The euro area's tightrope walk: debt and competitiveness in Italy and Spain. Bruegel Policy Contribution 2013/11, September 2013

Competitiveness adjustment in struggling southern euro-area members requires persistently lower inflation than in major trading partners, but low inflation worsens public debt sustainability. When average euro-area inflation undershoots the two percent target, the conflict between intra-euro relative price adjustment and debt sustainability is more severe. In our baseline scenario, the projected public debt ratio reduction in Italy and Spain is too slow and does not meet the European fiscal rule. Debt projections are very sensitive to underlying assumptions and even small negative deviations from GDP growth, inflation and budget surplus assumptions can easily result in a runaway debt trajectory. The case for a greater than five percent of GDP primary budget surplus is very weak. Beyond vitally important structural reforms, the top priority is to ensure that euro area inflation does not undershoot the two percent target, which requires national policy actions and more accommodative monetary policy. The latter would weaken the euro exchange rate, thereby facilitating further intra-euro adjustment. More effective policies are needed to foster growth. But if all else fails, the European Central Bank’s Outright Monetary Transactions could reduce borrowing costs.

Fiscal policy, banks and the financial crisis. National Bank of Belgium Working Paper No. 234, October 2012

This paper studies the effectiveness of Euro Area (EA) fiscal policy, during the recent financial crisis, using an estimated New Keynesian model with a bank. A key dimension of policy in the crisis was massive government support for banks—that dimension has so far received little attention in the macroeconomics literature. We use the estimated model to analyze the effects of bank asset losses, of government support for banks, and other fiscal stimulus measures, in the EA. Our results suggest that support for banks had a stabilizing effect on EA output, consumption and investment. Increased government purchases helped to stabilize output, but crowded out consumption. Higher transfers to households had a positive impact on private consumption, but a negligible effect on output and investment. Banking shocks and increased government spending explain half of the rise in the public debt/GDP ratio since the onset of the crisis.

The EMS Crisis of the 1990s: Parallels with the present crisis? CEPS Working Document No. 393, 28 March 2014

The EMS crisis of the 1990s illustrated the importance of a lack of confidence in price or exchange rate stability, whereas the present crisis illustrates the importance of a lack of confidence in fiscal sustainability. Theoretically the difference between the two should be minor since, in terms of the real return to an investor, the loss of purchasing power can be the same when inflation is unexpectedly high, or when the nominal value of government debt is cut in a formal default. Experience has shown, however, that expropriation via a formal default is much more disruptive than via inflation. The paper starts by providing a brief review of the EMS crisis, emphasising that the most interesting period might be the ‘post-EMS’ crisis of 1993-95. It then reviews in section 2 the crisis factors, comparing the EMS crisis to today’s euro crisis. Section 3 outlines the main analytical issue, namely the potential instability of high public debt within and outside a monetary union. Section 4 then compares the pressure on public finance coming from the crises for the case of Italy. Section 5 uses data on ‘foreign currency’ debt to disentangle expectations of devaluation/inflation from expectations of default. Section 6 concludes.

Strengthening the euro area. CHALLENGE EUROPE Issue 22. Challenges and new beginnings: Priorities for the EU's new leadership, September 2014

Since 2007, a series of acute crises have threatened the very existence of the euro area. The financial crisis which spilled into the currency union in 2007 was followed by an unexpectedly strong downturn of the real economy. As of 2010, the euro area was confronted with a severe sovereign debt and banking crisis. Despite these troublesome developments, the euro area has proven to have a considerable degree of resilience. In each phase, governance weaknesses were revealed – and national governments together with the EU institutions have designed an impressive series of policy responses in crisis management and institutional innovation. The euro area today is completed by a banking union with a Single Supervisory and a Single Resolution Mechanism. National budgetary and economic policies are more closely overseen and coordinated. With the European Stability Mechanism, the euro area now has a permanent tool in place to manage sovereign liquidity crises and instabilities in the banking sector. Most importantly, the euro area's only true federal institution, the European Central Bank (ECB), has become its most effective crisis manager: with the announcement of its Outright Monetary Transactions (OMT) programme, the ECB finally managed to calm the self fulfilling crisis in 2012. Meanwhile, the announcement of credit easing and quasi-quantitative easing in September 2014 is a move towards reducing financial fragmentation and countering deflation. The euro area in 2014 is hence a lot different from the one in 2007. And yet, further challenges need to be overcome. Prevailing stagnation, fragmentation and problems of legitimacy require a rethink of policies and further governance reform.

