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The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics

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Page 1: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

The Sovereign Debt Crisis and the Future of the

Eurozone

Paul De Grauwe

London School of Economics

Page 2: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Outline of presentation

• Legacy of the sovereign debt crisis

• Design failures of Eurozone

• Redesigning the Eurozone:

o Role of central bank

o Role of banking union

o Towards a budgetary and political union?

Page 3: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Eurozone split into creditor and debtor nations

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Figure 5: Cumulated current accounts

Belgium

Germany

Ireland

Greece

Spain

France

Italy

Netherlands

Austria

Portugal

Finland

Page 4: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Creditor nations have imposed their rule:

Thou shall repay thy debt

• In order to achieve this, austerity rule is

imposed

• This has created asymmetric adjustment

mechanism where most of the adjustment

has been borne by the debtor nations

• Without compensating stimulus by the

creditor nations

Page 5: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

90

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Relative unit labour costs Eurozone: debtor nations

Italy

Ireland

Spain

Portugal

Greece

Page 6: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

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Relative unit labour costs Eurozone: creditor nations

Finland

Belgium

Netherlands

France

Austria

Germany

Page 7: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Asymmetric adjustment mechanism has created

deflationary bias in the Eurozone

• Leading to significant poorer economic

developments in Eurozone as compared to rest of

developed economies

Page 8: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Stagnation in Eurozone

90

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135

2000 2002 2004 2006 2008 2010 2012 2014

ind

ex 2

000=

100

Figure 1: Real GDP in Eurozone, EU10 and US

(prices of 2010)

Eurozone

EU10

US

Page 9: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Increasing unemployment

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Figure 5: Unemployment rate in Eurozone, EU10 and US

Eurozone

EU10

US

Page 10: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Increasing savings as a result of austerity

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2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1 2012Q3 2013Q1 2013Q3 2014Q1 2014Q3

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DP

Figure 6: Current account Euro area

Page 11: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Deflation threat

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Figure 7: Inflation in US and Eurozone

US Eurozone

Page 12: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Most striking feature of legacy of Eurocrisis is

that despite intense austerity programs that

have been triggered since 2010

• there is no evidence that these programs

have increased the capacity of the

governments of the debtor countries to

continue to service their debt

• On the contrary: deflation makes it harder to

reduce debt burdens

Page 13: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Secular stagnation increases debt burdens

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Figure 4: Gross government debt to GDP ratio

Ireland

Greece

Spain

Italy

Portugal

Page 14: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Pain in Spain

Debt to GDP dynamics:

∆D = (r – g)D – S

S = primary budget surplus,

r = nominal interest rate on the government debt,

g = nominal growth rate of the economy

D = government debt to GDP ratio.

Let us contrast Spain and the UK

Page 15: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

0

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Figure 3: 10-year Government bond yields

UK

Spain

Page 16: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

-5%

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Figure 4: Nominal growth GDP in UK and Spain

UK

Spain

Page 17: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

-3%

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Figure 5: Nominal interest rate - nominal growth rate

UK

Spain

Page 18: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline
Page 19: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

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Figure 2: Government Debt to GDP ratio in Spain and UK

Spain UK

Page 20: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

TINA • Is austerity not a necessary price to pay in order to

redress the disequilibria in the Eurozone?

• Issue is not whether the periphery had to engage in

austerity or not. They had to (although they should

have been allowed more time).

• The issue is whether for the Eurozone as a whole a

more symmetric adjustment may not have

improved the unfavourable tradeoff between

budget balance and economic growth in the

periphery.

Page 21: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• It is my contention that a more symmetric fiscal

adjustment (creditor nations stimulate their

economies)

• would have reduced the price the periphery had

to pay (in terms of lost output) to achieve a given

improvement in their government budget balances.

Page 22: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Fallacy of composition • The imposition of austerity programs in the Eurozone

has been victim of the “fallacy of composition”.

• What works for one nation fails to work when everybody applies the same policies.

