paul de grauwe: the governance of a fragile eurozone
TRANSCRIPT
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
1/35
THEGOVERNANCEOFAFRAGILEEUROZONE
PaulDeGrauwe*UniversityofLeuvenandCEPS
Abstract:
Whenenteringamonetaryunion,member-countrieschangethenatureoftheirsovereign debt in a fundamentalway, i.e. they cease to have control over thecurrencyinwhichtheirdebtisissued.Asaresult,financialmarketscanforce
these countries sovereigns into default. In this sensemember countries of amonetary union are downgraded to the status of emerging economies. Thismakes the monetary union fragile and vulnerable to changing marketsentiments.Italsomakesitpossiblethatself-fulfillingmultipleequilibriaarise.IanalyzetheimplicationsofthisfragilityforthegovernanceoftheEurozone.Iconclude that the new governance structure (ESM) does not sufficientlyrecognizethisfragility.Someofthefeaturesofthenewfinancialassistancearelikely to increase this fragility. In addition, it is also likely to rip member-countriesoftheirabilitytousetheautomaticstabilizersduringarecession.Thisis surely a step backward in the long history of social progress in Europe. Isuggestadifferentapproachtodealwiththeseproblems.
April2011
*IamgratefultoDanielGros,MartinWolfandCharlesWyploszforcommentsandsuggestions
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
2/35
2
1.Introduction
InordertodesigntheappropriategovernanceinstitutionsfortheEurozoneitis
important to make the right diagnosis of the nature of the debt crisis in the
Eurozone.Failuretodoso,canleadtodesigningagovernancestructurethatis
inappropriate for dealingwith theproblems of theEurozone. In this paper I
arguethatthegovernancestructurethathasemergedafteraseriesofdecisions
ofsuccessiveEuropeanCouncilmeetings,althoughanimportantstepforwards,
failstoaddresssomefundamentalproblemsinamonetaryunion.
2.AParadox
IstartwiththeparadoxthatisimmediatelyvisiblefromacomparisonofFigures
1and2. Figure1showsthedebttoGDPratiosof theUKandSpain. It canbe
seenthatsincethestartof the financialcrisisthegovernmentdebtratioofthe
UKhasincreasedmorethanthatofSpain.Asaresult,in2011asapercentof
GDPtheUKgovernmentdebtstood17%higherthantheSpanishGovernment
debt(89%versus72%).YetfromFigure2itappearsthatthefinancialmarkets
havesingledoutSpainandnottheUKasthecountrythatcouldgetentangledin
agovernmentdebtcrisis.Thiscanbeseenfromthefactthatsincethestartof
2010theyieldonSpanishgovernmentbondshasincreasedstronglyrelativeto
theUK,suggestingthatthemarketspriceinasignificantlyhigherdefaultriskon
SpanishthanonUKgovernmentbonds.Inearly2011thisdifferenceamounted
to200basispoints.Whyisitthatfinancialmarketsattachamuchhigherdefault
risk on Spanish than on UK government bonds government bonds, while it
appearsthattheUKfacesalessfavourablesovereigndebtanddeficitdynamics?
Onepossibleansweristhatitmayhavesomethingtodowiththebankingsector.
Thisisunconvincing,though.ThestateoftheUKbankingsectoriscertainlynot
much better than the one of Spain. I will argue that this difference in the
evaluationofthesovereigndefaultrisksisrelatedtothefactthatSpainbelongs
toamonetaryunion,whiletheUKisnotpartofamonetaryunion,andtherefore
hascontroloverthecurrencyinwhichitissuesitsdebt.
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
3/35
3
Figure1
Source:EuropeanCommission,Ameco Figure2:
Source:Datastream
0
10
20
30
40
50
60
70
80
90
100
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Grossgovernmentdebt(%ofGDP)
UK
Spain
2
2.5
3
3.5
4
4.5
5
5.5
6
percent
10-yeargovernmentbondratesSpainandUK
Spain
UK
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
4/35
4
3.Onthenatureofsovereigndebtinamonetaryunion
Inanutshellthedifferenceinthenatureofsovereigndebtbetweenmembers
andnon-membersofamonetaryunionboilsdowntothefollowing.Membersof
amonetaryunionissuedebtinacurrencyoverwhichtheyhavenocontrol.Itfollows that financial markets acquire the power to force default on these
countries.Thisisnotthecaseincountriesthatarenotpartofamonetaryunion,
and have kept control over the currency in which they issue debt. These
countriescannoteasilybeforcedintodefaultbyfinancialmarkets.
Letme expand on thisby considering in detail what happenswhen investors
starthavingdoubtsaboutthesolvencyofthesetwotypesofcountries.Iwilluse
theUKasaprototypemonetarystand-alonecountryandSpainasaprototype
member-country of a monetary union (see Kopf(2011) for an insightful
analysis).
TheUKscenario
Lets first trace what would happen if investors were to fear that the UK
governmentmightbedefaultingonitsdebt.Inthatcase,theywouldselltheirUK
governmentbonds,drivinguptheinterestrate.Aftersellingthesebonds,theseinvestorswouldhavepoundsthatmostprobablytheywouldwanttogetridof
bysellingtheminthe foreignexchangemarket. Thepriceof thepoundwould
dropuntilsomebodyelsewouldbewillingtobuythesepounds.Theeffectofthis
mechanismisthatthepoundswouldremainbottledupintheUKmoneymarket
tobeinvestedinUKassets.Putdifferently,theUKmoneystockwouldremain
unchanged. Part of that stock of money would probably be re-invested in UK
government securities. But even if that were not the case so that the UKgovernment cannot find the funds to roll over its debt at reasonable interest
rates, itwould certainly force the BankofEngland tobuy up the government
securities. Thus the UKgovernment is ensured that the liquidity is around to
funditsdebt.Thismeansthatinvestorscannotprecipitatealiquiditycrisisinthe
UKthatcouldforcetheUKgovernmentintodefault.Thereisasuperiorforceof
lastresort,theBankofEngland.
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
5/35
5
TheSpanishscenario
Thingsaredramaticallydifferentforamemberofamonetaryunion,likeSpain.
Suppose that investors fear a default by the Spanish government.Asa result,
theysellSpanishgovernmentbonds,raisingtheinterestrate.Sofar,wehavethesameeffectsasinthecaseoftheUK.Therestisverydifferent.Theinvestorswho
haveacquiredeurosarelikelytodecidetoinvesttheseeuroselsewhere,sayin
German government bonds. As a result, the euros leave the Spanish banking
system.Thereisnoforeignexchangemarket,noraflexibleexchangeratetostop
this. Thus the total amount of liquidity (money supply) in Spain shrinks. The
Spanishgovernmentexperiencesaliquiditycrisis,i.e.itcannotobtainfundsto
roll over its debt at reasonable interest rates. In addition, the SpanishgovernmentcannotforcetheBankofSpaintobuygovernmentdebt.TheECB
canprovidealltheliquidityoftheworld,buttheSpanishgovernmentdoesnot
control that institution. The liquidity crisis, if strong enough, can force the
Spanishgovernmentintodefault.Financialmarketsknowthisandwilltestthe
Spanish government when budget deficits deteriorate. Thus, in a monetary
union,financialmarketsacquiretremendouspowerandcanforceanymember
countryonitsknees.
ThesituationofSpainisreminiscentofthesituationofemergingeconomiesthat
havetoborrowinaforeigncurrency.Theseemergingeconomiesfacethesame
problem,i.e.theycansuddenlybeconfrontedwithasuddenstopwhencapital
inflowssuddenlystopleadingtoaliquiditycrisis(seeCalvo,etal.(2006)).
