monetary policy dealt with by a competent European authority with aims of stability and orderly functioning of inter-bank market. This is only one of the required conditions. Two further fundamental conditions are inexorable for the context of national economic policies: On the one hand, there must be some rules on behaviour in budgetary and economic policy compatible with the efficiency criteria in the allocation of production factors and with growth and employment aims. The problem of moral hazard must be totally eliminated. On the other hand, there must be unconditional willingness of the governments to observe these rules and act according to them. There must be a clear division of work and responsibility between the governments and the ECB.
Indeed, efficient European governance means the transfer of the national sovereignty to the European Union in budgetary matters and in areas essential to the real economy. This would entail a qualitative leap in the process of integration.
The three pillars of the new architecture are: The Euro Plus Pact (approved at the European Summit of 24-25 March 2011, with immediate effect); The Fiscal Stability Pact (approved at the European Summit on 1st March 2012, with the exception of the United Kingdom and
118
the Czech Republic, and estimated to come into force, after ratification by the national parliaments, on 1st January 2013); The Macro-economic Governance Pact (approved by the European Parliament in September 2011 and ratified by the European Council, which is in force already).
The three Pacts complement one another. Without quality of public finances there will be no appropriate economic growth (distrust effect), but without economic growth it will be impossible to have organised public accounts (tax collection weakness effect), and with no macro-economic balance growth will be slower (effect of inefficiency in the allocation of production factors).
5.1. The Euro Plus Pact, it is not binding on anyone

This Pact is based on right diagnosis: the potention of growth in southern countries and the capacity to create employment (to a greater or lesser extent) are low owing to the persistence of negative national factors: non-qualified labour, insufficient technological innovation in companies, over-regulation of the labour market and of various services, inefficient bureaucracy, deplorable tax fraud and corruption. For this reason, structural reforms in the economy and the institutions are so necessary.
The governments of the countries of the euro area have undertaken to implement it; other six countries of the EU have also
119
undertaken this commitment (for this reason the term Plus has been added to the name of the Pact).6 The scope of action that the Pact contemplates affects the labour market, the educational system, the environment for research, the tax system and a long etcetera. All this is praiseworthy.
But the main problem of the Pact is that it gives full freedom to the governments to take the measures that they deem appropriate and not to take others that would also be necessary from an objective point of view. There is no sanction in case of lack of strictness. Therefore, this pillar of economic governance of the euro area does not offer security.
5.2. The Fiscal Stability Pact, a test of nine

Rightly, the inexorable key is the commitment from the governments to maintain orderly and balanced public finances in the future.
This is no dogmatic approach (neoliberal, as some call it pejoratively), but it is the consequence of an economic analysis, supported by theory and empirical experience. Government deficit must be limited, owing to the Domar condition, according to which, for reasons of assignative efficiency, long-term interest rates
6 European Council, Conclusions 24/25 March 2011, Annex I: The Euro Plus Pact Stronger Economic Policy Coordination for Competitiveness, Bruselas, 25/3/11 (EUCO 10/11, CO EUR 6, CONCL 3).
120
must be higher than the economic growth rate. With no ceiling for government deficit sooner or later we reach a point from which the financial expenditure of the State (for servicing the debt) increases substantially, which progressively reduces the room for manoeuvre of the government to seek its economic and social aims. The level of public debt must be limited because of the
Reinhart/Rogoff rule, derived from econometric studies, which establish a critical threshold of 90% of GDP, from which the secular economic growth rate may diminish at least half a percentage point per year for three reasons: one, because public debt servicing reduces the margin for productive investment of the State (infrastructures); two, because payment of interest to foreign creditors reduces available national income and, therefore, the capacity of consumption of households; and three, because the need to refinance sovereign debt makes financing of private companies in capital markets difficult (expulsion effect).
The Ltmus test is characterised by strictness under which the governments deepen in budgetary consolidation. Despite the fact that in different countries of the euro area some measures involving tax adjustment have been taken already, public finances are not consolidated at all. According to the European Office of Statistics (Eurostat), government deficit is excessive (more than 3% of GDP) in most of the countries, also in Spain (2011: 8.5% of GDP). Germany (1%) and four small countries (Estonia, Finland, Luxembourg and Malta) are the few exceptions. Most of the government deficits are structural, in other words, not cyclic but
121
permanent, and, therefore, destructive for the good functioning of the economy. The level of public debt is also too high (higher than 60% of GDP) in almost all the countries, including Germany (2011: 81.2%) and France (85.8%) and now also Spain (68.5%), for the first time since 2011, Spain (68%). Where public debt greatly exceeds all acceptable levels according to the Reinhart/Rogoff rule is in the three countries that have been rescued (Greece, Ireland and Portugal) and in Italy. For the latter country, however, there is a differentiating factor in its favour, most of the public debt is internal and, thus, its servicing may be managed directly with its own instruments (by increasing fiscal pressure on its citizens).
As mentioned above, the rules on sustainability of public finances as set forth in the Treaty of the European Union and in the SGP have not been efficient to impose budgetary discipline. Its application has been highly politicised. The mechanisms of penalisation have never been implemented. The new Fiscal Pact has been arranged in such a manner that it could put the screws, firstly, on the euro countries on which the agreement is binding.7 The most important advances as regards the SGP, for the moment only on paper, are the following three: Firstly, the seriousness of government deficit is explicitly acknowledged when it is structural. The explicit ceiling established
7 European Council, Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, 2/3/12, artculos 3-8. Internet: http//:eur-lex.europa.eu.
122
is 0.5% of GDP, maintaining the threshold of 3% for total deficit. There is thus a large margin for the operation of automatic stabilisers in the economic cycle and for discretionary governmental measures if there is recession. Secondly, the aim of limiting the level of public debt at 60% of GDP through a procedure which, if the debt exceeds this percentage, may activate the supervisory mechanism for excessive government deficit, even if the deficit is below 3% of GDP. The country in question shall be forced to reduce it at an average rate of one twentieth per year as a benchmark (1/20 clause). Thirdly, the obligation for each member country to define its medium-term budgetary objective (MTO), quantifying an indicator for public expenditure evolution and making sure that the estimated expenditure shall be financed by sustainable income (golden rule of budgetary balance). If a country does not organise its budgets in a balanced manner it will be required by the European Commission to submit new budgetary plans.
If the new rules are important, a mechanism to enforce them is equally important. The most relevant three new elements are the following: First, continuous supervision of the policies applied in both summits of the euro area has been devised (two per year, at least, called and chaired by the President of the EU, currently Herman Van Rompuy). Second, there is a change in the decision process on financial sanctions (of up to 0.2% of GDP) in case of breach and non-ful123
filment of the specific recommendations to remedy the situation in the sense that a proposal of the European Commission is considered approved if the Council of the Heads of State and Government of the euro area does not vote against it with a qualified majority (until now such a majority was required for the European Council to approve the sanction). Therefore, there will be less room for political maneuvre to prevent the fine (as it was normal in the past after the Schrder/Chirac precedent mentioned above). The sanctions are not totally automatic as one would like them to be, but they are moving in that direction. Furthermore, they have a broader scope than before, because the manipulation of fiscal statistics shall also be punished. Third, the obligation for each member country to transpose the fiscal stability rule into its national legislation is established and, therefore, be explicitly responsible for its fulfilment. The Court of Justice of the EU shall ensure its fulfilment.
For the States to decide the medium-term budgetary stability (equivalent to the economic cycle), the most credible formula is to constitutionally estabish a ceiling for structural government deficit. Germany has already done it (0.35% of GDP for the central government, from 2016, and cero deficit for the federal states, from 2020). Spain is moving in that direction after the reform of article 135 of the Constitution at the end of the previous term of office and the recent approval of the Budgetary Stability Law which will require from 2020 cero structural deficit to the public authorities (which could be up to 0.4% of GDP in exceptional circumstances). Other
124
countries are moving in that direction. The advantage of a constitutional rule as regards de margin of debt of the government is that, if a country incurs deficit and constitutional breach, it will need better arguments for its society than if it only needs to be explained before the Community authorities and take there the relevant warnings; Brussels is far and it is under suspicion of meddling in national affairs.
The Fiscal Pact will only work if the euro area countries are willing to do without most of its sovereignty in budgetary matters, which will be transferred to Community institutions. Obviously, this affects the main prerogative of national parliaments, which is to shape the budgets of the State and decide how to finance expenditure. This will meet great opposition, in all the countries. It is not a trivial matter that the Fiscal Pact must be institutionalised through an inter-governmental agreement, that is to say, a level lower than the Treaty of the EU, which reform would have required the unanimous approval of the twenty-seven, which was not reached. This procedure has opened in the legal field a debate to decide if the procedure chosen is compatible with Community Law, specifically in relation to the mechanisms of sanctions for excessive government deficit as set forth in article 126 of the Treaty. For European leaders to have lowered the quorum required for parliamentary approval of the inter-governmental agreement is not a trivil matter either, to 12 of the 17 States that form part of the euro area. Could it be that some partners are not reliable? It is true that it has been decided that the countries that do not ratify the
125
Pact and transpose to their national legislation the ceiling of government deficit will be excluded from possible financial bailout. However, is this credible, especially if the stability of the euro area is at risk? This being so, it would be better not to be too hopeful about this Fiscal Pact.
5.3. The Macro-economic Governance Pact, with vague parameters

The same caution is advisable with regards to the solemnly proclaimed Six Pack (so called because its content has been drafted through a Community directive and five regulations). Nodoby doubts that, for the feasibility of the euro area, macroeconomic stability is a necessary condition (although not enough if the requirements for an optimal monetary area are not fulfilled). Furthermore, it is true that macro-economic stability goes beyond budgetary balance, as it has been proven with the recent experience of different countries (inflationary pressure, property bubble, excessive private sector debt, competitive weakness of companies, current account imbalance, etc.). However, the European Commission, the European Parliament and the European Council seem to have faith in the capacity of economic policy to handle crucial factors in the real economy. This is highly questionable.
An alert mechanism scoreboard was created for the appearance of internal and external imbalances in the countries, which will be
126
managed by the European Commission based on ten parameters, as follows: 8 Internal imbalance parameters: evolution of unit labour cost, unemployment rate, private sector indebtedness, credit to the private sector, evolution of property prices and government indebtedness. External imbalance parameters: surplus and deficit of current account balance, net international investment position, change of export market shares and change of the real effective exchange rates of the euro.
For these parameters, critical thresholds have been established, from which the alarm would be triggered, and this would start a procedure to analyse the causes in order to decide from Europe if corrective measures need to be taken or not. For instance, for unit labour costs the threshold is an increase of 9% in three years, for unemployment rates it is 10% of the workforce as a three-year average or for current account balance the threshold established is 3 year backward moving average of the current account balance as a per cent of GDP, with a threshold of +6% of GDP (surplus) and -4% of GDP (deficit). If there is excessive imbalance, the European Commission will make the relevant recommendations for the government of the country in question to remedy the imbalance; in case of non-fulfilment, a fine may be imposed (up to 0.1% of GDP).
8 European Commission, EU Economic governance Six Pack enters into force, MEMO/11/898, 12/12/2011.
127
The thresholds set are not a consequence of a detailed economic and empirical analysis that may indicate for sure when an imbalance is excessive for a country and negatively affects the euro area as a whole. The numerical values rather represent the perception of politicians of the recent events; therefore, they are, unavoidably, arbitrary. But the fundamental question is different: How can a government act efficiently?
We must remember that the EU proposes an open market economy with free competition (article 119 of the Treaty of the EU). All euro countries have this concept of economic system, some because of the Ludwig Erhard tradition (Germany), and others with reservation in favour of the government (France). In a market economy, the government lacks the instruments to control the variables contemplated in this Macro-economic Governance Pact. Therefore, the governments should activate a series of interventionist measures, with no guarantee of their efficiency and with a high risk of distorting efficiency in the allocation of production factors. In a market economy, responsibilities are distributed in a different way: for level of employment, social partners (unions and employers); for export development, private companies (technology); or for granting loans, commercial banks (based on the appropriate risk estimate). The current account balance, among other things, represents the saving trend rooted in society and objective conditions for fixed capital investment (as explained by the macro-economic equation and the Bhm-Bawerk theorem). Unions will not accept government interference in the negotiation of collective agree128
ments and companies will not stop being creative or innovative in organisational management and product development for which elasticity-income of international demand is higher than the unit, and banks will not neglect their classical business, which is to provide credit to companies and households.
This economic governance project has no clear future. In the best-case scenario, the new Summits of the euro area would have matters to discuss. The countries in which the economy works well could be taken as a benchmark for the others to rectify their structural deficiencies and improve their productive and competitiveness levels. In the worst-case scenario, the euro area would be exposed to continuous political conflicts, which would not promote economic growth with high employment. It is so easy, and especially politically profitable in countries with domestic problems, to look for the villain abroad, maybe Germany?
Conclusion
The sovereign debt crisis has had a healthy effect in convincing politicians that by providing liquidity to governments and banks the stability of the euro area will not be attained in the medium and long term. The quality of the economic policy must improve in the countries, there must be impeccable follow-up by independent institutions to weigh up the economic and fiscal situation and it must be guaranteed that national accounts and other relevant statistics are arranged under utmost scientific accuracy at all times.
129
If in all the euro countries the governments understand that sound public finances and application of structural reforms is their responsibility and if they act seriously according to them, no State will have to rescue another State because of over-indebtedness and waste, and the ECB may stop indirectly financing States and focus more on its task, ensuring stability in price levels in the euro area. The ESM fund would be reserved to emergency situations caused by external factors beyond the governments control. The Fiscal Pact would have fulfilled its mission and the Euro Plus Pact would be filled with efficient contents. We would not need to resort to market interventionism as entailed with the Six Pack.
If, on the contrary, there is no determination in the member countries, any attempt of European economic governance would result more from proactive intentions than harsh reality. The euro area would have an uncertain future. The alternative of a European Political Union, in which all necessary economic policies could be undertaken from a Community Executive under the control of the European Parliament, with all democratic rights, cannot be seen on the horizon.
130
/GONZALO GARCA ANDRS * /
The turbulent adolescence of the euro and its path to maturity
1. Introduction; 2. Anatomy of the crisis: Greece, the contagion and the perverse dynamics of debt; 2.1. Sovereign credit risk within the euro: from zero to infinity; 2.2. A fiscal problem, not the fiscal problem; 2.3. Contagion: the fragmentation of the single monetary policy; 2.4 A particular manifestation of the global financial crisis; 3. The Eurosystem at a crossroads; 3.1. Intrasystem balances as an expression of the fragmentation of monetary policy; 3.2. Quantitative easing for banks only; 4. The definitive solution must begin in 2012; 5. Conclusion; Bibliography
* Member of the Technical Body of the Spanish Civil Services (Tcnico Comercial Economista del Estado) and Graduate of Economics at Universidad Autnoma de Madrid. He has spent a large part of his professional career in the current General Office of Treasury and Financial Policy in the Ministry of the Economy and Competitiveness of Spain. He held the office of Deputy Director of Financial and Strategic Analysis, responsible for financial stability and crisis management issues, international financial policy (EU, G20) and adviser to the Social Security Reserve Fund. In September 2009 he was appointed Deputy Director of Funding and Debt Management, where within a few months he was involved in the adaptation of the Treasury funding programme to the instability generated by the Greek fiscal crisis and its contagion throughout the rest of the euro region. From September 2010 to January 2012 he has held the office of Director General for International Finance, which has enabled him to form part of the management boards of the European Investment Bank and of CESCE. He has likewise been Associate Professor in Economic Theory at Universidad Rey Juan Carlos and has published several articles on regulatory, financial and monetary matters in Spanish journals.
131
1. Introduction
The Monetary Union is a political construction, the boldest and most significant step forward by the European project since the Treaty of Rome. Its conception also had an economic basis, that of completing the consolidation of the economic integration process which was begun in 1985. However, its implementation was a great adventure. The countries that use the euro are far from constituting an optimal monetary zone. In addition to the evident initial differences in the economic and institutional structure of the countries and in their histories of stability, the euro was forced to make room for disparate economic philosophies.
The European leaders elected to create a very light institutional structure, with an independent federal monetary authority, an apparently severe budgetary discipline (the Stability and Growth Pact or SGP) and the rule of no mutual support (in order to reinforce the individual fiscal stability of each State).
During its first ten years the euro appeared to be working relatively well. Average real growth exceeded 2% and both the level and the volatility of inflation improved in comparison to the previous
He is currently an adviser in the General Deputy Office of Financial and Economic Matters of the European Union and the Eurozone which is part of the General Office of the Treasury and Financial Policy. The opinions expressed in this article pertain to the author and under no circumstance may be attributed to the Ministry of the Economy and Competitiveness.
132
decade, although the differences in the macro-economic and financial behaviour of the members were quite considerable. Although the Stability and Growth Pact was reformed mid-decade, no significant alterations were made to the institutional framework and the number of members gradually grew. The onset of the financial crisis in 2007 initially underlined this perception of the euro as something imperfect but solid.
However, a little after its 11th anniversary, three interconnected calamities fell upon the euro. Firstly, one of its members plummeted towards insolvency in just three months. Secondly, the political pact on which the single currency was built began to shake when financial assistance within the area became inevitable. And thirdly, the unity in regard to monetary policy fell apart with the dislocation of the public debt markets.
Two years later, and despite having taken decisive steps in national policies and in institutional framework reform, the crisis of the euro has deteriorated to the point of calling its survival into question; and a definitive solution is yet to be glimpsed. With the benefit of hindsight, it is worth attempting to interpret was has happened, taking into account the extreme complexity both of the initial situations (with accumulated imbalances and structural deficiencies in several countries), as well as the outbreak, contagion and escalation of the crisis. And to do so moreover against the broader backdrop of the global financial crisis, which has influenced economic and financial evolution for five years, in order to identify
133
which specific aspects of the euro have played a vital role. All the above with the aim of helping come up with solutions, bringing together the most urgent ones and those of a longer term basis.
2. Anatomy of the crisis: Greece, contagion and the perverse dynamics of debt
2.1. Sovereign credit risk within the euro: from zero to infinity
The natural starting point of the analysis of the crisis is the behaviour of sovereign debt markets. The creation of the euro gave way to a number of markets for debt securities issued by sovereign states but denominated in the same currency. This is an atypical configuration with few precedents, given that sovereign debt securities are usually associated with the bond that exists between the issuer and monetary sovereignty.
Until 2007 the markets considered that the very creation of the Monetary Union had reduced sovereign credit risk to a very small level. For example, the spread between the ten year Greek bond and the ten year German bund fell within a range between 10 and 30 basis points between 2002 and 2007. In spite of GDP growing at relatively high rates, the level and performance of the fiscal and current account imbalances in Greece had justified a much higher risk premium.
134
With the outbreak of the global financial crisis, credit risk spreads among Eurozone countries widened. But this trend common to all of the world financial markets , was mainly due to risk aversion and an increase in the demand of assets deemed to be safer (Barrios et al, 2009). The spreads thus adopted a trend towards moderation throughout 2009, all amid a context of low absolute financing costs for the sovereign issuers.
Towards November 2009, an alteration in the behaviour of sovereign debt markets took place, which in hindsight can be considered as a structural change. The almost perfect convergence since the beginning of the Monetary Union1 therefore gave way to a cumulative bifurcation, reflecting the binary behaviour of the markets. This is a dynamic system with two main features:
Systematic inefficiency. Bond market prices do not reflect the fundamental information on credit risk determining factors. Until 2009, the spreads had been smaller than would be justified by the main variables (debt stock, deficit, international investment position, real exchange rate); since autumn 2009, the spreads have been systematically higher than would be justified by the performance of the fundamental variables. This gap between market prices and economic fundamentals has been noted in several empirical studies (Aizenman, Hutchison & Jinjarak (2011), De Grauwe & Ji (2012)).
1 The average 10 year debt spread in Eurozone countries against Germany was of only 18 basis points between 1999 and mid-2007.
135
Tendency towards instability. The euro sovereign debt markets have shown themselves to be incapable of adjusting their credit risk assessments in a stable manner. Their capacity for discrimination has been non-existent for years, with a high demand for bonds from countries exposed to vulnerability, which were deemed to be almost perfect replacements for the German bund. And in these last two years, the trend has been explosive. In micro-economic terms, instability means that given an excess supply of bonds, a drop in price does not bring it back to balance. But furthermore, we must point out that the explosive nature of the sovereign debt markets since the beginning of 2010 has become more noticeable than that reflected in market prices. ECB intervention has lessened the trend towards increases which are sharp and not related with new fundamental information on the likelihood of default by various countries in the region.
On the basis of this general outlook of the dynamics of debt markets, a distinction must be made between the Greek market and the rest.
2.2 A fiscal problem, not the fiscal problem

The Greek situation is special. In October 2009, the new Greek government announced that the public deficit for the year would be somewhat over double that which had been forecast (12.7% of GDP versus the expected 6%). This setback of Greek public debt
136
was thus triggered by a fundamental fiscal surprise of considerable dimensions.
Greece has systematically managed its public finances poorly since joining the euro.2 It has taken advantage of the financial benefits of belonging to the euro to increase expenditure, while maintaining a pro-cyclical fiscal orientation during a clearly expansive phase. The Hellenic country has thus made real one of the worst fears of the founders of the euro in regard to the risk of freerider fiscal behaviours. The bad news is that neither the market discipline under the non-mutual guarantee clause nor the Stability and Growth Pact have managed to correct this situation, which has worsened further due to continuous problems regarding reliability of public accounts.
The Greek public debt market has also followed a pattern of inefficiency and instability. Gibson, Hall & Tavlas (2011) have identified a systematic bias between the credit risk spread adjusted to the main determining variables and the market spread. Nevertheless, the collapse of the market is not difficult to explain. The depth of the fiscal crisis and its structural nature, added to the uncertainty and lack of confidence generated by the handling of accounts, spread the perception among investors of inevitable insolvency with a certain risk of loss of principal.
2 In fact, its public deficit has never been below 3% since it joined the monetary union.
137
What is hard to explain is why the Greek crisis spread to the rest of the public debt markets in the area. Firstly, the weight of Greece in the GDP of the Eurozone (around 2.3%) does not justify that its fiscal crisis should become a systemic problem. Secondly, no other Eurozone member country is anywhere near this level of systematic poor management of public funds and continuous breach of the rules of the Monetary Union.
There are two factors in the Greek collapse during the first semester of 2010 which became important for the operation of the rest of the Monetary Union. To begin with, the fragility of the domestic debt markets within the Eurozone became clear. Secondly, the political tension generated by the intra-zone financial aid revealed a considerable institutional weakness. Discussions prior to the approval of the loan to Greece brought to light that the politics of the countries in the zone were about to take on a hard line of fiscal adjustments and onerous conditions in the financial aid defended by creditor countries, in stark contrast with the position of countries which were beginning to feel the effect of the turbulence in Greece as of January.
Even so, it seems impossible to explain how the Greek crisis became a euro crisis in light of only these two factors. Particularly, following the creation in May 2010 in response to the explosive market situation, of the European Financial Stability Facility and the start of the intervention by the Eurosystem via the Securities Market Programme.
138
2.3 Contagion: the fragmentation of the single monetary policy

The strategy we have chosen to explain the spread from Greece throughout all of the Monetary Union is a two-phased approach. The first phase attempts to define the morphology of the crisis, which may help, at a second phase, to get to the bottom of its nature.
These are the main morphological characteristics of the crisis: Systemic for the entire Eurozone. The crisis is often discussed as if it only affects part of the Monetary Union; along the same lines, it is argued that this is not a crisis of the euro, on the grounds of exchange rate levels or price stability. In fact, since the generalised dislocation of the debt markets was sparked off towards the end of April 2010, the crisis has indeed become a euro crisis. It affects all member countries, albeit in opposite way. There has been a flow of capital from the more indebted countries to the creditor countries, which has been reflected in the yields of public debt and other securities. Thus, the impact of the fiscal irresponsibility of one of the members has not resulted in a generalised increase in interest rates as was expected (Dombret (2012)). It has had an asymmetric impact, punishing countries with greater financial vulnerability and benefiting the stronger ones.
Specific to the Eurozone. The financial bifurcation movement has been limited to the member states, despite having some
139
effect on the rest of the world.3 There is no sovereign debt global crisis; on the contrary, public debt yields in the main developed countries have reached historic minimal levels. Thus, the main non Euro indebted countries (United Kingdom, United Sates) have seen an increase in the demand of sovereign debt as a result of the euro crisis. For instance, at the start of 2010, ten year British debt securities traded at levels similar to the Spanish ones. The worsening of the crisis in the Eurozone has meant that the British debt is just a few basis points away from the German debt. The negative contagion has therefore only affected euro members, whereas the positive contagion of public debt has managed to reach other markets.
Its dynamics are financial and autonomous, not defined by fundamental economic variables. This statement calls for an explanation because doesnt Ireland have a serious solvency problem in its banking system? Isnt Portugal undergoing a current unsustainable imbalance? Doesnt Spain have a high public deficit and an excess of private debt? How will Italy manage to sustain a public debt stock of 120% of the GDP and a GDP growth trend below 1%? and we could move on to Belgium and then to France. All the euro countries which have suffered the restriction of their external financing terms in the
3 The Euro crisis has become the main factor threatening the recovery of the world economy and the consolidation of the progress made in restoring financial stability after the global crisis. However, at this point only direct spreading via debt markets is discussed.
140
last two years are facing serious problems. But the existence of such problems does not make them causes for the dislocation of the debt markets and the consequences thereof. In fact, in all cases we are dealing with problems with which the markets have been well acquainted for years. There are two ways of illustrating the secondary role played by economic fundamentals in the crisis. One is to compare euro countries affected with other noneuro countries with similar fundamentals. Aizenman et al (2011) have done this by matching Spain with South Africa and concluding that the greater risk spread in Spain cannot be explained by the worse levels in the variables which have determined credit quality ratings. The other is to verify whether an improvement in the fundamentals (including economic policy measures required to achieve this) has had a positive impact on the financing terms. For example, affected countries have considerably reduced their primary deficits adjusted to the cycle, although this has not helped to improve the perception of the fiscal situation. This does not mean that the fundamentals are not important when determining the vulnerability of a country, or that the economic policies adopted in response to the crisis have not proven vital in halting or slowing down the impact of the crisis. But it is important to stress that the crisis is essentially not a problem of fundamental economic variables.
It has become apparent through the inversion of the capital flow pattern within the euro. For years, the economies with lower rates of savings (such as Greece or Portugal) or higher
141
investment rates (such as Spain) comfortably financed their large deficits via private flows of capital from countries with higher rates of savings and lower investment rates. As of spring 2010, many of these countries have been forced to face an interruption, and in some cases a sudden inversion, of external funds, as shown by the performances of their financial accounts (see Graph 1 for Spain). Part of that capital has been diverted to creditor countries. From this perspective, the crisis can be understood as a series of sudden stops (with their pertaining sudden goes) in capital flows within the Monetary Union. The most acute episodes of the crisis have thus coincided with an intensification of the external financial restriction. In short, it is about a crisis in the balance of payments within the particular framework of the Monetary Union, whose adjustment variable is not the amount of reserves but the net funding of the Eurosystem.
By combining these characteristics, the crisis can be defined as a cumulative coordination failure, with a positive feedback.4 The key mechanism underlying this failure is the effect that the dislo4 The concept of coordination failure arises as part of an alternative interpretation of Keynes analysis to that of the Neoclassical Synthesis, which considers there is a deeper explanation for unemployment and instability problems than salary rigidity. In a first formulation, it can be associated with the Macroeconomics of imbalance. Subsequently, within the framework of New Keynesian Economics, this is analysed with different models which have strategic interdependence and multiple balances in common (Cooper and John, 1991). In the context of the financial crisis, the coordination failures have played a core role, linked to uncertainty and the effect thereof on expectations.
142
Graph 1 Net Loan and Financial Account balance of Spain
Source: Bank of Spain
cation of the operation of the public debt market has over the mechanism of monetary transmission and, in the last resort, on the financing conditions of the non-financial private sector.
Indeed, the public debt markets, in addition to procuring state funding, play a central role in the operation of the monetary and financial systems. The yield curve of public debt, considered to be the risk-free asset, serves as the main price reference for the rest of the credit and securities markets, acting as a floor for financing costs for all other agents. On the other hand, the implementation of monetary policy traditionally uses government securities as asset guarantees. And financial institutions, and credit institutions, UCITs and pension funds in particular, often keep a considerable amount of sovereign bonds in their portfolios.
143
The dislocation of the public debt markets has had a devastating effect on the affected economies. The increase in volatility (see Graph 2 for the Spanish market) and the upturn in the credit risk spread without any underlying new fundamental information have restricted funding for the non-financial sector in various ways. Directly, insofar as market-funded companies must pay more for issues. And indirectly, and more importantly given the financial structure of the euro economies, it operates via the banking system. Bank access to market funding is restricted in terms of volume and prices, whilst the value of both their public debt holdings and other market shares continues to fall. The result is a restriction in funding available to businesses and households.
Graph 2 Historical volatility of Spanish debt
Source: Bloomberg
144
This situation gives rise a contracting spiral which generates a perverse dynamics in the sustainability of public debt. The first reaction from countries suffering from a financial restriction mainly of their debt markets is the acceleration of fiscal adjustment which, in principle, appears to be a logical and reasonable response. The problem is that a combination of a strong contractive fiscal approach and financial restriction weakens the nominal GDP. This leads to an increase in the nominal fiscal adjustment required to achieve a deficit target in relation to the GDP. Unemployment rises, disposable income falls and the creditworthiness of businesses and households deteriorates. The result is a deterioration of the Debt/GDP ratio, with a feedback effect.
In summary, the dislocation of public debt markets generated an endogenous monetary restriction, equal to a drastic toughening up of monetary policy in the most affected countries. The transmission mechanism of the policy established by the ECB no longer works in a fairly uniform manner, upset by the intensity of the private funding flows and the effect thereof on expectations. The result is the breakdown of the single monetary policy.
2.4. A particular manifestation of the global financial crisis