• When one nation is forced to deleverage through austerity (i.e. is trying to save more) this may work when it is alone to do so.

• When, however, all the countries try to save more at the same time, i.e. they all attempt to create current account surpluses, each country’s attempt to do so makes it harder for the others to achieve their objectives, forcing them to increase their austerity efforts.

• In the end, they are not more successful but GDP will be lower everywhere.

Page 23: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

European Commission: the

agent of creditor nations • European Commission as the guardian of the

interests of the Eurozone as a whole did not take

the system-wide implications of generalized

austerity programs into account.

• This may have something to do with the fact that

the Commission acted as an agent defending the

interests of the creditor nations,

• and not the interests of the Eurozone as a whole

Page 24: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Austerity also leads to breakdown of social security

• I look into how two different categories of

spending for social security have been

affected

o Health care

o Social protection

Page 25: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Health spending most affected

y = -2,4101x + 2,2161

R² = 0,6061

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)

austerity(percent GDP)

Austerity and real growth in health spending (2009-11)

Page 26: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

y = -0,3556x + 2,321

R² = 0,2093

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austerity (% GDP)

Austerity and real growth spending social protection (2009-11)

Page 27: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Eurozone undermines legitimacy of governments

• Austerity undermines legitimacy of

governments that entered Eurozone with

mandate to provide some protection

against booms and busts of capitalism

• This mandate is being eroded.

• At the same time austerity has weakened

capacity of governments to service their

debts

Page 28: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Sooner or later political systems in periphery

will crack under the burden

• Especially when it is recognized that the

benefits of austerity are for the rich creditor

nations,

• Success of Syriza and Podemos is direct

result of this failed policy

Page 29: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Options for the future

1. Solving legacy of eurocrisis

o Debt restructuring

o Debt monetization?

2. Correcting for design failures

Page 30: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Solving legacy problem

• legacy of the crisis has led to unsustainable

debt levels

• Debt default (restructuring) in a number of

countries will be inevitable

• Only issue: when?

Page 31: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline
Page 32: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Rational solution dictates that creditor

nations accept a loss now (after all they

are equally responsible for the mess)

• Unlikely to happen

• Large part of claims are now in public

hands o In many Northern countries, Manichean views of

good and evil prevail, leading to an emotional

desire that evil be punished.

o This attitude makes it difficult for politicians in these

countries to choose the rational outcome that

would increase economic welfare for everybody.

Page 33: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Eurozone’s design failures

and the role of the ECB

Paul De Grauwe

Page 34: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Eurozone’s design failures: in a nutshell

1. Dynamics of booms and busts are endemic in

capitalism

o continued to work at national level and monetary union in no

way disciplined these into a union-wide dynamics.

o On the contrary the monetary union probably exacerbated

these national booms and busts.

2. Stabilizers that existed at national level were stripped

away from the member-states without being

transposed at the monetary union level.

o This left the member states “naked” and fragile, unable to deal

with the coming disturbances.

3. Deadly embrace sovereign and banks

Let me expand on these points.

Page 35: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Design failure I

Booms and bust dynamics: national

• In Eurozone money is fully centralized

• All the rest of macroeconomic policies is organized at national level

• Thus booms and busts are not constrained by the fact that a monetary union exists.

• As a result, these booms and busts originate at the national level, not at the Eurozone level, and can have a life of their own for quite some time.

• At some point though when the boom turns into a bust, the implications for the rest of the union become acute

Page 36: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Monetary union can exacerbate

national booms and busts

• In fact the existence of the monetary union can

exacerbate booms and busts at the national level.

• This has to do with the existence of only one policy

interest rate when underlying macroeconomic conditions

are very different.

• The fact that only one interest rate exists for the union

exacerbates these differences,

o i.e. it leads to a stronger boom in the booming countries and

o a stronger recession in the recession countries than if there had

been no monetary union.

Page 37: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Design failure II:

no stabilizers left in place

• Lender of last resort existed in each member country at

national level.

