Restructuring the economic and monetary union Zsolt Darvas Bruegel, Corvinus University, IE HAS IKV Events on the Euro Crisis 24 February 2012, Istanbul

The aggregate fiscal position of the euro area is better than that of the US – Why is the € in crisis? 2 Note: US general gov debt also includes the debt of states and local governments (IMF and EC data only report federal debt)

Outline 1.Major reasons behind euro-area problems 2.The EU’s policy response so far 3.What to do? 3

1. Major reasons behind Euro-area problems (1) Pre-crisis - weak governance & incomplete economic integration: 1.The rules-based Stability and Growth Pact failed  High public debt in Greece and Italy at the outbreak of the crisis 2.Sole focus on fiscal issues  Unsustainable credit and housing booms in some countries (eg Ireland and Spain)  Structural imbalances (eg current account, wage) developed 3.No proper mechanisms to foster structural adjustment  Disappointing growth performance in some countries even before the crisis (eg Italy, Portugal) 4.No crisis resolution mechanism  Sovereign debt and banking crises came as a surprise 4

Paul De Grauwe (2011): EMU is shockingly fragile 5 Illustrated by comparison between Spain and the UK

1. Major reasons behind Euro-area problems (2) The crisis revealed more fundamental problems: 1.Strict no-monetary financing by the ECB/Eurosystem  no lender of last resort (cf. Spain vs. the UK)  Sovereign borrowing is like borrowing in a ”foreign” currency 2.National bank resolution regimes & large home bias in banks government bond holdings  Lethal correlation of banking and sovereign debt crises 3.Interdependence across countries  Fall of a ”small” country can create contagion, fall of a ”large” country leads to meltdown 4.Downward spiral in adjusting countries  Vicious circle of fiscal austerity and low growth in the absence of a stand-alone central bank 5.Negative feedback loop between the crisis and growth  No euro-area level macro policy 6.Governance crisis: partial, inadequate and belated responses  Lost policy credibility 6

2. The EU’s policy response so far ECB unlimited liquidity support to banks  very effective, yet the ECB can turn into a bad bank should the banking crisis escalate Strengthened governance, including surveillance & sanctions (6- Pack, Fiscal compact, European Semester, assessment of excessive private sector imbalances)  some helpfuls aspects, can be useful once the crisis is solved and there is no more recession, but won’t solve the crisis, and the fiscal compact will lead to procylical fiscal policy during recessions Financial backstop to sovereigns (bilateral loans to Greece, EFSF, EFSM, ESM)  but limited lending capacity ECB purchase of government bonds at the secondary market  but temporary, limited, and ”only to help monetary transmission” New institutions for financial stability (eg ESRB, EBA)  but with limited powers Stress testing of major European banks  discredited almost immediately 7

The EU’s policy response – Overall assessment New governance framework addresses only 3 of the 4 pre- crisis flaws of the euro area SGP: focus on debt as well Excessive Imbalance Procedure (EIP): focus on private sector vulnerabilities European Semester: fostering structural adjustment Not well addressed: no proper way to address sovereign debt and banking crises With a lot of luck – the strategy might work But the strategy does not address the fundamental problems revealed by the crisis: No lender of last resort for sovereigns Lethal correlation of banking and sovereign debt crises Interdependence across countries Downward spiral in adjusting countries Negative feedback betwen crisis and growth Governance crisis Markets may deny funding from Italy (and Belgium and Spain) and nobody knows what will come afterwards 8

3. What to do?  Address the fundamental problems revealed by the crisis Restore lender of last resort for sovereigns  ECB – note: I do not like money printing! Break the lethal interdependence of banks and sovereigns  Banking federation (centralised regulation, supervision, resolution, deposit guarantee)  Limit bank holdings of government debt  Eurobond Address interdependence across countries  Banking federation Downward spiral in adjusting countries  ’Federal’ economic stabilisation/risk-sharing instrument Negatve feedback loop between crisis and growth  Euro-area fiscal policy; Banking federation Governance crisis  Strengthen centralised decision making instead of inter-governmentalism Note: a (limited) budget is needed for a banking federation & stabilisation, but need not be more redistribution 9

What fiscal integration? Sometimes regarded as magic bullet, but what fiscal integration? More coordination & survelliance  would not be enough Veto power over national budgets, ie partial loss of national sovereignty  may be necessary More redistribution or transfers  no Stabilisation instruments (ie when there is a common economic shock)  yes Risk-sharing (ie when there is an asymmetric economic shock)  yes Banking federation, ie centralised bank regulation, supervision, resolution and deposit insurance  yes Central taxing power  yes (but limited, needed for the above three tasks) Eurobonds  yes, but with what governance? Financed by federal taxes or national contributions? And how to merge existing debt? I.e.: Should the federal tax rate be the same in Estonia (8% debt today) and Italy (120% debt today)? 10

Conclusions The new European economic governance framework: several useful instruments that will improve the functioning of the EU and the euro area But largely addresses 3 ( public debt, private sector vulnerabilities, fostering adjustment ) of the 4 pre-crisis flaws ( still no proper crisis resolution mechanism ) With a lot of luck, the new governance framework along with other crisis management instruments might work But: does not address the fundamental problems revealed by the crisis ( lender of last resort for sovereigns, interdependence of banks and sovereigns, interdependence across countries, downward spiral in adjusting countries, negative feedback between crisis and growth; governance crisis )  current governance framework is unlikely the ultimate solution Limiting national fiscal sovereignty and setting-up ’federal’ functions, such economic stabilisation, economic risk-sharing and banking resolution/deposit guarantee Limited Eurobond (Bruegel, EC) or Debt Redemption Fund (German Council of Economic Experts) would improve governance and crisis resolution a lot – much better than ECB financing of public debt 11