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January 2013

Lecture 4: European monetary policy, fiscal policy and the

global financial crisis

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Overview

The monetary unification of the EU Monetary and fiscal coordination in the euro zone Fiscal policy and the Stability and Growth Pact The performance of EMU 1999-2012 The global financial crisis Moral hazard, bail-outs and strains within the eurozone The outlook for European monetary union

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The long road to Maastricht and the euro

2011 Estonia joins

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The Maastricht Treaty (1)

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The Maastricht Treaty (2)

A firm commitment to launch the single currency by January 1999 at the latest

A list of five criteria for admission to the monetary union

A precise specification of central banking institutions

Additional conditions mentioned (the excessive deficit procedure)

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The Maastricht convergence criteria

Inflation: not to exceed by more than 1.5 per cent the average of the three lowest

rates among EU countries Long-term interest rate:

not to exceed by more than 2 per cent the average interest rate in the three lowest inflation countries

ERM membership: at least two years in ERM (now ERM-2) without being forced to devalue

Budget deficit: deficit less than 3 per cent of GDP

Public debt: debt less than 60 per cent of GDP (or declining satisfactorily)

All observed in 1997 for decision in 1998

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Interpretation of the convergence criteria: inflation

Straightforward fear of allowing in unrepentant inflation-prone countries

0.00

5.00

10.00

1991 1992 1993 1994 1995 1996 1997 1998

France Italy

Spain Germany

Belgium PortugalGreece average of three lowest + 1.5%

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Interpretation of the convergence criteria: long-term interest rates

Easy to bring inflation down in 1997 – artificially or not – and then let go again

Long interest rates incorporate bond markets expectations of long term inflation

So criterion requires convincing markets Problem: self-fulfilling prophecy:

if markets believe admission to euro area, they expect low inflation and long-term interest rate is low, which fulfils the admission criterion

conversely, if they don’t, all is lost

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Interpretation of the convergence criteria: ERM membership

Same logic as the long-term interest rate: need to convince the exchange markets

Same aspect of self-fulfilling prophecy

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Interpretation of the convergence criteria: budget deficit and debt

Historically, all big inflation episodes born out of runaway public deficits and debts

Hence requirement that house is put in order before admission.

How are the ceilings chosen? deficit: the German ‘golden rule’ debt: the 1991 EU average

Problem No 1: a few years of budgetary discipline do not guarantee long-term

discipline Need Stability and Growth Pact

Problem No 2: artificial ceilings

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The deficit and debt criteria in 1997

Maastricht fiscal criteria 1997

0

20

40

60

80

100

120

-3 -2 -1 0 1 2 3 4 5

Deficit (% GDP)

Pu

bli

c D

eb

t (%

GD

P)

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A tour of the acronyms

National Central Banks (NCBs) continue operating but with no monetary policy function

A new central bank at the centre: the European Central Bank (ECB)

Eurosystem/ECB independent of national governments

The European System of Central Banks (ESCB): the ECB and all EU NCBs

The Eurosystem: the ECB and the NCBs of euro area member countries (N=17)

Jean-Claude Trichet, ECB

President

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How does the Eurosystem work?

Objectives: what is it trying to achieve?

Instruments: what are the means available?

Strategy: how is the system formulating

its actions?

ECB building, Frankfurt

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Objectives (1)

The Maastricht Treaty’s Art. 105.1: ‘The primary objective of the ESCB shall be to maintain price

stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2.’

Article 2: ‘The objectives of European Union are a high level of employment

and sustainable and non-inflationary growth.’ So:

fighting inflation is the absolute priority supporting growth and employment comes next

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Objectives (2)

Making the inflation objective operational: does the Eurosystem have a target?

It has a definition of price stability: ‘The ECB has defined price stability as a year-on-year

increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.’

…and it has an aim: ‘In the pursuit of price stability, the ECB aims at

maintaining inflation rates below, but close to, 2% over the medium term.’

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Instruments

Main channels of monetary policy: longer run interest rates credit asset prices exchange rate

These are all beyond central bank control Instead it can control the very short-term interest rate:

European Over Night Index Average (EONIA) EONIA affects the channels through market expectations

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The ‘two-pillar’ strategy

The monthly Eurosystem’s interest rate decisions (every month) rests on two pillars

Economic analysis: broad review of economic conditions - growth,

employment, exchange rates, economic developments abroad (eg, oil prices)

Monetary analysis: evolution of monetary aggregates (M3, etc)

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Comparison with other strategies

The US Fed: legally required to achieve both price stability and a high level

of employment does not articulate an explicit strategy

Inflation-targeting central banks (NZ, Czech Republic, Poland, Sweden, UK, etc): announce a target (eg, 3 per cent in NZ), a margin (eg, ±1%)

and a horizon (2–3 years) compare inflation forecast and target, and act accordingly

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Taylor Rule interpretation (1)

i = i* + a( - *) + b (y - y*) i* = equilibrium interest rate

= inflation * = inflation objective (eg, 2%) y = GDP growth y* = trend GDP growth a = aversion to inflation b = aversion to cyclical fluctuations

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Taylor Rule interpretation (2)

i = i* + a( - *) + b (y - y*) By Fisher equation, i* = r* + * (eg, r* = 2%, then i* = 4%) and y* = 1.2%

ECNB weights are estimated at: a = 2.0 B = 0.8

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The ECB’s ‘Taylor Rule’?