• Absence of lender of last resort in government bond market

in Eurozone

• exposed fragility of government bond market in a monetary

union

Page 38: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Fragility of government bond market

in monetary union

• Governments of member states cannot guarantee to

bond holders that cash would always be there to pay

them out at maturity

• Contrast with stand-alone countries that give this implicit

guarantee

o because they can and will force central bank to provide liquidity

o There is no limit to money creating capacity

Page 39: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Self-fulfilling crises

• This lack of guarantee can trigger liquidity crises

o Distrust leads to bond sales

o Interest rate increases

o Liquidity is withdrawn from national markets

o Government unable to rollover debt

o Is forced to introduce immediate and intense austerity

o Producing deep recession and Debt/GDP ratio increases

• This leads to default crisis

• Countries are pushed into bad equilibrium

Page 40: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• This happened in Ireland, Portugal and Spain

o Greece is different problem: it was a solvency

problem from the start

• Thus absence of LoLR tends to eliminate other

stabilizer: automatic budget stabilizer

o Once in bad equilibrium countries are forced to

introduce sharp austerity

o pushing them in recession and aggravating the

solvency problem

o Budget stabilizer is forcefully switched off

Page 41: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Banking crisis

• When investors pull out from domestic bond market,

interest rate on government bonds increases, and

prices plunge; domestic banks make large losses.

• Domestic banks are caught up in a funding problem. – As argued earlier, domestic liquidity dries up (the money stock

declines)

– making it difficult for the domestic banks to rollover their deposits,

except by paying prohibitive interest rates.

• Thus the sovereign debt crisis spills over into a

domestic banking crisis, even if the domestic banks

were sound to start with.

• Deadly embrace between sovereign and banking

sector

Page 42: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Summary

• The Eurozone was left unprepared to deal with

endemic booms and busts in capitalism

o Probably these were even enhanced because of the

existence of the monetary union

• While nothing was in place to stabilize an

unstable system that pushed some countries

into bad equilibria and others in good equilibria

• In fact some of the pre-existing stabilizing forces

were switched off

Page 43: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

How to redesign the Eurozone

• Role of ECB

• Coordination of macroeconomic

policies in the Eurozone

• Political Union o Banking Union

o Fiscal Union

Page 44: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Role of ECB

Page 45: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

The common central bank

as lender of last resort

Liquidity crises are avoided in stand-alone

countries that issue debt in their own

currencies mainly because central bank will

provide all the necessary liquidity to

sovereign.

This outcome can also be achieved in a

monetary union if the common central bank

is willing to buy the different sovereigns’ debt

in times of crisis.

Page 46: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Analogy with banks

• Banks borrow short and lend long

• As a result they are vulnerable to collective

movements of distrust

• When all depositors run to the bank

• Bank does not have liquidity to pay out all

deposit holders

• This fragility has been eliminated by the

implicit guarantee that central bank will

provide liquidity in times of crisis (lender of

last resort)

Page 47: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Governments’ assets and liabilities in a monetary union have the same structure as those of the banks.

• Governments’ liabilities are liquid while most of their assets are illiquid (e.g. infrastructure, tax claims).

• Thus when bondholders massively sell bonds, these governments may not be able to generate enough cash to pay out bondholders at maturity

• That’s why they need central bank

Page 48: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

ECB has acted 2012

• On September 6, ECB announced it will buy

unlimited amounts of government bonds.