There is an additional difference in the debt dynamics imposed by financial
marketsonmemberandnon-membercountriesofamonetaryunion.IntheUK
scenariowehaveseenthatasinvestorsselltheproceedsoftheirbondsalesin
theforeignexchangemarket,thenationalcurrencydepreciates.Thismeansthat
theUKeconomyisgivenaboostandthatUKinflationincreases.Thismechanism
isabsentintheSpanishscenario.TheproceedsofthebondsalesinSpainleave
theSpanishmoneymarketwithoutchanginganyrelativeprice.
InFigure3and4IshowhowthisdifferencehasprobablyaffectedGDPgrowth
andinflationintheUKandSpainsincethestartofthesovereigndebtcrisisin
theEurozone.Itcanbeseenthatsince2010inflationisalmosttwiceashighin
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
6/35
6
theUKthaninSpain(2.9%versus1.6%).InadditiontheyearlygrowthofGDPin
theUKaverages2%since2010againstonly0.2%inSpain.Thisiscertainlynot
unrelated to the fact that since the start of the financial crisis the pound has
depreciatedbyapproximately25%againsttheeuro.
Source:EuropeanCommission,Ameco
Thisdifferenceininflationandgrowthcanhaveaprofoundeffectonhowthe
solvency of the governments of these two countries is perceived. It will berememberedthatanecessaryconditionforsolvencyisthattheprimarybudget
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
2009 2010 2011
Figure3:InlationinUKandSpain
UK
Spain
-6.0%
-5.0%
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
2009 2010 2011
Figure4:GrowthGDPinUKandSpain
UK
Spain
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
7/35
7
surplusshouldbeatleastashighasthedifferencebetweenthenominalinterest
rateandthenominalgrowthratetimesthedebtratio 1.Iapplythisconditionand
showthenumbersintable1.IassumethatSpainandtheUKwillcontinuetoface
the long-term interest rates that the markets have imposed since the last 6months (on average 3.5% in the UK and 5% in Spain). Applying the average
nominalgrowthratessince2010(4.9%intheUKand1.8%inSpain)wecansee
thatintheUKthereisnoneedtogenerateaprimarysurplusinordertostabilize
thedebttoGDPratio(andassumingthesegrowthrateswillbemaintained).In
Spaintheprimarysurplusmustbemorethan2%toachievethisresult.Thus,
SpainisforcedtoapplymuchmoreausteritythantheUKtosatisfythesolvency
condition.Putdifferently,SpaincouldnotgetawaywiththeUKbudgetarypolicy
without beingbranded as insolvent despite the fact that ithasa substantially
lowerdebtlevel.
Table1:Primarysurplusneededtostabilizedebtat2011level
(percentGDP)
UK
-1,21
Spain
2,30
Thepreviousanalysisillustratesanimportantpotentiallydestructivedynamics
in a monetary union. Members of a monetary union are very susceptible to
liquiditymovements.Wheninvestorsfearsomepaymentdifficulty(e.g.triggered
by a recession that leads to an increase in the government budget deficit),
liquidityiswithdrawnfromthenationalmarket(asuddenstop).Thiscanset
inmotion a devilish interactionbetween liquidityandsolvencycrises. Once a
membercountrygetsentangledinaliquiditycrisis,interestratesarepushedup.
Thustheliquiditycrisisturnsintoasolvencycrisis.Investorscanthenclaim
thatitwasrighttopulloutthemoneyfromaparticularnationalmarket.Itisa
self-fulfillingprophecy:thecountryhasbecomeinsolventbecauseinvestorsfear
insolvency.
1TheformulaisS(rg)D,whereSistheprimarybudgetsurplus,risthenominalinterestrateonthegovernmentdebt,gisthenominalgrowthrateoftheeconomyandDisthegovernmentdebttoGDPratio.
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
8/35
8
NotethatIamnotarguingthatallsolvencyproblemsintheEurozoneareofthis
nature. In the case of Greece, for example, one can argue that the Greek
governmentwas insolvent before investorsmade theirmovesandtriggereda
liquidity crisis in May 2010.What I am arguing is that in a monetary unioncountriesbecomevulnerabletoself-fulfillingmovementsofdistrustthatsetin
motionadevilishinteractionbetweenliquidityandsolvencycrises.
Thisinteractionbetweenliquidityandsolvencyisavoidedinthestand-alone
country,wheretheliquidityisbottledupinthenationalmoneymarkets(thereis
no sudden stop), and where attempts to export it to other markets sets in
motion an equilibrating mechanism, produced by the depreciation of the
currency.Thus,paradoxically,distrustleadstoandequilibratingmechanismintheUK,andtoapotentiallydisequilibratingmechanisminSpain.
From the preceding analysis, it follows that financial markets acquire great
powerinamonetaryunion.Willthispowerbebeneficialfortheunion?
Believersinmarketefficiencyhavebeentellingusthatthispowerissalutary,as
itwillactasadiscipliningforceonbadgovernments.Ihavelostmuchofmy
faithintheideathatfinancialmarketsareadiscipliningforce.Thefinancialcrisis
hasmadeabundantlyclearthatfinancialmarketsareoftendrivenbyextreme
sentiments of either euphoria orpanic. During periods of euphoria investors,
cheeredbyratingagencies,collectivelyfailtoseetherisksandtakeontoomuch
of it. After the crash, fear dominates, leading investors, prodded by rating
agencies,todetectriskseverywheretriggeringpanicsalesmuchofthetime.
4.Multipleequilibria
The inherent volatility of financial markets leads to another fundamental
problem.Itcangiverisetomultipleequilibria,someofthemgoodones;others
badones. This arises from theself-fulfilling natureofmarket expectations. In
appendix, I present a simple theoretical model showing more formally how
multipleequilibriacanarise.
SupposemarketstrustgovernmentA.Investorsthenwillshowawillingnessto
buy government bonds at a low interest rate. A low interest rate embodiesa
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
9/35
9
belief that thedefault risk is low. But the same low interest ratealso has the
effect of producing a low risk of default. This is made very clear from our
solvencycalculationsintable1.MarketstrustthattheUKgovernmentwillnot
default (despite its having a high debt ratio). As a result, theUK governmentenjoysalowinterestrate.Oursolvencycalculationthenshowsthatindeedthe
UKgovernmentisverysolvent.FinancialmarketsgentlyguidetheUKtowardsa
goodequilibrium.
Suppose market distrusts government B. As a result, investors sell the
governmentbonds.Theensuingincreaseintheinterestrateembedsthebelief
thatthereisadefaultrisk.Atthesametimethishighinterestrateactuallymakes
default more likely. Thus in our calculation from table 1 it appears that themarkets distrust in the Spanish government in a self-fulfilling wayhasmade
defaultmorelikely.FinancialmarketspushSpaintowardsabadequilibrium.
The occurrence of bad equilibria ismore likely with members of amonetary
union,whichhavenocontrolofthecurrencyinwhichtheyissuetheirdebt,than
withstand-alonecountriesthathaveissueddebtinacurrencyoverwhichthey
have fullcontrol.Asmentionedearlier, themembersofamonetaryunionface
the same problem as emerging countries that because of underdeveloped
domesticfinancialmarkets,areforced toissuetheirdebtina foreigncurrency
(Calvo,etal.(2006),seeEichengreen,atal.(2005)).InthewordsofEichengreen
etal.(2005)thisworksastheoriginalsinthatleadsthesecountriesintoabad
equilibriumfullofpainandmisery.
Thereisanadditionalcomplicationinamonetaryunion.Thisisthatinsucha
union financial markets become highly integrated. This also implies that
government bonds of member countries are held throughout the union.
AccordingtotheBISdata,formanyEurozonemembercountriesmorethanhalf
of government bonds areheld outside the countryof issue. Thuswhen a bad
equilibriumisforcedonsomemembercountries,financialmarketsandbanking
sectors in other countries enjoying a good equilibrium are also affected (see
Azerki,etal.(2011)whofindstrongspillovereffectsintheEurozone).
