the future of the euro (brown book 2012)

El futuro del euro

TheFutureoftheEuro

XXVIIIED

ICIÓNDEL

LIBRO

MARR

ÓN

JULIO2012

ANDRÉS DOMINGO AND DOMÉNECH VILARIÑO /DÍEZ GANGAS / DONGES /GARCÍA ANDRÉS / GROS Y ALCIDI /MARTÍNEZ RICO / REQUEIJO GONZÁLEZ /SÁNCHEZ FUENTES, HAUPTMEIER AND SCHUKNECHT /

CÍRCULO DE EMPRESARIOSC/ MARQUÉS DE VILLAMAGNA, 3, 10ª. 28001 MADRIDTEL 915781472. FAX 915774871www.circulodeempresarios.org July 2012

BROW

NBO

OK

The Future of the EuroBROWN EDITION BOOK XXVIII

The Brown Book in 2012 meets his XXVIII edition. Year after year since1984, this flagship publication of the Círculo de Empresarios has offe-red the most varied backgrounds a platform from which to contributetheir ideas and proposals on economic policy that requires ourcountry to its further development. The Brown Book contributes to oneof the founding objectives of the Círculo as the center of the view thatencourages and promotes debate on key issues for the benefit ofSpanish society as a whole.

The Future of the Euro

BrownBookMadrid, July 2012

EDITION SPONSORED BY

© 2012, Círculo de Empresarios

C/ Marqués de Villamagna, 3, 28001 Madrid

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The articles reflect the opinions of the contributors, and not

necessarily those held by Círculo de Empresarios.

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4

5

Prologue 7

1. The future of the Euro

after the Great Recession 15

Javier Andrés and Rafael Domenech

2. Nature and Causes of the Euro crisis 63

José Carlos Díez

3. The European crisis and the challenge

of efficient economic governance 97

Juergen B. Donges

4. The turbulent adolescence of the euro

and its path to maturity 131

Gonzalo García Andrés

5. Breaking the common fate of banks

and governments 197

Daniel Gros and Cinzia Alcidi

Index


6

6. The fiscal institution in the

Economic and Monetary Union:

the contribution of Spain 227

Ricardo Martínez Rico

7. The European Monetary Union:

the Never-Ending Crisis 265

Jaime Requeijo

8. Public expenditure policies during the

EMU period: Lessons for the future? 289

A. Jesús Sánchez Fuentes,

Sebastian Hauptmeier

and Ludger Schuknecht

The crisis in Spain is, to a large extent, the crisis of the Euro. On

the one hand, the sustainability or otherwise of the monetary inte-

gration project hinges on Spain, as the fourth economy in the

Eurozone. On the other, Spain has no leeway available for fiscal sti-

mulus packages, and the success of its adjustments required stabi-

lity in the Eurozone. Hence, both crises are the two sides of the

same token.

The crisis faced by Euro economies and the adjustments made

and which will be made in the most vulnerable ones, are coming at

a high price which has not yielded tangible results to date. Círculo

de Empresarios believes that the current situation calls for an impro-

vement in European institutional architecture, in regard to greater

integration and, above all, more commitment to reforms in Spain.

The natural environment of our country is the Eurozone.

Over the last few weeks, citizens are beginning to live with the

different rescue modalities, as they had already done with the risk

premiums. Financial aid for troubled economies is quite diverse in

terms of implications, instrumentation, conditionality and scope of

application, therefore requiring detailed analysis for determination.

Although each carries its benefits and disadvantages, in the opi-

7

Prologue

nion of Círculo de Empresarios, the greater scope and conditionality

scenarios – known as country-rescue – are not a desirable option.

This is why these must be avoided.

Indeed, an intervention or rescue, of its own accord, without

advancements made in the Eurozone architecture, shall not protect

any of its members from future scares. Domestic adjustment may

be less effective if no advancements are made in fiscal and banking

union, and in the European capacity to provide asymmetrical res-

ponses to national situations which are also different. The most

vulnerable countries in the Eurozone must no longer be perceived

as foreign currency debtors and it is imperative that the coordina-

tion of economic policies of Member States is improved. Without

such adjustments, a sustained growth path will not be possible to

achieve.

On the other hand, the crisis in Spain is the result of an accu-

mulation of imbalances due to a series of inadequate signals and

policies. Spain must face up to its responsibilities in terms of fiscal

consolidation and structural reform. All in the interest of recove-

ring competitiveness and encouraging a suitable environment to

attract growth-contributing investments.

In such circumstances, Círculo de Empresarios cannot help but

take part in the debate on the future of the Euro. The XXVIII edi-

tion of the Brown Book is dedicated to this matter and gathers a

varied number of authors, all with broad experience in the issue

8

and proven academic and professional records. Therefore, this

publication, with the sponsorship of BBVA as in previous years,

maintains its nature as a publication which is open to different

ideas and opinions, not necessarily shared by Círculo de Empresarios.

As in previous editions, the articles appear in alphabetical order

by the surnames of their authors, although these can be grouped

into three broad categories: the crisis of the sovereign debt in

Europe and the future of the Eurozone; the reform of economic

governance and operations of the institutions in order to solve the

sovereign debt crisis in Europe; and the integration into the

Eurozone, the fiscal coordination mechanisms, Eurobonds and the

assignment of sovereignty.

In their paper, Javier Andrés and Rafael Doménech analyse

the challenges faced by the Eurozone and the proposals to handle

them by improving economic governance. To this end, they begin

by reviewing the reasons underlying the accumulation of signifi-

cant imbalances in developed economies and among EMU coun-

tries, mainly from 2001 until the start of the crisis in 2007, as a

result of an unsustainable growth pattern in many developed eco-

nomies. Secondly, the magnitude and implications of such imba-

lances and the heterogeneity between EMU countries are closely

examined. Finally, the authors analyse the challenges involved in

the improvement of economic governance of the EMU on the fis-

cal, financial and economic integration fronts, which will determi-

ne its short and long term economic future.

9

José Carlos Díez analyses the Euro crisis. He reviews the histori-

cal background of the European and single currency projects, and

the theory of exchange rates to provide conceptual support to ena-

ble an understanding of the nature and the causes of the crisis.

According to him, this is an infrequent, but highly destructive, dise-

ase found in economics, especially in developed countries, since it

causes devastating damage to the employment and public debt of

the affected countries. For this reason, he believes it is essential to

come up with the correct diagnosis in order to define the economic

policy that will put an end to the crisis. The main causes analysed

are financial integration, the under-assessment of risk, local imba-

lances within the Eurozone and the Great Recession.

The aim of Juergen B. Donges is to bring the current debate on

the need for economic governance in the European Union, and par-

ticularly in the Eurozone, into the context of political realities. He

analyses the issue of governance from a historical and current pers-

pective, and highlights the significant fact that the Eurozone does

not constitute an optimal monetary area. He then moves on to

analyse the forms of governance to date and considers new approa-

ches to European governance. Finally, he ends his analysis with a

tone of moderate expectation. If the Governments of the Euro countries

understand that the solidity of public finances and the application of struc-

tural reforms are their responsibility and act in accordance, no State must

rush to the aid of another due to over-indebtedness and overspending, and

the ECB may stop indirectly funding the States and focus on its own duty,

which is to ensure the stability of the price levels within the Eurozone.

10

Gonzalo García Andrés highlights that, despite having taken

decisive steps in national policies and institutional framework

reform, the Euro crisis has worsened to the point of calling its sur-

vival into question; and no definitive solution is yet on the hori-

zon. In his article he attempts to offer an interpretation of what has

happened, assuming the extreme complexity both of the starting

point (with accumulated imbalances and structural deficiencies in

several countries), as of the outbreak, the contagion and the esca-

lation of the crisis. And he does so in the broader context of the

global financial crisis, which has affected economic and financial

development for five years, in order to determine which specific

aspects of the Euro have played a key role. All this with a view to

encouraging a reflection on solutions, bringing together the most

urgent and the ones with a longer term effect.

Cinzia Alcidi and Daniel Gros point out that the Eurozone cri-

sis encompasses different dimensions, from foreign debt and

current account balance problems, to the weak situation of the ban-

king sector. The document focuses on this last issue, the situation

of the banking system, and attempts to show the way in which

current characteristics of the regulatory framework of the financial

market have influenced the development of the crisis. In addition,

they express their concern about the false idea that the recently sig-

ned fiscal convention shall become the fundamental ingredient of

the recipe to overcome the crisis, when the banking sector conti-

nues to be heavily indebted and exposed to the vicissitudes of sove-

reign States. For this reason, they present a few ideas to break the

11

close ties between governments and banks, since these links them

in a common fate and constitute a clear impediment to recovery

from the crisis in the Eurozone.

Ricardo Martínez Rico, throughout his work, analyses the way

in which the sustainability of public finances requires a sold fiscal

institution and a firm political commitment by European govern-

ments. Subsequently, he tackles the close relationship between fis-

cal rigour, macroeconomic stability and growth, concluding that, in

order to achieve a positive inter-relation, the establishment of fiscal

rules which are simple, transparent, automatically applied and with

preventive control mechanisms for all Public Administrations, is

essential. All these items are key when designing a fiscal policy

which contributes to recovering the credibility required by Europe

along its route towards greater integration to handle the sovereign

debt crisis. Lastly, he examines the measures taken in Europe and

Spain since the start of the sovereign debt crisis, and reflects on the

next steps that should be taken towards a fiscal institution.

The work of Jaime Requeijo aims to provide a reasoned expla-

nation of the causes of the financial shocks affecting several

Eurozone countries, and which endanger the survival of the single

currency (the Monetary Union is a poorly built structure because

political urgency has prevailed over economic prudence; the fiscal

irresponsibility of many member state governments has translated

into the appearance of large public debt; such debts generate

doubts as to their holders; and, contributing factors such as the

12

effects of contagion or of the opinions of the rating agencies and

IMF predictions). In the article he also attempts to reply to three

questions on the measures taken, the results thereof, and the

impact of a potential decomposition of the euro. The article ends

with a brief final reflection on the solution to be applied in order

to maintain the Monetary Union.

A. Jesús Sánchez-Fuentes, Sebastian Hauptmeier and Ludger

Schuknecht state in their article that an ambitious fiscal reform

within a broader programme of reforms would have highly positi-

ve effects insofar as it would provide for a safer fiscal position, in

line with the requirements of the Stability and Growth Pact (SGP).

Expenditure control policies must therefore go hand in hand with

structural reforms, mainly focused on reducing rigidity in the

labour and product markets, on the correction of macroeconomic

imbalances, on the improvement of competitiveness and on sus-

taining potential growth. This becomes particularly key for the

most vulnerable countries in the Eurozone, which no longer have

the option of currency devaluation to increase competitiveness.

Finally, and on behalf of Círculo de Empresarios, I wish to thank

all the authors for their contributions to this new edition of the

Brown Book and I trust that these articles help to shed light on a

solution to the European trilemma.

Mónica de Oriol

President of Círculo de Empresarios

13

The future of the Euroafter the Great Recession 1

* Javier Andrés is professor of Fundamentals of Economic Analysis at the University of

Valencia and visiting professor of the University of Glasgow. http://iei.uv.es/javierandres/

** Rafael Doménech is Chief Economist of Developed Economies, BBVA Research and

Professor of Fundamentals of Economic Analysis at the University of Valencia.

http://iei.uv.es/rdomenec

1 The authors thank A. Deligiannido, A. García, M. Jiménez, and E. Prades for their assis-

tance and comments on this work, as well as the help from CICYT projects ECO2008-

04669 and ECO2011-29050.

Summary

In this chapter we shall analyse the challenges the Eurozone is facing and

proposals to deal with them via improved economic governance. To do so,

15

/JAVIER ANDRES*/ RAFAEL DOMENECH**/

Summary; 1. Introduction; 2. From the Great Moderation to the GreatRecession; 3. The imbalances in Europe and in the EMU; 4. The newEuropean governance and the future of the Euro; 4.1. Changes in fiscalgovernance; 4.2. Financial integration; 4.3. Economic integration; 5.Conclusions.

16

The future of the Euro after the Great Recession

we shall first examine the reasons behind the accumulation of significant

imbalances in the developed economies and among the EMU countries,

mainly since 2001 until the crisis in 2007, as a result of a pattern of unsus-

tainable growth in many developed economies. Secondly, we shall offer an

in-depth analysis of the significance of such imbalances and the heteroge-

neity which exists between EMU countries. Lastly, we shall study the cha-

llenges presented by the improvement of the economic governance of the

EMU from a fiscal, financial and economic integration perspective, which

shall determine its economic future in the short and long term.

1. Introduction

The international economic crisis which begun in 2007 is

having an extraordinary impact on the European economy, and for

the coming decades, will leave a deep mark in many of its mem-

bers. The crisis has shown that the growth process undergone bet-

ween 1994 and 2007, particularly following the creation of the

Economic and Monetary Union (EMU) in 1999, had entered into

an unsustainable dynamics in the long term. The appearance of

important macroeconomic imbalances among EMU members was

taking shape within the framework of steady growth, inflation

under control, very low interest rates and a very reduced risk assess-

ment (partly as a result of the disappearance of currency risk) in the

context of a world saving glut. Although the Eurozone as a whole

presents smaller aggregate imbalances in terms of deficit and pri-

vate, public and foreign debt than, for instance, the US or the

United Kingdom, the expectations of economic convergence

17


among Eurozone countries and the appearance of financial bubbles

with the promise of high yields, led to very significant capital flows

among its members. This added to a spiralling increase in house-

hold debt and businesses in some of the member countries, gene-

rating very considerable and longstanding deficits in current

account balances. These expectations petered out sharply as of the

subprime crisis of 2007 and, since then, Europe has been experien-

cing different surges of financial crises, economic crises and sove-

reign debt crises, which have been following on and feeding off

each other over time.2 The result of this complex situation has been

that, albeit with differences in the intensity and the severity of the

problems (see, for instance, Doménech and Jiménez, 2010), a sig-

nificant number of European countries have experienced a situa-

tion similar to that of the sudden stops experienced in the past by

some emerging economies, leaving public and private sectors heavily

indebted and, in some cases, extremely high rates of unemployment.

The aim of this chapter is to analyse the changes required by the

EMU and proposals with which to face such challenges with suc-

cess. In order to understand what the problems are and, therefore,

their possible solutions, in the second section we analyse the rea-

sons why important imbalances accumulated in the developed eco-

nomies and among the EMU countries during one of the most sta-

ble periods of economic prosperity in the last decades (the Great

Moderation), which nevertheless gave way to an unsustainable

2 Shambaugh (2012) performs an excellent analysis of the interaction between fiscal,

financial and economic crises in the Eurozone.

18


growth pattern in many economies. In the third section, we offer

an in-depth analysis of the magnitude and implications of such

imbalances throughout the crisis, which are well summarised in the

Excessive Imbalance Procedure (EIP) recently implemented by the

EU, as well as the current heterogeneity among EMU countries. The

fourth section analyses the challenges of improvement of economic

governance of the EMU from a fiscal, financial and economic inte-

gration standpoint, which shall determine its short and long term

economic future. Lastly, the fifth section presents the main conclu-

sions reached in this paper.

2. From the Great Moderation to the Great Recession

In the period between the mid-1990s and 2007, developed eco-

nomies enjoyed one of the greatest economic growth periods,

known as the Great Moderation due to the low volatility of growth

rates in those years. Graph 1 shows evidence of this for the US and

the EMU in terms of GDP per person of employable age. As can be

seen, from the mid-1990s to 2007 there was sustained growth, with

levels well above the historical trend estimated since 1970 for both

geographical areas. In fact, the growth in GSP per person of emplo-

yable age was slightly higher in the EMU than in the US, although

not enough to bridge the gap between both economies.

The Great Moderation generated the perception that economic

cycles would have less volatility, as a result of better managed eco-

19


nomic policy (see, for instance, Galí and Gambeti, 2009, or the

references appearing in this article). In fact, these high growth rates

with low volatility came hand in hand with inflation under con-

trol and low interest rates across the board of financial assets, with

practically inexistent risk premiums in many cases as a result of the

underassessment of the risk. In light thereof, some analysts went as

far as to proclaim the disappearance of the economic cycle and the

capacity to avoid significant economic recessions. It was the com-

binations of these forces which fed the financial imbalances which,

for economists like Rajan (2005) or Borio & White (2005), among

others, are behind the crisis which began in 2007.

There are various economic factors which contributed to genera-

te this combination on which the Great Moderation was erected. In

the first place, the central banks of the developed economies carried

out a low interest rate policy or money glut, as a result of: i) the drop

in the inflation of sellable assets following the inrush of exporting

countries in the international economy with a very abundant and

cheap workforce and depreciated currencies; ii) the benign neglect

policy in regard to the high prices of financial and real estate assets

(Bordo & Jeane, 2002, or Bean 2004 & 2010); and iii) the attempt to

prevent the recession in the US, following the burst of the techno-

logical bubble, or in Germany, following the costly process of reu-

nification and the burst of its real estate bubble.

Secondly a savings glut took place on a worldwide level in

China, Japan, Germany, oil producing countries or the pension

funds of developed economies.

Thirdly, and as a response the savings glut in some countries

and sectors, a formidable increase took place in the demand of safe

assets, moving from the pre-eminence of individual savers to that

of large sovereign funds, investment funds or pension funds which

prioritize safety over yield and which seek to channel savings

towards fixed income rather than towards the acquisition of any

other kind of asset. At the same time that the demand for safe

financial assets (i.e. AAA) increased, there was a relative scarcity of

such assets in the case of sovereign debt, due to the fiscal consoli-


20

Chart 1GDP per person of employable age in the US and in the EMU

Source: OEDC (2012) Economic Outlook Database.

dation taking place simultaneous in many developed economies as

a result of the high growth in GDP. This surplus demand for safe

assets created enormous pressure in the financial markets and in

certain types of assets, which in turn led to the appearance of bub-

bles in certain market segments. The pressure was such that finan-

cial deregulation and engineering came to the rescue, enabling the

response of the financial markets to this scarcity in AAA assets to

be the creation of multiple derivatives and the issue of huge volu-

mes of asset backed securities, as shown in Graph 2. In turn, this

generated enormous liquidity to fund those assets acting as the

underlying assets (for example, mortgages on homes), thus crea-


21

Chart 2Issue of Asset backed Securities 1985-2011

Source: SIFMA

ting a circle in which asset demand stimulated supply, which in

turn was fed back into the process by boosting demand with the

creation of new assets.

As a result of this process, a specialization in asset production

took place on an international level, leading to enormous hetero-

geneity by country, sector and agents. Whereas some countries

generated a surplus in net savings, others (US, Spain or Ireland) res-

ponded to the very low interest rate incentive by generating the

real investments which served as the underlying assets for finan-

cial securities. The US produced assets on a world scale considered

safe by the markets, thanks to the specialization of its financial ser-

vices. Other countries, such as Spain and Ireland, carried out a

similar role, but on a European scale, producing assets backed by

safe collateral (homes) or with no collateral, but issued by financial

institutions deemed to be safe, which attracted savings funds or

large European banks.

In fourth place, the creation of the EMU meant the disappearan-

ce of exchange rate risk among its members. This removed an impor-

tant barrier to capital flows within the EMU and encouraged the pre-

viously described process. But its effects went even beyond the disap-

pearance of currency risk. In the international financial markets, as

well as in the EMU countries, expectations that the greater monetary

and economic integration ensured the economic convergence of its

members were generated, which justified the disappearance of any

type of risk premiums (see Ehrmann et al, 2011).


22

Graph 3 clearly shows the almost full disappearance of risk pre-

miums for countries becoming part of the EMU. Without doubt,

Greece was a paradigmatic example of this process, going from fun-

ding at 25% in 1993 to do at the same interest rate as Germany, follo-

wing its entry into the Eurozone.

The implications of such expectations of economic convergence

were very important in terms of imbalances in the current balance.

Under the assumption that a real and economic convergence pro-

cess was taking place, well beyond the nominal, it seemed natural

that capital should flow towards the economies with lower per capi-


23

Chart 310 year public debt interest rates in the EMU, 1995-2011

Source: ECB, Bloomberg

ta incomes, as economic theory predicts (see, for example, Barro,

Mankiw & Sala-i-Martin, 1995).

In fact, as the risk premiums were disappearing, the correlation

between the savings rated and investment rate were reduced. As

was already anticipated by Blanchard and Giavazzi (2002), since

1999 to the start of the crisis, the Feldstein-Horioka paradox disap-

peared completely, as shown in Graph 4. Coinciding with the

reduction in the typical deviation of risk premiums, which reached


24

Chart 4Typical deviation of risk premiums and correlation between the rate of investment andthe rate of savings, EMU, 1993-2011

Source: Bloomberg

almost zero as of 1998, the correlation between the national invest-

ment rate and the savings rate was observed to have been nil or

even negative, compared to the positive and statistically significant

values of the beginning of the nineties.

In fifth place, a permissive regulation, together with reduced

interest rates and very high competition in the financial sector

generated the incentives required for the generation of profit to be

done via transaction volume instead of via price margins (mainly

interest rates), favouring a very important leveraging of broad seg-

ments of the private sector. One of the results of this process was

the intensification of a new banking business model, based on the

granting of collateral backed loans, the generation of financial

assets from such loans and the distribution thereof as asset-backed

securities in asset packages (originate to distribute) which transfe-

rred credit risk in full to the purchasers of these new generated

assets. Compared with the traditional bank business, in which

financial institutions that grant the credits keep the risk on their

balance sheets, this new business model led to greater intercon-

nection of the balance sheets among financial institutions all over

the world and a significant increase in contagion risk.

3. The imbalances in Europe and the EMU

The financial crisis was preceded by a period of economic prospe-

rity, measured by conventional indicators of growth, macroecono-


25

mic stability and inflation, during which enormous imbalances of a

financial and competitive nature have been created. However, a

glance of the macroeconomic picture of the EMU reflects a situation

of balance which we do not find in other important economic

regions of the world (Table 1). Both the deficit and public debt levels

and the net foreign positions and private indebtedness are generally

lower to those recorded in the United States or the United Kingdom.

However, the EMU has had other problems hanging over it which

have led the economy of the region – and that of the whole of the

EU by extension – to the situation of stagnation which it is currently

undergoing. Some of these problems are of a structural nature, and

others are related to the extraordinary disparities between member

states in their key indicators to which, until very recently, we had

paid little attention. Among the first are demographic evolution and

low productivity growth which in turn have provoked a limited rate

of growth in employment. But the disparities and the heterogeneity

within the EMU are the most outstanding imbalances, as they call

for a serious amendment in the operation of the Euro, whose main

objective was to accelerate convergence among countries who adop-

ted the single currency along with other common institutions.

The European Commission has recently implemented a pro-

gramme to monitor a number of indicators to detect and track

macroeconomic and financial imbalances in countries within the

EU (the EIP). One of these indicators summarises, over all others,

the nature of the main problem facing the European economy:


26

the gradual and persistent disparity in the current account of its

member countries. Although the EMU and the EU are economies

which can be described as economies which contribute (and

demand) little net savings to (and from) foreign savings, their

aggregate results is the sum of extremely disparate realities. As

Lane (2010) points out, in 2010 European countries accounted for

approximately one third of all current account deficits and sur-

pluses worldwide. As can be seen in Graph 5, the current account

deficits and surpluses of the EMU have gradually polarised from

levels ranging between the [-3%-, +3%] interval, in proportion to

the GDP to position itself outside of this range and even persis-

tently above it by 5%. The underlying causes and macroeconomic

implications of this type of imbalance are extremely complex.


27

EA17 US UK

Budget balance ofpublic administrations 2011 -4.4 -9.6 -8.9

Debt of publicadministrations 2011 87.6 100.0 84.8

Household debt 2010 67.3 92.1 106.1

Corporate debt 2010 119.1 74.6 123.7

Current accountbalance 2011 0.1 -3.1 -2.7

Net internationalposition 2010 -7.2 -17.0 -13.9

Table 1Debts and deficits in the EMU, US and United Kingdom (% GDP)

Sources: AMECO, Haver, IMF, national sources and BBVA Research

It is true that this polarisation is not an exclusively European

phenomenon, as it happens in parallel with the so-called “global

imbalances” generated during the recent globalisation process.

However, in contrast to what is happening on a world scale and par-

ticularly in a series of developed countries (the Anglosphere) and

emerging countries (particularly China) in Europe there is a positi-

ve correlation between levels of income per capita and sales deficit,

so that the capital flows from the more advanced countries to the

less developed. This has rendered such imbalances less conspicuous,

as they have been associated with the real convergence process. The

traditional view considered foreign indebtedness as a natural con-

sequence of the catching up process during which the countries

undergoing rapid growth required foreign savings to fund strong

domestic investment in commercial goods. Thus, the availability of

savings and the Euro allowed for the funding of the productivity

convergence without financial and exchange rate strangulation.

The international allocation of savings was deemed to be optimal

(“consenting adults”, Obstfeld, 2012), and there was no reason for

public political intervention – what became known as “benign

neglect” by Blanchard and Giavazzi (2002) or Edwards (2002).

It is not easy to determine an optimal level, or even an adequate

one, for the current account deficit which already reflects the gap

between domestic savings and investment in a country which is

assumed to have been optimally determined by consumers and busi-

nesses, unless it is associated with high public deficit, in which case

we would be dealing with a fiscal problem. Moreover, a country may


28

have a deficit current account without having a serious foreign

financing problem, or may have it despite having a regularised

account, in this case because despite a reduced net capital flow, what

matters in the event of a financial crisis is the size of the gross flows,

as nothing guarantees that national savers are willing to fund

domestic liabilities should the international markets become una-

vailable. However, the evolution of the current account of EMU coun-

tries (EU) reflects more deep-rooted problems where the adjustment

role of the market mechanism has proven insufficient and in which

gross financial flows have grown in a fast and imbalanced way.


29

Chart 5Current account balance (% GDP)

Source: BBVA Research with data from national sources

The deficits have not been linked with productivity convergen-

ce, as is evident in the cases of Spain, Portugal and, to a certain

extent, Ireland, which accumulated growing deficits despite the

slow growth of total productivity of the factors. As can be seen in

Graph 6, productivity grew by 1% on average, whereas the current

account balance varied between surpluses over 5% (the

Netherlands and Germany) and deficits of 10% (as in Portugal and

Spain). In fact, it has not only been the lure of investment but

mainly the fall in savings in peripheral countries which has caused

the gap in commercial deficit which has exceeded both in volume

– percentage of GDP – and in persistence, that observed in many

emerging countries prior to the crisis of the eighties and nineties.

Moreover, much of the foreign financing to the receiving countries

has not been channelled through direct and portfolio investment,

but by way of bank bonds, which increases the risk of bank crises

and ‘sudden stops’ (Jaumotte and Sodsriwiboon, 2010; Land,

2010).

However, the most worrying characteristic of the unequal per-

formance of the current account in Europe is its persistence. Far

from being a transitory phenomenon, the divergence between

commercial balances has sharpened until 2007 (see Graph 5). The

design of the Euro took into account that the absence of own

currency would hinder the traditional adjustment to which most

countries resorted in times of crisis in the balance of payments.

The impossibility of this recourse to devaluation has not come

hand in hand with the strengthening of real devaluation mecha-


30

nisms, that is, with a more flexible response by prices and salaries.

Between 2000 and 2010, enough time has lapsed to have expected

that the countries with most foreign debt and strong real apprecia-

tions should have begun a process of correction towards a surplus

in the commercial balance. Nevertheless, this has not been the

case. The correlation between the commercial deficit and the net

foreign position was positive in 2011 and in 2010 (Graph 7) as it

had been in the last decade, indicating that the private

savings/investment balance does not seem to respond to the cumu-

lative net foreign position.


31

Chart 6Current Account Balance in 2007 (% of GDP) and average productivity growth bet-ween 2000 and 2009.

Source: BBVA Research based on AMECO

In 2010 only four EMU countries had a net positive foreign posi-

tion – Belgium, Germany, the Netherlands and Finland – and only

Finland had managed it after correcting a very negative position in

2001 (that is, after a decade of foreign rapid growth and surplus).

Practically all other EMU countries saw their net indebtedness

increase substantially or, at best, such as in France or Austria, they

managed a moderate reduction thereof within the first ten years of

the single currency.

Therefore, the performance of the current account is a very use-

ful indicator – although naturally not infallible – of the way in

which a country responds to the commercial and financial globa-

lisation process and to the existence of other types of imbalances

associated with private sector debt, both financial and non-finan-

cial. Before reviewing these indicators for the EMU (EU), it is worth

asking why the (market) adjustment mechanisms have failed in

this case and what the risk of this situation is happening again in

the future.

The conventional current account approach indicates that

financial flows are a mere counterpart of commercial flows, so that

sustainability of foreign debt must be guaranteed by the expecta-

tion of future current account surpluses or, what is the same, by a

significant proportion of the commercial goods production in the

economy. Foreign financing is no at risk while foreign investors

consider the economy to be competitive. The domestic economy

must maintain a high productivity growth rate and competitive


32

labour costs, as the opposite would render the foreign deficit

unsustainable, foreign investment would drop, reducing prices and

salaries and improving the foreign balance. In this way, given rea-

sonable elasticity in the demand of exports and imports, the

periods of real appreciation and foreign deficit can be reversed wit-

hout deep structural changes.

However, this market mechanism has not worked in peripheral

Europe. Foreign funding has been used to a large extent to fund


33

Chart 7Current account balance and net international position

Source: BBVA Research based on Eurostat

non-commercial goods, leading to strong expansion of demand, of

prices and of labour costs (see Graph 8). Despite the loss of com-

petitive capacity, the appeal for foreign lenders continues provided

the value of the asset with real guarantees – such as homes – con-

tinues, which is perceived as relatively safe. Thus, the worsening

competitiveness is the effect and not only the cause for the dete-

rioration of the current account. But the existence of high com-

mercial deficit is not corrected of its own accord nor is it done in a

smooth and orderly manner. When the bubble bursts and prices of

the assets used as guarantees plummet, foreign investors perceive

that the national economy is no longer able to guarantee their

debt, leading to the well-known processes of flight to quality,

increase in the cost of debt and, in extreme cases, to sudden stops.

This integration process has led to a number of other imbalan-

ces in the European economies. The objective of the EIP is to go

beyond the control of deficit and debt, and to follow a number of

economic indicators which enable the detection of inadequate

macroeconomic development in a country and can lead to locali-

sed financial crises and even contagion in the future. Such indi-

cators come hand in hand with a number of ‘limits’ that are con-

sidered to be security measures which, when exceeded by a

country, special tracking must be carried out by the Commission.

If an economy is showing imbalance in several of these indicators,

it must propose a plan of action for correction thereof which, if

not suitably applied, might result in some form of political or eco-

nomic penalty. The list of indicators is the following (the limits


34


35

above which a form of relevant imbalance is detected appear in

brackets): current account balance (% GDP, -4%, 6%); net inter-

national position (% GDP, -35%); real effective exchange rate

(variation rate, -5%, 5%); export market share (growth rate, -6%);

nominal unitary labour cost (growth rate, 9%); cost of housing

(growth rate, 6%); credit flow to private sector (% GDP, 15%); pri-

vate sector debt (% GDP, 1605); public debt (% GDP, 60%); and

unemployment rate (10%).

Chart 8Growth of nominal salaries and real productivity

Source: BBVA Research based on Eurostat

The first report issued on the monitoring of these indicators

shows that in the third year since the start of the crisis (2010), the

imbalances accumulated in recent years are far from being correc-

ted, some of them having worsened since 2007 (Table 2). Greece,

Portugal, Ireland and Spain are the countries with worse qualitati-

ve results. They belong to the Eurozone periphery, where they fail

in at least five of the ten criteria.3

It is within the framework of such imbalances that we must

interpret the fiscal crisis that has been reflected in the general

growth of risk premiums of sovereign debt in Europe, especially in

peripheral countries – although not exclusively. The levels of public

debt in the EMU are comparable to those in the rest of the develo-

ped world, both if we consider the region as a whole or the coun-

tries within it separately. As is shown in Graph 6, only in 2008

three EMU countries (Greece, Italy and Belgium) had a public debt

above that of the US and in any case much lower than that of

Japan. The growth in public debt during the crisis period places

EMU countries – with the exception of Greece and Ireland – in the

realm of 20%, similar to what had happened in most of the deve-

loped countries. Therefore, behind the sovereign debt crisis there

are issues related to the economic governance of the EU in general

and the Eurozone in particular. But also, deeper reasons which have


36

3 The situation is worse if we take into account that indicators such as the growth rate

of housing prices and credit for the private sector are nowadays within the limits accep-

ted by the MIP as a result of the extraordinary restriction on credit suffered by most EU

economies.


37

become evident following the segmentation of the financial mar-

kets due to the crisis. On the one hand, we have the demographic

and structural characteristics of most of the countries, which

herald for the future a scenario of lesser growth than that before

the crisis. Graph 9 shows the growth rates up to 2007 and the fore-

casts made by the IMF up to 2015 for EMU countries, the United

Kingdom, Japan, and the US.

The aging population and its effects on participation in the

labour market, the low savings rates – with the ensuing difficulties

in funding investments – and the slow rate of productivity growth

explain such expectations, which in turn severely affect the capa-

city to absorb the strong increase in public indebtedness.

In second place, the economic crisis itself has generated an

additional burden on public finances by way of contingent liabili-

ties, the realisation of which shall depend on the performance of

the private debt and the need to apply measures to assist in the

reconversion of the financial sector. As stated by Reinhart & Rogoff

(2008 and 2009), one of the main consequences of financial crises

is that a large part of the private sector debt becomes public. Table

3 (ECB, 2012) shows the impact on public finances of the two

main contingent-type averages within the EMU: provisions for the

European Financial Stability Facility (EFSF) and the guarantees for

the banking sector. The sum of both would mean an additional

impact on the public debt in the EMU of almost 13% of the GDP.

It is true that such contingencies do not necessarily have to mate-


38

Table2

Imbalances

attheEM

U

Source:EuropeanCommission

(2012):FirstA

lertMechanism

Report(movingaverages,3

or5years)

rialise, but it is also true that provisions have proven insufficient

and have had to be extended in successive programmes.

Lastly, the aging of the population gives way to the generation

of implicit liabilities which are not considered in public debt figu-

res but should be taken into consideration when evaluating the

sustainability of public finances (Cecchetti, Mohanty and

Zampolli, 2010). In 2009 the IMF (IMF, 2009) calculated the sum of

implicit and contingent liabilities in securities exceed – in present

value – 400% of the average GDP of the G20. Of these, those of a

contingent nature associated with the crisis account for approxi-


39

Chart 9GDP Growth in 2007 and 2015

Source: IMF (2012)

mately one tenth, whereas that associated with an aging popula-

tion – pensions and social security – account for much higher

implicit obligations. As a whole, this type of liability will demand

a remarkable effort from public finances in the future. Cecchetti,

Mohanty and Zampolli (2010) place the additional permanent

financing required to meet such obligations at between 5 and 10

GDP points assuming a public debt at levels similar to the current

ones in developed countries.

In summary, some European economies may have reached debt

levels which exceed or are dangerously close to their fiscal limits,

defined as the maximum level of debt which a country is able to

fund. The fiscal limit depends on the political will of its citizens

and the capacity to increase income by means of tax rate rises (Bi,

2012 and Leeper & Walker 2011) which makes it specific to each

country. This might explain, at least in part, the differences obser-

ved in risk premiums between countries with similar levels of debt

or even that some countries pay a higher cost of financing that

others with much higher levels of debt. Moreover, the relationship

between the risk premium and the fiscal limit is non-linear, incre-

asing rapidly when fiscal performance places debt at such levels

that the likelihood of reaching the limit is significant (Bi, 2012).

That is to say, in order to observe significant risk premiums, it is

enough for investors to understand that the fiscal strategy of a

country leads it to a fair likelihood of reaching the maximum level

of debt financed, even if the probability of this taking place in the

short term is very small. This probability in turn grows over the


40

economic cycle, which obliges countries with greater volatility in

economic activity and unemployment to opt for stricter fiscal

rules.4


41

4 When the economies reach this limit, the efficacy of the fiscal and monetary policy

is substantially reduced and both instruments no longer have the expected effects on

economic activity. The fiscal multipliers are reduced and the monetary authority loses

the capacity to control inflation, irrespective of the aggressiveness of its monetary

policy.

EFSF Banking sectorguarantees

Belgium 7,3 12,7Germany 8,22 3Estonia 12,46 0Ireland 42,8Greece 25,8Spain 8,61 6,2France 7,97 3,1Italy 8,78 2,7Cyprus 8,78 15,7Luxembourg 4,66 3,2Malta 10,91 0The Netherlands 7,32 6,1Austria 7,19 5,7Portugal 9Slovenia 10,23 4,4Slovakia 11,05 0Finland 7,34 0

EMU 7,71 5,2

Table 3Contingent Obligations of the governments 2008-2010

Source: BCE

4. The new European governance and the future of the Euro

The economic crisis has highlighted the need to carry out

important changes in European governance. It is obvious that

there have been failures in coordination in the economic policy

and mistakes in the policies adopted by national government,

which have generated a sovereign debt crisis and a financial crisis.

And it is also obvious that Europe was not first resorting to the

supranational institutions and bodies to prevent the crisis and to

provide a rapid and efficient response once it had begun. The EU,

and particularly the EMU, need to improve their economic gover-

nance in at least three areas: fiscal, financial and economic inte-

gration. Below we shall analyse each of these aspects and the cha-

llenges faced in each by the EMU.

4.1. Changes in fiscal governance

In regard to fiscal integration, over recent months important

inroads have been made, among which are the Stability,

Coordination and Governance Treaty and the creation of the

European Stability Mechanism (ESM). The new Treaty, which shall

come into force on 1 January 2013, has been signed by all EU coun-

tries except for the United Kingdom and the Czech Republic, and

aims to make public finances sustainable and prevent the onset of

excessive public deficits, in order to safeguard the stability of the

Eurozone as a whole. In fact, this Treaty can be interpreted as a

second version of the Maastricht Treaty of 1992, with the differen-


42

ce that whereas the former determined the conditions to enter the

EMU, the new treaty can be said to detail the conditions to be met

by the members of the EMU to continue to belong to the Eurozone.

To this end, the Treaty introduces specific rules (the structural defi-

cit may not exceed 0.5% of the GDP, as of a date to be determined

by the European Commission, and a public debt below 60% of

GDP) and automatic mechanisms which enable the adoption of

corrective actions in the event of deviation from targets.

The rules introduced by the Treaty are in general well designed.

When establishing an objective in terms of structural fiscal balance it

allows for the influence of automatic stabilisers, the minimum being

between 0.5% of structural deficit and the deficit limit of 3%.

However, a good design does not necessarily guarantee a good imple-

mentation, as was the case with the Stability and Growth Pact (SGP).

It is true that the new Treaty entails a criterion of “reverse majority”:

from now on the adoption of corrective or disciplinary mechanisms

proposed by the European Commission must be rejected by a majo-

rity, whereas in the SGP the majority needed to be reached in order

to approve such proposals. It is also the experience of the current debt

crisis has led to an accumulation of collective knowledge which shall

prove very useful when adopting the right decisions in the future to

prevent new crises of this kind. Just as eighty years later the Federal

Reserve is currently preventing some of the well-known mistakes

which were made during the Great Depression of the 1930s, the

European Commission and the European Council shall endeavour to

prevent imbalances similar to those we are currently undergoing.


43

Available empirical and theoretical literature (see, for instance,

Andrés & Doménech, 2006, and the references included in this

paper), indicates that use of fiscal rules has proven useful in the

containment of public debt and the deficit, without the effective-

ness of the automatic stabilisers adversely affecting the effective-

ness of the discretionary fiscal policies. Therefore, the fiscal rules

like those included in the Stability Treaty do not have to be an

impediment for the fiscal policy to carry out its duty of stabilisa-

tion of economic cycles. Quite the opposite: when the economic

agents know, that as a consequence of the existence of such rules,

expansive fiscal policies in the short term shall be offset in the

medium term by counter-adjustment measures in order to prevent

the accumulation of public debt, the effectiveness of these discre-

tionary stabilisation policies increases, as has been proven by

Corsetti, Meier and Müller (2011).

In any event, it shall be very difficult to achieve an optimal

implementation of the Treaty. In the first place, because all govern-

ments are often too complacent when allocating probabilities to

possible risk scenarios which may render public finances unsustai-

nable. Secondly, because it is difficult that sanctions may come

about from the European Union Court of Justice on the basis of fai-

lure to meet the structural deficit targets, which depend of estima-

tes of the cyclical position of the economies and the elasticity of

public income and expenses to this cyclical position. Nevertheless,

what the Stability Treaty does provide is that, prior to reaching

sanctions, the Commission may exert much greater pressure on


44

national governments and alert markets about excessive imbalan-

ces, so that it is the markets themselves that impose discipline via

higher interest rates.

As for the ESM, at the ECOFIN on 30 March the decision was

taken to extend it to 500 thousand million euros, which shall be

provided over two years, and beginning on 1 July 2012. The extent

to which this fund will be sufficient is still unknown, in that it

shall depend on how it is used and whether it allows for fund leve-

raging. Without leveraging, the fund shall only be enough to cover

the financing needs of small or medium sized economies in the

EMU, but not of the big four. However, it may prove effective for

specific, selective but highly intensive interventions designed to

reduce risk premiums, that is, to replace the ECB in its Securities

Market Programme (SMP). In addition, if the ESM should obtain

liquidity from the ECB itself, each of these entities might be able to

separately specialise in the management of a risk: the SMP would

manage the ‘solvency risk’ of sovereign debt and the ECB would

managed the ‘liquidity risk’, thus enabling the central bank to resu-

me the natural role for which it was created, as it would be creating

an EU fund, with a joint and several guarantee, instead of sove-

reign debt with a national guarantee.

It is very important that the intervention of the SMP is as effi-

cient as possible. To this end, the Commission must be clear about

which countries are solvent, with adoption of any necessary adjust-

ment measures and structural reforms, and which countries need


45

some kind of debt restructuring. In the first case, which is clearly

applicable to countries such as Spain and Italy, SMP intervention

on risk premiums should be as intense as necessary until market

doubt and uncertainty have been obliterated. It would otherwise

be very difficult to convince sovereign, pension or investment

funds to purchase the public debt of such countries if Europe is not

the first to refrain from doing so.

Obviously, a more decisive intervention by the SMP, which

would lead to a rapid relaxation of the European sovereign debt

markets, requires the adoption and follow-up of the necessary

adjustments and reforms, but with sufficient time frame so as not

to asphyxiate the economic growth of the countries adopting such

policies. Specifically, the EU could change the fiscal consolidation

strategy which is currently being demanded from member states.

The obsession for nominal deficit targets should be replaced by a

more plausible, rigorous multi-annual fiscal policy strategy which,

in seeking to prevent a spiralling negative growth, truly contribu-

tes towards supporting sustainability in the long term of the public

finances of all countries. Specifically, the European consolidation

strategy should be based on the following principles:

1. Deficit reduction targets should refer to structural deficit inste-

ad of nominal deficit, as proposed by the new Stability Treaty.

This implies that countries should be asked to take specific and

detailed measures to ensure a certain amount ex ante in terms

of reduction in expenditure or increase in income in the


46

coming years. If, as a result of such measures, the economic

activity should be adversely affect with an impact on nominal

deficit (by the mere intervention of the automatic stabilisers),

the member states should not be obliged to take new savings

measures in that same financial year.

2. The pace of structural consolidation should be ambitious

enough to ensure sustainability in the medium to long term of

public finances, and gradual enough to prevent excessively

adverse effects on activity and employment in the short term.

3. The long term balance of public finances requires reforms

which guarantee the sustainability of public systems of pen-

sions and social protection.

Blanchard (2011) recently recommended that, in order to return to

prudent levels of public debt, it would be advisable to apply the pro-

verb of “slow and steady wins the race”. A similar recommendation to

that of De Long and Summers (2012), for whom a fiscal consolidation

which is too intense and too fast might endanger the very sustainabi-

lity of public finances instead of guaranteeing it.