• Program is called “Outright Monetary

Transactions” (OMT)

• Success was spectacular

Page 49: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Success OMT-program

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Figure 7: Spreads 10-year government bond rates eurozone

Greece

Portugal

Spain

Italy

Ireland

Belgium

France

Austria

Netherlands

Finland

Page 50: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• This was the right step: the ECB saved the

Eurozone

• But then ECB waited too long to stop

deflationary dynamics

• Only in January 2015 did it act to fight deflation

• QE-programme: monthly purchase of €60 billion

until at least Sept 2016: planned increase in

balance sheet (money base) = €1 trillion

Page 51: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

0

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s Figure 2: Balance Sheet FED and ECB (2004-14)

FED ECB

Page 52: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Role ECB

is put into question again

• German Constitutional Court has declared OMT to be illegal and urges ECJ to impose restrictions on OMT, i.e. its unlimited support

• Only under those conditions is it willing to accept legality

• If accepted OMT would be ineffective and risk of new self-fulfilling crises would emerge again

• Advocate-General of ECJ has made preliminary ruling that OMT is legal according to European law.

• Possible clash between two courts

Page 53: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Criticism of OMT

• Three points of criticism o Inflation risk

o Moral hazard

o Fiscal implications

• Is this criticism valid?

Page 54: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Inflation risk Distinction should be made between money

base and money stock

When central bank provides liquidity as a

lender of last resort money base and money

stock move in different direction

In general when debt crisis erupts, investors

want to be liquid

Page 55: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

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Money Base M3

Figure 1: Money Base, Money Stock (M3) in Eurozone

Page 56: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Thus during debt crisis banks accumulate

liquidity provided by central bank

• This liquidity is hoarded, i.e. not used to extend

credit

• As a result, money stock does not increase; it

can even decline

• No risk of inflation

• Same as in the 1930s (cfr. Friedman)

Page 57: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Deflation threat

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t

Figure 7: Inflation in Eurozone

Page 58: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Moral hazard

Like with all insurance mechanisms there is a risk of moral hazard.

By providing a lender of last resort insurance the ECB gives an incentive to governments to issue too much debt.

This is indeed a serious risk.

But this risk of moral hazard is no different from the risk of moral hazard in the banking system.

It would be a mistake if the central bank were to abandon its role of lender of last resort in the banking sector because there is a risk of moral hazard.

In the same way it is wrong for the ECB to abandon its role of lender of last resort in the government bond market because there is a risk of moral hazard

Page 59: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Separation of liquidity provision

from supervision

The way to deal with moral hazard is to impose rules

that will constrain governments in issuing debt,

very much like moral hazard in the banking sector is

tackled by imposing limits on risk taking by banks.

In general, it is better to separate liquidity provision

from moral hazard concerns.

Liquidity provision should be performed by a central

bank; the governance of moral hazard by another

institution, the supervisor.

Page 60: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• This should also be the design of the governance within

the Eurozone.

• The ECB assumes the responsibility of lender of last

resort in the sovereign bond markets.

• A different and independent authority (European

Commission) takes over the responsibility of regulating

and supervising the creation of debt by national

governments.

• This leads to the need for mutual control on debt

positions, i.e. some form of political union

Page 61: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Metaphor of burning house

To use a metaphor: When a house is burning the fire department is responsible for extinguishing the fire.

Another department (police and justice) is responsible for investigating wrongdoing and applying punishment if necessary.

Both functions should be kept separate.

A fire department that is responsible both for fire extinguishing and punishment is unlikely to be a good fire department.

The same is true for the ECB. If the latter tries to solve a moral hazard problem, it will fail in its duty to be a lender of last resort.

Page 62: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Fiscal consequences

• Third criticism: lender of last resort operations in the

government bond markets can have fiscal

consequences.

• Reason: if governments fail to service their debts, the

ECB will make losses. These will have to be borne by

taxpayers.

• Thus by intervening in the government bond markets,

the ECB is committing future taxpayers.

• The ECB should avoid operations that mix monetary

and fiscal policies

Page 63: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Fiscal implications: one country

• When central bank buys government bonds it

substitutes one type of liabilities of the public sector

with another one.

o Government bonds that promise a fixed interest rate are

replaced by a monetary liability without interest but carrying

an inflation risk.

o Note: if this is done to fight deflation it is welfare improving

• As a result, it changes the budget constraint of the

government.

o By monetizing government debt the central bank relieves the

government from paying interest on the debt.

o This is the moment seigniorage is created.