The symptoms of this disease afflicting the Monetary Union seem very familiar by now: debt markets which no longer work normally, spreads with an explosive tendency, asset liquidation at discounted prices (fire sales), banks in the grip of liability restrictions
145
and falling asset values, gaps between the financial sector and the real economy. In fact the mechanism is identical to that which led to the subprime mortgage debacle in the systemic crisis of developed economies in 2007-2009. The main difference is that both the source and the means of contagion were in that case the private debt markets, whereas in the Eurozone the dislocation has mainly taken place in public debt markets. But the analogy is valid in analytical terms and can prove quite useful when considering the regulatory implications which will result from the crisis resolution.
The effect on monetary policy was similar, although at that time the public debt markets carried on as normal and could continue to be used to tackle the endogenous restriction in the financing conditions of the private sector with firm and innovative measures.
Several studies on the nature of the global financial crisis have highlighted the importance of the increase in uncertainty when seeking to understand and resolve it. Caballero (2010) considers that the financial crisis, which appears similar to a heart attack, is the product of a combination of uncertainty as defined by Knight and the complexity of the structure of the financial system. These two factors amplify the initial shock effect, with forced sales of assets and liquidity strangulations which drive a wedge between the financial sector and the real economy, preventing the proper operation of the economy and the markets.5 The solution requi5 This then leads to large scale coordination failure, in the sense mentioned at the end of the previous note.
146
res the State to become an insurer of last resort, providing insurance against uncertainty to persuade the agents that the less likely negative scenarios will not take place. This enables the coil to snap, thus coordinating agents at higher comfort levels.
This financial crisis model can be applied to the Eurozone. The Greek fiscal surprise and its rapid decline towards insolvency would be the initial shock, generating confusion among agents and leading them to reconsider their perception of sovereign risk within the euro. The complexity of the financial interrelations within the area, along with the emergence of political differences, disseminates lack of confidence to all other markets. And the rapid dislocation of the debt markets increases uncertainty, hits the banks in affected countries and ends up by paralyzing the workings of their financial system and depressing the real economy. The intensity of self-fulfilling prophecies in the markets increases the uncertainty regarding the outlooks for the countries and for the Monetary Union as a whole. Investors fear the possibility that the market dynamics should cause solvent countries to lose access to new funding.
Definitive uncertainty appears when the disintegration of the Monetary Union, which seemed like a bad joke even at the start of 2010, becomes a scenario deemed likely by main investors. In fact, the persistence of such huge spreads between the public debt of member countries is an unequivocal indicator that the market is taking the possibility of disintegration very seriously. Investors
147
accept negative real returns in the short term and no return in the medium and long term of the German public debt because they believe that, given a break-up scenario, these assets are the ones which will guarantee the security and continuity of the euro.
It is a fact that certain partial insurance mechanisms to deal with the effects of the crisis have been implemented in the Eurozone. On the one hand, the Eurosystem has performed the role of lender of last resort for the banking system with force, adapting its role to perceived needs. On the other hand, the creation of a system of financial aid as a component of the institutional framework of the Monetary Union also constitutes a significant collective insurance item. But as we pointed out in the introduction, for the time being these instruments, along with the steps taken at a national level, have not managed to prevent crisis relapses. The relapse of summer 2011 was particularly serious, as it underlined its systemic nature and struck both Italy and Spain, with an ensuing financial strangulation that has led to a new recession in the region.
3. The Eurosystem at a crossroads

The ECB and the 17 National Central Banks (NCB) comprise the most powerful institution in the Monetary Union. Its legal independence is greater than that of other central banks in developed countries and, like them, it has the essential power of unlimited cre148
ation of money. In contrast with the rest of Monetary Union bodies, the Eurosystem is capable of making decisions and of expediently executing them. Even so, it is not a central bank like all the others. During its first decade of life, the difficulty entailed in setting a single monetary policy to be applied to a group of economies with different fiscal policies and economic and financial cycles became patently clear. But since the Greek crisis, the task has become extraordinarily complicated: on the one hand, due to mix of the fiscal origin of the problem and the financial nature of the contagion; and on the other, as a result of the tension which the solutions considered has produced between the Bundesbank philosophy and that of the more pragmatic (and closer to Federal Reserve and Bank of England standards) monetary policy of the all the others.
The Eurosystem has been in the eye of the storm for the last two years and its performance has been the target of criticism from all angles: there are those who resent it not having acted in a sufficiently forceful way and there are others who believe that the SMP and the Long-Term Funding Operations are causing it to deviate from its mandate and endanger price stability.
With our sights set on the search for a definitive solution to the crisis, let us attempt to better understand the implications of what has happened for the single monetary policy and the response given by the Eurosystem.
149
3.1. Intra-system balances as an expression of the fragmentation of monetary policy

It would have all been simpler if the impact of the Greek fiscal debacle would have been a generalised increase in public securities interest rates in all other euro members. The Eurosystem would have been able to counteract this effect by adjusting the tone of its monetary policy. However, the contagion has driven a wedge within the euro-debt financial markets, where capital is flowing towards creditor countries and away from debtor countries.
The dislocation of the debt markets has endowed the net funding of the private sector in each country with strongly endogenous dynamics, as can be observed in Graph 3. Despite the expansive tone of the monetary policy of the ECB, in Ireland, Portugal, Greece and Spain, businesses and households have had to face a drop in the supply of funds, which in recent months has also affected Italy. In countries such as Finland, the net capital inflow has magnified the expansive tone of the monetary policy.
The Eurosystem has thus had to face the most difficult problem since its foundation, in that it directly questions the unity of the monetary policy within the area.
The alteration in the pattern of financial flows within the region has substantially modified the geographical distribution of balances within the Eurosystem. As we have already mentioned,
150
within a monetary union a deficit in the domestic balance of payments is best funded with a greater appeal made by the banking system of the country to the Eurosystem. If we take a close look at the evolution of the financial account balance of Spain, excluding the Bank of Spain and the Net Eurosystem Loan granted to the Spanish banking system (Graph 1), we can conclude that deficits in the balance of payments have been offset by an increase in appeals to funding via monetary policy operations.
The result of this is that the counterparts of the monetary base (which can be calculated from the Eurosystem consolidated balance sheet) are now more concentrated in those countries which
Graph 3 Bank Funding of the non-financial private sector
Interannual Growth rate in Feb 2012
Source: Bank of Spain
151
have experienced the dislocation of their debt markets and the restriction of private sector funding.
The accounting reflection of these financial dynamics can be found in the sharp increase of the so-called intra-system balances. The monetary policy decided by the Eurosystem is applied in a decentralised fashion, in that it is carried out via national central banks. The net balance of the operations of a given country with all other countries in the area generates a book entry shown as the balance variation between each national central bank (NCB) and the ECB. These intra-system balances, required to ensure the identity between assets and liabilities in the NCBs and an appropriate distribution of seigniorage, disappear when the balances are aggregated in the consolidated balance sheet of the Eurosystem, as the sum of positive balances is equal to the sum of the negative ones.
The component of these intra-system balances which explains its sharp increase during the crisis is the one that relates to the variations in the net balance of outstanding operations settled via TARGET2, whose counterpart entity is the ECB.6 These operations can be either private inter-bank transactions or monetary policy opera6 The other basic component of intra-system balances is that related with the issue of euro banknotes. Both the ECB and the NCBs issue euro banknotes in accordance with a key (8% allocated to ECB and an adjusted allocation by the NCBs). Then the NCBs release them based on demand. The difference between the allocated issue of banknotes and the release thereof into real circulation generates an intra-system balance, which is required for a fair distribution of seniority associated with banknote issue. Germany has the highest negative balance under this heading.
152
tions between a NCB and a private counterparty. To a large extent, the sign and amount of the balance depend on the relationship between the public or private source of the money of commercial banks in the central bank. When commercial banks increase their deposits in the central bank as a result of an increase in private funding received (deposits, loans or security issues), they tend to reduce their appeal to central bank funding (as we assume that they seek to limit their reserve surplus). The counterpart of this increase in liabilities and decrease in assets as a result of the net loan is a positive balance held by the central bank with the Eurosystem, accruing at the reference interest rate. On the contrary, a drop in private funding makes the banks increase their appeal to the central bank. In this case, the counterpart of the increase in assets is a negative balance in the liabilities with the Eurosystem.
Germany, which had a very moderate positive balance before the outbreak of the global financial crisis, has gone on to have over half a billion euros of positive balance by the end of February 2012 (see Graph 4). The German Banks have reduced their appeals to the Eurosystem, as they receive funding at very favourable terms from the market and have furthermore reduced their asset positions in other euro member countries.
On the contrary, Greece, Ireland, Portugal and, more recently, Spain and Italy, have experienced an increase in their negative balances to very high levels, due to their banks having had to offset the loss of private funding.
153
Graph 4 TARGET2 Balanace
Source: Whitaker, Central Bank of Ireland, Bank of Spain, Bank of Greece, Bank of Portugal, Deutsche Bundesbank
The growing trend of intra-system balances was interpreted by Sinn (2010) as a stealth bailout by Germany of countries with negative balances, going as far as proposing correction measures thereof. Although it found some support among German academic media (see Declaration of Bobenberg, 2011), Sinns interpretation was subsequently refuted in several articles which have attempted to shed light on the nature and significance of intra-system balances (Bindseil & Knig (2011), Jobst (2011), Borhorst & Mody (2012)). The debate saw a later resurgence, to a large extent due to the concern expressed by the Chairman of the Bundesbank in a letter addressed to the Chairman of the ECB.7 Sinn (2012) suggests
7 Shortly after this letter was made public, the Chairman of the Bundesbank published an article in the press which explained the position of his institution in this debate.
154
the establishment of a system for annual settlement of intra-system balances with liquid assets with guarantees from each country (on real estate assets or on future tax income). In his opinion, it would be a system similar to that which exists in the United States within the Federal Reserve System.
In order to adequately interpret the evolution of intra-system balances it is worth remembering the following points: Balances are the result of the normal execution of monetary policy. These are therefore flows between the Eurosystem and the banking systems (in no case bilateral between central banks), of a monetary nature (these are not real flows of cash or fiscal transfers) and resulting from the use that the Eurosystem counterparts make of monetary policy operations. Under present conditions, the greater appeal to the Eurosystem Net Loan by the banking system of a country does not reduce the funding available to the banking system of another country. The risk of loss assumed by the NCB on the assets of the Eurosystem balance is in line with its allocation of the ECB capital and does not depend on the size of its intra-system balance. Proposals to limit the maximum volume of these balances are equal to calling into question an essential principle of the operation of the Monetary Union, and the adoption thereof would probably lead to the disintegration of the area. It is not appropriate to use the example of the United States, as the Federal Reserve System operates within a fully integrated banking and capital market.
155
In summary, the accumulation of intra-system balances is the normal result of an asymmetrical crisis in the balance of payments within the area. As is pointed out by Pisany-Ferry (2012), the evolution of the intra-system balances is only a symptom of the disease afflicting the Monetary Union: the best expression of the fragmentation of the monetary policy.
As we discussed earlier, access to Eurosystem funding has acted as a security valve to prevent a generalised problem of illiquidity eventually leading to situations of default. However, to date, this insurance mechanism has proven incapable of correcting coordination failure. And on many occasions, the appeal of a countrys banking system to the Eurosystem has been interpreted by the market as a risk factor, so that it has become an additional component of the self-fulfilling prophecy process. The greater the increase in funding via monetary policy, the greater the restriction on funding from the market. Bear in mind the aberrant nature of this sequence and its lack of sense in an environment other than that of the Monetary Union. During the shutdown of the wholesale financial markets at the end of 2008 and beginning of 2009 nobody thought to judge that a greater appeal to the credit of the Fed or of the Bank of England was an act of weakness.8
8 Among other reasons because the names of the institutions that most used these facilities were not known, and because the geographical distribution of the use (in the case of the districts of the Federal Reserve system) was not significant
156
During spring of 2011, it seemed that the combination of the SMP, the maintenance of the full allocation in monetary policy operations and start of financial aid programmes in the cases deemed to be more vulnerable (Ireland in November 2010 and Portugal in May 2011) allowed the Eurosystem to take on a less leading role in the crisis resolution.
The position of the ECB, as explained by Trichet (2011), was based on the diagnosis that this was not a crisis of the euro, but rather a problem of poor macro-economic management, linked to an insufficient budgetary discipline and the persistence of real and financial imbalance. The solution could only come about from a combination of fiscal adjustment and structural reforms at a national level, and the strengthening of the institutional framework of the Monetary Union. Much emphasis was placed on the importance of the full activation of the EFSF and the future European Stability Mechanism (ESM). As for monetary policy, this supported the principle of separation between the setting of the interest reference rate and the maintenance of unconventional measures to deal with the distortions in the financial markets and the transmission mechanisms. As an unequivocal example of application of this principle, the Governing Council decided to raise interest rates on two occasions in response to the inflationist risk associated with the rising price of fuel and raw materials.
But the deterioration of the crisis since the end of June 2011 once again placed the ECB at a crossroads. The dislocation of the
157
Italian public debt market, the second largest in the euro region, triggered a new and virulent bifurcation dynamics which severely punished the banking system. Although the negative balance of its international investment position is moderate, Italy underwent a sudden restriction of external funding which led to the liquidity crisis of its banking system. The value of traded stocks of the banks in the region plummeted and the perception of default risk, reflected in the credit derivative contract premiums, shot up. During those weeks of August and September, the euro crisis reached its most dangerous systemic repercussions since its onset.
The Eurosystem was forced once again to react in order to contain the spiralling instability which threatened to spread the rest of the world. It reactivated and expanded the SMP, by purchasing Italian and Spanish public debt for the first time. The bloodbath was successfully avoided, but throughout the month of October, in the debates held prior to the European Council and G20 meetings, the need for the ECB to adopt a firmer and more efficient strategy to solve the crisis was the main topic. And the Eurosystem finally took a new step.
3.2. Quantitative easing for banks only

The central banks of the main developed economies have had to revolutionise the implementation of monetary policy in order to respond to the financial crisis. At a first phase, they modified the conditions of liquidity provision, both in regard to terms and types
158
of counterparties and guarantees, maintaining a relatively stable balance. When the crisis became systemic in autumn 2008, it became clear that the cut in the interest reference rate to its minimum level (zero or close to zero) would not prove enough to halt the spiralling contraction between the financial conditions and the real economy.
Henceforward, the monetary policy of the Fed, the Bank of England and the ECB was implemented mainly through unconventional measures, which was the start of the stage in which we remain to date. Despite the sudden departure from the practice of the last two decades, this was not a totally untraveled path. The Bank of Japan had spent years trying unconventional measures in an attempt to overcome the persistent deflation generated by the financial crisis at the end of the eighties. And the Japanese experience, not very successful, brought about a debate on how to implement an efficient monetary policy in a context of a liquidity trap, distortions in the transmission mechanism and a banking crisis.
The Fed paid special attention to the problems of Japan and the conclusion of its analyses served as the basis for the deflation prevention policy of 2002 and 2003. Bernanke & Reinhart (2004) identify three categories of these measures: i) the use of communication to influence agent expectations ii) quantitative easing via the increase in the size of the balance sheet and iii) the alteration of the composition of the balance sheet in order to directly affect the prices of certain financial assets. Each of the aforementioned central banks
159
has applied the unconventional approach in its own way, but all have coincided in having significantly expanded the balance sheet.
Both the Fed and the Bank of England have carried out a threefold increase of the weight of their balance sheet in regard to the GDP (see Graph 5). And both have done so by the mass acquisition of financial assets, which traditionally made up the main component of the assets in their balance sheets. The US monetary authority began by concentrating its purchases on mortgage bonds, having subsequently moved on to Treasury bonds. The Bank of England has mainly purchased significant volumes of short and medium term public debt securities (around 14% of GDP and 30% of the amount of securities in circulation). The objective in both cases has been to have a direct influence on the nominal expenditure in order to reduce the risk of deflation and help the economy to reabsorb idle resources.
Although it is too early to carry out a full evaluation, the evidence suggests that the unconventional strategies of the Fed and the Bank of England have proven successful. Estimates indicate a significant positive effect on asset prices, both of those assets which have been directly purchased and those with higher risk and greater impact on the funding terms of the non-financial private sector (See Meaning & Zhu (2011)). The evolution of the nominal demand has also been positive, although in this case it is harder to estimate the impact of unconventional measures. We must also highlight the credibility of the strategy and its contribution to the
160
reduction of uncertainty, given that the forceful and voluminous interventions and the communication thereof have managed to modify agent expectation and to coordinate these towards balances equilibria which are at some distance from more catastrophic scenarios. It has not been a magical solution for all problems, but they have managed to stabilize the operation of the financial system, to lend strength to the recovery of the economy and to create conditions so that the correction of the structural problems of public and private indebtedness is carried out at a moderate cost.
From the start, the Eurosystem elected to concentrate its unconventional measures on the provision of funding to the banking system, in line with the financial structure of the area, particularly in terms of full allotprent and the performance of unusually long term operations. The purchase of assets has been more modest in relative terms and has now become sterilised. In December 2011 this strategy was reaffirmed, by deciding to enter into two special financing operations for a three-year term, along with other credit support measures designed to favour bank lending and the money markets in the region.
The demand for liquidity of both operations was very high, with a very high participation of entities compared to the average number of previous long term financing operations. The total amount granted was 1.018 trillion euros. The distribution of liquidity followed a concentrated geographical pattern reflecting the effect of funding restrictions on the banking system. The percentages of
161
Graph 5 Balance fo the Central Banks during the crisis (in % of the GDP)
Source: ECB, BoE, FED
Spanish and Italian banks were much higher than their respective allocations in the ECB, whereas the banks from creditor countries were granted much lower percentages, and further increased their resources in the Deposit Facility.
Following these two operations, the consolidated balance sheet of the Eurosystem reached 32% of the GDP for the region, exceeding the percentages of the Fed and Bank of England. However, the impact of the unconventional strategy in the balance sheet of the central banks has been somewhat lower in the ECB that in the other two, due to the increase in total weight over the GDP, as well as having only used assets related to monetary policy, which account for a lesser percentage of the balance sheet in the European case.
162
The immediate impact of the three year funding operations was very positive. The coverage for a three year period of the liquidity requirements of the banks considerably reduced the uncertainty which had frozen the workings of the banking system. The perception of bank credit risk improved with significant drops in the premiums of credit derivatives and increases in the value of capital. The money markets and bank debt markets underwent a revitalisation, with new flows of funds and the return of European and foreign institutional investors. At the same time, the public debt market spreads also experienced a significant narrowing down, returning in the case of the Spain and Italy to around 300 basis points. The disabling of the loop-shaped coordination failure between sovereign debt and bank risk also had some effect on the monetary and credit performance, as well as on the real economy. Towards the end of the first quarter, both the European Commission and the ECB stated that the M3 and private sector loans exhibited positive albeit very low expansion rates, whereas activity stabilised after the drop in the last quarter and first months of 2012.
Beyond its short term efficacy as an insurance mechanism in the face of the systemic deterioration of the crisis, the full effect of the quantitative easing for banks only in the Eurosystem will only be assessable over time. Nevertheless, the strategy adopted has some weak points, among which we highlight the following: It emphasises the Eurosystems tendency towards geographical concentration of net funding. The net amount and the dis163
persal of the net lending volumes by country and of intra-system balances have increased substantially. The Eurosystem has thus decided to carry on its clearing role for private funds movements, directly avoiding having to deal with the underlying causes of such movements in order to modify them. The sideeffect is the increase in the risk volume of the Eurosystem and in its geographical concentration, assumed by member countries in proportion to their share of the capital. It fails to put an end to the fragility of the public debt markets in the face of dislocation, and might even increase it. According to BIS figures, Spanish Banks have increased their public debt holdings by over 40,000 million between December 2011 and January 2012, whereas the Italians did so at around 15,000 million euros. This evolution, which is due to the entities taking advantage of the possibility of generating margin by borrowing from the Eurosystem and buying public debt, might end up being counter-productive for two reasons. In first place, because these are not resources geared towards credit for the non-financial private sector (which is the main objective behind it). And secondly, because it might even intensify the means of contagion towards the banking system if the public debt spreads widen once again. A demand has therefore been generated for the more castigated public debt securities, but nothing can guarantee that the market evolution will not suffer further dislocation episodes which will increase volatility once again and widen the gap between market prices and prices based on fundamental variables. The SMP might be relegated an amortised instrument. It
164
seems logical that the Programme activity was interrupted almost at the time when the positive impact of long term funding operations became evident. The problem is that, within the Governing Council, the opposition to the reactivation of the SMP is likely to increase in the event of a new dislocation of the markets, arguing that both the levels of risk in the balance sheet and degree of geographical concentration are way too high. This eventually would be cause for grave concern, given that the SMP was the instrument which had succeeded in preventing a systemic collapse of the euro region both in May 2010 and in AugustSeptember 2011.
There is an alternative, which the Eurosystem has ruled out, which might prove more effective as a contribution towards a definitive solution to the crisis. It would involve directly tackling the source of the problem, which is the instability that the dislocation of some public debt markets have brought upon the core of the economys funding system. The aim would be to ensure that a limit is established on the deviation between the market prices and prices adjusted to fundamental economic variables which must not be exceeded. Although there are various ways of implementing this type of measure, they all involve direct intervention in the market in a plausible way. Only the central bank, with its power to create unlimited money, will be able to successfully carry out such a task.
A reasonable option would be to publicly commit to ensuring that the spread between short term sovereign debt in euro countries
165
does not surpass a certain value threshold. Given the arbitrage relationship between the various terms of a countrys public debt yield curve, the application of this stability limit on the shorter part of the curve (bills and bonds up to 2 years) would suffice, for this then to be applied to longer terms. In fact, the epicentre of the dislocation episodes in the public debt markets can be found in the shorter part of the curve, where volatility increases and exorbitant probabilities of default emerge, which in turn adversely affect the repo market, which is crucial for short term financing of the banking system.
The stability limits should be defined for each country on the basis of its vulnerability and adapted as the case may be to take into account potential default in commitments of fiscal consolidation and structural reform. By way of illustration, for Spain and Italy the stability limits might be around 200 basis points: this level would be clearly above what can be considered a fair value spread. But what is important is not to compress the spreads as much to ensure the stability thereof to enable the transmission mechanism of the monetary policy to operate under relative normality.
The Eurosystem should purchase public debt when the price reaches the stability limit. But if this proposal is viable, the volume of debt eventually purchased by the Eurosystem is likely to be more limited than that already in place in the SMP. Moreover, the volume of purchase of public debt could be sterilised, as is already done now. The problem is less about amount of money, and more about price structure and risk, as well as market operation.
166
This type of initiative would enable to transform the perverse dynamics of debt into a virtuous circle. The recovery of monetary and financial stability in the more adversely affected countries would establish the conditions for fiscal consolidation and structural reform measures to have the positive impact that they should have had on the confidence of agents and markets.
It is not about the Eurosystem taking on a new role as lender of last resort to the States, which would be entirely inappropriate.9 The idea would be to preserve the good operation of the debt markets as a key component in the transmission mechanism of monetary policy and funding of the economy. We are speaking of a public good of great economic value, the protection of which is an essential (albeit not explicit) task of any central bank. But as we recalled earlier, the Eurosystem is not a central bank like the rest.
The rejection by the Governing Council of a plausible intervention in the public debt markets designed to limit the instability seems to be related to a number of economic and legal objections. It is argued that this type of action does not pertain to a central bank and that it carries inflationist risks in that it would be assuming a quasi-fiscal role, attempting to solve problems of lack of budgetary discipline and/or
9 De Grauwe (2011), after performing a thorough analysis of the crisis, uses the notion of lender of last resort for sovereign debt markets. Subsequently, this idea has been used by others to assimilate a plausible intervention in the debt markets with State funding via the central bank.
167
competitiveness by means of creating money. It is also argued that it may violate section 123 of the Treaty, or at least the spirit thereof.
Despite having the seal of respectability granted by the Bundesbank, such arguments are questionable. It is true that the Eurosystem should not intervene in public debt markets if the widening of the spreads is due to irresponsible fiscal policies or an impairment of fundamental variables (a drop in the GDP, an increase in the external deficit). For this reason it is highly probable that a mistake was made when in May 2010 the Eurosystem purchased Greek public debt. But when the market dislocation begins via contagion and, furthermore, is endogenous and subject to feedback, if the central bank does not act, it is opening the door to monetary restriction which would endanger price stability not only of the country but of all the region. As for inflation, this type of unconventional measure would carry lesser inflationist risk than the other two long term funding operations unanimously approved by the Governing Council. The argument to intervene becomes even stronger when the affected countries have reacted to contagion by accelerating their fiscal adjustment plans and implementing significant structural reforms.
On the other hand, a more plausible and decisive intervention in debt markets would not only not violate what is set forth in section 123, but would in fact be fully coherent with the spirit thereof. The text of the section refers to the direct purchase of public debt securities in the primary market, excluding from the ban the
168
purchase of bonds on the secondary market. The ban on monetary funding seeks to ensure the independence of monetary policy in regard to the needs imposed by the fiscal policy. The public indebtedness requirements (arising from treasury deficits, net asset variation and the refinancing of debt maturities) must be covered by appealing to the market, without resorting to the expansion of the monetary base, which ends up generating an inflationist bias. However, compliance with this healthy principle requires the existence and proper operation of a liquid and deep public debt market. A lack of action in the face of the dislocation of public debt markets means accepting the gradual destruction of one of the basic foundation stones of the separation between fiscal policy and monetary policy.10
In our opinion, the reason why the Eurosystem has not chosen this solution, more in line with the practice of other comparable central banks, is not economic but political. This is difficult to believe, in that it is a fiercely independent institution managed by qualified professionals. But as was pointed out in the first sentence, the Monetary Union is a political construction; and the euro crisis carries, as is natural, a very influential political dimension. The governments and central bank authorities of Germany and all other
10 Within the monetary union, the loss of access to the market as a result of contagion does not mean resorting to monetary funding of public debt, but the use of official funding on a temporary basis. However, this situation quickly leads to some to request to exit the euro and the recovery of monetary sovereignty as a means of escaping the perverse dynamics of debt.
169
countries benefiting from the positive contagion of the Greek crisis, have viewed the crisis as a vindication of their economic philosophies and an opportunity to reconsolidate the Monetary Union in accordance with their principles. And as part of this process, they understand that market pressure is an efficient discipline that must not be neutralised. In their opinion, the markets may exaggerate, but in the end they reflect the fundamental economic problems.
In summary, the Eurosystem has proven to be essential in containing the crisis at the times of greater systemic danger, but it has not done what any national central bank would have done to tackle the perverse dynamics of debt which threaten the survival of the euro. In a way, it cannot be blamed. It has acted in accordance with its nature.
4. The definitive solution must begin in 2012