In regard to the debate on Eurobonds, although not necessary

or sufficient, these can indeed become a useful tool in the con-

text of streamlined national finances. They are not necessary, as

the Eurozone can operate without them, if the Stability Treaty

and the mechanism for the prevention and correction of excessi-


47

ve imbalances work properly. And they are not sufficient to pre-

vent debt crises if the fiscal or current account imbalances are not

corrected. If growth is imbalanced (private indebtedness, current

account balance deficit), they imply a permanent transfer of

income from one country to another, which is unsustainable in

the long term. But they are convenient as an efficient mechanism

to ensure and pool risks in the face of asymmetric shocks and,

above all, as an element of political legitimacy of the European

project: European citizens must see that there are specific bene-

fits to belonging to the EMU. And Eurobonds are one of these

benefits, particularly now when many countries need to make

considerable sacrifices and carry out adjustments and reforms.

In this regard, the Eurobond proposal (blue and red) of Delpla

and von Weizsäcker (2010), has the advantage that it would allow

countries to benefit from risk pooling and the creation of a more

liquid asset (the blue bond) than that of the debt of each of the

EMU members, which would strengthen the euro as an internatio-

nal reserve currency, but with the benefit of preserving market dis-

cipline for national debt issued over and above 60% of GDP (red

bonds).5 This proposal consists of the EMU countries pooling their


48

5 Attinasi, Checherita and Nickel (2009) believe that this market discipline is behind

the increase in sovereign spreads between 2007 and 2009, as a result of the increase in

risk aversion and the concern for the sustainability of public finances. However, Favero

and Misale (2012) believe that this market discipline acts in an interrupted fashion over

time and, occasionally, in an exaggerated way, which in fact justifies the issue of euro-

bonds.

public debt up to 60% of their GDP as senior debt under the joint

and several responsibility of all members, whereas the issue of

national debt beyond such a limit would be junior debt under indi-

vidual responsibility. From this perspective, it is easy to conclude

that the decision of the European Council reached in December

2010 to ensure the solvency of the debt issued until June 2013, but

not that issued as of that date was a mistake, as the decision should

have been the opposite: ensure as of a given date all debt issued

under 60%, which would in effective terms be equal to the creation

of the Eurobonds proposed by Delpla and von Weizsäcker (2010).

4.2. Financial integration

As Pisany-Ferri and Sapir (2010) have pointed out, to date the

EMU has worked without a European institution able to rescue

transnational financial entities and without authentic European

stress tests for its banking institutions. Oversight duties have

remained with national authorities and coordination problems

have been managed by means of a combination of discretionary

cooperation and dependence on rules approved by the EU.

One of the lessons to be learned from the current crisis is that

it is difficult to manage a financial crisis on a European scale wit-

hout supranational regulators, supervisors and insurance mecha-

nisms. A large part of the head start that the US has over Europe

in terms of crisis management and resolution is precisely due to

the non-existence or the delay in creating such bodies. The US has


49

federal institutions to manage banking crises, whereas Europe

does not, which renders true the saying that banks are internatio-

nal when expanding and national upon demise. The problem is

that, for some governments (Ireland is a perfect example of this),

banks are too large in relation to their public budgets.

Likewise, the US has a federal regulation, whereas Europe has

enormous national dispersion of its regulations, despite the

efforts of the European Commission and regulators to homoge-

nise and converge towards a common financial regulation.

Occasionally, headways made in certain rules give rise to inequa-

lities among the agents who intervene in the markets, due to

other rules continuing to be different. This was the case, for ins-

tance, of the requirement of the European Banking Authority

that potentially systemic banks must exceed a capital ratio of 9%

before 30 June 2012, when the measurement of risk weighted

assets is regulated by different rules.

Banking oversight in Europe is furthermore carried out via

national supervisors instead of via a single European institution,

which introduces heterogeneity in oversight levels of the financial

system. The result of this financial fragmentation is that one can-

not speak of a single market, which generates the possibility of

regulatory arbitrage, different conditions of competency, ineffi-

ciencies and, in general, a disadvantage in regard to other world

financial areas.


50

In summary, financial integration requires an improvement to be

made in the mechanisms through which information is shared on

the financial systems of each country and the way in which their

activities are supervised, the harmonisation of the guarantees on

bank deposits and of consumer protection regulations, the creation

of European bank restructuring and rescue mechanisms, and the

advancement towards a Single Market not with more, but with a bet-

ter, European regulation which, instead of adding to and prevailing

over national legislation, should simplify and replace it.

4.3. Economic integration

With greater fiscal and financial integration the Eurozone could

operate with less tension in the future, without ensuring the economic

convergence among countries. Is convergence of income or welfare

levels in European countries necessary? Probably not, but it is still con-

venient, as has been stated earlier, to enable societies to believe that

being within an economic and monetary union has advantages well

beyond those which are provided by monetary stability. One of les-

sons to be learned from the Eurozone crisis is precisely that monetary

integration does not ensure economic convergence, as this requires an

advancement in convergence of the determining factors (economic,

social and institutional) of economic growth.

Table 4 shows that the differences in medium and long term

determinants of per capita income are very significant. The relati-

ve position of each country has been obtained on the basis of the


51

IMF analysis (2010), whereas the allocation of each country to one

of three groups under consideration has been carried out on the

basis of the criteria put forward by Hall and Soskice (2001). On the

basis of a number of criteria, both institutional and based on the

workings of economic relations, Hall and Soskice classify the varie-

ties of capitalism into liberal economies (the US being the pro-

totype) and coordinated economics (Scandinavian countries are

the paradigm). In both models (either with high or minimum

coordination), the economies can function efficiently. Market eco-

nomies which cannot be classified into either group are classified

as mixed economies.

In order to transform the qualitative IMF indicator into a quan-

titative one, such as analysing its correlation with per capita inco-

me, values of 1 to 3 have been allocated for each of the three levels

considered by the IMF, where a higher score suggests a greater need

for implementing structural reforms. This enables the obtention of

an average for each country and for each of the nine indicators

which are shown in Table 4. The differences shown in this table are

very marked, not only between developed economies, but also bet-

ween European ones. In light of this evidence it is not surprising

that, except in the case of Ireland, the countries which have accu-

mulated the most imbalances and which are suffering more form

the tensions in the debt market are precisely those which shown

greater structural weaknesses and the ones which must implement

the most reforms. Countries which in turn have been classified as

mixed market economies, presenting more inefficient institutions.


52


53

Table4

Structuralcapacityofthedevelopedeconom

ies

Source:BBV

AResearch

(2010)basedon

IMF(2010)andHall&Soskice(2010)

The changes in the regulations which affect the operation of the

labour, goods and services markets, trade, telecommunications

markets, are easier to implement in the short term, although the

changes thereof are felt in the medium term. An example of this

can be found in the recent reform of the labour market in Spain,

which is bringing its operation in line with that of countries like

Germany (in terms of internal flexibility mechanisms) or to that of

free market economies (by prioritising company agreements and

opt out clauses for collective bargaining agreements). Making

headway in these types of reforms (for example, linking salaries to

productivity) is crucial to remove the differences in competitive-

ness which exist between EMU countries, particularly bearing in

mind that the crisis may have had an effect on the potential

growth of these economies (see, for example, the European

Commission analysis, 2009).

However, in long term indicators such changes can take a lot

longer and, in some cases, even decades. This is the case with

human capital. Even in the event that the many younger workers

of countries such as Spain, Italy, Greece or Portugal should enter

into the labour market with the same human capital as in better

placed countries, 25 years would be needed to half the distance for

the whole of the population of employable age.


54

5.Conclusions

The economic crisis has highlighted the excessive complacency

of the markets, agents, supranational institutions and governments

when interpreting the imbalances which were being generated in

the previous expansion period and the absence of supranational

institutions and mechanisms, firstly to prevent the imbalances

which led to the crisis and secondly, to provide a fast and efficient

response once they had happened. Such institutions and mecha-

nisms are necessary because the evidence shows that the markets

react in a discontinuous way, and occasionally in an exaggerated

way, are pro-cyclical and do not generate of their own accord suf-

ficient disciplinary mechanisms in the short and medium term

whenever these are needed. Insofar as the current Eurozone crisis

has taken place mainly in three areas (debt crisis, banking crisis

and crisis in growth and competitiveness, with huge heterogeneity

between countries), the EU and, particularly the EMU, need to

improve their economic governance in at least three areas: the fis-

cal, the financial and that of economic integration.

As for the improvement in fiscal governance, the Treaty of

Stability, Coordination and Governance needs to be effectively

applies in a preventive way and that, during its transition towards

medium and long term structural deficit targets, this is done with

sufficient rigor and the right flexibility to prevent that countries

required to make the most efforts in the short term should enter

into a negative growth spiral. In this regard, intervention by the


55

ESM on risk premiums should be as intense as necessary until

market doubts and uncertainty have been removed, so that the

countries which are implementing fiscal adjustments and structu-

ral reforms have a sufficiently broad time period to enable such

measures to have positive effects on economic growth. As for the

Eurobonds, although they are not necessary or sufficient to ensu-

re the operation of the EMU, they are indeed convenient as an

efficient mechanism providing assurance and pooling risk in the

face of asymmetrical shocks and, above all, as a political legiti-

macy item in the European project: European citizens must disco-

ver that there are specific benefits to being part of the EMU.

Although it is difficult for such Eurobonds to become a viable ins-

trument in the current situation of divergence, they must become

an essential part of the future European Treasury when the main

imbalances are well under way to being corrected through the

decisive application of the reforms in the various countries in the

EU.

The second area where headway must be made is that of finan-

cial integration, in order to prevent future banking crises and to

manage them in a more efficient and rapid way. Europe must have

supranational financial institutions, regulators and supervisors, as

the current financial fragmentation prevents us from speaking of a

single market. An important limitation which gives rise the regu-

latory arbitrage, different competency conditions, inefficiencies

and, in general, a disadvantage in regard to other world financial

areas competing against the European entities.


56

Lastly, although greater fiscal and financial integration may suf-

fice to enable the Eurozone to operate with less tension in the futu-

re, it is worth establishing the bases for greater economic conver-

gence among its members, in order to increase the political legiti-

macy of the economic and monetary union project, with benefits

which go beyond those provided by economic stability. The diffe-

rences between the EMU countries in the workings of factor, goods

and services markets are very significant, as well as in long term

growth determinants. The structural reforms undertaken to enable

the markets to work more efficiently can bring positive effects in a

relatively reasonable period of time, enabling competitiveness to

improve and the imbalances accumulated during the expansion

and the crisis to disappear more rapidly. In this regard, it is essen-

tial to ensure the success of the Excessive Imbalances Procedure

and other imbalance monitoring mechanisms, ensuring a more

efficient preventive and corrective action than that provided by

the Stability and Growth Pact. However, in terms of long term

growth determinants, such changes can take longer and, in some

cases, even decades; it shall therefore be necessary for Europe to

boost the solidarity mechanisms required to accelerate this conver-

gence process in a more effective and efficient way than that done

in the past.

To simultaneous progress on all these fronts, both at suprana-

tional and national levels, is a necessary condition for the Euro to

overcome this crisis and for its members to continue to form part

of this project in the future. Insofar as the starting point is very


57

different in each country, the main challenge now facing the

EMU is to combine in a fair way the rigor and the ambition of the

adjustments and structural reforms, on the one hand, with an

appropriate time frame and solidarity with all other members of

the Eurozone, on the other.

If, on the contrary, the member states should fail to show such

determination, any attempt towards European economic gover-

nance will be due more an intention than a hard reality. The

Eurozone would have an uncertain future. The alternative of a

Political European Union, in which all necessary economic policies

could be implemented from a community Executive under the

control of a European Parliament and with all democratic rights, is

currently not expected for the time being.

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62

Nature and Causesof the Euro crisis

* José Carlos Díez is an economist who has combined his academic and corporate roles

throughout his professional career. His academic activity is linked to the University of

Alcalá, where he was an undergraduate and PhD student and now is Professor of

Fundamentals of Economic Analysis.

He is currently the Chief Economist at Intermoney, a company founded in 1979 and

leader in Spain in money market brokerage. He contributes with his forecasts to the

panel of experts of the ECB on European economy and the panel of FUNCAS on the

Spanish economy, and advises companies, financial entities and institutions both natio-

nal and international.

Summary

This work analyses the Euro crisis. It includes a review of its his-

torical background and the exchange rate theory to provide con-

ceptual arguments to help understand the nature and causes the-

reof. It is an infrequent pathology in economics, particularly in

developed countries, but with an enormous destructive capacity.

/JOSÉ CARLOS DÍEZ */

63

Summary; 1. Introduction; 2. Historical background of the Euro; 3. Natureof the Euro crisis; 4. Fixed versus flexible exchange rates: a review; 5. Causesof the Euro Crisis; 6. Conclusions; Bibliography

Nature and Causes of the Euro crisis

For this reason, it is important to get the right diagnosis when defi-

ning the economic policy that will solve the crisis. The main cau-

ses analysed herein are financial integration, the under-assessment

of risks, local imbalances within the Eurozone and the Great

Recession.

1. Introduction

The world financial crisis, whose first symptom was the collap-

se of the subprime asset-backed securities market at the start of

2007, has been changing. It is currently focused on Europe, and is

calling into question the future viability of the Euro and the

European project itself. This work aims to classify the nature of the

Euro Crisis and to identify the main causes thereof. Although the

objective is not to analyse potential economic measures designed

to solve the crisis, without an accurate diagnosis of the origin and

dynamics of the crisis, finding the right solution would be an exer-

cise in chance.

To this end, section 2 includes the history of the European pro-

ject and the single currency. Section 3 describes the nature of the

crisis, which is a seldom seen pathology in economics but which

causes devastating damage to unemployment and public debt of

affected countries. In order to provide the conceptual arguments

required to analyse the crisis, section 4 contains a review of the lite-

rature on exchange rates. Section 5 analyses the main causes of the

crisis, which are: i) financial integration and under-assessment of

64


risk; ii) local imbalances; and iii) the Great Recession. Finally, sec-

tion 6 includes the main conclusions reached in the article and

establishes the requirements to be met by the roadmap in order to

put an end to the Euro Crisis.

2. Historical Background of the Euro

The Euro is the first monetary experiment of the 21st century. It

is not the first in history and shall not be the last, but it affects an

economy like that of the Eurozone which accounts for 15% of the

GDP and for 40% of world exports. The European Union is a poli-

tical project designed to prevent a third world war in Europe. The

first assignment of sovereignty was control by a supranational

body of the coal and steel production in France and Germany, basic

raw materials to produce weaponry. Europe was not an optimal

monetary area; therefore, if a country suffered from an asymmetri-

cal disturbance which did not affect the rest and it saw the effects

thereof on tis unemployment rate, this could not be offset by wor-

kers migrating to other countries with lower unemployment rates.

The bubble in Spain is a good example of this. Spain created one

third of the jobs in the Eurozone during the boom years, but wor-

kers from Germany, where the unemployment rate was reaching

historical levels, did not come: instead, it was workers from outsi-

de the Eurozone who came. When the bubble burst, our unem-

ployment rate shot up, but very few Spanish workers have gone to

work in Germany.

65


The example of an optimal monetary area is always the US.

However, we tend to forget that in order to get there; they first

had to annihilate the original settlers and then have a civil war

which led to a default on payment of foreign debt. The European

project belongs to the 21st century and when in Asia, America or

Africa integration processes begin, they look to Europe for inspi-

ration. Nevertheless, the Euro was a risky headlong rush. Since the

end of the Bretton Woods agreement, Europe has tried to avoid

the unfair competition of competitive devaluations within a cus-

toms union. Germany, with the strongest currency in the system,

has always led the monetary agreements, as its companies suffe-

red the industrial delocalisation created by devaluations, mainly

that of the Italian Lira, a country a few hours away by lorry from

Bavaria. After the fall of the Berlin Wall, the acceleration of the

monetary union was decided so that it would become the striker

of the political union. However, the political union reached stag-

nation after the severe German crisis of 2000, and the single

currency project began to crack.

3. Nature of the Euro Crisis

The nature of the crisis which is hitting the European Union is

a classical debt deflation crisis (Fischer, 1933). Since the Great

Depression, this type of crisis had mainly taken place in emerging

countries and was associated with countries with financial vulne-

rability, with little tradition of macroeconomic stability and insti-

66


tutional fragility. Japan had suffered a crisis of this kind in the

nineties and its economy is today trapped under deflation and

liquidity, but it was viewed as an exotic case in the Far East. In

2008, the Great Recession led to an abrupt disruption of the paths

of growth in developed economies, and the ghost of the Great

Depression began to haunt the world. By contrast, the decisive and

coordinated action of global economic policies prevented another

Great Depression (Eichengreen, 2010). Since then, world trade and

industrial production are 10% higher to levels prior to the Great

Recession, although the MSCI world stock index continues to be

20% below the levels of spring 2008.

Nonetheless, the crash of Lehman Brothers led to the collapse of

world trade, and all countries and areas entered abruptly into reces-

sion, which favoured policy coordination. But the recovery from

2009 was asymmetric, and the coordination of world economic

policies was conspicuously absent. In the Eurozone, from summer

of 2008 to spring of 2009, the euphoria in support of an interven-

tion to avoid a depression gave way to exit strategies in autumn of

that same year and to begin implementing these in spring of 2010.

The debt crisis affected a country with huge imbalances in the

balance of payments and high level of indebtedness such as

Greece, which accounts for 2% of the GDP and population of the

Eurozone, and has extended first to Ireland, then to Portugal, and

now to Italy and to Spain. One third of the GDP of the area is alre-

ady affected, and it has thus become a systemic and global pro-

blem. This is a crisis in the balance of payments, but the existence

67

of a currency and the high level of indebtedness mean the lack of

any comparable historical precedents, which in turn makes the

diagnosis and the search for policies to solve it much harder. For

this reason, we must carry out a review of classical literature on

exchange rates in order to establish the conceptual bases for the

explanation of the crisis, without which the search for a solution

would become a random wander.

4. Fixed exchange rates versus flexible exchange rates: a review

An exchange rate is a relative price between two hypothetical

shopping baskets of two countries. However, exchange rates are

closely related to interest rates (Keynes, 1992), and we are therefo-

re speaking of a relative price which is essential when explaining

economic development. Probably for this reason and as a result of

the advance of globalisation, both commercial and financial since

the fifties, in recent decades economists have paid special attention

to exchange rates. Exchange rates can be:

i. Free floating: the exchange rate is set freely in the market on the

basis of supply and demand, without the intervention of the

central bank or the government of a country. The Euro and the

Dollar are the closest free floating currencies.

ii. Dirty or managed float: the government or central bank suppo-

sedly does not intervene but there are verbal interventions or


68

changes in monetary policy which attempt to alter the bases of

supply and demand in the currency market. At times of maxi-

mum volatility both the US government and the European ones

verbally intervene in the market. During the Great Recession,

the Federal Reserve, without expressly acknowledging this, has

applied a monetary policy which has significantly weakened the

dollar. The ECB has always followed in the footsteps of the Fed

but in 2011 it managed to exceed its action by weakening the

Euro, also without express recognition thereof. Japan is without

question the best example of dirty flotation. The country sup-

posedly enjoys free exchange rates but when there is tension in

the markets and the savers repatriate capital, the central bank

intervenes massively in the currency market to counteract the

pressures of appreciation on its currency, which would have a

very negative repercussion on activity and employment.

iii. Fluctuation bands: the European Monetary System or EMS, the

predecessor of the Euro, was the clearest example of this system.

A central parity and fluctuation bands were established. Whilst

the exchange rate in the market fluctuated within the bands,

the system behaved like a flexible currency rate, but if it reached

the bands then the central bank intervened to prevent these

being exceeded, therefore becoming a fixed Exchange rate.

iv. Fixed on a currency basket: equal to a fixed rate, but instead of

fixing the anchor on one single currency it is fixed on a basket.

It has been speculated for some time that China wants to apply


69

this system. It makes more sense that just fixing it against the

dollar, as the basket should replicate the composition of the

current account and financial balance and would allow for bet-

ter stabilisation of real exchange rates, which are the ones

which determine the impact on activity and employment.

v. Fixed adjustable: this is a fixed exchange rate which allows

for adjustments. These may be discretionary or else subject

to rules such as in the Bretton Woods system, or periodically

adjustable. The latter were used in emerging countries which

had sustained soaring inflation rates in the eighties and

nineties during their stabilisation programmes, especially in

Latin America.

vi. Non-adjustable or true fixed rate: the country fixes a nominal

anchor with a fixed rate relative to another currency with no

possibility of change. Middle Eastern countries have fixed

exchange rates against the dollar, which is justified by income

from oil being collected in dollars. China had a fixed exchange

rate against the dollar until 2005, when it moved onto daily

fluctuation bands which it has recently broadened to +/- 1%

daily.

vii.Cash conversion: the monetary supply of a country is determi-

ned by the level of currency reserves, and thus monetary sove-

reignty is subject to capital flows. This was the exchange system

in Argentina until 2001.


70

viii.Exchange Union: the countries waive their national sove-

reignty and assume a new currency. This may be a dollarization

as has been proposed in some Latin American countries, or else

a Euroization where the dollar would be adopted but without

representation in the central bank. Or else a monetary and

exchange union such as the Eurozone, where countries assume

the same currency and are represented in the central bank and

in monetary and exchange decision making processes.

The debate on fixed or floating exchange rates is as old as macroe-

conomics. During the happy twenties and then during the Great

Depression, capital movements were accused of being speculative due

to the extreme volatility of exchange (Nurkse 1942). Subsequently,

another school of thought argued that the volatility was caused by

destabilising economic policies and that freedom and speculation had

stabilising effects (Friedman 1953). Rudiger Dornsbush opened up a

new avenue of research according to which, even with investors with

rational expectations, there was volatility in exchange rates. An incre-

ase in the money in circulation by the central bank would increase

inflation expectations and lead to a depreciation in the exchange rate.

However, for investors to buy once again there should be expectations

of appreciation; the exchange rate should therefore over-react and

exceed its level of equilibrium to enable capital flows to return to the

country.

The truth is that neither the theory nor the empirical evidence

are conclusive in this debate. The problem facing the countries is


71

threefold: exchange rate stability, monetary independence and

financial aperture. Conceptually speaking, flexible exchange rates

are the optimal solution, but for these to be stable the country

must have monetary credibility. Flexible exchange rates provide

leeway to the central bank in terms of fiscal policy, whereas the

fixed exchange rate means this is lost and it becomes dependent on

the decisions made by the central bank to which it has anchored

its currency. The problem is that credibility takes a long time to

achieve and takes very little time to lose. Moreover, it cannot be

imposed; it is the society of the country in question which must

understand stability to be a public asset and to accept sacrifices and

limitations in order to preserve it.

Countries lacking monetary credibility have hardly any leeway in

monetary policy, and this reduces the costs of accepting a fixed

exchange rate. If the country has suffered from hyperinflation or a

spiralling inflation, a nominal anchor on a stable currency allows for

stabilisation of the prices of imported goods in the shopping basket

and, combined with a stabilisation plan, proves to be highly effecti-

ve to get the economy out of hyperinflation. This is what happened

in Argentina in 1990, but then the fixed exchange rate allowed imba-

lances to go beyond what was sustainable and ended up by explo-

ding in mid-air and amplifying the effects of the severe crisis of 2001.

During the nineties the debate in Europe prior to the creation of

the Euro was very intense (Rodríguez Prada, 1994). Most econo-

mists did not call into question the fact that Europe was an opti-


72

mal monetary area (Meade 1957 and Mundell 1961). Although

much progress has been made in the freedom of movements of

capital and people, the labour markets continue to be segmented,

mainly due to language and cultural differences, and when a region

suffers an asymmetric disturbance with an increase in unemploy-

ment, this is not offset by transferring workers from another region

as they do, for example, in the US. In this scenario, the country

needs to transfer capital and work to the sector of non-corporate

goods to the corporate goods sector and needs to depreciate the real

exchange rate. Without the capacity to devaluate the nominal

exchange rate, all the adjustment must be made via inflation or

productivity. When the central country has inflation rates close to

2% the strategy must be deflationist, which is where the problems

start, as many economists warned prior to the creation of the Euro

and has been proven since the Great Recession (Obstfeld 1998).

Nevertheless, the lack of an optimal monetary union is clearly a

downside to the creation of the euro, but in the nineties it was the

benefits that were highlighted (De Grauwe 2009). The main bene-

fit is that we Europeans already had a customs union and high

level of commercial integration. Nowadays, approximately 70% of

the Spanish exports are concentrated in the European Union and

60% of what we import comes from our partners. Therefore, natio-

nal exchange policies were very destabilising in this scenario, put-

ting the European project at risk.


73

The main benefits were concentrated in the financial area.

Integration would enable the removal of currency risk and risk pre-

miums, leading to a drop in real interest rates and therefore incre-

asing the potential growth of the Eurozone and of each of the

countries therein, in turn allowing for convergence in income per

inhabitant with the US, which experience a sharp boom in pro-

ductivity in the nineties. Chart 1 shows how the introduction of

the euro did not achieve the desired convergence, except in the

case of Spain.


74

Chart 1Gross Domestic Product per inhabitant

Source: Eurostat structural indicators and own work

In the debate of costs and benefits prior to the creation of the Euro,

many economists warned of institutional problems in the design of

the monetary union. The main ones were the absence of a fiscal

union which would offset the asymmetric disturbances that might

take place in some states and, that in the absence of exchange rates

and monetary policy, the country would be left without economic

policy leeway to counteract them (Eichengreen 1998). The other

main limitation was the absence of a true lender of last resort which

the statutes imposed on the ECB (Obstfeld 1998).

5. Causes of the Euro Crisis

The Euro crisis is extremely complex like all debt deflation cri-

ses in history (Díez 2012), which is why we shall now review the

main events to enable us to understand the fundamentals of the

over-indebtedness without which we shall not be able to come up

with appropriate economic policies to help digest this.

5.1. Financial integration and under-assessment of risk

When a country adopts a fixed exchange rate and investors con-

sider it sustainable in the future, the risk premium drops. A rational

investor must choose between an infinite variety of international

assets in which to invest his savings, but his yield estimates are

made in local currency as the objective of purchasing financial

assets is to protect against the impairment of purchasing power


75

caused by inflation during the investment period. If an investor

purchases an asset in another currency that then appreciates

during the investment period, his yield will increase in the local

currency, but if it depreciates it will drop, which explains the direct

relationship between interest and exchange (Dornbusch 1976).

In the case of the Euro we are dealing with the exchange rate

with the largest commitment and greatest exit costs; therefore its

added credibility is also greater, just as the drop in risk premiums is

also highly intense. Chart 2 shows the intense process of financial

integration which took place in Europe following the creation of

the single currency. Investment funds and financial institutions in

the Eurozone went from having 20% of assets from other countries

in the region in their portfolios in 1998, to 45% and 40% respecti-

vely in 2007. This means a huge transfer of capitals from countries

with a savings surplus, mainly Germany, to countries with savings

deficits and especially those with higher risk premiums.

This arrival of capital flows, along with the credibility granted

by the investors to the Euro since its inception, help to explain the

intense convergence of interest rates between the public debt of the

various member countries that can be observed in Chart 3.

However, as is the case with all bubbles, at the beginning there are

fundamentals which justify investor behaviour, but usually, follo-

wing such sharp changes in financial flows, there is usually and

over-reaction and asset prices move away from the fundamentals.


76

Chart 4 shows how not only did convergence take place in

public debt interest rates, but that the process was more intense in

private debt. Covered bonds are the assets with the least likelihood

of default following the public debt of a country and it might even

be the case, in extreme cases, of default on Treasury bonds but not

on covered bonds, as has happened in Greece. The covered bond is

a bond with a senior guarantee from the financial institution that

issues it, but which also has a second guarantee. The issuing entity

selects its highest credit quality mortgages, those for the main resi-

dence, with a debt under 80% of appraisal and a monthly instal-

ment below 35% of the household income, and these are attached

as bond guarantees. Therefore, in the event of bankruptcy of the


77

Chart 2Financial integration

Source: European Central Bank

entity, the buyers of the covered bond would prevail over the rest

of creditors to collect on such mortgages until recovery of their

investment, irrespective of whoever purchases the bankrupt entity.

This is what distinguishes them from asset-backed securities where

the investor assumes the direct default of the mortgages. In the

case of the covered bond, the risk belongs to the entity and, second

to the default of the mortgages, and thus they have a dual guaran-

tee and lesser likelihood of default. Moreover, the rating agencies

require the over-collateralisation of the issue, so that if an institu-


78

Chart 310 years Public debt spread v. Germany

Source: Bloomberg and own data

tion issues a covered bond worth 1000 million euros, they would

be required to provide between 1300 and 1500 in mortgage portfo-

lio as a guarantee. Hence, the entity would first have to be declared

bankrupt and then it should have to have a default in the mortga-

ge portfolio of over 50% for the investor not to recover 100% of his

investment. This helps one to understand that since 2007 no cove-

red bond issued by a European entity has experienced default.

These types of assets do not exist in the US, as the Fannie Mae and

Freddy Mac played the same role, but evidence has shown that the

European system, by maintaining the risk in each institution, was

more efficient and, in fact, there are legislative proposals under way

to develop a covered bond market in the US.

Until 1997, the companies of peripheral countries such as Spain

found it difficult to issue bonds on the international markets. The

Peseta was a currency which had experienced several devaluations

over the last few decades, its financial markets were very narrow

and were practically taken over in full by public debt. The entry of

the Euro enabled Spanish financial entities to access an organised

market of covered bonds with a longstanding tradition and depth

in Germany, which rapidly spread to all other countries in the area.

As we shall explain shortly, this coincided with a deep and complex

debt crisis in Germany, as a result of the excesses of its Unification,

which increased the savings rate in a structural way, and thus the

supply of top quality credit assets for its financial institutions, insu-

rance companies and pension funds, which in turn boosted the

rapid growth of this market as well as its (Díez 2012b).


79

In Chart 5 we can see how such structural changes in the fun-

damentals led to a credit boom in the Spanish economy. The ori-

gin of the boom was justified by the fundamentals, but in the end

the only fundamentals were the self-realisable expectations, lea-

ding to the bubble. In 1995, when the likelihood assigned by inves-

tors that Spain would form part of the founder members of the

Euro was very low, practically all of the Spanish bonds in the hands

of non-residents were public. Since then, the percentage of public

debt over GDP had become constant, but when our incorporation


80

Chart 4Spanish covered bonds spreads

Source: Bloomberg and own data

into the single currency was approved in 1998, the international

issues market opened up for the private sector and grew exponen-

tially until it doubled that of public debt in terms of GDP. The hea-

ding “other resident sectors” includes the asset-backed securities

funds, rendering most of debt as pertaining to banks.

Covered bonds are purely a bank product, despite carrying a

second mortgage guarantee, and are accounted for as bank debt. The

most developed covered bond market in the world was the German


81

Chart 5Spanish bonds in the hands of non-residents

Source: Bank of Spain, INE and own data

one of Pfandbrife but in Chart 6 one can see how in 2006 the

Spanish banks issued 70,000 million euros in covered bonds, 30%

less than the German banks which had a balance three times as

large as that of Spanish banks. In summer 2007, before the start of

the financial crisis, the outstanding balance of covered bonds issued

by Spanish banks exceeded 300,000 million euros, 30% of the GDP

and an amount equal to the outstanding balance of Spanish public

debt. In 2006, the issues of covered bonds and asset-backed securi-

ties by Spanish banks comfortably exceeded the current account

deficit which was approaching 100,000 million and were the main

financing instrument of our economic, without which it is not pos-

sible to explain the credit and real estate bubble.

The dynamics were straightforward. The Spanish banks used the

loans granted in retail banking as a guarantee for new issues which

allowed the granting of new credits. The issues of covered bonds

were carried out at variable interest rates of Euribor plus 10 basis

points and the mortgages were granted at Euribor plus 50 basis

points. A strong growth in credit, low rate of default and spreads

between stable asset and liability rates constituted the basis of the

demand for funds of Spanish banks. What were the fundamentals

of the supply of funds? The key lay in the Shadow Banking System

(FSB 2011, European Commission 2012). This consisted mainly of

vehicles created by international banks, based in tax havens and

not consolidated in their balance sheets and thus outside the peri-

meter of oversight by the central banks. The vehicles purchased

assets, mainly of high credit quality and were funded by the com-


82


83

mercial paper market using those assets as guarantees. Let us assu-

me that the vehicle bought a covered bond at Euribor plus 10 basis

points and was funded by Euribor commercial paper. This resulted

in a profit of 10 basis points per transaction. If the vehicle only had

5% of capital and 95% of debt, this meant a 20-fold leverage, such

that the yield over equity was Euribor plus 200 basis points.

The growth of the shadow banking system was exponential and

in 2007 in the US reached 20 billion dollars, whereas the non-sha-

dow banking system supervised by the Federal Reserve amounted

Chart 6Issues of Covered Bonds

Source: International Monetary Fund

to 16 billion dollars. The asset-based leverage which used mortgage

guarantees already granted enabled the banking system to generate

liquidity in an endogenous manner without having to resort to the

central bank, leading to the loss of monopoly by the monetary aut-

horities of the issue of money in circulation. When in February

2005 Alan Greenspan, then President of the Federal Reserve,

announced that there was an enigma in the behaviour of the bond

market, he was responsible for this for allowing the development of

the shadow banking system. Until 2009, no statistics were publis-

hed on the shadow banking system but, once they became public,

it was much easier to understand the causes of the largest global cre-


84

Chart 7Current account balance

Source: International Monetary Fund


85

dit bubble burst since the Great Depression and which was parti-

cularly severe in some Eurozone countries, including Spain.

5.2. Local imbalances:

Over the last few decades, the economic paradigm has analysed

the real economy and the financial economy separately. The Great

Recession has proven the failure of the paradigm and, as we were

shown by Luca Paciolo in the 13th century, when an economy is

analysed, the assets and liabilities cannot be separated. Therefore,

although it is evident that the hurricane began in the financial

realm, there are imbalances in the real economy which also help

to explain the crisis. Chart 7 shows the divergence between

current account balances among developed and emerging coun-

tries in the last decade. Several causes help explain this phenome-

non which the literature has called “global imbalances” (Caballero

2009).

The main cause was the aftermath of the Asian crisis of 1997.

The affected countries had large current account deficits and low

levels of currency reserves before the crisis, and subsequently they

geared their economic policy towards exports. This led to current

account surpluses and high currency reserves, and the ensuing

structural increase of the world savings rate (Bernanke 2005). The

accumulation of reserves was concentrated on sovereign funds and

central banks with a conservative approach, which significantly

increased the demand for fixed income funds of top credit quality,

known as AAA. Without understanding the Asian crisis and its con-

sequences it is not possible to understand the intense development

of the shadow banking system and the strong increase in leverage

in the world banking system which has been analysed in the pre-

vious section (Caballero 2008).

Chart 8 shows how the Eurozone was hardly affected by the

phenomenon of Global Imbalances, with a current account balan-

ce close to equilibrium since the Asian crisis. However, Chart 8

shows that there have indeed been huge differences between the

countries within the Euro and, for this reason, the phenomenon

has now been called Local Imbalances. In 2001 Germany suffered a

debt crisis similar to the one suffered at present in Spain, although

it hardly translated into a current account or foreign debt deficit.

Germany, as was the case in Japan in the eighties, suffered from a

problem of over-indebtedness of households and businesses, with

real estate bubble, burst and depression all thrown in to the packa-

ge. Following the burst of the bubble in 2000, German households

were reluctant to take on debt and structurally increased their

savings rate to reduce such a debt. Private consumption plumme-

ted and businesses sought the supply that was absent in the domes-

tic market in the export market. The fiscal revenue dropped dra-

matically and Germany failed to meet the Stability Pact and wat-

ched its public debt increase significantly until 2005.

The birth of the euro and the credit boom in peripheral coun-

tries enabled Germany to overcome the severe recession thanks to


86

the strength of its exports. Moreover, German savings found an

easy path without assuming exchange rate risk with its partners in

the Eurozone. The causes of the Euro crisis are focused on the

analysis of the imbalances of debtor countries, but it is not possi-

ble to understand and explain the crisis without analysing the

saver countries, particularly Germany. Debtor countries are facing

a prolonged period of debt reduction, which will ensure a weak

internal demand, and shall be obliged to show a current account

surplus as was the case in Asia in 1998 and in Germany in 2001.

But this will not be possible if the creditor countries reduce their

current account surpluses and boost internal demand.


87

Chart 8Current account balance

Source: International Monetary Fund and own data

5.3. The Great Recession:

The European Monetary Union was born with institutional pro-

blems but these did not become evident and to put its viability at

risk until 2009. Chart 9 shows how the Great Recession which rava-

ged the world and Europe in 2008 has been the worst for seventy

years, although it did not reach the depth and length of the Great

Depression, which it is being called the Great Recession. Without

an earthquake of this force, it is possible that the institutional flaws

of the European project could have endured for longer, but the cri-

sis has highlighted them and the Euro is now at a crossroads.

In 2007 it was financial disturbances which anticipated the

recession. Chart 6 shows how the covered bond market practically

dried up for Spanish banks as well as for all other indebted coun-

tries. This brought the credit boom to a halt and acted as the trig-

ger for the recession. In 2008 the disorderly collapse of Lehman led

to the worst global run since the Great Depression. The investors

quickly resorted to short term public debt of the internal reserve

currencies, the money markets dried up as did the currency mar-

kets, and world trade collapsed in a matter of weeks. The coordi-

nated reaction of the G20 with the most expansive monetary, fis-

cal and financial policy in history prevented the world from ente-

ring into a depression and enabled a V-shaped recovery of world

economy and trade in 2009.


88

Economics is an empirical science but it is difficult to find

homogeneous experiments to compare policies, but this crisis has

provided one. The Great Recession was synchronized and most

countries entered into recession at the same time. However, the

recovery since 2009 has been disparate and the economic policies

have been very different between the US and the Eurozone, which

enables a comparison of its effects to be drawn. Europe began fis-

cal consolidation at the beginning of 2010, despite the boost

given in 2008 to get out of the recession, whereas the US has con-

tinued to renew its fiscal incentive plans. The ECB has been reluc-

tant to intervene and has only done so when the markets have

been on the edge of collapse and it even took the liberty of incre-


89

Chart 9GDP EU 15

Source: Angus Maddison. University of Groningen

asing the interest rated in July 2011, making the same mistake as

in July 2008, anticipating the recession. The Federal Reserve has

kept its rates at 0% and has renewed its quantitative policies.

After two years of experimenting, what has the result been? The

growth in the US has been twice that of Europe, its inflation has

also doubled and its unemployment rate has reduced to 8.5%,

whereas in Europe it has exceeded 10%. In the US, several states,

among them California and Florida, burst their real estate bubbles

and California defaulted on payments and created its own

currency, what was known in Argentina as Patacones. Therefore,

the Euro crisis is not the cause of the problems in Europe but

simply the result of mistakes made in economic policy in Europe

since 2009. Neither is the argument of the greater rigidity of

European labour markets and the mobility problems between

countries valid. In the US, the unemployment rate increased with

equal intensity in states which did not have a real estate bubble,

thus confirming that the cause of the growth in unemployment

was a sharp drop in demand caused by an intense banking crisis

and credit restriction. But the most spectacular result of the expe-

riment is probably what happened with public finances. The US,

without resorting to raising taxes, without great cuts and simply by

freezing public expenditure has managed to increase fiscal revenue

by 12% and has reduced the deficit by four percentage points of

GDP. Europe, by raising taxes and cutting costs has managed a

revenue increase of 6% and a reduction of the deficit of two points

of GDP.


90

The emergence of almost ten points of public deficit in a new

Government in Greece was the spark which ignited the Euro crisis

which we currently face. The Greek Tragedy spread first to Portugal,

then to Ireland, and currently threatens Spain and Italy, thus

having affected one third of the GDP of the Eurozone, (Díez, 2012).

Chart 2 shows how the Great Recession began a process of finan-

cial disintegration in the Eurozone which was intensified by the

Greek Tragedy and the contagion of all other economies. In a

monetary union, the outflow of capital is equal to a contractive

monetary policy and, on the contrary, the inflow of capital is

expansive. This helps us to understand why the countries subjected

to financial tension entered once again into deep recession in 2011

whereas Germany, the main receiver of capital flows, has continued

to grow.

6. Conclusion

The European project is a political one and it is born out of the

need to end wars and conflicts which had ravaged Europe in the

20th century. The Euro was an attempt to accelerate the political

union but has ended up being a headlong flight.

· The Euro is the most extreme version of a fixed exchange rate.

Indeed, it is reinforced and with high cost of departure, which

renders it more credible, but while it lacks a political union there

will always be doubts as to whether it will be a single currency.


91

· In the nineties the benefits – and there were some which have

been clearly demonstrated – of the creation of the euro were

overvalued. But at the same time there was an under-assessment

of the costs which reality has proven were also there. The two

main institutional problems which must be solved are: i) the

absence of a fiscal union to complement the monetary union

and ii) the absence of a lender of last resort due to the limita-

tions imposed on the ECB in its bylaws.

· Financial integration and the undervaluation of risk, both glo-

bal phenomena, are essential to explain the credit boom and the

problem of over-indebtedness which are the origin of the Euro

Crisis. The case of the covered bonds is a good example that not

only were credit risks undervalued, but liquidity risk was likewi-

se under-assessed.

· The Local Imbalances, the high current account surplus in

Germany and the deficits in Spain and other countries forced

the transfer of financial flows and boosted the credit boom and

over-indebtedness. Countries subjected to financial tension are

implementing sharp reductions in their current accounts, but

Germany has hardly reduced its foreign surplus since 2007.

· The institutional problems of the Eurozone became apparent at

the Great Recession, as a result of the sharp drop in activity and

the collapse of the financial markets and credit channels which

have rendered many debts unsustainable and unpayable.


92

Without such a deep recession, the problems would have taken

longer to appear.

· The aim of this article was not to discuss solutions, but from the

analysis of the nature and causes of the Euro crisis, we can con-

clude that the solution must: i) dispel doubts as to the future via-

bility of the euro, ii) to do so we must work towards the fiscal

union and the creation of Eurobonds would be the precedent for

a future single European treasury, iii) we must change the bylaws

of the ECB so that it may act as a lender of last resort as the

Federal Reserve does in the US, iv) we must halt the process of

financial disintegration and ensure the return of part of the capi-

tal flows which have exited from peripheral countries, and v) we

must urgently reactivate growth in Europe. In order to do so, the

monetary policy must opt for quantitative strategies of debt pur-

chase, the fiscal policy must be less restrictive and the financial

institutions and countries with greater solvency problems must

be recapitalized in order to restore the credit channels as soon as

possible.


93

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96

The European crisis and the challengeof efficient economic governance

* Professor emeritus of economics at the Faculty of Economic and Social Sciences of the

University of Cologne (Germany). From 1969 to 1989 he managed several economic

analysis departments at the Kiel Institute for the World Economy, in which he was the

Vice-chairman for the previous six years until he took the chair in 1989 in Cologne. He

is currently a Senior Fellow of the Cologne Institute for Economic Policy. He was the

Chairman of the German Council of Economic Experts (the so-called “Five Wise Men”)

and the German Commission on Economic Deregulation. He is an economic advisor in

several academic institutions and foundations in Germany, Spain and in other coun-

tries. He is also a member of the Supervisory Board of several multinational companies.

He is the author of several books and articles published in academic journals on inter-

national economy and public policies in the field of macro and micro economy.

/JUERGEN B. DONGES*/

97

1. Introduction; 2. The root cause of the problem: too much economic diver-gence; 2.1. A suboptimal monetary area; 3. Attempted governance in anindirect manner; 3.1. Breach of the fiscal rules; 4. Governance as activismagainst the crisis; 4.1. Constituent principles, violated; 4.2. Financial assis-tance, a never-ending story?; 4.3. Political pressure to impose discipline,insufficient so far; 4.4. Financial markets, with capacity to persuade; 5. Newgovernance design: own responsibility as the key; 5.1. The euro Plus Pact, itis not binding on anyone; 5.2. The Fiscal Stability Pact, a test of nine; 5.3.The Macro-economic Governance Pact, with vague parameters; Conclusion

The European Crisis and the challenge of efficient economic governance

1. Introduction

The purpose of this article is to focus the current discussion on the

need for economic governance in the European Union (EU) and, in

particular, in the euro area, in the context of the political reality.