Page 64: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Most central banks maintain fiction that the government bonds still exist economically by keeping them on their balance sheet.

• These bonds are just a claim of one branch of the public sector (the central bank) against another branch of the public sector (the government).

• These two branches should be consolidated into the public sector and then these claims and liabilities cancel out.

Page 65: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Another way to see the same thing is by

considering the flows.

o When the government bonds are kept on the

balance sheet of the central bank, the

government transfers interest to the central bank.

o The latter then transfers this interest revenue

back to the government.

o They could as well agree to stop this comedy

Page 66: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Implication

• Central bank can write-off these bonds (and reduce

the equity in the same amount; a central bank does

not need equity in contrast to private company).

• This makes no difference for the government budget

(and the taxpayer).

• As long as the money base is not reduced, the

government continues to enjoy the yearly

seigniorage

o that arises from the fact that it does not have to pay interest

on the debt that the central bank has purchased.

• The seigniorage is independent of the value given to

the bonds in the balance sheet of the central bank

and of the equity posted by the central bank.

Page 67: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

What about a monetary union

(Eurozone)? • More complicated in a monetary union where

one central bank faces 19 governments

(Eurozone).

• Complication arises because a bond-buying

program can lead to a fiscal transfer between

member-countries.

• Bond-buying program can be organized in

such a way that it does not lead to fiscal

transfers

• even if one of the participating member

countries’ government defaults.

Page 68: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

How can this be achieved?

• The rule of “juste retour”: the interest on the

government bonds purchased from the

different member countries is returned to the

same governments in the same amounts.

• Such a rule ensures that any write-off of

government bonds due for example to a

default, leaves the taxpayers of the other

countries unaffected.

Page 69: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline
Page 70: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Example: Italy defaults • Suppose after QE Italy defaults on total debt,

quite a catastrophic event

• Italy stops paying interest on €179 billion to the

ECB,

• Under “juste restour” ECB stops paying back the

same amount of interest to the Banca d’Italia

(and hence to the Italian Treasury).

• The other interest flows between the ECB and the

other national central banks remain unaffected.

• There is no fiscal transfer

• German and Dutch taxpayers can sleep quietly:

ECB pays back the same amount of interest he

has paid to the ECB

Page 71: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

What about write-off of Italian

bonds? • ECB just puts value of the Italian bonds

equal to zero and reduces equity by the

amount of the write-off

• This is just an accounting convention

• It does not affect the yearly seigniorage that

the other member countries enjoy

• The latter remains the same as long as the

ECB keeps the money base unchanged

Page 72: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

ECB balance sheet before Italian default (in billion euros A L

Government bonds: 1,000

Money base: 1,000

Page 73: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

ECB balance sheet after Italian default A L

Government bonds: 821 Money base: 1,000 Equity: -179

Total: 821

Page 74: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• The recently announced ECB bond-buying

program has this “juste retour” feature for

80% of the program.

• Technically this is achieved by keeping the

government bonds on the balance sheets

of the national central banks.

• These could also have been kept on the

ECB’s balance sheet using the rule of “juste

retour” described earlier

Page 75: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Coordination of macroeconomic

policies in the Eurozone

Page 76: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Towards symmetric

macroeconomic policies

Stimulus in the North, where spending is below

production (current account surplus)

Austerity in the South (but spread out over more

years)

This also allows to deal with current account

imbalances

It takes two to tango

This symmetric approach should start from the

different fiscal positions of the member countries of

the Eurozone

Page 77: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Coordination of macroeconomic

policies: “Six-pack” measures • “Six pack” of measures strengthening the control on

budgetary policies and coordinating macroeconomic policies have been adopted and are being put into place. o tightening of the mutual control on each member’s

budgetary situation (the so-called Stability and Growth Pact) including a stronger sanctioning procedure;

o the “European Semester”, which requires national governments to present their annual budgets to the European Commission prior to their approval in national parliaments;

o the monitoring of a number of macroeconomic variables (current account balances, competitiveness measures, house prices and bank credit) aimed at detecting and redressing national macroeconomic imbalances;

Page 78: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

However

• This procedure is being implemented in an asymmetric way

• Deficit countries experience much more pressure to act, i.e. to reduce spending than surplus countries

• Competitiveness measures have same problem

o This leads to downward pressure on wages

• Deflationary bias is not solved

• The creditor countries prevail

• Creating political problems

• And rejection of system in which European Commission is seen to defend interests of creditor nations and remains unaccountable

Page 79: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Que faire?