Inflation

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1

Output gap

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1

0

1

2

3

4

5

6

7

1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1

EONIA Taylor rule

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Independence and accountability

Current conventional wisdom is that central banks ought to be independent: governments tend not to resist to the ‘printing press’

temptation the Bundesbank has set an example

ECB set up to be independent of national and EU government

What does independence mean? How does accountability work?

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Independence

Article 7: Independence

…neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body…

Article 21: Operations with public entities

…overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments

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Accountability: redressing the democratic deficit

Misbehaving governments are eventually punished by voters

What about central banks? Independence removes them from such pressure - a democratic deficit?

In return for their independence, central banks must be held accountable:

to the public

to elected representatives

The Eurosystem must report to the EU Parliament

The ECB’s President must appear before the EU Parliament when requested, and does so every quarter

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Fiscal policy in a monetary union

In a monetary union, fiscal policy

the only macroeconomic instrument at national level

government borrows in recession and pays back on behalf of citizens in good times

government acts as substitute to inter-country transfers in case of asymmetric shock

Effectiveness depends on private expectations Slow implementation of fiscal policy

Inside vs outside lags Result: countercyclical actions can have procyclical effects

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Automatic versus discretionary fiscal policy

Automatic stabilisers: tax receipts decline when the economy slows down, and

conversely welfare spending rises when the economy slows down, and

conversely no decision, so no lag: nicely countercyclical rule of thumb: deficit worsens by 0.5 per cent of GDP when

GDP growth declines by 1 per cent

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Automatic stabilisers

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Actual versus cyclically-adjusted budget balance

Discretionary actions: a voluntary decision to change tax rates or spending

Cyclically adjusted budget shows what the balance would be if the output gap is zero in a given year

Difference between actual and cyclically adjusted budget = footprint of automatic stabilisers

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The Netherlands

-6

-4

-2

0

2

4

6

1991 1993 1995 1997 1999 2001 2003 2005

Output gapBudget balanceCyclically adjusted budget balance

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Fiscal policy externalities

In a monetary union, should fiscal policy be subjected to some form of collective control? Yes, if national fiscal policies are a source of externalities

Externality #1 - income spillover via trade: important and strengthened by monetary union lack of co-ordination means that with a symmetric shock, too

much policy action can be used to counteract shock

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Other externalities

Borrowing cost externalities: one country’s deficit would induce higher interest rate for everyone long-term growth effects capital inflows appreciate common currency and affect

competitiveness

Most serious is the risk of default in one member country: capital outflows and a weak euro pressure on other governments to help out pressure on the Eurosystem to help out

Answer to address risk: the ‘no-bailout’ clause in Maastricht Treaty Prevention procedure

Alert: moral hazard

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Maastricht Treaty

1.2. Monitoring of budgetary discipline As from Stage 2, the Treaty prohibits the direct financing of public

entities’ deficits by national central banks (Art. 101), be it overdraft facilities, other types of credit facility or the purchase of debt instruments, except for the purpose of monetary policy. The Treaty also prohibits public entities' privileged access to financial institutions (Art. 102).

Moreover, the “no bail-out” clause in Article 103 stipulates explicitly that neither the Community nor any Member State is liable for or can assume the commitments of any other Member State.

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Arguments for/against fiscal policy controls

The arguments for:

serious externalities

a bad European track record on debt and deficits

The arguments against:

the only remaining macroeconomic instrument

national governments know their domestic economic circumstances best

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The Stability and Growth Pact (SGP)

The SGP: meant to avoid excessive deficits upon entry into euro area

Excessive Deficit Procedure (EDP) makes permanent the 3% GDP deficit and 60% GDP ceilings and calls for fines

Final word remains with ECOFIN, and countries avoided fines so far

SGP reformulated in 2005 to avoid rigidity of Pact negative growth or accumulated loss of output over a period of low

growth exceptional taking account of ‘all relevant factors’ no specific definitions

New reform makes fines automatic

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How the SGP works

A limit on acceptable deficits: 3% of GDP

A preventative arm

Aims at avoiding reaching the limit in bad years

Calls for surpluses in good years

A corrective arm

‘early warning’ when deficit is believed to breach limit + recommendations

EDP procedure for excessive deficit: recommendations, to be followed by corrective measures, and ultimately sanctions

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The SGP fine schedule

The sum is retained from payments from the EU to the country (CAP, Structural and Cohesion Funds)

The fine is imposed every year when the deficit exceeds 3 per cent.