This is not such an easy task, as it may seem; in practice the rela-

tions between national governments, on the one hand, and these

and the European Commission and the European Parliament, on

the other, end up being profoundly redefined, with more European

powers and less national sovereignty.

This topic is not new; it has been on the table at the mee-

tings of the European Council of the Heads of State and

Government since the formation of the European Single Market 25

years ago (1986 Single European Act). We can interpret agreements

leading to a coordination of economic policies, as the initial step

towards “smooth” European economic governance, specifically to

(i) promote employment (1997 European Summit of Luxembourg),

(ii) apply structural reforms conducive to flexibility in the product

and factor markets (1998 Cardiff Summit), and (iii) institutionalise

macro-economic dialogue among the governments, the European

Central Bank (ECB) and social partners (1999 Cologne Summit).

Apart from the above steps we should add (iv) the agreement of the

European Council in 2010 to launch a strategy of structural reforms

that would make the EU at the end of that decade the most dyna-

mic economic area in the world.

98


These agreements which were then celebrated as a landmark in

the European integration process have not given the desired results.

The reason is very simple: over and above the rhetoric, the govern-

ments were not willing to co-operate if the alleged or true national

interests indicated otherwise. Such governance installed in the

European Council, the Ecofin and in other councils of ministers

involved, lacked any kind of power of management and supervi-

sion of the economic and fiscal policies of the member states.

At the current debate the great hope is that in the future

national interests will come second, giving way to the “More

Europe”, as the new political logo reads. The aim is to reach gre-

ater and efficient intra-European co-ordination of the economic

policy of the member countries. This aim was raised in 2011-

2012 in three basic agreements: (i) the Euro Plus Pact (to strengt-

hen the competitiveness and growth capacity of the economies),

(ii) The Fiscal Stability Pact (Fiscal Compact to guarantee in all

the countries the sustainability of public finances in the medium

and long term) and (iii) the Macro-economic Governance Pact

(Economic Governance Six Pack, to ensure economic and fiscal

policies compatible with the internal and external balance in the

economies). Now, the declarations of intent are one thing, put-

ting them into practice and applying the appropriate economic

policies, is quite another. Why should what politicians promise

today be believable, if in the past (and today, as many of them

are still around) did not fulfil their commitments?

99


I will now analyse governance in its past and present dimen-

sions. The following section emphasises the significant fact that

the euro area is not an optimal monetary area. In the third and

fourth sections the forms of governance relied on until now are

analysed. The fifth section deals with the new approach for

European governance. The last section concludes the analysis in a

tone of moderate hope.

2. The root cause of the problem: too much economicdivergence

The crisis of the sovereign debt in Europe has shown a serious

fault in the formation of the single currency: trusting that the

governments of the member countries would apply quality econo-

mic policies in accordance with the common interest of all the

partners, as set forth in the EU Treaty (articles 2 and 121), was

naive. In Germany, I together with many other economists noticed

this fault then, but political leaders took no notice or it was labe-

lled as “academic” and, therefore, irrelevant to take great historical

decisions. The leaders simply invoked the criterion of the so-called

supremacy of politics over economics, as they do today when they

run from one summit to the next to rescue certain countries from

bankruptcy and try to stabilise the euro area.

100


2.1. A suboptimal monetary area

The architects of the euro area, from the 1989 Delors Report,

knew that a monetary union would not be feasible in the long run

without a fiscal union, not to mention political union. The history

of the different monetary unions in Europe in the 19th Century

had left an unequivocal message: all of them failed because of

incompatibilities among the budgetary policies of the member

countries. However, during the negotiations of what would become

the Maastricht Treaty (of 1992) the prerogative of national budge-

tary policy was sealed. The then two main characters of the

European project, the German Chancellor Helmut Kohl and the

French President François Mitterrand, fascinated their counterparts

with their vision of the euro as a pacemaker to accelerate and to go

into greater integration. More than one will remember the famous

statement of the French Finance Minister, Jacques Rueff, ‘Europe

shall be made through the currency, or it shall not be made’ (1950),

and they took it literally. The French statesman could never have

imagined such a deteriorated environment of public finances as we

have today in many European countries.

It was also clear that the five convergence criteria set forth in the

Maastricht Treaty, even if they could be fulfilled (something that

not all countries have done), did not guarantee an optimal mone-

tary area (in terms of the theory of Robert Mundell and others). In

Europe, it would have been essential for the countries to be quite

homogeneous in terms of economic development and functioning

101

of the institutions or the prices and salaries in the various countries

should have been flexible enough (especially downwards in coun-

tries with weak growth and great structural unemployment), or for

European mobility of labour to be high (from backward regions

with high unemployment rates to dynamic regions with shortage

of workers). These conditions for an optimal monetary area did not

happen twenty years ago and do not happen today. The difference

between Europe and the United States in this is significant.

Only a group of countries in the euro area (in central and nort-

hern Europe) at least met then and meets now the condition of

homogeneity. The countries in the southern periphery were not,

strictu sensu, ready for their accession in 1999 to the monetary

union and, therefore, to waive a monetary and exchange rate

policy as adjustment facilities of internal imbalances (inflation)

and external imbalances (current account deficit) and to under-

take tax regulations that would restrict government deficit and

the level of government debt. It is not a coincidence that these

countries have had for the past two years a risk of insolvency (not

to have the capacity to re-finance the debt in the capital market

under affordable conditions), as only sovereign countries have, if

the State may not resort to the Central Bank to secure financing

and must get it by issuing bonds in a foreign currency. Greece

may be the most illustrative example of having done what the

German Council of Economic Experts has classified as an “origi-

nal sin”, in other words, having rushed into accessing the mone-

tary union in 2001, forced even through deceit (hiding the truth


102

of their fiscal statistics): the country is now at the mercy of the

international financial markets (rating agencies), after having

revealed the serious structural deficiencies in the economy and

the public institutions, which has led to a low growth potential

and low levels of productivity and competitiveness clearly insuf-

ficient at this time (globalisation of competition).

3. Attempted governance in an indirect manner

It was conceptually logical that with the creation of the single

currency the powers on monetary policy would be transferred

from the National Central Banks to the new ECB. However, as the

budgetary policy would carry on being a national responsibility,

two principles constituting the euro area were established in

order to guarantee the sustainability of the public finances in the

member countries and to ensure that the monetary union would

work as a price stability union.

• The two principles proclaimed in the Maastrich Treaty are the

prohibition to bail out insolvent partners, on the one hand,

and the prohibition imposed on the ECB to finance govern-

ment deficits (no monetisation), on the other hand. These

clauses are contained in the most recent version of the Treaty

on the European Union (the Treaty of Lisbon of 2007) in arti-

cles 125 and 123, respectively.


103

• The two provisions were supplemented with the Stability and

Growth Pact (SGP) approved in 1997 at the European Summit

in Amsterdam; in it a ceiling for national budget deficits (3%

of GDP) and government debt (60% of GDP) were established

under the assumption that the growth rate of the nominal

GDP in the euro area would be 5% in the medium term.1

With all this, indirect governance elements were created, in

other words, formally maintaining national powers in budgetary

policy, but controlling the use of the powers that could destroy

the feasibility of the euro area.

The monetary union was not designed to pay debts jointly and

generate financial transfers from certain States to others, as many

today think that that is the case, appealing to solidarity among

peoples. There was already solidarity, and there still is, in the

good sense of the concept: the more developed countries of the

EU must help the least developed for these to advance in real

convergence; the various European Structural Funds are for this.

But it is not compatible with the concept of solidarity; it rather

constitutes a “perversion” (Issing) of it, having to rescue a society

that underestimates saving, tends to consume ostentatiously,

tolerates waste by the public authorities, does not fulfil tax obli-


104

1 For a profound analysis see A. Brunila, M. Buti and D. Franco (ed.), The Stability and

Growth Pact: The architecture of fiscal policy in EMU. Houndsmills/Basingstoke (United

Kingdom): Palgrave, 2001 – Círculo de Empresarios (ed.), Pacto de Estabilidad y

Crecimiento: alternativas e implicaciones. Libro Marrón 2002. Madrid (December).

gations and claims social benefits beyond the means of the

country, given its own resources.

3.1. Breach of the fiscal rules

The architecture of indirect governance crumbled when it had to

pass the first real test, in 2002/03. In those days, Germany

(Schröder) and France (Chirac) violated the the fiscal rules of the

game. In Germany, government deficit had reached 3.7% of GDP

in 2002 and 3.8% in 2003; in France, it was 3.2% and 4.1% respec-

tively. In both cases, most part of the deficit was structural. The

European Commission had activated, according to the SGP, the

supervisory mechanism for ‘excessive government deficit’ against

these two countries. The German Chancellor explicitly rejected the

intervention from Brussels, the same as the French President. They

both imposed their criterion at the European Council in November

2003, which suspended the process (against the votes of Austria,

Spain, Finland and Holland). The then President of the European

Commission, Romano Prodi, had described the SGP in an inter-

view (on 18/10/02) as “stupido”, which is highly surprising coming

from the custodian of the European Treaties.

At the European Summit held in March 2005, the SGP was

amended, watering it down a great deal: with new exceptions for

breaking the rules, an assessment of the budgetary situation on a

case-by-case basis, considering the special circumstances of each

country, relaxing the periods to take the necessary adjustment


105

measures, the differentiation among countries as regards the goal

of budgetary consolidation in the medium-term and some com-

plex and non-transparent supervisory mechanisms.2 We must

remember this in order to understand the reason for the current

proposals to depoliticise (“automate”) the decisions on sanctions

in case of an infringement of the fiscal regulations.

With the erosion of the SGP, the factors that determined the cri-

sis of the current sovereign debt, put down roots, a crisis which

would have happened anyway, if the 2007-09 global financial and

economic crisis had not have appeared. If the governments of the

two main countries of the euro area are skipping the Treaty of

Europe and the SGP, why wouldn’t the rest do the same if this is

what is best for them and open the tap of non-productive public

expenditure? Structural government deficits increased conside-

rably and with this the volume of the government debt. With this

precedent, the supervision of national budgetary policies by the

European Commission was reduced to merely a rhetorical exercise

that did not scare the rulers much. Economic governance in an

indirect manner had failed. The ECB, however, fulfilled its role and

its first president, Wim Duisenberg, did not allow political leaders

to tie his hands, despite their attempts.


106

2 For this purpose, the European Commission adapted the original regulations No

1466/97 and 1467/97 of 7/7/1997; see COM (2005) 154 and COM (2005) 155 of

20/4/2005.

4. Governance as activism against the crisis

The threat of Greece’s suspension of payments two years ago

showed lack of efficient European economic governance. Instead,

a rare and disconcerting political activism appeared. The nume-

rous measures taken since May 2010 in Europe seem more like an

exercise of muddling through than implementation of a consis-

tent and long-term strategy.

4.1. Constituent principles, violated

It all started in the worst possible manner: the Governments eli-

minated in one fell swoop the two principles establishing the euro

area mentioned above.

The lifting of the non-rescue clause created the problem of

moral hazard for Governments with a tendency to excessive public

expenditure and for reckless banks when it comes to buying

government bonds. The Governments could pass the cost of exces-

sive indebtedness to taxpayers from other countries (who had no

right to speak or vote when the budgets of the State in question

were drafted). The banks started a tremendous communication

campaign to warn of the danger of the euro area (systemic risks) if

indebted countries were not rescued, efficiently concealing to the

public opinion that their true intention was to protect their share-

holders.


107

Under the presidency of Trichet, the ECB was under pressure to

undertake a new role: the role of being a “repair shop” for the

faults in the fiscal and growth policies. It acquired in the Securities

Markets Programme, big sums of Treasury bonds from countries in

trouble which nobody wants. Here lies the difference with other

relevant central banks (the Federal Reserve, the Bank of England,

the Bank of Japan), they also buy government securities in the con-

text of their non-conventional monetary policies, but these are

assets with considerable profitability. Furthermore, the ECB

currently grants unlimited liquidity to banks for three years, at a

symbolic interest rate (1%) and it accepts low quality securities as

guarantee. But it is not in its hand to lead banks to proper granting

of credit to companies or households in the country under affor-

dable conditions; the ECB must resign itself to banks choosing

more profitable business in the short-term, as purchasing the debt

of the State; therefore, there is not much change in the scenario of

credit restriction in the private sector in several countries, like in

Spain. The European monetary entity is not only “a last resort len-

der” anymore, which in situations of financial emergency is justi-

fiable, but it has also become “a public debt buyer of last resort”,

which is more questionable, because it delays the fiscal adjust-

ments of the Governments (and it caused in 2011 the resignation

of two German senior members of the monetary authority bodies,

first the resignation of Axel Weber, President of the Bundesbank

and ex officio member of the ECB Governing Council and, subse-

quently, the resignation of Jürgen Stark, member of the Board of

the ECB and its chief economist). The role that the ECB is playing,


108

for the moment also under its new president (Draghi), may dama-

ge its reputation as an institution independent of political powers

and commited to price stability, which is what it has been entrus-

ted with in the European Treaty.

An additional problem is that the same standards of asset qua-

lity, which are used as collateral in the re-financing of commercial

banks by the National Central Bank itself (and, as such, part of the

Eurosystem), do not govern in the whole of the euro area anymo-

re. In several countries in trouble, especially with persistent current

account deficits which (already) do not finance in a conventional

manner import of capital or through financial assistance from

abroad, the respective National Central Banks, with permission

from the ECB, accept low quality securities as guarantee of loans,

more than what is allowed for emergency liquidity assistance. It is

as if they were using the money printing press. This somewhat

undermines the monopoly of the ECB to create money. What is

questionable from an economic perspective is hidden behind the

enormous increase in the amount of these operations in the

Eurosystem Target 2 in the past years, which has been vehemently

warned by the Ifo Institute of Munich for the last year.3 The

Bundesbank has become a gigantic creditor of hundreds of millions

of euros for the National Central Banks of the other countries, wit-


109

3 See H.-W. Sinn and T. Wollmershäuser, “Target Loans, Current Account Balances and

Capital Flows: The ECB’s Rescue Facility”, NBER Working Paper, No 17626 (November).

CESifo, “The European Balance of Payments Crisis”, CESifo Forum, Special Issue, January

2012.

hout protection and right to any kind of compensation if there is

any significant bankruptcy of banks and savings banks or if the

euro area collapses. The Governments of debtor countries have in

reserve a powerful argument to manage to get from others, espe-

cially from Germany, concessions in the negotiations over finan-

cial assistance.

4.2. Financial assistance, a never-ending story?

Political leaders believed, and some of them still do, that the

creation of a common rescue fund is the solution to the problems

of countries in trouble and it eliminates possible spillover effects.

The first rescue mechanism was created with the European

Financial Stability Facility (EFSF).4 This fund is provisional (three

years, until 2013) and at the beginning had a provision of 440,000

million euros in loans guaranteed by the euro countries; as the

Fund wanted to place their issues with the highest ranking ‘AAA’

to get attractive profitability, the real lending capacity would be

lower than the allocation, about 250,000 million euros. Ireland

(87,500 million euros) and Portugal (78,000 million euros) had to

resort to this Fund. Subsequently, in July 2011, the European

Council decided to increase the real lending capacity of this rescue

fund to 440,000 million euros and, in addition, increase their


110

4 EU Council of Ministers (Ecofin), EFSF Framework Agreement, 9/5/10 and 7/6/10.

Web page: http://www.efsf.europa.eu (Legal documents).

powers and relax the conditions for granting the loans to countries

in trouble. It even received leverage instruments (with a 4 factor)

and the so-called ‘special purpose vehicles’ (off-balance); such ins-

truments, applied by private banks, were exactly the ones that trig-

gered very harmful effects for the global financial crisis to break in

2008.

In mid-2012, six months in advance to the original schedule, a

new permanent rescue fund will come into force, the ‘European

Stabilisation Mechanism’ (ESM).5 This fund will have a provision

in nominal terms of 700,000 million euros (with capital contribu-

tions from the member countries amounting to 80,000 million

euros); the real lending capacity of this new Fund is 500,000

million euros. Provisionally, the amount of available resources may

amount to about 800,000 million euros, by transferring the unused

EFSF resources. The IMF, the OECD, the United States and China,

among others, recommend a higher firewall (up to 1.5 billion

euros).

In parallel with these events, a special treatment has been given

to Greece. After the initial financial assistance plan approved in

May 2010 (110,000 million euros, of which 30,000 million euros

came from the IMF), of which politicians said that it would enable


111

5 European Council, Treaty Establishing the European Stability Mechanism (ESM), 25/3/11.

Internet: http://www.efsf.europa.eu (Legal documents). – European Council, Treaty sig-

ned by the 17 euro area Member States, 2/2/12. Internet:

http://www.european.council.europa.eu.

the country to return to the capital market in 2013, in February

this year a second package was agreed (130,000 million euros,

including a contribution from the IMF, to which a further amount

of 24,400 million euros of the first package pending payment will

be added). The latest thing is that private creditors will undertake

(about 85.8% voluntarily and the rest will be obliged by law) a

deduction of 53.5% and will agree for the rest of their securities an

exchange for new Greek long-term treasury bonds and of the EFSF

Fund at a moderate interest rate (which will reduce the Greek

public debt in about 107,000 million euros of a total of 350,000

million euros). Greece’s main public creditor, the ECB, has escaped

this operation and the asset losses derived from it, by means of a

trick, quickly exchanging their former Hellenic bonds, which

would have undergone a reduction, for new exempt bonds under

the same condition.

The official aim is to get the public debt to be reduced from the

current 160% of GDP to about 120% of GDP in 2020. The Ecofin

believes that this level is sustainable, which is quite surprising for

three reasons: firstly, this level was what Greece had in 2008/09,

already in the increase and considered unsustainable then;

secondly, the tax authorities must improve a great deal in order to

promote the capacity to collect taxes and stop tax fraud and capi-

tal flight; and thirdly the IMF’s estimates of 2-3% economic growth

per year from 2014 must be fulfilled, which implies that the neces-

sary structural reforms must be quickly implemented and the eco-

nomy must reach considerable gains in international competitive-


112

ness by substantial salary and price reductions (according to the

estimates, about 50%). All of these points are question marks. The

most probable thing is that the announced aim of debt reduction

will not be attained and that the European governments sooner or

later will again have on the negotiating table Greece’s request for

further financial assistance.

4.3. Political pressure to impose discipline, insufficient so far

The European form of governance since the sovereign crisis star-

ted in Greece has always been “more of the same”: to want to solve

a problem of excessive indebtedness with more debt. The critical

public opinion, as in Germany, was calmed down by saying that no

cash was going to be paid from national budgets and, therefore,

from taxpayers (although there will be in the ESM), but that each

government “only” had to provide guarantees (distributed among

the countries according to the holdings of the national central

banks in the share capital of the ECB). As if guarantees could not be

enforced at the demand of the creditors, in other words, buyers of

the securities issued by the EFSF/ESM! The expectations to calm

down the markets, restore confidence and stabilise the euro area

were not met. The markets had noticed that, in the countries badly

affected by the sovereign debt crisis, progress in fiscal consolidation

and structural reforms that raise the potential of growth and com-

petitiveness, which there are, were too slow and incomplete.


113

This was caused from outside. The aided governments have not

forgotten the political messages launched from the beginning of

the crisis from Brussels/Paris/Berlin. The messages that are least for-

gotten and carry on being repeated with slight variations, are the

following: (i) “We will rescue the euro, no matter what it costs”

(Barroso); (ii) “We will not allow anyone to fall into insolvency”

(Sarkozy); (iii) “If the euro fails, Europe fails” (Merkel). There could

be no better invitation for irresponsible governments to blackmail.

That is how a government in trouble is tempted not to consistently

take pure and hard measures, therefore reducing the cost of loss of

political support, which any severe fiscal adjustment plan (with

unnavoidable cuts in salaries and social benefits and necessary rise

of taxes) would imply. In Greece it is already normal for the Troika

(the European Commission, the ECB and the IMF), each time that

it visits Athens to verify if Greece’s government has implemented

its commitments, to confirm that there is lack of forcefulness in the

policies applied, especially in relation to the structural reforms. But

as the President of the euro group, Juncker, and the Ecofin finally

have given the green light for new aid tranches to be given, the

government (after Papandreou, Papademos) could, after long nego-

tiations, according to the demands of his European partners, and

once at home, do half of it. He could even reject the proposals made

by his partners (Germany, the first) to provide administrative advi-

ce in situ, for instance, in order to create an efficient tax agency and

to design and manage infrastructure investment projects.


114

If with the aid programmes the idea was to buy time to imple-

ment structural reforms in the real economy, as the political leaders

repeatedly emphasised, time was not used productively in all the

countries involved, and Spain was no exception during the last

part of Zapatero’s government, when the crisis was not officially

denied anymore: fiscal and economic consolidation policies arri-

ved late and lacked consistency and force.

4.4. Financial markets, with capacity to persuade

One way of overcoming the reluctance of the governments to

inexorable political and economic changes in their respective

countries comes from the market, specifically the spreads of the

risk premiums included in the interest rates where the Treasury

may place their issues.

As mentioned above, the risk premiums of ten-year bonds, with

reference to the German bond, “bund”, reached rocket prices in

Greece in 2011 and also considerably in the other peripheral coun-

tries with debt problems, including Spain, where the interest rates

reached all-time highs of several hundred basis points. The same

happened with the credit default swaps (CDS) premiums. No mat-

ter how much the governments criticised financial agents for this,

not to mention also the three main rating agencies (Fitch, Moody’s,

Standard & Poor’s), we cannot understimate its deterrent effect

when it is intended to go into greater debt. The increase in price of

the debt convinced political leaders in the countries in trouble that


115

the time of spending happily had gone and that they had to be

prepared for a future characterised by austerity. The new govern-

ment of Spain (Rajoy) is an example of strict action to modify

unsustainable habits in society and restore the economy. In Italy

there was a big change of direction since a government of techno-

crats (Monti) started in November last year. Ireland had already

started in March 2011, after early parliamentary elections and the

formation of the new government (Kenny). Three months after

that, the same happened in Portugal (Passos Coelho).

Therefore, any decision to artificially reduce the interest rates of

government bonds, as it has already been taken within the context

of rescue packages and as some governments claim, is counterpro-

ductive. Eliminating the mechanisms of the market that act, wit-

hout political interference, in favour of the quality of public finan-

ces, is pointless. Mutualisation of the sovereign debt, no matter

how much it is proclaimed by certain political circles (also Spanish,

irrespective of ideologies), as well as academic (including German,

Keynesian ideas) and financial (especially the most important

banks which are anxious to operate in capital markets with great

liquidity, comparable to the U.S. market) circles, is also pointless.

There is no reason why we should think that issuing eurobonds

would improve the quality of the economic policy in the euro area.

On the contrary, a reduction in the price of credit in the countries

in trouble, which the eurobond would entail, would deteriorate the

estimates of low cost, which all categories of public sector outlays

and any decision by the public authorities on loan finance, would


116


117

be subjected to; furthermore, it would be impossible to put pressu-

re on a government from outside to control expenditure and opti-

mise tax collection; and, in addition, restructuring processes in the

real economy, which are so important to raise the potential of

growth, would be postponed. It is far better for the financial mar-

kets to deploy their penalising effects and thus complement the

relevant mechanisms planned by the SGP and the coming Fiscal

Stability Pact.

5. New governance design: own responsibility as the key

It seems that European leaders got it into their heads that the euro

area needs another kind of governance different from what we have

had until now.

We will have to carry on thinking in the need for official assiss-

tance for certain countries, not only for Greece. As regards Greece,

maybe we must think of two options: one, exiting the euro, in

principle on a provisional basis (until the fundamental problems

have been solved) and continue as a EU member; two, exiting the

Economic and Monetary Union, also for a certain time, but kee-

ping the euro as dual currency circulation with their own currency.

Politicians now understand better than in the past that, for the

feasibility of the monetary union in the long term, we need robust

and resilient foundations to prevent external shocks of offer and

demand, both from outside and from inside (which in some way or

another will happen again). It is not enough to have a determined

common monetary policy dealt with by a competent European aut-

hority with aims of stability and orderly functioning of inter-bank

market. This is only one of the required conditions. Two further fun-

damental conditions are inexorable for the context of national eco-

nomic policies:

• On the one hand, there must be some rules on behaviour in bud-

getary and economic policy compatible with the efficiency crite-

ria in the allocation of production factors and with growth and

employment aims. The problem of “moral hazard” must be

totally eliminated.

• On the other hand, there must be unconditional willingness of

the governments to observe these rules and act according to

them. There must be a clear division of work and responsibility

between the governments and the ECB.

Indeed, efficient European governance means the transfer of the

national sovereignty to the European Union in budgetary matters

and in areas essential to the real economy. This would entail a qua-

litative leap in the process of integration.

The three pillars of the new architecture are:

• The Euro Plus Pact (approved at the European Summit of 24-25

March 2011, with immediate effect);

• The Fiscal Stability Pact (approved at the European Summit on

1st March 2012, with the exception of the United Kingdom and


118


119

the Czech Republic, and estimated to come into force, after rati-

fication by the national parliaments, on 1st January 2013);

• The Macro-economic Governance Pact (approved by the

European Parliament in September 2011 and ratified by the

European Council, which is in force already).

The three Pacts complement one another. Without quality of

public finances there will be no appropriate economic growth (“dis-

trust effect”), but without economic growth it will be impossible to

have organised public accounts (“tax collection weakness effect”),

and with no macro-economic balance growth will be slower (“effect

of inefficiency in the allocation of production factors”).

5.1. The Euro Plus Pact, it is not binding on anyone

This Pact is based on right diagnosis: the potention of growth in

southern countries and the capacity to create employment (to a gre-

ater or lesser extent) are low owing to the persistence of negative

national factors: non-qualified labour, insufficient technological

innovation in companies, over-regulation of the labour market and

of various services, inefficient bureaucracy, deplorable tax fraud and

corruption. For this reason, structural reforms in the economy and

the institutions are so necessary.

The governments of the countries of the euro area have under-

taken to implement it; other six countries of the EU have also

undertaken this commitment (for this reason the term “Plus” has

been added to the name of the Pact).6 The scope of action that the

Pact contemplates affects the labour market, the educational sys-

tem, the environment for research, the tax system and a long etce-

tera. All this is praiseworthy.

But the main problem of the Pact is that it gives full freedom to

the governments to take the measures that they deem appropriate

and not to take others that would also be necessary from an objec-

tive point of view. There is no sanction in case of lack of strictness.

Therefore, this pillar of economic governance of the euro area does

not offer security.

5.2. The Fiscal Stability Pact, a test of nine

Rightly, the inexorable key is the commitment from the govern-

ments to maintain orderly and balanced public finances in the

future.

This is no dogmatic approach (“neoliberal”, as some call it pejo-

ratively), but it is the consequence of an economic analysis, sup-

ported by theory and empirical experience. Government deficit

must be limited, owing to the “Domar condition”, according to

which, for reasons of assignative efficiency, long-term interest rates


120

6 European Council, Conclusions 24/25 March 2011, Annex I: The Euro Plus Pact –

Stronger Economic Policy Coordination for Competitiveness, Bruselas, 25/3/11 (EUCO 10/11,

CO EUR 6, CONCL 3).

must be higher than the economic growth rate. With no ceiling for

government deficit sooner or later we reach a point from which the

financial expenditure of the State (for servicing the debt) increases

substantially, which progressively reduces the room for manoeuv-

re of the government to seek its economic and social aims. The

level of public debt must be limited because of the

“Reinhart/Rogoff rule”, derived from econometric studies, which

establish a critical threshold of 90% of GDP, from which the secu-

lar economic growth rate may diminish at least half a percentage

point per year for three reasons: one, because public debt servicing

reduces the margin for productive investment of the State (infras-

tructures); two, because payment of interest to foreign creditors

reduces available national income and, therefore, the capacity of

consumption of households; and three, because the need to re-

finance sovereign debt makes financing of private companies in

capital markets difficult (“expulsion effect”).

The Ltmus test is characterised by strictness under which the

governments deepen in budgetary consolidation. Despite the fact

that in different countries of the euro area some measures invol-

ving tax adjustment have been taken already, public finances are

not consolidated at all. According to the European Office of

Statistics (Eurostat), government deficit is excessive (more than

3% of GDP) in most of the countries, also in Spain (2011: 8.5% of

GDP). Germany (1%) and four small countries (Estonia, Finland,

Luxembourg and Malta) are the few exceptions. Most of the

government deficits are structural, in other words, not cyclic but


121

permanent, and, therefore, destructive for the good functioning

of the economy. The level of public debt is also too high (higher

than 60% of GDP) in almost all the countries, including

Germany (2011: 81.2%) and France (85.8%) and now also Spain

(68.5%), for the first time since 2011, Spain (68%). Where public

debt greatly exceeds all acceptable levels according to the

“Reinhart/Rogoff rule” is in the three countries that have been

rescued (Greece, Ireland and Portugal) and in Italy. For the latter

country, however, there is a differentiating factor in its favour,

most of the public debt is internal and, thus, its servicing may be

managed directly with its own instruments (by increasing fiscal

pressure on its citizens).

As mentioned above, the rules on sustainability of public finan-

ces as set forth in the Treaty of the European Union and in the SGP

have not been efficient to impose budgetary discipline. Its applica-

tion has been highly politicised. The mechanisms of penalisation

have never been implemented. The new Fiscal Pact has been arran-

ged in such a manner that it could put the screws, firstly, on the

euro countries on which the agreement is binding.7 The most

important advances as regards the SGP, for the moment only on

paper, are the following three:

• Firstly, the seriousness of government deficit is explicitly ack-

nowledged when it is structural. The explicit ceiling established


122

7 European Council, Treaty on Stability, Coordination and Governance in the Economic and

Monetary Union, 2/3/12, artículos 3-8. Internet: http//:eur-lex.europa.eu.

is 0.5% of GDP, maintaining the threshold of 3% for total defi-

cit. There is thus a large margin for the operation of “automatic

stabilisers” in the economic cycle and for discretionary govern-

mental measures if there is recession.

• Secondly, the aim of limiting the level of public debt at 60% of

GDP through a procedure which, if the debt exceeds this per-

centage, may activate the supervisory mechanism for “excessive

government deficit”, even if the deficit is below 3% of GDP. The

country in question shall be forced to reduce it at an average

rate of one twentieth per year as a benchmark (“1/20 clause”).

• Thirdly, the obligation for each member country to define its

medium-term budgetary objective (MTO), quantifying an indi-

cator for public expenditure evolution and making sure that the

estimated expenditure shall be financed by sustainable income

(“golden rule” of budgetary balance). If a country does not orga-

nise its budgets in a balanced manner it will be required by the

European Commission to submit new budgetary plans.

If the new rules are important, a mechanism to enforce them is

equally important. The most relevant three new elements are the

following:

• First, continuous supervision of the policies applied in both

summits of the euro area has been devised (two per year, at

least, called and chaired by the President of the EU, currently

Herman Van Rompuy).

• Second, there is a change in the decision process on financial

sanctions (of up to 0.2% of GDP) in case of breach and non-ful-


123

filment of the specific recommendations to remedy the situa-

tion in the sense that a proposal of the European Commission is

considered approved if the Council of the Heads of State and

Government of the euro area does not vote against it with a qua-

lified majority (until now such a majority was required for the

European Council to approve the sanction). Therefore, there will

be less room for political maneuvre to prevent the fine (as it was

normal in the past after the Schröder/Chirac precedent mentio-

ned above). The sanctions are not totally automatic as one

would like them to be, but they are moving in that direction.

Furthermore, they have a broader scope than before, because the

manipulation of fiscal statistics shall also be punished.

• Third, the obligation for each member country to transpose the

fiscal stability rule into its national legislation is established and,

therefore, be explicitly responsible for its fulfilment. The Court

of Justice of the EU shall ensure its fulfilment.

For the States to decide the medium-term budgetary stability

(equivalent to the economic cycle), the most credible formula is to

constitutionally estabish a ceiling for structural government deficit.

Germany has already done it (0.35% of GDP for the central govern-

ment, from 2016, and cero deficit for the federal states, from 2020).

Spain is moving in that direction after the reform of article 135 of

the Constitution at the end of the previous term of office and the

recent approval of the Budgetary Stability Law which will require

from 2020 cero structural deficit to the public authorities (which

could be up to 0.4% of GDP in exceptional circumstances). Other


124

countries are moving in that direction. The advantage of a consti-

tutional rule as regards de margin of debt of the government is that,

if a country incurs deficit and constitutional breach, it will need bet-

ter arguments for its society than if it only needs to be explained

before the Community authorities and take there the relevant war-

nings; Brussels is “far” and it is “under suspicion” of meddling in

national affairs.

The Fiscal Pact will only work if the euro area countries are

willing to do without most of its sovereignty in budgetary matters,

which will be transferred to Community institutions. Obviously,

this affects the main prerogative of national parliaments, which is

to shape the budgets of the State and decide how to finance expen-

diture. This will meet great opposition, in all the countries. It is not

a trivial matter that the Fiscal Pact must be institutionalised

through an inter-governmental agreement, that is to say, a level

lower than the Treaty of the EU, which reform would have requi-

red the unanimous approval of the twenty-seven, which was not

reached. This procedure has opened in the legal field a debate to

decide if the procedure chosen is compatible with Community

Law, specifically in relation to the mechanisms of sanctions for

excessive government deficit as set forth in article 126 of the

Treaty. For European leaders to have lowered the quorum required

for parliamentary approval of the inter-governmental agreement is

not a trivil matter either, to 12 of the 17 States that form part of the

euro area. Could it be that some partners are not reliable? It is true

that it has been decided that the countries that do not ratify the


125

Pact and transpose to their national legislation the ceiling of

government deficit will be excluded from possible financial bai-

lout. However, is this credible, especially if the stability of the euro

area is at risk? This being so, it would be better not to be too hope-

ful about this Fiscal Pact.

5.3. The Macro-economic Governance Pact, with vague

parameters

The same caution is advisable with regards to the solemnly

proclaimed Six Pack (so called because its content has been draf-

ted through a Community directive and five regulations).

Nodoby doubts that, for the feasibility of the euro area, macro-

economic stability is a necessary condition (although not enough

if the requirements for an optimal monetary area are not fulfi-

lled). Furthermore, it is true that macro-economic stability goes

beyond budgetary balance, as it has been proven with the recent

experience of different countries (inflationary pressure, property

bubble, excessive private sector debt, competitive weakness of

companies, current account imbalance, etc.). However, the

European Commission, the European Parliament and the

European Council seem to have faith in the capacity of economic

policy to handle crucial factors in the real economy. This is

highly questionable.

An alert mechanism scoreboard was created for the appearance

of internal and external imbalances in the countries, which will be


126

managed by the European Commission based on ten parameters,

as follows: 8

• Internal imbalance parameters: evolution of unit labour cost,

unemployment rate, private sector indebtedness, credit to the

private sector, evolution of property prices and government

indebtedness.

• External imbalance parameters: surplus and deficit of current

account balance, net international investment position, change of

export market shares and change of the real effective exchange

rates of the euro.

For these parameters, critical thresholds have been established,

from which the alarm would be triggered, and this would start a

procedure to analyse the causes in order to decide from Europe if

corrective measures need to be taken or not. For instance, for unit

labour costs the threshold is an increase of 9% in three years, for

unemployment rates it is 10% of the workforce as a three-year ave-

rage or for current account balance the threshold established is 3

year backward moving average of the current account balance as a

per cent of GDP, with a threshold of +6% of GDP (surplus) and -4%

of GDP (deficit). If there is excessive imbalance, the European

Commission will make the relevant recommendations for the

government of the country in question to remedy the imbalance; in

case of non-fulfilment, a fine may be imposed (up to 0.1% of GDP).


127

8 European Commission, EU Economic governance “Six Pack“ enters into force,

MEMO/11/898, 12/12/2011.

The thresholds set are not a consequence of a detailed economic

and empirical analysis that may indicate for sure when an imba-

lance is excessive for a country and negatively affects the euro area

as a whole. The numerical values rather represent the perception of

politicians of the recent events; therefore, they are, unavoidably,

arbitrary. But the fundamental question is different: How can a

government act efficiently?

We must remember that the EU proposes an open market eco-

nomy with free competition (article 119 of the Treaty of the EU). All

euro countries have this concept of economic system, some becau-

se of the Ludwig Erhard tradition (Germany), and others with reser-

vation in favour of the government (France). In a market economy,

the government lacks the instruments to control the variables con-

templated in this Macro-economic Governance Pact. Therefore, the

governments should activate a series of interventionist measures,

with no guarantee of their efficiency and with a high risk of distor-

ting efficiency in the allocation of production factors. In a market

economy, responsibilities are distributed in a different way: for level

of employment, social partners (unions and employers); for export

development, private companies (technology); or for granting

loans, commercial banks (based on the appropriate risk estimate).

The current account balance, among other things, represents the

saving trend rooted in society and objective conditions for fixed

capital investment (as explained by the “macro-economic equa-

tion” and the “Böhm-Bawerk theorem”). Unions will not accept

government interference in the negotiation of collective agree-


128

ments and companies will not stop being creative or innovative in

organisational management and product development for which

elasticity-income of international demand is higher than the unit,

and banks will not neglect their classical business, which is to pro-

vide credit to companies and households.

This economic governance project has no clear future. In the

best-case scenario, the new Summits of the euro area would have

matters to discuss. The countries in which the economy works well

could be taken as a benchmark for the others to rectify their struc-

tural deficiencies and improve their productive and competitive-

ness levels. In the worst-case scenario, the euro area would be expo-

sed to continuous political conflicts, which would not promote

economic growth with high employment. It is so easy, and espe-

cially politically profitable in countries with domestic problems, to

look for the villain abroad, maybe Germany?

Conclusion

The sovereign debt crisis has had a healthy effect in convincing

politicians that by providing liquidity to governments and banks

the stability of the euro area will not be attained in the medium

and long term. The quality of the economic policy must improve

in the countries, there must be impeccable follow-up by indepen-

dent institutions to weigh up the economic and fiscal situation and

it must be guaranteed that national accounts and other relevant

statistics are arranged under utmost scientific accuracy at all times.


129

If in all the euro countries the governments understand that

sound public finances and application of structural reforms is their

responsibility and if they act seriously according to them, no State

will have to rescue another State because of over-indebtedness and

waste, and the ECB may stop indirectly financing States and focus

more on its task, ensuring stability in price levels in the euro area.

The ESM fund would be reserved to emergency situations caused by

external factors beyond the government’s control. The Fiscal Pact

would have fulfilled its mission and the Euro Plus Pact would be

filled with efficient contents. We would not need to resort to mar-

ket interventionism as entailed with the Six Pack.

If, on the contrary, there is no determination in the member

countries, any attempt of European economic governance would

result more from proactive intentions than harsh reality. The euro

area would have an uncertain future. The alternative of a European

Political Union, in which all necessary economic policies could be

undertaken from a Community Executive under the control of the

European Parliament, with all democratic rights, cannot be seen on

the horizon.


130

The turbulent adolescence of the euroand its path to maturity

* Member of the Technical Body of the Spanish Civil Services (Técnico Comercial

Economista del Estado) and Graduate of Economics at Universidad Autónoma de

Madrid. He has spent a large part of his professional career in the current General Office

of Treasury and Financial Policy in the Ministry of the Economy and Competitiveness

of Spain. He held the office of Deputy Director of Financial and Strategic Analysis, res-

ponsible for financial stability and crisis management issues, international financial

policy (EU, G20) and adviser to the Social Security Reserve Fund. In September 2009 he

was appointed Deputy Director of Funding and Debt Management, where within a few

months he was involved in the adaptation of the Treasury funding programme to the

instability generated by the Greek fiscal crisis and its contagion throughout the rest of

the euro region. From September 2010 to January 2012 he has held the office of Director

General for International Finance, which has enabled him to form part of the manage-

ment boards of the European Investment Bank and of CESCE. He has likewise been

Associate Professor in Economic Theory at Universidad Rey Juan Carlos and has publis-

hed several articles on regulatory, financial and monetary matters in Spanish journals.

/GONZALO GARCÍA ANDRÉS */

131

1. Introduction; 2. Anatomy of the crisis: Greece, the contagion and the per-verse dynamics of debt; 2.1. Sovereign credit risk within the euro: from zeroto infinity; 2.2. A fiscal problem, not the fiscal problem; 2.3. Contagion: thefragmentation of the single monetary policy; 2.4 A particular manifestationof the global financial crisis; 3. The Eurosystem at a crossroads; 3.1. Intra-system balances as an expression of the fragmentation of monetary policy;3.2. Quantitative easing for banks only; 4. The definitive solution mustbegin in 2012; 5. Conclusion; Bibliography

The turbulent adolescence of the euro and its path to maturity

1. Introduction

The Monetary Union is a political construction, the boldest and

most significant step forward by the European project since the

Treaty of Rome. Its conception also had an economic basis, that of

completing the consolidation of the economic integration process

which was begun in 1985. However, its implementation was a great

adventure. The countries that use the euro are far from constituting

an optimal monetary zone. In addition to the evident initial diffe-

rences in the economic and institutional structure of the countries

and in their histories of stability, the euro was forced to make room

for disparate economic philosophies.

The European leaders elected to create a very light institutional

structure, with an independent federal monetary authority, an

apparently severe budgetary discipline (the Stability and Growth

Pact or SGP) and the rule of no mutual support (in order to rein-

force the individual fiscal stability of each State).

During its first ten years the euro appeared to be working relati-

vely well. Average real growth exceeded 2% and both the level and

the volatility of inflation improved in comparison to the previous

132

He is currently an adviser in the General Deputy Office of Financial and Economic

Matters of the European Union and the Eurozone which is part of the General Office of

the Treasury and Financial Policy. The opinions expressed in this article pertain to the

author and under no circumstance may be attributed to the Ministry of the Economy

and Competitiveness.


decade, although the differences in the macro-economic and finan-

cial behaviour of the members were quite considerable. Although

the Stability and Growth Pact was reformed mid-decade, no signi-

ficant alterations were made to the institutional framework and the

number of members gradually grew. The onset of the financial cri-

sis in 2007 initially underlined this perception of the euro as somet-

hing imperfect but solid.

However, a little after its 11th anniversary, three interconnected

calamities fell upon the euro. Firstly, one of its members plumme-

ted towards insolvency in just three months. Secondly, the politi-

cal pact on which the single currency was built began to shake

when financial assistance within the area became inevitable. And

thirdly, the unity in regard to monetary policy fell apart with the

dislocation of the public debt markets.

Two years later, and despite having taken decisive steps in natio-

nal policies and in institutional framework reform, the crisis of the

euro has deteriorated to the point of calling its survival into ques-

tion; and a definitive solution is yet to be glimpsed. With the bene-

fit of hindsight, it is worth attempting to interpret was has happe-

ned, taking into account the extreme complexity both of the initial

situations (with accumulated imbalances and structural deficien-

cies in several countries), as well as the outbreak, contagion and

escalation of the crisis. And to do so moreover against the broader

backdrop of the global financial crisis, which has influenced eco-

nomic and financial evolution for five years, in order to identify

133


which specific aspects of the euro have played a vital role. All the

above with the aim of helping come up with solutions, bringing

together the most urgent ones and those of a longer term basis.

2. Anatomy of the crisis: Greece, contagion and the perversedynamics of debt

2.1. Sovereign credit risk within the euro: from zero to infinity

The natural starting point of the analysis of the crisis is the

behaviour of sovereign debt markets. The creation of the euro gave

way to a number of markets for debt securities issued by sovereign

states but denominated in the same currency. This is an atypical

configuration with few precedents, given that sovereign debt secu-

rities are usually associated with the bond that exists between the

issuer and monetary sovereignty.