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
10/35
10
Theseexternalitiesareastrongforceofinstabilitythatcanonlybeovercomeby
government action. Iwill return to this issue when I analyze the governance
questionoftheEurozone.
Towrapupthepreviousdiscussion:membersofmonetaryunionaresensitivetomovementsofdistrustthathaveself-fulfillingpropertiesandthatcanleadthem
tobepushedintoabadequilibrium.Thelatterarisesbecausedistrustcansetin
motion a devilish interaction between liquidity and solvency crises. Being
pushedintoabadequilibriumhastwofurtherconsequences.Ianalyzethesein
thefollowingsection.
5.Thebadnewsaboutabadequilibrium
Therearetwofeaturesofabadequilibriumthatareworthanalyzingfurther.
First, domestic banks are affected by the bad equilibrium in different ways.
When investors pull out from the domestic bondmarket, the interest rate on
government bonds increases. Since the domestic banks are usually the main
investors inthedomestic sovereign bondmarket, this showsupassignificant
lossesontheirbalancesheets.Inaddition,domesticbanksarecaughtupinafundingproblem.Asarguedearlier,domesticliquiditydriesup(themoneystock
declines)making it difficult for the domestic banks to rollover their deposits,
exceptbypayingprohibitiveinterestrates.Thusthesovereigndebtcrisisspills
overintoadomesticbankingcrisis,evenifthedomesticbanksweresoundto
startwith.Thisfeaturehasplayedanimportantrole inthecaseofGreeceand
Portugalwherethesovereigndebtcrisishasledtoafull-blownbankingcrisis.In
the case of Ireland, therewas a bankingproblemprior to the sovereign debtcrisis(whichinfacttriggeredthesovereigndebtcrisis).Thelatter,however,
intensifiedthebankingcrisis.
Second, once in a bad equilibrium, members of monetary union find it very
difficult to use automatic budget stabilizers: A recession leads to higher
government budget deficits; this in turn leads to distrust of markets in the
capacityofgovernmentstoservice theirfuturedebt, triggeringa liquidityand
solvencycrisis;thelatterthenforcesthemtoinstituteausterityprogramsinthe
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
11/35
11
midst of a recession. In the stand-alone country (UK) this does not happen
because the distrust generated by higher budget deficit triggers a stabilizing
mechanism.
Thus,membercountriesofamonetaryunionaredowngradedtothestatusofemerging economies, which find itdifficult ifnot impossible touse budgetary
policiestostabilizethebusinesscycle.Thisfeaturehasbeenshowntoproduce
pronounced booms and busts in emerging economies (see Eichengreen, et al.
(2005)).
Thisfeatureofamonetaryunionmakesitpotentiallyverycostly.Theautomatic
stabilizersinthegovernmentbudgetconstituteanimportantsocialachievement
inthedevelopedworldastheysoftenthepainformanypeoplecreatedbythe
boomsandbustsincapitalistsocieties.Ifamonetaryunionhastheimplicationof
destroying these automatic stabilizers, it is unclear whether the social and
politicalbasisforsuchaunioncanbemaintained.Itisthereforeimportantto
designagovernancestructurethatmaintainstheseautomaticstabilizers.
6.Competitivenessandsovereigndebt
The previous analysis allows us to connect sovereign debt dynamics and
competitivenessproblems.
It is now widely recognized that one of the fundamental imbalances in the
Eurozoneistheincreaseddivergenceincompetitivepositionsofthemembersof
the Eurozone since 2000. The phenomenon is shown in figure 5, which I am
confidentmostreadersmusthaveseensomewhere.Onemaycriticizethisfigure
becauseofthechoiceof2000asthebaseyear.Indeed,thischoiceassumesthatin 2000 there were no imbalances in competitive positions, so that any
movementaway fromthe2000-level isa departure fromequilibriumandthus
problematic.Thisissurelynotthecase(seeAlcidiandGros(2010).Anumberof
countries may have been far from equilibrium in 2000 so that movements
observedsincethatdatecouldconceivablybemovementstowardsequilibrium.
InordertotakethiscriticismintoaccountIpresentrelativeunitlabourcostsof
themembercountriesusingthelong-termaverageovertheperiod1970-2010as
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
12/35
12
thebase.The resultsare shownin figure6.Thedivergence islessspectacular,
but stillvery significant.Figure7 confirms this: the standard deviationof the
yearlyindicesincreasedsignificantlysince1999.
Source:EuropeanCommission,Ameco
Source:EuropeanCommission,Ameco
85
90
95100
105
110
115
120
125
20002001200220032004200520062007200820092010
Figure5:RelativeunitlaborcostsEurozone(2000=100)
ItalyGreecePortugalSpainIrelandNetherlandsFinland
BelgiumFranceAustriaGermany
80
85
90
95
100
105
110
115
120125
199920002001200220032004200520062007200820092010
GreecePortugal
Spain
Italy
Belgium
Netherlands
Austria
Ireland
France
Finland
Germany
Figure6:RelativeunitlaborcostsinEurozone
(average1970-2010=100)
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
13/35
13
Note:ComputedusingdataofFigure6.
Thecountries that lost competitiveness from1999 to2008 (Greece, Portugal,
Spain, Ireland) have to start improving it. Given the impossibility of using a
devaluation of the currency, an internal devaluation must be engineered, i.e.
wages andpricesmust bebrought down relative to those of thecompetitors.
This can only be achieved by deflationary macroeconomic policies (mainly
budgetary policies). Inevitably, this will first lead to a recession and thus
(through the operation of the automatic stabilizers) to increases in budget
deficits.
Most of the analyses in textbooks now stop by noting that this is a slow and
painfulprocess.Theanalysisoftheprevioussections,however,allowsustogoa
littlefurtherandtolinkitwiththedebtdynamicsdescribedearlier.Ascountries
experience increasing budget deficits while they attempt to improve their
competitiveness,financialmarketsarelikelytogetnervous.Distrustmayinstallitself. If strong enough, the latter may lead to a liquidity crisis as described
before.Thistheninevitablytriggersasolvencycrisis.
Thustheperiodduringwhichcountriestrytoimprovetheircompetitivenessis
likely to be painful and turbulent: Painful, because of the recession and the
ensuing increase in unemployment; turbulent, becauseduring the adjustment
period,thecountycanbehitbyasovereigndebtandbankingcrises.Ifthelatter
occur, the deflationary spiral is bound to be intensified. For in that case the
4
5
6
7
8
9
10
11
199920002001200220032004200520062007200820092010
percent
Figure7:Standarddeviationrelativeunitlabour
costsinEurozone(inpercent)
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
14/35
14
domesticlongterminterestrateincreasesdramatically,forcingtheauthorities
toapplyevenmorebudgetaryausterity,which in turn leads toanevenmore
intense recession. The banks that are trapped ina funding crisis reduce their
credit to the economy. The country finds itself stuck in a bad equilibrium,characterizedbyausterityprogramsthatfailtoreducebudgetdeficitsbecause
theyleadtoadownwardeconomicspiralandpunishinginterestratelevels.The
pathtowardsrecoveryformembersofamonetaryunionislikelytobecrisis-
prone.
Thecontrastwithstand-alonecountriesthathavethecapacity toissuedebtin
their own currency is stark. When these countries have lost competitiveness,
theywilltypicallytrytorestoreitbyallowingthecurrencytodropintheforeignexchangemarket.Thismakesitpossiblenotonlytoavoiddeflation,butalsoto
avoid a sovereign debt crisis. As we have seen earlier, these countries
governmentscannotbeforcedintodefaultbytriggeringaliquiditycrisis.Whatis
morethewholeadjustmentprocessinvolvingcurrencydepreciationislikelyto
boostoutputandinflation,therebyimprovingthesolvencyofthesovereign.