The Financial Crisis and the Future of the Eurozone. Bruges European Economic Policy (BEEP) Briefing 21/2010

The government debt crisis, erupted in the Eurozone in 2009, nearly led to the collapse of European monetary union. Now that this has been averted, the question is what should be done to make the Eurozone sustainable in the long run. The survival of the Eurozone hinges on the capacity of its leaders to improve the eurozone's governance. With the exception of Greece, the root cause of the government debt crisis has little to do with the poor performance of the SGP, rather, with unsustainable debt accumulation by private actors. Also, the method of convergence implicit in the SGP has not worked well – macroeconomic divergences have stubbornly remained for nearly a decade and several countries experienced boom and bust dynamics. Although strong declines in real interest rates may explain part of the story (but e.g. Italy did not experience boom & bust), self-fulfilling waves of optimism and pessimism which might be called 'animal spirits' and are of mainly national origin, seem a good candidate for explanation. These national animal spirits endogenously trigger credit expansion and contraction. It follows that (national) movements of credit ought to be under much firmer control and this is up to the monetary authorities, including the ECB. Critical recommendations for better governance of the Eurozone should therefore combine credible measures to maintain fiscal discipline over the medium term with such instruments as minimum reserve requirements to control the growth of bank credit as well as minimum reserve requirements in different national banking systems. Finally, the idea of adding more sanctions to the SGP may be ill-conceived since, in future, it might pre-empt national governments to come to the rescue of banks (under credible threats of contagion) and/or prevent a downward spiral in economic activity.

The Ghost of Deflation Past. CEPS Hi-level Brief, 13 December 2013

This note takes a look at the development of monetary aggregates and debt in the G7 (US, UK, France, Germany, Italy, Canada and Japan), plus non-G7 euro-area countries, which have an important bearing on the future development of price levels. It also discusses the problem of restoring external competitiveness in the weaker euro-area countries without aggravating their debt burden. The key conclusions are i) monetary and debt developments in the G7 countries point to relatively sluggish growth but do not signal deflation risks and ii) the realignment of ‘internal real exchange rates’ in the euro area will most likely come through a rise in prices in Germany (and a few other stronger countries). The lessons learned in the early 1930s have made a come-back of deflation quite unlikely.

The Eurozone crisis and the erosion of democratic legitimacy: Lessons from the gold standard. ACES Cases No. 2013.3

This paper makes four propositions. First, it argues that the euro’s institutional design makes it function like the interwar gold exchange standard during periods of stress. Just like the gold exchange standard during the 1930s, the euro created a ‘core’ of surplus countries and a ‘periphery’ of deficit countries. The latter have to sacrifice their internal domestic economic equilibrium in order to restore their external equilibrium, and therefore have no choice but to respond to balance of payments crises by a series of deflationary spending, price and wage cuts. The paper’s second claim is that the euro’s institutional design and the EU’s response to its ‘sovereign debt crisis’ during 2010-13 deepened the recession in the Eurozone periphery, as EMU leaders focused almost exclusively on austerity measures and structural reforms and paid only lip service to the need to rebalance growth between North and South. As Barry Eichengreen argued in Golden Fetters, the rigidity of the gold standard contributed to the length and depth of the Great Depression during the 1930s, but also underscored the incompatibility of the system with legitimate national democratic government in places like Italy, Germany, and Spain, which is the basis for the paper’s third proposition: the euro crisis instigated a crisis of democratic government in Southern Europe underlining that democratic legitimacy still mainly resides within the borders of nation states. By adopting the euro, EMU member states gave up their ability to control major economic policy decisions, thereby damaging their domestic political legitimacy, which in turn dogged attempts to enact structural reforms. Evidence of the erosion of national democracy in the Eurozone periphery can be seen in the rise of anti-establishment parties, and the inability of traditional center-left and center-right parties to form stable governments and implement reforms. The paper’s fourth proposition is that the euro’s original design and the Eurozone sovereign debt crisis further widened the existing democratic deficit in the European Union, as manifested in rising anti-EU and anti-euro sentiment, as well as openly Eurosceptic political movements, not just in the euro periphery, but also increasingly in the euro core.

