european monetary policy, fiscal policy and the global financial crisis
DESCRIPTION
University of Cnnterbury course ECON339: Lecture 4TRANSCRIPT
ECON339EURO339
January 2013
Lecture 4: European monetary policy, fiscal policy and the
global financial crisis
ECON339 / EURO339
2
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
ECON339 / EURO339
3
The long road to Maastricht and the euro
2011 Estonia joins
ECON339 / EURO339
4
The Maastricht Treaty (1)
ECON339 / EURO339
5
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)
ECON339 / EURO339
6
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
ECON339 / EURO339
7
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%
ECON339 / EURO339
8
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
ECON339 / EURO339
9
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
ECON339 / EURO339
10
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
ECON339 / EURO339
11
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)
ECON339 / EURO339
12
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
ECON339 / EURO339
13
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
ECON339 / EURO339
14
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
ECON339 / EURO339
15
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.’
ECON339 / EURO339
16
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
ECON339 / EURO339
17
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)
ECON339 / EURO339
18
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
ECON339 / EURO339
19
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
ECON339 / EURO339
20
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
ECON339 / EURO339
21
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
ECON339 / EURO339
22
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?
ECON339 / EURO339
23
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
ECON339 / EURO339
24
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
ECON339 / EURO339
25
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
ECON339 / EURO339
26
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
ECON339 / EURO339
27
Automatic stabilisers
ECON339 / EURO339
28
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
ECON339 / EURO339
29
The Netherlands
-6
-4
-2
0
2
4
6
1991 1993 1995 1997 1999 2001 2003 2005
Output gapBudget balanceCyclically adjusted budget balance
ECON339 / EURO339
30
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
ECON339 / EURO339
31
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
ECON339 / EURO339
32
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.
ECON339 / EURO339
33
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
ECON339 / EURO339
34
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
ECON339 / EURO339
35
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
ECON339 / EURO339
36
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
ECON339 / EURO339
37
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
ECON339 / EURO339
38
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
ECON339 / EURO339
39
Inflation: missing the objective, a little …until 2008 commodity boom, 2008-12 financial crisis
Source: European Central Bank
ECON339 / EURO339
40
The performance of the euro against US$
Source: European Central Bank
ECON339 / EURO339
41
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
ECON339 / EURO339
42
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
ECON339 / EURO339
43
Eurozone GDP growth
Source: European Central Bank
ECON339 / EURO339
44
Eurozone unemployment
Source: European Central Bank
ECON339 / EURO339
45
Eurozone one-year interbank rate
Source: European Central Bank
ECON339 / EURO339
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
46
ECON339 / EURO339
47
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
ECON339 / EURO339
48
Eurozone budget balance (% GDP)
Source: European Central Bank
ECON339 / EURO339
49
Eurozone government debt (% GDP)
Source: European Central Bank
Ratio has never been below 60% GDP
ECON339 / EURO339
50
Government debt in key Eurozone countries
ECON339 / EURO339
51
Deficits and debt
Source: Eurostat
ECON339 / EURO339
52
National long-term interest rates
ECON339 / EURO339
53
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
ECON339 / EURO339
54
Greece debates budget cuts
ECON339 / EURO339
55
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
ECON339 / EURO339
56
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
ECON339 / EURO339
57
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