The fine is initially considered as a deposit: if the deficit is corrected within two years, the deposit is returned if it is not corrected within two years, the deposit is considered as a fine

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Issues raised by the SGP

It could make fiscal policies procyclical: budgets deteriorate during economic slowdowns reducing the deficit in a slowdown may further deepen the

slowdown a fine both worsens the deficit and has a procyclical effect

In practice, the Pact encourages countries to: aim at surpluses (so public debts will disappear) in normal times,

to give them scope to use fiscal policy in a downturn reduce reliance on discretionary policy and just use automatic

stabilisers

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The record of EMU so far…..

A difficult period: an oil shock in 2000 and again in 2007 a worldwide slowdown in early 2000s September 11, 2001 the stock market crash in 2002 Afghanistan, Iraq wars the weak US dollar The 2008 global financial crisis The European (Eurozone) sovereign debt crisis

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Inflation: missing the objective, a little …until 2008 commodity boom, 2008-12 financial crisis

Source: European Central Bank

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The performance of the euro against US$

Source: European Central Bank

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Current financial crisis

“ The European Central Bank's main task is to keep inflation down. But over the past month, it has thrown caution to the wind in trying to prevent Europe's financial system and integrated economy from falling apart.

The ECB has transformed itself into a crisis manager of the sort that its architects could hardly have imagined when the bank took up its work 10 years ago. The bank, charged with managing the euro, was given a single mandate - to keep prices under control.

Lately, however, the central bank has cast aside worries about inflation, cutting interest rates once already, with more cuts in the pipeline. At the same time, it is lending ever more cash to strapped banks.”

International Herald Tribune, October 16, 2008

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Early stages of the recession

Eurozone entered recession in 2008Q3 European Council agreed package to avert financial

meltdown in October 2008 National governments (not ECB) would bail out

commercial banks ECB would reduce interest rates and inject liquidity into

banking system

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Eurozone GDP growth

Source: European Central Bank

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Eurozone unemployment

Source: European Central Bank

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Eurozone one-year interbank rate

Source: European Central Bank

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Remember from Lecture 1: government debt and the euro

Eurozone governments are effectively borrowing in ‘foreign currency’

They cannot borrow from their own central banks, monetise the debt and inflate away their debts (like US and UK)

Financial markets demand ever-higher risk premium from indebted governments

This increases debt service costs, the deficit and so the need to borrow more and eventually the government will default

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From financial crisis to sovereign debt crisis

From 2010, growing concern about sovereign debt levels in Greece, Spain, Ireland, Portugal and Italy

Bond yield differentials between this group and France and Germany widened

March 2010, European Council agreed on a bailout mechanism for Greece

Other countries could apply if needed Widely believed bailout violates EU treaties – note: bailout is

by EU national governments, not ECB, which cannot directly monetise debt

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Eurozone budget balance (% GDP)

Source: European Central Bank

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Eurozone government debt (% GDP)

Source: European Central Bank

Ratio has never been below 60% GDP

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Government debt in key Eurozone countries

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Deficits and debt

Source: Eurostat

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National long-term interest rates

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The bailouts

In April 2010, bailout mechanism used - €30bn lent to Greece In May 2010, EU established a full fund of €750bn

€440bn from eurozone states €60 billion from European Commission €250 billion from the IMF

European Financial Stability Facility (EFSF) established issues debt on capital markets, backed by guarantees from the eurozone

states lends to indebted eurozone governments once recovery plan agreed

Long-term solution is the European Stability Mechanism, agreed in December 2010 Replaces the EFSF and similar legal instruments Combined with a monitoring body

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Greece debates budget cuts

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Trying to make the SGP work

In June 2010, the Council agreed that national governments would present their budget plans to the Council and Commission six months before budget time

Governments would have to justify deficits Tougher scrutiny for deficits if debt > 60% GDP Sanctions still unclear – possibly having voting rights in the

Council suspended

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Is the medicine working?

The EU has given bail-outs to five Eurozone members: G, IRL, P, E, I

Loans have been conditional on budgetary cuts and return to sustainable debt levels

In some countries (Greece), budget cuts have deepened the recession

Long-term interest rates are coming down But indebted states still have poor credit ratings and

face many years of austerity and political unrest

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Conclusions

The ECB set up with primary objective of price stability and independent of national and EU governments

May not directly monetise debt In EMU, national fiscal policy more effective, only

macroeconomic policy tool to adjust to asymmetric shocks But there are important external effects of fiscal policy EU has so far failed to design and enforce controls on national

fiscal policy EMU presently at risk of being destabilised by sovereign

default… but countries in crisis small and the EU has acted decisively so far