Preventing another Euro Area Crisis: EU Economic Governance ‘Six Pack’ – a case of too little, too late? Paper from the Colloquium: The Politics and Economics of the Euro Crisis, Institute for European Studies, University of Malta, 2 December 2011

Summary: The ‘Six Pack’ forms part of the economic governance reforms which are being implemented in order to prevent a repeat of the current sovereign debt crisis in the Euro Area. This legislative package involves strengthening the Stability and Growth Pact, with stronger financial sanctions and more focus on debt; a new directive on national budgetary frameworks and a new framework to monitor and correct macroeconomic imbalances. Furthermore, the implementation of the ‘Six Pack’ also involves procedural reforms, in particular reverse majority voting, as well as more oversight by the European Parliament. Inter-institutional negotiations on the ‘Six Pack’ took over a year. In the meantime, the sovereign debt crisis had deepened and broadened, implying that the ‘Six Pack’ may have come ‘too late’. The ‘Six Pack’ has also proved to be ‘too little’ to address the crisis and by the time it entered into force, further measures and proposals to strengthen economic governance had to be made. Nevertheless, the ‘Six Pack’ comprises some positive developments. In particular, recognising that fiscal policy is a matter of national sovereignty, it sets a new approach which relies on institutional reforms at national level. As such, it constitutes a first, small step to improve economic governance in the Euro Area.

The Cost of Servicing Greece’s Debt: A Sisyphean task? CEPS Commentary, 4 February 2015

Following the victory of Syriza in the Greek elections on January 25th, policy-makers, economists and concerned EU citizens are scrambling to understand the causes, modalities and consequences of a possible Greek default in order to anticipate and prepare for what is likely to unfold in the coming weeks and months. The debate on the sustainability of Greek public finances has often been characterised by a lack of clarity and even a certain degree of confusion. This brief note focuses first on the cost that Greece faces in servicing its debt and then asks whether this is a manageable or a Sisyphean task. It concludes by reflecting on the political implications of the new government’s announced intentions and whether these are being taken into account in the current debate over debt restructuring.

The Monetary Policy of the European Central Bank (2002-2015). CEPS Special Report No. 109/May 2015

This paper examines the policies pursued by the European Central Bank (ECB) since the inception of the euro. The ECB was originally set up to pursue price stability, with an eye also to economic growth and financial stability as subsidiary goals, once the primary goal was secured. The application of a single monetary policy to a diverse economic area has entailed a pronounced pro-cyclicality in its real economic effects on the eurozone periphery. Later, monetary policy became the main policy instrument to tackle financial instability elicited by the failure of Lehman Brothers and the sovereign debt crisis in the eurozone. In the process, the ECB emerged as the lender of last resort in the sovereign debt markets of participating countries. Persistent economic depression and deflation eventually brought the ECB into the uncharted waters of unconventional policies. That the ECB could legally perform all of these tasks bears witness to the flexibility of the TFEU and its Statute, but its tools and operating procedures were stretched to their limit. In the end, the place of the ECB amongst EU policy-making institutions has been greatly enhanced, but has entailed repeated intrusions into the broader domain of economic policies – not least because of its market intervention policies – whose consequences have yet to be ascertained.

Ukraine on the financial front – the problem of Ukraine’s foreign public debt. OSW COMMENTARY NUMBER 178|05.08.2015

One of the key challenges that Ukraine is facing is the scale of its foreign debt (both public and private). As of 1st April it stood at US$ 126 billion, which is 109.8% of the country’s GDP. Approximately 45% of these financial obligations are short-term, meaning that they must be paid off within a year. Although the value of the debt has fallen by nearly US$ 10 billion since the end of 2014 (due to the private sector paying a part of the liabilities), the debt to GDP ratio has increased due to the recession and the depreciation of the hryvnia. The value of Ukraine’s foreign public debt is also on the rise (including state guarantees); since the beginning of 2015 it has risen from US$ 37.6 billion to US$ 43.6 billion. Ukraine does not currently have the resources to pay off its debt. In this situation a debt restructuring is necessary and this is one of the top priorities for the Ukrainian government as well as for the International Monetary Fund (IMF) and its assistance programme. Without this it will be much more difficult for Ukraine to overcome the economic crisis.

The Monetary Policy of the European Central Bank (2002-2015). Bruges European Economic Policy Briefings (BEEP) 35/2015.

