Lessons from the Crisis - Minimal Elements for a Fiscal Union in the Euro Area Discussant Rolf Strauch, Member of the Management Board, Paris, 10 September 2013
Lessons from the crisis elements for a fiscal union Key questions: What are the minimal elements of a fiscal union that would reduce the incidence and severity of future crises? What architectural changes towards deeper fiscal integration are needed to close the gaps becoming apparent in the crisis? The paper provides: A thorough and comprehensive analysis Based on deep knowlege of current policy debate in the Euro area Therefore we find a number of agreeable lessons and policy recommendation The paper could be even more convincing, if it would sharpen the analysis in proving the effectiveness and efficiency of larger fiscal capacity at the center for crisis prevention and mitigation. 1
Lessons from the Crisis Lessons from the crisis = Causes of the crisis Large county-specific shocks have remained prevalent Member States did not fully accept the policy constraints of being in EMU - Weak fiscal policy Structural rigidities - labour and prices Market failure - mispricing of risk Combination of lack of fiscal discipline and financial weaknesses exacerbated the sovereign-banking link Deeper financial integration lead to stronger contagion after the start of the crisis?? 2
Lessons from the Crisis Macro-economic Imbalances Macroeconomic divergence emerged as a consequence of the structural change marked by the inception of EMU and misaligned economic policies. Current account balance as share of GDP Nominal unit labour costs, whole economy (2000=100) 150 Germany Ireland Greece Spain Italy Portugal 140 130 120 110 100 90 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 Source: Eurostat 3
Lessons from the Crisis Financial Integration and Contagion The increasing perceived risk among financial institutions was preceded and accompanied by a process of financial disintegration,. 4
Lessons from the Crisis and may have been driven by a high degree of uncertainty about bank balance sheets and general concerns about the financial stability of the euro area. 100 80 60 40 20 0-20 -40-60 -80-100 Cumulative returns on basket of safe assets eurozone banks stocks 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Source, Bloomberg, ESM calculations Note: cumulative returns of DE/US 10 year yields, Gold, EUR visavis CHR, JPY, NOK, euro area consumer goods visavis the index and high US dividend firms visavis S&P 500 5
Minimal Elements of Fiscal Union European Policy Initiatives European Member States have taken a broad set of initiatives to address the causes of the crisis and prevent future incidents or mitigate the impact. - EFSF/ESM (incl DBR Instrument) Euroa area financial / fiscal support - SRF - ECB non-standard MP measures (incl. OMT) Regulation/ Governance - Two Pack; Six Pack; Fiscal Compact - ESIs, ESRB - Bank regulatory strengthening (Basel III, EBA) - SSM - BRRD/SRM - State Aid Regulation Risk reduction / crisis prevention Risk sharing / crisis mitigation 6
Minimal Elements of Fiscal Union - What else? - Better governance and more fiscal capacity at the center - EFSF/ESM (incl DBR Instrument) - SRF Euro area financial / fiscal support - ECB non-standard MP measures (incl. OMT) - Rainy day fund - Unemployment insurance - Euro area budget - Two Pack; Six Pack; Fiscal Compact - ESIs, ESRB - BRRD/SRM - State Aid Regulation Regulation/ governance - Bank regulatory strengthening (Basel III, EBA) - SSM - Credible no-bail out rule - Centralized fiscal decision-making Risk reduction / crisis prevention 7 Risk sharing / crisis mitigation
Governance Bail-out The financial crises has brought a fundamental change to the financial market view on default risk and bail-out. 10-year government bond yields 35 DE ES IT GR IE FR AT BE NL PT FI 30 25 20 15 10 5 0 1999 2001 2003 2005 2007 2009 2011 2013 Note: Monthly averages Latest observations: August 2013 Source: Bloomberg 8
Governance Bail-out Art 125 plus ESM Treaty provisions (ESM sustainability check in line with IMF practice) plus the introduction of CACs provide a credible no bail-out regime. In practice, implementation of PSI/bail-in in Greece and Cyprus support the credibility of a no nobailout claim in the context of a rescue package. Asking for the easing of PSI eg with an automatic regime of debt-equity conversion for sovereigns bonds or very low CAC levels may itself add to market volatility and liquidity shortage. Financial markets have already adjusted to this reality (euro area countries are traded as credit risk), but an underpricing of risk may nonetheless occur due to a hunt for yield and ample liquidity Non-linearities and volatility of future market reactions when uncertainty emerges cannot be excluded. 9