Until 2007 the markets considered that the very creation of the

Monetary Union had reduced sovereign credit risk to a very small

level. For example, the spread between the ten year Greek bond

and the ten year German bund fell within a range between 10 and

30 basis points between 2002 and 2007. In spite of GDP growing

at relatively high rates, the level and performance of the fiscal and

current account imbalances in Greece had justified a much higher

risk premium.

134


With the outbreak of the global financial crisis, credit risk spre-

ads among Eurozone countries widened. But this trend – common

to all of the world financial markets –, was mainly due to risk aver-

sion and an increase in the demand of assets deemed to be safer

(Barrios et al, 2009). The spreads thus adopted a trend towards

moderation throughout 2009, all amid a context of low absolute

financing costs for the sovereign issuers.

Towards November 2009, an alteration in the behaviour of sove-

reign debt markets took place, which in hindsight can be conside-

red as a structural change. The almost perfect convergence since

the beginning of the Monetary Union1 therefore gave way to a

cumulative bifurcation, reflecting the binary behaviour of the mar-

kets. This is a dynamic system with two main features:

• Systematic inefficiency. Bond market prices do not reflect the

fundamental information on credit risk determining factors.

Until 2009, the spreads had been smaller than would be justified

by the main variables (debt stock, deficit, international invest-

ment position, real exchange rate); since autumn 2009, the spre-

ads have been systematically higher than would be justified by

the performance of the fundamental variables. This gap betwe-

en market prices and economic fundamentals has been noted in

several empirical studies (Aizenman, Hutchison & Jinjarak

(2011), De Grauwe & Ji (2012)).

135

1 The average 10 year debt spread in Eurozone countries against Germany was of only

18 basis points between 1999 and mid-2007.

• Tendency towards instability. The euro sovereign debt markets

have shown themselves to be incapable of adjusting their credit

risk assessments in a stable manner. Their capacity for discrimi-

nation has been non-existent for years, with a high demand for

bonds from countries exposed to vulnerability, which were dee-

med to be almost perfect replacements for the German bund.

And in these last two years, the trend has been explosive. In

micro-economic terms, instability means that given an excess

supply of bonds, a drop in price does not bring it back to balan-

ce. But furthermore, we must point out that the explosive natu-

re of the sovereign debt markets since the beginning of 2010 has

become more noticeable than that reflected in market prices.

ECB intervention has lessened the trend towards increases

which are sharp and not related with new fundamental infor-

mation on the likelihood of default by various countries in the

region.

On the basis of this general outlook of the dynamics of debt

markets, a distinction must be made between the Greek market

and the rest.

2.2 A fiscal problem, not the fiscal problem

The Greek situation is special. In October 2009, the new Greek

government announced that the public deficit for the year would

be somewhat over double that which had been forecast (12.7% of

GDP versus the expected 6%). This setback of Greek public debt


136

was thus triggered by a fundamental fiscal surprise of considerable

dimensions.

Greece has systematically managed its public finances poorly

since joining the euro.2 It has taken advantage of the financial

benefits of belonging to the euro to increase expenditure, while

maintaining a pro-cyclical fiscal orientation during a clearly expan-

sive phase. The Hellenic country has thus made real one of the

worst fears of the founders of the euro in regard to the risk of free-

rider fiscal behaviours. The bad news is that neither the market dis-

cipline under the non-mutual guarantee clause nor the Stability

and Growth Pact have managed to correct this situation, which has

worsened further due to continuous problems regarding reliability

of public accounts.

The Greek public debt market has also followed a pattern of

inefficiency and instability. Gibson, Hall & Tavlas (2011) have

identified a systematic bias between the credit risk spread adjusted

to the main determining variables and the market spread.

Nevertheless, the collapse of the market is not difficult to explain.

The depth of the fiscal crisis and its structural nature, added to the

uncertainty and lack of confidence generated by the handling of

accounts, spread the perception among investors of inevitable

insolvency with a certain risk of loss of principal.


137

2 In fact, its public deficit has never been below 3% since it joined the monetary union.

What is hard to explain is why the Greek crisis spread to the rest

of the public debt markets in the area. Firstly, the weight of Greece

in the GDP of the Eurozone (around 2.3%) does not justify that its

fiscal crisis should become a systemic problem. Secondly, no other

Eurozone member country is anywhere near this level of systema-

tic poor management of public funds and continuous breach of

the rules of the Monetary Union.

There are two factors in the Greek collapse during the first

semester of 2010 which became important for the operation of the

rest of the Monetary Union. To begin with, the fragility of the

domestic debt markets within the Eurozone became clear.

Secondly, the political tension generated by the intra-zone finan-

cial aid revealed a considerable institutional weakness. Discussions

prior to the approval of the loan to Greece brought to light that the

politics of the countries in the zone were about to take on a hard

line of fiscal adjustments and onerous conditions in the financial

aid defended by creditor countries, in stark contrast with the posi-

tion of countries which were beginning to feel the effect of the tur-

bulence in Greece as of January.

Even so, it seems impossible to explain how the Greek crisis

became a euro crisis in light of only these two factors. Particularly,

following the creation in May 2010 in response to the explosive

market situation, of the European Financial Stability Facility and

the start of the intervention by the Eurosystem via the Securities

Market Programme.


138

2.3 Contagion: the fragmentation of the single monetary policy

The strategy we have chosen to explain the spread from Greece

throughout all of the Monetary Union is a two-phased approach.

The first phase attempts to define the morphology of the crisis,

which may help, at a second phase, to get to the bottom of its

nature.

These are the main morphological characteristics of the crisis:

• Systemic for the entire Eurozone. The crisis is often discussed

as if it only affects part of the Monetary Union; along the same

lines, it is argued that this is not a crisis of the euro, on the

grounds of exchange rate levels or price stability. In fact, since

the generalised dislocation of the debt markets was sparked off

towards the end of April 2010, the crisis has indeed become a

euro crisis. It affects all member countries, albeit in opposite

way. There has been a flow of capital from the more indebted

countries to the creditor countries, which has been reflected in

the yields of public debt and other securities. Thus, the impact

of the fiscal irresponsibility of one of the members has not

resulted in a generalised increase in interest rates as was expec-

ted (Dombret (2012)). It has had an asymmetric impact, punis-

hing countries with greater financial vulnerability and benefi-

ting the stronger ones.

• Specific to the Eurozone. The financial bifurcation movement

has been limited to the member states, despite having some


139

effect on the rest of the world.3 There is no sovereign debt glo-

bal crisis; on the contrary, public debt yields in the main deve-

loped countries have reached historic minimal levels. Thus, the

main non Euro indebted countries (United Kingdom, United

Sates) have seen an increase in the demand of sovereign debt as

a result of the euro crisis. For instance, at the start of 2010, ten

year British debt securities traded at levels similar to the Spanish

ones. The worsening of the crisis in the Eurozone has meant that

the British debt is just a few basis points away from the German

debt. The negative contagion has therefore only affected euro

members, whereas the positive contagion of public debt has

managed to reach other markets.

• Its dynamics are financial and autonomous, not defined by

fundamental economic variables. This statement calls for an

explanation because… doesn’t Ireland have a serious solvency

problem in its banking system? Isn’t Portugal undergoing a

current unsustainable imbalance? Doesn’t Spain have a high

public deficit and an excess of private debt? How will Italy

manage to sustain a public debt stock of 120% of the GDP and

a GDP growth trend below 1%? … and we could move on to

Belgium and then to France. All the euro countries which have

suffered the restriction of their external financing terms in the


140

3 The Euro crisis has become the main factor threatening the recovery of the world eco-

nomy and the consolidation of the progress made in restoring financial stability after

the global crisis. However, at this point only direct spreading via debt markets is dis-

cussed.

last two years are facing serious problems. But the existence of

such problems does not make them causes for the dislocation of

the debt markets and the consequences thereof. In fact, in all

cases we are dealing with problems with which the markets have

been well acquainted for years. There are two ways of illustrating

the secondary role played by economic fundamentals in the cri-

sis. One is to compare euro countries affected with other non-

euro countries with similar fundamentals. Aizenman et al (2011)

have done this by matching Spain with South Africa and con-

cluding that the greater risk spread in Spain cannot be explained

by the worse levels in the variables which have determined cre-

dit quality ratings. The other is to verify whether an improve-

ment in the fundamentals (including economic policy measures

required to achieve this) has had a positive impact on the finan-

cing terms. For example, affected countries have considerably

reduced their primary deficits adjusted to the cycle, although

this has not helped to improve the perception of the fiscal situa-

tion. This does not mean that the fundamentals are not impor-

tant when determining the vulnerability of a country, or that

the economic policies adopted in response to the crisis have not

proven vital in halting or slowing down the impact of the crisis.

But it is important to stress that the crisis is essentially not a pro-

blem of fundamental economic variables.

• It has become apparent through the inversion of the capital

flow pattern within the euro. For years, the economies with

lower rates of savings (such as Greece or Portugal) or higher


141

investment rates (such as Spain) comfortably financed their

large deficits via private flows of capital from countries with hig-

her rates of savings and lower investment rates. As of spring

2010, many of these countries have been forced to face an inte-

rruption, and in some cases a sudden inversion, of external

funds, as shown by the performances of their financial accounts

(see Graph 1 for Spain). Part of that capital has been diverted to

creditor countries. From this perspective, the crisis can be

understood as a series of sudden stops (with their pertaining

sudden goes) in capital flows within the Monetary Union. The

most acute episodes of the crisis have thus coincided with an

intensification of the external financial restriction. In short, it is

about a crisis in the balance of payments within the particular

framework of the Monetary Union, whose adjustment variable

is not the amount of reserves but the net funding of the

Eurosystem.

By combining these characteristics, the crisis can be defined as

a cumulative coordination failure, with a positive feedback.4 The

key mechanism underlying this failure is the effect that the dislo-


142

4 The concept of coordination failure arises as part of an alternative interpretation of

Keynes’ analysis to that of the Neoclassical Synthesis, which considers there is a deeper

explanation for unemployment and instability problems than salary rigidity. In a first

formulation, it can be associated with the Macroeconomics of imbalance. Subsequently,

within the framework of New Keynesian Economics, this is analysed with different

models which have strategic interdependence and multiple balances in common

(Cooper and John, 1991). In the context of the financial crisis, the coordination failu-

res have played a core role, linked to uncertainty and the effect thereof on expectations.

cation of the operation of the public debt market has over the

mechanism of monetary transmission and, in the last resort, on

the financing conditions of the non-financial private sector.

Indeed, the public debt markets, in addition to procuring state

funding, play a central role in the operation of the monetary and

financial systems. The yield curve of public debt, considered to be

the risk-free asset, serves as the main price reference for the rest of

the credit and securities markets, acting as a floor for financing

costs for all other agents. On the other hand, the implementation

of monetary policy traditionally uses government securities as asset

guarantees. And financial institutions, and credit institutions,

UCITs and pension funds in particular, often keep a considerable

amount of sovereign bonds in their portfolios.


143

Graph 1Net Loan and Financial Account balance of Spain

Source: Bank of Spain

The dislocation of the public debt markets has had a devastating

effect on the affected economies. The increase in volatility (see

Graph 2 for the Spanish market) and the upturn in the credit risk

spread without any underlying new fundamental information

have restricted funding for the non-financial sector in various

ways. Directly, insofar as market-funded companies must pay more

for issues. And indirectly, and more importantly given the finan-

cial structure of the euro economies, it operates via the banking

system. Bank access to market funding is restricted in terms of

volume and prices, whilst the value of both their public debt hol-

dings and other market shares continues to fall. The result is a res-

triction in funding available to businesses and households.


144

Graph 2Historical volatility of Spanish debt

Source: Bloomberg

This situation gives rise a contracting spiral which generates a

perverse dynamics in the sustainability of public debt. The first reac-

tion from countries suffering from a financial restriction mainly of

their debt markets is the acceleration of fiscal adjustment which, in

principle, appears to be a logical and reasonable response. The pro-

blem is that a combination of a strong contractive fiscal approach

and financial restriction weakens the nominal GDP. This leads to

an increase in the nominal fiscal adjustment required to achieve a

deficit target in relation to the GDP. Unemployment rises, disposa-

ble income falls and the creditworthiness of businesses and house-

holds deteriorates. The result is a deterioration of the Debt/GDP

ratio, with a feedback effect.

In summary, the dislocation of public debt markets generated an

endogenous monetary restriction, equal to a drastic toughening up

of monetary policy in the most affected countries. The transmis-

sion mechanism of the policy established by the ECB no longer

works in a fairly uniform manner, upset by the intensity of the pri-

vate funding flows and the effect thereof on expectations. The

result is the breakdown of the single monetary policy.

2.4. A particular manifestation of the global financial crisis

The symptoms of this disease afflicting the Monetary Union

seem very familiar by now: debt markets which no longer work nor-

mally, spreads with an explosive tendency, asset liquidation at dis-

counted prices (fire sales), banks in the grip of liability restrictions


145

and falling asset values, gaps between the financial sector and the

real economy. In fact the mechanism is identical to that which led

to the subprime mortgage debacle in the systemic crisis of develo-

ped economies in 2007-2009. The main difference is that both the

source and the means of contagion were in that case the private

debt markets, whereas in the Eurozone the dislocation has mainly

taken place in public debt markets. But the analogy is valid in

analytical terms and can prove quite useful when considering the

regulatory implications which will result from the crisis resolution.

The effect on monetary policy was similar, although at that time

the public debt markets carried on as normal and could continue to

be used to tackle the endogenous restriction in the financing con-

ditions of the private sector with firm and innovative measures.

Several studies on the nature of the global financial crisis have

highlighted the importance of the increase in uncertainty when

seeking to understand and resolve it. Caballero (2010) considers

that the financial crisis, which appears similar to a heart attack, is

the product of a combination of uncertainty as defined by Knight

and the complexity of the structure of the financial system. These

two factors amplify the initial shock effect, with forced sales of

assets and liquidity strangulations which drive a wedge between

the financial sector and the real economy, preventing the proper

operation of the economy and the markets.5 The solution requi-


146

5 This then leads to large scale coordination failure, in the sense mentioned at the end

of the previous note.

res the State to become an insurer of last resort, providing insurance

against uncertainty to persuade the agents that the less likely nega-

tive scenarios will not take place. This enables the coil to snap, thus

coordinating agents at higher comfort levels.

This financial crisis model can be applied to the Eurozone. The

Greek fiscal surprise and its rapid decline towards insolvency

would be the initial shock, generating confusion among agents and

leading them to reconsider their perception of sovereign risk wit-

hin the euro. The complexity of the financial interrelations within

the area, along with the emergence of political differences, disse-

minates lack of confidence to all other markets. And the rapid dis-

location of the debt markets increases uncertainty, hits the banks

in affected countries and ends up by paralyzing the workings of

their financial system and depressing the real economy. The inten-

sity of self-fulfilling prophecies in the markets increases the uncer-

tainty regarding the outlooks for the countries and for the

Monetary Union as a whole. Investors fear the possibility that the

market dynamics should cause solvent countries to lose access to

new funding.

Definitive uncertainty appears when the disintegration of the

Monetary Union, which seemed like a bad joke even at the start of

2010, becomes a scenario deemed likely by main investors. In fact,

the persistence of such huge spreads between the public debt of

member countries is an unequivocal indicator that the market is

taking the possibility of disintegration very seriously. Investors


147

accept negative real returns in the short term and no return in the

medium and long term of the German public debt because they

believe that, given a break-up scenario, these assets are the ones

which will guarantee the security and continuity of the euro.

It is a fact that certain partial insurance mechanisms to deal

with the effects of the crisis have been implemented in the

Eurozone. On the one hand, the Eurosystem has performed the

role of lender of last resort for the banking system with force, adap-

ting its role to perceived needs. On the other hand, the creation of

a system of financial aid as a component of the institutional fra-

mework of the Monetary Union also constitutes a significant

collective insurance item. But as we pointed out in the introduc-

tion, for the time being these instruments, along with the steps

taken at a national level, have not managed to prevent crisis relap-

ses. The relapse of summer 2011 was particularly serious, as it

underlined its systemic nature and struck both Italy and Spain,

with an ensuing financial strangulation that has led to a new reces-

sion in the region.

3. The Eurosystem at a crossroads

The ECB and the 17 National Central Banks (NCB) comprise the

most powerful institution in the Monetary Union. Its legal inde-

pendence is greater than that of other central banks in developed

countries and, like them, it has the essential power of unlimited cre-


148

ation of money. In contrast with the rest of Monetary Union bodies,

the Eurosystem is capable of making decisions and of expediently

executing them. Even so, it is not a central bank like all the others.

During its first decade of life, the difficulty entailed in setting a sin-

gle monetary policy to be applied to a group of economies with dif-

ferent fiscal policies and economic and financial cycles became

patently clear. But since the Greek crisis, the task has become extra-

ordinarily complicated: on the one hand, due to mix of the fiscal

origin of the problem and the financial nature of the contagion;

and on the other, as a result of the tension which the solutions con-

sidered has produced between the Bundesbank philosophy and that

of the more pragmatic (and closer to Federal Reserve and Bank of

England standards) monetary policy of the all the others.

The Eurosystem has been in the eye of the storm for the last two

years and its performance has been the target of criticism from all

angles: there are those who resent it not having acted in a suffi-

ciently forceful way and there are others who believe that the SMP

and the Long-Term Funding Operations are causing it to deviate

from its mandate and endanger price stability.

With our sights set on the search for a definitive solution to the

crisis, let us attempt to better understand the implications of what

has happened for the single monetary policy and the response

given by the Eurosystem.


149

3.1. Intra-system balances as an expression of the fragmentation of

monetary policy

It would have all been simpler if the impact of the Greek fiscal

debacle would have been a generalised increase in public securities

interest rates in all other euro members. The Eurosystem would

have been able to counteract this effect by adjusting the tone of its

monetary policy. However, the contagion has driven a wedge wit-

hin the euro-debt financial markets, where capital is flowing

towards creditor countries and away from debtor countries.

The dislocation of the debt markets has endowed the net fun-

ding of the private sector in each country with strongly endoge-

nous dynamics, as can be observed in Graph 3. Despite the expan-

sive tone of the monetary policy of the ECB, in Ireland, Portugal,

Greece and Spain, businesses and households have had to face a

drop in the supply of funds, which in recent months has also affec-

ted Italy. In countries such as Finland, the net capital inflow has

magnified the expansive tone of the monetary policy.

The Eurosystem has thus had to face the most difficult problem

since its foundation, in that it directly questions the unity of the

monetary policy within the area.

The alteration in the pattern of financial flows within the

region has substantially modified the geographical distribution of

balances within the Eurosystem. As we have already mentioned,


150


151

within a monetary union a deficit in the domestic balance of pay-

ments is best funded with a greater appeal made by the banking

system of the country to the Eurosystem. If we take a close look at

the evolution of the financial account balance of Spain, excluding

the Bank of Spain and the Net Eurosystem Loan granted to the

Spanish banking system (Graph 1), we can conclude that deficits

in the balance of payments have been offset by an increase in

appeals to funding via monetary policy operations.

The result of this is that the counterparts of the monetary base

(which can be calculated from the Eurosystem consolidated balan-

ce sheet) are now more concentrated in those countries which

Graph 3Bank Funding of the non-financial private sector

Source: Bank of Spain

Interannual Growth ratein Feb 2012

have experienced the dislocation of their debt markets and the res-

triction of private sector funding.

The accounting reflection of these financial dynamics can be

found in the sharp increase of the so-called intra-system balances.

The monetary policy decided by the Eurosystem is applied in a

decentralised fashion, in that it is carried out via national central

banks. The net balance of the operations of a given country with all

other countries in the area generates a book entry shown as the

balance variation between each national central bank (NCB) and

the ECB. These intra-system balances, required to ensure the iden-

tity between assets and liabilities in the NCBs and an appropriate

distribution of seigniorage, disappear when the balances are aggre-

gated in the consolidated balance sheet of the Eurosystem, as the

sum of positive balances is equal to the sum of the negative ones.

The component of these intra-system balances which explains its

sharp increase during the crisis is the one that relates to the varia-

tions in the net balance of outstanding operations settled via TAR-

GET2, whose counterpart entity is the ECB.6 These operations can

be either private inter-bank transactions or monetary policy opera-


152

6 The other basic component of intra-system balances is that related with the issue of

euro banknotes. Both the ECB and the NCBs issue euro banknotes in accordance with

a key (8% allocated to ECB and an adjusted allocation by the NCBs). Then the NCBs

release them based on demand. The difference between the allocated issue of bankno-

tes and the release thereof into real circulation generates an intra-system balance,

which is required for a fair distribution of seniority associated with banknote issue.

Germany has the highest negative balance under this heading.


153

tions between a NCB and a private counterparty. To a large extent,

the sign and amount of the balance depend on the relationship bet-

ween the public or private source of the money of commercial

banks in the central bank. When commercial banks increase their

deposits in the central bank as a result of an increase in private fun-

ding received (deposits, loans or security issues), they tend to redu-

ce their appeal to central bank funding (as we assume that they seek

to limit their reserve surplus). The counterpart of this increase in

liabilities and decrease in assets as a result of the net loan is a posi-

tive balance held by the central bank with the Eurosystem, accruing

at the reference interest rate. On the contrary, a drop in private fun-

ding makes the banks increase their appeal to the central bank. In

this case, the counterpart of the increase in assets is a negative

balance in the liabilities with the Eurosystem.

Germany, which had a very moderate positive balance before

the outbreak of the global financial crisis, has gone on to have over

half a billion euros of positive balance by the end of February 2012

(see Graph 4). The German Banks have reduced their appeals to

the Eurosystem, as they receive funding at very favourable terms

from the market and have furthermore reduced their asset posi-

tions in other euro member countries.

On the contrary, Greece, Ireland, Portugal and, more recently,

Spain and Italy, have experienced an increase in their negative

balances to very high levels, due to their banks having had to off-

set the loss of private funding.

The growing trend of intra-system balances was interpreted by

Sinn (2010) as a stealth bailout by Germany of countries with nega-

tive balances, going as far as proposing correction measures there-

of. Although it found some support among German academic

media (see Declaration of Bobenberg, 2011), Sinn’s interpretation

was subsequently refuted in several articles which have attempted

to shed light on the nature and significance of intra-system balan-

ces (Bindseil & König (2011), Jobst (2011), Borhorst & Mody

(2012)). The debate saw a later resurgence, to a large extent due to

the concern expressed by the Chairman of the Bundesbank in a let-

ter addressed to the Chairman of the ECB.7 Sinn (2012) suggests


154

7 Shortly after this letter was made public, the Chairman of the Bundesbank published

an article in the press which explained the position of his institution in this debate.

Graph 4TARGET2 Balanace

Source: Whitaker, Central Bank of Ireland, Bank of Spain, Bank of Greece, Bank ofPortugal, Deutsche Bundesbank

the establishment of a system for annual settlement of intra-system

balances with liquid assets with guarantees from each country (on

real estate assets or on future tax income). In his opinion, it would

be a system similar to that which exists in the United States within

the Federal Reserve System.

In order to adequately interpret the evolution of intra-system

balances it is worth remembering the following points:

• Balances are the result of the normal execution of monetary

policy. These are therefore flows between the Eurosystem and

the banking systems (in no case bilateral between central

banks), of a monetary nature (these are not real flows of cash or

fiscal transfers) and resulting from the use that the Eurosystem

counterparts make of monetary policy operations.

• Under present conditions, the greater appeal to the Eurosystem

Net Loan by the banking system of a country does not reduce

the funding available to the banking system of another country.

• The risk of loss assumed by the NCB on the assets of the

Eurosystem balance is in line with its allocation of the ECB capi-

tal and does not depend on the size of its intra-system balance.

• Proposals to limit the maximum volume of these balances are

equal to calling into question an essential principle of the opera-

tion of the Monetary Union, and the adoption thereof would pro-

bably lead to the disintegration of the area. It is not appropriate to

use the example of the United States, as the Federal Reserve System

operates within a fully integrated banking and capital market.


155

In summary, the accumulation of intra-system balances is the

normal result of an asymmetrical crisis in the balance of payments

within the area. As is pointed out by Pisany-Ferry (2012), the evo-

lution of the intra-system balances is only a symptom of the dise-

ase afflicting the Monetary Union: the best expression of the frag-

mentation of the monetary policy.

As we discussed earlier, access to Eurosystem funding has acted

as a security valve to prevent a generalised problem of illiquidity

eventually leading to situations of default. However, to date, this

insurance mechanism has proven incapable of correcting coordi-

nation failure. And on many occasions, the appeal of a country’s

banking system to the Eurosystem has been interpreted by the

market as a risk factor, so that it has become an additional compo-

nent of the self-fulfilling prophecy process. The greater the increase in

funding via monetary policy, the greater the restriction on funding

from the market. Bear in mind the aberrant nature of this sequen-

ce and its lack of sense in an environment other than that of the

Monetary Union. During the shutdown of the wholesale financial

markets at the end of 2008 and beginning of 2009 nobody thought

to judge that a greater appeal to the credit of the Fed or of the Bank

of England was an act of weakness.8


156

8 Among other reasons because the names of the institutions that most used these faci-

lities were not known, and because the geographical distribution of the use (in the case

of the districts of the Federal Reserve system) was not significant

During spring of 2011, it seemed that the combination of the

SMP, the maintenance of the full allocation in monetary policy

operations and start of financial aid programmes in the cases dee-

med to be more vulnerable (Ireland in November 2010 and

Portugal in May 2011) allowed the Eurosystem to take on a less lea-

ding role in the crisis resolution.

The position of the ECB, as explained by Trichet (2011), was

based on the diagnosis that this was not a crisis of the euro, but rat-

her a problem of poor macro-economic management, linked to an

insufficient budgetary discipline and the persistence of real and

financial imbalance. The solution could only come about from a

combination of fiscal adjustment and structural reforms at a natio-

nal level, and the strengthening of the institutional framework of

the Monetary Union. Much emphasis was placed on the impor-

tance of the full activation of the EFSF and the future European

Stability Mechanism (ESM). As for monetary policy, this supported

the principle of separation between the setting of the interest refe-

rence rate and the maintenance of unconventional measures to

deal with the distortions in the financial markets and the trans-

mission mechanisms. As an unequivocal example of application of

this principle, the Governing Council decided to raise interest rates

on two occasions in response to the inflationist risk associated with

the rising price of fuel and raw materials.

But the deterioration of the crisis since the end of June 2011

once again placed the ECB at a crossroads. The dislocation of the


157

Italian public debt market, the second largest in the euro region,

triggered a new and virulent bifurcation dynamics which severely

punished the banking system. Although the negative balance of its

international investment position is moderate, Italy underwent a

sudden restriction of external funding which led to the liquidity

crisis of its banking system. The value of traded stocks of the banks

in the region plummeted and the perception of default risk, reflec-

ted in the credit derivative contract premiums, shot up. During

those weeks of August and September, the euro crisis reached its

most dangerous systemic repercussions since its onset.

The Eurosystem was forced once again to react in order to con-

tain the spiralling instability which threatened to spread the rest of

the world. It reactivated and expanded the SMP, by purchasing

Italian and Spanish public debt for the first time. The bloodbath

was successfully avoided, but throughout the month of October, in

the debates held prior to the European Council and G20 meetings,

the need for the ECB to adopt a firmer and more efficient strategy

to solve the crisis was the main topic. And the Eurosystem finally

took a new step.

3.2. Quantitative easing for banks only

The central banks of the main developed economies have had to

revolutionise the implementation of monetary policy in order to

respond to the financial crisis. At a first phase, they modified the

conditions of liquidity provision, both in regard to terms and types


158

of counterparties and guarantees, maintaining a relatively stable

balance. When the crisis became systemic in autumn 2008, it beca-

me clear that the cut in the interest reference rate to its minimum

level (zero or close to zero) would not prove enough to halt the spi-

ralling contraction between the financial conditions and the real

economy.

Henceforward, the monetary policy of the Fed, the Bank of

England and the ECB was implemented mainly through unconven-

tional measures, which was the start of the stage in which we remain

to date. Despite the sudden departure from the practice of the last

two decades, this was not a totally untraveled path. The Bank of

Japan had spent years trying unconventional measures in an attempt

to overcome the persistent deflation generated by the financial crisis

at the end of the eighties. And the Japanese experience, not very suc-

cessful, brought about a debate on how to implement an efficient

monetary policy in a context of a liquidity trap, distortions in the

transmission mechanism and a banking crisis.

The Fed paid special attention to the problems of Japan and the

conclusion of its analyses served as the basis for the deflation pre-

vention policy of 2002 and 2003. Bernanke & Reinhart (2004) iden-

tify three categories of these measures: i) the use of communication

to influence agent expectations ii) quantitative easing via the incre-

ase in the size of the balance sheet and iii) the alteration of the com-

position of the balance sheet in order to directly affect the prices of

certain financial assets. Each of the aforementioned central banks


159

has applied the unconventional approach in its own way, but all

have coincided in having significantly expanded the balance sheet.

Both the Fed and the Bank of England have carried out a three-

fold increase of the weight of their balance sheet in regard to the

GDP (see Graph 5). And both have done so by the mass acquisition

of financial assets, which traditionally made up the main compo-

nent of the assets in their balance sheets. The US monetary autho-

rity began by concentrating its purchases on mortgage bonds,

having subsequently moved on to Treasury bonds. The Bank of

England has mainly purchased significant volumes of short and

medium term public debt securities (around 14% of GDP and 30%

of the amount of securities in circulation). The objective in both

cases has been to have a direct influence on the nominal expendi-

ture in order to reduce the risk of deflation and help the economy

to reabsorb idle resources.

Although it is too early to carry out a full evaluation, the evi-

dence suggests that the unconventional strategies of the Fed and

the Bank of England have proven successful. Estimates indicate a

significant positive effect on asset prices, both of those assets

which have been directly purchased and those with higher risk and

greater impact on the funding terms of the non-financial private

sector (See Meaning & Zhu (2011)). The evolution of the nominal

demand has also been positive, although in this case it is harder to

estimate the impact of unconventional measures. We must also

highlight the credibility of the strategy and its contribution to the


160

reduction of uncertainty, given that the forceful and voluminous

interventions and the communication thereof have managed to

modify agent expectation and to coordinate these towards balan-

ces equilibria which are at some distance from more catastrophic

scenarios. It has not been a magical solution for all problems, but

they have managed to stabilize the operation of the financial sys-

tem, to lend strength to the recovery of the economy and to crea-

te conditions so that the correction of the structural problems of

public and private indebtedness is carried out at a moderate cost.

From the start, the Eurosystem elected to concentrate its uncon-

ventional measures on the provision of funding to the banking sys-

tem, in line with the financial structure of the area, particularly in

terms of full allotprent and the performance of unusually long term

operations. The purchase of assets has been more modest in relative

terms and has now become sterilised. In December 2011 this stra-

tegy was reaffirmed, by deciding to enter into two special financing

operations for a three-year term, along with other credit support

measures designed to favour bank lending and the money markets

in the region.

The demand for liquidity of both operations was very high, with

a very high participation of entities compared to the average num-

ber of previous long term financing operations. The total amount

granted was 1.018 trillion euros. The distribution of liquidity follo-

wed a concentrated geographical pattern reflecting the effect of

funding restrictions on the banking system. The percentages of


161

Spanish and Italian banks were much higher than their respective

allocations in the ECB, whereas the banks from creditor countries

were granted much lower percentages, and further increased their

resources in the Deposit Facility.

Following these two operations, the consolidated balance sheet

of the Eurosystem reached 32% of the GDP for the region, excee-

ding the percentages of the Fed and Bank of England. However, the

impact of the unconventional strategy in the balance sheet of the

central banks has been somewhat lower in the ECB that in the other

two, due to the increase in total weight over the GDP, as well as

having only used assets related to monetary policy, which account

for a lesser percentage of the balance sheet in the European case.


162

Graph 5Balance fo the Central Banks during the crisis(in % of the GDP)

Source: ECB, BoE, FED

The immediate impact of the three year funding operations was

very positive. The coverage for a three year period of the liquidity

requirements of the banks considerably reduced the uncertainty

which had frozen the workings of the banking system. The percep-

tion of bank credit risk improved with significant drops in the pre-

miums of credit derivatives and increases in the value of capital.

The money markets and bank debt markets underwent a revitalisa-

tion, with new flows of funds and the return of European and

foreign institutional investors. At the same time, the public debt

market spreads also experienced a significant narrowing down,

returning in the case of the Spain and Italy to around 300 basis

points. The disabling of the loop-shaped coordination failure bet-

ween sovereign debt and bank risk also had some effect on the

monetary and credit performance, as well as on the real economy.

Towards the end of the first quarter, both the European

Commission and the ECB stated that the M3 and private sector

loans exhibited positive – albeit very low – expansion rates, where-

as activity stabilised after the drop in the last quarter and first

months of 2012.

Beyond its short term efficacy as an insurance mechanism in the

face of the systemic deterioration of the crisis, the full effect of the

quantitative easing for banks only in the Eurosystem will only be

assessable over time. Nevertheless, the strategy adopted has some

weak points, among which we highlight the following:

• It emphasises the Eurosystem’s tendency towards geographi-

cal concentration of net funding. The net amount and the dis-


163

persal of the net lending volumes by country and of intra-sys-

tem balances have increased substantially. The Eurosystem has

thus decided to carry on its clearing role for private funds move-

ments, directly avoiding having to deal with the underlying

causes of such movements in order to modify them. The side-

effect is the increase in the risk volume of the Eurosystem and

in its geographical concentration, assumed by member coun-

tries in proportion to their share of the capital.

• It fails to put an end to the fragility of the public debt markets

in the face of dislocation, and might even increase it.

According to BIS figures, Spanish Banks have increased their

public debt holdings by over 40,000 million between December

2011 and January 2012, whereas the Italians did so at around

15,000 million euros. This evolution, which is due to the entities

taking advantage of the possibility of generating margin by borro-

wing from the Eurosystem and buying public debt, might end up

being counter-productive for two reasons. In first place, because

these are not resources geared towards credit for the non-financial

private sector (which is the main objective behind it). And

secondly, because it might even intensify the means of contagion

towards the banking system if the public debt spreads widen once

again. A demand has therefore been generated for the more casti-

gated public debt securities, but nothing can guarantee that the

market evolution will not suffer further dislocation episodes

which will increase volatility once again and widen the gap bet-

ween market prices and prices based on fundamental variables.

• The SMP might be relegated an amortised instrument. It


164

seems logical that the Programme activity was interrupted

almost at the time when the positive impact of long term fun-

ding operations became evident. The problem is that, within the

Governing Council, the opposition to the reactivation of the

SMP is likely to increase in the event of a new dislocation of the

markets, arguing that both the levels of risk in the balance sheet

and degree of geographical concentration are way too high. This

eventually would be cause for grave concern, given that the SMP

was the instrument which had succeeded in preventing a syste-

mic collapse of the euro region both in May 2010 and in August-

September 2011.

There is an alternative, which the Eurosystem has ruled out,

which might prove more effective as a contribution towards a defi-

nitive solution to the crisis. It would involve directly tackling the

source of the problem, which is the instability that the dislocation

of some public debt markets have brought upon the core of the

economy’s funding system. The aim would be to ensure that a limit

is established on the deviation between the market prices and pri-

ces adjusted to fundamental economic variables which must not be

exceeded. Although there are various ways of implementing this

type of measure, they all involve direct intervention in the market

in a plausible way. Only the central bank, with its power to create

unlimited money, will be able to successfully carry out such a task.

A reasonable option would be to publicly commit to ensuring

that the spread between short term sovereign debt in euro countries


165

does not surpass a certain value threshold. Given the arbitrage rela-

tionship between the various terms of a country’s public debt yield

curve, the application of this stability limit on the shorter part of the

curve (bills and bonds up to 2 years) would suffice, for this then to

be applied to longer terms. In fact, the epicentre of the dislocation

episodes in the public debt markets can be found in the shorter part

of the curve, where volatility increases and exorbitant probabilities

of default emerge, which in turn adversely affect the repo market,

which is crucial for short term financing of the banking system.

The stability limits should be defined for each country on the

basis of its vulnerability and adapted as the case may be to take into

account potential default in commitments of fiscal consolidation

and structural reform. By way of illustration, for Spain and Italy the

stability limits might be around 200 basis points: this level would

be clearly above what can be considered a fair value spread. But

what is important is not to compress the spreads as much to ensu-

re the stability thereof to enable the transmission mechanism of the

monetary policy to operate under relative normality.

The Eurosystem should purchase public debt when the price rea-

ches the stability limit. But if this proposal is viable, the volume of

debt eventually purchased by the Eurosystem is likely to be more limi-

ted than that already in place in the SMP. Moreover, the volume of

purchase of public debt could be sterilised, as is already done now. The

problem is less about amount of money, and more about price struc-

ture and risk, as well as market operation.


166

This type of initiative would enable to transform the perverse

dynamics of debt into a virtuous circle. The recovery of monetary

and financial stability in the more adversely affected countries

would establish the conditions for fiscal consolidation and structu-

ral reform measures to have the positive impact that they should

have had on the confidence of agents and markets.

It is not about the Eurosystem taking on a new role as lender of

last resort to the States, which would be entirely inappropriate.9

The idea would be to preserve the good operation of the debt mar-

kets as a key component in the transmission mechanism of mone-

tary policy and funding of the economy. We are speaking of a

public good of great economic value, the protection of which is an

essential (albeit not explicit) task of any central bank. But as we

recalled earlier, the Eurosystem is not a central bank like the rest.

The rejection by the Governing Council of a plausible intervention

in the public debt markets designed to limit the instability seems to be

related to a number of economic and legal objections. It is argued that

this type of action does not pertain to a central bank and that it carries

inflationist risks in that it would be assuming a quasi-fiscal role,

attempting to solve problems of lack of budgetary discipline and/or


167

9 De Grauwe (2011), after performing a thorough analysis of the crisis, uses the notion

of lender of last resort for sovereign debt markets. Subsequently, this idea has been used

by others to assimilate a plausible intervention in the debt markets with State funding

via the central bank.

competitiveness by means of creating money. It is also argued that it

may violate section 123 of the Treaty, or at least the spirit thereof.

Despite having the seal of respectability granted by the

Bundesbank, such arguments are questionable. It is true that the

Eurosystem should not intervene in public debt markets if the

widening of the spreads is due to irresponsible fiscal policies or an

impairment of fundamental variables (a drop in the GDP, an incre-

ase in the external deficit). For this reason it is highly probable that

a mistake was made when in May 2010 the Eurosystem purchased

Greek public debt. But when the market dislocation begins via con-

tagion and, furthermore, is endogenous and subject to feedback, if

the central bank does not act, it is opening the door to monetary

restriction which would endanger price stability not only of the

country but of all the region. As for inflation, this type of uncon-

ventional measure would carry lesser inflationist risk than the

other two long term funding operations unanimously approved by

the Governing Council. The argument to intervene becomes even

stronger when the affected countries have reacted to contagion by

accelerating their fiscal adjustment plans and implementing signi-

ficant structural reforms.

On the other hand, a more plausible and decisive intervention

in debt markets would not only not violate what is set forth in sec-

tion 123, but would in fact be fully coherent with the spirit there-

of. The text of the section refers to the direct purchase of public

debt securities in the primary market, excluding from the ban the


168

purchase of bonds on the secondary market. The ban on monetary

funding seeks to ensure the independence of monetary policy in

regard to the needs imposed by the fiscal policy. The public indeb-

tedness requirements (arising from treasury deficits, net asset varia-

tion and the refinancing of debt maturities) must be covered by

appealing to the market, without resorting to the expansion of the

monetary base, which ends up generating an inflationist bias.

However, compliance with this healthy principle requires the exis-

tence and proper operation of a liquid and deep public debt mar-

ket. A lack of action in the face of the dislocation of public debt

markets means accepting the gradual destruction of one of the

basic foundation stones of the separation between fiscal policy and

monetary policy.10

In our opinion, the reason why the Eurosystem has not chosen

this solution, more in line with the practice of other comparable

central banks, is not economic but political. This is difficult to belie-

ve, in that it is a fiercely independent institution managed by qua-

lified professionals. But as was pointed out in the first sentence, the

Monetary Union is a political construction; and the euro crisis

carries, as is natural, a very influential political dimension. The

governments and central bank authorities of Germany and all other


169

10Within the monetary union, the loss of access to the market as a result of contagion

does not mean resorting to monetary funding of public debt, but the use of official fun-

ding on a temporary basis. However, this situation quickly leads to some to request to

exit the euro and the recovery of monetary sovereignty as a means of escaping the per-

verse dynamics of debt.

countries benefiting from the positive contagion of the Greek crisis,

have viewed the crisis as a vindication of their economic philosop-

hies and an opportunity to reconsolidate the Monetary Union in

accordance with their principles. And as part of this process, they

understand that market pressure is an efficient discipline that must

not be neutralised. In their opinion, the markets may exaggerate,

but in the end they reflect the fundamental economic problems.

In summary, the Eurosystem has proven to be essential in con-

taining the crisis at the times of greater systemic danger, but it has

not done what any national central bank would have done to tac-

kle the perverse dynamics of debt which threaten the survival of

the euro. In a way, it cannot be blamed. It has acted in accordance

with its nature.

4. The definitive solution must begin in 2012

After the bad omens with which 2011 came to an end, the first

few months of 2012 have seen the danger of a systemic collapse of

the euro fade into the distance, and it even seems that certain sig-

nificant steps have been taken towards a definitive solution to the

crisis. The insurance provided by the Eurosystem has brought

about time and tranquillity.

But the situation is still critical, if we look beyond the financial

tension gauges and we measure the situation of the real economy


170

and political cohesion within the area. The deterioration of the cri-

sis in the second half of 2011 has come at a very high cost in terms

of a fall into recession for Spain and Italy and other member coun-

tries, as well as the worsening outlook for countries with a pro-

gramme. To the rise in unemployment we must add new fiscal

adjustment measures, required to meet the targets in a context of

lesser growth of tax bases and higher cyclical expenditure. At the

same time, the detachment towards the Monetary Union is on the

increase, both in countries punished by financial pressure as well

as in creditor countries.

Given such conditions, the definitive solution to the crisis, this

being understood as the one allowing recovery of sustained

growth throughout the region and a reduction and stabilisation of

the credit risk spreads, cannot take as long as the refund of the

money by the banks to the ECB. It is urgent and the effect of

Eurosystem long term funding operations should be harnessed in

order to implement it.

In our opinion, the definitive solution is made up of 4 compo-

nents. Two of them are already well on track. The third is the key:

the one requiring greater effort due to its political and technical

complexity. And the last is fundamental to prevent future crises and

to encourage the stable operation of the Monetary Union; but this

can be taken more slowly, as it is not a pressing need and will even-

tually happen when the time is right.


171

A SUITABLE HANDLING OF THE INSOLVENCY PROBLEM IN

GREECE. Immediately after the approval by the States in the euro

region of the Loan to Greece which gave rise to the first adjust-

ment programme carried out jointly with the IMF in April 2010,

the prevailing opinion in the financial markets was that Greece

had a solvency problem which required debt restructuring.

However, among the European authorities, including the ECB, the

overriding idea was that any measure generating losses for inves-

tors had to be avoided at all costs. It was believed that this appro-

ach might exacerbate contagion to other public debt markets.

But the delay in recognising this problem undoubtedly was very

onerous. In the Deauville Declaration of October 2010, the leaders

of France and Germany, guided by the healthy aim of involving

private investors in the assumption of losses as a result of their

decisions, extended the potential risk beyond Greece, moreover

projecting it to the future. And in spring 2011, it became clear that

the first Greek programme was not in line with the assumption of

return to the market expected for 2012.11 Finally, the Heads of

State and Government of the Eurozone countries decided in

October 2011 that the restructuring of Greek debt had to allow suf-

ficient reduction of its stock and that this solution was meant

exclusively for the exceptional case of Greece.


172

11 The alarm bell was sounded by the IMF, given that the approval of program disbur-

sements requires a reasonable guarantee that the financing needs of the country are

A year and a half after the outbreak of the crisis, one of the most

decisive conclusions was thus reached: the problem of Greece is

special and requires special handling. And a series of questionable

decisions that had amalgamated, consciously or unconsciously, the

Greek situation with that of other vulnerable countries in the

region, was thus left behind.