7.Governanceissues
ThedebtcrisishasforcedEuropeanleaderstosetupnewinstitutionscapableof
dealingwiththecrisis.Themostspectacularresponsehasbeenthecreationof
the European Financial Stability Mechanism (EFSF) in May 2010 to be
transformed into a permanent European rescue fund, the European Stability
Mechanism(ESM)from2013on. Surely thesewere important stepsthatwere
necessarytomaintainthestabilityoftheEurozone.Yet the opposition against these decisions continues to be high especially in
Northern European countries. Opposition is also strong among economists of
these countries (see the statement of 189German economists warning about
future calamities if the EFSF were to be made permanent, Plenum der
konomen,(2011)).
This opposition is based on an incomplete diagnosis of the sovereign debt
problemintheEurozone.Forthe189Germaneconomiststhestoryissimple:
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
15/35
15
some countries (Greece, Ireland, Portugal, Spain) have misbehaved. Their
governmentshaveirresponsiblyspenttoomuch,producingunsustainabledebt
levels.Theyarenowinsolventthroughtheirownmistakes.Thereisnopointin
providingfinancialassistancebecausethisdoesnotmakethemsolvent.Itonlygives them incentives to persevere in irresponsible behavior (moral hazard).
Thus in this diagnostics, the problem is a debt crisis of a limited number of
individual countries, that can only be solved by an orderly debt default
mechanism.ThelatteriscrucialtoavoidthatGermantaxpayershavetofootthe
bill.
WhilethisanalysismaybecorrectinthecaseofGreece,itfailstounderstandthe
natureofthedebtcrisisinotherEurozonecountries,becauseittreatsthedebtproblemas a series of individual problems; not as the outcomeof a systemic
problemintheEurozone, that Ihavedescribedearlier.This systemicproblem
hasseveralingredients.First,byacquiringthestatusofemergingcountries,the
sovereigns of the member states in a monetary union are fragilized, as
unfavorablemarketsentimentscanforcethemintodefault.Thishastheeffectof
pushing thecountry intoabadequilibrium,characterized bypunishinglyhigh
interest rates, chronically high budget deficits, low growth and a domesticbankingcrisis.Second,thedegreeoffinancialintegrationinthemonetaryunion
issuchthatwhensomesovereignsarepushedinabadequilibrium,thisaffects
theothercountries.Inparticularitfragilizesthebankingsystemsintheseother
countries.Thus,strongexternalitiesarecreated,makingitimpossibletoisolatea
financialproblemofonecountryfromtherestoftheEurozone.Putdifferently,
whenonecountryexperiencesadebtproblemthisbecomesaproblemofthe
Eurozone.Itismycontentionthatthegovernancestructurethatisnowbeingdesigneddoesnotsufficientlytakeintoaccountthesystemicnatureofthedebt
problem.
8.Whatkindofgovernance?
Iidentifiedtwoproblemsofamonetaryunionthatrequiregovernmentaction.
First,thereisacoordinationfailure.Financialmarketscandrivecountriesintoa
badequilibriumthatistheresultofaself-fulfillingmechanism.Thiscoordination
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
16/35
16
failurecaninprinciplebesolvedbycollectiveactionaimedatsteeringcountries
towardsagoodequilibrium.Second,theEurozonecreatesexternalities(mainly
throughcontagion).Likewithallexternalities,governmentactionmustconsist
ininternalizingthese.Collectiveactionandinternalizationcanbetakenattwolevels.Oneisatthelevel
ofthecentralbanks;theotheratthelevelofthegovernmentbudgets.
Liquiditycrisesareavoidedinstand-alonecountriesthatissuedebtintheirown
currencies mainly because the central bank can be forced to provide all the
necessary liquidity to the sovereign. This outcome can also be achieved in a
monetary union if the common central bank is willing to buy the different
sovereignsdebt.InfactthisiswhathappenedintheEurozoneduringthedebt
crisis. The ECB bought government bonds of distressed member-countries,
eitherdirectly,orindirectlybythefactthatitacceptedthesebondsascollateral
initssupportofthebanksfromthesamedistressedcountries.Indoingso, the
ECBrechanneledliquiditytocountrieshitbyaliquiditycrisis,andpreventedthe
centrifugalforcescreatedbyfinancialmarketsfrombreakinguptheEurozone.It
wastherightpolicyforacentralbankwhoseraisondtreitistopreservethe
monetary union. Yet, the ECB has been severely criticized for saving the
Eurozonethisway.Thiscriticism,whichshowsablatantincomprehensionofthe
fundamentalsofamonetaryunion,hasbeenpowerfulenoughtoconvincethe
ECB thatit shouldnotbe involvedinsuchliquidityoperation,andthatinstead
theliquiditysupportmustbedonebyotherinstitutions,inparticularaEuropean
MonetaryFund.Ireturntothisissueinthenextsection.
Collectiveactionand internalization can also be taken at the budgetary level.
Ideally, a budgetary union is the instrument of collective action and
internalization.Byconsolidating(centralizing)nationalgovernmentbudgetsinto
onecentralbudgetamechanismofautomatictransferscanbeorganized.Sucha
mechanism works as an insurance mechanism transferring resources to the
country hit by a negative economic shock. In addition, such a consolidation
createsacommonfiscalauthoritythatcanissuedebtinacurrencyunderthe
controlofthatauthority.Insodoing,itprotectsthememberstates frombeing
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
17/35
17
forced into default by financialmarkets. It also protects themonetary union
fromthecentrifugalforcesthatfinancialmarketscanexertontheunion.
ThissolutionofthesystemicproblemoftheEurozonerequiresafar-reaching
degreeofpoliticalunion. Economists have stressed that such apolitical unionwillbenecessarytosustainthemonetaryunion inthelongrun(seeEuropean
Commission(1977)andDeGrauwe(1992)).Itisclear,however,thatthereisno
willingnessinEuropetodaytosignificantlyincreasethedegreeofpoliticalunion.
Thisunwillingnesstogointhedirectionofmorepoliticalunionwillcontinueto
maketheEurozoneafragileconstruction.
Thisdoesnotmean,however,thatoneshoulddespair.Wecanmoveforwardby
takingsmallsteps.Suchastrategyofsmallstepsnotonlyallowsustosolvethe
most immediate problems. It also signals the seriousness of European
policymakersinmovingforwardinthedirectionofmorepoliticalunion.
9.AStrategyofsmallsteps
Idistinguishbetweenthreestepsthateachrequiresinstitutionalchanges.Some
ofthesestepshavealreadybeentaken.Unfortunately,asIwillarguetheyhave
beenloadedwithfeaturesthatthreatentounderminetheireffectiveness
9.1:AEuropeanMonetaryFund
AnimportantstepwastakeninMay2010whentheEuropeanFinancialStability
Facility(EFSF)wasinstituted.Thelatterwillbetransformedintoapermanent
fund, the European StabilizationMechanism (ESM), whichwill obtain fundingfrom the participating countries and will provide loans to countries in
difficulties. Thus,aEuropeanMonetaryFundwill be inexistence, aswas first
proposedbyGrosandMaier(2010).
It is essential that the ESM take a more intelligent approach to lending to
distressedcountriesthantheEFSFhasbeendoinguptonow.Theinterestrate
appliedbytheEFSFintheIrishrescueprogramamountstoalmost6%.Thishigh
interestratehasa veryunfortunateeffect.First, bychargingthishigh interest
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
18/35
18
rate it makes it more difficult for the Irish government to reduce its budget
deficitandtoslowdowndebtaccumulation.Second,bychargingariskpremium
of about 3% above the risk free rate that the German, Dutch and Austrian
governmentsenjoy,theEFSFsignalstothemarketthatthereisasignificantriskof default, and thus that the Irish government maynot succeed in putting its
budgetary house in order. No wonder that financial markets maintain their
distrust and also charge a high-risk premium. All this, in a self-fulfilling way,
increasestheriskofdefault.