This paper examines the policies pursued by the European Central Bank (ECB) since the inception of the euro. The ECB was originally set up to pursue price stability, with an eye also to economic growth and financial stability as subsidiary goals, once the primary goal was secured. The application of a single monetary policy to a diverse economic area has entailed a pronounced pro-cyclicality in its real economic effects on the eurozone periphery. Later, monetary policy became the main policy instrument to tackle financial instability elicited by the failure of Lehman Brothers and the sovereign debt crisis in the eurozone. In the process, the ECB emerged as the lender of last resort in the sovereign debt markets of participating countries. Persistent economic depression and deflation eventually brought the ECB into the uncharted waters of unconventional policies. That the ECB could legally perform all of these tasks bears witness to the flexibility of the TFEU and its Statute, but its tools and operating procedures were stretched to their limit. In the end, the place of the ECB amongst EU policy-making institutions has been greatly enhanced, but has entailed repeated intrusions into the broader domain of economic policies – not least because of its market intervention policies – whose consequences have yet to be ascertained.

State Transformation and the European Integration Project. Lessons from the financial crisis and the Greek paradigm. CEPS Special Report No. 130/February 2016

The financial crisis that erupted in the eurozone not only affected the EU’s financial governance mechanisms, but also the very nature of state sovereignty and balances in the relations of member states; thus, the actual inequalities between the member states hidden behind their institutional equality have deteriorated. This transformation is recorded in the case law of the Court of Justice of the European Union and the member states’ constitutional courts, particularly in those at the heart of the crisis, with Greece as the most prominent example. It is the issue of public debt (sovereign debt) of the EU member states that particularly reflects the influence of the crisis on state sovereignty as well as the intensely transnational (intergovernmental) character of European integration, which under these circumstances takes the form of a continuous, tough negotiation. The historical connection between public debt (sovereign debt) and state sovereignty has re-emerged because of the financial crisis. This development has affected not only the European institutions, but also, at the member state level, the actual institutional content of the rule of law (especially judicial review) and the welfare state in its essence, as the great social and political acquis of 20th century Europe. From this perspective, the way that the Greek courts have dealt with the gradual waves of fiscal austerity measures and structural reforms from 2010 to 2015 is characteristic. The effect of the financial crisis on the sovereignty of the member states and on the pace of European integration also has an impact on European foreign and security policy, and the correlations between the political forces at both the national and European level, thus producing even more intense pressures on European social democracy. In light of the experience of the financial crisis, the final question is whether the nation state (given the large real inequalities among the EU member states) currently functions as a brake or as an engine for future European integration.

Banking crisis yet again and how to fix it. CEPS Commentary, 15 February 2016

Almost out of the blue, a combination of diverse factors has elicited a run on bank stocks and junior and senior debt, raising the spectre of a renewed systemic bank crisis within the European Union. The policy response cannot come from the European Central Bank but, instead, must consist of regulatory responses capable of dispelling the uncertainty over future prudential capital requirements while also temporarily suspending the rules on state aid cum bail-in that had ignited the crisis.

The Challenges of the EU Banking Union - will it succeed in dealing with the next financial crisis? Bruges European Economic Policy Briefings 36/2015

The EU Banking Union combines micro- and macro-prudential regulation. It aims at breaking the “doom loop” between banks and sovereign debt, promoting financial stability and mitigating the next financial shock to the real EU economy, at the lowest possible cost to the financial institutions and to the taxpayers. Success, or failure, is determined by how the banking union copes with the challenges to its two main pillars, the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). Under the SSM, in its new supervisory role, the ECB may be subject to conflicts between the objectives of price and financial stability, and the single-supervisor role may be sub-optimal. Two regulators might have been preferable and more focus on ECB accountability will now be required. The shock-absorbing Single Resolution Fund (SRF), which is part of the SRM, may not have the capacity to deal with a crisis of the size of the one of 2008. Especially as the nature and severity of a future financial crisis cannot be forecasted. The design of the banking union is not the result of theoretical studies, but a political compromise to deal with an acute crisis. The theoretical studies that are included in this paper are not supportive of the banking union in its current form. Nevertheless, there is a good chance that the EU Banking Union may succeed, as ECB supervision of the 123 systemically important banks should contain potential demands on the SRM. In the event of a crisis that is too severe for the banking union to absorb with its current capability, the crucial assumption is that there is political will to rapidly provide new resources. The same applies, if a major financial crisis develops before the banking union is fully operational.