Greece has continued to be a source of uncertainty which has

affected the crisis dynamics. Its economic depression (a 13% drop

in real GDP between 2009 and 2011, a 30% drop in deposits in the

banking system during the same period) and the proof of its insti-

tutional frailty have led to a situation of clear unsustainability of

its public debt,12 calling into question the viability of its perma-

nence in the euro. And the risk of Greece’s departure is a very dis-

turbing scenario, as this is not contemplated in the Treaties and it

is difficult to imagine the consequences it may lead to.

The Private Sector Involvement (PSI) Operation in the reduction

of debt, a prior condition for the approval of the second program-

me by the Eurogroup and the IMF, was quite successfully executed

throughout the month of March. The operation is a sophisticated


173

met for the following year; and given the market situation, the IMF considered that

Greece could not be expected to return to the market in 2012 as expected.

12 The deterioration of the sustainability analyses of the Troika since the start of the

programme has been overwhelming. At the start of the program the public debt vs.

GDP was expected to reach its peak in 2012 with 158% of GDP and no reduction. In

autumn 2011, this peak was changed to 186%; finally, the sustainability analysis carried

out after the PSI operation suggests a peak of 164% of the GDP.

and European version of the Brady Plan,13 which has used bonds

issued by the European Financial Stability Facility (EFSF) to soften

the drop in present value of over 50% in exchange for new ultra

long term bonds. The credible threat of a disordered bankruptcy

and the retroactive introduction of Collective Action Clauses in

the issues subject to Greek legislation managed to achieve a per-

centage participation in the exchange above 95%. The operation

has succeeded in reducing the debt load and Greek state’s refinan-

cing needs very substantially.

From a liquidity approach and at punitive rates at the start of

2010, reality has taken over through an operation in which priva-

te investors rightly take on a part of the cost of bankruptcy pre-

vention14 and Eurozone countries assume greater risks, for longer

periods and in exchange for lower interest rates.

Despite the magnitude of the debt reduction (100,000 million

euros, which would allow it to reach a ratio over GDP of 116.5% in

2020, according to the sustainability analysis of the Troika), the


174

13 Name of the Plan used at the end of the 1980s to solve the foreign debt crisis of deve-

loping countries, mainly Latin American. It consisted in exchanging outstanding bonds

for new bonds with a lower present value and longer terms, guaranteed by US Treasury

issued securities.

14 The policy of loss avoidance for investors led to a perverse dynamics whereby priva-

te investors reduced their exposure, in many cases with substantial gains, thanks to the

ever increasing involvement of official creditors. Taken to the extreme, this logic would

have led to a process whereby private investors would not suffer any losses whereas the

official lenders were left funding the entire Greek debt.

prevailing opinion seems to emphasise the main risks facing the

second Greek programme.15 After the last two years, any glimpse

of a positive assessment in regard to what is going on in Greece

seems completely off the wall. It is true that the sharp drop in the

GDP, the fiscal adjustment and the reforms carried out have not

achieved sufficient reduction in the primary budgetary balance or

in the current deficit (which is still around 10% of GDP). However,

in our opinion, the PSI operation and the approval of the new pro-

gramme, which supports devaluation via the reduction of labour

costs, the gradual continuation of the fiscal adjustment and the

50,000 million euros to ensure the solvency of the banking system,

will be able to restore certain stability to the Greek economy.

Taking into account the reduction in uncertainty, the moderate

deflation of costs and the effort invested in structural reforms,

there is a very clear potential for economic recovery. This stabiliza-

tion would exert a positive impact on expectations, leading in turn

to a virtuous circle. All this depends on the country being able to

maintain a stable political leadership which is committed to com-

pliance with the second programme.

In any event, the value of the PSI operation and the second pro-

gramme for the definitive solution of the euro crisis arises from the

reduction in uncertainty. Despite the need to continue to adopt

policies which require sacrifices on the part of the citizenship for


175

15 See for instance the IMF report on the request for a new program, which emphasizes

the risk of new accidents and the importance of Euro members undertaking to continue

to finance Greece in concessional terms whilst the appropriate policies are implemented.

some time, the reduction of the debt and the funding of the long

term needs of the State render the option of staying in the euro

much more attractive than the option of departure (although the

latter will continue to have its supporters both in and outside of

Greece).

A FISCAL PACT TO STRENGTHEN POLITICAL CONFIDENCE.

The Greek experience clearly justifies a reinforcement of the fiscal

regulations of the euro, so that these are more efficient during the

expansive stages of the cycle, therefore obliging member states to

internalise the external cost of unbalanced public finances.

The European Union already approved in 2011 a substantial

toughening of the Stability Pact and Growth, as part of the reform

of the macro-economic governance known as Six Pack, which also

broadens the multilateral supervision of macro-economic imbalan-

ces of a non-fiscal nature. The preventive section includes the quan-

titative definition of what is understood to be a substantial deviation

from the Medium Term Objective of structural budgetary balance or

from the path established to achieve it. The corrective section brings

about the Excessive Deficit Procedure due to the non-fulfilment of

the public debt criterion and introduces the reverse qualified majo-

rity rule for decision-making, which will make it harder for member

states to put a stop to a Commission proposal. Minimum require-

ments are also established for the budgetary frameworks of the coun-

tries, in terms of coverage of all administrations, multiannual natu-

re and quality of the public accounting systems.


176

This exhaustive reform of the fiscal rules culminated with the

signature on 2 March 2012 of the Treaty on Stability, Coordination

and Governance. This new Treaty:

• Has been signed by 25 of the 27 EU member countries, alt-

hough it will only be legally binding for euro members.

• It shall come into force on 1 January 2013, provided it has been

ratified by 12 euro member states, thus avoiding the uncer-

tainty associated with the ratification process of a modification

of EU Treaties. Even so, its content is expected to be added to

community legislation within five years.

• It introduces the rule of budget balancing. This will be unders-

tood to be met when the structural deficit reaches its Medium

Term Objective (MTO) with a maximum deficit of 0.5% (which

can reach 1% if the debt is significantly below 60% and the sus-

tainability risks are low).

• Any significant deviation from MTO or from the path of adjust-

ment towards the MTO that is observed will trigger an automa-

tic correction mechanism, defined in the national legislation

but inspired by the principles established by the Commission.

The foregoing shall be of application unless in the event of

exceptional circumstances.16

• Both the rule and the correction mechanism must be added to

the national legislative systems, preferably at a constitutional

level, within the year subsequent to the entry in force of the


177

16 This refers to i) An unusual event outside of the control of the country which has a

large impact on the financial position of the public administrations or to ii) periods of

Treaty. And the transposition shall be subject to verification by

the EU Court of Justice, which shall be empowered to take dis-

ciplinary action in the event of infringement.

• The euro countries undertake to support Commission propo-

sals within the framework of the excessive deficit procedure

concerning any of them, except in the event of a qualified

majority thereof against it.

The new Treaty is consistent with the system of fiscal regula-

tions established in the revised SGP and actually uses its basic com-

ponents (the MTO, the significant deviation and the exceptional

circumstances). What it does is to toughen these rules and increa-

se the legal rank thereof within the internal legal system. The two

most important items are the rule of budget balance and the auto-

matic correction mechanism.

In technical terms, the new framework of fiscal rules for the

euro is reasonable from a medium to long term perspective, inso-

far as:

• It reinforces the discipline mechanism during the expansive

phases of the cycle, which will oblige budgets to be kept in

balance or with surplus.


178

serious economic contraction as this is defined in the revised Stability and Growth Pact

and, in both cases, provided the temporary deviation does not endanger medium term

fiscal sustainability.

• It increases control at a European level on the quality of the

public accounts as a basis for multilateral supervision of the fis-

cal policies.

• It increases the credibility of the prevention and sanctioning

mechanisms, assisting in non-discretional decision-making and

toughening sanctions.

• It obliges national legal systems to fully incorporate both the

fiscal rules and the minimum requirements of quality and coor-

dination of budgetary frameworks.

In the medium to long term, the application of such rules, assu-

ming a trend nominal growth of 3% per annum, would lead to a

public debt stock of 17% of GDP (Whelan, 2012). The key for such

rules to generate anti-cyclical fiscal policies is that they are able to

impose tough discipline during the expansive phases, that the

reliability of the fiscal information is assured and that the sanc-

tions are applied in rigorous and equitable way for all.

The use of a non-observable variable such as the structural

balance in order to assess compliance with the deficit rule makes

sense, but it complicates the practical application thereof due to

uncertainty in regard to the correct estimate of potential GDP. The

case of Spain during the phase prior to the crisis is paradigmatic:

during the period 2005-2007, the Commission estimated the struc-

tural budgetary balance to be very close to the nominal balance,

given that the growth estimate for potential GDP was around 3%.

The subsequent performance of the economy and of the public


179

income and expenditure has shown that in the years previous to

the crisis, Spain was growing over and above its potential and that

the structural balance was much worse than that indicated by the

nominal surplus.

In reality, the value of the Treaty on Stability, Coordination and

Governance is above all political, as it helps to bring about once

again a new political understanding among the euro member

countries. Several countries have interpreted the financial aid as a

breach, at least in spirit, of the non-mutual guarantee clause in the

Treaty. It was hard for Germany and other countries in the D-mark

area to bring their monetary sovereignty in line with that of coun-

tries with a lesser tradition of stability. And the non-guarantee

clause was one of the essential conditions to do so. Part of the atti-

tude of governments and central bank authorities in these coun-

tries in the last two years could be explained by this feeling that

rules have been broken.

The new Treaty, with its reflection in the Constitutions of several

countries, is one more step for countries in the north and centre to

believe that the countries which are currently more vulnerable are

adopting a longstanding commitment to fiscal discipline, beyond

the adjustment forced upon them by the markets. And this confi-

dence is essential to the creation of political conditions which will

enable decisions to be taken with a view to solving the crisis. The

Fiscal Pact is therefore a necessary condition, but in no way is it

enough to make 2012 the year of the start of the end of the crisis.


180

The Treaty will strengthen the policy of firm advancement in fis-

cal consolidation in the most vulnerable countries, which has been

applied for the last two years. But we are already aware that the per-

verse dynamics can make a steadfast programme of fiscal adjustment

which lacks a complement to help restore growth fail in its objecti-

ve of stabilising public debt. Without nominal growth and financial

stability, the efforts made in regard to deficit reduction not only fail

to reduce the debt/GDP ratio, but actually increase it.

THE GRADUAL AND FLEXIBLE CONSTRUCTION OF A SIN-

GLE PUBLIC DEBT MARKET. The key to doing away with the per-

verse dynamics of debt is to restore the good working order of the

public debt markets, so that the spreads are more in line with eco-

nomic fundamentals and more stable. This is an essential condition

for relaxing financial terms in vulnerable countries and for allowing

growth to benefit from the positive effects of the reforms adopted.

We have already pointed out that there is no confidence that the

Eurosystem will adopt the strategy required to achieve this objecti-

ve. A second alternative on the table is the EFSF/ESM. In theory, the

EFSF/ESM, with the set of intervention instruments which it

currently contains, has the effective capacity to stabilise the public

debt markets. However, in our opinion, financial aid is not an effi-

cacious solution to the perverse dynamics of debt. Under current

conditions, the preventive funding facilities would soon become

ordinary adjustment programmes; the result would be the exten-

sion of the loss of access to market funding and the escalation of the


181

political tension arising from the concentration of funding in the

area from only a few contributor countries. On the other hand, the

design of the secondary market intervention instruments has too

many political and operational limitations to even appear plausible.

In our opinion, the most suitable way is the creation of a new

public debt market with jointly and severally guaranteed securities.

This is a very important and delicate political decision, as it involves

the pooling together of sovereign risk, which is an essential part of

fiscal sovereignty. Countries with higher credit rating have been hit-

herto reluctant to share the issue of debt with those of a lower cre-

dit quality. This attitude is fair and understandable; to ask Finland,

Holland or Germany to pool together all the debt issued with more

indebted and vulnerable countries is politically unrealistic.

But given the current crossroads of the Monetary Union, this

step must be taken, and the way to do it is to design it in such a

way that it is politically feasible. This design should abide by the

following principles:

• The construction of a single public debt market in euros must

be done gradually. The first stone must be solid but of a mode-

rate size. The next stones shall be placed little by little and on

the basis of experience.

• At the first stage, the percentage of public debt pooled together

must be limited. This requirement should be in line with the

doctrine of the German Constitutional Court, which requires

bonds issued by the State to have a clear quantitative limit.


182

• The pooled debt must be senior to the national debt, in order to

reduce the risk of the joint and several guarantee.

• Incentives restricting moral hazard must be introduced, taking

in account the strengthened governance framework of the

Monetary Union.

In the Eurobond debate, several specific formulae have been

considered which are compatible with such principles. The pione-

er was the blue bond/red bond proposal (Delpla & Weizsäcker,

2009), which suggested pooling together up to 60% of the public

debt over the GDP (blue debt), leaving the rest as subordinate

national debt (red debt). The Commission published a Green Paper

containing various different options of Stability Bonds which

aimed at feeding the debate. Lastly, the proposal of a European

Debt Redemption Fund from the Group of German Economic

Experts (2011), which advises the Federal Government, is also of

great interest, in that it considers the pooling together of the sur-

plus of the 60% of debt over GDP in exchange for real guarantees

in order to overcome the crisis. 17

In our opinion, the most attractive alternative would be the

Eurobills proposal made by Hellwig & Phillippon (2011) which

would consist of:

• The issue with a joint and several guarantee of all public debt

securities with initial maturities of up to 1 year (Eurobills).


183

17 The formula of the surplus over and above the 60% does not seem fair, as it rewards

the more indebted countries.

• The participation of each member country would be limited to

10% of the GDP. The Eurobill market would therefore have a

maximum size, based on the GDP for 2011, of 1 billion euros.

• The Eurobills would be senior to all other longer term debt, as

the short term debt is already de facto senior to medium and

long term debt.

• The loss of access to the Eurobills could be considered discipli-

nary action within the framework of multilateral supervision

of fiscal policies and macro-economic imbalances.

The Eurobills are a simple formula with many advantages:

• Efficacy. As we have already mentioned, the core of the dislo-

cation in economy funding mechanisms lies with the shorter

part of the debt markets and its connection to the money mar-

kets. The Eurobills would manage to directly tackle the failure

and the effect would be foreseeably transmitted throughout

the yield curve. They would thus represent an alternative to

stability limits.

• Political feasibility. The high level of political and legal com-

mitment to fiscal stability brought by the new Treaty should

allow for the more solvent countries to accept the Eurobills.

Given their term, the risk is limited; and in terms of cost if

issue, the loss would be small or non-existent.18

• Operating facility. The EFSF/ESM already issues bills, so it could

easily assumed the issue of Eurobills. A system would have to


184

18 The bills issued by the EFSF with proportional guarantees from euro member coun-

tries have a small spread compared to German bills. Taking as a reference the issue of

be established to consolidate the treasury needs for each State,

as Bills play a certain role as treasury management instruments.

• Additional benefits. Eurobills could be used to meet Basel III

liquidity requirements and would attract a strong demand from

institutional investors in and outside of the region.

The construction of a single public debt market in euros will be

a long and complicated process, likely to take decades. It is a basic

ingredient in the path of the euro towards institutional maturity,

which shall have to develop alongside advancements made in fis-

cal integration. But it must commence now, as it is the key to over-

come the crisis once and for all.

THE FEDERALISATION OF BANKING SUPERVISION IN THE

EUROSYSTEM AND THE CREATION OF A EUROPEAN DEPOSIT

GUARANTEE FUND. In hindsight, one of the most serious flaws of

the institutional framework of the first decade of the euro has to do

with banking supervision and crisis management. In order to reach

a definitive solution, this flaw must be corrected.

Despite having harmonised prudential legislation from the

start, the euro region has worked with banking systems which have

continued to be governed by an essentially national approach. On


185

March 6 month bills, the spread compared to the German bills is lower than 20 basis

points. The cost of issue of the Eurobills would naturally be lower than that of the EFSF

bills, thanks to the joint and several guarantees, closer to the levels at which bills are

currently issued by Germany and by other countries with a higher credit rating.

the other hand, despite the efforts begun following the Brouwer

Report (2001) to build a crisis management plan within the EU,

when the crisis was broke out weak in deposit guarantee and prac-

tically non-existent in the intervention and liquidation of credit

institutions.

One of the most illustrative indicators of this persistence of the

national approach in the realm of banking is that the integration

has advanced more between euro countries and non-euro coun-

tries than within the euro region itself. Among the problems asso-

ciated with this situation, we shall highlight two:

The absence of global overview of the funding structure of

the area and its relation with monetary policy. The creation of

the euro led to a strong expansion of gross and net flows within

the area. In a way, this was the reallocation of capital towards those

countries where it was scarce and could obtain better returns. But

in some countries this process ended up by creating bubbles in the

real estate sector, which reached hitherto unknown peaks partly

due to belonging to the Monetary Union (low interest rates, very

elastic supply of external funds). In light of the high short term

economic benefits in terms of extraction of income, employment,

fiscal activity and collection, the economic policy renders very dif-

ficult, as we have seen, the adoption of domestic measures to burst

the bubble. At the same time, given that monetary policy is exo-

genous to the authorities of a country, the effect thereof is not

internalised in regard to the creating or blowing up a bubble furt-

her. But it is not only about bubbles. The global crisis showed up


186

other weaknesses in the funding structure of the banks in the euro

region, such as its dependence on the liquidity of the US money

markets.

The possibility that a banking crisis might bring down a

country. National supervision goes hand in hand with the natio-

nal responsibility for covering costs in the event of a crisis. As we

have seen in Ireland, the bank solvency problems can overwhelm

the fiscal capacity of the country. Moreover, and continuing with

the Irish example, the potential effects of contagion within the

Monetary Union limit the capacity of the affected country to solve

the crisis by the assumption of losses by private creditors.

Since the start of the crisis, considerable progress has been made

in terms of coordination of bank supervision and crisis manage-

ment in Europe. Nevertheless, the maturity of the Monetary Union

still has a way to go. The essential public policies on the banking

system must be common within the euro area, in accordance with

a plan with two main cornerstones:

• Federal banking supervision within the Eurosystem. The time

has come to make use of a provision of the Treaty on the fede-

ralization of banking supervision within the euro area. Given

that only in 5 euro countries the banking supervisor is separate

from the central bank, and that the ECB is the most powerful

euro institution, the most natural approach to achieve this is by

awarding competencies to the Eurosystem. And the competen-

cies assumed must include micro-prudential regulation, macro-


187

prudential regulation and part of the crisis prevention and

management function.

• A European Deposit Guarantee Fund (EDGF). The crisis has

proven that the deposit guarantee systems are basic instruments

in the prevention and management of banking crises. During

the global crisis, the risk of having systems with insufficient

coverage (eg. Northern Rock) or the chaos generated by unilate-

ral decisions on levels of coverage within the euro (movements

of deposits between countries at the end of 2008) became

patently clear. With the generalized increase in coverage of

deposits up to 100,000 euros (which increases the cost of the

liquidation of the institutions), the guarantee funds, in princi-

ple, assume a crucial responsibility. However, the models of

deposit guarantee systems within the area as still quite different

from one another. For this reason an obligatory adhesion fund

should be created to assume the guarantee of all deposits in the

banks of the euro area and their branches in the EU. The fund

should be made up of the contributions from entities, determi-

ned on the basis of credit and liquidity risk and have a system

of governance similar to that of the Spanish guarantee funds,

presided over by the ECB and with broad representation of the

private sector in its Board of Governance. The functions of this

EDGF should include the resolution of banking crises, assisting

the mandate of the Eurosystem in early intervention and crisis

resolution at the lowest cost for the public treasury. As an addi-

tional and exceptional mechanism of funding, a system could

be established whereby the ESM could lend funds to the EDGF.


188

The improvement in the operation of the Monetary Union as a

result of the federalisation of banking supervision and crisis mana-

gement would be considerable in the medium and long term. The

following are among the possible positive changes associated with

this reform:

• The monetary transmission mechanism would become more

robust against national fiscal evolutions and the fluctuations of

the financial markets.

• A boost to cross-border integration and consolidation. The pro-

tection of domestic industry would become more difficult,

which would lead to benefits of risk diversification and econo-

mies of scale. And competition would gradually become more

intense, which is essential after the re-nationalisation of the

banking markets and the strong public support provided to cri-

sis- affected entities.

• Support for incentives to implement measures to prevent the

creation of speculative bubbles.

• The internalisation of external effects and public service provi-

sion problems associated with financial stability within the

area. This would allow for the creation of a structure where the

central bank and the Ministries (Eurogroup) work much more

efficiently towards preserving financial stability.

• It would support the introduction of measures to achieve grea-

ter involvement of the private sector in the solution of future

crises.


189

5. Conclusion

The adolescent crisis of the euro is extremely serious. European

and national authorities have taken courageous and significant

decisions in recent months, in many cases having learned from

previous mistakes. The restructuring of the debt and the new

adjustment programme are an intelligent and well executed res-

ponse to the serious solvency problem in Greece. Ireland and

Portugal are applying their programmes with excellent assessments

made by the troika. And an institutional framework is under way,

which will render the generation of a crisis in the future a lot less

likely.

Much political and social capital has been spent on implemen-

ting such measures. It is clear that the euro member countries are

willing to make great sacrifices in order to preserve the project. But

the truth is that the crisis has not yet been overcome, because the

root causes of the uncertainty and the instability generated by the

dislocation of the public debt markets have not been attacked.

The economy within the euro area will foreseeably face a second

recession three years after the sharp blow of 2009. Ireland and

Portugal are watching their expectations of recovery fade as a

result of lower foreign demand and maintenance of financial pres-

sure. And there are questions as to the likelihood of its return to

the markets within the timeframes set and even in regard to the

Greece and no more commitment. Spain and Italy are implementing


190

strong fiscal adjustments and deep structural reforms in an envi-

ronment of recession and financial vulnerability.

The euro cannot afford to undergo another episode like the one

in August-September 2011. It is imperative that a measure is taken

to protect us against that risk and removes, once and for all, the

devastating coordination failure of the global crisis of 2009. Having

assumed that the stabilisation of the debt markets cannot be pro-

vided by the central bank as in other countries, we have to choose

a new market. Eurobills are an efficient and balanced solution;

2012 should be their birth year. They will help reunify monetary

policy, by first restoring stability and establishing the foundations

for a solid economic recovery. These conditions are essential for the

programmes to work, for the debt to stabilize and for the consoli-

dation and reform policies to be effective and have continuity.

There is no future without stability and growth.

It is not necessary to search for great constructions or to come

up with solutions for all the problems. The Eurozone shall never be

an optimal monetary region. It does not need to be. For the time

being, we must concentrate on a series of efficient and plausible fis-

cal regulations, a single monetary policy based on debt markets

which are operating fairly and a stable banking system capable of

funding the economy. And to continue to learn and build an incre-

asingly closer union. The countries that are currently suffering will

learn from their mistake; one cannot prosper within the euro with

the same institutional framework that one had out of the euro:


191

foreign finances continue to be a restriction, the real exchange rate

and the flexibility in real salaries and mark-ups are important, cre-

dit excesses cost dearly… but we must allow some time for the les-

sons learned to be put into practice and produce good results.


192


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Breaking the common fate of banksand governments

* Dr. Daniel Gros is the Director of the Centre for European Policy Studies (CEPS) since

2000. Among other current activities, he serves as adviser to the European Parliament

and is a member of the Advisory Scientific Committee of the European Systemic Risk

Board (ESRB), the Bank Stakeholder Group (BSG) of the European Banking Authority

(EBA) and the Euro 50 Group of eminent economists. He also acts as editor of Economie

Internationale and International Finance. In the past, Daniel Gros worked at the IMF

(1984-86), at the European Commission (1989-91), has been a member of high-level

advisory bodies and provided strategic advice to numerous governments and central

banks. Gros holds a PhD. in economics from the University of Chicago, has taught at

prestigious universities throughout Europe and is the author of several books and nume-

rous contributions to scientific journals and newspapers. Since 2005, he has been Vice-

President of Eurizon Capital Asset Management.

** Dr. Cinzia Alcidi holds a Ph.D. degree in International Economics from the Graduate

Institute of International and Development Studies, Geneva (Switzerland). She is

/DANIEL GROS*/ CINZIA ALCIDI**/

197

1. Introducción; 2. Recent eurozone history: From bad to worse; 2.1. Recallingthe building blocks of the EMU construction; 3. A false solution to the crisis: thefiscal compact; 4. Fiscal indiscipline versus financial regulation inconsistency;5. A proposal for a new regulatory treatment of sovereign debt securities in theeuro area; 6. Conclusions; Bibliography

Breaking the common fate of banks and governments

1. Introduction

Since 2010 the news about Europe has gone from bad to worse.

In early 2012, it still cannot be claimed that the eurozone crisis is

solved, thought markets within the euro area seems to return

(maybe only temporarily) to more normal conditions.

Interestingly enough, the average of the fundamentals of the

euro area looks actually relatively good: compared to the US, the

eurozone as whole has a much lower fiscal deficit (4% of GDP in

2011 against almost 10% for the US) and unlike the US, it has no

external deficit. Its current account is close to balance, which

means that enough savings exist within the monetary union to

finance the public deficits of all its member states. This implies, in

turn, that potentially enough, domestic, euro zone’s resources exist

to solve the debt problem, without recurring to external lenders.

Whether these resources will be invested to finance eurozone

governments is a different question.

198

currently LUISS Research Fellow at Centre for European Policy Studies (CEPS) in

Brussels where she is part of the Economic Policy Unit dealing mainly with issues rela-

ted to monetary and fiscal policy in the European Union. Before joining CEPS in early

2009, she taught undergraduate courses at University of Perugia (Italy) and worked at

International Labour Office in Geneva. Her research interest focuses on international

economics and economic policy. Since her arrival at CEPS, she has worked extensively

with Daniel Gros on the macroeconomic and financial aspects of crisis in Europe and

at global level, as well on the policy response to it. She has published several articles on

the topic and participates regularly in international conferences.


In spite of this relative strength, eurozone policy-makers seem

incapable to solve the debt crisis. Meeting after meeting, heads of

state and Government or finance ministers have failed to convince

markets of the validity of their strategy, which has focused almost

exclusively on fiscal discipline and has repeatedly advocated the

need of financial help from outside investors, e.g. IMF and Asian

investors, regardless of whether resources exist within the eurozo-

ne. This approach has been both misguided and unconvincing.

Against this background, the paper emphasizes that while the

political agenda is almost obsessively focused on fiscal issues, the

euro zone crisis does not have a mere fiscal nature neither a simple

fiscal solution. It involves different dimensions running from

current account and external debt problems to the weak state of the

banking sector, which is still largely undercapitalized. This paper

will focus on the last element, the state of the banking system and

attempts at highlighting how features of the existing financial mar-

ket regulation framework which are inconsistent with main buil-

ding blocks of the monetary union have affected the course of the

crisis. We will argue that this inconsistency has crucially contribu-

ted to eurozone crisis and still remains unaddressed. The paper also

expresses concern about the misleading, prevailing view that the

just signed fiscal compact will work as crucial ingredient in the reci-

pe to overcome the eurozone crisis, while the banking sector

remains highly leveraged and exposed to the fortune and misfortu-

ne of sovereign governments. On this ground, the paper puts for-

ward some ideas about how to break the tight linkage between

199


governments and banks. This is at the root of their common fate

and represents a decisive obstacle to overcome the eurozone crisis.

2. Recent eurozone history: From bad to worse

To understand why the euro crisis has gone from bad to worse,

one needs to develop a better understanding of the inconsistencies

in the setup of European Monetary Union (EMU) that caused the

problem in the first place. The official reading is that this is not a

crisis of the euro, but of the public debt of some profligate euro

area member countries. Therefore, tackling the causes of this crisis

and averting future ones requires only a new, tighter framework for

fiscal policy – which will be delivered by the new ‘fiscal compact’.

Yet, financial markets do not seem much impressed by a further

strengthening of fiscal rules: Portugal and other countries still have

to pay high risk premia while Greece has defaulted on its debt and

still teeters on the brink of a total collapse. This suggests that the

official approach captures only part of the problem and still misses

the full picture.

It is not only fiscal indiscipline in the periphery which turned

the public debt problems of a small country like Greece into a cri-

sis of the entire euro area banking system. The euro zone crisis is

the result of a constellation of vulnerabilities within the eurozone.

They include balance of payments problems, foreign debt, sudden-

200


stops of crosser-border financing running from North to South

combined with a generalized undercapitalization of the banking

system.

This financial fragility has been the result of inconsistencies in

the setup of the EMU as well as a fundamental inconsistency in

financial market regulation that has yet to be addressed.

2.1. Recalling the building blocks of the EMU construction

The original design of EMU, as established by the Maastricht

Treaty in 1992, contained three key elements:

i) An independent central bank, the ECB, devoted only to price

stability.

ii) Limits on fiscal deficits enforced via the excessive deficit pro-

cedure (Treaty based) and the Stability and Growth Pact (SGP,

essentially an intergovernmental agreement, although still

within the EU’s legal framework).

iii) The ‘no bail-out’, or rather ‘no co-responsibility’ clause (art.

125 of the TFEU).

The treaty also contained other elements of economic gover-

nance,1 but this remained mostly declamatory as in reality

201

1 For instance, Article 121 of the TFEU contains the provision that member states

should regard economic policies as a matter of common concern and shall coordinate

them within the Council.


202

Member States did not see any need to coordinate economic poli-

cies; at least, not before the crisis.

The first key element of the Maastricht Treaty, i.e. the very

strong independence of the ECB, was based on a large consensus

among both economists and policy makers that the task of a cen-

tral bank should mainly be to maintain price stability. The con-

sensus was based on a common reading of the experience of the

previous decades that higher inflation did not buy more growth

and independent central banks (with the Bundesbank as the most

prominent example) are best placed to achieve and maintain price

stability.2

Some academic economists and some observers at international

financial institutions worried already in the 1990s about financial

instability and advocate a clear role of the EBC in safeguarding

financial stability.3 Some also emphasized that a common currency

area also requires a common system of supervision of financial

markets.4 But the issue of financial stability did not attract the

attention of policy makers mainly for two main reasons. The first

one is theoretical: most prominent economic models before 2007

suggested that price stability delivers financial stability as by-pro-

2 A prominent paper of the period when plans for EMU were taking shape encapsula-

ted this insight in the title ‘The advantage of tying one’s hands’ (see Giavazzi and

Pagano (1988).

3 See for instance Garber (1992).

4 Among others Tommaso Padoa Schioppa (1994).


203

duct, with no need to add another tool to achieve it. The second

one is much less sophisticated and relates to the fact that the two

key member states driving EMU, France and Germany, had not

experienced a systemic financial crisis for decades.

The second element of the Maastricht Treaty, namely the limits

on fiscal policy, did not enjoy the same consensus in the academic

profession (nor among policy makers) as central bank indepen-

dence. During the 1990s a wide ranging debate took place about

the sense or non-sense of the Maastricht ‘reference’ values of 3% of

GDP for the deficit and 60% for the debt level. Apparently the

advantage of tying one’s hands was much less recognized in the field

of fiscal policy. However, this debate did not need to be resolved as

long as benign financial market conditions prevailed and even the

core countries conspired to weaken the limits on deficits set by the

SGP in 2003.

The third element was only in the background and remained

untested until recently. Contrary to a widespread misconception,

Article 125 of the TFEU does not prohibit bail outs. It merely

asserts that the EU does not guarantee the debt of its member sta-

tes and that member states do not guarantee each other’s obliga-

tions. Germany had insisted on the no bail-out clause when the

Maastricht Treaty was negotiated about 20 years ago. Today, it is

clear that this clause does not provide the kind of protection that

was sought and widespread financial market turbulences threaten

to engulf Germany to agree to huge bail-out packages which would


204

have been unthinkable only recently. However, instead of working

on averting the repeat of this situation in the future, German

policy makers are focusing exclusively on the need to ensure lower

fiscal deficits. This is the purpose of theTreaty on Stability, Coordination

and Governance in the Economic and Monetary Union also called the

‘fiscal compact’ under which euro area member countries agree to

adopt strict rules, ‘at the constitutional or equivalent level’, limi-

ting the cyclically adjusted deficit of the government to less than

0.5% of GDP. Will this fiscal compact work where the Stability Pact

failed?

The ‘original’ SGP already contained the engagement by mem-

ber states to balance their budget over the cycle. If implemented

since the onset of the monetary union, the rule would have led to

a continuous reduction of the debt-to-GDP ratio towards the 60%

target. But this did not happen. The promise or rather exhortation

contained in the SGP to balance budgets over the cycle was widely

ignored, given that the rule was not binding and financial markets

remained in a ‘permissive’ mood. All of the larger euro area mem-

bers ran budget deficits in excess of 3% of GDP threshold for the

first 4-5 years of the euro’s existence. Even Germany ran deficits

above 3% of GDP from 2001 to 2005. In 2003 a proposal put for-

ward by the Commission to ratchet up the excessive deficit proce-

dure to the point where fines might have been imposed on France

and Germany was defeated in the Council (of finance ministers,

ECOFIN). In the crucial vote the large countries (most of which

had excessive deficits, except Spain) colluded to water down the


205

proposal and won the opposition of the smaller countries. The

’band of three large sinners’ (Germany, France and Italy) even

managed to put together a qualified majority to ‘hold the proce-

dure in abeyance’.5

This narrative is interesting in the light of the new ‘fiscal com-

pact’ which is supposed to radically strengthen the enforcement of

the fiscal rules by the application of the ‘reverse qualified majo-

rity’. Under this principle, an excessive deficit procedure launched

by the Commission is taken to be approved unless it is opposed by

a qualified majority. As past experience shows, despite the new sys-

tem makes the opposition harder, it does not ensure enforcement.

In 2005, following the 2003 episode, the SGP was changed. The

official justification was the need to improve its economic rational

and thus ownership,6 but it clear that it was necessary to avoid the

repeat of the embarrassing situation in which a literal application

of the rules would have led to sanctions for Germany and France

among others. The reaction in academia and among policy makers

was mixed: the SGP was ‘softened’ according to some, but ‘impro-

ved’ according to others. The very fact that professional opinion

on the merits of ’binding rules for fiscal policy’ was divided from

the start certainly facilitated the change in the SGP when it beca-

me politically opportune.

5 See Gros et al. (2004). 3 See for instance Garber (1992).

6 Annex to the 2005 Council conclusions

(http://register.consilium.europa.eu/pdf/en/05/st07/st07619-re01.en05.pdf).


206

As matter of facts, shortly after the SGP was made less stringent,

the upturn of the business cycle allowed most governments to

reduce their deficits to below 3% seemingly vindicating the official

position that the ‘improved’ Stability Pact had led to a more res-

ponsible fiscal policy. But structural deficits (i.e. adjusted for the

cycle) actually improved very little even at time the boom reached

the peak in 2006-7 and, when the crisis hit, any remaining caution

was thrown overboard as deficits were allowed to increase again.

The euro area countries thus never lived up to the rules they gave

themselves. But even so, on average they remained relatively con-

servative in fiscal terms. In 2009, the average deficit peaked at 6.5%

of GDP, its highest level, whereas both the UK and the US went

above 11% during that year. Moreover, while the eurozone deficit

has brought back to 4% of GDP in 2011, it has remained at double

digits levels in both the UK and the US. In this limited sense, one

could argue that the Maastricht provisions against ‘excessive’ defi-

cits did have some influence after all, at least on average.

While the average deficits for the euro area appear today

‘modest’ by the standard of other large developed countries, one

euro area country, Greece, clearly violated all rules for years. But

mounting evidence that the Greek fiscal numbers did not add up

was never acted upon until it was too late. As long as financial mar-

kets provided financing at favorable rates any action was politically

inconvenient and was avoided.


207

When the euro debt crisis started in early 2010 following the

discovery that Greece was running a deficit of 15% of GDP (and

that previous deficits had been misreported), some policymakers,

German in particular, started to call for tighter fiscal rules as essen-

tial to the survival of the euro.Despite Greece was an extreme case,

the case of Italy is widely seen as providing another justification

for tighter fiscal rules. However, the country seems to stand for

complacency rather than fiscal profligacy. Over the last ten years

the deficits of Italy have on average been lower than those for

France and even today its deficit is below the euro area average

(and declining rapidly).Yet, the incapacity of the country to redu-

ce its very high debt-to-GDP ratio has made it vulnerable to a loss

of investor’s confidence.

3. A false solution to the crisis: the fiscal compact

The new Treaty that was agreed upon in March 2012 has a long

title, Treaty on Stability, Coordination and Governance in the Economic

and Monetary Union, but upon closer examination it is long on

good intentions and rather short on substance in terms of binding

provisions.

The core of the new ‘fiscal compact’ is an obligation to enshrine in

national constitutions the commitment not to allow cyclically adjus-

ted deficits to exceed about ½ of 1% of GDP, which is roughly equi-

valent to balancing the budget over the cycle as in the original SGP.


208

This should be done ‘preferable at the constitutional level’. The

European Court of Justice (of the EU) can be asked to pass a judg-

ment on these national rules, but the maximum fine that could be

assessed is capped at 0.1% of GDP – hardly a strong deterrent by

itself. This Treaty concerns only the framework for fiscal policy, i.e.

the rules setting up national ‘debt brakes’, not their implementa-

tion. This Treaty thus does not give any new powers to the Court

of Justice (neither to the Commission) to interfere with the actual

conduct of national fiscal policy. None of the provisions on eco-

nomic policy coordination are binding. Essentially they reiterate

the already often repeated statements of good intentions on struc-

tural reforms.

Among the provisions, the specification on governance institu-

tes regular meetings, at least twice a year, of the heads of state and

government of the euro area. However, since these meetings will

remain informal, in truth, there was no need for an international

treaty to establish them.

As far as the non-euro EU member states who signed the Treaty

are concerned, there is no obligation for them to do anything, but

the signature constitutes a political statement which gives them a

partial ‘seat at the table’ of the eurozone meetings, allowing them

to participate in most of the euro area summits.

From a purely legal point of view, this Treaty contains an inhe-

rent contradiction: it implies that its signatory countries agree on


209

binding constraints for their constitutional order via an ordinary

international treaty. In most countries the national constitution is

of a higher in legal hierarchy than international treaties. This

means that even the provisions on the ‘fiscal compact’ constitute

essentially a political statement, unless the treaty is ratified with a

constitutional majority, as will be done in Germany.

The main value of this political statement coming from all euro

area member states is of course that it provides political cover for

the German government in its efforts to sell the euro rescue ope-

rations to a sceptical domestic audience. However, it is doubtful

that the ‘fiscal compact’ was really needed for this purpose. Data

on German support of the euro show that public opinion remains

much more constructive on the euro than widely assumed (see

Gros and Roth, 2011). Moreover even before the fiscal compact

existed, all votes in the Bundestag have resulted in very large majo-

rities in favour of the euro area rescue operations, even when they

contained large fiscal risks for Germany.

In judging the value of this Treaty one should also keep in mind

that, of the four large euro area countries, three have already natio-

nal debt brakes at the constitutional level: in Germany it is already

operational, in Spain has been adopted recently and in Italy is in

course of adoption. In the fourth country, France, it is already clear

that the Treaty will be implemented, if at all given the negative

attitude of the current opposition, via a so-called ‘loi organique’ and

that the French constitution will not be changed.


210

All in all, the fiscal compact is probably useful in the long run

and may contribute to avert a future crisis. It forces Member States

to adopt stronger national fiscal frameworks at home. Some, per-

haps most, would have done so anyway under the pressure of the

markets, but it is unlikely that the new Treaty will make a signifi-

cant difference. The main danger is that that it has been oversold.

It is likely that the ratification process (e.g. the referendum in

Ireland) and then the implementation process in some difficult

countries (e.g. France) will receive a lot of attention and create a

distorted impression of the importance of the Fiscal Compact.

However, the initial excitement will be over once the national

fiscal rules have been put into place and this Treaty will quietly be

forgotten. Its only remaining impact will consist in the meetings of

the euro area heads of state which are likely to produce the regular

conclusions that ‘Member States commit’ to everything desirable

(structural reforms, etc.). Conclusions which become irrelevant

once the heads of state return to their capitals and their domestic

political realities.

The experience with the SGP suggests that how this new ‘fiscal

compact’ will be applied in future will depend on the degree of con-

sensus on the need to balance the budget over the cycle. If anything,

political will to follow this balanced budget rule will be even more

important for the new ‘fiscal compact’ since it will take the form of

an intergovernmental Treaty outside the legal framework of the EU.


211

Today the consensus that only balancing budgets can solve this

crisis and allow the euro to survive seems strong and the position

of the German government seems particularly tough. This is cer-

tainly desirable to prevent future public debt problems but it

neglects the crucial role financial market fragility has played in this

crisis. The case of Greece is emblematic in this sense: despite

Greece accounts for less than 3% of the euro area’s GDP, the pros-

pect of the Greek government becoming bankrupt caused Europe’s

financial markets to go into a tailspin. The reason behind it was

the fragility of banks due to their undercapitalization and their

large holdings of government debt.

In this perspective, while for a creditor country like Germany it

might be important that other member states are forced to copy its

balanced budget rules, it should be even more important to ensu-

re that financial regulation helps to provide additional incentives

for good fiscal policy and that financial markets become more

robust and able to withstand a sovereign insolvency. This is what

would reduce the need for future bail outs by the German govern-

ment. German savers have over the last decade of current account

surpluses accumulated about one trillion euro worth of claims on

other euro area countries. Safeguarding the value of these claims

(which amount to about 50% of GDP) and ensuring the future

German savings surpluses are invested with minimal risk should

thus be a key policy goal for German policy makers.


212

4. Fiscal indiscipline versus financial regulation inconsistency

The key insight that has been overlooked in the official circles

dominating EU policy making today is that today’s crisis is largely

due to an inconsistency in the original design of EMU, not in the

area of fiscal policy, but in the area of financial market regulation.

Even after the start of the EMU, financial regulation in general, and

banking regulation in particular, continued to be based on the

assumption that in the euro area all government debt is riskless.

This was from the start logically incompatible with the no-bail out

clause in the Maastricht Treaty, which implies that a euro area

member country can become insolvent, and the institution of an

independent central bank which cannot monetize government

debt. But it was adopted anyway, maybe because of the perception,

expressed recently in a spectacularly mis-timed paper from the IMF,

which proclaimed: “Default in Today's Advanced Economies:

Unnecessary, Undesirable, and Unlikely”.7

In the much more forgiving environment of the turn of the cen-

tury, it was quite natural for policy makers to ignore the logical

inconsistency between the no bail-out clause and maintaining the

assumption that government was really risk less. Yet this contra-

diction had two important consequences. First, banks did not (and

still do not) have to hold any capital against their sovereign expo-

7 Cottarelli, C., L. Forni, J. Gottschalk, and P. Mauro (2010) Staff Position Note No.

2010/12.


213

sure. Second, it was also deemed unnecessary to impose any con-

centration limit on the claims any bank can hold on any one sove-

reign. This lack of a concentration limit for sovereign debt is in

clear contrast to the general rule that banks must keep their expo-

sure to any single name below 25% of their capital. This exception

would make sense only if government debt is really totally riskless.

The main result of this special treatment reserved to govern-

ment debt securities on banks’ balance sheets has been that about

one third of all public debt of the eurozone is held by eurozone

financial institutions, which also tend to privilege the financing of

their own government. The fate of governments and banks is thus

tightly linked.

To the inconsistency of financial market regulation it must be

added that the ECB failed to apply differentiated haircuts to

government debt it accepted as collateral. Debt securities issued by

euro area governments ware accepted in indiscriminate fashion

provided that the country was rated at investment grade. This was

the case for all euro area member countries, of Greece as Germany.