Theintelligentapproachinfinancialassistanceconsistsinusingapolicyofthe
carrot and the stick. The stick is the conditionality, i.e. an austerity package
spelledoutoverasufficientlylongperiodoftime,sothateconomicgrowthgetsachance.Withouteconomicgrowthdebtburdenscannotdecline.Thecarrotisa
concessionalinterestratethatmakesiteasierforthecountryconcernedtostop
debtaccumulation.Alowinterestratealsoexpressestrustinthesuccessofthe
package;trustthatfinancialmarketsneedinordertoinducethemtobuythe
governmentdebt ata reasonable interestrate. Unfortunately, thefuture ESM
willapplyaninterestratethatis200basispointsaboveitsfundingrate.Thereis
nogoodreasonfortheESMtodothis.Byapplyingsuchariskpremium,theESMwillsignaltothemarketthatisdoesnottrulybelieveinthesuccessofitsown
lendingprogram.
ThereareotherfeaturesoftheESMthatwillundermineitscapacitytostabilize
thesovereignbondmarketsintheEurozone.From2013on,allmembersofthe
Eurozone will be obliged to introduce collective actions clauses when they
issuenewgovernmentbonds.Thepracticalimplicationofthisisthefollowing.
Wheninthefuture,agovernmentoftheEurozoneturnstotheESMtoobtain
funding,privatebondholdersmaybeaskedtoshareintherestructuringofthe
debt. Put differently, theymaybe asked to take some of the losses. Thismay
seemtobeagooddecision.Bondholderswillbeforcedtothinktwicewhenthey
invest in government bonds, as these bonds may not be as secure as they
thought.
Theintentionmaybegood;theeffectwillbenegative(seeDeGrauwe(2010)).In
factwehavealreadyseen theeffects.WhentheGermangovernmentmadethe
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
19/35
19
first proposal to introduce collective action clauses at the European Council
meetingofOctober2010,theimmediateeffectwastointensifythecrisisinthe
Eurozonesovereignbondmarkets.IshowevidenceforthisinFigure8,which
presentsthegovernmentbondspreadsofanumberofEurozonecountries.ItcanbeseenthatimmediatelyaftertheEuropeanCouncilmeetingofOctober28-29,
when the first announcement was made to attach collective action clauses
(CACs) to future government bond issues, the government bond spreads of
Ireland, Portugal and Spain shot up almost immediately. Since then these
spreadshaveremainedhigh.ThiscontrastswiththepreviousEuropeanCouncil
meetings,whicheitherdidnotseemtoaffectthespreads,orasinthecaseofthe
May2010meetingwasfollowedbya(temporary)declineinthespreads.
Figure8
Source:Datastream
ThereactionofthemarketstotheannouncementoffutureCACsshouldnothave
beensurprising.Whenprivatebondholdersknowthatinthefuturetheirbonds
willautomaticallyloosevaluewhenacountryturnstotheESM,theywillwantto
becompensatedfortheaddedriskwithahigherinterestrate.Inaddition,and
evenmoreimportantly,eachtimetheysuspectthatacountrymayturntothe
ESMforfundingtheywillimmediatelyselltheirbonds,soastoavoidapotential
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
20/35
20
loss.Butthissellingactivitywillraisetheinterestrateonthesebonds,andwill
makeitmorelikelythatthegovernmentwillhavetoaskforsupportfromthe
ESM.
Thusthecollectiveactionclauseswillmakethegovernmentbondmarketsmorefragileandmoresensitivetospeculativefears.Iarguedearlierthatthesystemic
problemoftheEurozoneliesinthefactthatinamonetaryunionthenational
governmentsaremorevulnerabletoliquiditycrisestriggeredbymovementsin
confidenceinfinancialmarkets.Insteadofalleviatingthisproblemthecollective
action clauses will intensify it, because with each decline in confidence
bondholderswillrunforcovertoavoidlosses,therebytriggeringacrisis.
CACsdowngradethemembersofthemonetaryuniontothestatusofemerging
marketsforwhichtheseclauseswereinvented.Inawayitisquiteextraordinary
thattheEuropeanleadershavedesignedasolutiontothesystemicproblem
thatwillturnouttomakethatproblemmoresevere.
There is another feature of the ESM that instead of solving a problem may
actually make it more pronounced. I argued earlier that when the member
countries of amonetary union are pushed into a bad equilibrium, they loose
muchoftheirabilitytoapplytheautomaticstabilizersinthebudgetduringa
recession.CountriesthatapplyforfinancingfromtheESMwillbesubjectedtoa
toughbudgetary austerityprogramasa condition for obtaining finance.Thus,
witheachrecession,whenanumberofEurozonecountriesmaybeforcedtoturn
totheESMtheywillbeobligedtofollowpro-cyclicalbudgetarypolicies, i.e.to
reducespendingandincreasetaxes.Asurewaytomaketherecessionworse.
Theanti-cyclicalityofgovernmentbudgets isanimportant achievement inthedevelopedworld. It has led to greater business cycle stability and to greater
social welfare, shielding people from the harshness of booms and busts in
capitalist systems. The way the ESM has been set up, however, risks
underminingthisachievement.
All this is quite unfortunate. Especially because the existence of a financial
support mechanism in the Eurozone is a great idea and a significant step
forwards in the building of an integrated Europe (Peirce, Micossi,
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
21/35
21
Carmassi(2011)). Unfortunately, by introducing all kinds of restrictions and
conditions,theESMhasbeentransformedintoaninstitutionthatisunlikelyto
producemorestabilityintheEurozone.
9.2:JointissueofEurobonds
A second step towards political union and thus towards strengthening the
EurozoneconsistsinthejointissueofEurobonds.AjointissueofEurobondsis
animportantmechanismofinternalizingtheexternalitiesintheEurozonethatI
identifiedearlier.
ByjointlyissuingEurobonds,theparticipatingcountriesbecomejointlyliableforthe debt they have issued together. This is a very visible and constraining
commitmentthatwillconvincethemarketsthatmembercountriesareserious
about the future of the euro (see Verhofstadt(2009), Juncker and
Tremonti(2010)). In addition, by pooling the issue of government bonds, the
member countriesprotect themselves against the destabilizing liquiditycrises
that arise form their inability to control the currency in which their debt is
issued.Acommonbondissuedoesnotsufferfromthisproblem.
TheproposalofissuingcommonEurobondshasmetstiffresistanceinanumber
of countries (see Issing(2010)). This resistance is understandable. A common
Eurobondcreatesanumberofseriousproblemsthathavetobeaddressed.
A first problem is moral hazard. The common Eurobond issue contains an
implicitinsurancefortheparticipatingcountries.Sincecountriesarecollectively
responsibleforthejointdebtissue,anincentiveiscreatedforcountriestorely
on this implicit insurance and to issue too much debt. This creates a lot of
resistanceintheothercountriesthatbehaveresponsibly.Itisunlikelythatthese
countrieswillbewillingtostepintoacommonEurobondissueunlessthismoral
hazardriskisresolved.
A second problem (not unrelated to the previous one) arises because some
countrieslikeGermany,FinlandandtheNetherlandstodayprofitfromtripleA
ratings allowing them to obtain the best possible borrowing conditions. The
questionarisesofwhatthebenefitscanbeforthesecountries.Indeed,itisnot
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
22/35
22
inconceivablethatbyjoiningacommonbondmechanismthatwillincludeother
countriesenjoyinglessfavourablecreditratings,countrieslikeGermany,Finland
andtheNetherlandsmayactuallyhavetopayahigherinterestrateontheirdebt.
Theseobjectionsareserious.TheycanbeaddressedbyacarefuldesignofthecommonEurobondmechanism.ThedesignofthecommonEurobondsmustbe
such as to eliminate the moral hazard risk and must produce sufficient
attractiveness for the countries with favourable credit ratings. This can be
achievedbyworkingbothonthequantitiesandthepricingoftheEurobonds.
