The euro crisis and the new impossible trinity Moneda y Crédito Symposium, Madrid, 3 November 2011 Jean Pisani-Ferry (Bruegel)* (*) With thanks to Silvia Merler for excellent research assistance
Outline 1. Introduction 2. The new impossible trinity 3. Which way out 4. Conclusions
1. Introduction Many non-surprises in the euro crisis (at least conceptually) Lack of fiscal discipline SGP credibility / enforcement problems (the foretold crisis) Weak SGP design Credit booms (remember the Walters critique?) Real exchange rate cycles (remember Trichet s charts) Adjustment without exchange rates (remember Mundell) Disregard for external imbalances Lack of crisis management mechanisms Weak governance (and some more..) Policy debate tends to focus on easy questions
A harder issue Paul De Grauwe (2011): EMU s shockingly fragile Illustrated by comparison between Spain and the UK Why? And what can be done?
2. The new impossible trinity National banking systems Strict no-monetary financing Financial union No co-responsibility over public debt
a. National banking systems National banking systems Responsibility of sovereigns for rescuing banks in their jurisdiction Home bias in the banks sovereign debt portfolio Results in lethal correlation of banking crises and sovereign crises Ireland Greece Italy Spain Was not perceived Financial specialisation akin any other specialisation Sovereign debt assumed safe
Sovereign exposure to banks is considerable Total bank assets to government tax receipts ratio, 2010 50.00 45.00 40.00 35.00 30.00 25.00 20.00 15.00 10.00 5.00 0.00 Source: Eurostat, Bruegel calculations
Banks exhibit strong home bias in holding of govt bonds Share of own sovereign s bonds in EA government bonds held by banks, 2010 90 80 70 60 50 40 30 20 10 0 GR MT ES PT AT IE IT DE SI LU FI BE NL FR CY share of domestic exp. in EA exposure by national banks Share in total EA General Gov. debt Share in total EA Central Gov. debt Source: EBA, Bruegel calculations
b. The no-coresponsibility principle No bail-out rule frequently misunderstood as prohibiting assistance. Art. 125: The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project Intended to ensure adequate pricing of sovereign risk by markets Did not work for 11 years Now works
c. Strict no-monetary financing Art. 123: Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as national central banks ) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments. Art. 123 prohibits institutionalised fiscal dominance, i.e. explicit agreements between government(s) and central bank(s) similar to the Fed-Treasury accord of 1951 But it does not prohibit central bank intervention on the secondary market
Where are the problems? 1. ECB has no financial stability mandate Art. 127-5 very weak The ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system Justification of SMP is to help ensure the proper transmission of monetary policy decisions 2. ECB does not have the proper governance structure One governor-one vote not appropriate for decisions with potential distributive consequences 3. ECB not made to exercise broad policy conditionality Legitimacy issue
3. Which way out The intended solution: Eliminate insolvency risk by making states super-safe The alternative solutions: Make sovereign risk manageable Restore the LLR function Revise the no-coresponsibility principle
a. Super-safe sovereigns Safe public debt levels lower than thought Need to move away from deterministic approach to budgetary surveillance, take into account implicit liabilities and tail risks Stress test the sovereigns But: Evaluation of safe debt levels elusive Goal VERY distant
The (long) way to go Required adjustment to reach 60 per cent debt ratio in 2030 2010 Illustrative Fiscal Adjustm ent Strategy to Achieve Debt Target in 2030 Gross debt Primary balance CAPB CAPB in 2020 30 Required adjustment between 2010 and 2020 Required adjustment and age-related spending, 2010 30 Austria 72.2-2.5-1.6 1.8 3.4 7.7 Belgium 96.7-0.9 0.3 3.1 2.8 8.4 Estonia 6.6 0.4 4.3 0.4-3.9-3.5 Finland 48.4-3.2-0.7 0.4 1.1 6.8 France 82.4-4.9-3.1 3.1 6.3 7.9 Germany 84.0-1.2-0.4 2.0 2.3 4.6 Greece 142.8-4.9-5.7 9.8 15.5 19.0 Ireland 94.9-28.9-6.4 5.6 12.0 13.5 Italy 119.0-0.3 1.2 4.3 3.1 4.1 Netherlands 63.7-3.9-3.1 1.3 4.4 9.7 Portugal 92.9-6.3-5.3 4.3 9.6 13.8 Slovak Republic 41.8-6.8-5.8 0.9 6.6 8.5 Slovenia 37.3-4.1-2.8 1.1 4.0 7.9 Spain 60.1-7.8-6.3 2.0 8.3 10.4 Source: IMF
b. Make sovereign risk manageable Much to do in this area Limit exposure of banks to their sovereign Prudential limits in the spirit of Art. 124 Art. 124: Any measure, not based on prudential considerations, establishing privileged access by Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States to financial institutions, shall be prohibited Banking federation Long term: European FDIC Short term: EFSF backstop to national guarantees
Euro area features not universal Country BREAK-DOWN OF GOVERNMENT DEBT BY HOLDING SECTORS (% TOTAL) Public Institutions (incl. National Central Bank) Domestic Banks other fin. institutions Non-Banks Non-Residents Greece 2.8 18.3 11.8 2.3 64.8 Ireland 1.1 13.8 2.1 0.3 82.7 Portugal 0.8 22.4 5.8 7.8 63.3 Italy 3.6 26.2 13.9 12.7 43.5 Spain 3.5 28.3 7.9 22.4 38.0 US 46.9 2.3 12.0 7.6 31.2 UK 19.8 10.8 29.0 10.0 30.4 Source: IMF, national sources, Bruegel calculations
Two limitations Political economy à la Carmen Reinhart: to limit sovereign access to their own financial institutions in times of fiscal stress is an uphill struggle Even with a safer financial system, the default of a medium-sized European state would be a major financial shock.
Qualitatively the same as in the US.. but not quantitatively 18 IT Central Government Debt as % of EA GDP versusstate Government Debt as % of US GDP 16 14 FR 12 DE % US or EA GDP 10 8 EA US 6 ES 4 GR NL BE 2 CA NY AT PT IE MASS ILLI NJ PENN FLO TEX MICH CONN 0 1 2 3 4 5 6 7 8 9 10 ranking Source: Eurostat, US Census, Bruegel calculations
c. Restore LLR role for the ECB EFSF leverage proposed by Gros-Mayer (2011) Advantages With appropriate haircut, most of the risk remains with EFSF EFSF has proper shareholding structure Distinction fiscal / monetary roles But difficulties EFSF borrowing conditions In the end was rejected
d. Fiscal union Co-responsibility and ex ante control Two key issues Which underlying guarantee structure? Joint and several Guarantee by EU budget with taxing power Responsibility for ex ante control Parliamentary (implies new body made up of NPs and EP) Judicial (ECJ)
4. Conclusions Not the only hard issue, not even the most pressing But response to the question of major importance for markets Non-exclusive solutions Yet need for package that addresses inherent weakness of euro construct Involves fundamental constitutional issues Deserves public debate