After the bad omens with which 2011 came to an end, the first few months of 2012 have seen the danger of a systemic collapse of the euro fade into the distance, and it even seems that certain significant steps have been taken towards a definitive solution to the crisis. The insurance provided by the Eurosystem has brought about time and tranquillity.
But the situation is still critical, if we look beyond the financial tension gauges and we measure the situation of the real economy
170
and political cohesion within the area. The deterioration of the crisis in the second half of 2011 has come at a very high cost in terms of a fall into recession for Spain and Italy and other member countries, as well as the worsening outlook for countries with a programme. To the rise in unemployment we must add new fiscal adjustment measures, required to meet the targets in a context of lesser growth of tax bases and higher cyclical expenditure. At the same time, the detachment towards the Monetary Union is on the increase, both in countries punished by financial pressure as well as in creditor countries.
Given such conditions, the definitive solution to the crisis, this being understood as the one allowing recovery of sustained growth throughout the region and a reduction and stabilisation of the credit risk spreads, cannot take as long as the refund of the money by the banks to the ECB. It is urgent and the effect of Eurosystem long term funding operations should be harnessed in order to implement it.
In our opinion, the definitive solution is made up of 4 components. Two of them are already well on track. The third is the key: the one requiring greater effort due to its political and technical complexity. And the last is fundamental to prevent future crises and to encourage the stable operation of the Monetary Union; but this can be taken more slowly, as it is not a pressing need and will eventually happen when the time is right.
171
A SUITABLE HANDLING OF THE INSOLVENCY PROBLEM IN GREECE. Immediately after the approval by the States in the euro region of the Loan to Greece which gave rise to the first adjustment programme carried out jointly with the IMF in April 2010, the prevailing opinion in the financial markets was that Greece had a solvency problem which required debt restructuring. However, among the European authorities, including the ECB, the overriding idea was that any measure generating losses for investors had to be avoided at all costs. It was believed that this approach might exacerbate contagion to other public debt markets.
But the delay in recognising this problem undoubtedly was very onerous. In the Deauville Declaration of October 2010, the leaders of France and Germany, guided by the healthy aim of involving private investors in the assumption of losses as a result of their decisions, extended the potential risk beyond Greece, moreover projecting it to the future. And in spring 2011, it became clear that the first Greek programme was not in line with the assumption of return to the market expected for 2012.11 Finally, the Heads of State and Government of the Eurozone countries decided in October 2011 that the restructuring of Greek debt had to allow sufficient reduction of its stock and that this solution was meant exclusively for the exceptional case of Greece.
11 The alarm bell was sounded by the IMF, given that the approval of program disbursements requires a reasonable guarantee that the financing needs of the country are
172
A year and a half after the outbreak of the crisis, one of the most decisive conclusions was thus reached: the problem of Greece is special and requires special handling. And a series of questionable decisions that had amalgamated, consciously or unconsciously, the Greek situation with that of other vulnerable countries in the region, was thus left behind.
Greece has continued to be a source of uncertainty which has affected the crisis dynamics. Its economic depression (a 13% drop in real GDP between 2009 and 2011, a 30% drop in deposits in the banking system during the same period) and the proof of its institutional frailty have led to a situation of clear unsustainability of its public debt,12 calling into question the viability of its permanence in the euro. And the risk of Greeces departure is a very disturbing scenario, as this is not contemplated in the Treaties and it is difficult to imagine the consequences it may lead to.
The Private Sector Involvement (PSI) Operation in the reduction of debt, a prior condition for the approval of the second programme by the Eurogroup and the IMF, was quite successfully executed throughout the month of March. The operation is a sophisticated
met for the following year; and given the market situation, the IMF considered that Greece could not be expected to return to the market in 2012 as expected. 12 The deterioration of the sustainability analyses of the Troika since the start of the programme has been overwhelming. At the start of the program the public debt vs. GDP was expected to reach its peak in 2012 with 158% of GDP and no reduction. In autumn 2011, this peak was changed to 186%; finally, the sustainability analysis carried out after the PSI operation suggests a peak of 164% of the GDP.
173
and European version of the Brady Plan,13 which has used bonds issued by the European Financial Stability Facility (EFSF) to soften the drop in present value of over 50% in exchange for new ultra long term bonds. The credible threat of a disordered bankruptcy and the retroactive introduction of Collective Action Clauses in the issues subject to Greek legislation managed to achieve a percentage participation in the exchange above 95%. The operation has succeeded in reducing the debt load and Greek states refinancing needs very substantially.
From a liquidity approach and at punitive rates at the start of 2010, reality has taken over through an operation in which private investors rightly take on a part of the cost of bankruptcy prevention14 and Eurozone countries assume greater risks, for longer periods and in exchange for lower interest rates.
Despite the magnitude of the debt reduction (100,000 million euros, which would allow it to reach a ratio over GDP of 116.5% in 2020, according to the sustainability analysis of the Troika), the
13 Name of the Plan used at the end of the 1980s to solve the foreign debt crisis of developing countries, mainly Latin American. It consisted in exchanging outstanding bonds for new bonds with a lower present value and longer terms, guaranteed by US Treasury issued securities. 14 The policy of loss avoidance for investors led to a perverse dynamics whereby private investors reduced their exposure, in many cases with substantial gains, thanks to the ever increasing involvement of official creditors. Taken to the extreme, this logic would have led to a process whereby private investors would not suffer any losses whereas the official lenders were left funding the entire Greek debt.
174
prevailing opinion seems to emphasise the main risks facing the second Greek programme.15 After the last two years, any glimpse of a positive assessment in regard to what is going on in Greece seems completely off the wall. It is true that the sharp drop in the GDP, the fiscal adjustment and the reforms carried out have not achieved sufficient reduction in the primary budgetary balance or in the current deficit (which is still around 10% of GDP). However, in our opinion, the PSI operation and the approval of the new programme, which supports devaluation via the reduction of labour costs, the gradual continuation of the fiscal adjustment and the 50,000 million euros to ensure the solvency of the banking system, will be able to restore certain stability to the Greek economy. Taking into account the reduction in uncertainty, the moderate deflation of costs and the effort invested in structural reforms, there is a very clear potential for economic recovery. This stabilization would exert a positive impact on expectations, leading in turn to a virtuous circle. All this depends on the country being able to maintain a stable political leadership which is committed to compliance with the second programme.
In any event, the value of the PSI operation and the second programme for the definitive solution of the euro crisis arises from the reduction in uncertainty. Despite the need to continue to adopt policies which require sacrifices on the part of the citizenship for
15 See for instance the IMF report on the request for a new program, which emphasizes the risk of new accidents and the importance of Euro members undertaking to continue to finance Greece in concessional terms whilst the appropriate policies are implemented.
175
some time, the reduction of the debt and the funding of the long term needs of the State render the option of staying in the euro much more attractive than the option of departure (although the latter will continue to have its supporters both in and outside of Greece).
A FISCAL PACT TO STRENGTHEN POLITICAL CONFIDENCE. The Greek experience clearly justifies a reinforcement of the fiscal regulations of the euro, so that these are more efficient during the expansive stages of the cycle, therefore obliging member states to internalise the external cost of unbalanced public finances.
The European Union already approved in 2011 a substantial toughening of the Stability Pact and Growth, as part of the reform of the macro-economic governance known as Six Pack, which also broadens the multilateral supervision of macro-economic imbalances of a non-fiscal nature. The preventive section includes the quantitative definition of what is understood to be a substantial deviation from the Medium Term Objective of structural budgetary balance or from the path established to achieve it. The corrective section brings about the Excessive Deficit Procedure due to the non-fulfilment of the public debt criterion and introduces the reverse qualified majority rule for decision-making, which will make it harder for member states to put a stop to a Commission proposal. Minimum requirements are also established for the budgetary frameworks of the countries, in terms of coverage of all administrations, multiannual nature and quality of the public accounting systems.
176
This exhaustive reform of the fiscal rules culminated with the signature on 2 March 2012 of the Treaty on Stability, Coordination and Governance. This new Treaty: Has been signed by 25 of the 27 EU member countries, although it will only be legally binding for euro members. It shall come into force on 1 January 2013, provided it has been ratified by 12 euro member states, thus avoiding the uncertainty associated with the ratification process of a modification of EU Treaties. Even so, its content is expected to be added to community legislation within five years. It introduces the rule of budget balancing. This will be understood to be met when the structural deficit reaches its Medium Term Objective (MTO) with a maximum deficit of 0.5% (which can reach 1% if the debt is significantly below 60% and the sustainability risks are low). Any significant deviation from MTO or from the path of adjustment towards the MTO that is observed will trigger an automatic correction mechanism, defined in the national legislation but inspired by the principles established by the Commission. The foregoing shall be of application unless in the event of exceptional circumstances.16 Both the rule and the correction mechanism must be added to the national legislative systems, preferably at a constitutional level, within the year subsequent to the entry in force of the
16 This refers to i) An unusual event outside of the control of the country which has a large impact on the financial position of the public administrations or to ii) periods of
177
Treaty. And the transposition shall be subject to verification by the EU Court of Justice, which shall be empowered to take disciplinary action in the event of infringement. The euro countries undertake to support Commission proposals within the framework of the excessive deficit procedure concerning any of them, except in the event of a qualified majority thereof against it.
The new Treaty is consistent with the system of fiscal regulations established in the revised SGP and actually uses its basic components (the MTO, the significant deviation and the exceptional circumstances). What it does is to toughen these rules and increase the legal rank thereof within the internal legal system. The two most important items are the rule of budget balance and the automatic correction mechanism.
In technical terms, the new framework of fiscal rules for the euro is reasonable from a medium to long term perspective, insofar as:
It reinforces the discipline mechanism during the expansive phases of the cycle, which will oblige budgets to be kept in balance or with surplus.
serious economic contraction as this is defined in the revised Stability and Growth Pact and, in both cases, provided the temporary deviation does not endanger medium term fiscal sustainability.
178
It increases control at a European level on the quality of the public accounts as a basis for multilateral supervision of the fiscal policies.
It increases the credibility of the prevention and sanctioning mechanisms, assisting in non-discretional decision-making and toughening sanctions.
It obliges national legal systems to fully incorporate both the fiscal rules and the minimum requirements of quality and coordination of budgetary frameworks.
In the medium to long term, the application of such rules, assuming a trend nominal growth of 3% per annum, would lead to a public debt stock of 17% of GDP (Whelan, 2012). The key for such rules to generate anti-cyclical fiscal policies is that they are able to impose tough discipline during the expansive phases, that the reliability of the fiscal information is assured and that the sanctions are applied in rigorous and equitable way for all.
The use of a non-observable variable such as the structural balance in order to assess compliance with the deficit rule makes sense, but it complicates the practical application thereof due to uncertainty in regard to the correct estimate of potential GDP. The case of Spain during the phase prior to the crisis is paradigmatic: during the period 2005-2007, the Commission estimated the structural budgetary balance to be very close to the nominal balance, given that the growth estimate for potential GDP was around 3%. The subsequent performance of the economy and of the public
179
income and expenditure has shown that in the years previous to the crisis, Spain was growing over and above its potential and that the structural balance was much worse than that indicated by the nominal surplus.
In reality, the value of the Treaty on Stability, Coordination and Governance is above all political, as it helps to bring about once again a new political understanding among the euro member countries. Several countries have interpreted the financial aid as a breach, at least in spirit, of the non-mutual guarantee clause in the Treaty. It was hard for Germany and other countries in the D-mark area to bring their monetary sovereignty in line with that of countries with a lesser tradition of stability. And the non-guarantee clause was one of the essential conditions to do so. Part of the attitude of governments and central bank authorities in these countries in the last two years could be explained by this feeling that rules have been broken.
The new Treaty, with its reflection in the Constitutions of several countries, is one more step for countries in the north and centre to believe that the countries which are currently more vulnerable are adopting a longstanding commitment to fiscal discipline, beyond the adjustment forced upon them by the markets. And this confidence is essential to the creation of political conditions which will enable decisions to be taken with a view to solving the crisis. The Fiscal Pact is therefore a necessary condition, but in no way is it enough to make 2012 the year of the start of the end of the crisis.
180
The Treaty will strengthen the policy of firm advancement in fiscal consolidation in the most vulnerable countries, which has been applied for the last two years. But we are already aware that the perverse dynamics can make a steadfast programme of fiscal adjustment which lacks a complement to help restore growth fail in its objective of stabilising public debt. Without nominal growth and financial stability, the efforts made in regard to deficit reduction not only fail to reduce the debt/GDP ratio, but actually increase it.
THE GRADUAL AND FLEXIBLE CONSTRUCTION OF A SINGLE PUBLIC DEBT MARKET. The key to doing away with the perverse dynamics of debt is to restore the good working order of the public debt markets, so that the spreads are more in line with economic fundamentals and more stable. This is an essential condition for relaxing financial terms in vulnerable countries and for allowing growth to benefit from the positive effects of the reforms adopted.
We have already pointed out that there is no confidence that the Eurosystem will adopt the strategy required to achieve this objective. A second alternative on the table is the EFSF/ESM. In theory, the EFSF/ESM, with the set of intervention instruments which it currently contains, has the effective capacity to stabilise the public debt markets. However, in our opinion, financial aid is not an efficacious solution to the perverse dynamics of debt. Under current conditions, the preventive funding facilities would soon become ordinary adjustment programmes; the result would be the extension of the loss of access to market funding and the escalation of the
181
political tension arising from the concentration of funding in the area from only a few contributor countries. On the other hand, the design of the secondary market intervention instruments has too many political and operational limitations to even appear plausible.
In our opinion, the most suitable way is the creation of a new public debt market with jointly and severally guaranteed securities. This is a very important and delicate political decision, as it involves the pooling together of sovereign risk, which is an essential part of fiscal sovereignty. Countries with higher credit rating have been hitherto reluctant to share the issue of debt with those of a lower credit quality. This attitude is fair and understandable; to ask Finland, Holland or Germany to pool together all the debt issued with more indebted and vulnerable countries is politically unrealistic.
But given the current crossroads of the Monetary Union, this step must be taken, and the way to do it is to design it in such a way that it is politically feasible. This design should abide by the following principles: The construction of a single public debt market in euros must be done gradually. The first stone must be solid but of a moderate size. The next stones shall be placed little by little and on the basis of experience. At the first stage, the percentage of public debt pooled together must be limited. This requirement should be in line with the doctrine of the German Constitutional Court, which requires bonds issued by the State to have a clear quantitative limit.
182
The pooled debt must be senior to the national debt, in order to reduce the risk of the joint and several guarantee.
Incentives restricting moral hazard must be introduced, taking in account the strengthened governance framework of the Monetary Union.
In the Eurobond debate, several specific formulae have been considered which are compatible with such principles. The pioneer was the blue bond/red bond proposal (Delpla & Weizscker, 2009), which suggested pooling together up to 60% of the public debt over the GDP (blue debt), leaving the rest as subordinate national debt (red debt). The Commission published a Green Paper containing various different options of Stability Bonds which aimed at feeding the debate. Lastly, the proposal of a European Debt Redemption Fund from the Group of German Economic Experts (2011), which advises the Federal Government, is also of great interest, in that it considers the pooling together of the surplus of the 60% of debt over GDP in exchange for real guarantees in order to overcome the crisis. 17
In our opinion, the most attractive alternative would be the Eurobills proposal made by Hellwig & Phillippon (2011) which would consist of: The issue with a joint and several guarantee of all public debt securities with initial maturities of up to 1 year (Eurobills).
17 The formula of the surplus over and above the 60% does not seem fair, as it rewards the more indebted countries.
183
The participation of each member country would be limited to 10% of the GDP. The Eurobill market would therefore have a maximum size, based on the GDP for 2011, of 1 billion euros.
The Eurobills would be senior to all other longer term debt, as the short term debt is already de facto senior to medium and long term debt.
The loss of access to the Eurobills could be considered disciplinary action within the framework of multilateral supervision of fiscal policies and macro-economic imbalances.
The Eurobills are a simple formula with many advantages: Efficacy. As we have already mentioned, the core of the dislocation in economy funding mechanisms lies with the shorter part of the debt markets and its connection to the money markets. The Eurobills would manage to directly tackle the failure and the effect would be foreseeably transmitted throughout the yield curve. They would thus represent an alternative to stability limits. Political feasibility. The high level of political and legal commitment to fiscal stability brought by the new Treaty should allow for the more solvent countries to accept the Eurobills. Given their term, the risk is limited; and in terms of cost if issue, the loss would be small or non-existent.18 Operating facility. The EFSF/ESM already issues bills, so it could easily assumed the issue of Eurobills. A system would have to
18 The bills issued by the EFSF with proportional guarantees from euro member countries have a small spread compared to German bills. Taking as a reference the issue of
184
be established to consolidate the treasury needs for each State, as Bills play a certain role as treasury management instruments. Additional benefits. Eurobills could be used to meet Basel III liquidity requirements and would attract a strong demand from institutional investors in and outside of the region.
The construction of a single public debt market in euros will be a long and complicated process, likely to take decades. It is a basic ingredient in the path of the euro towards institutional maturity, which shall have to develop alongside advancements made in fiscal integration. But it must commence now, as it is the key to overcome the crisis once and for all.
THE FEDERALISATION OF BANKING SUPERVISION IN THE EUROSYSTEM AND THE CREATION OF A EUROPEAN DEPOSIT GUARANTEE FUND. In hindsight, one of the most serious flaws of the institutional framework of the first decade of the euro has to do with banking supervision and crisis management. In order to reach a definitive solution, this flaw must be corrected.
Despite having harmonised prudential legislation from the start, the euro region has worked with banking systems which have continued to be governed by an essentially national approach. On
March 6 month bills, the spread compared to the German bills is lower than 20 basis points. The cost of issue of the Eurobills would naturally be lower than that of the EFSF bills, thanks to the joint and several guarantees, closer to the levels at which bills are currently issued by Germany and by other countries with a higher credit rating.
185
the other hand, despite the efforts begun following the Brouwer Report (2001) to build a crisis management plan within the EU, when the crisis was broke out weak in deposit guarantee and practically non-existent in the intervention and liquidation of credit institutions.
One of the most illustrative indicators of this persistence of the national approach in the realm of banking is that the integration has advanced more between euro countries and non-euro countries than within the euro region itself. Among the problems associated with this situation, we shall highlight two: The absence of global overview of the funding structure of the area and its relation with monetary policy. The creation of the euro led to a strong expansion of gross and net flows within the area. In a way, this was the reallocation of capital towards those countries where it was scarce and could obtain better returns. But in some countries this process ended up by creating bubbles in the real estate sector, which reached hitherto unknown peaks partly due to belonging to the Monetary Union (low interest rates, very elastic supply of external funds). In light of the high short term economic benefits in terms of extraction of income, employment, fiscal activity and collection, the economic policy renders very difficult, as we have seen, the adoption of domestic measures to burst the bubble. At the same time, given that monetary policy is exogenous to the authorities of a country, the effect thereof is not internalised in regard to the creating or blowing up a bubble further. But it is not only about bubbles. The global crisis showed up
186
other weaknesses in the funding structure of the banks in the euro region, such as its dependence on the liquidity of the US money markets.
The possibility that a banking crisis might bring down a country. National supervision goes hand in hand with the national responsibility for covering costs in the event of a crisis. As we have seen in Ireland, the bank solvency problems can overwhelm the fiscal capacity of the country. Moreover, and continuing with the Irish example, the potential effects of contagion within the Monetary Union limit the capacity of the affected country to solve the crisis by the assumption of losses by private creditors.
Since the start of the crisis, considerable progress has been made in terms of coordination of bank supervision and crisis management in Europe. Nevertheless, the maturity of the Monetary Union still has a way to go. The essential public policies on the banking system must be common within the euro area, in accordance with a plan with two main cornerstones: Federal banking supervision within the Eurosystem. The time has come to make use of a provision of the Treaty on the federalization of banking supervision within the euro area. Given that only in 5 euro countries the banking supervisor is separate from the central bank, and that the ECB is the most powerful euro institution, the most natural approach to achieve this is by awarding competencies to the Eurosystem. And the competencies assumed must include micro-prudential regulation, macro187
prudential regulation and part of the crisis prevention and management function. A European Deposit Guarantee Fund (EDGF). The crisis has proven that the deposit guarantee systems are basic instruments in the prevention and management of banking crises. During the global crisis, the risk of having systems with insufficient coverage (eg. Northern Rock) or the chaos generated by unilateral decisions on levels of coverage within the euro (movements of deposits between countries at the end of 2008) became patently clear. With the generalized increase in coverage of deposits up to 100,000 euros (which increases the cost of the liquidation of the institutions), the guarantee funds, in principle, assume a crucial responsibility. However, the models of deposit guarantee systems within the area as still quite different from one another. For this reason an obligatory adhesion fund should be created to assume the guarantee of all deposits in the banks of the euro area and their branches in the EU. The fund should be made up of the contributions from entities, determined on the basis of credit and liquidity risk and have a system of governance similar to that of the Spanish guarantee funds, presided over by the ECB and with broad representation of the private sector in its Board of Governance. The functions of this EDGF should include the resolution of banking crises, assisting the mandate of the Eurosystem in early intervention and crisis resolution at the lowest cost for the public treasury. As an additional and exceptional mechanism of funding, a system could be established whereby the ESM could lend funds to the EDGF.
188
The improvement in the operation of the Monetary Union as a result of the federalisation of banking supervision and crisis management would be considerable in the medium and long term. The following are among the possible positive changes associated with this reform: The monetary transmission mechanism would become more robust against national fiscal evolutions and the fluctuations of the financial markets. A boost to cross-border integration and consolidation. The protection of domestic industry would become more difficult, which would lead to benefits of risk diversification and economies of scale. And competition would gradually become more intense, which is essential after the re-nationalisation of the banking markets and the strong public support provided to crisis- affected entities. Support for incentives to implement measures to prevent the creation of speculative bubbles. The internalisation of external effects and public service provision problems associated with financial stability within the area. This would allow for the creation of a structure where the central bank and the Ministries (Eurogroup) work much more efficiently towards preserving financial stability. It would support the introduction of measures to achieve greater involvement of the private sector in the solution of future crises.
189
5. Conclusion
The adolescent crisis of the euro is extremely serious. European and national authorities have taken courageous and significant decisions in recent months, in many cases having learned from previous mistakes. The restructuring of the debt and the new adjustment programme are an intelligent and well executed response to the serious solvency problem in Greece. Ireland and Portugal are applying their programmes with excellent assessments made by the troika. And an institutional framework is under way, which will render the generation of a crisis in the future a lot less likely.
Much political and social capital has been spent on implementing such measures. It is clear that the euro member countries are willing to make great sacrifices in order to preserve the project. But the truth is that the crisis has not yet been overcome, because the root causes of the uncertainty and the instability generated by the dislocation of the public debt markets have not been attacked.
The economy within the euro area will foreseeably face a second recession three years after the sharp blow of 2009. Ireland and Portugal are watching their expectations of recovery fade as a result of lower foreign demand and maintenance of financial pressure. And there are questions as to the likelihood of its return to the markets within the timeframes set and even in regard to the Greece and no more commitment. Spain and Italy are implementing
190
strong fiscal adjustments and deep structural reforms in an environment of recession and financial vulnerability.
The euro cannot afford to undergo another episode like the one in August-September 2011. It is imperative that a measure is taken to protect us against that risk and removes, once and for all, the devastating coordination failure of the global crisis of 2009. Having assumed that the stabilisation of the debt markets cannot be provided by the central bank as in other countries, we have to choose a new market. Eurobills are an efficient and balanced solution; 2012 should be their birth year. They will help reunify monetary policy, by first restoring stability and establishing the foundations for a solid economic recovery. These conditions are essential for the programmes to work, for the debt to stabilize and for the consolidation and reform policies to be effective and have continuity. There is no future without stability and growth.
It is not necessary to search for great constructions or to come up with solutions for all the problems. The Eurozone shall never be an optimal monetary region. It does not need to be. For the time being, we must concentrate on a series of efficient and plausible fiscal regulations, a single monetary policy based on debt markets which are operating fairly and a stable banking system capable of funding the economy. And to continue to learn and build an increasingly closer union. The countries that are currently suffering will learn from their mistake; one cannot prosper within the euro with the same institutional framework that one had out of the euro:
191
foreign finances continue to be a restriction, the real exchange rate and the flexibility in real salaries and mark-ups are important, credit excesses cost dearly but we must allow some time for the lessons learned to be put into practice and produce good results.
192
Bibliography
- Aizenman, J., Hutchison, M. and Jinjarak, Y. (2011) What is the risk of European sovereign debt defaults? Fiscal Space, CDS Spreads and Market pricing of Risk. NBER Working Paper 17407.
- Barrios, S., Iversen, P., Lewandowska, M. and Setzer, R. (2009) Determinants of intra-euro area government bond spreads during the financial crisis Economic Papers 388. European Commission.
- Bernanke, B. and Reinhart, V. (2004) Conducting Monetary Policy at Very Low Short-Term Interest Rates American Economic Review, 94(2): 85-90.
- Bernanke, B., Reinhart, V. and Sack, B. (2004) Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment Staff Paper. US Federal Reserve
- Bindseil, U. and Knig, J. (2011) The Economics of TARGET2 balances SFB 649 Discussion Paper, Universidad Humboldt de Berln.
- Bornhorst, F. and Mody, A. (2012) TARGET imbalances: Financing the capital-account reversal in Europe VoxEU.org, 7 March.
- Caballero, R. (2010) Sudden Financial Arrest Mundell-Fleming Lecture prepared for the IMF 10th Jacques Polack Annual Research Conference. IMF Economic Review, July 20, 2010.
193
- CESifo (2011) The Bobenberg Declaration: 16 theses on the situation of European Monetary Union. December 2011.
- Cooper, R and John, A. (1991) Coordinating coordination failures in Keynesian models in Mankiw, G. and Romer, D. eds New Keynesian Economics The MIT Press.
- Delpla, J. and Weizsacker, J. (2010), The Blue Bond Proposal, Bruegel Policy Brief 420.
- De Grauwe, P. and Ji. Y. (2012) Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone. Working Paper, mimeo www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/
- Dombret, A. (2012) New year, old problems Europes sovereign debt crisis, Speech of a member of the Executive Board of the Deutsche Bundesbank to the International Bankers Club in Luxembourg, 6 February 2012.
- Economic and Financial Committee (2001) Report on Financial Crisis Management/Brouwer Report Council of the European Union.
- EU Commission (2011), Green Paper: Feasibility of Stability Bonds, November.
- German
Council
of
Economic
Experts
(2011)
Assume
Responsibility for Europe First Chapter of the 2011/2012 Report.

194
- Hellwig, T. and Philippon, T. (2011) Eurobills, not Eurobonds, VoxEU.org, 2 December 2011.
- Jobst, C. (2011) A balance sheet view on TARGET-and why restrictions on TARGET would have hit Germany first Vox 19 July 2011.
- Joyce, M., Tong, M. and Woods, R. (2011) "The United Kingdoms quantitative easing policy: design, operation and impact Quarterly Bulletin 2011 Q3. Bank of England.
- Meaning, J. and Zhu, F. (2011) The impact of recent central bank asset purchase programmes BIS Quarterly Review, December 2011.
- Pisani Ferry, J. (2012) The Euro crisis and the new impossible trinity Bruegel Policy Contribution January 2012.
- Pisany-Ferry, J. (2012) Debate on Target 2: Dont confuse symptom and disease! Blog de Bruegel, 2 de marzo de 2012.
- Sinn, H.W. (2011) The ECB Stealth Bailout VoxEU.org, 1 June.
- Sinn, H.W. (2012) Fed versus ECB: how Target debts can be repaid VoxEU.org 10 March 2012.
- Trichet, J.C. (2011) The monetary policy of the ECB during the financial crisis Speech by the President of the ECB, Montreal, 6 June 2011.
195
- Weidmann, J. (2012) What is the origin and meaning of the Target2 balances? Carta del Presidente del Bundesbank publicada en el Frankfurter Allgemeine Zeitung y el Het Financieele Dagblad el 13 de marzo de 2012.
- Whelan, K. (2011) Fiscal Rules: Stocks, Flows and All That The Irish Economy Blog, December 9th, 2011.
- Whitaker, J. (2011) Intra-eurosystem debts Monetary Research, Lancaster University Management School. 30 March 2011.
- Whitaker, J. (2011) Eurosystem debts, Greece and the role of banknotes. Monetary Research, Lancaster University Management School. 14 November 2011.
196
/DANIEL GROS * / CINZIA ALCIDI**/
Breaking the common fate of banks and governments
1. Introduccin; 2. Recent eurozone history: From bad to worse; 2.1. Recalling the building blocks of the EMU construction; 3. A false solution to the crisis: the fiscal compact; 4. Fiscal indiscipline versus financial regulation inconsistency; 5. A proposal for a new regulatory treatment of sovereign debt securities in the euro area; 6. Conclusions; Bibliography
* Dr. Daniel Gros is the Director of the Centre for European Policy Studies (CEPS) since 2000. Among other current activities, he serves as adviser to the European Parliament and is a member of the Advisory Scientific Committee of the European Systemic Risk Board (ESRB), the Bank Stakeholder Group (BSG) of the European Banking Authority (EBA) and the Euro 50 Group of eminent economists. He also acts as editor of Economie Internationale and International Finance. In the past, Daniel Gros worked at the IMF (1984-86), at the European Commission (1989-91), has been a member of high-level advisory bodies and provided strategic advice to numerous governments and central banks. Gros holds a PhD. in economics from the University of Chicago, has taught at prestigious universities throughout Europe and is the author of several books and numerous contributions to scientific journals and newspapers. Since 2005, he has been VicePresident of Eurizon Capital Asset Management. ** Dr. Cinzia Alcidi holds a Ph.D. degree in International Economics from the Graduate Institute of International and Development Studies, Geneva (Switzerland). She is
197
1. Introduction
Since 2010 the news about Europe has gone from bad to worse. In early 2012, it still cannot be claimed that the eurozone crisis is solved, thought markets within the euro area seems to return (maybe only temporarily) to more normal conditions.
Interestingly enough, the average of the fundamentals of the euro area looks actually relatively good: compared to the US, the eurozone as whole has a much lower fiscal deficit (4% of GDP in 2011 against almost 10% for the US) and unlike the US, it has no external deficit. Its current account is close to balance, which means that enough savings exist within the monetary union to finance the public deficits of all its member states. This implies, in turn, that potentially enough, domestic, euro zones resources exist to solve the debt problem, without recurring to external lenders. Whether these resources will be invested to finance eurozone governments is a different question.
currently LUISS Research Fellow at Centre for European Policy Studies (CEPS) in Brussels where she is part of the Economic Policy Unit dealing mainly with issues related to monetary and fiscal policy in the European Union. Before joining CEPS in early 2009, she taught undergraduate courses at University of Perugia (Italy) and worked at International Labour Office in Geneva. Her research interest focuses on international economics and economic policy. Since her arrival at CEPS, she has worked extensively with Daniel Gros on the macroeconomic and financial aspects of crisis in Europe and at global level, as well on the policy response to it. She has published several articles on the topic and participates regularly in international conferences.
198
In spite of this relative strength, eurozone policy-makers seem incapable to solve the debt crisis. Meeting after meeting, heads of state and Government or finance ministers have failed to convince markets of the validity of their strategy, which has focused almost exclusively on fiscal discipline and has repeatedly advocated the need of financial help from outside investors, e.g. IMF and Asian investors, regardless of whether resources exist within the eurozone. This approach has been both misguided and unconvincing.
Against this background, the paper emphasizes that while the political agenda is almost obsessively focused on fiscal issues, the euro zone crisis does not have a mere fiscal nature neither a simple fiscal solution. It involves different dimensions running from current account and external debt problems to the weak state of the banking sector, which is still largely undercapitalized. This paper will focus on the last element, the state of the banking system and attempts at highlighting how features of the existing financial market regulation framework which are inconsistent with main building blocks of the monetary union have affected the course of the crisis. We will argue that this inconsistency has crucially contributed to eurozone crisis and still remains unaddressed. The paper also expresses concern about the misleading, prevailing view that the just signed fiscal compact will work as crucial ingredient in the recipe to overcome the eurozone crisis, while the banking sector remains highly leveraged and exposed to the fortune and misfortune of sovereign governments. On this ground, the paper puts forward some ideas about how to break the tight linkage between
199
governments and banks. This is at the root of their common fate and represents a decisive obstacle to overcome the eurozone crisis.
2. Recent eurozone history: From bad to worse