Thus,myproposalwould be toseek a combinationof theEurobondproposal
made byBruegel (Delpla andvonWeizscker(2010)and the onemade byDe
GrauweandMoesen(2009).Itwouldworkasfollows.Countrieswouldbeable
toparticipateinthejointEurobondissueupto60%oftheirGDP,thuscreating
bluebonds.Anythingabove60%wouldhavetobeissuedinthenationalbond
markets (red bonds). This would create a senior (blue) tranche that would
enjoythebestpossiblerating.Thejunior(red)tranchewouldfaceahigherrisk
premium.Thisexistenceofthisriskpremiumwouldcreateapowerfulincentive
for the governments to reduce their debt levels. In fact, it is likely that the
interest rate that countrieswould have to pay on their red bonds would be
higherthantheinterestratetheypaytodayontheirtotaloutstandingdebt(see
Gros(2010) on this). The reason is that by creating a senior tranche, the
probabilityofdefaultonthe junior tranchemayactuallyincrease. Thisshould
increase the incentive for countries to limit the red component of their bond
issues.
TheBruegelproposalcanbecriticizedonthefollowinggrounds.Totheextent
that theunderlying risk of the government bonds isunchanged, restructuring
thesebondsintodifferenttranchesdoesnotaffectitsrisk.Thus,ifthebluebond
carriesa lowerinterestrate,theredbondwillhaveahigherinterestratesuch
thattheaverageborrowingcostwillbeexactlythesameaswhenthereisonly
onetypeofbond(seeGros(2011)).ThisisanapplicationoftheModigliani-Miller
theorem which says that the value of a firm is unaffected by the way the
liabilitiesofthatfirmarestructured.
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
23/35
23
All this is true to the extent that the underlying risk isunchanged. The point,
however, is that the common bond issue is an instrument to shield countries
frombeingpushedintoabadequilibrium.Ifthecommonbondissuesucceedsin
doingso,theunderlyingriskofthebondsofthesecountriesdoesindeeddecline.Inthatcasethesecountriesareabletoenjoyaloweraverageborrowingcost.At
the same time the marginal borrowing cost is likely to be higher than the
average.Thisisexactlywhatonewantstohave:adeclineoftheaveragedebt
cost,andanincreaseinthemarginalcostofthedebt.Theformermakesiteasier
toservice thedebt;the latterprovidesstrong incentives towards reducing the
levelofthedebt.Thisfeatureisimportanttoreducethemoralhazardrisk.
ThesecondfeatureofourproposalworksonthepricingoftheEurobondsanditfollowstheproposalmadebyDeGrauweandMoesen(2009).Thisconsistsin
usingdifferentfeesforthecountriesparticipatinginthebluebondissue.These
feeswouldberelatedtothefiscalpositionoftheparticipatingcountries.Thus,
countries with high government debt levels would face a higher fee, and
countrieswith lowerdebtlevelswouldpaya lowerfee.Inpractical termsthis
meansthattheinterestratepaidbyeachcountryinthebluebondtranchewould
be different. Fiscally prudent countrieswould have topay a somewhat lowerinterestratethanfiscallylessprudentcountries.Thiswouldensurethattheblue
bondissuewouldremainattractiveforthecountrieswiththebestcreditrating,
therebygivingthemanincentivetojointtheEurobondmechanism.
It should be noted that if successful, such a common Eurobond issue would
createalargenewgovernmentbondmarketwithalotofliquidity.Thisinturn
wouldattractoutsideinvestorsmakingtheeuroareservecurrency.Asaresult
theeurowouldprofitfromanadditionalpremium.Ithasbeenestimatedthatthe
combined liquidity and reserve currency premium enjoyed by the dollar
amounts to approximately 50 basis points (Gourinchas and Rey(2007)). A
similarpremiumcouldbeenjoyedbytheeuro.Thiswouldmakeitpossiblefor
theeurozonecountriestolowertheaveragecostofborrowing,verymuchlike
theUShasbeenabletodo.
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
24/35
24
9.3:Coordinationofeconomicpolicies
A third important step in the process towards political union is to set some
constraints on the national economic policies of the member states of the
Eurozone. The fact that while monetary policy is fully centralized, the otherinstruments of economic policies have remained firmly in the hands of the
national governments is a serious design failure of the Eurozone. Ideally,
countries should hand over sovereignty over the use of these instruments to
European institutions. However, the willingness to take such a drastic step
towards politicalunion is completely absent. Here also small steps shouldbe
taken.
The European Commission has proposed a scoreboard of macroeconomic
variables(privateandpublicdebt,currentaccountimbalances,competitiveness
measures,houseprices)thatshouldbemonitored,andthatshouldbeusedto
pushcountriestowardsusingtheireconomicpolicyinstrumentssoastocreate
greaterconvergenceinthesemacroeconomicvariables.Failuretotakeactionto
eliminatetheseimbalancescouldtriggerasanctioningmechanismverymuchin
the spirit of the sanctioning mechanism of the Stability and Growth Pact
(EuropeanCommission(2010)).
While an important step forward, this approach is incomplete. National
governments have relatively little control over many of the macroeconomic
variablestargetedbytheEuropeanCommission.Infacttheevidencewehaveof
thepre-crisisdivergencedynamicsisthatmuchofitwasproducedbymonetary
andfinancialdevelopmentsoverwhichnationalgovernmentshadlittlecontrol.
LocalboomsandbubblesdevelopedintheperipheryoftheEurozone.These
weredrivenmainlybybankcreditexpansion.ThisisvividlyshowninFigure9.It
is the combination of bubbles (especially in the housing markets) and credit
expansion that makes bubbles potentially lethal (see Borio(2003)). This has
beenmadevaryclearbytheexperienceofSpainandIreland.
Thus,anypolicyaimedatstabilizinglocaleconomicactivitymustalsobeableto
control local credit creation. It is clear that because themember states of the
Eurozonehaveenteredamonetaryuniontheylacktheinstrumentstodealwith
this.Putdifferently,ifthemovementsofeconomicactivityaredrivenbycredit-
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
25/35
25
fueledanimalspiritstheonlyinstrumentsthatcaneffectivelydealwiththisare
monetary instruments. Members of a monetary union, however, have
relinquishedtheseinstrumentstotheEuropeanmonetaryauthorities.
The next question then becomes: can the European monetary authorities, inparticulartheECB,helpoutnationalgovernments?Wehavebeentoldthatthisis
impossible because the ECB should only be concerned by system-wide
aggregates.Itcannotbemaderesponsiblefornationaleconomicconditions.The
reasonisthatithasoneobjectivewhichisthemaintenancesofpricestabilityin
theEurozoneasawhole,andbecauseithasonlyoneinstrumenttoachievethis
goal.
ThisIbelieveistoocheapananswer.TheECBisnotonlyresponsibleforprice
stabilitybutalsoforfinancialstability.Thefinancialcrisisthateruptedinthe
Eurozonein2010haditsorigininalimitednumberofcountries.Itistherefore
importantthattheECBfocusesnotonlyonsystem-wideaggregatesbutalsoon
what happens in individual countries. Excessive bank credit creation in a
numberofmembercountriesshouldalsoappearontheradarscreenoftheECB
inFrankfurtuponwhichtheECBshouldact.
Figure9
Source:Kannan,etal.(2009)
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
26/35
26
One may object that the ECB does not have the instruments to deal with
excessive bank credit in parts of theEurozone. This, however, isnot so. The
Eurosystem has the technicalability to restrictbank credit in some countries
morethaninothersbyapplyingdifferentialminimumreserverequirements,orby imposing anti-cyclical capital ratios. These can and should be used as
stabilizinginstrumentsatthenationallevel.