When the Stability Pact was weakened by Germany and France in

2005, the ECB took member countries to court, but it did not

change its collateral policy. By doing so it would have given a con-

crete signal that it was worried about the long run sustainability of

fiscal policy and its consequences for the future of the single

currency. Alas, it did not do so, not even during the crisis, after it

was clear that it was changing its policy stance. Only now, the ECB


214

applies a sliding scale of graduated haircuts which makes it less

attractive for banks to hold lower rated government debt.

The idea that governments provide the only safe assets even in

a monetary union where a no bail-out clause exists was also the

main reason for another omission: a common euro area (or EU)

deposit insurance scheme was never seriously considered. At EU

level, deposit insurance is regulated by the 1994 Directive on depo-

sit guarantee schemes, but the minimum harmonization approach

adopted at that time has proven largely insufficient and the ulti-

mate back up for all national schemes remains the national govern-

ment. A common European deposit insurance modeled on the US

approach of a fund financed ex-ante by risk based contributions

from banks like the Federal Deposit Insurance Company – FDIC-

would have had obvious advantages in terms of risk diversification.

But the preference for national solutions (based on the fear that a

European equivalent to the FDIC would lead to large transfers

across countries) and the bureaucratic interests of the existing

national deposit guarantee schemes ensured that such ideas do not

get a hearing even today.

The experience with Greece should have served to rest the idea

that government debt in the euro area is riskless. But so far no cri-

sis summit has drawn the conclusion from this experience for ban-

king regulation. Of course, it is true that once the crisis has hit it is

no longer possible to tighten the rules on government debt becau-

se this is pro-cyclical as the mayhem which followed the only


215

attempt to shore up the banking system in the context of the

recent EBA stress tests on government debt has shown.

However in order to illustrate the importance of thinking about

the larger benefits from a different kind of banking regulation it is

still worthwhile speculating what would have been different if

banking regulation had been ‘Maastricht’ conform, i.e. if it had

recognized that belonging to the European Monetary Union

implies that national government debt is no longer riskless.

One could thus consider how the crisis would have played out

if the following rules had applied since 1999:

i) Forcing banks to have capital against their holdings of euro area

government debt.

ii) Applying the normal concentration limits also to government

exposure.

iii) A different collateral policy of the ECB, for example with a sli-

ding scale of increasing haircuts on government debt in func-

tion of the country’s deficit and debt and its position in the

excessive deficit procedure.

One can only speculate what would have been different if this

kind of regulation had been in place during the boom years. But a

few conclusions seem certain.


216

Greece would certainly have encountered much more difficul-

ties selling its bonds to banks which would have had to hold capi-

tal against it would be less able to use them to access ECB funds.

The same applies to Italy, whose rating went already in 2006 below

the threshold at which under normal banking rules higher capital

requirements kick in. Both these countries would thus have seen

gradually increasing market signals, which would have most pro-

bably led to a more prudent fiscal policy.

Moreover, their problems would today have been much easier

to deal with because banks would have more capital and the con-

centration limit would have prevented Greek banks to accumulate

Greek government debt worth several times their capital. The

resources necessary to prevent the collapse of the Greek banking

system has increased considerably (by about 40 to 50 billion euro)

the size of the financial support Greece needed so far.

The negative feedback loop between the drop in the value of

banks and in the yields on government bonds which destabilized the

entire European banking system so much during the summer and fall

of 2011 would also have been very much mitigated if the concentra-

tion limit had been observed. Italian banks would have accumulated

less Italian debt and would have been able to offset some of the mark

to market losses on the Italian debt with their gains on German debt

holdings which they would have had to hold as well.


217

Common euro area wide deposit insurance would have contri-

buted in several ways to deal with the financial crisis from the

beginning. First of all, in 2008 it would have obviated the percei-

ved need for the competitive rush to provide national guarantees

for bank deposits. The Irish government would thus probably not

have had felt the need to provide the blanket guarantee for all lia-

bilities of its local banks which proved fatal once the extent of the

losses was revealed.

Ireland would still have suffered from a massive real estate bust

with all the consequences in terms of unemployment, but the Irish

government would not have been bankrupted by its own banks.

Paul Krugman has drawn attention to the parallels in terms of eco-

nomic fundamentals between Nevada and Ireland8 arguing that

explicit fiscal transfers and higher labour mobility within the US

constitute the main differences. However, Ireland has actually

experienced a degree of labour mobility which is quite similar to

that among US states like Nevada. During the boom it had immi-

gration running at over 1% of its population, which after the bust

turned into emigration of a similar order of magnitude. The wides-

pread held opinion that the euro could never work because there is

not enough labour mobility in Europe is not entirely correct.

In the case of Ireland the key issue was not one of a lack of labor

mobility, but of the absence of a common safety net for banks. A

8 See http://krugman.blogs.nytimes.com/2010/12/29/ireland-nevada/.


218

European deposit insurance would have provided stability to the

deposit base. It is also likely that the European Deposit insurance

would have been less complacent and less beholden to the inte-

rests of Irish banks and would thus have started to increase its risk

premium when the signs of a local real estate bubble were clear to

almost everybody outside the country.

Greece, where the national deposit guarantee scheme is now

practically worthless because it is backed up only by the Greek

government, which has just defaulted on its debt, provides anot-

her example of the potential importance of stabilizing the banking

system. With a European deposit guarantee scheme there would

have been no deposit flight, which has amounted so far to about

50 billion, or over 25% of GDP. There would have thus been much

less need for the ECB to refinance the Greek banking system, lowe-

ring again the cost of the Greek bail out.

The next crisis will be different from the current crisis, but it is

clear that different rules for the banking system could bring two

advantages: they would provide graduated market based signals

against excessive deficits and debts. Moreover, a better capitalized

banking system with less concentrated risks would be much better

able to absorb a sovereign insolvency, thus reducing the need for

future bail outs. Acting on this front seems a much more promi-

sing route to reduce the likelihood for future crises and minimize

the cost should they occur anyway.


219

Perceptions matter. Europe’s policy makers seem to be driven by

the perception that this crisis was caused by excessively lax fiscal

policy in some countries. In reality, however, the public debt pro-

blems of some countries have become a systemic, area wide, finan-

cial crisis because of the fragility of the European banking system.

The ‘euro’ crisis is likely to fester until this fundamental problem

has been tackled decisively.

5. A proposal for a new regulatory treatment of sovereigndebt securities in the euro area

The purpose of this section is to sketch a simple proposal for a

new regulatory treatment of sovereign debt securities in the euro

area which follows the arguments illustrated in the previous sec-

tions.

1. Any risk weights to be introduced after the crisis might better be

based on ‘objective’ criteria, rather than ratings.

2. Diversification of banks’ exposure; this is even more important

than risk weighting for sovereign exposure.

A simple way to attach a risk weight on government debt secu-

rities of a given country would be to make the weight function of

objective factors like the debt and deficit of the country. For exam-

ple, one could imagine that the risk weight could remain at zero if

both government debt and fiscal deficit relative to GDP remain

below 60% and 3% respectively. If the deficit and/or the debt ratio


220

exceed the ‘reference’ values of the Treaty, the risk weight would

increase by certain percentage points in a proportional or progres-

sive fashion. In addition the risk weights should be linked to the

stages of the excessive deficit procedure (EDP). When the procedu-

re is launched, the risk weight is increased and at each additional

stage of the EDP the risk weighting would be increased further. This

would provide the EDP with real incentives even without the need

to impose fines.

Introducing positive risk weights for government debt will not

be enough to prevent crisis because of the ‘lumpiness’ of sovereign

risk. Experience has shown that sovereign defaults are rare events;

but the losses are typically very large (above 50%) when default

does materialize. Even with a risk weight of 100% banks would

have capital only to cover losses of 8%. Risk weights would thus

have to become extremely high before they could protect banks

against realistic loss given default scenarios. This suggests that the

more important aspect is diversification.

All regulated investors, i.e. banks, insurance companies, invest-

ment funds, pension funds, have rules which limit their exposure

vis-à-vis a given counterpart to a fraction of their total investment

or capital (for banks). However, this limit does not apply to sove-

reign debt, especially within the eurozone for banks. The result of

this lack of exposure limits has been that, in the periphery, banks

have too much debt of their own government on their balance

sheet which has led to the deadly feedback loop between sovereign


221

and banks. In Northern Europe, investors, such as investment

funds and life insurance companies, which typically cannot avoid

government debt have also concentrated their holdings nationally.

This has led to a significant fall and in some cases even to negati-

ve value of government bond yields, not only in Germany but

throughout Northern Europe. From the point of view of core

Europe investors, today this might appear as being a prudent stra-

tegy, but this concentration increases the vulnerability of the sys-

tem to any reversal of fortunes. Moreover, if Northern investors

were required to diversify their holdings there would be a natural

demand for Southern European bonds, which would bring some

oxygen to those governments which have experienced a dramatic

surge in their borrowing cost.

Introducing exposure limits during a crisis period would be

much less pro-cyclical than introducing capital requirements. In

practical terms, the simplest approach would be to grandfather the

existing stocks, but apply exposure limits to new investments.

6. Conclusions

This paper has emphasized that while the political agenda has

been obsessively focusing on fiscal issues since the early onset of

the euro zone crisis; this crisis has neither a mere fiscal nature nor

an exclusively fiscal solution. Despite the Greek episode seemed to

point only to fiscal indiscipline, the reasons why the crisis did not


222

confined itself to Greece but spread out to the entire euro area assu-

ming a systemic nature should be sought in the state of the euro

area banking sector. European banks were, and still are, largely

undercapitalized and too tightly linked to the fortune and the mis-

fortune of governments.

The paper spots three contradictory building blocks of the EMU

construction: the no bail-out rule in the Stability and Growth Pact,

the independence of the European central bank and the provision

in the financial market regulation framework that government

bonds are considered as risk free assets. The combination of the no-

bail clause with the institution of an independent central bank

implies that fiscally undisciplined countries may have to face

default as no other country, nor the EU can take on its debt and the

central bank cannot monetize it. This definitely collides with the

principle that banks are not required to hold any capital against

government debt securities as it assumed that they do not carry

any default risk. In fact, Greece has proved this assumption wrong.

This contradiction was completely overlooked during the good

years in the turn of the new century and the politically more con-

venient approach suggested by financial regulation became the

dominant. The ‘risk free treatment’ of public debt securities has clearly

worked as incentive for banks to finance profitable government

spending and accumulate large amounts of government bonds.


223

This is at the root of the common fate of euro area banks and

governments. Alas, the crisis has made that fate an evil one.

Though these contradictory elements have now emerged clearly,

the issue has not been addressed and the regulator treatment of the

government bonds has not changed yet.

On this ground, the paper puts forward some concrete ideas

about how to break the tight linkage between governments and

banks, which represents a decisive obstacle to overcome of the

euro zone crisis.

We argue that positive risk weights for government debt securi-

ties must be introduced in the banks’ balance sheet, but alone this

measure will not be enough to prevent a new crisis. A clear pres-

cription to reduce concentration of the risk and impose diversifi-

cation is at least equally important and complementary to the risk

weighting.

While developing the arguments for the regulatory changes, the

paper expresses skepticism about the official, widespread view that

the just signed fiscal compact will have a crucial role in overco-

ming the eurozone crisis. As far as the banking sector remains weak

and highly exposed to governments, and the common fate of

government and banks is not broken, the crisis will be hard to die.


224

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Governance in the Economic and Monetary Union (aka Fiscal

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Publication: Oxford.

The fiscal institution in the Economicand Monetary Union:

the contribution of Spain

* Public Sector economist, on leave, and Founding Partner, President and CEO of Equipo

Económico, S.L. He has held office as Deputy Finance Minister Working inside the team

of the Deputy Prime Minister, Rodrigo Rato, and Finance Minister, Cristóbal Montoro.

Graduate cum laude in Business Administration at the University of Zaragoza, he stu-

dies in the Deutsche Schule of Bilbao and Valencia. He has attended postgraduate cour-

ses at the London School of Economics, Kennedy School at Harvard University and

Wharton Business School.

1. Introduction

The current financial crisis in the European Union (EU) has

highlighted the importance of establishing a common framework

/RICARDO MARTÍNEZ RICO*/

227

1. Introduction; 2. Evolution of the fiscal policies in Europe and Spain;3. Analysis of the relationship between fiscal rigour, macroeconomic sta-bility and growth; 4. Next steps in the Fiscal Institution of the Economicand Monetary Union: the necessary contribution of Spain; 5. Conclusion

The fiscal institution in the Economic and Monetary Union:the contribution of Spain

which enables the economic agents to act in a macroeconomic sce-

nario of stability and confidence in the coming years.

In this crisis situation, once again the discussion has sparked

the debate in Europe of whether the necessary fiscal stability,

which will demand the rationalisation of public spending in the

member states, will be achieved at the expense of prolonging the

crisis and limiting economic growth possibilities. However, there

should be no dilemma between sustainability of public accounts

and medium term economic growth. The crisis of the European

sovereign debt is a consequence of overspending and debt which

the markets are not prepared to fund. In this regard, the only

recourse is a fiscal policy designed to mitigate the harsh effects of

the crisis and boost economic growth within the framework of

macroeconomic stability, continuous supervision over the sustai-

nability of public sector accounts and economic reforms.

Spain must cease to be a burden for Europe and once again

become a driver of growth. Compliance with a route of plausible

cuts in public spending in all Public Administrations is a necessary

condition to do so, though not the only. As previously shown, in

the case of the Spanish economy, stability and reforms make up the

formula required to revitalize investment, consumption and job

creation. Thus, economic reforms and budgetary discipline are

equally important.

228


The Spanish case is a clear example of a solid and plausible bud-

getary institution, where the principle of subsidiarity enables each

government with sound finances to tackle its internal decisions in

accordance with its economic and social reality (not only because

of its significance from a regulatory perspective but also because of

the parallels between the European scenario relative to the coun-

tries and the Spanish scenario relative to the Autonomous

Communities). At the same time, those who are forced to ask for

help must abide by the ensuing conditionality.

In Europe, likewise, the need for greater economic and mone-

tary integration must take us along the path of clear fiscal rules. But

it must also do so to encouraging income transmission mechanisms

between countries and regions, availability of financial resources

and support by way of providing the necessary liquidity to face

emergency situations and the pooling of risks, always in exchange

for strong sets of conditions to prevent moral hazard. Moreover,

within the monetary and economic union the imbalances must be

addressed, not only of highly indebted countries, but also those

with surplus balances. In some way, it must be recovered an incen-

tive system to ensure political commitment and compliance with

goals set. Nowadays, the fiscal institution1 is a basic component of

European and Spanish economic policy.

229

1 González Páramo defines it as "the rules which govern the preparation of the budgets, their

debate and approval in parliament, execution and subsequent control”. "Costs and benefits of fis-

cal discipline: the Law of Fiscal Stability in perspective” (Costes y beneficios de la disciplina fis-

cal: la Ley de Estabilidad presupuestaria en perspectiva), J.M. González-Páramo, 2001.


Throughout this work we shall examine, in first place, how the

sustainability of the public finances requires a solid fiscal institu-

tion and a firm political commitment by the different European

governments. Only on the basis of the conviction of the benefits of

this statement can one contribute towards the construction of a

stronger Europe.

Then we shall go on to examine the close relationship between

fiscal rigour, macroeconomic stability and growth, arriving at the

conclusion that the establishment of simple, transparent, automati-

cally applied rules with preventive control mechanisms for all

Public Administrations is essential for this ‘positive’ interrelation.

All these components are basic for the design of a fiscal policy

which helps to recover the credibility that Europe needs in its path

towards greater integration to face the sovereign debt crisis.

In the last chapter we shall examine the measures taken in Europe

and in Spain since the start of the sovereign debt crisis, and we shall

reflect on the following steps to be taken in support of the budgetary

institution. Then close with the appropriate conclusions.

2. Evolution of fiscal policy in Europe and Spain

The European political integration project came about in the

post World War years, as an extension of the economic integration

process. This was envisaged by one of the founding fathers of the

230


current Union, Jean Monnet. In 1950, he proposed the creation of

a space of peace and prosperity for Europe, via the formation of the

European Coal and Steel Community, which became a reality a

year later. His way of conceiving the European construction as a

project made up of very specific steps – beginning with the eco-

nomy – is the way to understand many of the milestones that

Europe has achieved in the last sixty years. Examples of this have

been the creation of the European Economic Communities, the

launch of the European Monetary System, the creation of the sin-

gle European market and the firm commitment that has led to the

Economic and Monetary Union (EMU).

During the first decades of the European unification project,

Spain was but a mere observer, although fully embraced the inte-

gration process along the same lines and endorsed the way of tra-

velling the path towards a united Europe. Thus, in the mid-1980s,

Spain understood that the current EU offered a chance to take a

decisive step in its integration into an international market which

would bring gains in efficiency, reinforce macroeconomic stability

and contribute to the increase of wealth and per capita income.

That would lead to the development and modernisation of the

country. And, indeed, this was the case in the first years, where eco-

nomic growth rate of Spain was positive over that of the EU, by a

maximum of 3pp in 1987 (see Chart 1). However, as of this time,

macroeconomic instability driven by an expansive fiscal policy,

became a burden for economic growth and job creation, and gene-

rated a fast and continuous rise in public debt. The importance of

231

having a solid fiscal institution in the economic development of

the Spanish economy became patently clear.

After the repeated failures of the European Monetary System star-

ted up in 1979, and the progress of the approval of the Single

European Act (1986) in favour of an internal market, the EU mem-

ber states took an additional step in Maastricht. EU member states

support, via the adoption of the Treaty on the European Union

(TEU) (1992), the creation of an Economic and Monetary Union,

whose third phase would entail the launch of the single currency,

the Euro. Title VIII of the Maastricht Treaty set three main axes

around which the design of the EMU should be built around: sin-


232

Chart 1Year-on-year growth in real GDP in Spain and in the European Union

Source: Prepared by Equipo Económico with data from the International MonetaryFund

gle monetary policy, fiscal policies subject to common rules and

coordination mechanisms for the remaining economic policies. A

clear view of establishing nominal convergence mechanisms based

on the fiscal institution was already existent at that stage, founded

on the following common rules: absolute ban on monetary funding

of public deficits, no liability held by the EU or by any other State

in regard to debts acquired by another member state, and the set-

ting of limits on deficit (3%) and public debt (60%). As of 1997, the

Stability and Growth Pact (SGP) introduce stricter rules with a defi-

cit target of balance or surplus, supported by an early alert system

and a disciplinary penalty structure designed to correct deviations.

For Spain the commitment to meet the convergence criteria esta-

blished in the TEU for eligibility for the third phase of the EMU

demanded a radical change to be made in our fiscal policy. Europe

then began to act as an anchor in Spanish budgetary policy.

However, even when the worst of the recession was over for Spain,

governments continued to face enormous difficulties in balancing

the budget in the pursuit of macroeconomic stability.

It would not be until the political change of 1996, and with the

reference and encouragement arising from the creation of the sin-

gle currency, when the necessary fiscal consolidation was finally

tackled, that macroeconomic stability was achieved and the bases

for a new economic growth phase were put in place. The starting

point was poor, in 1995 with a deficit around 7% of the GDP and a

growing public indebtedness which reached 67% in 1996.


233

Although the level of indebtedness was lower than the average for

the EU, in the case of Spain the combination of the primary defi-

cit, the high cost of financing of the debt and the recession had

rendered unsustainable the growing public debt. As of that time

there was a change in fiscal policy, which took on a markedly coun-

ter-cyclical approach. As shown in chart 2, an ambitious fiscal con-

solidation programme was implemented which allowed the annual

budgets to close with primary surpluses from 1996 until the end of

the period and to slow down the growth trend in public debt

which, after peaking in 1996, dropped by more than 20pp of GDP

until 2004.


234

Chart 2Evolution of income and expenditure of Public Administrations and of their budgetbalances

Source: Prepared by Equipo Económico with data from the Ministry of Finance andPublic Administrations

During the period, the fiscal consolidation drive contributed

towards a strong growth in GDP (average rate of 3.6 between 1996

and 2004), which helped reducing debt stock via the positive spre-

ad between the economic growth rates and interest rates. The suc-

cess in the change of direction in fiscal policy was due to a firm

political commitment, a well-designed fiscal consolidation pro-

gramme and a substantial reform of the fiscal institution.2

For countries that, like Spain, managed to take part in its foun-

dation and for others which joined subsequently – such as the case

of Greece which, with the support of Germany and despite not

meeting at the time the requirements established by the Maastricht

Treaty, became part of the Eurozone two years later – the incorpo-

ration to the euro meant the relinquishment of monetary policy in

favour of the European Central Bank (ECB). And this total integra-

tion in the establishment of monetary policy has fostered greater

price stability during these years. On the other hand, this relin-

quishment made budgetary policy, along with economic liberalisa-

tion policies, into the main economic policy instruments in each of

the Eurozone member countries.

We must highlight that, once the objective of forming part of

the euro was met in full, Spain took an additional step beyond what

was required in Maastricht. And, in line with the principles agreed


235

2 “The Spanish fiscal institution: from the Stability Pact to the rules of fiscal stability” (La

institución presupuestaria española: del Pacto de Estabilidad a las reglas de estabilidad

pre¬supuestaria), R. Martínez Rico (2005).

in the SGP, it rounded off the fiscal consolidation effort with a deep

reform of the fiscal institution. As a result thereof, the approval of

the fiscal stability laws (the General Law on Fiscal Stability and the

Organic Law additional thereto) brought about a change in the

budgeting process. This mainly consisted of: the definition of a fis-

cal stability target (fiscal balance) in the medium term for all Public

Administrations; for the State, a non-financial expenditure limit,

the so-called expenditure ceiling, was applied following parliamen-

tary approval during the first half of the year; as a novelty, the

Contingency Fund was added into the State budget, as a flexibility

component during the life of the budget which removes the need

for making fiscal adjustments, equal to 2% of the non-financial

expenditure ceiling approved by Parliament. The approval of the

Fiscal Stability Laws was further completed with a new General

Fiscal Law and a new General Subsidies Law. Specifically, the

General Fiscal Law aimed at achieving greater rationalisation of the

fiscal process, whereas the General Subsidies Law, on its part, aimed

at transferring the governing principles of Fiscal Stability Laws (effi-

ciency, transparency and multi-annual framework) to the expendi-

ture on subsidies (which would mean 20% of expenditure budget).

However, in 2005, the European process of integration and

reform came to a halt. The solution provided to the reiterated vio-

lations of the 3% limit on public deficit established at Maastricht –

and following the pressure exerted by Germany and France in this

regard, backed by the European Commission – was none other

than the SGP, introducing greater discretionary power and taking a


236

step back in the capacity of the fiscal institution to contribute to

growth.

Along the same lines, with a comfortable fiscal position and

with the same philosophy as that of the reform of the SGP, Spain in

2006 approved a reform to render the fiscal and Territorial

Administration funding processes more flexible, which is the sour-

ce of our current fiscal crisis. The relaxation of fiscal stability led to

a loss of transparency in its application as a result of the flexible

new rules.

With the outbreak of the international financial crisis as of 2008,

the primary surplus of the first years of the period quickly ran out.

Discretionary expenditure decisions, the impact of automatic sta-

bilisers and the major errors in revenue estimates led to a deficit

balance, which worsened over two years (from 2007 to 2009) by

13pp of GDP. This deterioration, which had also taken place in the

rest of EU members, was more notable in Spain due to its speed and

magnitude (see Chart 3), with few comparable examples within the

scope of the OECD (except for the cases of Iceland or Ireland). The

deficit fiscal position generated a fast increase in public debt, lea-

ding to doubts about sustainability thereof, and translating into

significant rises in the risk premium of the country.

At the start of 2010, given the lack of confidence displayed by

international markets, and in light of the fast deterioration of

public finances, the previous Government was forced to implement


237

a radical change in its fiscal policy and announce a fiscal consoli-

dation programme.

The sovereign debt crisis, which especially affects several of the

“peripheral” member states of the Eurozone (but which has also

affect countries such as France and Austria), has highlighted the

need to reinforce the budgetary coordination mechanisms within

the EMU. In the face of the problems arising from the sovereign


238

Chart 3Budget balance in 2006 and change in budget balance in 2007-2009

Source: Prepared by Equipo Económico with OECD data

debt crisis and as a result of the fluctuations in the risk premiums

of the Eurozone member states, a double reinforcement movement

of the budgetary crisis has taken place from Brussels since the onset

of the crisis. On the one hand, that implemented by the European

Commission, the result of which is, for instance, the legislative pac-

kage comprising five regulations and one directive designed to rein-

force the preventive part and the disciplinary part of EC mecha-

nisms. On the other, that of the member states which, via the

European Council, have brought about agreements such as the

Fiscal Pact, which seeks to guarantee that all countries will commit

to fiscal stability under the highest level of regulation. The reform

enacted last year of the Spanish Constitution must be understood

within the framework of this new drive from Europe in support of

the fiscal institution. The reform, as we shall discuss further in this

paper, guarantees the principle of fiscal stability via the highest ran-

king law.

Despite efforts invested, and despite the positive effect of the

liquidity injections made by the ECB, the current economic scena-

rio in Europe continues to be marked by the risk premiums of EU

peripheral countries, which continue to be too high. The questions

as to the capacity of such countries to meet their debt commit-

ments have burdened economic European Union results over the

last two years. This has led the Commission to forecast a drop in

GDP for all of the EU of -0.5% for this year, which sets it back in

terms of the growth of the world economy. Although it must be

said, that all countries are not behaving in the same way. Germany,


239

for instance, closed last year with 3% growth, expecting to do so

this year at 0.6%, whereas Italy will experience a drop of around -

1.3% of GDP. From a growth perspective, there is an important dif-

ference between northern and southern European countries arising

from the financial crisis. However, it is worth remembering the

strong interdependence between all member states, including

Germany (second country in the world in terms of export volume,

of which 60% are directed to the EU).

On its part, the Spanish economy is clearly included in the “slo-

wer” group, at an extremely difficult time. In recent months, the

return to recession, which accumulates after four years of crisis, the

adverse effect on employment and on businesses, has led to a 24%

unemployment rate. At the same time, there is high external debt,

exceeding 160% of the GDP, with a high accumulation of public and

private debt maturities this year. All these factors have led to a risk

premium of around 340 basis points in the last few months and, more

recently, well above 450 basis points, and to be closely watched by the

markets, that is to say, our creditors. Given this scenario, in 2012, the

Spanish economy faces challenges associated with its macroeconomic

imbalances yet to be corrected, as well as the potential problems ari-

sing from a new challenge from international financial markets. In

this framework, we expect a drop in GDP during the first quarters,

and although its performance will improve towards the end of the

year, it will result in an overall drop in GDP of around -1.5% this year.

Meanwhile, the reality experienced by the rest of the world is diffe-

rent, with a world economy growth rate of around 3.5% of GDP.


240

Undoubtedly, the unemployment rate is our main negative dif-

ferentiating factor compared to all other EU members and the main

concern for Spanish society. As a result of the economic crisis, no

country in the OECD has experienced a downturn in the jobless

rate as negative as ours. Our rate of unemployment has gone from

8.3% of active population in 2007 to almost 24% at the end of

2011. The crisis has highlighted the problem with our employment

model, as our economy is adjusted by means of redundancies ins-

tead of by adding greater flexibility to employment conditions.

Despite the gradual correction of the external imbalance (the

current account deficit has been reduced from 10% of GDP recor-

ded for 2007 to less than 4% in 2011), Spain continues to be signi-

ficantly reliant on foreign funding (around 40,000M€ per annum).

The need for funds shown by the current account deficit, cannot in

fact be met by attracting foreign investment to our country.

Indeed, the opposite is the case, with recent years witnessing a

divestment process, particularly of portfolio assets. The forecast

drop in the GDP combined with the high level of debt, puts the

sustainability of our funding at risk. Given such conditions, the cri-

sis is requiring a must faster deleveraging process than that initially

expected.

Since the common denominator of the European sovereign debt

crisis is insufficient GDP growth, only by articulating the reforms

in Europe and in Spain in an expedient and firm manner can the

current increasing loss of confidence by financial markets be sta-


241

lled. In the case of the Spanish economy, this is a path which we

travelled successfully in the second half of the nineties, when

Spain took part in the foundation of the euro and then went on to

lead the fiscal consolidation process in Europe. The new govern-

ment seems to have understood this, having begun reforms in

three main areas: sustainability of the public finances and moder-

nisation of the public sector, the restructuring and reorganization

of the financial sector and the reform of the labour market. In the

coming years, political commitment to fiscal rigour, macroecono-

mic stability and growth must go hand in hand in Spain and

Europe, and happen in parallel.

3. Analysis of the relationship between fiscal rigour, macroe-conomic stability and growth

In the context described in the previous section, fiscal consolida-

tion within the EMU is a fundamental tool for recovering macroeco-

nomic stability, the confidence of economic players and the path to

growth, leading in turn to job creation.

Moreover, the balance in public finances provides the econo-

mies participating in the monetary union, which therefore cannot

resort to instruments such as currency rates, with greater leeway to

deal with external shocks, enabling the implementation of anti-

cyclical policies and of automatic stabilisers.


242

At the same time, as has been amply studied in the literature,3

fiscal balance fosters a macroeconomic stability scenario which pro-

vides a more efficient framework for the development of economic

activity. The reduction in the deficit increases the confidence of

savers and investors. This translates into a stimulus for investment

and job creation, as well as allowing households and businesses to

plan the purchase of durable goods in the long term, thus leading to

sustained consumption, which is a key factor of economic growth.

One of the most relevant aspects is the stronger credibility of the

economic policy and the improvement in the funding terms of the

economies in the international markets, thanks to the reduction of

the risk premium, which in turn leads to a drop in financial costs,

as shown in Chart 4 in the case of Spain as of 1996. The subjection

of European monetary and fiscal policies to certain rules, and the

assumption thereof by Spain as a participant in the foundation of

the Euro, helped to provide additional credibility to the govern-

ment’s fiscal consolidation strategy. This strategy was strengthened

by the regulatory reforms introduced by said government as we dis-

cussed in the previous section. This positive impact4 on the expec-

tations and on the confidence of economic agents explains the

sharp drop in long term interest rates, compared to the 10 year

German bond. The spread in the Spanish risk premium was actually

zeroed as of 2003.


243

3 “Fiscal policy and long-run growth”, V. Tanzi and H. Zee, 1997.

4 “The Spanish economic model 1996-2004” (El modelo económico español 1996-2004), L.

Bernaldo de Quirós and R. Martínez Rico, 2005.

However, since 2008, with the arrival of the international finan-

cial crisis, the macroeconomic imbalances accumulated by the

Spanish economy led to the opposite effect. Furthermore, as a

result of the degradation of Spanish public finances between 2003

and 2009, as shown in the aforementioned graph 3, and the doubts

in regard to the sustainability of the Spanish public debt, the risk

premium increased once again in a significant way as of 2010, now

reaching the 450 base point mark.

The significance of fiscal consolidation as a tool for the recovery

of stability and long term growth has also been proven in practice

in many successful fiscal adjustment processes implemented in the

last decades in certain European countries, such as Spain (1996-

2004), Ireland (1982-1989) or Sweden and Finland (1993-2000),

some of which have been studied in depth in the literature.5

The most successful process was the one implemented in

Finland between 1993 and 2000, which managed to reduce pri-

mary expenditure by 14pp of GDP. This was mainly based on per-

sonnel cost containment, reduction in transfers from the Central

Administration to Local Corporations and the pursuit of efficiency

in social expenditure, particularly in health services, education and

pensions. Moreover, the fiscal institution underwent a reform with

the introduction of expenditure ceilings, which proved to be a key


244

5 "Fiscal expansions and adjustments in OECD countries", A. Alesina y R. Perotti, 1995. “An

Empirical Analysis of Fiscal Adjustments", C. McDermott & R. Wescott, 1996.

tool for cost containment. At the same time, the pension system,

the labour market and the financial system underwent a structural

reform. The only expenditure programme that was deliberately

maintained, thus keeping its 1% share of the GDP, was that of

Research and Development.

The Swedish experience between 1993 and 2000 obtained similar

results in terms of a reduction in primary expenditure (14% GDP),

which led to the attainment of fiscal balance in 1997, having closed

financial year 1993 with a deficit of 12.9%. In contrast with Finland,


245

Chart 4Evolution of risk premium

Source: Financial Times

in Sweden the fiscal consolidation took place due to both the cut in

expenditure and the increase in revenue through a tax rise, while

also implementing simultaneous structural reforms such as the pri-

vatisation of public corporations and the liberalisation of the labour

market. Public spending was reduced by 16pp of GDP over a seven

year period, mainly through a reduction of the expenses in transfers

and benefits (including unemployment benefits) and a reduction in

personnel and current costs of all public administrations. The intro-

duction of three-year expenditure ceilings and annual productivity

targets must be added to such measures.

The starting point of all the above was the strict cut in primary

expenditure, as the basis for the adjustment process, mainly cen-

tred on personnel costs, transfers and health services.

Undoubtedly, a key factor in all such measures is that they were

done hand in hand with important structural reforms, particularly

those implemented in the labour market, the fiscal system and the

privatisations. Those allowed the adjustment process consolidation

and the increase in potential growth, on the basis of a firm politi-

cal commitment. Furthermore, it helped proved that fiscal consoli-

dation strategies based on spending cuts are more enduring and

promote a better economic performance than those based on reve-

nue increase.

Experience has likewise proven that fiscal consolidation cannot

be maintained in the medium term without a proper fiscal institu-

tion articulation. As shown in the previous section, from the start,


246


247

the construction of Europe has been evolving towards a greater

relinquishment of national policies in favour of European ones. It

is a slow and complicated process in which political divergences

often prevail over the overall view of what this process means. This

relinquishment has meant the need for greater autonomy in the

establishment of rules and objectives, as has been the case, for ins-

tance, with monetary policy. Aside from the current supervision

problems, it is clear that the role of the ECB in regard to price con-

trol has been a success. This example should be transferred to the

fiscal policy as a source of inspiration to maintain the necessary

political commitment and thus achieve effective fiscal coordina-

tion in the Eurozone.

We live in an open economy, where freedom of movement of

persons, goods, capital, information and technology are necessary

conditions for improvement of competitiveness and economic

development. A globalised market, with a high level of competi-

tion, but also great opportunities, requires a disciplined, foreseea-

ble and transparent behaviour by the countries, designed to gene-

rate confidence among economic agents. The EMU was born out of

this perspective although there have been mechanisms, or even

relevant design components, which have failed.

In general, The European construction has been preceded by the

establishment of rules seeking to limit the risks of integration. The

problem has arisen from the lack of rigour in compliance with such

rules, probably as result of the insufficient clarity of the rules and

of political leadership committed to integration. When this hap-

pens, it is easier to interpret the situation in one’s own favour, par-

ticularly when high political power is held. Therefore, it is impor-

tant to have clear and simple rules, in order to reduce the possibili-

ties of interpretation and to help control subsequent compliance.

At the same time, the establishment of preventing rules to ena-

ble the anticipation of sharp increases in public deficit, should be

articulated via a greater participation by the EU in the preparation

of national budgets, in line with the latest legislative proposals of

the European Commission on the matter. Preliminary control is a

guarantee of compliance and greater co-responsibility with Brussels,

which should in turn lead to better access to European funding.

According to economic literature,6 those countries exerting con-

siderable effort to achieve fiscal consolidation amid a context of

economic uncertainty, should design and announce the establish-

ment of a fiscal rule within a reasonable period of time designed to

improve credibility. In the case of Spain, this step has been taken by

way of the reform of section 135 of the Constitution, a historical

event of special political relevance.

In our case, constitutional reform has managed to raise to the

level of fundamental Law – a relevant issue in our highly decentra-

lised State – the commitment of all the Administrations to fiscal


248

6 “Fiscal Rules – anchoring expectations for sustainable public finances”, FMI, 2009.


249

sustainability. The approval of this reform has meant the recogni-

tion of the benefits of fiscal discipline, having assumed the flaws in

the relaxation of the Stability Laws in 2006 as well as the need to

provide a new common legal framework for all of the public sector.

Except for force majeure cases (natural disasters or emergency

situations), compliance with the limits on public debt and fiscal

balance set by the EU are guaranteed. Likewise, priority is given to

servicing the debt in the budget, a condition which helps build the

necessary confidence in lenders, and is an appropriate antidote for

preventing the loss of confidence in Eurozone countries.

The reform also established the need for articulation in a new

organic Law, designed, on the one hand, to regulate the distribu-

tion of deficit and debt limits between the various

Administrations, the exceptional cases of surpluses therein, and

the means and terms for correction of any deviations in one or the

other that might take place. On the other hand, it had to establish

the methodology and procedure for calculation of structural defi-

cit. It is important that the calculation methodology respects the

procedure used in the EU, to provide discipline and transparency

to the fiscal process and help in the statement of accounts. The cal-

culation rule must be clear, and serve to consolidate fiscal discipli-

ne, as a permanent long term commitment. Lastly, it must esta-

blish the responsibility of the Administrations in the event of fai-

lure to achieve fiscal stability targets. In this regard, the credibility

of the reform will depend on the existence of efficient systems

which encourage the Administrations to meet the fiscal targets. As

we shall mention in the next section, such principles have been

included in the Law on Fiscal Stability and Financial Sustainability

of Public Administrations.

4. Next steps in the Fiscal Institution of the Economic andMonetary Union: the necessary contribution of Spain

The European debate on sustainability of public finances and

the future of the Euro is set at a time in which, following the con-

version of the international crisis into the crisis of the sovereign

debt of several Eurozone countries, we have witnessed myriad

European summits, each of which seeming to be the last chance to

tackle the doubts of the markets in relation to the viability of the

debt, in the first place, of Greece, Portugal and Ireland, and more

recently, of Italy and Spain.

It is true that the crisis is far from being resolved. The EU has not

always shown a capacity to react with the speed required by econo-

mic relations nowadays – until the tensions reached non peripheral

economies such as Austria or France, the pace in reaching consen-

sus had been much slower than necessary. Moreover, during the cri-

sis, it has become obvious that the institutional design of the

Monetary Union was incomplete and, above all, as we have men-

tioned in this paper, that there has been insufficient political com-

mitment to the application of the existing mechanisms of fiscal

coordination. But it is also true that in the last four years, a consi-


250

derable path has been travelled towards European construction,

towards an improvement in economic governance, so that in addi-

tion to a single monetary policy, Europe is also able to benefit from

greater integration of fiscal policies.

As such, it is worth highlighting the agreements reached, either

via the community procedure or via inter-governmental agree-

ments, in terms of strengthening coordination, supervision and

policing mechanisms of fiscal and macroeconomic policies.

In the first place, the European Semester establishes a new sche-

dule whereby, on the basis of the macroeconomic situation of each

member state and its growth forecast, the budgets and economic

policies required to meet the commitments undertaken in the Euro

Plus Pact and the 2020 Growth Strategy are discussed during the

first six months of the year in a coordinated fashion and in accor-

dance with common rules.

In the second place, the adoption of the so-called Six-pack (one

directive and five regulations) constitutes the greatest reform of the

SGP and of economic Governance since the Maastricht Treaty

which created the EMU. As of the adoption of the new legislation,

the European Commission may establish automatic penalties (of

up 0.2% of GDP) for those countries with excessive deficits which

do not follow the recommendations for correction. At the same

time, the public debt control mechanism and the required reduc-

tion are reinforced in the event of exceeding the 60% GDP level


251

assumed. It also introduces a mechanism designed to prevent

excessive imbalances such as unsustainable current account defi-

cits, loss of competitiveness and other macroeconomic imbalances.

Lastly, the signature of the new Treaty on Stability,

Coordination and Growth (by all member states of the EU except

for the United Kingdom and the Czech Republic) brings changes at

the highest legislative level to fiscal stability regulation. This must

be translated in each country in that the structural deficit of the

public sector may not exceed 0.5 GDP per annum, subject to auto-

matic penalties.

These steps will be followed in the months to come by impro-

vements seeking to fine-tune the mechanisms of economic con-

vergence, via two legislative proposals7 of the European

Commission, by establishing a clearer and more demanding sche-

dule for fiscal coordination in Europe and implementing fiscal

control and monitoring mechanisms in countries facing serious

difficulties in regard to their financial stability within the

Eurozone.

All these measures help towards the consolidation of economic

governance, and establish the bases to enable progress to be made


252

7 "Proposal for a regulation of the European Parliament and of the Council on common

provi¬sions for monitoring and assessing draft budgetary plans and ensuring the correction of

exces¬sive deficit of the Member States in the euro area" and "Proposal for a regulation of the

European Parliament and of the Council on the strengthening of economic and budgetary sur-

via other instruments, in order to provide funding and liquidity to

handle emergency situations, to the extent of including euro-

bonds, if necessary, as well as helping the ECB to have greater lee-

way when acting in the markets in pursuit of economic stability.

Without doubt, greater fiscal coordination broadens the funding

margin of these countries. But we must be clear that access to fun-

ding requires preliminary fiscal control, and not the reverse.

Conditionality in all these mechanisms is an essential requirement

when seeking to limit risk. Any funding requires certain minimum

guarantees of repayment of the loan, and this translates into

adjustments and reforms. This is nothing new, but something that

has cropped up on many occasions in IMF interventions.

Eurobonds might get to play a key role, but cannot be the only

item to support the fiscal union, which will drive the Eurozone

towards optimum monetary union, and for which to date there is

no more than a highly experimental road map.

Within this working programme so badly needed in Europe, and

supported by conditionality, greater mechanisms for EU income

transmission should be created to help countries facing serious pro-

blems – such as that of the sovereign debt crisis – in order to imple-

ment the structural reforms required by their economies, with the

support of Europe in driving growth. This can be done via the

encouragement of youth employment and entrepreneur program-


253

veillance of Member States experiencing or threatened with serious difficulties with respect to

their finan¬cial stability in the euro area", European Commission, November 2011

mes, the reinforcement of resources available, among other uses,

for structural funds or for the activity of the European Investment

Bank.

On their part, the Eurozone member states can and must con-

tribute to guarantee the future of the single currency, and to the

generation of the economic growth required to clear any doubts as

to the sustainability of sovereign debt, either via their contribu-

tions towards the establishment of common rules so that the EMU

becomes an optimum monetary zone, or via the reforms on a

national scale which constitute an example for all the others.

There is also a high degree of parallelism between the rules

required and which must be institutionalized in the Monetary

Union at a European level, and the process which must be follo-

wed in Spain in regard to responsibility, conditionality and subsi-

diarity of regional and local Public Administrations. In both cases,

the need for a political will capable of applying clear and straight-

forward rules, with prevention mechanisms, supported by coordi-

nation, monitoring and automatic sanction systems for those who

fail to comply with the targets undertaken, has become clearly evi-

dent. In this sense, the fact that the new fiscal pact at a European

level and the recent legislative changes in Spain seem to be going

in the same direction is a positive factor.

The case of Spain, where we have a very high degree of decentra-

lisation and where the Autonomous Communities and Local


254

Corporations manage approximately 50% of the public expenditure,

is a clear example of the need for coordination of fiscal policies to

ensure that the right signals are sent to markets and investors in

regard to the orientation of the fiscal policy. The consolidation efforts

made by some countries and regions are useless if there are others

which do not honour their commitments and destabilise the zone,

region or country. Europe and, of course, Spain have their own iden-

tity, and this applies to act as a unique body in order to establish the

aims. The scope of action of each government to achieve fiscal targets

undertaken, via the instruments deemed appropriate, is a different

thing altogether. The principle of subsidiarity must be respected pro-

vided that the principle of fiscal balance is observed. Each country

must have autonomy to define and design its fiscal structure so

long as the limits set for deficit, debt and growth in expenditure are

respected. Fiscal competition allows for improvement in revenue

collection efficiency and greater rigour in expenditure control, and

thus the greater fiscal coordination in Europe must not be envisaged

as a single fiscal policy. However, one of the main instruments at the

disposal of the governments when coordinating fiscal policies is con-

ditionality. In any regional funding system there are income transmis-

sion mechanisms and penalties aiming to fulfil the set fiscal targets.

Therefore, in the event that fiscal stability criteria are not met, be it at

a national level within the Eurozone or at a regional level within

Spain, the aid provided, as the case may be via special liquidity facili-

ties and even, if necessary, by way of eurobonds or hispanobonds, or

by way of larger revenue transmissions at a European level, cannot

take place without the acceptance of the conditionality it carries.