To understand why the euro crisis has gone from bad to worse, one needs to develop a better understanding of the inconsistencies in the setup of European Monetary Union (EMU) that caused the problem in the first place. The official reading is that this is not a crisis of the euro, but of the public debt of some profligate euro area member countries. Therefore, tackling the causes of this crisis and averting future ones requires only a new, tighter framework for fiscal policy which will be delivered by the new fiscal compact.
Yet, financial markets do not seem much impressed by a further strengthening of fiscal rules: Portugal and other countries still have to pay high risk premia while Greece has defaulted on its debt and still teeters on the brink of a total collapse. This suggests that the official approach captures only part of the problem and still misses the full picture.
It is not only fiscal indiscipline in the periphery which turned the public debt problems of a small country like Greece into a crisis of the entire euro area banking system. The euro zone crisis is the result of a constellation of vulnerabilities within the eurozone. They include balance of payments problems, foreign debt, sudden200
stops of crosser-border financing running from North to South combined with a generalized undercapitalization of the banking system.
This financial fragility has been the result of inconsistencies in the setup of the EMU as well as a fundamental inconsistency in financial market regulation that has yet to be addressed.
2.1. Recalling the building blocks of the EMU construction

The original design of EMU, as established by the Maastricht Treaty in 1992, contained three key elements:
i) An independent central bank, the ECB, devoted only to price stability. ii) Limits on fiscal deficits enforced via the excessive deficit procedure (Treaty based) and the Stability and Growth Pact (SGP, essentially an intergovernmental agreement, although still within the EUs legal framework). iii) The no bail-out, or rather no co-responsibility clause (art. 125 of the TFEU).
The treaty also contained other elements of economic governance,1 but this remained mostly declamatory as in reality
1 For instance, Article 121 of the TFEU contains the provision that member states should regard economic policies as a matter of common concern and shall coordinate them within the Council.
201
Member States did not see any need to coordinate economic policies; at least, not before the crisis.
The first key element of the Maastricht Treaty, i.e. the very strong independence of the ECB, was based on a large consensus among both economists and policy makers that the task of a central bank should mainly be to maintain price stability. The consensus was based on a common reading of the experience of the previous decades that higher inflation did not buy more growth and independent central banks (with the Bundesbank as the most prominent example) are best placed to achieve and maintain price stability.2
Some academic economists and some observers at international financial institutions worried already in the 1990s about financial instability and advocate a clear role of the EBC in safeguarding financial stability.3 Some also emphasized that a common currency area also requires a common system of supervision of financial markets.4 But the issue of financial stability did not attract the attention of policy makers mainly for two main reasons. The first one is theoretical: most prominent economic models before 2007 suggested that price stability delivers financial stability as by-pro-
2 A prominent paper of the period when plans for EMU were taking shape encapsulated this insight in the title The advantage of tying ones hands (see Giavazzi and Pagano (1988). 3 See for instance Garber (1992). 4 Among others Tommaso Padoa Schioppa (1994).
202
duct, with no need to add another tool to achieve it. The second one is much less sophisticated and relates to the fact that the two key member states driving EMU, France and Germany, had not experienced a systemic financial crisis for decades.
The second element of the Maastricht Treaty, namely the limits on fiscal policy, did not enjoy the same consensus in the academic profession (nor among policy makers) as central bank independence. During the 1990s a wide ranging debate took place about the sense or non-sense of the Maastricht reference values of 3% of GDP for the deficit and 60% for the debt level. Apparently the advantage of tying ones hands was much less recognized in the field of fiscal policy. However, this debate did not need to be resolved as long as benign financial market conditions prevailed and even the core countries conspired to weaken the limits on deficits set by the SGP in 2003.
The third element was only in the background and remained untested until recently. Contrary to a widespread misconception, Article 125 of the TFEU does not prohibit bail outs. It merely asserts that the EU does not guarantee the debt of its member states and that member states do not guarantee each others obligations. Germany had insisted on the no bail-out clause when the Maastricht Treaty was negotiated about 20 years ago. Today, it is clear that this clause does not provide the kind of protection that was sought and widespread financial market turbulences threaten to engulf Germany to agree to huge bail-out packages which would
203
have been unthinkable only recently. However, instead of working on averting the repeat of this situation in the future, German policy makers are focusing exclusively on the need to ensure lower fiscal deficits. This is the purpose of the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union also called the fiscal compact under which euro area member countries agree to adopt strict rules, at the constitutional or equivalent level, limiting the cyclically adjusted deficit of the government to less than 0.5% of GDP. Will this fiscal compact work where the Stability Pact failed?
The original SGP already contained the engagement by member states to balance their budget over the cycle. If implemented since the onset of the monetary union, the rule would have led to a continuous reduction of the debt-to-GDP ratio towards the 60% target. But this did not happen. The promise or rather exhortation contained in the SGP to balance budgets over the cycle was widely ignored, given that the rule was not binding and financial markets remained in a permissive mood. All of the larger euro area members ran budget deficits in excess of 3% of GDP threshold for the first 4-5 years of the euros existence. Even Germany ran deficits above 3% of GDP from 2001 to 2005. In 2003 a proposal put forward by the Commission to ratchet up the excessive deficit procedure to the point where fines might have been imposed on France and Germany was defeated in the Council (of finance ministers, ECOFIN). In the crucial vote the large countries (most of which had excessive deficits, except Spain) colluded to water down the
204
proposal and won the opposition of the smaller countries. The band of three large sinners (Germany, France and Italy) even managed to put together a qualified majority to hold the procedure in abeyance.5
This narrative is interesting in the light of the new fiscal compact which is supposed to radically strengthen the enforcement of the fiscal rules by the application of the reverse qualified majority. Under this principle, an excessive deficit procedure launched by the Commission is taken to be approved unless it is opposed by a qualified majority. As past experience shows, despite the new system makes the opposition harder, it does not ensure enforcement.
In 2005, following the 2003 episode, the SGP was changed. The official justification was the need to improve its economic rational and thus ownership,6 but it clear that it was necessary to avoid the repeat of the embarrassing situation in which a literal application of the rules would have led to sanctions for Germany and France among others. The reaction in academia and among policy makers was mixed: the SGP was softened according to some, but improved according to others. The very fact that professional opinion on the merits of binding rules for fiscal policy was divided from the start certainly facilitated the change in the SGP when it became politically opportune.
5 See Gros et al. (2004). 3 See for instance Garber (1992). 6 Annex to the 2005 Council conclusions (http://register.consilium.europa.eu/pdf/en/05/st07/st07619-re01.en05.pdf).
205
As matter of facts, shortly after the SGP was made less stringent, the upturn of the business cycle allowed most governments to reduce their deficits to below 3% seemingly vindicating the official position that the improved Stability Pact had led to a more responsible fiscal policy. But structural deficits (i.e. adjusted for the cycle) actually improved very little even at time the boom reached the peak in 2006-7 and, when the crisis hit, any remaining caution was thrown overboard as deficits were allowed to increase again.
The euro area countries thus never lived up to the rules they gave themselves. But even so, on average they remained relatively conservative in fiscal terms. In 2009, the average deficit peaked at 6.5% of GDP, its highest level, whereas both the UK and the US went above 11% during that year. Moreover, while the eurozone deficit has brought back to 4% of GDP in 2011, it has remained at double digits levels in both the UK and the US. In this limited sense, one could argue that the Maastricht provisions against excessive deficits did have some influence after all, at least on average.
While the average deficits for the euro area appear today modest by the standard of other large developed countries, one euro area country, Greece, clearly violated all rules for years. But mounting evidence that the Greek fiscal numbers did not add up was never acted upon until it was too late. As long as financial markets provided financing at favorable rates any action was politically inconvenient and was avoided.
206
When the euro debt crisis started in early 2010 following the discovery that Greece was running a deficit of 15% of GDP (and that previous deficits had been misreported), some policymakers, German in particular, started to call for tighter fiscal rules as essential to the survival of the euro.Despite Greece was an extreme case, the case of Italy is widely seen as providing another justification for tighter fiscal rules. However, the country seems to stand for complacency rather than fiscal profligacy. Over the last ten years the deficits of Italy have on average been lower than those for France and even today its deficit is below the euro area average (and declining rapidly).Yet, the incapacity of the country to reduce its very high debt-to-GDP ratio has made it vulnerable to a loss of investors confidence.
3. A false solution to the crisis: the fiscal compact

The new Treaty that was agreed upon in March 2012 has a long title, Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, but upon closer examination it is long on good intentions and rather short on substance in terms of binding provisions.
The core of the new fiscal compact is an obligation to enshrine in national constitutions the commitment not to allow cyclically adjusted deficits to exceed about of 1% of GDP, which is roughly equivalent to balancing the budget over the cycle as in the original SGP.
207
This should be done preferable at the constitutional level. The European Court of Justice (of the EU) can be asked to pass a judgment on these national rules, but the maximum fine that could be assessed is capped at 0.1% of GDP hardly a strong deterrent by itself. This Treaty concerns only the framework for fiscal policy, i.e. the rules setting up national debt brakes, not their implementation. This Treaty thus does not give any new powers to the Court of Justice (neither to the Commission) to interfere with the actual conduct of national fiscal policy. None of the provisions on economic policy coordination are binding. Essentially they reiterate the already often repeated statements of good intentions on structural reforms.
Among the provisions, the specification on governance institutes regular meetings, at least twice a year, of the heads of state and government of the euro area. However, since these meetings will remain informal, in truth, there was no need for an international treaty to establish them.
As far as the non-euro EU member states who signed the Treaty are concerned, there is no obligation for them to do anything, but the signature constitutes a political statement which gives them a partial seat at the table of the eurozone meetings, allowing them to participate in most of the euro area summits.
From a purely legal point of view, this Treaty contains an inherent contradiction: it implies that its signatory countries agree on
208
binding constraints for their constitutional order via an ordinary international treaty. In most countries the national constitution is of a higher in legal hierarchy than international treaties. This means that even the provisions on the fiscal compact constitute essentially a political statement, unless the treaty is ratified with a constitutional majority, as will be done in Germany.
The main value of this political statement coming from all euro area member states is of course that it provides political cover for the German government in its efforts to sell the euro rescue operations to a sceptical domestic audience. However, it is doubtful that the fiscal compact was really needed for this purpose. Data on German support of the euro show that public opinion remains much more constructive on the euro than widely assumed (see Gros and Roth, 2011). Moreover even before the fiscal compact existed, all votes in the Bundestag have resulted in very large majorities in favour of the euro area rescue operations, even when they contained large fiscal risks for Germany.
In judging the value of this Treaty one should also keep in mind that, of the four large euro area countries, three have already national debt brakes at the constitutional level: in Germany it is already operational, in Spain has been adopted recently and in Italy is in course of adoption. In the fourth country, France, it is already clear that the Treaty will be implemented, if at all given the negative attitude of the current opposition, via a so-called loi organique and that the French constitution will not be changed.
209
All in all, the fiscal compact is probably useful in the long run and may contribute to avert a future crisis. It forces Member States to adopt stronger national fiscal frameworks at home. Some, perhaps most, would have done so anyway under the pressure of the markets, but it is unlikely that the new Treaty will make a significant difference. The main danger is that that it has been oversold.
It is likely that the ratification process (e.g. the referendum in Ireland) and then the implementation process in some difficult countries (e.g. France) will receive a lot of attention and create a distorted impression of the importance of the Fiscal Compact.
However, the initial excitement will be over once the national fiscal rules have been put into place and this Treaty will quietly be forgotten. Its only remaining impact will consist in the meetings of the euro area heads of state which are likely to produce the regular conclusions that Member States commit to everything desirable (structural reforms, etc.). Conclusions which become irrelevant once the heads of state return to their capitals and their domestic political realities.
The experience with the SGP suggests that how this new fiscal compact will be applied in future will depend on the degree of consensus on the need to balance the budget over the cycle. If anything, political will to follow this balanced budget rule will be even more important for the new fiscal compact since it will take the form of an intergovernmental Treaty outside the legal framework of the EU.
210
Today the consensus that only balancing budgets can solve this crisis and allow the euro to survive seems strong and the position of the German government seems particularly tough. This is certainly desirable to prevent future public debt problems but it neglects the crucial role financial market fragility has played in this crisis. The case of Greece is emblematic in this sense: despite Greece accounts for less than 3% of the euro areas GDP, the prospect of the Greek government becoming bankrupt caused Europes financial markets to go into a tailspin. The reason behind it was the fragility of banks due to their undercapitalization and their large holdings of government debt.
In this perspective, while for a creditor country like Germany it might be important that other member states are forced to copy its balanced budget rules, it should be even more important to ensure that financial regulation helps to provide additional incentives for good fiscal policy and that financial markets become more robust and able to withstand a sovereign insolvency. This is what would reduce the need for future bail outs by the German government. German savers have over the last decade of current account surpluses accumulated about one trillion euro worth of claims on other euro area countries. Safeguarding the value of these claims (which amount to about 50% of GDP) and ensuring the future German savings surpluses are invested with minimal risk should thus be a key policy goal for German policy makers.
211
4. Fiscal indiscipline versus financial regulation inconsistency

The key insight that has been overlooked in the official circles dominating EU policy making today is that todays crisis is largely due to an inconsistency in the original design of EMU, not in the area of fiscal policy, but in the area of financial market regulation. Even after the start of the EMU, financial regulation in general, and banking regulation in particular, continued to be based on the assumption that in the euro area all government debt is riskless. This was from the start logically incompatible with the no-bail out clause in the Maastricht Treaty, which implies that a euro area member country can become insolvent, and the institution of an independent central bank which cannot monetize government debt. But it was adopted anyway, maybe because of the perception, expressed recently in a spectacularly mis-timed paper from the IMF, which proclaimed: Default in Today's Advanced Economies: Unnecessary, Undesirable, and Unlikely.7
In the much more forgiving environment of the turn of the century, it was quite natural for policy makers to ignore the logical inconsistency between the no bail-out clause and maintaining the assumption that government was really risk less. Yet this contradiction had two important consequences. First, banks did not (and still do not) have to hold any capital against their sovereign expo-
7 Cottarelli, C., L. Forni, J. Gottschalk, and P. Mauro (2010) Staff Position Note No. 2010/12.
212
sure. Second, it was also deemed unnecessary to impose any concentration limit on the claims any bank can hold on any one sovereign. This lack of a concentration limit for sovereign debt is in clear contrast to the general rule that banks must keep their exposure to any single name below 25% of their capital. This exception would make sense only if government debt is really totally riskless.
The main result of this special treatment reserved to government debt securities on banks balance sheets has been that about one third of all public debt of the eurozone is held by eurozone financial institutions, which also tend to privilege the financing of their own government. The fate of governments and banks is thus tightly linked.
To the inconsistency of financial market regulation it must be added that the ECB failed to apply differentiated haircuts to government debt it accepted as collateral. Debt securities issued by euro area governments ware accepted in indiscriminate fashion provided that the country was rated at investment grade. This was the case for all euro area member countries, of Greece as Germany. When the Stability Pact was weakened by Germany and France in 2005, the ECB took member countries to court, but it did not change its collateral policy. By doing so it would have given a concrete signal that it was worried about the long run sustainability of fiscal policy and its consequences for the future of the single currency. Alas, it did not do so, not even during the crisis, after it was clear that it was changing its policy stance. Only now, the ECB
213
applies a sliding scale of graduated haircuts which makes it less attractive for banks to hold lower rated government debt.
The idea that governments provide the only safe assets even in a monetary union where a no bail-out clause exists was also the main reason for another omission: a common euro area (or EU) deposit insurance scheme was never seriously considered. At EU level, deposit insurance is regulated by the 1994 Directive on deposit guarantee schemes, but the minimum harmonization approach adopted at that time has proven largely insufficient and the ultimate back up for all national schemes remains the national government. A common European deposit insurance modeled on the US approach of a fund financed ex-ante by risk based contributions from banks like the Federal Deposit Insurance Company FDICwould have had obvious advantages in terms of risk diversification. But the preference for national solutions (based on the fear that a European equivalent to the FDIC would lead to large transfers across countries) and the bureaucratic interests of the existing national deposit guarantee schemes ensured that such ideas do not get a hearing even today.
The experience with Greece should have served to rest the idea that government debt in the euro area is riskless. But so far no crisis summit has drawn the conclusion from this experience for banking regulation. Of course, it is true that once the crisis has hit it is no longer possible to tighten the rules on government debt because this is pro-cyclical as the mayhem which followed the only
214
attempt to shore up the banking system in the context of the recent EBA stress tests on government debt has shown.
However in order to illustrate the importance of thinking about the larger benefits from a different kind of banking regulation it is still worthwhile speculating what would have been different if banking regulation had been Maastricht conform, i.e. if it had recognized that belonging to the European Monetary Union implies that national government debt is no longer riskless.
One could thus consider how the crisis would have played out if the following rules had applied since 1999: i) Forcing banks to have capital against their holdings of euro area government debt. ii) Applying the normal concentration limits also to government exposure. iii) A different collateral policy of the ECB, for example with a sliding scale of increasing haircuts on government debt in function of the countrys deficit and debt and its position in the excessive deficit procedure.
One can only speculate what would have been different if this kind of regulation had been in place during the boom years. But a few conclusions seem certain.
215
Greece would certainly have encountered much more difficulties selling its bonds to banks which would have had to hold capital against it would be less able to use them to access ECB funds. The same applies to Italy, whose rating went already in 2006 below the threshold at which under normal banking rules higher capital requirements kick in. Both these countries would thus have seen gradually increasing market signals, which would have most probably led to a more prudent fiscal policy.
Moreover, their problems would today have been much easier to deal with because banks would have more capital and the concentration limit would have prevented Greek banks to accumulate Greek government debt worth several times their capital. The resources necessary to prevent the collapse of the Greek banking system has increased considerably (by about 40 to 50 billion euro) the size of the financial support Greece needed so far.
The negative feedback loop between the drop in the value of banks and in the yields on government bonds which destabilized the entire European banking system so much during the summer and fall of 2011 would also have been very much mitigated if the concentration limit had been observed. Italian banks would have accumulated less Italian debt and would have been able to offset some of the mark to market losses on the Italian debt with their gains on German debt holdings which they would have had to hold as well.
216
Common euro area wide deposit insurance would have contributed in several ways to deal with the financial crisis from the beginning. First of all, in 2008 it would have obviated the perceived need for the competitive rush to provide national guarantees for bank deposits. The Irish government would thus probably not have had felt the need to provide the blanket guarantee for all liabilities of its local banks which proved fatal once the extent of the losses was revealed.
Ireland would still have suffered from a massive real estate bust with all the consequences in terms of unemployment, but the Irish government would not have been bankrupted by its own banks. Paul Krugman has drawn attention to the parallels in terms of economic fundamentals between Nevada and Ireland8 arguing that explicit fiscal transfers and higher labour mobility within the US constitute the main differences. However, Ireland has actually experienced a degree of labour mobility which is quite similar to that among US states like Nevada. During the boom it had immigration running at over 1% of its population, which after the bust turned into emigration of a similar order of magnitude. The widespread held opinion that the euro could never work because there is not enough labour mobility in Europe is not entirely correct.
In the case of Ireland the key issue was not one of a lack of labor mobility, but of the absence of a common safety net for banks. A
8 See http://krugman.blogs.nytimes.com/2010/12/29/ireland-nevada/.
217
European deposit insurance would have provided stability to the deposit base. It is also likely that the European Deposit insurance would have been less complacent and less beholden to the interests of Irish banks and would thus have started to increase its risk premium when the signs of a local real estate bubble were clear to almost everybody outside the country.
Greece, where the national deposit guarantee scheme is now practically worthless because it is backed up only by the Greek government, which has just defaulted on its debt, provides another example of the potential importance of stabilizing the banking system. With a European deposit guarantee scheme there would have been no deposit flight, which has amounted so far to about 50 billion, or over 25% of GDP. There would have thus been much less need for the ECB to refinance the Greek banking system, lowering again the cost of the Greek bail out.
The next crisis will be different from the current crisis, but it is clear that different rules for the banking system could bring two advantages: they would provide graduated market based signals against excessive deficits and debts. Moreover, a better capitalized banking system with less concentrated risks would be much better able to absorb a sovereign insolvency, thus reducing the need for future bail outs. Acting on this front seems a much more promising route to reduce the likelihood for future crises and minimize the cost should they occur anyway.
218
Perceptions matter. Europes policy makers seem to be driven by the perception that this crisis was caused by excessively lax fiscal policy in some countries. In reality, however, the public debt problems of some countries have become a systemic, area wide, financial crisis because of the fragility of the European banking system. The euro crisis is likely to fester until this fundamental problem has been tackled decisively.
5. A proposal for a new regulatory treatment of sovereign debt securities in the euro area
The purpose of this section is to sketch a simple proposal for a new regulatory treatment of sovereign debt securities in the euro area which follows the arguments illustrated in the previous sections. 1. Any risk weights to be introduced after the crisis might better be based on objective criteria, rather than ratings. 2. Diversification of banks exposure; this is even more important than risk weighting for sovereign exposure.
A simple way to attach a risk weight on government debt securities of a given country would be to make the weight function of objective factors like the debt and deficit of the country. For example, one could imagine that the risk weight could remain at zero if both government debt and fiscal deficit relative to GDP remain below 60% and 3% respectively. If the deficit and/or the debt ratio
219
exceed the reference values of the Treaty, the risk weight would increase by certain percentage points in a proportional or progressive fashion. In addition the risk weights should be linked to the stages of the excessive deficit procedure (EDP). When the procedure is launched, the risk weight is increased and at each additional stage of the EDP the risk weighting would be increased further. This would provide the EDP with real incentives even without the need to impose fines.
Introducing positive risk weights for government debt will not be enough to prevent crisis because of the lumpiness of sovereign risk. Experience has shown that sovereign defaults are rare events; but the losses are typically very large (above 50%) when default does materialize. Even with a risk weight of 100% banks would have capital only to cover losses of 8%. Risk weights would thus have to become extremely high before they could protect banks against realistic loss given default scenarios. This suggests that the more important aspect is diversification.
All regulated investors, i.e. banks, insurance companies, investment funds, pension funds, have rules which limit their exposure vis--vis a given counterpart to a fraction of their total investment or capital (for banks). However, this limit does not apply to sovereign debt, especially within the eurozone for banks. The result of this lack of exposure limits has been that, in the periphery, banks have too much debt of their own government on their balance sheet which has led to the deadly feedback loop between sovereign
220
and banks. In Northern Europe, investors, such as investment funds and life insurance companies, which typically cannot avoid government debt have also concentrated their holdings nationally. This has led to a significant fall and in some cases even to negative value of government bond yields, not only in Germany but throughout Northern Europe. From the point of view of core Europe investors, today this might appear as being a prudent strategy, but this concentration increases the vulnerability of the system to any reversal of fortunes. Moreover, if Northern investors were required to diversify their holdings there would be a natural demand for Southern European bonds, which would bring some oxygen to those governments which have experienced a dramatic surge in their borrowing cost.
Introducing exposure limits during a crisis period would be much less pro-cyclical than introducing capital requirements. In practical terms, the simplest approach would be to grandfather the existing stocks, but apply exposure limits to new investments.
6. Conclusions
This paper has emphasized that while the political agenda has been obsessively focusing on fiscal issues since the early onset of the euro zone crisis; this crisis has neither a mere fiscal nature nor an exclusively fiscal solution. Despite the Greek episode seemed to point only to fiscal indiscipline, the reasons why the crisis did not
221
confined itself to Greece but spread out to the entire euro area assuming a systemic nature should be sought in the state of the euro area banking sector. European banks were, and still are, largely undercapitalized and too tightly linked to the fortune and the misfortune of governments.
The paper spots three contradictory building blocks of the EMU construction: the no bail-out rule in the Stability and Growth Pact, the independence of the European central bank and the provision in the financial market regulation framework that government bonds are considered as risk free assets. The combination of the nobail clause with the institution of an independent central bank implies that fiscally undisciplined countries may have to face default as no other country, nor the EU can take on its debt and the central bank cannot monetize it. This definitely collides with the principle that banks are not required to hold any capital against government debt securities as it assumed that they do not carry any default risk. In fact, Greece has proved this assumption wrong.
This contradiction was completely overlooked during the good years in the turn of the new century and the politically more convenient approach suggested by financial regulation became the dominant. The risk free treatment of public debt securities has clearly worked as incentive for banks to finance profitable government spending and accumulate large amounts of government bonds.
222
This is at the root of the common fate of euro area banks and governments. Alas, the crisis has made that fate an evil one.
Though these contradictory elements have now emerged clearly, the issue has not been addressed and the regulator treatment of the government bonds has not changed yet.
On this ground, the paper puts forward some concrete ideas about how to break the tight linkage between governments and banks, which represents a decisive obstacle to overcome of the euro zone crisis.
We argue that positive risk weights for government debt securities must be introduced in the banks balance sheet, but alone this measure will not be enough to prevent a new crisis. A clear prescription to reduce concentration of the risk and impose diversification is at least equally important and complementary to the risk weighting.
While developing the arguments for the regulatory changes, the paper expresses skepticism about the official, widespread view that the just signed fiscal compact will have a crucial role in overcoming the eurozone crisis. As far as the banking sector remains weak and highly exposed to governments, and the common fate of government and banks is not broken, the crisis will be hard to die.
223
Bibliography
- Cottarelli C., L. Forni, J. Gottschalk and P. Mauro (2010), Default in Today's Advanced Economies: Unnecessary, Undesirable, and Unlikely, IMF Staff Position Note No. 2010/12.
- Graber M. And D. Folkerts-Landa (1992) The European Central Bank: A bank of a Monetary Policy Rule, NBER Working Paper N.4016.
- Giavazzi, F. and M. Pagano (1988), The advantage of tying one's hands: EMS discipline and Central Bank credibility, European Economic Review, Vol. 32, No. 5, June, pp 1055-1075
(http://www.sciencedirect.com/science/article/pii/0014292188900657).
- Gros, D., T. Mayer and A. Ubide (2004), The Nine Lives of the Stability Pact, Special Report of the CEPS Macroeconomic Policy Group, CEPS, Brussels, February (http://www.ceps.eu/book/ninelives-stability-pact).
- Gros D. and F. Roth (2011) Do Germans support the euro? CEPS Working Paper Document No. 359, December 2011.
- Gros D. (2012), The misdiagnosed debt crisis, Current History, Vol.111, Issue 773 p.83.
224
- Gros D. (2012), The Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (aka Fiscal Compact), CEPS Commentary, March 2012.
- Padoa Schipppa T. (1994), The Road to the Monetary Union: The Emperor, the King and Genies, Clarendon Press. Place of Publication: Oxford.
225
226
/RICARDO MARTNEZ RICO * /
The fiscal institution in the Economic and Monetary Union: the contribution of Spain
1. Introduction; 2. Evolution of the fiscal policies in Europe and Spain; 3. Analysis of the relationship between fiscal rigour, macroeconomic stability and growth; 4. Next steps in the Fiscal Institution of the Economic and Monetary Union: the necessary contribution of Spain; 5. Conclusion
1. Introduction
The current financial crisis in the European Union (EU) has highlighted the importance of establishing a common framework
* Public Sector economist, on leave, and Founding Partner, President and CEO of Equipo Econmico, S.L. He has held office as Deputy Finance Minister Working inside the team of the Deputy Prime Minister, Rodrigo Rato, and Finance Minister, Cristbal Montoro. Graduate cum laude in Business Administration at the University of Zaragoza, he studies in the Deutsche Schule of Bilbao and Valencia. He has attended postgraduate courses at the London School of Economics, Kennedy School at Harvard University and Wharton Business School.
227
which enables the economic agents to act in a macroeconomic scenario of stability and confidence in the coming years.
In this crisis situation, once again the discussion has sparked the debate in Europe of whether the necessary fiscal stability, which will demand the rationalisation of public spending in the member states, will be achieved at the expense of prolonging the crisis and limiting economic growth possibilities. However, there should be no dilemma between sustainability of public accounts and medium term economic growth. The crisis of the European sovereign debt is a consequence of overspending and debt which the markets are not prepared to fund. In this regard, the only recourse is a fiscal policy designed to mitigate the harsh effects of the crisis and boost economic growth within the framework of macroeconomic stability, continuous supervision over the sustainability of public sector accounts and economic reforms.
Spain must cease to be a burden for Europe and once again become a driver of growth. Compliance with a route of plausible cuts in public spending in all Public Administrations is a necessary condition to do so, though not the only. As previously shown, in the case of the Spanish economy, stability and reforms make up the formula required to revitalize investment, consumption and job creation. Thus, economic reforms and budgetary discipline are equally important.
228
The Spanish case is a clear example of a solid and plausible budgetary institution, where the principle of subsidiarity enables each government with sound finances to tackle its internal decisions in accordance with its economic and social reality (not only because of its significance from a regulatory perspective but also because of the parallels between the European scenario relative to the countries and the Spanish scenario relative to the Autonomous Communities). At the same time, those who are forced to ask for help must abide by the ensuing conditionality.
In Europe, likewise, the need for greater economic and monetary integration must take us along the path of clear fiscal rules. But it must also do so to encouraging income transmission mechanisms between countries and regions, availability of financial resources and support by way of providing the necessary liquidity to face emergency situations and the pooling of risks, always in exchange for strong sets of conditions to prevent moral hazard. Moreover, within the monetary and economic union the imbalances must be addressed, not only of highly indebted countries, but also those with surplus balances. In some way, it must be recovered an incentive system to ensure political commitment and compliance with goals set. Nowadays, the fiscal institution1 is a basic component of European and Spanish economic policy.
1 Gonzlez Pramo defines it as "the rules which govern the preparation of the budgets, their debate and approval in parliament, execution and subsequent control. "Costs and benefits of fiscal discipline: the Law of Fiscal Stability in perspective (Costes y beneficios de la disciplina fiscal: la Ley de Estabilidad presupuestaria en perspectiva), J.M. Gonzlez-Pramo, 2001.
229
Throughout this work we shall examine, in first place, how the sustainability of the public finances requires a solid fiscal institution and a firm political commitment by the different European governments. Only on the basis of the conviction of the benefits of this statement can one contribute towards the construction of a stronger Europe.
Then we shall go on to examine the close relationship between fiscal rigour, macroeconomic stability and growth, arriving at the conclusion that the establishment of simple, transparent, automatically applied rules with preventive control mechanisms for all Public Administrations is essential for this positive interrelation. All these components are basic for the design of a fiscal policy which helps to recover the credibility that Europe needs in its path towards greater integration to face the sovereign debt crisis.
In the last chapter we shall examine the measures taken in Europe and in Spain since the start of the sovereign debt crisis, and we shall reflect on the following steps to be taken in support of the budgetary institution. Then close with the appropriate conclusions.
2. Evolution of fiscal policy in Europe and Spain