Anotherobjectionisthatitistheresponsibilityofthefinancialsupervisorsto
dealwithexcessiverisktakingbybanks.Whenbanksextendtoomuchcredit
andtherebyincreasetheriskoftheirbalancesheets,nationalsupervisorsshould
intervene. This is undoubtedly so. At the same time it does not absolve the
Eurosystem from its responsibility in maintaining financial stability. When acredit-fueledboomemergesinsomememberstates,itisalsotheresponsibility
oftheEurosystemtoact.TheEurosystemalsohasthemostpowerfultoolkitin
controllingthemacroeconomicconsequencesofboomsandbusts.
TherecentreformsinthesupervisorylandscapeintheEurozoneincreasethe
scopeforactionbytheEurosystem.TheEuropeanSystemicRiskBoard(ESRB)
whichwascreatedin2010isofparticularimportancehere.Verypointedly,the
presidentoftheECBwillalsopresideovertheESRB.Thusthecreatorsofthe
ESRBhaveclearlyunderstoodthattheECBisatthecenterofthemonitoringof
emergingsystemicrisksintheEurozone.Itwouldbequiteparadoxicalthatthe
presidentoftheESRB(ECB)wouldemitwarningsignalsaboutsystemicriskand
wouldthennotfollow-upthiswarningbyactiontoreducetherisks,leavingitto
thenationalsupervisorstoactalone.
The steps described in this and the previous sections, involving both the
responsibilities of national governments, the European institutions and the
Eurosystem are important tomove towards politicalunion. They also give an
important signal in the financial markets that the member countries of the
Eurozoneareserious intheirdesiretoguaranteethesurvivalof theEurozone.
These steps are also to be seen as commitment devices that enhance the
credibility of the monetaryunion. They are crucial in stabilizing the financial
marketsintheEurozone.
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
27/35
27
10.Conclusion
Amonetaryunionismorethanonemoneyandonecentralbank.Countriesthat
join a monetary union loose more than an instrument of economic policy
(interestrateorexchangerate).Whenenteringthemonetaryunion,theyloosetheircapacitytoissuedebtinacurrencyoverwhichtheyhavefullcontrol.Asa
result, a loss of confidence of investors can in a self-fulfilling way drive the
countryintodefault.Thisisnotsoforcountriescapableofissuingdebtintheir
own currency. In these countries the central bank can always provide the
liquiditytothesovereigntoavoiddefault.Thismayleadtofutureinflation,butit
shieldsthesovereignfromadefaultforcedbythemarket.
Thus, member-countries of a monetary union become more vulnerable.
Changingmarket sentiments can lead to sudden stops in the funding of the
governmentdebt,settinginmotionadevilishinteractionbetweenliquidityand
solvency crises. There is an important further implication of this increased
vulnerability.Thisisthatmember-countriesofamonetaryunionloosemuchof
their capacity to apply counter-cyclical budgetary policies. When during a
recessionthebudgetdeficitsincrease,thisriskscreatingalossofconfidenceof
investorsinthecapacityofthesovereigntoservicethedebt.Thishastheeffect
of raising the interest rate,making the recession worse, and leading to even
higherbudgetdeficits.Asaresult,countriesinamonetaryunioncanbeforced
into a bad equilibrium, characterized by deflation, high interest rates, high
budgetdeficitsandabankingcrisis.
These systemic featuresofamonetaryunionhave not sufficientlybeen taken
intoaccountinthenewdesignoftheeconomicgovernanceoftheEurozone.Too
muchof this new design has been influenced by the notion (based on moral
hazardthinking)thatwhenacountryexperiencesbudgetdeficitsandincreasing
debts,itshouldbepunishedbyhighinterestratesandtoughausterityprograms.
I have argued that this approach isusually not helpful in restoring budgetary
balance.
In addition, a number of features of the design of financial assistance in the
EurozoneasembodiedintheESM,willhavetheeffectofmakingcountrieseven
moresensitivetoshiftingmarketsentiments.Inparticular,thecollectiveaction
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
28/35
28
clauseswhichwillbeimposedonthefutureissueofgovernmentdebtinthe
Eurozone, will increase the nervousness of financial markets. With each
recessiongovernmentbondholders,fearinghaircuts,willrunforcover,thereby
making a default crisismore likely. All this is likely to increase the risk thatcountriesintheEurozoneloosetheircapacitytolettheautomaticstabilizersin
thebudgetplaytheirnecessaryroleofstabilizingtheeconomy.
Amonetaryunion creates collective problems. When one government faces a
debtcrisisthisislikelytoleadtomajorfinancialrepercussionsinothermember
countries. This is so because a monetary union leads to intense financial
integration.Whether one likes it ornot,member countries are forced tohelp
each other out. Surely, it is important to provide the right incentives forgovernmentssoastoavoidprofligacythatcouldleadtoadebtcrisis.Discipline
bythethreatofpunishmentispartofsuchanincentivescheme.Ihaveargued,
however, that too much importance has been given to punishment and not
enoughtoassistanceinthenewdesignoffinancialassistanceintheEurozone.
This excessive emphasis on punishment is also responsible for a refusal to
introducenewinstitutionsthatwillprotectmembercountriesfromthevagaries
of financial markets that can trap countries into a debt crisis and a bad
equilibrium.Onesuchaninstitutionisthecollectiveissueofgovernmentbonds.
Iarguedthatsuchacommonbondissuemakesitpossibletohaveacollective
defense system against the vagaries of euphoria and fears that regularly grip
financialmarkets.
Amonetaryunioncanonlyfunctionifthereisacollectivemechanismofmutual
supportandcontrol. Suchacollectivemechanismexists ina politicalunion. In
the absence of a political union, the member countries of the Eurozone are
condemnedtofillinthenecessarypiecesofsuchacollectivemechanism.The
debtcrisishasmadeitpossibletofillinafewofthesepieces.Whathasbeen
achieved, however, is still far from sufficient to guarantee the survival of the
Eurozone.
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
29/35
29
References
Alcidi,C.,andGros,D.,(2010),TheEuropeanExperiencewithLargeFiscal
Adjustments,CEPSPolicyBrief,http://www.ceps.eu/book/european-experience-large-fiscal-adjustments
Arezki,R.,Candelon,B,andSy,A.,(2011),SovereignRatingNewsandFinancialMarketsSpillovers:EvidencefromtheEuropeanDebtCrisis,IMFWorkingPaper,11/69,March.
BorioC.,2003,TowardsaMacroprudentialFrameworkforFinancialSupervisionandRegulation?,BISWorkingPaper,n.128
BorioC.,2005,TheSearchfortheElusiveTwinGoalsofMonetaryandFinancialStability,NationalInstituteEconomicReview
Calvo,Guillermo(1988):ServicingthePublicDebt:TheRoleofExpectations,
AmericanEconomicReview,Vol.78,No.4,pp.647-661De Grauwe, P. (1992), The Economics of Monetary Integration, 1st Edition,
OxfordUniversityPress.
DeGrauwe,P.,andMoesen,W.,(2009),GainsforAll:AProposalforaCommonEurobond,Intereconomics,May/June
DeGrauwe,P.(2010),AMechanismofSelf-destructionoftheEurozone,CEPSPolicyBriefs,http://www.ceps.eu/book/mechanism-self-destruction-eurozone
Delpla,J.,andvonWeizscker,J.,(2010),TheBlueBondProposal,BruegelPolicy
Brief,May.EC Commission (1977) Report of the Study Group on the Role of Public Finance in
European Integration (MacDougall Report), Brussels.
EuropeanCommission,(2010),AStructuredFrameworktoPreventandCorrectMacroeconomicImbalances:OperationalizingtheAlertMechanism,Brussels,November.
Eichengreen,B.,Hausmann,R.,Panizza,U.,(2005),ThePainofOriginalSin,inEichengreen,B.,andHausmann,R.,Otherpeoplesmoney:Debtdenominationandfinancialinstabilityinemergingmarketeconomies,ChicagoUniversityPress.