255

Spain has understood the need to contribute to the stability in

Europe and is leading, for the second time, a solid process of

reforms towards fiscal balance. Following the general elections of

November 2011, the new government and a reinforced political

capital constitute the main assets to bring about the necessary

reforms. The proof thereof is evident in the fiscal reforms: the

Royal Decree of non-availability, the reform of the Law on

Stability, the new system for payment to suppliers, the new bill on

Transparency or the bill of General State Budgets for 2012 (which

establishes an adjustment of 27,300 million euros to be made bet-

ween cost control and revenue increase).

The modification of section 135 of the Spanish Constitution

assumed its inclusion in a subsequent organic Law (the Law of

Budgetary Stability and Financial Sustainability of the Public

Administrations, recently presented), which specifies changes in

the preparation, execution and control of the Spanish fiscal insti-

tution. The recent approval of this bill means a return to the com-

mitment to the control of public finances and, more importantly,

it adds all of the Public Administrations to its scope of application,

which the previous Stability Law failed to do.

The three main objectives of this bill are to guarantee the fiscal

sustainability of all Public Administrations, to strengthen econo-

mic confidence and to reinforce the commits of Spain with the

European Union.


256

All Public Administrations must present a balance or a surplus

calculated according to EAS terms and none may incur in structural

deficit. However, there are two exceptions in the case of structural

reforms with long term fiscal effects (a structural deficit of 0.4% of

the GDP may be achieved) and in the event of natural disasters, eco-

nomic recession and extraordinary economic emergency.

In establishing the objectives of stability and public debt, the

recommendations of the EU in regard to the Stability Programme

must be taken into account, and all Public Administrations must

approve an expenditure ceiling in line with the stability target and

the expenditure rule. One of the most important aspects, in accor-

dance with European regulations, restricts the growth in expendi-

ture by the Public Administrations, as this may not exceed the GDP

growth rate.

Failure to comply with the targets shall require the presenta-

tion of an economic and financial plan to allow the correction of

the deviation for a period of one year. This plan must explain the

causes underlying the deviation and the measures which will

bring it back within the limit. In the event of non-compliance

with the plan, the responsible Administration must automatically

approve the non-availability of loans to guarantee compliance

with the set target and the meeting of the targets shall be taken

into account when authorising debt issues, granting subsidies and

signing agreements.


257

The Law, on the other hand, strengthens the preventive and

monitoring systems of stability and debt objectives. Therefore, a

debt threshold of a preventive nature is established, beyond which

the only debt operations allowed will be cash transactions.

In order to render all Public Administrations jointly responsible,

the penalties imposed in Spain in matters of stability shall be assu-

med by the responsible administration. In the event of failure to

produce an economic-financial plan, the administration in breach

must put of a deposit of 0.2% of its nominal GDP, which after six

months may be converted into a penalty in the event that the vio-

lations should continue. After nine months, the Ministry of

Finance and Public Administrations may send a delegation to

assess the economic and budgetary situation of the delinquent

Administration.

In order to strengthen the principle of transparency, each

Public Administration must establish the equivalence between

the budget and the national accounts. Prior to approval, each

Public Administration must provide information on its main

budget guidelines, in order to comply with European regulatory

requirements.

As was set forth in the new draft of section 135 of the

Constitution, the Law establishes a temporary period until 2020

for gradual compliance, until public debt is 60% of GDP. In order

to ensure compliance with this scenario, public debt must be redu-


258

ced whenever the economy experiences positive real growth. Upon

reaching a growth rate of 2% or net yearly employment is genera-

ted, the debt ratio shall be reduced each year at least by two GDP

points. On its part, the global structural deficit must be reduced by

0.8% of the annual average GDP.

Beyond the institutional importance of the reform, it is worth

considering the political capital that is allowing the deficit problem

to be addressed in an integral way and with long term vision. Doubts

as to possible deficit deviations in the current and following finan-

cial years should not lead us to lose perspective of the importance of

the reform. This reform set a trend designed to transform public bud-

gets into a reliable institution, with a simple structure, with no room

for interpretation, equal for all and with an automatic application

which allows it to be protected from temptations from other govern-

ments. In this regard, we also view the provisions included in the Bill

for the Transparency Law, which, undoubtedly, shall contribute

towards generating better knowledge of public finances.

The fiscal systems being approved in Spain matched with the

European model. There is a strong parallelism between the two,

and the construction errors of the European design and of the fis-

cal institution in Spain must be corrected by means of a coordina-

tion of fiscal policies in which the principles of regulatory equity,

subsidiarity, conditionality and sustainability should prevail above

all others.


259

Without doubt, the future of the euro requires more Europe.

The construction of Europe needs rules, adjustments and reforms.

Without growth the European model is doomed for failure. The

current crisis is but a result of the structural deficiencies of our eco-

nomy, of our excess indebtedness, of our lack of flexibility and our

lack of competitiveness in some aspects.

Once again, Spain, on its part, must become a role model of the

fiscal institution in Europe, and of the benefits which macroeco-

nomic stability brings to the economies, in terms of higher growth,

more wealth and greater employment. This is unquestionably the

best way to redistribute income. This is the only way we will mana-

ge to get Europe and Spain out of the sovereign debt crisis they

face, ensuring a solid future for the process of European construc-

tion, which is the greatest milestone in the search for peace and

prosperity in Europe.

5. Conclusion

Following the same pattern set since the inception of the

European integration project after the World War, the EMU came

about in 1999 as a result of the political aspiration of increasing

integration and as a European response to the globalisation pro-

cess. In reality, the integration via the monetary union which

makes up the Eurozone was not an objective in and of itself, but

rather a means to improve competitiveness and efficiency among


260

member countries. The ultimate goal, therefore, was growth, job

creation and the improvement of social welfare, while at the same

time making inroads in terms of political integration.

At that time the countries were aware of the need to set fiscal dis-

cipline targets as stability factors for Europe. However, those impor-

tant advances in the European construction process became diluted

over the years with the introduction of components carrying greater

flexibility and discretionality in the fiscal institution. The best exam-

ple is that the solution provided in 2005 to the violation of the SGP

by Germany and France was none other than the reform thereof

which included greater ambiguity in the search for fiscal stability, for

which they gained the support of the European Commission. The

diminishing political commitment with the fiscal institution and its

fragility in the face of the vicissitudes of the different governments

and ideologies became clear at that time. Therefore, with an institu-

tional design which was incomplete, and gradually declining over

the years, the EMU was far from representing an optimal monetary

area, and therefore the imbalances of the Eurozone economies incre-

ased, instead of decreasing, placing Europe in a difficult situation in

the face of the global financial crisis.

In this context, the current European debt crisis has highlighted

the urgent need for better coordination of the fiscal policies in

Europe. At the same time and particularly during the crisis, the

experience since the foundation of the euro has shown the impor-

tance of political commitment with the fiscal institution and the


261

need for preventive rules instead of penalties which are difficult to

apply. It is essential to ensure that the accumulation of excessive

deficits does not lead to unsustainable situations which call into

question traditional European security and seriously complicate

the capacity for funding growth and job creation. Rules are a

necessary condition to ensure compliance with fiscal targets. But

these rules must be of straightforward and automatic application.

Despite the difficulties, the present economic time obliges

Europe and Spain to make fast and efficient decisions in order to

straighten out the situation. It is important to take advantage of

current circumstances to tackle ambitious reforms designed to

correct some of the structural flaws of the Eurozone and of our eco-

nomy. It is important to face the current problems from a long

term outlook and to establish the rules of a fiscal institution which

ensure the viability of the European project.

The future and survival of the euro rests on all member states

being able to implement domestic reforms seriously, thus genera-

ting a sign of confidence for international investors and which

shall also serve, again in our case, as a calling card for our busines-

ses abroad. In Spain, one of the countries which has sustained the

most damage from the sharp budgetary deviations of recent years,

regional configuration shows evident parallelisms with Europe,

both in terms of the need to establish common objectives, and in

terms of the control systems or the transmission and penalty

mechanisms.


262

Spain, as a country which has already proven its ability to take

on this role at the end of the 1990s in the foundation of the Euro,

once again has an important role to play. In this regard, it is worth

mentioning that, thanks to the latest reforms implemented in sup-

port of the fiscal institution, Spain is once again contributing to

the European debate in pursuit of macroeconomic stability in the

Eurozone and its recovery. The challenge to be addressed, by means

of a change in the economic policy, is to recover confidence and

credibility of our economy, to enable businesses and consumers to

concentrate efforts in business, labour or consumer decisions, and

that macroeconomic issues, such as the risk premium, cease to be

cause for concern. Only in this way may Spain avoid lagging

behind like a second rate club, to which we have already said no a

few years back.

In order to move forward in building a fiscal union in Europe,

which succeeds in turning the EMU into an optimal monetary area

and ensures the good health of the euro and of the European eco-

nomy, the necessary mechanisms of income transmission, ensure

the availability of financial resources and required liquidity, to the

extent, if necessary, of creating risk pooling instruments, such as

eurobonds and, in parallel, the hispanobonds in the case of Spain.

These require, however, the establishment of prerequisites, that is,

economic adjustments and reforms to be implemented by the

countries facing the most difficulties. The rules are very important,

but without reforms it is impossible to grow, and without growth,

budgets become unsustainable. A different issue is, provided agre-


263

ed commitments are met, the respect for the autonomy of each

country to decide on its income and expenditure structure.

Subsidiarity must govern in Europe for those who are taking the

necessary steps, as is being done in Spain, in order to adapt the

budgets to the economic and social reality of each country.

The European construction has taken important steps since the

start of the crisis, but it needs to continue to progress via an incen-

tive system to ensure the political commitment with the fiscal ins-

titution in the medium and long term. The objectives of peace and

prosperity established by the founding fathers of the European

construction, on a long term horizon, once again depend on our

capacity to recover the growth and competitiveness of the eco-

nomy, and hence employment and the European welfare model.


264

The European Monetary Union:the Never-Ending Crisis

* Ph.D in Economics, BA in Law, Former Civil Servant attached to the Ministry of

Commerce, Emeritus Professor of Applied Economics (UNED and IEB).Former positions

include : General Director for Imports and Tariff Policy at the Ministry of Commerce,

Chief Executive Officer of Caja Postal de Ahorros, Member of the Board of Banco

Zaragozano, Director of the School of Financial Studies (UCM) and Member of the

Board of Banco de España.

His fields of research focus on monetary and financial matters, international economics

and the Spanish economy. He has written seven books and published more then

seventy papers in Spanish economic reviews..

/JAIME REQUEIJO*/

265

1. Introduction; 2. The Euro: a Badly Constructed Building; 3. The fiscalSpillover; 4. The Consequences of the Doubtful Debt; 5. ContributingFactors; 6. Main Measures Adopted to Solve the Monetary Union Crisis; 7.Outcome of the Measures Adopted so far; 8. Consequences of the Breakupof the Euro; 9. The Missing Link

The European Monetary Union: the Never-Ending Crisis

1. Introduction

The constant financial trepidation afflicting different countries

of the Eurozone, and which threatens the survival of the single

currency, is not the result of random events. In our view, they can

be put down to four fundamental reasons. First, the Monetary

Union is a badly constructed building as political urgency prevai-

led over economic prudence. Second, there is the fiscal irresponsi-

bility of many member state governments, an irresponsibility that

has materialized as hefty public debts. Thirdly, the doubts being

generated among the debt holders, mainly institutional investors

and banks, and which has led to significant fluctuations in the

interest rates of those assets and, in general, to a cost hike for the

issuers. Four, what we could call the contributing aspects: the spi-

llover and contagion effects that batter the financial markets,

effects linked to the opinions of the rating agencies and, on occa-

sions, to the worst-case scenarios of the International Monetary

Fund regarding the medium-term performance of the European

Union economies and, particularly important, those of the

Monetary Union.

Faced with that panorama, and given the absence of clear solu-

tions, there are three questions raised by many observers of the cri-

sis. The first question is what the measures are that have been

adopted so far to try and avoid the recurring disruption. The

second question is whether those measures, or further ones

currently under debate, will be sufficient to solve the problem or,

266


on the other hand, will the fate of the Monetary Union be to totally

or partially break up? The third question is if the Monetary Union

proves to be totally unviable and the national currencies have to be

re-introduced, what will the consequences be of the failure of the

euro?

This paper seeks to provide a reasoned explanation of the cau-

ses underpinning the current major upheaval and it also aims to

answer the aforementioned three questions regarding the measu-

res, their outcome and impact of a possible breakup of the euro.

The paper ends with a short section considering the solution that

should be adopted to keep the Monetary Union in place.

2. The Euro: a Badly Constructed Building

Even though the dream of the single currency had been always

present since the Treaty of Rome, the definitive decision, contained

in the Maastricht Treaty, is the outcome of the political desires of

France and Germany. Of France as French governments believed

that having a single European currency would avoid the constant

pressures on the franc, pressures that usually led to the devaluation

of its currency. Of Germany as accepting the single currency meant

highlighting the European vocation of the most important

European economy after reunification in 1990, a process that ope-

ned up many raw wounds – particularly in France. Driven by those

dual interests, the currency unification project prospered, not wit-

267


hout significant frictions, until it became reality in 1999, the year

when eleven countries, including Spain, ceded their monetary

autonomy to the European System of Central Banks; Greece would

join in 2001, followed by other countries until it reached the

current seventeen members.1

Joining the Eurozone required the countries to meet the so-

called Maastricht convergence criteria, those rules aimed at ensu-

ring that the different economies had a certain nominal similarity.

During the year prior to the Compatibility Test, the inflation rate

could not be more than 1.5 points over the average of the three

most stable candidate countries; as the end of that year, the public

sector deficit could not exceed 3% of the Gross Domestic Product

or the debt be greater than 60% of that figure; the candidate

country had to have been part of the European Monetary System

during the two years prior to the test and without its currency

having experienced significant fluctuations; and, during the pre-

vious year, the long-term nominal interest rate had not exceeded

the average of the three most stable countries by more than 2

points.2 After the failure of the European Monetary System in

1993, only the other three criteria were required to determine

which countries could join the euro, and those criteria have conti-

268

1 Note that the countries that initially joined the Monetary Union were Germany,

Austria, Belgium, Spain, Finland, France, the Netherlands, Italy, Luxembourg and

Portugal. Greece joined later and, successively, followed by Slovenia, Cyprus, Malta,

Slovakia and Estonia.

2 Article 121 of the 1992 Maastricht Treaty.


nued to be applied to accept the application for entry of the suc-

cessive candidates.

Please note that those criteria were only required at the time of joi-

ning. The subsequent restrictions were laid down by the 1997

Stability and Growth Pact, aimed at maintaining budgetary stability

within the Union. Thus, the country could not exceed the annual

limit of the deficit and the debt: 3% and 60% of the GDP respectively.

Exceeding those limits meant that the European Commission would

implement the excessive deficit procedure, which would result in the

country in question having to face certain penalties. Subsequently, in

2005, the rules were reformed so that the deficits tested were not the

nominal but rather the structural ones. Therefore, not only the

current deficit, but also the sustainability of the long-term public debt

was taken into account in the supervision and monitoring process

entrusted to the European Commission.3 In short, and right from the

outset, the nominal similarities that a series of economies with clear

real differences had to offer were what seemed to matter to European

leaders. And, proof of that difference could be seen when, in 2002 –

Greece had already joined – the typical deviation of labour producti-

vity per hour worked, calculated as CWA was 29.46;4 which clearly

showed the different competitive capacity of the different countries,

right from the start. Those differences were a hint of the future sym-

269

3 See “The Stability and Growth Pact: Public Finances in the Euro Zone” of the Sub-

Directorate General for Financial and Economic Affairs of the European Union, SCI

Economic Gazette No. 2906, 16-28 October 2007.

4 Prepared using the Eurostat data for the twelve member countries.

metric upheavals to come in the zone, and that group of countries,

for different reasons, did not constitute – or constitutes – an optimum

monetary zone. And thus, the European Monetary Union was built

on quicksand, quicksand that would begin to overwhelm it as soon

as the fiscal irresponsibility of some of the governments made a sig-

nificant dent in the building overall.

3. The Fiscal Spillover

Can governments of countries with weak currencies issue debt in

their currency and ensure that attracts foreign investors? The like-

lihood is minimum as the potential investor will think that, at some

point, the currency will depreciate substantially, leading to a loss.

Can countries with a strong currency do so? They can because

the investors will not fear the losses following on from devalua-

tion. And proof of this is that institutional or private investors, resi-

dent in a wide variety of countries, have traditionally kept debts in

dollars, marks, Swiss francs or yens in their portfolios.

The euro sought to be a strong currency right from the outset.

This strength was based on the monetary policy of the European

Central Bank, whose primary objective would be to keep prices sta-

ble.5 And which, furthermore, represented a series of important


270

5 Art. 2 of the Statues of the European System of Central Banks and the European

Central Banks.

economies, with Germany at the head. Moreover, the exchange

rate risk disappeared for member countries and it therefore facilita-

ted the setting up of a large financial market in euro.

The appearance of the euro, therefore, meant the disappearance

of the original sin experienced by countries with weak currencies:

the difficultly of leverage in other currencies, which meant that

they were at huge risk of financial fragility.6 The way was therefore

left clear for governments of euro countries that had found it diffi-

cult to finance themselves in other currencies prior to joining the

single currency, to easily raise leverage in the powerful financial

market of the euro. The only thing missing was the imperative need

to do so.

And that imperative need arrived with the economic crisis,

which began in 2007, and with the general downturn in the rates

of growth, a fall that is reflected in the following table.

It should be noted that even through the downturn in growth

was widespread, the countries with the sharpest recession were

Ireland, Italy, Portugal and Spain within the initial group of twelve

countries.

When the growth rate shrank, which was greatest in those cases

with the sharpest change in cycle, the budgetary revenue fell and


271

6 See Eichengreen, B. & Haussmann, R. “Exchange Rates and Financial Fragility”, NBER

WP 7418, 1999.

the deficits appeared or increased and grew even further if the bud-

gets included automatic stabilisers, by virtue of which the fiscal

policy became expansive in periods of recession, and even more

expansive if the governments relied on additional fiscal stimulus to

overcome the economic crisis.

All of these are reasons have been given to explain the rapid

increase in the public sector debt, as can be seen in Table No. 2.

Given that panorama of slow growth, or decline, and of growing

public debts, it comes of no surprise that debt holders would soon

have greater misgivings – misgivings that particularly affected those


272

CCoouunnttrryy AAvveerraaggee22000044--22000066

AAvveerraaggee 22000077--22001111

Germany 1.87 1.20Austria 2.90 1.30Belgium 2.57 1.12Cyprus 4.07 1.68Slovenia 4.73 0.74Slovakia 6.70 3.80Spain 3.67 0.26Estonia 8.43 -0.14Finland 3.70 0.80France 2.20 0.52Greece 4.07 -1.90The Netherlands 2.53 1.14Ireland 5.03 -0.82Italy 1.27 0.52Luxembourg 4.93 1.28Malta 2.33 2.20Portugal 1.27 -0.20

Table No. 1. Average Growth of the Eurozone (17 countries)

Source: Own preparation, using Eurostat data (Europe in figures, 2012)

countries where the recession was combined with spiralling debt and

the few prospects for recovery. It was, therefore, foreseeable that any

event that affected the debt of a country would lead to a chain reac-

tion that would challenge the financial stability of the Eurozone.

That event was Greece going into virtual receivership on 23 April

2010: on that date the Greek government asked the International

Monetary Fund and the European Union for a 45,000 million euro

loan to meet their financial obligations, four months after Fitch, the

rating agency, had downgraded its debt.


273

CCoouunnttrryy 22000077 22001111 GGrroowwtthh

Germany 65.2 81.8 25%Austria 60.2 72.2 20%Belgium 84.1 97.2 16%Cyprus 58.8 64.9 10%Slovenia 23.1 45.5 97%Slovakia 29.6 44.5 50%Spain 36.2 69.6 92%Estonia 3.7 5.8 57%Finland 35.2 49.1 38%France 64.2 85.4 33%Greece 107.4 162.8 52%The Netherlands 45.3 64.3 42%Ireland 24.9 108.1 334%Italy 103.1 120.5 17%Luxembourg 6.7 19.5 191%Malta 62.4 69.6 12%Portugal 68.3 101.6 49%Eurozone 66.3 88 33%

Table No. 2. Evolution of the public debt of the eurozone (% GDP)

Source: Own preparation, with data from the Statistical Annex of European Economy,autumn 2011. The data refer to the gross debt as they are the liabilities that the govern-ment must face.

4. The Consequences of the Doubtful Debt

From then onwards, there were constant indications of concern

in different channels about the sovereign debts with a question

mark over them. First of all, the increase of the risk premiums of

certain securities; secondly, the increase in the cost of the credit

insurance for the same securities; third, the greater occasional cost

of the new issues by the countries under suspicion, the so-called

peripheral countries: Greece, Portugal, Ireland, Italy and Spain.

The three aforementioned reactions clearly moved in the same

direction. As is known, hikes in risk premiums on the secondary mar-

kets consist of discounts on the value of the securities, discounts that

are equivalent to an increase in the relevant interests and which are

compared to the interests of the benchmark debt, the German one,

for the same market. In its simplest version, credit insurance (Credit

Default Swaps) are contracts by virtue of which, and by means of

paying a premium, the bondholder is guaranteed the collection of

the nominal amount. And in increase of the risk premiums and the

price of the swaps affect, by definition, the cost of the new issues: the

more expensive the premiums and swaps become, the higher the

interest that the new issues should offer and the greater the cost for

the relevant governments. All of which tends to worsen the financial

situation of the governments, a situation that will enter a downward

spiral if the average interest rate of the outstanding debt is greater

than the growth rate of its economy.


274

5. Contributing Factors

Current financial markets are markets of news and rumour

mills.7

The first report on how the turbulence develop and reflect veri-

fiable facts: the initial request for help by the Greek government;

the successive austerity measures demanded by the European aut-

horities and the International Monetary Fund for the bailout to be

granted; the social response to the austerity plans in different

countries or the downgrading of the sovereign debts of different

countries of the Eurozone, including France. All of the events show

the constant severity of an ongoing crisis.

The second are, in general, interpretations, opinions that are

usually transmitted through the different media, whether they are

journals, the daily press, television and radio programmes or news

spread online. Some are reasonably based opinions that are trying

to consider the difficult situation of the Monetary Union and to

offer some type of solution.8 Others are purely and simply seeking

to be alarmist, to the point of suggesting to their readers that they


275

7 An extensive study into the subject of rumours is by Mark Schindler: “Rumors in

Financial Markets”, Wiley&Sons, UK, 2007.

8 Examples of opinions of this type are “Beware of fallen masonry”, The Economist,

26/11/2011, and those expressed by K. Rogoff in the interview published by Spiegel on

27/2/2012, entitled “Germany Has Been the Winner in the Globalization Process”.

should stock up on food to survive the chaos that will reign, on the

world scale, when the euro implodes and triggers a financial tsu-

nami that will spread over the five continents.9

Furthermore, there are the constant threats of downgrading the

sovereign debt by the three major US agencies – Standard & Poors,

Moody’s and Fitch –, the three who were so optimistic when it came

to US mortgage junk bonds,10 and the doubts expressed, from time

to time, by the International Monetary Fund regarding the future of

the euro zone. There is also the risk that the whole set of views,

from the most founded to the most alarmist, will awaken many

fears and the prophecy will become self-fulfilling: the disaster will

occur because the avalanche of negative opinions will set it in

motion.

6. Main Measures Adopted to solve the Monetary UnionCrisis

At the time of writing (April 2012), these measures have invol-

ved setting up general bailout funds, the approval of a Greek Loan


276

9 Read “Will Greek Sovereign Debt Default on March 23” by Patrik Heller, Coinweck,

22/2/2012 (online).

10 In the opinion of John Kiff, from the International Monetary Fund, the opinion of

the agencies increases the uncertainties on the sovereign debt markets, due to the

importance that the participants on those markets seem to attribute to them. See his

article “Reducing Role of Credit Ratings Would Aid Markets” IMF Survey Magazine,

29/9/2010. Also Arezki et al: “Sovereign Rating News and Financial Markets

Spillovers”, IMF, WP/11/68.

Facility, the interventions of the European Central Bank and the

fine tuning of a new Treaty on Stability, Coordination and

Governance of the Monetary and Economic Union.

In 2010, the European Financial Stability Fund was set up,

whose aim is to facilitate resources to euro countries in financial

difficulties. It is a company whose headquarters are in Luxembourg

and its loan capacity is to the tune of 440,000 million euros.11 To

grant a loan to a Euro country, the government of the country has

to request it and sign an austerity programme. Part of the loans to

Ireland and Portugal were arranged through that Fund.

In 2011, the European Financial Stabilisation Mechanism was

created for a similar purpose. It is an institution, supervised by the

European Commission, which obtains its resources from the capi-

tal markets by means of issuing bonds underwritten by the

European Union budget. It may provide aid to members of the

European Union, whether or not they are members of the

Eurozone, is compatible with aid provided by other channels and

also requires the prior approval of an austerity package. Loans

have also been granted through this programme to Ireland and

Portugal.

The two aforementioned funds would duly be subsumed in the

European Stability Mechanism), agreed by the Eurozone countries


277

11 All the data referring to the bailout fund and to the Greek Loan Facility are taken

from European Commission official documents.

in February 2012 and which should begin to function in July of

that year. Its aid will not be limited to granting loans, but it will

likewise be able to acquire bonds issued by the member countries,

either on the primary or on the secondary markets, and facilitate

resources aimed at recapitalising financial institutions. In princi-

ple, it would have 80,000 million euros of capital and an initial cre-

dit capacity of 500,000 million euros. In May 2010, the members

of the Eurozone bilaterally decided to lend Greece 80,000 million

euros that, in addition to the 30,000 million from the

International Monetary Fund, meant that the first Greek bailout

totalled 110,000 million euros. At the end of 2011, and 73,000

million euros had been paid out from that fund, a payment that

required an austerity undertaking. On 14 March 2012, a new bai-

lout programme was approved, with substantial write offs for the

creditors and austerity obligations for the Greek Government, to

the tune of 130,000 million euros, an amount which includes the

International Monetary Fund contribution of 28,000 million

euros. The purpose of that financial support, which will last until

2014, is to bring the Greek public deficit under the 117% of its

Gross Domestic Product by 2020. Part of that bailout will be chan-

nelled through the European Financial Stability Fund.

A crisis intervention of particular importance is by the

European Central Bank, an intervention channelled in two lines.

In a non-recurrent way, the Bank acquires debt on the secondary

market, which reduces the risk premium and means that the issues

of new securities are at a lower cost. On the other hand, it lends


278

resources at a very low interest rate to financial brokers – its basic

rate has remained at 1% for some time – which means that the

banks of the worst hit countries acquire part of the new issues.

They, therefore, facilitate the placement of securities, securities that

are profitable for the financial institutions and less costly for the

issuers.

On 2 March 2012 and after many debates in the European

Council, the representatives of twenty-five countries of the

European Union – as neither the United Kingdom nor in the

Czech Republic wanted to sign up – signed the Treaty on Stability,

Coordination and Governance in the Economic and Monetary

Union. Even though the new Treaty was signed by members of the

European Union that are not part of the Monetary Union, its fun-

damental proposal is to force the euro countries to ensure that

their public finances are balanced. Further proof of that purpose is

that the Treaty will come into force when it has been ratified by at

least twelve euro countries.

A key aspect of the agreement is the so-called Budgetary

Agreement that forces those countries to tighten their budgetary

discipline and which introduces the balanced budget rule, a rule

that must be included in national legislation and, preferentially, in

the Constitution. The structural deficit must not exceed a specific

limit and cycle deficits are accepted, resulting from substantial

downturns in the economic activity, provided that they do not

alter the balanced budget rule in the medium term. And, in the


279

case that the deficit exceeds the permitted limit, a series of auto-

matic penalties are envisaged.12

7. Outcome of the Measures Adopted so far

Judging by the data that appeared in early April 2012, recovery

from the downturn has not yet started, in particular, as far as the

peripheral countries are concerned: volatility remains high both

on the sovereign debt markets and on the variable income ones –

in the case of the latter, the downward trend is reflected by the

drop in share prices of the most exposed banks to the sovereign

debt of those countries – and the doubts persist regarding the capa-

city of several of them to meet their obligations. Which is not at

all strange for several reasons.

The required restructuring to bring the debt back to more bea-

rable levels would hinder, in the short term, the growth capacity of

the five countries, as economic recovery would be further compli-

cated by the shrink in their tax revenue. And all of this would

occur in a climate of recession and economic stagnation that appe-

ars to have taken hold of the European Union, over all, and the

Monetary Union, in particular.13


280

12 The full text of the Treaty can be seen at the European Council website.

13 The forecasts can be seen at the European Economic Forecast, Autumn 2011 (online).

The situation of Greece is at the forefront of all the economic

analysis of the euro zone as very few believe so far that the recently

approved second bailout will result in the country solving pro-

blems and many believe that a third bailout will soon be on the

cards. And those doubts regarding the future of the Greek economy

are spreading to the rest of the peripheral countries and, to a great

extent, to the very future of the Monetary Union.

Despite the measures approved so far, the decision processes have

dragged on as an agreement needs to be reached by country repre-

sentatives, who are very aware of the opinion of their citizens, and

by representatives of community institutions. Long processes, where

multiple opinions, sometimes discrepancies, are mixed, that increa-

se the uncertainties regarding the future of the euro, even though

the disappearance of the single currency could raise much more

wide-ranging problems than the current ones trying to be solved.

8. Consequences of the Breakup of the Euro

The breakup of the Monetary Union could occur should one or

more member states decided to leave the single currency and rein-

troduce their own currency. That split could either be due to the

departure of one or more weak-economies or to one or more

strong-economies breaking. In either of the two cases, the Union

would be broken.


281

From the legal perspective, such a possibility does not currently

exist as the Maastricht Treaty does not include any clause that

opens up the way; only the 200714 Lisbon Treaty accepts the

voluntary withdrawal of a member state from the European Union,

but says nothing about the Monetary Union. This may be because

the architects of the common currency always thought that, given

that the single currency was an extremely important step in the

political and economic construction of Europe, the decision of

each country should be irrevocable.

Yet, leaving the legal aspect on one side, despite its importance,

the collapse of the Eurozone would lead to a series of disastrous con-

sequences for the country or countries that had left the euro, for the

Eurozone overall and for the world economy.

Let us first consider the departure of a weak economy. The mere

presumption by its citizens of leaving would result in a large-scale

transference of deposits from its banks towards other banks located

outside the country, given that nobody would want to see their euro

assets converted into balances in the devalued currency; the

Government in question would be forced to impose, as a preventive

measure and prior to the decision to abandon the euro, a limit on

withdrawing deposits and a strict exchange rate control. As it is to be

supposed that part of the private debt of the country would be held

by foreign institutions, individuals and companies would find them-

selves in the worrying situation of having to face such debts with a


282

14 Art. 50 of the Treaty regarding the voluntary withdrawal for a member country.

national currency of a lower value. With respect to the sovereign

debt, the problem would be the same: the Government would be

compelled to honour it at a higher cost. And the internal economic

adjustments would be of such a magnitude that the main purpose

sought by returning to the national currency – regaining the exchan-

ge rate policy and, thus, making the exportable goods more compe-

titive – would take many years to occur. Without even going into the

social and legal conflicts that would occur, in that country, as a seve-

re recession for an unforeseeable length would occur.

If the country decided to abandon the euro were a very strong

economy, would there be more advantages than disadvantages? It is

not easy to answer that question, for two reasons. First of all, becau-

se the foreseeable outcome is that its currency would appreciate,

which, even though it would mean an initial advantage, would also

raise problems. For example, and from that moment onwards, its

banks would have deposits in the new currency, but it is to be sup-

posed that part of its assets would be for operations with residents

in the euro zone and, therefore, the financial brokers would have to

face losses through that channel, and would moreover have to face

its fiscal obligations in the new currency. Second, and this is the

more important aspect, the appreciation of its currency would affect

its competitiveness in the remaining euro countries – the main mar-

ket of all the countries of the Monetary Union – which, undoub-

tedly, would hit its growth capacity for many years to come.15


283

15 On these aspects, see “Euro break-up: the consequences” of UBS Investment

Research, 6/9/2011 (online). Also the opinions of Eric Dior: “Leaving the euro zone: a

The departure from the Eurozone of any country, or several

countries, would break up the Monetary Union in both political

and economic terms. In economic terms, because the growing dis-

trust of all its citizens would lead to substantial capital flights and,

probably, to the collapse of different financial systems, which

would cloud the very limited economic perspectives of the zone

and would lead to a long recession. In political terms as its inter-

national clout would be considerably reduced, based on a situa-

tion, the current one, which is not particularly brilliant: its lack of

political unity and its indecisiveness, which characterises it as a

soft power area clearly reduce the international presence of a zone

that, we should not forget, is, taken overall, the second economy

and the second market of the world.16 Its breakup and the ensuing

recession would cloud the international presence of that group of

countries to unimaginable limits. And without taking into account

the likely decline of the European Union.

It is interesting to observe the distancing that many non-

European analysts show when considering the spasms of the

Monetary Union. Which is the equivalent, in many cases, to con-

sidering them as a local problem: the Eurozone is having to bear

great tensions, arising from the sovereign debt crisis, and there is

a question mark over its survival. And they go no further. They

forget that, in a world of fully integrated financial markets, the


284

user’s guide”. IESEG School of Management (Lille Catholic University), October 2011

(online).

16 With World Bank and World Trade Organisation data for 2010.


285

Eurozone crisis would have a global impact. For two reasons. First

of all, because a good part of the sovereign debt is in bank port-

folios; secondly, because the credit insurances (CDS) are, pos-

sibly, held by financial institutions around the world.

In December 2011, 513,000 million euros of public debt of the

five peripheral countries (Greece, Ireland, Italy, Portugal and Spain)

appeared in the portfolios of European banks.17 If we take into

account that the financial institutions around the world are linked

by a series of international transactions, it is not difficult to con-

clude that the breakup of the euro would have global repercussions.

In the March 2011, the CDS linked to European sovereign debt

stood at 145,000 million dollars.18 Neither of these two figures are

high but they are sufficiently important for the upheavals of the euro

zone, following on from the breakup of the currency, to be transferred

to other regions of the world with substantial multiplying effects.

It therefore can be supposed that the Monetary Union will

manage to overcome this crisis. Yet, from our point of view, the

current firewalls – the bailout funds, however they are called – and

the budgetary obligations, included in the Treaty on Stability,

Coordination and Governance, will not be enough to overcome

17 Jenkins, P. y Stabe, M: “EU banks slash sovereign holdings”. With European Bank

Association data (online).

18 ISDA: “The Impact of Derivative Collateral Policies of European Sovereigns and

Resulting Basel III Capital Issues”, 19/12/2011 (online).

the current problems and ensure that the Monetary Union is the

threshold to what, when all said and done, has been what they

wanted to achieve through the single currency: a certain degree of

Political Union. An additional link is therefore now needed.

9. The Missing Link

The endeavours aimed at solving the crisis have so far been along

two paths: creating financial instruments to avoid the bankruptcy of

some governments – the most worrying case is Greece – and strengthe-

ning the obligation of member countries to reach and maintain a rea-

sonable budgetary balance. Important steps, but which have not mana-

ged to eliminate the continuous tension that has been observed in the

financial markets, tension that the interventions of the European

Central Bank have only managed to soften. Soften, not eliminate.

Note that all the actions undertaken so far – bailout and rules –

do not imply any joint liability. It involves combining financial aid

and remembering that fiscal policy in a single currency arena must

be very similar and very prudent in all member countries. The lia-

bility therefore falls on the Government of each country.

Yet these measures will not be sufficient if the aim is to shore up

the badly constructed building of the Eurozone. It would be neces-

sary to show that the members of the Monetary Union are capable

of jointly and severally assuming liability of the problems of all its


286


287

members. And what is necessary, to affirm that joint liability, is to

issue the so-called Eurobonds or Stability Bonds; in other words,

bonds jointly issued that will replace, totally or partly, the current

sovereign debt. That measure, that would be a highly important

step forward in the construction of the common building that is

based on the single currency, would result in three far-reaching

consequences: the sovereign debt crisis of some countries would

be rapidly alleviated; the cost of future issues would be reduce as a

consequence of the overall solvency; and the financial system of

the Eurozone would be more resistant to any future upheaval, and

the overall financial stability would therefore be strengthened.

This decision necessarily implies the setting up of a common trea-

sury and likewise the application of a fiscal policy.

Clearly, that decision would entail many economic difficulties

and highly complex political problems, as the citizens of the most

prosperous and stable countries of the Union will be not very

willing to accept that type of shared liability which they would see

as the financial problems of others being placed on their shoul-

ders. Yet we should not forget that that possibility has already been

raised by the European Commission itself, precisely to attain those

objectives.19 And we should not forget, above all, that, as I have

attempted to explain in this paper, the end of the Monetary Union

is not a zero-sum game, where there are winners and losers; it is a

negative sum game, where everyone loses.

19 See European Commission: “Green Paper on the feasibility of introducing Stability

Bonds”, 23/11/2011.COM (2011) 818 final (online).


288

Public expenditure policies during theEMU period: Lessons for the future?1

*He currently works as Ph. D Assistant professor at Complutense University of Madrid.

Before he worked as external consultant at European Central Bank, as (Ph. D) Assistant

professor at Pablo de Olavide University (Seville, Spain) and as research assistant at

Foundation centrA. He holds a Ph.D in Economics from Pablo de Olavide University

(with distinctions) and a Bachelor in Mathematics from University of Seville. His rese-

arch areas are mainly public economics and computational economics.

** He currently works as an Economist at the German Ministry of Finance. He was also

an Economist in the Fiscal Policies Division of the European Central Bank and worked

as a research assistant at the Centre for European Economic Research (ZEW). He holds

a Ph.D. in Economics from Munich University (LMU). His research focuses on empiri-

cal public finance and fiscal policy.

***Is heading the Directorate General Fiscal Policy and International Financial and

Monetary Policy at the German Ministry of Finance. Previously, he worked at the

European Central Bank, the World Trade Organisation and the International Monetary

Fund. His recent research mainly focuses on public expenditure policies and reform and

the analysis of economic boom-bust episodes.

A. JESÚS SÁNCHEZ FUENTES*/SEBASTIAN HAUPTMEIER**/

/LUDGER SCHUKNECHT***/

289

1. Introduction; 2. Long-term public expenditure in industrialised coun-tries; 3. The first decade of EMU period: a missed opportunity?; 3.1. Adisaggregated assessment of past expenditure policies; 3.2. Determinantsof the expenditure stance; 3.3. Implications for public debt; 4. Lookingbackward to the past, lessons for the future? an episodes based approach;5. The need for prudent expenditure rules; 6. Concluding remarks;Bibliography

Public expenditure policies during the EMU period: Lessons for the future?

1. Introduction

The outlook for public finances in the advanced economies for

the second decade of the 21st century is extremely challenging, not

least due to the substantial fiscal expansion that took place in the

context of the financial and economic crisis. Public deficits in 2010

averaged around 6% of GDP in the euro area and exceeded 10% of

GDP in the US and the UK (Chart 1, panels a, and b). At the same

time, public debt in advanced economies has increased signifi-

cantly between 2007 and 2010: by some 20pp of GDP to around

86% in the euro area and so far by 30pp or more in the UK (to 80%)

and in the US (to over 90% of GDP). When including Japan, public

debt in the G7 countries already averaged over 100% of GDP in

2010.

A closer look suggests that most of the deficit increase since the

start of the crisis in 2007 was due to an increase in public expendi-

ture ratios which have reached or approached historical highs. By

contrast, revenue ratio declines have been rather limited (panels c

and d). It is, therefore, logical to look at public expenditure when

striving to correct fiscal imbalances in industrialised countries. This

approach is in fact pursued already by a number of countries with

fiscal difficulties. It was also the approach used—successfully—by

290

1 The views expressed are the authors’ and do not necessarily reflect those of the authors’

employers. Correspondence to: A. Jesús Sánchez-Fuentes. Universidad Complutense de

Madrid. Campus de Somosaguas, 28223, Madrid (Spain). Tel: +34 913942542, Fax: +34

913942431. Email: [email protected].


291

Chart 1. Developments in public finances, 1990-2011a) Fiscal balance

b) Public debt

Source: Ameco.


292

Chart 1. (cont.) Developments in public finances, 1990-2011c) Total public expenditure

Source: Ameco.

d) Total revenue


many advanced economies in the 1980s to return to sound public

finances and at the same time reinvigorate the economy.

The case of the euro area is of special relevance for a number of

reasons. While the crisis-related deterioration of public finances in

the euro area as a whole has not been as pronounced as for example

in the US or Japan (see Chart 1), heterogeneity at the Member State

level is substantial. A number of countries, in particular Greece,

Ireland and Portugal, recorded double-digit deficit ratios and expe-

rienced significant increases in government debt as a ratio to GDP.

Unsustainable fiscal positions coupled with structural economic

weaknesses and competitiveness deficiencies, in turn, fuelled market

tensions which - due to strong financial interlinkages – undermine

financial stability in the monetary union as a whole. Therefore, at

the time of writing, there is a particular urgency for euro area coun-

tries to regain market confidence through a swift return to sound

public finances. At the same time, euro area membership tends to

exacerbate adjustment efforts since the exchange rate mechanism is

not available, preventing an external devaluation. Therefore, fiscal

consolidation and the restoration of external competitiveness need

to strongly rely on internal adjustment processes.

Against the background, this study assesses expected public

expenditure developments of selected euro area countries for the

coming years. Based on the experience with expenditure reform in

the 1980s and 1990s, we argue that ambitious and high quality

expenditure reform as part of comprehensive economic reform pro-

293

grammes have the best chance of success. Furthermore, the role of

a prudent expenditure rule and the relevance of having a suitable

institutional framework are discussed.

Section 2 reviews public expenditure trends over the past 30

years. Section 3 reports on the main findings of earlier studies on

public expenditure policies during the first decade of EMU. Section

4 looks backward to the past to extract important conclusions on

the successful strategy exit of current crisis. Section 5 provides an

illustration on the preventive role of prudent expenditure rules

before section 6 concludes and draws some policy lessons.

2. Long-term public expenditure in industrialised countries

With a view to assessing recent developments in a broader his-

toric perspective, it is worth briefly taking stock of trends in public

expenditure and the size of the state over the past 30 years (Table

1).2 After a strong increase in the size of government in industria-

lised countries in the 1960s and 1970s, the average total public

expenditure ratio across OECD, G7 or euro area was broadly

unchanged in 2007 -just before the financial crisis- from 2000, 1990

and 1980. The average spending ratio for the euro area remained

around 45% of GDP and that of OECD and G7 around 40%.


294

2 See also Tanzi and Schuknecht (2000) for more details on historic expenditure deve-

lopments.