The European political integration project came about in the post World War years, as an extension of the economic integration process. This was envisaged by one of the founding fathers of the
230
current Union, Jean Monnet. In 1950, he proposed the creation of a space of peace and prosperity for Europe, via the formation of the European Coal and Steel Community, which became a reality a year later. His way of conceiving the European construction as a project made up of very specific steps beginning with the economy is the way to understand many of the milestones that Europe has achieved in the last sixty years. Examples of this have been the creation of the European Economic Communities, the launch of the European Monetary System, the creation of the single European market and the firm commitment that has led to the Economic and Monetary Union (EMU).
During the first decades of the European unification project, Spain was but a mere observer, although fully embraced the integration process along the same lines and endorsed the way of travelling the path towards a united Europe. Thus, in the mid-1980s, Spain understood that the current EU offered a chance to take a decisive step in its integration into an international market which would bring gains in efficiency, reinforce macroeconomic stability and contribute to the increase of wealth and per capita income. That would lead to the development and modernisation of the country. And, indeed, this was the case in the first years, where economic growth rate of Spain was positive over that of the EU, by a maximum of 3pp in 1987 (see Chart 1). However, as of this time, macroeconomic instability driven by an expansive fiscal policy, became a burden for economic growth and job creation, and generated a fast and continuous rise in public debt. The importance of
231
having a solid fiscal institution in the economic development of the Spanish economy became patently clear.
Chart 1 Year-on-year growth in real GDP in Spain and in the European Union
Source: Prepared by Equipo Econmico with data from the International Monetary Fund
After the repeated failures of the European Monetary System started up in 1979, and the progress of the approval of the Single European Act (1986) in favour of an internal market, the EU member states took an additional step in Maastricht. EU member states support, via the adoption of the Treaty on the European Union (TEU) (1992), the creation of an Economic and Monetary Union, whose third phase would entail the launch of the single currency, the Euro. Title VIII of the Maastricht Treaty set three main axes around which the design of the EMU should be built around: sin232
gle monetary policy, fiscal policies subject to common rules and coordination mechanisms for the remaining economic policies. A clear view of establishing nominal convergence mechanisms based on the fiscal institution was already existent at that stage, founded on the following common rules: absolute ban on monetary funding of public deficits, no liability held by the EU or by any other State in regard to debts acquired by another member state, and the setting of limits on deficit (3%) and public debt (60%). As of 1997, the Stability and Growth Pact (SGP) introduce stricter rules with a deficit target of balance or surplus, supported by an early alert system and a disciplinary penalty structure designed to correct deviations.
For Spain the commitment to meet the convergence criteria established in the TEU for eligibility for the third phase of the EMU demanded a radical change to be made in our fiscal policy. Europe then began to act as an anchor in Spanish budgetary policy. However, even when the worst of the recession was over for Spain, governments continued to face enormous difficulties in balancing the budget in the pursuit of macroeconomic stability.
It would not be until the political change of 1996, and with the reference and encouragement arising from the creation of the single currency, when the necessary fiscal consolidation was finally tackled, that macroeconomic stability was achieved and the bases for a new economic growth phase were put in place. The starting point was poor, in 1995 with a deficit around 7% of the GDP and a growing public indebtedness which reached 67% in 1996.
233
Although the level of indebtedness was lower than the average for the EU, in the case of Spain the combination of the primary deficit, the high cost of financing of the debt and the recession had rendered unsustainable the growing public debt. As of that time there was a change in fiscal policy, which took on a markedly counter-cyclical approach. As shown in chart 2, an ambitious fiscal consolidation programme was implemented which allowed the annual budgets to close with primary surpluses from 1996 until the end of the period and to slow down the growth trend in public debt which, after peaking in 1996, dropped by more than 20pp of GDP until 2004.
Chart 2 Evolution of income and expenditure of Public Administrations and of their budget balances
Source: Prepared by Equipo Econmico with data from the Ministry of Finance and Public Administrations
234
During the period, the fiscal consolidation drive contributed towards a strong growth in GDP (average rate of 3.6 between 1996 and 2004), which helped reducing debt stock via the positive spread between the economic growth rates and interest rates. The success in the change of direction in fiscal policy was due to a firm political commitment, a well-designed fiscal consolidation programme and a substantial reform of the fiscal institution.2
For countries that, like Spain, managed to take part in its foundation and for others which joined subsequently such as the case of Greece which, with the support of Germany and despite not meeting at the time the requirements established by the Maastricht Treaty, became part of the Eurozone two years later the incorporation to the euro meant the relinquishment of monetary policy in favour of the European Central Bank (ECB). And this total integration in the establishment of monetary policy has fostered greater price stability during these years. On the other hand, this relinquishment made budgetary policy, along with economic liberalisation policies, into the main economic policy instruments in each of the Eurozone member countries.
We must highlight that, once the objective of forming part of the euro was met in full, Spain took an additional step beyond what was required in Maastricht. And, in line with the principles agreed
2 The Spanish fiscal institution: from the Stability Pact to the rules of fiscal stability (La institucin presupuestaria espaola: del Pacto de Estabilidad a las reglas de estabilidad presupuestaria), R. Martnez Rico (2005).
235
in the SGP, it rounded off the fiscal consolidation effort with a deep reform of the fiscal institution. As a result thereof, the approval of the fiscal stability laws (the General Law on Fiscal Stability and the Organic Law additional thereto) brought about a change in the budgeting process. This mainly consisted of: the definition of a fiscal stability target (fiscal balance) in the medium term for all Public Administrations; for the State, a non-financial expenditure limit, the so-called expenditure ceiling, was applied following parliamentary approval during the first half of the year; as a novelty, the Contingency Fund was added into the State budget, as a flexibility component during the life of the budget which removes the need for making fiscal adjustments, equal to 2% of the non-financial expenditure ceiling approved by Parliament. The approval of the Fiscal Stability Laws was further completed with a new General Fiscal Law and a new General Subsidies Law. Specifically, the General Fiscal Law aimed at achieving greater rationalisation of the fiscal process, whereas the General Subsidies Law, on its part, aimed at transferring the governing principles of Fiscal Stability Laws (efficiency, transparency and multi-annual framework) to the expenditure on subsidies (which would mean 20% of expenditure budget).
However, in 2005, the European process of integration and reform came to a halt. The solution provided to the reiterated violations of the 3% limit on public deficit established at Maastricht and following the pressure exerted by Germany and France in this regard, backed by the European Commission was none other than the SGP, introducing greater discretionary power and taking a
236
step back in the capacity of the fiscal institution to contribute to growth.
Along the same lines, with a comfortable fiscal position and with the same philosophy as that of the reform of the SGP, Spain in 2006 approved a reform to render the fiscal and Territorial Administration funding processes more flexible, which is the source of our current fiscal crisis. The relaxation of fiscal stability led to a loss of transparency in its application as a result of the flexible new rules.
With the outbreak of the international financial crisis as of 2008, the primary surplus of the first years of the period quickly ran out. Discretionary expenditure decisions, the impact of automatic stabilisers and the major errors in revenue estimates led to a deficit balance, which worsened over two years (from 2007 to 2009) by 13pp of GDP. This deterioration, which had also taken place in the rest of EU members, was more notable in Spain due to its speed and magnitude (see Chart 3), with few comparable examples within the scope of the OECD (except for the cases of Iceland or Ireland). The deficit fiscal position generated a fast increase in public debt, leading to doubts about sustainability thereof, and translating into significant rises in the risk premium of the country.
At the start of 2010, given the lack of confidence displayed by international markets, and in light of the fast deterioration of public finances, the previous Government was forced to implement
237
Chart 3 Budget balance in 2006 and change in budget balance in 2007-2009
Source: Prepared by Equipo Econmico with OECD data
a radical change in its fiscal policy and announce a fiscal consolidation programme.
The sovereign debt crisis, which especially affects several of the peripheral member states of the Eurozone (but which has also affect countries such as France and Austria), has highlighted the need to reinforce the budgetary coordination mechanisms within the EMU. In the face of the problems arising from the sovereign
238
debt crisis and as a result of the fluctuations in the risk premiums of the Eurozone member states, a double reinforcement movement of the budgetary crisis has taken place from Brussels since the onset of the crisis. On the one hand, that implemented by the European Commission, the result of which is, for instance, the legislative package comprising five regulations and one directive designed to reinforce the preventive part and the disciplinary part of EC mechanisms. On the other, that of the member states which, via the European Council, have brought about agreements such as the Fiscal Pact, which seeks to guarantee that all countries will commit to fiscal stability under the highest level of regulation. The reform enacted last year of the Spanish Constitution must be understood within the framework of this new drive from Europe in support of the fiscal institution. The reform, as we shall discuss further in this paper, guarantees the principle of fiscal stability via the highest ranking law.
Despite efforts invested, and despite the positive effect of the liquidity injections made by the ECB, the current economic scenario in Europe continues to be marked by the risk premiums of EU peripheral countries, which continue to be too high. The questions as to the capacity of such countries to meet their debt commitments have burdened economic European Union results over the last two years. This has led the Commission to forecast a drop in GDP for all of the EU of -0.5% for this year, which sets it back in terms of the growth of the world economy. Although it must be said, that all countries are not behaving in the same way. Germany,
239
for instance, closed last year with 3% growth, expecting to do so this year at 0.6%, whereas Italy will experience a drop of around 1.3% of GDP. From a growth perspective, there is an important difference between northern and southern European countries arising from the financial crisis. However, it is worth remembering the strong interdependence between all member states, including Germany (second country in the world in terms of export volume, of which 60% are directed to the EU).
On its part, the Spanish economy is clearly included in the slower group, at an extremely difficult time. In recent months, the return to recession, which accumulates after four years of crisis, the adverse effect on employment and on businesses, has led to a 24% unemployment rate. At the same time, there is high external debt, exceeding 160% of the GDP, with a high accumulation of public and private debt maturities this year. All these factors have led to a risk premium of around 340 basis points in the last few months and, more recently, well above 450 basis points, and to be closely watched by the markets, that is to say, our creditors. Given this scenario, in 2012, the Spanish economy faces challenges associated with its macroeconomic imbalances yet to be corrected, as well as the potential problems arising from a new challenge from international financial markets. In this framework, we expect a drop in GDP during the first quarters, and although its performance will improve towards the end of the year, it will result in an overall drop in GDP of around -1.5% this year. Meanwhile, the reality experienced by the rest of the world is different, with a world economy growth rate of around 3.5% of GDP.
240
Undoubtedly, the unemployment rate is our main negative differentiating factor compared to all other EU members and the main concern for Spanish society. As a result of the economic crisis, no country in the OECD has experienced a downturn in the jobless rate as negative as ours. Our rate of unemployment has gone from 8.3% of active population in 2007 to almost 24% at the end of 2011. The crisis has highlighted the problem with our employment model, as our economy is adjusted by means of redundancies instead of by adding greater flexibility to employment conditions.
Despite the gradual correction of the external imbalance (the current account deficit has been reduced from 10% of GDP recorded for 2007 to less than 4% in 2011), Spain continues to be significantly reliant on foreign funding (around 40,000M per annum). The need for funds shown by the current account deficit, cannot in fact be met by attracting foreign investment to our country. Indeed, the opposite is the case, with recent years witnessing a divestment process, particularly of portfolio assets. The forecast drop in the GDP combined with the high level of debt, puts the sustainability of our funding at risk. Given such conditions, the crisis is requiring a must faster deleveraging process than that initially expected.
Since the common denominator of the European sovereign debt crisis is insufficient GDP growth, only by articulating the reforms in Europe and in Spain in an expedient and firm manner can the current increasing loss of confidence by financial markets be sta241
lled. In the case of the Spanish economy, this is a path which we travelled successfully in the second half of the nineties, when Spain took part in the foundation of the euro and then went on to lead the fiscal consolidation process in Europe. The new government seems to have understood this, having begun reforms in three main areas: sustainability of the public finances and modernisation of the public sector, the restructuring and reorganization of the financial sector and the reform of the labour market. In the coming years, political commitment to fiscal rigour, macroeconomic stability and growth must go hand in hand in Spain and Europe, and happen in parallel.
3. Analysis of the relationship between fiscal rigour, macroeconomic stability and growth
In the context described in the previous section, fiscal consolidation within the EMU is a fundamental tool for recovering macroeconomic stability, the confidence of economic players and the path to growth, leading in turn to job creation.
Moreover, the balance in public finances provides the economies participating in the monetary union, which therefore cannot resort to instruments such as currency rates, with greater leeway to deal with external shocks, enabling the implementation of anticyclical policies and of automatic stabilisers.
242
At the same time, as has been amply studied in the literature,3 fiscal balance fosters a macroeconomic stability scenario which provides a more efficient framework for the development of economic activity. The reduction in the deficit increases the confidence of savers and investors. This translates into a stimulus for investment and job creation, as well as allowing households and businesses to plan the purchase of durable goods in the long term, thus leading to sustained consumption, which is a key factor of economic growth.
One of the most relevant aspects is the stronger credibility of the economic policy and the improvement in the funding terms of the economies in the international markets, thanks to the reduction of the risk premium, which in turn leads to a drop in financial costs, as shown in Chart 4 in the case of Spain as of 1996. The subjection of European monetary and fiscal policies to certain rules, and the assumption thereof by Spain as a participant in the foundation of the Euro, helped to provide additional credibility to the governments fiscal consolidation strategy. This strategy was strengthened by the regulatory reforms introduced by said government as we discussed in the previous section. This positive impact4 on the expectations and on the confidence of economic agents explains the sharp drop in long term interest rates, compared to the 10 year German bond. The spread in the Spanish risk premium was actually zeroed as of 2003.
3 Fiscal policy and long-run growth, V. Tanzi and H. Zee, 1997. 4 The Spanish economic model 1996-2004 (El modelo econmico espaol 1996-2004), L. Bernaldo de Quirs and R. Martnez Rico, 2005.
243
However, since 2008, with the arrival of the international financial crisis, the macroeconomic imbalances accumulated by the Spanish economy led to the opposite effect. Furthermore, as a result of the degradation of Spanish public finances between 2003 and 2009, as shown in the aforementioned graph 3, and the doubts in regard to the sustainability of the Spanish public debt, the risk premium increased once again in a significant way as of 2010, now reaching the 450 base point mark.
The significance of fiscal consolidation as a tool for the recovery of stability and long term growth has also been proven in practice in many successful fiscal adjustment processes implemented in the last decades in certain European countries, such as Spain (19962004), Ireland (1982-1989) or Sweden and Finland (1993-2000), some of which have been studied in depth in the literature.5
The most successful process was the one implemented in Finland between 1993 and 2000, which managed to reduce primary expenditure by 14pp of GDP. This was mainly based on personnel cost containment, reduction in transfers from the Central Administration to Local Corporations and the pursuit of efficiency in social expenditure, particularly in health services, education and pensions. Moreover, the fiscal institution underwent a reform with the introduction of expenditure ceilings, which proved to be a key
5 "Fiscal expansions and adjustments in OECD countries", A. Alesina y R. Perotti, 1995. An Empirical Analysis of Fiscal Adjustments", C. McDermott & R. Wescott, 1996.
244
tool for cost containment. At the same time, the pension system, the labour market and the financial system underwent a structural reform. The only expenditure programme that was deliberately maintained, thus keeping its 1% share of the GDP, was that of Research and Development.
The Swedish experience between 1993 and 2000 obtained similar results in terms of a reduction in primary expenditure (14% GDP), which led to the attainment of fiscal balance in 1997, having closed financial year 1993 with a deficit of 12.9%. In contrast with Finland,
Chart 4 Evolution of risk premium
Source: Financial Times
245
in Sweden the fiscal consolidation took place due to both the cut in expenditure and the increase in revenue through a tax rise, while also implementing simultaneous structural reforms such as the privatisation of public corporations and the liberalisation of the labour market. Public spending was reduced by 16pp of GDP over a seven year period, mainly through a reduction of the expenses in transfers and benefits (including unemployment benefits) and a reduction in personnel and current costs of all public administrations. The introduction of three-year expenditure ceilings and annual productivity targets must be added to such measures.
The starting point of all the above was the strict cut in primary expenditure, as the basis for the adjustment process, mainly centred on personnel costs, transfers and health services.
Undoubtedly, a key factor in all such measures is that they were done hand in hand with important structural reforms, particularly those implemented in the labour market, the fiscal system and the privatisations. Those allowed the adjustment process consolidation and the increase in potential growth, on the basis of a firm political commitment. Furthermore, it helped proved that fiscal consolidation strategies based on spending cuts are more enduring and promote a better economic performance than those based on revenue increase.
Experience has likewise proven that fiscal consolidation cannot be maintained in the medium term without a proper fiscal institution articulation. As shown in the previous section, from the start,
246
the construction of Europe has been evolving towards a greater relinquishment of national policies in favour of European ones. It is a slow and complicated process in which political divergences often prevail over the overall view of what this process means. This relinquishment has meant the need for greater autonomy in the establishment of rules and objectives, as has been the case, for instance, with monetary policy. Aside from the current supervision problems, it is clear that the role of the ECB in regard to price control has been a success. This example should be transferred to the fiscal policy as a source of inspiration to maintain the necessary political commitment and thus achieve effective fiscal coordination in the Eurozone.
We live in an open economy, where freedom of movement of persons, goods, capital, information and technology are necessary conditions for improvement of competitiveness and economic development. A globalised market, with a high level of competition, but also great opportunities, requires a disciplined, foreseeable and transparent behaviour by the countries, designed to generate confidence among economic agents. The EMU was born out of this perspective although there have been mechanisms, or even relevant design components, which have failed.
In general, The European construction has been preceded by the establishment of rules seeking to limit the risks of integration. The problem has arisen from the lack of rigour in compliance with such rules, probably as result of the insufficient clarity of the rules and
247
of political leadership committed to integration. When this happens, it is easier to interpret the situation in ones own favour, particularly when high political power is held. Therefore, it is important to have clear and simple rules, in order to reduce the possibilities of interpretation and to help control subsequent compliance.
At the same time, the establishment of preventing rules to enable the anticipation of sharp increases in public deficit, should be articulated via a greater participation by the EU in the preparation of national budgets, in line with the latest legislative proposals of the European Commission on the matter. Preliminary control is a guarantee of compliance and greater co-responsibility with Brussels, which should in turn lead to better access to European funding. According to economic literature,6 those countries exerting considerable effort to achieve fiscal consolidation amid a context of economic uncertainty, should design and announce the establishment of a fiscal rule within a reasonable period of time designed to improve credibility. In the case of Spain, this step has been taken by way of the reform of section 135 of the Constitution, a historical event of special political relevance.
In our case, constitutional reform has managed to raise to the level of fundamental Law a relevant issue in our highly decentralised State the commitment of all the Administrations to fiscal
6 Fiscal Rules anchoring expectations for sustainable public finances, FMI, 2009.
248
sustainability. The approval of this reform has meant the recognition of the benefits of fiscal discipline, having assumed the flaws in the relaxation of the Stability Laws in 2006 as well as the need to provide a new common legal framework for all of the public sector. Except for force majeure cases (natural disasters or emergency situations), compliance with the limits on public debt and fiscal balance set by the EU are guaranteed. Likewise, priority is given to servicing the debt in the budget, a condition which helps build the necessary confidence in lenders, and is an appropriate antidote for preventing the loss of confidence in Eurozone countries.
The reform also established the need for articulation in a new organic Law, designed, on the one hand, to regulate the distribution of deficit and debt limits between the various
Administrations, the exceptional cases of surpluses therein, and the means and terms for correction of any deviations in one or the other that might take place. On the other hand, it had to establish the methodology and procedure for calculation of structural deficit. It is important that the calculation methodology respects the procedure used in the EU, to provide discipline and transparency to the fiscal process and help in the statement of accounts. The calculation rule must be clear, and serve to consolidate fiscal discipline, as a permanent long term commitment. Lastly, it must establish the responsibility of the Administrations in the event of failure to achieve fiscal stability targets. In this regard, the credibility of the reform will depend on the existence of efficient systems which encourage the Administrations to meet the fiscal targets. As
249
we shall mention in the next section, such principles have been included in the Law on Fiscal Stability and Financial Sustainability of Public Administrations.
4. Next steps in the Fiscal Institution of the Economic and Monetary Union: the necessary contribution of Spain
The European debate on sustainability of public finances and the future of the Euro is set at a time in which, following the conversion of the international crisis into the crisis of the sovereign debt of several Eurozone countries, we have witnessed myriad European summits, each of which seeming to be the last chance to tackle the doubts of the markets in relation to the viability of the debt, in the first place, of Greece, Portugal and Ireland, and more recently, of Italy and Spain.
It is true that the crisis is far from being resolved. The EU has not always shown a capacity to react with the speed required by economic relations nowadays until the tensions reached non peripheral economies such as Austria or France, the pace in reaching consensus had been much slower than necessary. Moreover, during the crisis, it has become obvious that the institutional design of the Monetary Union was incomplete and, above all, as we have mentioned in this paper, that there has been insufficient political commitment to the application of the existing mechanisms of fiscal coordination. But it is also true that in the last four years, a consi250
derable path has been travelled towards European construction, towards an improvement in economic governance, so that in addition to a single monetary policy, Europe is also able to benefit from greater integration of fiscal policies.
As such, it is worth highlighting the agreements reached, either via the community procedure or via inter-governmental agreements, in terms of strengthening coordination, supervision and policing mechanisms of fiscal and macroeconomic policies.
In the first place, the European Semester establishes a new schedule whereby, on the basis of the macroeconomic situation of each member state and its growth forecast, the budgets and economic policies required to meet the commitments undertaken in the Euro Plus Pact and the 2020 Growth Strategy are discussed during the first six months of the year in a coordinated fashion and in accordance with common rules.
In the second place, the adoption of the so-called Six-pack (one directive and five regulations) constitutes the greatest reform of the SGP and of economic Governance since the Maastricht Treaty which created the EMU. As of the adoption of the new legislation, the European Commission may establish automatic penalties (of up 0.2% of GDP) for those countries with excessive deficits which do not follow the recommendations for correction. At the same time, the public debt control mechanism and the required reduction are reinforced in the event of exceeding the 60% GDP level
251
assumed. It also introduces a mechanism designed to prevent excessive imbalances such as unsustainable current account deficits, loss of competitiveness and other macroeconomic imbalances.
Lastly, the signature of the new Treaty on Stability, Coordination and Growth (by all member states of the EU except for the United Kingdom and the Czech Republic) brings changes at the highest legislative level to fiscal stability regulation. This must be translated in each country in that the structural deficit of the public sector may not exceed 0.5 GDP per annum, subject to automatic penalties.
These steps will be followed in the months to come by improvements seeking to fine-tune the mechanisms of economic convergence, via two legislative proposals7 of the European Commission, by establishing a clearer and more demanding schedule for fiscal coordination in Europe and implementing fiscal control and monitoring mechanisms in countries facing serious difficulties in regard to their financial stability within the Eurozone.
All these measures help towards the consolidation of economic governance, and establish the bases to enable progress to be made
7 "Proposal for a regulation of the European Parliament and of the Council on common provisions for monitoring and assessing draft budgetary plans and ensuring the correction of excessive deficit of the Member States in the euro area" and "Proposal for a regulation of the European Parliament and of the Council on the strengthening of economic and budgetary sur-
252
via other instruments, in order to provide funding and liquidity to handle emergency situations, to the extent of including eurobonds, if necessary, as well as helping the ECB to have greater leeway when acting in the markets in pursuit of economic stability. Without doubt, greater fiscal coordination broadens the funding margin of these countries. But we must be clear that access to funding requires preliminary fiscal control, and not the reverse. Conditionality in all these mechanisms is an essential requirement when seeking to limit risk. Any funding requires certain minimum guarantees of repayment of the loan, and this translates into adjustments and reforms. This is nothing new, but something that has cropped up on many occasions in IMF interventions. Eurobonds might get to play a key role, but cannot be the only item to support the fiscal union, which will drive the Eurozone towards optimum monetary union, and for which to date there is no more than a highly experimental road map.
Within this working programme so badly needed in Europe, and supported by conditionality, greater mechanisms for EU income transmission should be created to help countries facing serious problems such as that of the sovereign debt crisis in order to implement the structural reforms required by their economies, with the support of Europe in driving growth. This can be done via the encouragement of youth employment and entrepreneur program-
veillance of Member States experiencing or threatened with serious difficulties with respect to their financial stability in the euro area", European Commission, November 2011
253
mes, the reinforcement of resources available, among other uses, for structural funds or for the activity of the European Investment Bank.
On their part, the Eurozone member states can and must contribute to guarantee the future of the single currency, and to the generation of the economic growth required to clear any doubts as to the sustainability of sovereign debt, either via their contributions towards the establishment of common rules so that the EMU becomes an optimum monetary zone, or via the reforms on a national scale which constitute an example for all the others.
There is also a high degree of parallelism between the rules required and which must be institutionalized in the Monetary Union at a European level, and the process which must be followed in Spain in regard to responsibility, conditionality and subsidiarity of regional and local Public Administrations. In both cases, the need for a political will capable of applying clear and straightforward rules, with prevention mechanisms, supported by coordination, monitoring and automatic sanction systems for those who fail to comply with the targets undertaken, has become clearly evident. In this sense, the fact that the new fiscal pact at a European level and the recent legislative changes in Spain seem to be going in the same direction is a positive factor.
The case of Spain, where we have a very high degree of decentralisation and where the Autonomous Communities and Local
254
Corporations manage approximately 50% of the public expenditure, is a clear example of the need for coordination of fiscal policies to ensure that the right signals are sent to markets and investors in regard to the orientation of the fiscal policy. The consolidation efforts made by some countries and regions are useless if there are others which do not honour their commitments and destabilise the zone, region or country. Europe and, of course, Spain have their own identity, and this applies to act as a unique body in order to establish the aims. The scope of action of each government to achieve fiscal targets undertaken, via the instruments deemed appropriate, is a different thing altogether. The principle of subsidiarity must be respected provided that the principle of fiscal balance is observed. Each country must have autonomy to define and design its fiscal structure so long as the limits set for deficit, debt and growth in expenditure are respected. Fiscal competition allows for improvement in revenue collection efficiency and greater rigour in expenditure control, and thus the greater fiscal coordination in Europe must not be envisaged as a single fiscal policy. However, one of the main instruments at the disposal of the governments when coordinating fiscal policies is conditionality. In any regional funding system there are income transmission mechanisms and penalties aiming to fulfil the set fiscal targets. Therefore, in the event that fiscal stability criteria are not met, be it at a national level within the Eurozone or at a regional level within Spain, the aid provided, as the case may be via special liquidity facilities and even, if necessary, by way of eurobonds or hispanobonds, or by way of larger revenue transmissions at a European level, cannot take place without the acceptance of the conditionality it carries.
255
Spain has understood the need to contribute to the stability in Europe and is leading, for the second time, a solid process of reforms towards fiscal balance. Following the general elections of November 2011, the new government and a reinforced political capital constitute the main assets to bring about the necessary reforms. The proof thereof is evident in the fiscal reforms: the Royal Decree of non-availability, the reform of the Law on Stability, the new system for payment to suppliers, the new bill on Transparency or the bill of General State Budgets for 2012 (which establishes an adjustment of 27,300 million euros to be made between cost control and revenue increase).
The modification of section 135 of the Spanish Constitution assumed its inclusion in a subsequent organic Law (the Law of Budgetary Stability and Financial Sustainability of the Public Administrations, recently presented), which specifies changes in the preparation, execution and control of the Spanish fiscal institution. The recent approval of this bill means a return to the commitment to the control of public finances and, more importantly, it adds all of the Public Administrations to its scope of application, which the previous Stability Law failed to do.
The three main objectives of this bill are to guarantee the fiscal sustainability of all Public Administrations, to strengthen economic confidence and to reinforce the commits of Spain with the European Union.
256
All Public Administrations must present a balance or a surplus calculated according to EAS terms and none may incur in structural deficit. However, there are two exceptions in the case of structural reforms with long term fiscal effects (a structural deficit of 0.4% of the GDP may be achieved) and in the event of natural disasters, economic recession and extraordinary economic emergency.
In establishing the objectives of stability and public debt, the recommendations of the EU in regard to the Stability Programme must be taken into account, and all Public Administrations must approve an expenditure ceiling in line with the stability target and the expenditure rule. One of the most important aspects, in accordance with European regulations, restricts the growth in expenditure by the Public Administrations, as this may not exceed the GDP growth rate.
Failure to comply with the targets shall require the presentation of an economic and financial plan to allow the correction of the deviation for a period of one year. This plan must explain the causes underlying the deviation and the measures which will bring it back within the limit. In the event of non-compliance with the plan, the responsible Administration must automatically approve the non-availability of loans to guarantee compliance with the set target and the meeting of the targets shall be taken into account when authorising debt issues, granting subsidies and signing agreements.
257
The Law, on the other hand, strengthens the preventive and monitoring systems of stability and debt objectives. Therefore, a debt threshold of a preventive nature is established, beyond which the only debt operations allowed will be cash transactions.
In order to render all Public Administrations jointly responsible, the penalties imposed in Spain in matters of stability shall be assumed by the responsible administration. In the event of failure to produce an economic-financial plan, the administration in breach must put of a deposit of 0.2% of its nominal GDP, which after six months may be converted into a penalty in the event that the violations should continue. After nine months, the Ministry of Finance and Public Administrations may send a delegation to assess the economic and budgetary situation of the delinquent Administration.
In order to strengthen the principle of transparency, each Public Administration must establish the equivalence between the budget and the national accounts. Prior to approval, each Public Administration must provide information on its main budget guidelines, in order to comply with European regulatory requirements.
As was set forth in the new draft of section 135 of the Constitution, the Law establishes a temporary period until 2020 for gradual compliance, until public debt is 60% of GDP. In order to ensure compliance with this scenario, public debt must be redu258
ced whenever the economy experiences positive real growth. Upon reaching a growth rate of 2% or net yearly employment is generated, the debt ratio shall be reduced each year at least by two GDP points. On its part, the global structural deficit must be reduced by 0.8% of the annual average GDP.
Beyond the institutional importance of the reform, it is worth considering the political capital that is allowing the deficit problem to be addressed in an integral way and with long term vision. Doubts as to possible deficit deviations in the current and following financial years should not lead us to lose perspective of the importance of the reform. This reform set a trend designed to transform public budgets into a reliable institution, with a simple structure, with no room for interpretation, equal for all and with an automatic application which allows it to be protected from temptations from other governments. In this regard, we also view the provisions included in the Bill for the Transparency Law, which, undoubtedly, shall contribute towards generating better knowledge of public finances.
The fiscal systems being approved in Spain matched with the European model. There is a strong parallelism between the two, and the construction errors of the European design and of the fiscal institution in Spain must be corrected by means of a coordination of fiscal policies in which the principles of regulatory equity, subsidiarity, conditionality and sustainability should prevail above all others.
259
Without doubt, the future of the euro requires more Europe. The construction of Europe needs rules, adjustments and reforms. Without growth the European model is doomed for failure. The current crisis is but a result of the structural deficiencies of our economy, of our excess indebtedness, of our lack of flexibility and our lack of competitiveness in some aspects.
Once again, Spain, on its part, must become a role model of the fiscal institution in Europe, and of the benefits which macroeconomic stability brings to the economies, in terms of higher growth, more wealth and greater employment. This is unquestionably the best way to redistribute income. This is the only way we will manage to get Europe and Spain out of the sovereign debt crisis they face, ensuring a solid future for the process of European construction, which is the greatest milestone in the search for peace and prosperity in Europe.
5. Conclusion
Following the same pattern set since the inception of the European integration project after the World War, the EMU came about in 1999 as a result of the political aspiration of increasing integration and as a European response to the globalisation process. In reality, the integration via the monetary union which makes up the Eurozone was not an objective in and of itself, but rather a means to improve competitiveness and efficiency among
260
member countries. The ultimate goal, therefore, was growth, job creation and the improvement of social welfare, while at the same time making inroads in terms of political integration.
At that time the countries were aware of the need to set fiscal discipline targets as stability factors for Europe. However, those important advances in the European construction process became diluted over the years with the introduction of components carrying greater flexibility and discretionality in the fiscal institution. The best example is that the solution provided in 2005 to the violation of the SGP by Germany and France was none other than the reform thereof which included greater ambiguity in the search for fiscal stability, for which they gained the support of the European Commission. The diminishing political commitment with the fiscal institution and its fragility in the face of the vicissitudes of the different governments and ideologies became clear at that time. Therefore, with an institutional design which was incomplete, and gradually declining over the years, the EMU was far from representing an optimal monetary area, and therefore the imbalances of the Eurozone economies increased, instead of decreasing, placing Europe in a difficult situation in the face of the global financial crisis.
In this context, the current European debt crisis has highlighted the urgent need for better coordination of the fiscal policies in Europe. At the same time and particularly during the crisis, the experience since the foundation of the euro has shown the importance of political commitment with the fiscal institution and the
261
need for preventive rules instead of penalties which are difficult to apply. It is essential to ensure that the accumulation of excessive deficits does not lead to unsustainable situations which call into question traditional European security and seriously complicate the capacity for funding growth and job creation. Rules are a necessary condition to ensure compliance with fiscal targets. But these rules must be of straightforward and automatic application.
Despite the difficulties, the present economic time obliges Europe and Spain to make fast and efficient decisions in order to straighten out the situation. It is important to take advantage of current circumstances to tackle ambitious reforms designed to correct some of the structural flaws of the Eurozone and of our economy. It is important to face the current problems from a long term outlook and to establish the rules of a fiscal institution which ensure the viability of the European project.
The future and survival of the euro rests on all member states being able to implement domestic reforms seriously, thus generating a sign of confidence for international investors and which shall also serve, again in our case, as a calling card for our businesses abroad. In Spain, one of the countries which has sustained the most damage from the sharp budgetary deviations of recent years, regional configuration shows evident parallelisms with Europe, both in terms of the need to establish common objectives, and in terms of the control systems or the transmission and penalty mechanisms.
262
Spain, as a country which has already proven its ability to take on this role at the end of the 1990s in the foundation of the Euro, once again has an important role to play. In this regard, it is worth mentioning that, thanks to the latest reforms implemented in support of the fiscal institution, Spain is once again contributing to the European debate in pursuit of macroeconomic stability in the Eurozone and its recovery. The challenge to be addressed, by means of a change in the economic policy, is to recover confidence and credibility of our economy, to enable businesses and consumers to concentrate efforts in business, labour or consumer decisions, and that macroeconomic issues, such as the risk premium, cease to be cause for concern. Only in this way may Spain avoid lagging behind like a second rate club, to which we have already said no a few years back.
In order to move forward in building a fiscal union in Europe, which succeeds in turning the EMU into an optimal monetary area and ensures the good health of the euro and of the European economy, the necessary mechanisms of income transmission, ensure the availability of financial resources and required liquidity, to the extent, if necessary, of creating risk pooling instruments, such as eurobonds and, in parallel, the hispanobonds in the case of Spain. These require, however, the establishment of prerequisites, that is, economic adjustments and reforms to be implemented by the countries facing the most difficulties. The rules are very important, but without reforms it is impossible to grow, and without growth, budgets become unsustainable. A different issue is, provided agre263
ed commitments are met, the respect for the autonomy of each country to decide on its income and expenditure structure. Subsidiarity must govern in Europe for those who are taking the necessary steps, as is being done in Spain, in order to adapt the budgets to the economic and social reality of each country.
The European construction has taken important steps since the start of the crisis, but it needs to continue to progress via an incentive system to ensure the political commitment with the fiscal institution in the medium and long term. The objectives of peace and prosperity established by the founding fathers of the European construction, on a long term horizon, once again depend on our capacity to recover the growth and competitiveness of the economy, and hence employment and the European welfare model.
264
/JAIME REQUEIJO * /
The European Monetary Union: the Never-Ending Crisis
1. Introduction; 2. The Euro: a Badly Constructed Building; 3. The fiscal Spillover; 4. The Consequences of the Doubtful Debt; 5. Contributing Factors; 6. Main Measures Adopted to Solve the Monetary Union Crisis; 7. Outcome of the Measures Adopted so far; 8. Consequences of the Breakup of the Euro; 9. The Missing Link
* Ph.D in Economics, BA in Law, Former Civil Servant attached to the Ministry of Commerce, Emeritus Professor of Applied Economics (UNED and IEB).Former positions include : General Director for Imports and Tariff Policy at the Ministry of Commerce, Chief Executive Officer of Caja Postal de Ahorros, Member of the Board of Banco Zaragozano, Director of the School of Financial Studies (UCM) and Member of the Board of Banco de Espaa. His fields of research focus on monetary and financial matters, international economics and the Spanish economy. He has written seven books and published more then seventy papers in Spanish economic reviews..
265
1. Introduction
The constant financial trepidation afflicting different countries of the Eurozone, and which threatens the survival of the single currency, is not the result of random events. In our view, they can be put down to four fundamental reasons. First, the Monetary Union is a badly constructed building as political urgency prevailed over economic prudence. Second, there is the fiscal irresponsibility of many member state governments, an irresponsibility that has materialized as hefty public debts. Thirdly, the doubts being generated among the debt holders, mainly institutional investors and banks, and which has led to significant fluctuations in the interest rates of those assets and, in general, to a cost hike for the issuers. Four, what we could call the contributing aspects: the spillover and contagion effects that batter the financial markets, effects linked to the opinions of the rating agencies and, on occasions, to the worst-case scenarios of the International Monetary Fund regarding the medium-term performance of the European Union economies and, particularly important, those of the Monetary Union.
Faced with that panorama, and given the absence of clear solutions, there are three questions raised by many observers of the crisis. The first question is what the measures are that have been adopted so far to try and avoid the recurring disruption. The second question is whether those measures, or further ones currently under debate, will be sufficient to solve the problem or,
266
on the other hand, will the fate of the Monetary Union be to totally or partially break up? The third question is if the Monetary Union proves to be totally unviable and the national currencies have to be re-introduced, what will the consequences be of the failure of the euro?
This paper seeks to provide a reasoned explanation of the causes underpinning the current major upheaval and it also aims to answer the aforementioned three questions regarding the measures, their outcome and impact of a possible breakup of the euro. The paper ends with a short section considering the solution that should be adopted to keep the Monetary Union in place.
2. The Euro: a Badly Constructed Building