• Policy mix should be:

oMonetary and fiscal expansion

• ECB has started QE

• Fiscal policy should focus on public

investment

• Why?

• It is one of the major victims of ill-advised

macroeconomic policies in Eurozone

Page 80: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Austerity programs led to strong decline in public investment

1,5

1,7

1,9

2,1

2,3

2,5

2,7

2,9

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Tit

olo

ass

e

Figure 8: General government gross fixed capital formation (%GDP)

Page 81: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• Leading to less aggregate demand today

• And less supply in the future

• Thus, start public investments

• These can be initiated everywhere,

• but especially in Germany, a country that

can borrow almost for free

Page 82: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Throw away dogmas

• We have to free ourselves of dogmas

• One such dogma: balanced budget, i.e. no bond

financing of investments

o All investments should be financed by current

revenue

o No well run company follows such a rule

• Result of this idea is that governments are reducing

their responsibility to provide essential public goods

(infrastructure, energy investments, environmental

investments)

• This reduces long-term growth of the Eurozone

Page 83: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Towards a political union

Page 84: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Towards a political union

Two components of political union are

necessary

o Banking Union

o Fiscal Union

Page 85: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Banking Union

• Banking Union is key in resolving the deadly embrace between sovereign and banks

• Three components: 1. Common supervision

2. Common deposit insurance

3. Common resolution

• Common supervision starts now with ECB as the common supervisor of the large banks (covering 85% of bank activities in Eurozone)

Page 86: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• No decision on common deposit insurance

• First steps towards common resolution

o Common resolution fund will be built up

gradually to reach €55 billion

o This is clearly insufficient

o Governance of resolution is so complicated as to

be impractical in times of crisis

Page 87: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Fiscal union

• Only governance that can be sustained in the

Eurozone is one where a Eurozone government

backed by a European parliament acquires

the power to tax and to spend.

• Put differently, the Eurozone can only be

sustained if it is embedded in a fiscal and

political union.

Page 88: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Fiscal union has two dimensions

1. consolidation of national government debts.

o consolidation creates a common fiscal authority

that can issue debt in a currency under the

control of that authority.

o This protects the member states from being forced

into default by financial markets.

o This restores the balance of power in favour of the

sovereign and against the financial markets

Page 89: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

2. mechanism of automatic transfers

o Such a mechanism works as an insurance

transferring resources to the country hit by a

negative economic shock.

o There are limits to such an insurance that arise

from moral hazard risk,

o But it remains true that such a mechanism is

essential for the survival of a monetary union, like

it is for the survival of a nation state.

o Without a minimum of solidarity (that’s what

insurance is) no union can survive.

Page 90: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

• All this is well known.

• It is equally clear that the willingness today

to move in the direction of a fiscal union in

Europe today is non-existent.

• This fact will continue to make the Eurozone

a fragile institution,

Page 91: The Sovereign Debt Crisis and the Future of the Eurozone 2015 (1).pdf · The Sovereign Debt Crisis and the Future of the Eurozone Paul De Grauwe London School of Economics . Outline

Conclusion

• The long run success of the Eurozone depends on

the continuing process of political unification.

• Which includes a fiscal union

• Such a political unification is also needed

because eurozone has dramatically weakened

the power and legitimacy of nation states

without creating a nation at the European level.

• This cannot last

• It is doubtful that there is a will to create such a

political union

• The future of the Eurozone is very much in doubt