295

%% ooff GGDDPP 11998800 oorr nneeaarreesstt 11999900 22000000 22000077 22001100

MMaaxxiimmuummvvaalluuee

CChhaannggeemmaaxxii--mmuumm ttoo 22001100YYeeaarr RRaattiioo

Austria 50,0 51,5 52,3 48,6 52,5 1995 56,4 -3,9

Belgium 54,9 52,3 49,1 48,3 52,9 1983 62,2 -9,2

Finland 40,1 48,1 48,3 47,2 55,1 1993 64,7 -9,6

France 46,0 49,6 51,7 52,6 56,6 2010 56,7 -0,1

Germany 47,4 44,2 47,6 43,5 48,1 1995 54,8 -6,7

Greece 27,0 45,2 47,1 47,6 50,2 2009 53,8 -3,6

Ireland 50,1 42,8 31,2 36,6 46,8 1982 54,2 -7,3

Italy 40,8 52,9 47,0 47,6 50,3 1993 56,3 -6,0

Luxembourg 48,4 37,7 37,6 36,3 42,5 1981 51,7 -9,2

Netherlands 55,2 54,9 44,8 45,3 51,2 1983 59,1 -7,9

Portugal 32,4 38,5 41,4 44,4 51,3 2010 51,3 0,0

Spain 31,1 42,1 39,3 39,2 45,6 1993 47,1 -1,4

EEuurroo aarreeaa ((1155) 4455,,44 4477,,99 4466,,22 4466,,00 5511,,00 11999955 5533,,11 --22,,11

Australia 32,5 35,4 35,5 33,4 38,5 1985 38,5 0,0

Canada 41,6 48,8 41,1 39,4 44,1 1992 53,3 -9,2

Denmark 52,7 55,4 53,7 50,8 58,5 1993 60,2 -1,7

Japan 33,0 31,6 39,0 35,9 41,1 1998 42,5 -1,4

Sweden 62,9 61,3 55,1 51,0 52,9 1993 71,7 -18,8

Switzerland 32,8 30,3 35,1 32,3 34,2 2003 36,4 -2,2United Kingdom 47,6 41,1 36,8 43,9 50,6 2009 51,5 -0,9

United States 34,2 37,2 33,9 36,8 42,5 2010 42,7 -0,2

GG77 3388,,33 3399,,88 3388,,55 3399,,99 4455,,00 22000099 4455,,55 --00,,55

OOEECCDD 3399,,11 4400,,22 3388,,88 3399,,88 4444,,66 22000099 4455,,22 --00,,66

Table1. Total expenditure developments

Source: Ameco, OECD.

However, this masks significant differences across countries.

The countries that undertook ambitious reforms in the 1980s and

1990s typically had much lower spending ratios in 2007 than in

1980 or at least than at their peak. A few countries, however, inclu-

ding many of those that we will refer to in the next sections (US,

Italy, Spain, Portugal, Greece, Ireland, UK) had significantly incre-

ased the size of government between 1980 and 2007 or least in the

2000-2007 period.3 This occurred notwithstanding an extended

economic boom in most of these when expenditure ratios should

have gone down.

With the start of the financial crisis, public expenditure ratios

went up everywhere by on average 5pp of GDP. This brought the

total expenditure ratio to about 50% in the euro area and 45% in

the OECD/G7 in 2010. For the euro area, the increase still consti-

tutes a decline in overall spending since the previous peak in 1995

but this was due to a lower interest bill. On the whole and for

many countries, public expenditure ratios are now at or near his-

torical peaks. This includes the European crisis countries, Portugal

and Greece and the UK and US.

These developments show that the challenge of containing the

size of the state is more present than ever. And together with deficit

and debt figures, the close link between rising public spending, defi-


296

3 See also Hauptmeier et al, 2011 for an assessment of the expenditure stance in euro

area countries since the start of EMU.

cit and debt figures is also obvious. But a number of countries mas-

tered the challenge of very large expenditure ratios with ambitious

reform programmes in the 1980s and 1990s. This experience will be

re-called in the next sections. These countries were typically not the

same that face such challenges now—except Ireland and the UK.

3. The first decade of EMU period: a missed opportunity?

In this section, we examine expenditure developments and plans

of a number of euro area economies, notably Greece, Ireland and

Portugal (programme countries), Germany, France, Italy and Spain

(large euro area countries) in comparison to the UK and US. The

common feature of most of these countries (except Germany and

Italy) for the period up to 2007 was a drawn out economic boom

characterised by significantly positive output gaps. In principle, this

should have allowed bringing down public expenditure ratios signi-

ficantly, firstly, due to the impact of automatic stabilisers and,

secondly, in some cases also due to lower interest spending thanks

to the euro.

However, this is not what happened. All countries pursued an

expansionary expenditure stance, of the order of 1-5pp of GDP

except for Germany (Hauptmeier et al, 2011).4 This basically “ate


297

4 One of analysing the expenditure stance of a country is to compare it with the expen-

diture levels that should have occurred if a country had followed certain fiscal rules.

up” the interest savings from introducing the euro. As a conse-

quence, total public expenditure only went down significantly in

Germany and even increased strongly in the three crisis countries

and the UK between 1999 and 2007 (Table 2). In the US, total spen-

ding grew by around 2pp of GDP between 2001 and 2006 but the

ratio remained well below 40% of GDP. Together with the US,

Ireland and Spain maintained the lowest spending ratios (below

40% of GDP), France’s public expenditure was the highest, at 52.4%

in 2007. The increase in public expenditure becomes even more

pronounced when looking at primary spending. For the crisis coun-

tries and the UK this went up by 3 to almost 6% of GDP between

1999 and 2007. As a result, most of the sample countries still had

significant deficits in 2007 while the debt ratio had hardly declined

or even increased between 1999 and 2007 (Schuknecht, 2009).

Expansionary expenditure policies during good times left most

of the countries “unprepared” when the crisis hit. As a consequen-

ce of the output fall and further expansionary programmes, public

expenditure ratios increased strongly between 2007 and 2009/2010.

Increases ranged from around 4pp of GDP in Italy and Germany, to

6-7½ pp in the UK and US to over 10pp in Ireland. The expenditu-

re increase was particularly strong in the countries where a credit-

fed real estate and financial sector boom had “artificially” inflated


298

Such an exercise was conducted by us last year (Hauptmeier et al, 2011). The study

found that most euro area countries had pursued expenditure policies that were more

expansionary than a reasonable expenditure rule would have proposed.


299

%% ooff GGDDPP 11999999 22000077 22000099 22001100 CChhaannggee MMeemmoorraadduumm:: ddeeffiicciitt

11999999--22000077 22000077--22001100 22000077 22001100

Programme countries

GGrreeeeccee 44,8 47,6 53,8 50,2 2,8 2,6 -6,8 -10,8

IIrreellaanndd 33,9 36,6 48,9 46,8 2,7 10,2 0,1 -11,3

PPoorrttuuggaall 41,0 44,4 49,9 51,3 3,4 7,0 -3,2 -9,8

Large euro area countries

GGeerrmmaannyy 48,2 43,5 48,1 48,1 -4,7 4,5 0,2 -4,1

FFrraannccee 52,6 52,6 56,7 56,6 0,0 4,0 -2,8 -7,1

IIttaallyy 48,1 47,6 51,6 50,3 -0,5 2,6 -1,6 -4,5

SSppaaiinn 39,9 39,2 46,3 45,6 -0,7 6,4 1,9 -9,3

Large non-euro area countries

UUnniitteedd SSttaatteess 34,2 36,8 42,7 42,5 2,7 5,6 -2,8 -10,6

UUnniitteedd KKiinnggddoomm 38,9 43,9 51,5 50,6 5,0 6,7 -2,7 -10,3

Table 2: Recent total expenditure developments

Table 2: Recent expenditure developments for selected countries

%% ooff GGDDPP 11999999 22000077 22000099 22001100 CChhaannggee

11999999--22000077 22000077--22001100

Programme countries

GGrreeeeccee 37,3 42,8 48,7 44,4 5,5 1,6

IIrreellaanndd 31,5 35,6 46,9 43,7 4,1 8,1

PPoorrttuuggaall 38,1 41,4 47,0 48,3 3,3 7,0


GGeerrmmaannyy 45,1 40,7 45,4 45,4 -4,4 4,7

FFrraannccee 49,6 49,9 54,3 54,2 0,3 4,3

IIttaallyy 41,5 42,7 47,1 45,9 1,2 3,2

SSppaaiinn 36,4 37,6 44,5 43,7 1,2 6,1

Large non-euro area countriesUUnniitteedd SSttaatteess 30,4 34,0 40,2 39,8 3,5 5,9

UUnniitteedd KKiinnggddoomm 36,0 41,7 49,6 47,7 5,6 6,0

Source: Ameco

Table 2: Recent cyclically adjusted primary expenditure developments

GDP. When this reversed over the crisis, both higher spending and

lower GDP drove up the expenditure ratio. Virtually all of the

expenditure ratio increase was on public consumption and transfers

and subsidies; public investment went up only slightly in a few

countries. Greece, Ireland and Spain also reported higher interest

expenditure as the rapidly rising debt ratio and higher interest rates

started to affect public budgets.

Where did countries stand in the third year of the crisis, 2010?

None of our sample countries still featured a relatively small public


300

%% ooff GGDDPP 11999999 22000077 22000099 22001100 CChhaannggee

11999999--22000077 22000077--22001100

Programme countries

GGrreeeeccee 37,3 42,9 48,6 44,4 5,5 1,5

IIrreellaanndd 31,7 35,8 46,6 43,5 4,0 7,7

PPoorrttuuggaall 38,2 41,4 46,9 48,3 3,2 6,9


GGeerrmmaannyy 45,1 40,9 45,0 45,2 -4,1 4,3

FFrraannccee 49,7 50,1 54,1 54,0 0,4 4,0

IIttaallyy 41,5 42,7 47,0 45,8 1,2 3,1

SSppaaiinn 36,5 37,7 44,3 43,4 1,2 5,7

Large non-euro area countries

UUnniitteedd SSttaatteess 0,0 0,0 0,0 0,0 0,0 0,0

UUnniitteedd KKiinnggddoomm 36,1 41,7 49,5 47,6 5,7 5,9

Source: Ameco

sector of below 40% of GDP (as defined by Tanzi and Schuknecht,

2000). Even the US, at 41.3% of GDP, featured a public sector that

was not much smaller than the euro area average before the crisis.

Greece, Portugal, France, Italy and the UK reported public spending

ratios of around to significantly above 50%.

It has been argued that the increase in expenditure ratios is not

very relevant as it presumably reflects almost solely the crisis and

should, thus, reverse itself over time as the economy normalises.

This reasoning implicitly assumes that output levels and growth

rates will more or less return to pre-crisis levels. As a large output gap

would be closed, public commitments should decline relative to

GDP. However, if the pre-crisis GDP was artificially inflated by boo-

ming sectors which have to shrink then both GDP level and growth

rates may be significantly lower post-crises. If the 2010 output gap

was only small, 2010 deficits and expenditure ratios would in fact

represent structural features of the examined economies. In any

case, significant fiscal adjustment is needed which in some cases

exceeds 10 pp of GDP in the coming years (IMF, 2011).

3.1. A disaggregated assessment of past expenditure policies

To assess in more detail what drove expenditure developments

since the start of EMU, this section provides an analysis the public

expenditure stance across the three main expenditure components

that governments can influence in the short term: government

consumption, transfers and subsidies and public investment. We


301

apply the same methodology as in Hauptmeier et al (2011): given

the existing levels at the start of the EMU (1999), actual public

expenditure developments are assessed against an expenditure

path that should have been taken if countries had followed a neu-

tral expenditure stance, i.e. if governments had aligned expenditu-

re growth to that of potential GDP. The latter is measured on the

basis of two expenditure rules: (a) nominal potential GDP growth

(NPG rule) and (b) real potential GDP growth plus the growth rate

of the GDP deflator capped at the ECB’s price stability objective of

below but close to 2% (RPECB) based either on real time or ex post

data. This counter factual analysis provides four measures of the

expenditure stance.5 Deviations are analysed by looking at margi-

nal (annual) and/or cumulative (total period) deviations (expressed

as percentage of GDP). According to this procedure, on the one

hand, marginal deviations help to identify the year(s) in which

expansionary/restrictive policies were implemented. On the other

hand, cumulative deviations measure the degree of expansio-

nary/restrictive policies in percentage points (pp) of GDP accumu-

lated over the period (1999-2010).

Firstly, to provide a general perspective, we focus on cumulati-

ve effects for the aggregate euro area (Chart 2), comparing actual

and rule-based expenditure developments (expressed as percentage

of GDP).


302

5 The earlier study applied six measures but the two additional ones did not provide

much additional insights.


303

Public consumption

Chart 2: Euro Area (12). Expenditures ratios as implied by a neutral expenditurestance, across rules.Primary expenditures


304

Chart 2: (cont.) Euro Area (12). Expenditures ratios as implied by a neutral expen-diture stance, across rules.

Public investment

Looking at the primary expenditures stance - panel a - suggests

a co-movement with the NPG rules which indicates the absence of

a prudence margin to operate when difficulties appear. Looking at

the disaggregated developments, i.e. the main expenditure compo-

nents, gives a different picture: First, the results for public con-

sumption show an expansionary expenditure stance on this cate-

gory adding up to 0.5-2pp of GDP, depending on the respective

expenditure rule. Second, for the transfers and subsidies compo-

nent, a strong counter-cyclical behaviour is observed, as one would

expect. However, the decreases in economic good times were much

less significant than the increases during the crisis. Finally, the pat-

tern for public investment is clearly pro-cyclical. At the same time,

the adjustments carried out by some countries during 2010 can be

already observed (returning to 2004 levels).

To complement this general view, we briefly describe the

country pattern for the main expenditure components.6 As in

Hauptmeier et al. (2011), for primary expenditures, we observe a

restrictive expenditure stance for Germany whereas all other coun-

tries show an expansionary policy stance over the 1999-2010

periods, notably as regards public consumption as well as transfers

and subsidies. However, the degree of expansion is different among

components. On the one hand, in the case of public consumption,

the magnitude of cumulative expansion ranged from near zero for


305

6 For the sake of brevity, related country-specific results are not included in the main

text. They are available from the authors upon request.

France to up to 5pp of GDP for Ireland. On the other hand, for

transfers and subsidies, Germany is highly restrictive by 2-3 pp,

and the rest is expansionary by 1-7pp depending on the rule and

country.

Finally, for public investment, the development of the cumula-

tive expenditure stance is quite interesting: restrictive for Germany

and Portugal, neutral for Italy and expansionary for all other coun-

tries with a tendency of neutralisation in 2010. However, overall

magnitudes are small.

In a second step, we repeat this same exercise component by

component, in order to decompose the cumulative deviation

observed. This analysis provides a view of the respective stance of

each expenditure component. The list of indicators included is in

line with those presented so far; i.e. (i) public consumption, (ii)

transfers and subsidies, (iii) public investment, and (iv) other

expenditures. Moreover, we split our sample period into sub-

periods to show the role of (i)-(iv) before (1999-2007) and during

the crisis (2008 – 2009, 2009-2010).

First, looking at the expenditures stance, Chart 3 presents the

decomposition of cumulative effects observed for ex-post and real-

time rules. When compared real-time and ex-post rules behaviour

both similarities and differences are found. While on the one hand

the dynamics are very similar, quantitative differences emerge

especially during sub-period (II), i.e. 2007-2009.


306


307

(II) Ex-post NPG rule. 1999-2007

Chart 3: Decomposition of cumulative changes to public primary spending ratioscompared to a neutral expenditure stance for selected periods

(I) Real-time NPG rule. 1999-2007

%GD

P%GD

P


308

Chart 3. (cont.) Decomposition of cumulative changes to public primary spendingratios compared to a neutral expenditure stance for selected periods



%GD

P%GD

P


309


Chart 3. (cont.) Decomposition of cumulative changes to public primary spendingratios compared to a neutral expenditure stance for selected periods


%GD

P%GD

P

An alternative way to look at these figures is going through the

different sub-periods. First, deviations in the pre-crisis period are

clearly dominated by public consumption. Moreover, if we leave

out Germany as the only restrictive country over this period, two

different country patterns can be observed: major deviations from

trend as regards public consumption in Italy, Spain and Ireland

while Greece and Portugal show strongly expansionary trends in

transfers and subsidies. Second, deviations from trend in transfers

become relatively more important with the start of the financial

and economic crisis.

3.2. Determinants of the expenditure stance

An empirical analysis of factors that influence countries’ expen-

diture stances can provide further information on the determinants

of expansionary expenditure policies in the past. Hauptmeier et al.

(2011) therefore applied standard fixed-effects panel estimation

techniques on a sample of 12 euro area countries for the 2000-2009

period using the measure for the expenditure stance described

above, i.e. the (marginal) deviations of actual spending growth from

rule-based or neutral spending (under the NPG and the RPECB rule

in ex-post terms), as the dependent variable.

The aim of this empirical exercise was to explain the govern-

ments’ expenditure stance on the basis of fiscal and macroecono-

mic factors, relevant institutional characteristics as well as political


310


311

economy variables. The results of the analysis are presented in

Table 3.

As one would expect, the macroeconomic environment measu-

red by the output gap (in % of potential GDP) constitutes an

important determinant of the expenditure stance. We find robust

support for a positive correlation between the output gap and the

expenditure stance across rules and estimations, suggesting a pro-

cyclical spending behaviour.

As regards fiscal factors, surprisingly the level of public indeb-

tedness does not seem to significantly affect our measure of the

expenditure stance. We also do not find robust evidence for an

effect of revenue windfalls that arguably could increase spending

profligacy. We capture such windfalls by including the excess reve-

nue growth in a given year relative to previous year’s Autumn fore-

cast by the European Commission. However, while we see the

expected positive sign the effect is not significant.

We find empirical support for the importance of political eco-

nomy factors. In particular, parliamentary elections at the national

level (Electoral cycle 1) tend to significantly increase the deviation

of actual from rule-based primary spending. The opposite holds true

for a second election-related variable (Electoral cycle 2) which cap-

tures the years left in the current election term. The negative sign on

this variable suggests that the incentives for fiscal discipline can be

expected to be higher at the beginning of the legislative period. We


312

((II)) ((IIII)) ((IIIIII)) ((IIVV)) ((VV)) ((VVII)) ((VVIIII))

Output gap (based on Potential GDP) 0,525 0,476 0,401 0,463 0,274 0,374 0,476

[3.78]*** [3.01]** [2.50]** [3.04]** [1.65] [2.22]* [3.00]**Public debt ratio (t-1) 0,054 0,056 0,035 0,071 0,042 0,033 0,057

[0.96] [1.04] [0.62] [1.20] [0.83] [0.67] [1.03]

Crisis dummy 3,946 3,649 4,028 3,138 2,241 2,34 3,341

[2.17]* [1.74] [1.64] [1.75] [1.08] [1.13] [1.22]Strenght of expenditure framework *Output Gap -0,262 -0,262

[2.09]* [2.08]*

Surprises in Revenues growth 0,09[0.46]

Strenght of expenditure framework * Surprises in revenues growth -0,08

[0.86]Electoral cycle 1 2,204

[3.64]***Electoral cycle 2 -0,812

[3.66]***Government Stability -2,699

[3.26]***EDP 0,308

[0.16]Constant -2,941 -2,998 -1,47 -4,148 -0,006 -0,512 -3,079

[0.72] [0.77] [0.39] [0.97] [0.00] [0.13] [0.78]

Observations 108 108 108 108 90 90 108

Number of countries 12 12 12 12 10 10 12

R-squared 0,1 0,11 0,11 0,14 0,13 0,11 0,11

corr u_i and Xb -0,76 -0,76 -0,57 -0,79 -0,52 -0,47 -0,77

adjusted R-squared 0 0,01 -0,01 0,05 0,01 -0,02 0

R-squared overall model 0,02 0,02 0,05 0,03 0,07 0,06 0,02

R-squared within model 0,1 0,11 0,11 0,14 0,13 0,11 0,11

R-squared between model 0,56 0,53 0,58 0,57 0,49 0,38 0,53

standard deviation of epsilon_it 4,52 4,51 4,54 4,42 4,15 4,2 4,53

panel-level standard deviation 2 2,13 1,43 2,55 1,24 1,05 2,17

fraction of variance due to u_i 0,16 0,18 0,09 0,25 0,08 0,06 0,19

Table 3: Determinants of expenditure stanceDependent variable: Deviation of primary spending growth from rule-based growth ratePanel A: Ex-post Nominal Potential GDP (NPG) rule


313

((II)) ((IIII)) ((IIIIII)) ((IIVV)) ((VV)) ((VVII)) ((VVIIII))

Output gap (based on Potential GDP) 0,469 0,429 0,299 0,419 0,277 0,377 0,429

[3.92]*** [2.74]** [2.39]** [3.20]*** [1.94]* [2.58]** [2.72]**

Public debt ratio (t-1) 0,057 0,059 0,031 0,071 0,053 0,044 0,058

[1.19] [1.33] [0.64] [1.40] [1.18] [0.98] [1.33]

Crisis dummy 2,882 2,634 3,267 2,223 1,685 1,793 2,654

[1.56] [1.26] [1.26] [1.22] [0.74] [0.78] [0.90]Strenght of expenditure framework *Output Gap -0,219 -0,219

[1.75] [1.74]

Surprises in Revenues growth 0,172

[0.91]Strenght of expenditure framework *Surprises in revenues growth -0,044

[0.59]

Electoral cycle 1 1,798

[3.40]***

Electoral cycle 2 -0,798

[4.17]***

Government Stability -2,544

[3.48]***

EDP -0,02

[0.01]

Constant -2,808 -2,855 -0,747 -3,792 -0,392 -0,879 -2,85

[0.75] [0.82] [0.22] [0.97] [0.10] [0.23] [0.83]

Observations 108 108 108 108 90 90 108

Number of countries 12 12 12 12 10 10 12

R-squared 0,08 0,09 0,09 0,11 0,14 0,11 0,09

corr u_i and Xb -0,82 -0,82 -0,55 -0,83 -0,61 -0,58 -0,82

adjusted R-squared -0,02 -0,02 -0,02 0,01 0,01 -0,01 -0,03

R-squared overall model 0,01 0,01 0,04 0,01 0,07 0,06 0,01

R-squared within model 0,08 0,09 0,09 0,11 0,14 0,11 0,09

R-squared between model 0,61 0,61 0,58 0,62 0,4 0,37 0,61

standard deviation of epsilon_it 4,34 4,34 4,35 4,28 4,09 4,15 4,36

panel-level standard deviation 2,04 2,16 1,24 2,49 1,36 1,18 2,16

fraction of variance due to u_i 0,18 0,2 0,07 0,25 0,1 0,07 0,2

Table 3. (cont)Panel B: Ex-Post Real Potential GDP +ECB price stability objective (RPECB) rule

Notes: Baseline (I), Baseline + Institutional framework (II and III), Baseline + electoralcycle and government stability , (IV - VI) and Baseline + European Institutions(VII).Source: Hauptmeier, S., Sánchez-Fuentes, A.J. & Schuknecht, L. (2011)

also control for government stability as measured by the respective

index of the World Bank and find that the policy stance on the spen-

ding side is less expansionary if a government scores a higher value.

Most interestingly from a policy perspective, our results suggest

that the country-specific institutional framework exerts a significant

effect on the expenditure stance. In particular, we control for the

extent to which national expenditure policy faces domestic institu-

tional constraints using the expenditure rules index as developed by

Debrun et al. (2008).7 We interact this index with the output gap to

analyse to what extent strong institutions reduce spending profli-

gacy and find that, indeed, the strength of the national institutional

framework on the expenditure side significantly reduces the pro-

cyclicality of the expenditure stance. This finding is along the lines

of Holm-Hadulla et al (2010), Turini (2008) and Wierts (2008). At the

same time, the EDP dummy which is included to capture whether a

country is facing an excessive deficit procedure (EDP) due to deficits

above the 3% of GDP reference value of the Stability and Growth

Pact, does not turn up significantly in our regressions.

The results on the impact of fiscal institutions may be put into

the perspective of the recent efforts to strengthen the European fis-

cal framework. One of the lessons from past fiscal developments in


314

7 For a definition and a detailed description of the computation of this index see

European Commission (2006) and Debrun et al. (2008). The index takes into account

the share of public spending covered by the rule and qualitative features such as the

type of enforcement mechanisms and media visibility.

euro area countries is that the implementation of the Stability and

Growth Pact has not been effective in delivering sound and sustai-

nable fiscal positions in Member States. While one has to be care-

ful when interpreting the non-significance of the effect of the EDP

procedure dummy, the result is in line with this perception.

Moreover, the empirical analysis suggests that national budgetary

rules if well-designed can help to effectively reduce spending pro-

fligacy and therefore serve as important tools to promote sound

and sustainable public finances in line with the European fiscal fra-

mework. This reinforces the need for enhancing national fiscal

rules and frameworks as had been proposed by the European

Commission in the autumn of 2010.

3.3. Implications for public debt

Based on the analysis presented in Section 3.1, it is possible to

compute to what extent deviations of expenditure growth from

trend led to increases in government debt. Chart 4 shows alterna-

tive debt paths for the sample economies and across expenditure

rules. Consistent with the previous results, real time rules typically

lead to higher debt paths than ex-post rules. In the case of France,

for example, following a neutral expenditure path since 2000

would have resulted in a significantly lower debt ratio in 2010, i.e.

between 70% and 75% of GDP. If Italy had followed a neutral spen-

ding path, public debt would now stand roughly between 80% and

100% of GDP in 2010, rather than at around 120% of GDP.


315

For a second group of countries (Spain, Greece, Ireland and

Portugal), the difference becomes even more drastic. Neutral spen-

ding policies in Portugal would have led to debt ratios of 40-60% of

GDP in 2010 rather than over 80% of GDP in reality. Spanish debt

would have been at a trough of 10-40% in 2007-08 and would have

remained well below the reference value in 2009 under all rules.

Ireland would have just about eliminated all its debt in good times

and thus created significant room for the subsequent rise. Under all

rules, debt would have remained below 60% of GDP in 2010.

Finally, Greek public debt would have fallen to 60-80% of GDP (rat-

her than remain broadly constant around 100% of GDP until the

start of the crisis) and increased much more slowly in the crisis.

All in all, public debt positions in the euro area would have

been much sounder at the start of the crisis and in 2010, if euro

area countries had pursued at least a neutral expenditure stance on

average during EMU. Public debt could have been well around or

below the reference value in the euro area in most of its members

by 2010 and nowhere above 100% of GDP.

4. Looking backward to the past, lessons for the future? anepisodes based approach

In an earlier study, Hauptmeier, Heipertz and Schuknecht

(2007) looked at the experience with public expenditure reform in

the 1980s and 1990s. They found that there were basically two


316


317

Chart 4: Public debt ratios - actual vs. rule-basedEuro area (12)

Germany


318

Chart 4: (cont.) Public debt ratios - actual vs. rule-based

France

Italy


319

Chart 4. (cont.) Public debt ratios - actual vs. rule-based

Spain

Greece


320

Chart 4: (cont.) Public debt ratios - actual vs. rule-based

Ireland

Portugal

reform waves in industrialised countries. Moreover, they found

that there were three groups of countries: (i) ambitious, (ii) timid

and (iii) non-reformers. Ambitious reformers were those that

managed to reduce public primary (non interest) expenditure by

more than 5pp of GDP from their peak within 7 years. Timid refor-

mers were those that cut primary spending between 0 and 5pp and

non-reformers never undertook much of a cut at all. These coun-

tries and country groups, the time and size of the maximum expen-

diture ratio and the change in the expenditure ratio within years

(T7) as reported in Hauptmeier et al. (2007) are depicted in Table 4.

The study argued that conceptually, reforms needed to be ambi-

tious in order to make a significant difference for the resulting

public deficits and adverse debt dynamics. The more ambitious they

were the more they would even allow tax cuts. Already in the 1980s,

Ireland, Belgium, the UK, Luxembourg and the Netherlands had sig-

nificantly reduced their public expenditure ratio. The UK, Ireland

and the Netherlands did so again in the 1990s plus a number of

other countries: Finland, Sweden, Canada and Spain. Four countries

reduced public primary expenditure by more than 10% of GDP.

During this period, 10 countries undertook timid expenditure

reforms (amongst them the US, France, Germany and Italy at which

we will look again later). The three non-reformers included

Australia, which had always maintained a rather small government

sector, and Portugal and Greece.


321

It is, however, not just the magnitude of spending and reform

that is important but also the composition. The literature (e.g.,

Alesina and Perotti, 1995 and 1997) argues that reductions in

public consumption/wages and transfers and subsidies are particu-

larly “high quality”. They increase the chance of success of reform

by providing a strong signal of “willingness” and cuts tend to focus

on unproductive expenditure.


322

Max. primary expenditurein year

Change maximum to T7

AAmmbbiittiioouuss'' rreeffoorrmmeerrssFinland 1993 -14,0Sweden 1993 -14,0Ireland (Phase 1) 1982 -12,4Belgium (Phase 1) 1983 -12,3Canada 1992 -9,5United Kingdom (Phase 1) 1981 -8,2Netherlands (Phase 2) 1993 -7,5United Kingdom (Phase 2) 1992 -7,2Spain 1993 -6,4Ireland (Phase 2) 1992 -6,2Luxembourg 1981 -5,7Netherlands (Phase 1) 1983 -5,1

TTiimmiidd'' rreeffoorrmmeerrssAustria 1993 -4,3Denmark 1993 -3,9New Zealand 1985 -3,8United States 1992 -3,4Italy 1993 -3,0Japan 1998 -2,7Belgium (Phase 2) 1993 -2,1Germany 1996 -0,6France 1996 -0,5Switzerland 1998 -0,3

NNoonn'' rreeffoorrmmeerrssPortugal 2004 0,0Greece 2000 0,4Australia 1985 0,4

TTaabbllee 44:: EExxppeennddiittuurree rreeffoorrmm pphhaasseess 11998800ss aanndd 11999900ss

Table 5 illustrates that much of the expenditure cuts of

ambitious reformers came from transfers and subsidies and also

from government consumption. About two-thirds of the reduc-

tion in the total expenditure ratio and over 80 per cent of the

decline in the primary expenditure ratio occurred in these two

categories. Nine out of 11 reform episodes reported a decline in

public consumption by more than 2 per cent of GDP and eight

out of 11 featured a fall in transfers and subsidies by over 3 per

cent of GDP. At the same time, in most cases, government

investment and public education expenditure did not decline

disproportionately or in some cases even increased as a share of

GDP. Timid reformers did not report much of a decrease in

public transfers and subsidies and focussed on public invest-

ment in some cases and on public consumption including edu-

cation in others.

The study by Hauptmeier et al. (2007) also argued that public

expenditure reform needed to be part of a comprehensive overall

structural reform strategy. It was argued on the basis of the litera-

ture that this would allow the improvement in public finances not

only via less spending but also via better growth prospects. An

overview of the reforms undertaken by ambitious countries is

reported in Table 6. Most of the ambitious reformers undertook

major reforms that were complementary to expenditure retrench-

ment. Most countries strengthened their national fiscal institu-

tions. This not only facilitated fiscal retrenchment but also tended


323


324

Change T0-T7

Total

expenditure

Interest

Spending

Primary

expenditure

Government

consum

ption

Government

investment

Transfers

and

Subsidies

Health

Education

Pensions

AAmmbbiittiioouuss''

rreeffoorrmmeerrss

Finland

-15,7

-1,6

-14,0

-3,8

-0,3

-9,4

-1,3

-1,8

-1,5

Sweden

-15,7

-1,8

-14,0

-2,8

-0,9

-8,0

-0,4

0,2

-1,7

Ireland (P

hase 1)

-13,3

-1,0

-12,4

-5,2

-3,2

-2,2

-1,7

-0,9

-0,7

Belgium (P

hase 1)

-10,9

-4,8

-6,2

-3,9

1,0

-4,7

-0,5

-0,9

-1,6

Canada

-11,4

-1,7

-9,5

-5,3

-0,5

-3,3

-1,1

-1,9

-0,2

United Kingdom (P

hase 1)

-10,5

-2,3

-8,2

-2,5

-0,3

-2,0

-0,3

-0,8

-0,5

Netherla

nds (Phase 2)

-9,8

-2,3

-7,5

-1,9

0,1

-6,5

-0,8

-0,4

-1,2

United Kingdom (P

hase 2)

-7,1

0,1

-7,2

-2,7

-1,1

-2,6

-0,1

-0,8

-0,4

Spain

-8,2

-1,8

-6,4

-1,5

-1,0

-4,1

-0,4

0,0

0,2

Ireland (P

hase 2)

-10,9

-4,8

-6,2

-3,9

1,0

-4,7

-0,5

-0,9

-1,6

Luxembourg

-5,9

-0,4

-5,7

-1,4

-2,1

0,0

0,1

-1,6

-0,8

Netherla

nds (Phase 1)

-5,0

0,2

-5,1

-2,0

-0,2

-2,2

-0,1

-1,1

0,4

TTaabbllee 55:: CCoomm

ppoossiittiioonn ooff eexxppeennddiittuurree rree

ffoorrmm

to make future budgetary control and thus the avoidance of fiscal

problems more likely.8 A number of countries devalued their

currencies. All ambitious reformers initiated significant labour

market reforms that improved work incentives. All but one

country reformed the tax system. And most countries reduced the


325

Expenditure reform

Institutionalreform

Other macroeco-nomic reform

Structural reform

Publicconsumption

1/

Transfers &subsidies 1/

Labourmarketincenti-ves

Taxation Privatisation

Ireland 1 XX XX X X X X X

Ireland 2 X XX X X X X

Sweden X XX X X X X X

Canada XX XX X X X X

Finland XX XX X X X X X

Belgium XX XX X X

Netherlands 1 X X X X X X

Netherlands 2 ~ XX X X X X

Spain ~ XX X X X X

UK 1 X X X X X X X

UK 2 X X X X X

All 99 1111 1100 66 1111 1100 88

TTaabbllee 66:: SSuummmmaarryy ffiinnddiinnggss ffoorr aammbbiittiioouuss rreeffoorrmm eeppiissooddeess

8 For the importance of fiscal rules and institutions, see, e.g., Poterba and Von Hagen

(1999). Debrun et al. (2008) and Holm-Hadulla et al (2011) focus on the numerical fis-

cal rules in EU countries.

role of the state in the economy via privatisation.

Based on the fact that the reforming countries fulfilled the con-

jectures of ambition, high quality and comprehensive reforms it is

not surprising that the impact on public finances and the economy

were quite positive, compared to timid reformers (Chart 5). Panel

a) shows that ambitious reformers (here differentiating early and

late reformers) brought the public expenditure ratio down signifi-

cantly to levels similar or lower than those of timid reformers. This

was mainly achieved through cuts in public consumption and

transfers and subsidies while public investment did not change

much, at least for late ambitious reformers (see panels b)-d)). Panel

e) illustrates that public deficits were brought down very substan-

tially by ambitious reformers. The group of late reformers even rea-

ched sizable surpluses. As regards public debt developments (panel

f)), timid reformers did not achieve any significant reversal in debt

dynamics. Ambitious reformers, by contrast, managed to bring

debt down once fiscal balances had been sound enough.

Contrary to the concerns of vocal special interests and politi-

cians, ambitious expenditure reforms had very little (if any) adver-

se growth impact even in the very short run while the medium to

long term impact was very positive. Ambitious reformers experien-

ced a significant increase in trend growth by 1-2 percentage points

(panel g). By contrast, timid reformers experienced no such incre-

ase. Real private consumption started to recover as of the first year

of public expenditure reduction and accelerated more strongly

where ambitious reforms were undertaken (panel g). Private invest-


326


327

Chart 5: Ambitious vs. timid reforms, 1980s and 1990s.a) Total public expenditures

b) Public consumption


328

Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.c) Transfers and subsidies

d) Public investment


329

Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.e) Fiscal balance

f) Public debt


330

Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.g) Trend growth

h) Real private consumption

ment initially declined or was flat and showed a relatively less

favourable trend than for timid reformers but this reversed in the

medium term. In the seventh reform year, the private investment

ratio of timid reformers had increased by 1pp of GDP while that of

ambitious reformers had increased by 2-3pp (panel i).

In a next step we assess recent and projected fiscal develop-

ments for 2012 and 2013 in selected euro area countries as well as

the UK and the US in the light of the evidence from past expendi-

ture reform periods described above. We do this on the basis of the

latest European Commission forecast (Autumn 2011) (see Table 7).

For the US we consider the latest IMF World Economic Outlook


331

Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.i) Private investment

Source: Hauptmeier, S., Heipertz, M. & Schuknecht, L. (2007)

projections. For all sample countries, the projections point to sig-

nificant primary expenditure reductions for the period up to 2013

(with the exception of France). This ranges from about 3-4pp of

GDP for Germany, Italy and the US to over 5pp in the UK and

Spain and to 7 to 10pp in the EU/IMF programme countries.

Expenditure reductions show a more or less linear pattern in most

countries. In the case of the US, the primary expenditure ratio

went down quite strongly in 2010. However, it is expected to decli-

ne only by another 1pp of GDP over 2011-13.


332

% of GDP PPrriimmaarryy eexxppeennddiittuurree

Actual Forecast

2009 2010 2011 2012 2013 2013 to max(0910)

PPrrooggrraammmmee ccoouunnttrriieess

Greece 48,7 44,4 43,6 42,4 41,7 -6,9

Ireland 46,9 43,7 42,1 39,6 37,0 -9,9

Portugal 46,9 48,3 44,9 42,0 39,9 -8,4

LLaarrggee eeuurroo aarreeaa ccoouunnttrriieess

Germany 45,4 45,4 43,3 43,2 42,8 -2,6

France 53,8 54,2 54,0 54,3 53,9 -0,3

Italy 47,1 45,9 44,8 43,8 43,0 -4,1

Spain 44,5 43,7 40,8 39,8 39,3 -5,2

LLaarrggee nnoonn--eeuurroo aarreeaa ccoouunnttrriieess

United States 42,1 39,3 39,6 39,0 38,5 -3,7

UK 49,6 47,7 46,8 45,3 43,9 -5,6

TTaabbllee 77:: EExxppeennddiittuurree ppllaannss

Sources: Actual and forecasts: EU Commission (Ameco), IMF for the US.

If projected spending developments materialise, primary expen-

diture ratios would decline to around 40% of GDP in most coun-

tries. The main exception is France where the ratio would remain

significantly above 50%.

Projected spending developments should also be assessed from

a longer term perspective. When comparing the 2013 figures to the

1999 primary expenditure ratios it is noteworthy that spending

would still be 1-7pp of GDP higher in 2013 than in 1999 for 8 out

of 9 countries. This relative increase would be particularly sizeable

for Ireland, the US and the UK and appears unwarranted in view of

the expected ageing-related increases in social security outlays in

the medium and long-term. Only Germany would post a signifi-

cantly lower primary expenditure ratio than at the start of EMU.

Coming back to the adjustment effort in countries’ expenditure

plans, it is noteworthy that five countries (Ireland, Greece,

Portugal, Spain and the UK) would meet the criteria of ambitious

reformers as applied in the earlier study by Hauptmeier et al. (2007)

whereas a second group of countries could be classified as “timid”

reformers (Germany, USA, and Italy).

5.The need for prudent expenditure rules

The evidence presented in this study supports the view that

public spending has been a major determinant of unsound public


333

finance developments in the past. Looking forward, it therefore

seems plausible to address this fact through the implementation of

prudent expenditure rules. Indeed, empirical studies suggest that

well-designed expenditure rules tend to limit the pro-cyclicality of

public spending (see, e.g. Holm-Hadulla et al (2010)). Recent policy

action in Europe goes in this direction. Notably, the EU fiscal sur-

veillance framework has been extended by a so called “expenditu-

re benchmark” which restricts the growth rate of public spending

net of discretionary tax measures to that of potential growth.

However, this new rule does not take into account some of the pro-

blems we identified in Section 3.1. Most notably, an effective rule-

based restriction of spending policies in real-time requires the

maintenance of a margin of prudence. This is necessary to account

for the tendency of overestimating potential GDP growth in real-

time. Given the past experience of systematic and persistent down-

ward revisions in potential growth, a margin of prudence of ½ pp

in expenditure growth per annum appears warranted. In addition,

excessive price developments should not automatically feed into

higher expenditure growth as expansionary fiscal policies may

accelerate an economic overheating. Therefore, the nominal com-

ponent of an effective expenditure growth rule should be capped,

e.g. at the ECB’s price stability objective (“close to but below 2%”).

Chart 6 shows that the application of such prudent expenditu-

re growth rules during EMU would have resulted in much safer fis-

cal positions. Primary expenditure ratios would have reached

much lower levels in 2009. As a result, also public debt ratios in


334


335

Chart 6: Actual ratios versus neutral expenditure policies-based ratios (based onNPG – ½ pp and RPECB – ½ pp rules), 2009

Panel A: Primary expenditure ratios

Panel B: Public Debt ratios

Note: Includes GDP multiplier and compound interest effects.


336

2009 would have generally been much closer to 60% of GDP with

the highest ratio of around 90% in Italy. It is important to note,

however, that the proposed expenditure rules are intended to pro-

vide guidance for an appropriate, i.e. neutral, policy stance in the

absence of fiscal imbalances. Any fiscal adjustment, e.g. to regain

sound fiscal positions in the aftermath of the crisis, would of cour-

se require a restrictive policy stance, i.e. spending growth rates

below potential GDP growth.

6. Concluding remarks

What are the main findings of this study and what policy lessons

can be drawn? Public finances in advanced economies are at a cross-

roads. In the fifth year of the crisis, fiscal deficits remain high and

public debt has reached unprecedented peace-time levels in most

industrialised countries. Public primary expenditure stands at or

near historical peaks in many countries and therefore constitutes an

important determinant of the fiscal imbalances. It therefore seems

straight forward to focus on expenditure restraint when striving to

regain sound fiscal positions in the aftermath of the crisis.

In the 1980s and 1990s a number of countries undertook ambi-

tious expenditure reforms. Their experience, which was briefly

reviewed here, has been very positive. Within a few years from the

start of expenditure reform, public expenditure ratios went down

significantly, fiscal deficits largely or fully disappeared, public debt

was brought on a downward path, and economic growth and pri-

vate consumption resumed swiftly. We argue that this was because

ambitious expenditure reform was conducted in a growth-friendly

manner as part of comprehensive adjustment programmes.

Our study emphasises the key role of expenditure policies in

explaining fiscal developments during EMU in the euro area. It finds

that, almost all euro area countries (with the notable exception of

Germany) applied expansionary expenditure policies already before

the crisis. This resulted in much higher expenditure and debt paths

compared to a counterfactual neutral expenditure stance. Rules-

based spending policies could have led to much safer fiscal positions

much more in line with the EU’s Stability and Growth Pact (SGP).

The policy recommendations from these findings are obvious:

countries should focus on reducing public spending in the context

of ambitious reform programmes. Spending based consolidation

efforts need to be complemented by structural reforms, notably

with a view to removing rigidities in national labour and product

markets, to reduce macroeconomic imbalances, improve competi-

tiveness and support potential growth. This will be particularly

important for the vulnerable countries in the euro area which do

not have available the exchange rate mechanism to improve exter-

nal competitiveness. Latest projections suggest that governments’

consolidation plans in a number of countries indeed put a focus on

reducing government expenditure as a ratio to GDP in the coming

years. However, the benefits of reforms are only going to materia-


337

lise under one condition, namely that all these plans are fully and

adequately implemented. This is their main challenge.

In addition, the empirical evidence on the determinants of euro

area countries’ expenditure stance provide a number of policy

implications. First, strong national budgetary institutions seem to

limit expansionary spending biases. Second, the European institu-

tional framework needs to feature prominently expenditure moni-

toring and control. The incorporation of an expenditure bench-

mark in the preventive arm of the Stability and Growth Pact in the

context of the recent “Six-Pack” reform therefore constitutes a step

in the right direction. An effective enforcement of this rule should

help to limit overly expansionary spending policies in the future.

Furthermore, this chapter argues that a potential growth rule

with an extra ½ percentage point deduction from the resulting

annual expenditure growth targets would be a sufficiently prudent

and, thus, advisable expenditure rule for euro area countries. As

economic (e.g., population aging) and political economy reasons

suggest that overestimating potential growth could also occur in

the future, such a rule could provide a reasonably prudent bench-

mark for a neutral expenditure stance looking forward.

How does the debate on the overhaul of European economic gover-

nance fare against these conclusions? At the time of completing this

study (March 2012), EU member states have set up new EU economic

governance principles with a view to ensuring a tighter and more


338

effective surveillance of economic and fiscal policies at the European

level. At the same time, policy makers have agreed - in the context of

the new fiscal pact - to strengthen national fiscal frameworks.

All in all, a stringent implementation and enforcement of the

fiscal surveillance at European level could well ensure the necessary

break with past expenditure trends and thus also secure sustainable

deficits and debt dynamics in the future. However, it remains to be

seen whether the main obstacle of the “old framework”—lack of

incentives and enforcement—is really sufficiently remedied.

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341