Even though the dream of the single currency had been always present since the Treaty of Rome, the definitive decision, contained in the Maastricht Treaty, is the outcome of the political desires of France and Germany. Of France as French governments believed that having a single European currency would avoid the constant pressures on the franc, pressures that usually led to the devaluation of its currency. Of Germany as accepting the single currency meant highlighting the European vocation of the most important European economy after reunification in 1990, a process that opened up many raw wounds particularly in France. Driven by those dual interests, the currency unification project prospered, not wit267
hout significant frictions, until it became reality in 1999, the year when eleven countries, including Spain, ceded their monetary autonomy to the European System of Central Banks; Greece would join in 2001, followed by other countries until it reached the current seventeen members.1
Joining the Eurozone required the countries to meet the socalled Maastricht convergence criteria, those rules aimed at ensuring that the different economies had a certain nominal similarity. During the year prior to the Compatibility Test, the inflation rate could not be more than 1.5 points over the average of the three most stable candidate countries; as the end of that year, the public sector deficit could not exceed 3% of the Gross Domestic Product or the debt be greater than 60% of that figure; the candidate country had to have been part of the European Monetary System during the two years prior to the test and without its currency having experienced significant fluctuations; and, during the previous year, the long-term nominal interest rate had not exceeded the average of the three most stable countries by more than 2 points.2 After the failure of the European Monetary System in 1993, only the other three criteria were required to determine which countries could join the euro, and those criteria have conti-
1 Note that the countries that initially joined the Monetary Union were Germany, Austria, Belgium, Spain, Finland, France, the Netherlands, Italy, Luxembourg and Portugal. Greece joined later and, successively, followed by Slovenia, Cyprus, Malta, Slovakia and Estonia. 2 Article 121 of the 1992 Maastricht Treaty.
268
nued to be applied to accept the application for entry of the successive candidates.
Please note that those criteria were only required at the time of joining. The subsequent restrictions were laid down by the 1997 Stability and Growth Pact, aimed at maintaining budgetary stability within the Union. Thus, the country could not exceed the annual limit of the deficit and the debt: 3% and 60% of the GDP respectively. Exceeding those limits meant that the European Commission would implement the excessive deficit procedure, which would result in the country in question having to face certain penalties. Subsequently, in 2005, the rules were reformed so that the deficits tested were not the nominal but rather the structural ones. Therefore, not only the current deficit, but also the sustainability of the long-term public debt was taken into account in the supervision and monitoring process entrusted to the European Commission.3 In short, and right from the outset, the nominal similarities that a series of economies with clear real differences had to offer were what seemed to matter to European leaders. And, proof of that difference could be seen when, in 2002 Greece had already joined the typical deviation of labour productivity per hour worked, calculated as CWA was 29.46;4 which clearly showed the different competitive capacity of the different countries, right from the start. Those differences were a hint of the future sym3 See The Stability and Growth Pact: Public Finances in the Euro Zone of the SubDirectorate General for Financial and Economic Affairs of the European Union, SCI Economic Gazette No. 2906, 16-28 October 2007. 4 Prepared using the Eurostat data for the twelve member countries.
269
metric upheavals to come in the zone, and that group of countries, for different reasons, did not constitute or constitutes an optimum monetary zone. And thus, the European Monetary Union was built on quicksand, quicksand that would begin to overwhelm it as soon as the fiscal irresponsibility of some of the governments made a significant dent in the building overall.
3. The Fiscal Spillover

Can governments of countries with weak currencies issue debt in their currency and ensure that attracts foreign investors? The likelihood is minimum as the potential investor will think that, at some point, the currency will depreciate substantially, leading to a loss.
Can countries with a strong currency do so? They can because the investors will not fear the losses following on from devaluation. And proof of this is that institutional or private investors, resident in a wide variety of countries, have traditionally kept debts in dollars, marks, Swiss francs or yens in their portfolios.
The euro sought to be a strong currency right from the outset. This strength was based on the monetary policy of the European Central Bank, whose primary objective would be to keep prices stable.5 And which, furthermore, represented a series of important
5 Art. 2 of the Statues of the European System of Central Banks and the European Central Banks.
270
economies, with Germany at the head. Moreover, the exchange rate risk disappeared for member countries and it therefore facilitated the setting up of a large financial market in euro.
The appearance of the euro, therefore, meant the disappearance of the original sin experienced by countries with weak currencies: the difficultly of leverage in other currencies, which meant that they were at huge risk of financial fragility.6 The way was therefore left clear for governments of euro countries that had found it difficult to finance themselves in other currencies prior to joining the single currency, to easily raise leverage in the powerful financial market of the euro. The only thing missing was the imperative need to do so.
And that imperative need arrived with the economic crisis, which began in 2007, and with the general downturn in the rates of growth, a fall that is reflected in the following table.
It should be noted that even through the downturn in growth was widespread, the countries with the sharpest recession were Ireland, Italy, Portugal and Spain within the initial group of twelve countries.
When the growth rate shrank, which was greatest in those cases with the sharpest change in cycle, the budgetary revenue fell and
6 See Eichengreen, B. & Haussmann, R. Exchange Rates and Financial Fragility, NBER WP 7418, 1999.
271
Table No. 1. Average Growth of the Eurozone (17 countries)
Country Germany Austria Belgium Cyprus Slovenia Slovakia Spain Estonia Finland France Greece The Netherlands Ireland Italy Luxembourg Malta Portugal
Average 2004-2006 1.87 2.90 2.57 4.07 4.73 6.70 3.67 8.43 3.70 2.20 4.07 2.53 5.03 1.27 4.93 2.33 1.27
Average 2 0 0 7 -2 0 1 1 1.20 1.30 1.12 1.68 0.74 3.80 0.26 -0.14 0.80 0.52 -1.90 1.14 -0.82 0.52 1.28 2.20 -0.20
Source: Own preparation, using Eurostat data (Europe in figures, 2012)
the deficits appeared or increased and grew even further if the budgets included automatic stabilisers, by virtue of which the fiscal policy became expansive in periods of recession, and even more expansive if the governments relied on additional fiscal stimulus to overcome the economic crisis.
All of these are reasons have been given to explain the rapid increase in the public sector debt, as can be seen in Table No. 2.
Given that panorama of slow growth, or decline, and of growing public debts, it comes of no surprise that debt holders would soon have greater misgivings misgivings that particularly affected those
272
Table No. 2. Evolution of the public debt of the eurozone (% GDP)
Country Germany Austria Belgium Cyprus Slovenia Slovakia Spain Estonia Finland France Greece The Netherlands Ireland Italy Luxembourg Malta Portugal Eurozone
2007 65.2 60.2 84.1 58.8 23.1 29.6 36.2 3.7 35.2 64.2 107.4 45.3 24.9 103.1 6.7 62.4 68.3 66.3
2011 81.8 72.2 97.2 64.9 45.5 44.5 69.6 5.8 49.1 85.4 162.8 64.3 108.1 120.5 19.5 69.6 101.6 88
Growth 25% 20% 16% 10% 97% 50% 92% 57% 38% 33% 52% 42% 334% 17% 191% 12% 49% 33%
Source: Own preparation, with data from the Statistical Annex of European Economy, autumn 2011. The data refer to the gross debt as they are the liabilities that the government must face.
countries where the recession was combined with spiralling debt and the few prospects for recovery. It was, therefore, foreseeable that any event that affected the debt of a country would lead to a chain reaction that would challenge the financial stability of the Eurozone.
That event was Greece going into virtual receivership on 23 April 2010: on that date the Greek government asked the International Monetary Fund and the European Union for a 45,000 million euro loan to meet their financial obligations, four months after Fitch, the rating agency, had downgraded its debt.
273
4. The Consequences of the Doubtful Debt

From then onwards, there were constant indications of concern in different channels about the sovereign debts with a question mark over them. First of all, the increase of the risk premiums of certain securities; secondly, the increase in the cost of the credit insurance for the same securities; third, the greater occasional cost of the new issues by the countries under suspicion, the so-called peripheral countries: Greece, Portugal, Ireland, Italy and Spain.
The three aforementioned reactions clearly moved in the same direction. As is known, hikes in risk premiums on the secondary markets consist of discounts on the value of the securities, discounts that are equivalent to an increase in the relevant interests and which are compared to the interests of the benchmark debt, the German one, for the same market. In its simplest version, credit insurance (Credit Default Swaps) are contracts by virtue of which, and by means of paying a premium, the bondholder is guaranteed the collection of the nominal amount. And in increase of the risk premiums and the price of the swaps affect, by definition, the cost of the new issues: the more expensive the premiums and swaps become, the higher the interest that the new issues should offer and the greater the cost for the relevant governments. All of which tends to worsen the financial situation of the governments, a situation that will enter a downward spiral if the average interest rate of the outstanding debt is greater than the growth rate of its economy.
274
5. Contributing Factors
Current financial markets are markets of news and rumour mills.7
The first report on how the turbulence develop and reflect verifiable facts: the initial request for help by the Greek government; the successive austerity measures demanded by the European authorities and the International Monetary Fund for the bailout to be granted; the social response to the austerity plans in different countries or the downgrading of the sovereign debts of different countries of the Eurozone, including France. All of the events show the constant severity of an ongoing crisis.
The second are, in general, interpretations, opinions that are usually transmitted through the different media, whether they are journals, the daily press, television and radio programmes or news spread online. Some are reasonably based opinions that are trying to consider the difficult situation of the Monetary Union and to offer some type of solution.8 Others are purely and simply seeking to be alarmist, to the point of suggesting to their readers that they
7 An extensive study into the subject of rumours is by Mark Schindler: Rumors in Financial Markets, Wiley&Sons, UK, 2007. 8 Examples of opinions of this type are Beware of fallen masonry, The Economist, 26/11/2011, and those expressed by K. Rogoff in the interview published by Spiegel on 27/2/2012, entitled Germany Has Been the Winner in the Globalization Process.
275
should stock up on food to survive the chaos that will reign, on the world scale, when the euro implodes and triggers a financial tsunami that will spread over the five continents.9
Furthermore, there are the constant threats of downgrading the sovereign debt by the three major US agencies Standard & Poors, Moodys and Fitch , the three who were so optimistic when it came to US mortgage junk bonds,10 and the doubts expressed, from time to time, by the International Monetary Fund regarding the future of the euro zone. There is also the risk that the whole set of views, from the most founded to the most alarmist, will awaken many fears and the prophecy will become self-fulfilling: the disaster will occur because the avalanche of negative opinions will set it in motion.
6. Main Measures Adopted to solve the Monetary Union Crisis

At the time of writing (April 2012), these measures have involved setting up general bailout funds, the approval of a Greek Loan
9 Read Will Greek Sovereign Debt Default on March 23 by Patrik Heller, Coinweck, 22/2/2012 (online). 10 In the opinion of John Kiff, from the International Monetary Fund, the opinion of the agencies increases the uncertainties on the sovereign debt markets, due to the importance that the participants on those markets seem to attribute to them. See his article Reducing Role of Credit Ratings Would Aid Markets IMF Survey Magazine, 29/9/2010. Also Arezki et al: Sovereign Rating News and Financial Markets Spillovers, IMF, WP/11/68.
276
Facility, the interventions of the European Central Bank and the fine tuning of a new Treaty on Stability, Coordination and Governance of the Monetary and Economic Union.
In 2010, the European Financial Stability Fund was set up, whose aim is to facilitate resources to euro countries in financial difficulties. It is a company whose headquarters are in Luxembourg and its loan capacity is to the tune of 440,000 million euros.11 To grant a loan to a Euro country, the government of the country has to request it and sign an austerity programme. Part of the loans to Ireland and Portugal were arranged through that Fund.
In 2011, the European Financial Stabilisation Mechanism was created for a similar purpose. It is an institution, supervised by the European Commission, which obtains its resources from the capital markets by means of issuing bonds underwritten by the European Union budget. It may provide aid to members of the European Union, whether or not they are members of the Eurozone, is compatible with aid provided by other channels and also requires the prior approval of an austerity package. Loans have also been granted through this programme to Ireland and Portugal.
The two aforementioned funds would duly be subsumed in the European Stability Mechanism), agreed by the Eurozone countries
11 All the data referring to the bailout fund and to the Greek Loan Facility are taken from European Commission official documents.
277
in February 2012 and which should begin to function in July of that year. Its aid will not be limited to granting loans, but it will likewise be able to acquire bonds issued by the member countries, either on the primary or on the secondary markets, and facilitate resources aimed at recapitalising financial institutions. In principle, it would have 80,000 million euros of capital and an initial credit capacity of 500,000 million euros. In May 2010, the members of the Eurozone bilaterally decided to lend Greece 80,000 million euros that, in addition to the 30,000 million from the International Monetary Fund, meant that the first Greek bailout totalled 110,000 million euros. At the end of 2011, and 73,000 million euros had been paid out from that fund, a payment that required an austerity undertaking. On 14 March 2012, a new bailout programme was approved, with substantial write offs for the creditors and austerity obligations for the Greek Government, to the tune of 130,000 million euros, an amount which includes the International Monetary Fund contribution of 28,000 million euros. The purpose of that financial support, which will last until 2014, is to bring the Greek public deficit under the 117% of its Gross Domestic Product by 2020. Part of that bailout will be channelled through the European Financial Stability Fund.
A crisis intervention of particular importance is by the European Central Bank, an intervention channelled in two lines. In a non-recurrent way, the Bank acquires debt on the secondary market, which reduces the risk premium and means that the issues of new securities are at a lower cost. On the other hand, it lends
278
resources at a very low interest rate to financial brokers its basic rate has remained at 1% for some time which means that the banks of the worst hit countries acquire part of the new issues. They, therefore, facilitate the placement of securities, securities that are profitable for the financial institutions and less costly for the issuers.
On 2 March 2012 and after many debates in the European Council, the representatives of twenty-five countries of the European Union as neither the United Kingdom nor in the Czech Republic wanted to sign up signed the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union. Even though the new Treaty was signed by members of the European Union that are not part of the Monetary Union, its fundamental proposal is to force the euro countries to ensure that their public finances are balanced. Further proof of that purpose is that the Treaty will come into force when it has been ratified by at least twelve euro countries.
A key aspect of the agreement is the so-called Budgetary Agreement that forces those countries to tighten their budgetary discipline and which introduces the balanced budget rule, a rule that must be included in national legislation and, preferentially, in the Constitution. The structural deficit must not exceed a specific limit and cycle deficits are accepted, resulting from substantial downturns in the economic activity, provided that they do not alter the balanced budget rule in the medium term. And, in the
279
case that the deficit exceeds the permitted limit, a series of automatic penalties are envisaged.12
7. Outcome of the Measures Adopted so far

Judging by the data that appeared in early April 2012, recovery from the downturn has not yet started, in particular, as far as the peripheral countries are concerned: volatility remains high both on the sovereign debt markets and on the variable income ones in the case of the latter, the downward trend is reflected by the drop in share prices of the most exposed banks to the sovereign debt of those countries and the doubts persist regarding the capacity of several of them to meet their obligations. Which is not at all strange for several reasons.
The required restructuring to bring the debt back to more bearable levels would hinder, in the short term, the growth capacity of the five countries, as economic recovery would be further complicated by the shrink in their tax revenue. And all of this would occur in a climate of recession and economic stagnation that appears to have taken hold of the European Union, over all, and the Monetary Union, in particular.13
12 The full text of the Treaty can be seen at the European Council website. 13 The forecasts can be seen at the European Economic Forecast, Autumn 2011 (online).
280
The situation of Greece is at the forefront of all the economic analysis of the euro zone as very few believe so far that the recently approved second bailout will result in the country solving problems and many believe that a third bailout will soon be on the cards. And those doubts regarding the future of the Greek economy are spreading to the rest of the peripheral countries and, to a great extent, to the very future of the Monetary Union.
Despite the measures approved so far, the decision processes have dragged on as an agreement needs to be reached by country representatives, who are very aware of the opinion of their citizens, and by representatives of community institutions. Long processes, where multiple opinions, sometimes discrepancies, are mixed, that increase the uncertainties regarding the future of the euro, even though the disappearance of the single currency could raise much more wide-ranging problems than the current ones trying to be solved.
8. Consequences of the Breakup of the Euro