Gourinchas,P.-O.,andRey,H.,(2007),FromworldBankertoWorldVentureCapitalis:theUSExternalAdjustmentandtheExorbitantPrivilege,inClarida,R.,G7CurrentAccountImbalances:SustainabilityandAdjustment,UniversityofChicagoPress.
Gros,D.,(2010),TheSeniorityConundrum:Bailoutcountriesbutbailinprivate
short-termcreditors,CEPSCommentary,10November.
Gros,D.,andMayer,T.,(2010),TowardsaEuropeanMonetaryFund,CEPSPolicyBrief,http://www.ceps.eu/book/towards-european-monetary-fund
Gros,D.,andMayer,(2011),DebtReductionwithoutDefault,CEPSPolicyBriefs,http://www.ceps.eu/book/debt-reduction-without-default
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
30/35
30
Issing,O.,(2009),WhyacommonEurozonebondisntsuchagoodidea,Europes
World,Summer,77-79.
Juncker,J.-C.,andTremonti,G.,(2010),E-bondswouldendthecrisis,FinancialTimes,December,5.
Kannan,K.,Rabanal,P.,andScott,A.,(2009),MacroeconomicPatternsandMonetaryPolicyintheRun-UptoAssetPriceBusts,IMFWorkingPaper,09,252
Kopf,Christian,(2011),Restoringfinancialstabilityintheeuroarea,15March2011,inCEPSPolicyBriefs.
Peirce,P.,Micossi,S.,Carmassi,J.,(2011),OntheTasksoftheEuropeanStabilityMechanism,CEPSPolicyBrief,March.
Plenumderkonomen,(2011),StellungnahmezurEU-Schuldenkrise,
http://www.wiso.uni-hamburg.de/lucke/?p=581
Verhofstadt,G.,(2009),DeWeguitdeCrisis.HoeEuropadewereldkanredden,DeBezigeBij,Amsterdam.
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
31/35
31
APPENDIX:AMODELOFGOODANDBADEQUILIBRIA
InthissectionIpresentaverysimplemodelillustratinghowmultipleequilibria
canarise.Thestartingpointisthatthereisacostandabenefitofdefaultingon
thedebt,andthatinvestorstakethiscalculusofthesovereignintoaccount.Iwillassumethatthecountryinvolvedissubjecttoashock,whichtakestheformofa
decline ingovernmentrevenues.The lattermaybecausedbya recession,ora
lossofcompetitiveness.Illcallthisasolvencyshock.Thehigherthisshockthe
greater is the lossof solvency. I concentrate firston thebenefit side. This is
representedinFigureA1.OnthehorizontalaxisIshowthesolvencyshock.On
theverticalaxisIrepresentthebenefitofdefaulting.Therearemanywaysand
degreesofdefaulting.TosimplifyIassumethistakestheformofa haircutofafixedpercentage.Thebenefitofdefaultinginthiswayisthatthegovernmentcan
reducetheinterestburdenontheoutstandingdebt.Asaresult,afterthedefault
itwill have toapply less austerity, i.e. itwill have to reducespendingand/or
increase taxes by less than without the default. Since austerity is politically
costly,thegovernmentprofitsfromthedefault.
Amajorinsightofthemodelisthatthebenefitofadefaultdependsonwhether
thisdefault isexpectedornot.Ishowtwocurvesrepresenting thebenefitofa
default.BU is thebenefit of adefault that investorsdo notexpect to happen,
whileBEisthebenefitofadefaultthatinvestorsexpecttohappen.Letmefirst
concentrate on theBUcurve.Itisupwardslopingbecausewhenthesolvency
shockincreases,thebenefitofadefaultforthesovereigngoesup.Thereasonis
thatwhenthesolvencyshockislarge,i.e.thedeclineintaxincomeislarge,the
cost of austerity is substantial. Default then becomes more attractive for the
sovereign.Ihavedrawnthiscurvetobenon-linear,butthisisnotessentialfor
the argument. I distinguish three factors that affect the position and the
steepnessoftheBUcurve:
Theinitialdebtlevel.Thehigheristhislevel,thehigheristhebenefitofadefault.ThuswithahigherinitialdebtleveltheBUcurvewillrotateupwards.
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
32/35
32
Theefficiencyofthetaxsystem.Inacountrywithaninefficienttaxsystem,thegovernment cannot easily increase taxation. Thus in such a country the
optionofdefaultingbecomesmoreattractive.TheBUcurverotatesupwards.
Thesizeoftheexternaldebt. Whenexternaldebttakesalargeproportionoftotal debt there will be less domestic political resistance against default,
makingthelattermoreattractive(theBUcurverotatesupwards).
FigureA1:Thebenefitsofdefaultafterasolvencyshock
B
Inowconcentrateonthe BEcurve.Thisshowsthebenefitofadefaultwhen
investors anticipate such a default. It is located above the BU curve for the
following reason. When investors expect a default, they will sell government
bonds.Asaresult,theinterestrateongovernmentbondsincreases.Thisraises
thegovernment budget deficit requiring amore intense austerityprogram of
spendingcutsandtaxhikes.Thus,defaultbecomesmoreattractive.Forevery
solvencyshock,thebenefitsofdefaultwillnowbehigherthantheywerewhen
thedefaultwasnotanticipated.
BU
Solvencyshock
BE
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
33/35
33
Inowintroducethecostsideofthedefault.Thecostofadefaultarisesfromthe
factthat,whendefaulting,thegovernmentsuffersalossofreputation.Thisloss
ofreputationwillmakeitdifficultforthegovernmenttoborrowinthefuture.I
willmakethesimplifyingassumptionthatthisisafixedcost.InowobtainFigureA2whereIpresentthefixedcost(C)withthebenefitcurves.
FigureA2:Costandbenefitsofdefaultafterasolvencyshock
B
Inowhavethe toolstoanalyze theequilibriumofthemodel. Iwilldistinguish
betweenthreetypesofsolvencyshocks,asmallone,anintermediateone,anda
largeone.Takeasmallsolvencyshock:thisisashockSS2.(This
couldbetheshockexperiencedbyGreece).Foralltheselargeshocksweobservethatthecostofadefaultisalwayssmallerthanthebenefits(bothofanexpected
BUBE
C
S1 S2
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
34/35
34
and an unexpected default). Thus the government will want to default. In a
rational expectations framework, investors will anticipate this. As a result, a
defaultisinevitable.
Inowturntotheintermediatecase:S1
-
8/4/2019 Paul De Grauwe: The Governance Of a Fragile Eurozone
35/35
Thusweobtain twopossible equilibria, a bad one (D) that leads to default, a
good one (N ) that does not lead to default. Both are equally possible. The
selectionofoneofthesetwopointsonlydependsonwhatinvestorsexpect.Ifthe
latterexpectadefault,therewillbeone;iftheydonotexpectadefaulttherewillbenone.Thisremarkableresultisduetotheself-fulfillingnatureofexpectations.
Since there is a lot of uncertainty about the likelihood of default, and since
investorshaveverylittlescientificfoundationtocalculateprobabilitiesofdefault
(therehasbeennoneinWesternEuropeinthelast60years),expectationsare
likely to be driven mainly by market sentiments of optimism and pessimism.
Smallchangesinthesemarketsentimentscanleadtolargemovementsfromone
typeofequilibriumtoanother.
Thepossibilityofmultipleequilibriaisunlikely tooccurwhen thecountry isa
stand-alonecountry,i.e.whenitcanissuesovereigndebtinitsowncurrency.
Thismakesitpossibleforthecountrytoalwaysavoidoutrightdefaultbecause
thecentralbankcanbeforcedtoprovidealltheliquiditythatisnecessaryto
avoidsuchanoutcome.Thishastheeffectthatthereisonlyonebenefitcurve.In
thiscasethegovernmentcanstilldecidetodefault(ifthesolvencyshockislarge
enough). But the country cannot be forced to do so by the whim of market
expectations