Governance Centralized Authority Given the continued limitations entailed in market discipline, sufficient central control to address fiscal weaknesses and macro-imbalances will remain key. Current initiatives are very far-reaching in strengtheing rules and imposing central control if strictly implemented Reinforcing the Stability and Growth Pact Automatic consequences if 3% deficit ceiling is breached More emphasis given to debt criterion Reversed voting in Council eliminates possibility for political interference New Fiscal Compact Annual structural public deficit shall not exceed 0.5% of nominal GDP Balanced budget rule to be introduced in national legal systems Reinforced surveillance and coordination of economic policies European Court of Justice monitors implementation European Semester : yearly cycle of economic and fiscal policy coordination Country-specific recommendations; priorities include growth-friendly fiscal consolidation New focus: avoid spill-overs Better understanding and more experience needed to judge what governance changes are a necessary condition to create the minimum elements for crisis prevention and risk reduction. 10
Fiscal capacity Sizeable firepower available for crisis mitigation First Greek support package Adjustment programmes for Ireland and Portugal (EU) Second Greek support package including PSI ESM Commitments from Europe 53 bn 97 bn 144 bn 500 bn Still available - 16 bn 11 bn 456 bn Additional resources provided by Europe to IMF ECB Securities Market Programme Available for disbursement In addition, 182 bn 181 bn 220 bn - 1,196 bn 665 bn ( 7% of GDP ) ECB provides unlimited liquidity to banks ECB may conduct unlimited bond purchases on secondary market (OMT) EFSF can leverage resources if requested 11
Fiscal Capacity Crisis prevention The existing capacity has proven to be effective in calming financial markets. Euro area experience raises questions on the additional confidence effect of a stabilisation fund (1.5-2.5% of GDP). Combination of elements: The current OMT arrangement combines in principle unlimited resources with EFSF/ESM financial support and conditionality, while past policy reforms have shown their effect, and the banking union project has been designed and approved. 8 7 6 5 4 3 2 Declining long term government bond yields DE ES IT OMT announcement 1 0 Jan.12 Apr.12 Jul.12 Oct.12 Jan.13 Apr.13 Jul.13 12
Fiscal capacity - crisis mitigation Using a euro area vehicle to issue bonds in order to stabilize financing costs for member states and secure market access is valuable for crisis resolution. This is in a nutshell the financial role of EFSF/ESM. Low EFSF/ESM lending rates and favourable lending conditions provide sizeable support or implicit grant element to borrowing countries. Support structure Amount (EUR bn) Lending/Borrowing capacity (EU bn) Rating EFSF Guarantees 790 192 (440) AA+/Aa1/AA+ ESM Capital 700 500 AAA/Aa1 EU Budget 960 (2014-20) 1) 60 (EFSM) 50 (BoP) AAA/Aaa/AAA Note: 1) in value of 2011; MFF Source: EFSF, ESM, Moody s 13
Fiscal Capacity Crisis prevention and mitigation The efficiency of a fiscal insurance system may vary strongly across types of shock. It is a fairly blunt tool to address causes of the crises related to balance sheets of financial institutions compared to other approaches. Bank capital requirements/bail-in Linked to investment decision and business plan Fiscal Insurance Scheme Enforced on general taxpayer Institution specific Rules based related to bank balance sheet Supporting general government Rules based linked to economic performance Close supervision of needs (technical entity) Subject to political process 14
EFSF and ESM: Variable and efficient set of instruments Mission : to safeguard financial stability in Europe by providing financial assistance to euro area Member States Instruments Loans Primary Market Purchases Secondary Market Purchases Precautionary Programme Bank recapitalisations through loans to governments* - EFSF and ESM finance their activity by issuing bonds or other debt instruments - All financial assistance is linked to conditionality * Including in non programme countries 15
Fiscal capacity The role of financial integration The potential of financial integration as an insurance mechanism was not sufficiently developed in EMU compared to other fiscal federations. The euro area banking system has remained more fragmented than bond or money markets. The problem during the crisis was the financial disintegration due to uncertainty and possible contagion risks. This was partly reinforced by public authorities Action by national supervisors State aid regulation Regulatory initiatives and banking union is designed to overcome financial weaknesses thereby removing the uncertainty about bank balance sheets. This should help to support sustained financial integration. Sustained financial flows and continued financial integration seem to be the predominant and necessary element to mitigate efficiently future crises. In light of existing federal structures, it may have the largest potential as risk sharing mechanism. 16
Minimal Elements of Fiscal Union - Conclusion The paper provides a number of useful insights regarding the causes of the crisis and the role of risk reduction and risk sharing in monetary union. The mutualisation of fiscal responsibility through a fiscal insurance mechanism could add to the general functioning of monetary union if linked to clear policy conditionality to address moral hazard. Building a case for fiscal insurance as a crisis prevention and mitigation mechanism requires more clarity on its economic effectiveness and efficiency in view of existing crisis resolution mechanism. The political priority at this stage should be to focus on the strict application of the improved governance structure and the completion of the banking union project. 17
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