The breakup of the Monetary Union could occur should one or more member states decided to leave the single currency and reintroduce their own currency. That split could either be due to the departure of one or more weak-economies or to one or more strong-economies breaking. In either of the two cases, the Union would be broken.
281
From the legal perspective, such a possibility does not currently exist as the Maastricht Treaty does not include any clause that opens up the way; only the 200714 Lisbon Treaty accepts the
voluntary withdrawal of a member state from the European Union, but says nothing about the Monetary Union. This may be because the architects of the common currency always thought that, given that the single currency was an extremely important step in the political and economic construction of Europe, the decision of each country should be irrevocable.
Yet, leaving the legal aspect on one side, despite its importance, the collapse of the Eurozone would lead to a series of disastrous consequences for the country or countries that had left the euro, for the Eurozone overall and for the world economy.
Let us first consider the departure of a weak economy. The mere presumption by its citizens of leaving would result in a large-scale transference of deposits from its banks towards other banks located outside the country, given that nobody would want to see their euro assets converted into balances in the devalued currency; the Government in question would be forced to impose, as a preventive measure and prior to the decision to abandon the euro, a limit on withdrawing deposits and a strict exchange rate control. As it is to be supposed that part of the private debt of the country would be held by foreign institutions, individuals and companies would find themselves in the worrying situation of having to face such debts with a
14 Art. 50 of the Treaty regarding the voluntary withdrawal for a member country.
282
national currency of a lower value. With respect to the sovereign debt, the problem would be the same: the Government would be compelled to honour it at a higher cost. And the internal economic adjustments would be of such a magnitude that the main purpose sought by returning to the national currency regaining the exchange rate policy and, thus, making the exportable goods more competitive would take many years to occur. Without even going into the social and legal conflicts that would occur, in that country, as a severe recession for an unforeseeable length would occur.
If the country decided to abandon the euro were a very strong economy, would there be more advantages than disadvantages? It is not easy to answer that question, for two reasons. First of all, because the foreseeable outcome is that its currency would appreciate, which, even though it would mean an initial advantage, would also raise problems. For example, and from that moment onwards, its banks would have deposits in the new currency, but it is to be supposed that part of its assets would be for operations with residents in the euro zone and, therefore, the financial brokers would have to face losses through that channel, and would moreover have to face its fiscal obligations in the new currency. Second, and this is the more important aspect, the appreciation of its currency would affect its competitiveness in the remaining euro countries the main market of all the countries of the Monetary Union which, undoubtedly, would hit its growth capacity for many years to come.15
15 On these aspects, see Euro break-up: the consequences of UBS Investment Research, 6/9/2011 (online). Also the opinions of Eric Dior: Leaving the euro zone: a
283
The departure from the Eurozone of any country, or several countries, would break up the Monetary Union in both political and economic terms. In economic terms, because the growing distrust of all its citizens would lead to substantial capital flights and, probably, to the collapse of different financial systems, which would cloud the very limited economic perspectives of the zone and would lead to a long recession. In political terms as its international clout would be considerably reduced, based on a situation, the current one, which is not particularly brilliant: its lack of political unity and its indecisiveness, which characterises it as a soft power area clearly reduce the international presence of a zone that, we should not forget, is, taken overall, the second economy and the second market of the world.16 Its breakup and the ensuing recession would cloud the international presence of that group of countries to unimaginable limits. And without taking into account the likely decline of the European Union.
It is interesting to observe the distancing that many nonEuropean analysts show when considering the spasms of the Monetary Union. Which is the equivalent, in many cases, to considering them as a local problem: the Eurozone is having to bear great tensions, arising from the sovereign debt crisis, and there is a question mark over its survival. And they go no further. They forget that, in a world of fully integrated financial markets, the
users guide. IESEG School of Management (Lille Catholic University), October 2011 (online). 16 With World Bank and World Trade Organisation data for 2010.
284
Eurozone crisis would have a global impact. For two reasons. First of all, because a good part of the sovereign debt is in bank portfolios; secondly, because the credit insurances (CDS) are, possibly, held by financial institutions around the world.
In December 2011, 513,000 million euros of public debt of the five peripheral countries (Greece, Ireland, Italy, Portugal and Spain) appeared in the portfolios of European banks.17 If we take into account that the financial institutions around the world are linked by a series of international transactions, it is not difficult to conclude that the breakup of the euro would have global repercussions.
In the March 2011, the CDS linked to European sovereign debt stood at 145,000 million dollars.18 Neither of these two figures are high but they are sufficiently important for the upheavals of the euro zone, following on from the breakup of the currency, to be transferred to other regions of the world with substantial multiplying effects.
It therefore can be supposed that the Monetary Union will manage to overcome this crisis. Yet, from our point of view, the current firewalls the bailout funds, however they are called and the budgetary obligations, included in the Treaty on Stability, Coordination and Governance, will not be enough to overcome
17 Jenkins, P. y Stabe, M: EU banks slash sovereign holdings. With European Bank Association data (online). 18 ISDA: The Impact of Derivative Collateral Policies of European Sovereigns and Resulting Basel III Capital Issues, 19/12/2011 (online).
285
the current problems and ensure that the Monetary Union is the threshold to what, when all said and done, has been what they wanted to achieve through the single currency: a certain degree of Political Union. An additional link is therefore now needed.
9. The Missing Link

The endeavours aimed at solving the crisis have so far been along two paths: creating financial instruments to avoid the bankruptcy of some governments the most worrying case is Greece and strengthening the obligation of member countries to reach and maintain a reasonable budgetary balance. Important steps, but which have not managed to eliminate the continuous tension that has been observed in the financial markets, tension that the interventions of the European Central Bank have only managed to soften. Soften, not eliminate.
Note that all the actions undertaken so far bailout and rules do not imply any joint liability. It involves combining financial aid and remembering that fiscal policy in a single currency arena must be very similar and very prudent in all member countries. The liability therefore falls on the Government of each country.
Yet these measures will not be sufficient if the aim is to shore up the badly constructed building of the Eurozone. It would be necessary to show that the members of the Monetary Union are capable of jointly and severally assuming liability of the problems of all its
286
members. And what is necessary, to affirm that joint liability, is to issue the so-called Eurobonds or Stability Bonds; in other words, bonds jointly issued that will replace, totally or partly, the current sovereign debt. That measure, that would be a highly important step forward in the construction of the common building that is based on the single currency, would result in three far-reaching consequences: the sovereign debt crisis of some countries would be rapidly alleviated; the cost of future issues would be reduce as a consequence of the overall solvency; and the financial system of the Eurozone would be more resistant to any future upheaval, and the overall financial stability would therefore be strengthened. This decision necessarily implies the setting up of a common treasury and likewise the application of a fiscal policy.
Clearly, that decision would entail many economic difficulties and highly complex political problems, as the citizens of the most prosperous and stable countries of the Union will be not very willing to accept that type of shared liability which they would see as the financial problems of others being placed on their shoulders. Yet we should not forget that that possibility has already been raised by the European Commission itself, precisely to attain those objectives.19 And we should not forget, above all, that, as I have attempted to explain in this paper, the end of the Monetary Union is not a zero-sum game, where there are winners and losers; it is a negative sum game, where everyone loses.
19 See European Commission: Green Paper on the feasibility of introducing Stability Bonds, 23/11/2011.COM (2011) 818 final (online).
287
288
A. JESS SNCHEZ FUENTES * /SEBASTIAN HAUPTMEIER ** / /LUDGER SCHUKNECHT *** /
Public expenditure policies during the EMU period: Lessons for the future?1
1. Introduction; 2. Long-term public expenditure in industrialised countries; 3. The first decade of EMU period: a missed opportunity?; 3.1. A disaggregated assessment of past expenditure policies; 3.2. Determinants of the expenditure stance; 3.3. Implications for public debt; 4. Looking backward to the past, lessons for the future? an episodes based approach; 5. The need for prudent expenditure rules; 6. Concluding remarks; Bibliography
*He currently works as Ph. D Assistant professor at Complutense University of Madrid. Before he worked as external consultant at European Central Bank, as (Ph. D) Assistant professor at Pablo de Olavide University (Seville, Spain) and as research assistant at Foundation centrA. He holds a Ph.D in Economics from Pablo de Olavide University (with distinctions) and a Bachelor in Mathematics from University of Seville. His research areas are mainly public economics and computational economics. ** He currently works as an Economist at the German Ministry of Finance. He was also an Economist in the Fiscal Policies Division of the European Central Bank and worked as a research assistant at the Centre for European Economic Research (ZEW). He holds a Ph.D. in Economics from Munich University (LMU). His research focuses on empirical public finance and fiscal policy. ***Is heading the Directorate General Fiscal Policy and International Financial and Monetary Policy at the German Ministry of Finance. Previously, he worked at the European Central Bank, the World Trade Organisation and the International Monetary Fund. His recent research mainly focuses on public expenditure policies and reform and the analysis of economic boom-bust episodes.
289
Public expenditure policies during the EMU period: Lessons for the future?
1. Introduction
The outlook for public finances in the advanced economies for the second decade of the 21st century is extremely challenging, not least due to the substantial fiscal expansion that took place in the context of the financial and economic crisis. Public deficits in 2010 averaged around 6% of GDP in the euro area and exceeded 10% of GDP in the US and the UK (Chart 1, panels a, and b). At the same time, public debt in advanced economies has increased significantly between 2007 and 2010: by some 20pp of GDP to around 86% in the euro area and so far by 30pp or more in the UK (to 80%) and in the US (to over 90% of GDP). When including Japan, public debt in the G7 countries already averaged over 100% of GDP in 2010.
A closer look suggests that most of the deficit increase since the start of the crisis in 2007 was due to an increase in public expenditure ratios which have reached or approached historical highs. By contrast, revenue ratio declines have been rather limited (panels c and d). It is, therefore, logical to look at public expenditure when striving to correct fiscal imbalances in industrialised countries. This approach is in fact pursued already by a number of countries with fiscal difficulties. It was also the approach usedsuccessfullyby
1 The views expressed are the authors and do not necessarily reflect those of the authors employers. Correspondence to: A. Jess Snchez-Fuentes. Universidad Complutense de Madrid. Campus de Somosaguas, 28223, Madrid (Spain). Tel: +34 913942542, Fax: +34 913942431. Email: antoniojesus.sanchez@ccee.ucm.es.
290
Chart 1. Developments in public finances, 1990-2011 a) Fiscal balance
b) Public debt
Source: Ameco.
291
Chart 1. (cont.) Developments in public finances, 1990-2011 c) Total public expenditure
d) Total revenue
Source: Ameco.
292
many advanced economies in the 1980s to return to sound public finances and at the same time reinvigorate the economy.
The case of the euro area is of special relevance for a number of reasons. While the crisis-related deterioration of public finances in the euro area as a whole has not been as pronounced as for example in the US or Japan (see Chart 1), heterogeneity at the Member State level is substantial. A number of countries, in particular Greece, Ireland and Portugal, recorded double-digit deficit ratios and experienced significant increases in government debt as a ratio to GDP. Unsustainable fiscal positions coupled with structural economic weaknesses and competitiveness deficiencies, in turn, fuelled market tensions which - due to strong financial interlinkages undermine financial stability in the monetary union as a whole. Therefore, at the time of writing, there is a particular urgency for euro area countries to regain market confidence through a swift return to sound public finances. At the same time, euro area membership tends to exacerbate adjustment efforts since the exchange rate mechanism is not available, preventing an external devaluation. Therefore, fiscal consolidation and the restoration of external competitiveness need to strongly rely on internal adjustment processes.
Against the background, this study assesses expected public expenditure developments of selected euro area countries for the coming years. Based on the experience with expenditure reform in the 1980s and 1990s, we argue that ambitious and high quality expenditure reform as part of comprehensive economic reform pro293
grammes have the best chance of success. Furthermore, the role of a prudent expenditure rule and the relevance of having a suitable institutional framework are discussed.
Section 2 reviews public expenditure trends over the past 30 years. Section 3 reports on the main findings of earlier studies on public expenditure policies during the first decade of EMU. Section 4 looks backward to the past to extract important conclusions on the successful strategy exit of current crisis. Section 5 provides an illustration on the preventive role of prudent expenditure rules before section 6 concludes and draws some policy lessons.
2. Long-term public expenditure in industrialised countries

With a view to assessing recent developments in a broader historic perspective, it is worth briefly taking stock of trends in public expenditure and the size of the state over the past 30 years (Table 1).2 After a strong increase in the size of government in industrialised countries in the 1960s and 1970s, the average total public expenditure ratio across OECD, G7 or euro area was broadly unchanged in 2007 -just before the financial crisis- from 2000, 1990 and 1980. The average spending ratio for the euro area remained around 45% of GDP and that of OECD and G7 around 40%.
2 See also Tanzi and Schuknecht (2000) for more details on historic expenditure developments.
294
Table1. Total expenditure developments
% of GDP
Maximum Change value 1980 maxi1990 2000 2007 2010 or nearest mum Year Ratio to 2010 50,0 54,9 40,1 46,0 47,4 27,0 50,1 40,8 48,4 55,2 32,4 31,1 4 5 ,4 32,5 41,6 52,7 33,0 62,9 32,8 47,6 34,2 3 8 ,3 3 9 ,1 51,5 52,3 48,1 49,6 44,2 45,2 42,8 52,9 37,7 54,9 38,5 42,1 4 7 ,9 35,4 48,8 55,4 31,6 61,3 30,3 41,1 37,2 3 9 ,8 4 0 ,2 52,3 49,1 48,3 51,7 47,6 47,1 31,2 47,0 37,6 44,8 41,4 39,3 4 6 ,2 35,5 41,1 53,7 39,0 55,1 35,1 36,8 33,9 3 8 ,5 3 8 ,8 48,6 48,3 47,2 52,6 43,5 47,6 36,6 47,6 36,3 45,3 44,4 39,2 4 6 ,0 33,4 39,4 50,8 35,9 51,0 32,3 43,9 36,8 3 9 ,9 3 9 ,8 52,5 52,9 55,1 56,6 48,1 50,2 46,8 50,3 42,5 51,2 51,3 45,6 51,0 38,5 44,1 58,5 41,1 52,9 34,2 50,6 42,5 45,0 44,6 1995 56,4 1983 62,2 1993 64,7 2010 56,7 1995 54,8 2009 53,8 1982 54,2 1993 56,3 1981 51,7 1983 59,1 2010 51,3 1993 47,1 1 9 9 5 5 3 ,1 1985 38,5 1992 53,3 1993 60,2 1998 42,5 1993 71,7 2003 36,4 2009 51,5 2010 42,7 2 0 0 9 4 5 ,5 2 0 0 9 4 5 ,2 -3,9 -9,2 -9,6 -0,1 -6,7 -3,6 -7,3 -6,0 -9,2 -7,9 0,0 -1,4 - 2 ,1 0,0 -9,2 -1,7 -1,4 -18,8 -2,2 -0,9 -0,2 - 0 ,5 - 0 ,6
Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Euro area (15) Australia Canada Denmark Japan Sweden Switzerland United Kingdom United States G7 OECD
Source: Ameco, OECD.
295
However, this masks significant differences across countries. The countries that undertook ambitious reforms in the 1980s and 1990s typically had much lower spending ratios in 2007 than in 1980 or at least than at their peak. A few countries, however, including many of those that we will refer to in the next sections (US, Italy, Spain, Portugal, Greece, Ireland, UK) had significantly increased the size of government between 1980 and 2007 or least in the 2000-2007 period.3 This occurred notwithstanding an extended economic boom in most of these when expenditure ratios should have gone down.
With the start of the financial crisis, public expenditure ratios went up everywhere by on average 5pp of GDP. This brought the total expenditure ratio to about 50% in the euro area and 45% in the OECD/G7 in 2010. For the euro area, the increase still constitutes a decline in overall spending since the previous peak in 1995 but this was due to a lower interest bill. On the whole and for many countries, public expenditure ratios are now at or near historical peaks. This includes the European crisis countries, Portugal and Greece and the UK and US.
These developments show that the challenge of containing the size of the state is more present than ever. And together with deficit and debt figures, the close link between rising public spending, defi-
3 See also Hauptmeier et al, 2011 for an assessment of the expenditure stance in euro area countries since the start of EMU.
296
cit and debt figures is also obvious. But a number of countries mastered the challenge of very large expenditure ratios with ambitious reform programmes in the 1980s and 1990s. This experience will be re-called in the next sections. These countries were typically not the same that face such challenges nowexcept Ireland and the UK.
3. The first decade of EMU period: a missed opportunity?

In this section, we examine expenditure developments and plans of a number of euro area economies, notably Greece, Ireland and Portugal (programme countries), Germany, France, Italy and Spain (large euro area countries) in comparison to the UK and US. The common feature of most of these countries (except Germany and Italy) for the period up to 2007 was a drawn out economic boom characterised by significantly positive output gaps. In principle, this should have allowed bringing down public expenditure ratios significantly, firstly, due to the impact of automatic stabilisers and, secondly, in some cases also due to lower interest spending thanks to the euro.
However, this is not what happened. All countries pursued an expansionary expenditure stance, of the order of 1-5pp of GDP except for Germany (Hauptmeier et al, 2011).4 This basically ate
4 One of analysing the expenditure stance of a country is to compare it with the expenditure levels that should have occurred if a country had followed certain fiscal rules.
297
up the interest savings from introducing the euro. As a consequence, total public expenditure only went down significantly in Germany and even increased strongly in the three crisis countries and the UK between 1999 and 2007 (Table 2). In the US, total spending grew by around 2pp of GDP between 2001 and 2006 but the ratio remained well below 40% of GDP. Together with the US, Ireland and Spain maintained the lowest spending ratios (below 40% of GDP), Frances public expenditure was the highest, at 52.4% in 2007. The increase in public expenditure becomes even more pronounced when looking at primary spending. For the crisis countries and the UK this went up by 3 to almost 6% of GDP between 1999 and 2007. As a result, most of the sample countries still had significant deficits in 2007 while the debt ratio had hardly declined or even increased between 1999 and 2007 (Schuknecht, 2009).
Expansionary expenditure policies during good times left most of the countries unprepared when the crisis hit. As a consequence of the output fall and further expansionary programmes, public expenditure ratios increased strongly between 2007 and 2009/2010. Increases ranged from around 4pp of GDP in Italy and Germany, to 6-7 pp in the UK and US to over 10pp in Ireland. The expenditure increase was particularly strong in the countries where a creditfed real estate and financial sector boom had artificially inflated
Such an exercise was conducted by us last year (Hauptmeier et al, 2011). The study found that most euro area countries had pursued expenditure policies that were more expansionary than a reasonable expenditure rule would have proposed.
298
Table 2: Recent total expenditure developments

% of G DP 1999 2007 2009 2010 Change 1999-2007 2007-2010 Programme countries Greece Ireland Portugal Large euro area countries Germany France Italy Spain Large non-euro area countries United States United Kingdom 34,2 38,9 36,8 43,9 42,7 42,5 51,5 50,6 2,7 5,0 5,6 6,7 -2,8 -2,7 -10,6 -10,3 48,2 52,6 48,1 39,9 43,5 52,6 47,6 39,2 48,1 48,1 56,7 56,6 51,6 50,3 46,3 45,6 -4,7 0,0 -0,5 -0,7 4,5 4,0 2,6 6,4 0,2 -2,8 -1,6 1,9 -4,1 -7,1 -4,5 -9,3 44,8 33,9 41,0 47,6 36,6 44,4 53,8 50,2 48,9 46,8 49,9 51,3 2,8 2,7 3,4 2,6 10,2 7,0 -6,8 0,1 -3,2 -10,8 -11,3 -9,8 Memoradum: deficit 2007 2010
Table 2: Recent expenditure developments for selected countries

% of GDP 1999 2007 2009 2010 Change 1999-2007 Programme countries Greece Ireland Portugal Large euro area countries Germany France Italy Spain Large non-euro area countries United States United Kingdom 30,4 36,0 34,0 41,7 40,2 49,6 39,8 47,7 3,5 5,6 5,9 6,0 45,1 49,6 41,5 36,4 40,7 49,9 42,7 37,6 45,4 54,3 47,1 44,5 45,4 54,2 45,9 43,7 -4,4 0,3 1,2 1,2 4,7 4,3 3,2 6,1 37,3 31,5 38,1 42,8 35,6 41,4 48,7 46,9 47,0 44,4 43,7 48,3 5,5 4,1 3,3 1,6 8,1 7,0 2007-2010
Source: Ameco
299
Table 2: Recent cyclically adjusted primary expenditure developments % of GDP 1999 2007 2009 2010 Change 1999-2007 2007-2010 Programme countries Greece Ireland Portugal Large euro area countries Germany France Italy Spain Large non-euro area countries United States United Kingdom Source: Ameco 0,0 36,1 0,0 41,7 0,0 49,5 0,0 47,6 0,0 5,7 0,0 5,9 45,1 49,7 41,5 36,5 40,9 50,1 42,7 37,7 45,0 54,1 47,0 44,3 45,2 54,0 45,8 43,4 -4,1 0,4 1,2 1,2 4,3 4,0 3,1 5,7 37,3 31,7 38,2 42,9 35,8 41,4 48,6 46,6 46,9 44,4 43,5 48,3 5,5 4,0 3,2 1,5 7,7 6,9
GDP. When this reversed over the crisis, both higher spending and lower GDP drove up the expenditure ratio. Virtually all of the expenditure ratio increase was on public consumption and transfers and subsidies; public investment went up only slightly in a few countries. Greece, Ireland and Spain also reported higher interest expenditure as the rapidly rising debt ratio and higher interest rates started to affect public budgets.
Where did countries stand in the third year of the crisis, 2010? None of our sample countries still featured a relatively small public
300
sector of below 40% of GDP (as defined by Tanzi and Schuknecht, 2000). Even the US, at 41.3% of GDP, featured a public sector that was not much smaller than the euro area average before the crisis. Greece, Portugal, France, Italy and the UK reported public spending ratios of around to significantly above 50%.
It has been argued that the increase in expenditure ratios is not very relevant as it presumably reflects almost solely the crisis and should, thus, reverse itself over time as the economy normalises. This reasoning implicitly assumes that output levels and growth rates will more or less return to pre-crisis levels. As a large output gap would be closed, public commitments should decline relative to GDP. However, if the pre-crisis GDP was artificially inflated by booming sectors which have to shrink then both GDP level and growth rates may be significantly lower post-crises. If the 2010 output gap was only small, 2010 deficits and expenditure ratios would in fact represent structural features of the examined economies. In any case, significant fiscal adjustment is needed which in some cases exceeds 10 pp of GDP in the coming years (IMF, 2011).
3.1. A disaggregated assessment of past expenditure policies

To assess in more detail what drove expenditure developments since the start of EMU, this section provides an analysis the public expenditure stance across the three main expenditure components that governments can influence in the short term: government consumption, transfers and subsidies and public investment. We
301
apply the same methodology as in Hauptmeier et al (2011): given the existing levels at the start of the EMU (1999), actual public expenditure developments are assessed against an expenditure path that should have been taken if countries had followed a neutral expenditure stance, i.e. if governments had aligned expenditure growth to that of potential GDP. The latter is measured on the basis of two expenditure rules: (a) nominal potential GDP growth (NPG rule) and (b) real potential GDP growth plus the growth rate of the GDP deflator capped at the ECBs price stability objective of below but close to 2% (RPECB) based either on real time or ex post data. This counter factual analysis provides four measures of the expenditure stance.5 Deviations are analysed by looking at marginal (annual) and/or cumulative (total period) deviations (expressed as percentage of GDP). According to this procedure, on the one hand, marginal deviations help to identify the year(s) in which expansionary/restrictive policies were implemented. On the other hand, cumulative deviations measure the degree of expansionary/restrictive policies in percentage points (pp) of GDP accumulated over the period (1999-2010).
Firstly, to provide a general perspective, we focus on cumulative effects for the aggregate euro area (Chart 2), comparing actual and rule-based expenditure developments (expressed as percentage of GDP).
5 The earlier study applied six measures but the two additional ones did not provide much additional insights.
302
Chart 2: Euro Area (12). Expenditures ratios as implied by a neutral expenditure stance, across rules. Primary expenditures
Public consumption
303
Chart 2: (cont.) Euro Area (12). Expenditures ratios as implied by a neutral expenditure stance, across rules.
Public investment
304
Looking at the primary expenditures stance - panel a - suggests a co-movement with the NPG rules which indicates the absence of a prudence margin to operate when difficulties appear. Looking at the disaggregated developments, i.e. the main expenditure components, gives a different picture: First, the results for public consumption show an expansionary expenditure stance on this category adding up to 0.5-2pp of GDP, depending on the respective expenditure rule. Second, for the transfers and subsidies component, a strong counter-cyclical behaviour is observed, as one would expect. However, the decreases in economic good times were much less significant than the increases during the crisis. Finally, the pattern for public investment is clearly pro-cyclical. At the same time, the adjustments carried out by some countries during 2010 can be already observed (returning to 2004 levels).
To complement this general view, we briefly describe the country pattern for the main expenditure components.6 As in
Hauptmeier et al. (2011), for primary expenditures, we observe a restrictive expenditure stance for Germany whereas all other countries show an expansionary policy stance over the 1999-2010 periods, notably as regards public consumption as well as transfers and subsidies. However, the degree of expansion is different among components. On the one hand, in the case of public consumption, the magnitude of cumulative expansion ranged from near zero for
6 For the sake of brevity, related country-specific results are not included in the main text. They are available from the authors upon request.
305
France to up to 5pp of GDP for Ireland. On the other hand, for transfers and subsidies, Germany is highly restrictive by 2-3 pp, and the rest is expansionary by 1-7pp depending on the rule and country.
Finally, for public investment, the development of the cumulative expenditure stance is quite interesting: restrictive for Germany and Portugal, neutral for Italy and expansionary for all other countries with a tendency of neutralisation in 2010. However, overall magnitudes are small.
In a second step, we repeat this same exercise component by component, in order to decompose the cumulative deviation observed. This analysis provides a view of the respective stance of each expenditure component. The list of indicators included is in line with those presented so far; i.e. (i) public consumption, (ii) transfers and subsidies, (iii) public investment, and (iv) other expenditures. Moreover, we split our sample period into subperiods to show the role of (i)-(iv) before (1999-2007) and during the crisis (2008 2009, 2009-2010).
First, looking at the expenditures stance, Chart 3 presents the decomposition of cumulative effects observed for ex-post and realtime rules. When compared real-time and ex-post rules behaviour both similarities and differences are found. While on the one hand the dynamics are very similar, quantitative differences emerge especially during sub-period (II), i.e. 2007-2009.
306
Chart 3: Decomposition of cumulative changes to public primary spending ratios compared to a neutral expenditure stance for selected periods (I) Real-time NPG rule. 1999-2007
%GDP
(II) Ex-post NPG rule. 1999-2007
%GDP
307
Chart 3. (cont.) Decomposition of cumulative changes to public primary spending ratios compared to a neutral expenditure stance for selected periods (I) Real-time NPG rule. 2007-2009
%GDP
(II) Ex-post NPG rule. 2007-2009
308
%GDP
Chart 3. (cont.) Decomposition of cumulative changes to public primary spending ratios compared to a neutral expenditure stance for selected periods (I) Real-time NPG rule. 2009-2010
%GDP (II) Ex-post NPG rule. 2009-2010

%GDP
309
An alternative way to look at these figures is going through the different sub-periods. First, deviations in the pre-crisis period are clearly dominated by public consumption. Moreover, if we leave out Germany as the only restrictive country over this period, two different country patterns can be observed: major deviations from trend as regards public consumption in Italy, Spain and Ireland while Greece and Portugal show strongly expansionary trends in transfers and subsidies. Second, deviations from trend in transfers become relatively more important with the start of the financial and economic crisis.
3.2. Determinants of the expenditure stance

An empirical analysis of factors that influence countries expenditure stances can provide further information on the determinants of expansionary expenditure policies in the past. Hauptmeier et al. (2011) therefore applied standard fixed-effects panel estimation techniques on a sample of 12 euro area countries for the 2000-2009 period using the measure for the expenditure stance described above, i.e. the (marginal) deviations of actual spending growth from rule-based or neutral spending (under the NPG and the RPECB rule in ex-post terms), as the dependent variable.
The aim of this empirical exercise was to explain the governments expenditure stance on the basis of fiscal and macroeconomic factors, relevant institutional characteristics as well as political
310
economy variables. The results of the analysis are presented in Table 3.
As one would expect, the macroeconomic environment measured by the output gap (in % of potential GDP) constitutes an important determinant of the expenditure stance. We find robust support for a positive correlation between the output gap and the expenditure stance across rules and estimations, suggesting a procyclical spending behaviour.
As regards fiscal factors, surprisingly the level of public indebtedness does not seem to significantly affect our measure of the expenditure stance. We also do not find robust evidence for an effect of revenue windfalls that arguably could increase spending profligacy. We capture such windfalls by including the excess revenue growth in a given year relative to previous years Autumn forecast by the European Commission. However, while we see the expected positive sign the effect is not significant.
We find empirical support for the importance of political economy factors. In particular, parliamentary elections at the national level (Electoral cycle 1) tend to significantly increase the deviation of actual from rule-based primary spending. The opposite holds true for a second election-related variable (Electoral cycle 2) which captures the years left in the current election term. The negative sign on this variable suggests that the incentives for fiscal discipline can be expected to be higher at the beginning of the legislative period. We
311
Table 3: Determinants of expenditure stance Dependent variable: Deviation of primary spending growth from rule-based growth rate Panel A: Ex-post Nominal Potential GDP (NPG) rule
(I) Output gap (based on Potential GDP) 0,525 Public debt ratio (t-1) Crisis dummy Strenght of expenditure framework * Output Gap (II) 0,476 (III) 0,401 (IV) 0,463 (V ) 0,274 [1.65] 0,042 [0.83] 2,241 [1.08] (VI) 0,374 [2.22]* 0,033 [0.67] 2,34 [1.13] (VII) 0,476 [3.00]** 0,057 [1.03] 3,341 [1.22] -0,262 [2.08]* 0,09 [0.46] -0,08 [0.86] Electoral cycle 1 Electoral cycle 2 Government Stability EDP Constant -2,941 [0.72] Observations Number of countries R-squared corr u_i and Xb adjusted R-squared R-squared overall model R-squared within model R-squared between model standard deviation of epsilon_it panel-level standard deviation fraction of variance due to u_i 108 12 0,1 -0,76 0 0,02 0,1 0,56 4,52 2 0,16 -2,998 [0.77] 108 12 0,11 -0,76 0,01 0,02 0,11 0,53 4,51 2,13 0,18 -1,47 [0.39] 108 12 0,11 -0,57 -0,01 0,05 0,11 0,58 4,54 1,43 0,09 -4,148 [0.97] 108 12 0,14 -0,79 0,05 0,03 0,14 0,57 4,42 2,55 0,25 -0,006 [0.00] 90 10 0,13 -0,52 0,01 0,07 0,13 0,49 4,15 1,24 0,08 -0,512 [0.13] 90 10 0,11 -0,47 -0,02 0,06 0,11 0,38 4,2 1,05 0,06 2,204 [3.64]*** -0,812 [3.66]*** -2,699 [3.26]*** 0,308 [0.16] -3,079 [0.78] 108 12 0,11 -0,77 0 0,02 0,11 0,53 4,53 2,17 0,19
[3.78]*** [3.01]** [2.50]** [3.04]** 0,054 0,056 0,035 0,071 [0.96] 3,946 [2.17]* [1.04] 3,649 [1.74] -0,262 [2.09]* [0.62] 4,028 [1.64] [1.20] 3,138 [1.75]
Surprises in Revenues growth Strenght of expenditure framework * Surprises in revenues growth
312

Table 3. (cont) Panel B: Ex-Post Real Potential GDP +ECB price stability objective (RPECB) rule
(I) Output gap (based on Potential GDP) Public debt ratio (t-1) Crisis dummy Strenght of expenditure framework * Output Gap Surprises in Revenues growth Strenght of expenditure framework * Surprises in revenues growth Electoral cycle 1 Electoral cycle 2 Government Stability EDP Constant -2,808 [0.75] Observations Number of countries R-squared corr u_i and Xb adjusted R-squared R-squared overall model R-squared within model R-squared between model standard deviation of epsilon_it panel-level standard deviation fraction of variance due to u_i 108 12 0,08 -0,82 -0,02 0,01 0,08 0,61 4,34 2,04 0,18 -2,855 [0.82] 108 12 0,09 -0,82 -0,02 0,01 0,09 0,61 4,34 2,16 0,2 -0,747 [0.22] 108 12 0,09 -0,55 -0,02 0,04 0,09 0,58 4,35 1,24 0,07 -3,792 [0.97] 108 12 0,11 -0,83 0,01 0,01 0,11 0,62 4,28 2,49 0,25 -0,392 [0.10] 90 10 0,14 -0,61 0,01 0,07 0,14 0,4 4,09 1,36 0,1 -0,879 [0.23] 90 10 0,11 -0,58 -0,01 0,06 0,11 0,37 4,15 1,18 0,07 0,469 0,057 [1.19] 2,882 [1.56] (II) 0,429 0,059 [1.33] 2,634 [1.26] -0,219 [1.75] 0,172 [0.91] -0,044 [0.59] 1,798 [3.40]*** -0,798 [4.17]*** -2,544 [3.48]*** -0,02 [0.01] -2,85 [0.83] 108 12 0,09 -0,82 -0,03 0,01 0,09 0,61 4,36 2,16 0,2 (III) 0,299 0,031 [0.64] 3,267 [1.26] (IV) 0,419 0,071 [1.40] 2,223 [1.22] (V) 0,277 0,053 [1.18] 1,685 [0.74] (VI) 0,377 [2.58]** 0,044 [0.98] 1,793 [0.78] (VII) 0,429 [2.72]** 0,058 [1.33] 2,654 [0.90] -0,219 [1.74]
[3.92]*** [2.74]** [2.39]** [3.20]*** [1.94]*
Notes: Baseline (I), Baseline + Institutional framework (II and III), Baseline + electoral cycle and government stability , (IV - VI) and Baseline + European Institutions(VII). Source: Hauptmeier, S., Snchez-Fuentes, A.J. & Schuknecht, L. (2011)
313
also control for government stability as measured by the respective index of the World Bank and find that the policy stance on the spending side is less expansionary if a government scores a higher value.
Most interestingly from a policy perspective, our results suggest that the country-specific institutional framework exerts a significant effect on the expenditure stance. In particular, we control for the extent to which national expenditure policy faces domestic institutional constraints using the expenditure rules index as developed by Debrun et al. (2008).7 We interact this index with the output gap to analyse to what extent strong institutions reduce spending profligacy and find that, indeed, the strength of the national institutional framework on the expenditure side significantly reduces the procyclicality of the expenditure stance. This finding is along the lines of Holm-Hadulla et al (2010), Turini (2008) and Wierts (2008). At the same time, the EDP dummy which is included to capture whether a country is facing an excessive deficit procedure (EDP) due to deficits above the 3% of GDP reference value of the Stability and Growth Pact, does not turn up significantly in our regressions.
The results on the impact of fiscal institutions may be put into the perspective of the recent efforts to strengthen the European fiscal framework. One of the lessons from past fiscal developments in
7 For a definition and a detailed description of the computation of this index see European Commission (2006) and Debrun et al. (2008). The index takes into account the share of public spending covered by the rule and qualitative features such as the type of enforcement mechanisms and media visibility.
314
euro area countries is that the implementation of the Stability and Growth Pact has not been effective in delivering sound and sustainable fiscal positions in Member States. While one has to be careful when interpreting the non-significance of the effect of the EDP procedure dummy, the result is in line with this perception. Moreover, the empirical analysis suggests that national budgetary rules if well-designed can help to effectively reduce spending profligacy and therefore serve as important tools to promote sound and sustainable public finances in line with the European fiscal framework. This reinforces the need for enhancing national fiscal rules and frameworks as had been proposed by the European Commission in the autumn of 2010.
3.3. Implications for public debt

Based on the analysis presented in Section 3.1, it is possible to compute to what extent deviations of expenditure growth from trend led to increases in government debt. Chart 4 shows alternative debt paths for the sample economies and across expenditure rules. Consistent with the previous results, real time rules typically lead to higher debt paths than ex-post rules. In the case of France, for example, following a neutral expenditure path since 2000 would have resulted in a significantly lower debt ratio in 2010, i.e. between 70% and 75% of GDP. If Italy had followed a neutral spending path, public debt would now stand roughly between 80% and 100% of GDP in 2010, rather than at around 120% of GDP.
315
For a second group of countries (Spain, Greece, Ireland and Portugal), the difference becomes even more drastic. Neutral spending policies in Portugal would have led to debt ratios of 40-60% of GDP in 2010 rather than over 80% of GDP in reality. Spanish debt would have been at a trough of 10-40% in 2007-08 and would have remained well below the reference value in 2009 under all rules. Ireland would have just about eliminated all its debt in good times and thus created significant room for the subsequent rise. Under all rules, debt would have remained below 60% of GDP in 2010. Finally, Greek public debt would have fallen to 60-80% of GDP (rather than remain broadly constant around 100% of GDP until the start of the crisis) and increased much more slowly in the crisis.
All in all, public debt positions in the euro area would have been much sounder at the start of the crisis and in 2010, if euro area countries had pursued at least a neutral expenditure stance on average during EMU. Public debt could have been well around or below the reference value in the euro area in most of its members by 2010 and nowhere above 100% of GDP.
4. Looking backward to the past, lessons for the future? an episodes based approach
In an earlier study, Hauptmeier, Heipertz and Schuknecht (2007) looked at the experience with public expenditure reform in the 1980s and 1990s. They found that there were basically two
316
Chart 4: Public debt ratios - actual vs. rule-based Euro area (12)
Germany
317
Chart 4: (cont.) Public debt ratios - actual vs. rule-based France
Italy
318
Chart 4. (cont.) Public debt ratios - actual vs. rule-based Spain
Greece
319
Chart 4: (cont.) Public debt ratios - actual vs. rule-based Ireland
Portugal
320
reform waves in industrialised countries. Moreover, they found that there were three groups of countries: (i) ambitious, (ii) timid and (iii) non-reformers. Ambitious reformers were those that managed to reduce public primary (non interest) expenditure by more than 5pp of GDP from their peak within 7 years. Timid reformers were those that cut primary spending between 0 and 5pp and non-reformers never undertook much of a cut at all. These countries and country groups, the time and size of the maximum expenditure ratio and the change in the expenditure ratio within years (T7) as reported in Hauptmeier et al. (2007) are depicted in Table 4.
The study argued that conceptually, reforms needed to be ambitious in order to make a significant difference for the resulting public deficits and adverse debt dynamics. The more ambitious they were the more they would even allow tax cuts. Already in the 1980s, Ireland, Belgium, the UK, Luxembourg and the Netherlands had significantly reduced their public expenditure ratio. The UK, Ireland and the Netherlands did so again in the 1990s plus a number of other countries: Finland, Sweden, Canada and Spain. Four countries reduced public primary expenditure by more than 10% of GDP. During this period, 10 countries undertook timid expenditure reforms (amongst them the US, France, Germany and Italy at which we will look again later). The three non-reformers included Australia, which had always maintained a rather small government sector, and Portugal and Greece.
321
Table 4: Expenditure reform phases 1980s and 1990s Max. primary expenditure in year Ambitious' reformers Finland Sweden Ireland (Phase 1) Belgium (Phase 1) Canada United Kingdom (Phase 1) Netherlands (Phase 2) United Kingdom (Phase 2) Spain Ireland (Phase 2) Luxembourg Netherlands (Phase 1) Timid' reformers Austria Denmark New Zealand United States Italy Japan Belgium (Phase 2) Germany France Switzerland Non' reformers Portugal Greece Australia 1993 1993 1982 1983 1992 1981 1993 1992 1993 1992 1981 1983 1993 1993 1985 1992 1993 1998 1993 1996 1996 1998 2004 2000 1985 Change maximum to T7 -14,0 -14,0 -12,4 -12,3 -9,5 -8,2 -7,5 -7,2 -6,4 -6,2 -5,7 -5,1 -4,3 -3,9 -3,8 -3,4 -3,0 -2,7 -2,1 -0,6 -0,5 -0,3 0,0 0,4 0,4
It is, however, not just the magnitude of spending and reform that is important but also the composition. The literature (e.g., Alesina and Perotti, 1995 and 1997) argues that reductions in public consumption/wages and transfers and subsidies are particularly high quality. They increase the chance of success of reform by providing a strong signal of willingness and cuts tend to focus on unproductive expenditure.
322
Table 5 illustrates that much of the expenditure cuts of ambitious reformers came from transfers and subsidies and also from government consumption. About two-thirds of the reduction in the total expenditure ratio and over 80 per cent of the decline in the primary expenditure ratio occurred in these two categories. Nine out of 11 reform episodes reported a decline in public consumption by more than 2 per cent of GDP and eight out of 11 featured a fall in transfers and subsidies by over 3 per cent of GDP. At the same time, in most cases, government investment and public education expenditure did not decline disproportionately or in some cases even increased as a share of GDP. Timid reformers did not report much of a decrease in public transfers and subsidies and focussed on public investment in some cases and on public consumption including education in others.
The study by Hauptmeier et al. (2007) also argued that public expenditure reform needed to be part of a comprehensive overall structural reform strategy. It was argued on the basis of the literature that this would allow the improvement in public finances not only via less spending but also via better growth prospects. An overview of the reforms undertaken by ambitious countries is reported in Table 6. Most of the ambitious reformers undertook major reforms that were complementary to expenditure retrenchment. Most countries strengthened their national fiscal institutions. This not only facilitated fiscal retrenchment but also tended
323
324
Interest Spending Health Education Pensions Primary expenditure Government consumption Government investment Transfers and Subsidies
Table 5: Composition of expenditure reform
Change T0-T7
Total expenditure
Ambitious' reformers
Finland
-15,7 -1,8 -14,0 -12,4 -6,2 -9,5 -5,3 -2,5 -1,9 -2,7 -1,5 -3,9 -1,4 -2,0 -1,1 -1,0 1,0 -2,1 -0,2 0,1 -0,3 -8,2 -7,5 -7,2 -6,4 -6,2 -5,7 -5,1 -0,5 -3,3 -2,0 -6,5 -2,6 -4,1 -4,7 0,0 -2,2 -3,9 1,0 -4,7 -5,2 -3,2 -2,2 -1,7 -0,5 -1,1 -0,3 -0,8 -0,1 -0,4 -0,5 0,1 -0,1 -2,8 -0,4 -1,0 -4,8 -1,7 -2,3 -2,3 0,1 -1,8 -4,8 -0,4 0,2 -0,9 -8,0
-1,6
-14,0
-3,8
-0,3
-9,4 -1,3
-1,8 0,2 -0,9 -0,9 -1,9 -0,8 -0,4 -0,8 0,0 -0,9 -1,6 -1,1
-1,5 -1,7 -0,7 -1,6 -0,2 -0,5 -1,2 -0,4 0,2 -1,6 -0,8 0,4
Sweden
-15,7
Ireland (Phase 1)
-13,3
Belgium (Phase 1)
-10,9
Canada
-11,4
United Kingdom (Phase 1)
-10,5
Netherlands (Phase 2)
-9,8
United Kingdom (Phase 2)
-7,1
Spain
-8,2
Ireland (Phase 2)
-10,9
Luxembourg
-5,9
Netherlands (Phase 1)
-5,0
to make future budgetary control and thus the avoidance of fiscal problems more likely.8 A number of countries devalued their
currencies. All ambitious reformers initiated significant labour market reforms that improved work incentives. All but one country reformed the tax system. And most countries reduced the
Table 6: Summary findings for ambitious reform episodes
Expenditure reform
Structural reform Institutional Other macroeco- Labour reform nomic reform market Taxation Privatisation incentives
Public Transfers & consumption subsidies 1/ 1/
Ireland 1 Ireland 2 Sweden Canada Finland Belgium Netherlands 1 Netherlands 2 Spain UK 1 UK 2 All
XX X X XX XX XX X ~ ~ X X 9
XX XX XX XX XX XX X XX XX X X 11
X X X X X
X X
X X X X X
X X X X X
X X
X X
X X X X X
X X X X X 10
X X X X X 10 8 X X X
X X
11
8 For the importance of fiscal rules and institutions, see, e.g., Poterba and Von Hagen (1999). Debrun et al. (2008) and Holm-Hadulla et al (2011) focus on the numerical fiscal rules in EU countries.
325
role of the state in the economy via privatisation. Based on the fact that the reforming countries fulfilled the conjectures of ambition, high quality and comprehensive reforms it is not surprising that the impact on public finances and the economy were quite positive, compared to timid reformers (Chart 5). Panel a) shows that ambitious reformers (here differentiating early and late reformers) brought the public expenditure ratio down significantly to levels similar or lower than those of timid reformers. This was mainly achieved through cuts in public consumption and transfers and subsidies while public investment did not change much, at least for late ambitious reformers (see panels b)-d)). Panel e) illustrates that public deficits were brought down very substantially by ambitious reformers. The group of late reformers even reached sizable surpluses. As regards public debt developments (panel f)), timid reformers did not achieve any significant reversal in debt dynamics. Ambitious reformers, by contrast, managed to bring debt down once fiscal balances had been sound enough.
Contrary to the concerns of vocal special interests and politicians, ambitious expenditure reforms had very little (if any) adverse growth impact even in the very short run while the medium to long term impact was very positive. Ambitious reformers experienced a significant increase in trend growth by 1-2 percentage points (panel g). By contrast, timid reformers experienced no such increase. Real private consumption started to recover as of the first year of public expenditure reduction and accelerated more strongly where ambitious reforms were undertaken (panel g). Private invest326
Chart 5: Ambitious vs. timid reforms, 1980s and 1990s. a) Total public expenditures
b) Public consumption
327
Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. c) Transfers and subsidies
d) Public investment
328
Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. e) Fiscal balance
f) Public debt
329
Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. g) Trend growth
h) Real private consumption
330
Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s. i) Private investment
Source: Hauptmeier, S., Heipertz, M. & Schuknecht, L. (2007)
ment initially declined or was flat and showed a relatively less favourable trend than for timid reformers but this reversed in the medium term. In the seventh reform year, the private investment ratio of timid reformers had increased by 1pp of GDP while that of ambitious reformers had increased by 2-3pp (panel i).
In a next step we assess recent and projected fiscal developments for 2012 and 2013 in selected euro area countries as well as the UK and the US in the light of the evidence from past expenditure reform periods described above. We do this on the basis of the latest European Commission forecast (Autumn 2011) (see Table 7). For the US we consider the latest IMF World Economic Outlook
331
projections. For all sample countries, the projections point to significant primary expenditure reductions for the period up to 2013 (with the exception of France). This ranges from about 3-4pp of GDP for Germany, Italy and the US to over 5pp in the UK and Spain and to 7 to 10pp in the EU/IMF programme countries. Expenditure reductions show a more or less linear pattern in most countries. In the case of the US, the primary expenditure ratio went down quite strongly in 2010. However, it is expected to decline only by another 1pp of GDP over 2011-13.
Table 7: Expenditure plans % of GDP Actual 2009 Programme countries Greece Ireland Portugal Large euro area countries Germany France Italy Spain Large non-euro area countries United States UK 42,1 49,6 39,3 47,7 39,6 46,8 39,0 45,3 38,5 43,9 -3,7 -5,6 45,4 53,8 47,1 44,5 45,4 54,2 45,9 43,7 43,3 54,0 44,8 40,8 43,2 54,3 43,8 39,8 42,8 53,9 43,0 39,3 -2,6 -0,3 -4,1 -5,2 48,7 46,9 46,9 44,4 43,7 48,3 43,6 42,1 44,9 42,4 39,6 42,0 41,7 37,0 39,9 -6,9 -9,9 -8,4 2010 2011 2012 Primary expenditure Forecast 2013 2013 to max(0910)
Sources: Actual and forecasts: EU Commission (Ameco), IMF for the US.
332
If projected spending developments materialise, primary expenditure ratios would decline to around 40% of GDP in most countries. The main exception is France where the ratio would remain significantly above 50%.
Projected spending developments should also be assessed from a longer term perspective. When comparing the 2013 figures to the 1999 primary expenditure ratios it is noteworthy that spending would still be 1-7pp of GDP higher in 2013 than in 1999 for 8 out of 9 countries. This relative increase would be particularly sizeable for Ireland, the US and the UK and appears unwarranted in view of the expected ageing-related increases in social security outlays in the medium and long-term. Only Germany would post a significantly lower primary expenditure ratio than at the start of EMU.
Coming back to the adjustment effort in countries expenditure plans, it is noteworthy that five countries (Ireland, Greece, Portugal, Spain and the UK) would meet the criteria of ambitious reformers as applied in the earlier study by Hauptmeier et al. (2007) whereas a second group of countries could be classified as timid reformers (Germany, USA, and Italy).
5.The need for prudent expenditure rules

The evidence presented in this study supports the view that public spending has been a major determinant of unsound public
333
finance developments in the past. Looking forward, it therefore seems plausible to address this fact through the implementation of prudent expenditure rules. Indeed, empirical studies suggest that well-designed expenditure rules tend to limit the pro-cyclicality of public spending (see, e.g. Holm-Hadulla et al (2010)). Recent policy action in Europe goes in this direction. Notably, the EU fiscal surveillance framework has been extended by a so called expenditure benchmark which restricts the growth rate of public spending net of discretionary tax measures to that of potential growth. However, this new rule does not take into account some of the problems we identified in Section 3.1. Most notably, an effective rulebased restriction of spending policies in real-time requires the maintenance of a margin of prudence. This is necessary to account for the tendency of overestimating potential GDP growth in realtime. Given the past experience of systematic and persistent downward revisions in potential growth, a margin of prudence of pp in expenditure growth per annum appears warranted. In addition, excessive price developments should not automatically feed into higher expenditure growth as expansionary fiscal policies may accelerate an economic overheating. Therefore, the nominal component of an effective expenditure growth rule should be capped, e.g. at the ECBs price stability objective (close to but below 2%).
Chart 6 shows that the application of such prudent expenditure growth rules during EMU would have resulted in much safer fiscal positions. Primary expenditure ratios would have reached much lower levels in 2009. As a result, also public debt ratios in
334
Chart 6: Actual ratios versus neutral expenditure policies-based ratios (based on NPG pp and RPECB pp rules), 2009 Panel A: Primary expenditure ratios
Panel B: Public Debt ratios
Note: Includes GDP multiplier and compound interest effects.
335
2009 would have generally been much closer to 60% of GDP with the highest ratio of around 90% in Italy. It is important to note, however, that the proposed expenditure rules are intended to provide guidance for an appropriate, i.e. neutral, policy stance in the absence of fiscal imbalances. Any fiscal adjustment, e.g. to regain sound fiscal positions in the aftermath of the crisis, would of course require a restrictive policy stance, i.e. spending growth rates below potential GDP growth.
6. Concluding remarks
What are the main findings of this study and what policy lessons can be drawn? Public finances in advanced economies are at a crossroads. In the fifth year of the crisis, fiscal deficits remain high and public debt has reached unprecedented peace-time levels in most industrialised countries. Public primary expenditure stands at or near historical peaks in many countries and therefore constitutes an important determinant of the fiscal imbalances. It therefore seems straight forward to focus on expenditure restraint when striving to regain sound fiscal positions in the aftermath of the crisis.
In the 1980s and 1990s a number of countries undertook ambitious expenditure reforms. Their experience, which was briefly reviewed here, has been very positive. Within a few years from the start of expenditure reform, public expenditure ratios went down significantly, fiscal deficits largely or fully disappeared, public debt
336
was brought on a downward path, and economic growth and private consumption resumed swiftly. We argue that this was because ambitious expenditure reform was conducted in a growth-friendly manner as part of comprehensive adjustment programmes.
Our study emphasises the key role of expenditure policies in explaining fiscal developments during EMU in the euro area. It finds that, almost all euro area countries (with the notable exception of Germany) applied expansionary expenditure policies already before the crisis. This resulted in much higher expenditure and debt paths compared to a counterfactual neutral expenditure stance. Rulesbased spending policies could have led to much safer fiscal positions much more in line with the EUs Stability and Growth Pact (SGP).
The policy recommendations from these findings are obvious: countries should focus on reducing public spending in the context of ambitious reform programmes. Spending based consolidation efforts need to be complemented by structural reforms, notably with a view to removing rigidities in national labour and product markets, to reduce macroeconomic imbalances, improve competitiveness and support potential growth. This will be particularly important for the vulnerable countries in the euro area which do not have available the exchange rate mechanism to improve external competitiveness. Latest projections suggest that governments consolidation plans in a number of countries indeed put a focus on reducing government expenditure as a ratio to GDP in the coming years. However, the benefits of reforms are only going to materia337
lise under one condition, namely that all these plans are fully and adequately implemented. This is their main challenge.
In addition, the empirical evidence on the determinants of euro area countries expenditure stance provide a number of policy implications. First, strong national budgetary institutions seem to limit expansionary spending biases. Second, the European institutional framework needs to feature prominently expenditure monitoring and control. The incorporation of an expenditure benchmark in the preventive arm of the Stability and Growth Pact in the context of the recent Six-Pack reform therefore constitutes a step in the right direction. An effective enforcement of this rule should help to limit overly expansionary spending policies in the future.
Furthermore, this chapter argues that a potential growth rule with an extra percentage point deduction from the resulting annual expenditure growth targets would be a sufficiently prudent and, thus, advisable expenditure rule for euro area countries. As economic (e.g., population aging) and political economy reasons suggest that overestimating potential growth could also occur in the future, such a rule could provide a reasonably prudent benchmark for a neutral expenditure stance looking forward.
How does the debate on the overhaul of European economic governance fare against these conclusions? At the time of completing this study (March 2012), EU member states have set up new EU economic governance principles with a view to ensuring a tighter and more
338
effective surveillance of economic and fiscal policies at the European level. At the same time, policy makers have agreed - in the context of the new fiscal pact - to strengthen national fiscal frameworks.
All in all, a stringent implementation and enforcement of the fiscal surveillance at European level could well ensure the necessary break with past expenditure trends and thus also secure sustainable deficits and debt dynamics in the future. However, it remains to be seen whether the main obstacle of the old frameworklack of incentives and enforcementis really sufficiently remedied.
Bibliography
- Alesina, A. and R. Perotti (1995) Fiscal expansions and adjustments in OECD countries, Economic Policy, vol. 10, pp. 20548.
- Alesina, A. and R. Perotti (1997) Fiscal adjustments in OECD countries: Composition and macroeconomic effects, IMF Staff Papers, vol. 44, pp. 21048.
- Brck, T. and R. Zwiener (2006) Fiscal policy rules for stabilisation and growth: A simulation analysis of deficit and expenditure targets in a monetary union, Journal of Policy Modeling, 28, 357369.
- Cimadomo, J. (2008) Fiscal policy in real time, Working Paper 919, European Central Bank.
339
- Coenen, G, C., Erceg, C. Freedman, D. Furceri, M. Kumhof, R. Lalonde, D. Laxton, J. Lind, A. Mourougane, D. Muir, S. Mursula, C. de Resende, J. Roberts, W. Roeger, S. Snudden, M. Trabandt and J. int Veld (2010) Effects of fiscal stimulus in structural models, Working Paper, 10/73, International Monetary Fund.
- Debrun, X., L. Moulin, A. Turrini, J. Ayuso-i-Casals and M. Kumar (2008) Tied to the mast? National fiscal rules in the European Union, Economic Policy, 23 (54), 297362.
- European Commission (2006) Public finances in EMU - 2006, European Economy, 3, Brussels.
- Hauptmeier, S., M. Heipertz and L. Schuknecht (2007) Expenditure reform in industrialised countries: a case study approach, Fiscal Studies, 28 (3), 293-342.
Hauptmeier, S., A.J. Snchez-Fuentes and L. Schuknecht (2007)
Towards expenditure rules and fiscal sanity in the euro area, Journal of Policy Modeling, 33, 597-617.
- Holm-Hadulla, F., S. Hauptmeier and P. Rother (2010) The impact of numerical expenditure rules on budgetary discipline over the cycle, Working Paper 1169, European Central Bank.
- International Monetary Fund (2011) Shifting Gears Tackling Challenges on the Road to Fiscal Adjustment, IMF Fiscal Monitor, April 2011, Washington D.C.
340
- Menguy, S. (2008) A dynamic rule applied to the threshold imposed on the European budgetary deficits, Journal of Policy Modeling, 30, 10931105.
- Morris, R. and L. Schuknecht (2007) Structural balances and revenue windfalls - the role of asset prices revisited, Working Paper 737, European Central Bank.
- Poterba, J. and J. Von Hagen (eds.) (1999) Fiscal Institutions and Fiscal Performance, University of Chicago Press, Chicago.
- Schuknecht, L. (2009) Booms, Busts and Fiscal Policy. Public Finances in the Future? London: Politeia.
- Schuknecht, L. (2011) Fiscal activism in booms, busts and beyond, forthcoming in Banca dItalia, 2011.
- Tanzi, V. and L. Schuknecht (2000) Public Spending in the 20th century: a global Perspective. Cambridge: Cambridge University Press.
- Turrini, A. (2008) Fiscal policy and the cycle in the Euro Area: The role of government revenue and expenditure, European Economy - Economic Papers 323, European Commission.
- Van Riet, A. (ed.) (2010) Euro area fiscal policies and the crisis, Occasional Paper 109, European Central Bank.
- Wierts, P. (2008) How do expenditure rules affect fiscal behaviour?, DNB Working Paper 166. 341

The Future of The Euro (Brown Book 2012)

Uploaded by

Copyright:

Available Formats

You might also like

The Future of The Euro (Brown Book 2012)

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Future of The Euro (Brown Book 2012)

Uploaded by

Copyright:

Available Formats

BROWN BOOK

XXVIII EDICIN DEL LIBRO MARRN

The Future of the Euro

The Future of the Euro

The Future of the Euro

2. Nature and Causes of the Euro crisis Jos Carlos Dez

Mnica de Oriol President of Crculo de Empresarios

/JAVIER ANDRES * / RAFAEL DOMENECH**/

The future of the Euro after the Great Recession

The future of the Euro after the Great Recession

The Future of the Euro

The future of the Euro after the Great Recession

2. From the Great Moderation to the Great Recession

The Future of the Euro

The future of the Euro after the Great Recession

funds of developed economies.

Source: OEDC (2012) Economic Outlook Database.

The Future of the Euro

The future of the Euro after the Great Recession

The Future of the Euro

Chart 3 10 year public debt interest rates in the EMU, 1995-2011

Source: ECB, Bloomberg

The future of the Euro after the Great Recession

The Future of the Euro

3. The imbalances in Europe and the EMU

The future of the Euro after the Great Recession

The Future of the Euro

Sources: AMECO, Haver, IMF, national sources and BBVA Research

The future of the Euro after the Great Recession

The Future of the Euro

Chart 5 Current account balance (% GDP)

Source: BBVA Research with data from national sources

The future of the Euro after the Great Recession

The Future of the Euro

Source: BBVA Research based on AMECO

The future of the Euro after the Great Recession

The Future of the Euro

Chart 7 Current account balance and net international position

Source: BBVA Research based on Eurostat

The future of the Euro after the Great Recession

The Future of the Euro

Source: BBVA Research based on Eurostat

The future of the Euro after the Great Recession

The Future of the Euro

38 The future of the Euro after the Great Recession

Table 2 Imbalances at the EMU

The Future of the Euro

Chart 9 GDP Growth in 2007 and 2015

Source: IMF (2012)

The future of the Euro after the Great Recession

The Future of the Euro

Table 3 Contingent Obligations of the governments 2008-2010

7,3 8,22 12,46

The future of the Euro after the Great Recession

4. The new European governance and the future of the Euro

4.1. Changes in fiscal governance

The Future of the Euro