FINANCE AT CENTER STAGESome Lessons of the Euro Crisis

Maurice ObstfeldUniversity of California, Berkeley, NBER, and CEPR

Shanghai Forum 2013May 2013

Introduction• The crisis that followed the events of August 2007 have shown

conventional macroeconomic models were ill equipped to capture the key role of financial markets:

• as a source of shocks• in the transmission of shocks and policies

• This is also a lesson of the euro zone crisis, which grew directly out of the 2007-2009 global crisis.

• But Maastricht Treaty focused on “conventional” macro.

• Financial markets must be at center stage in any discussion of the future of EMU.

Growth of Global Banking• Financial markets expanded worldwide after 1990s.

• Especially true given the low interest rates and liquidity boom of 2000s; global trend toward deregulation.

• Banking expanded markedly in Europe.

• International financial integration made it easy for banks to get big, even in small countries.

• In many, banking assets far surpassed GDP.

Banking Assets Relative to GDP

Source: OECD

Bank and Sovereign Solvency Now Closely Linked• Sovereign debt markets are subject to multiple equilibria.

• Analogous liquidity risk characterizes financial institutions.

• Financial system depends on sovereign’s fiscal health in two distinct ways, the first less discussed than the second:• sovereign backstops financial system, but cannot maintain confidence in banks

if it has insufficient fiscal space – “too big to save” problem (modeled by Acharya, Drechsler, Schnabl, “Pyrrhic Victory,” 2011)

• system holds sovereign national debt (absent a euro zone bond) but sovereigns cannot print money, as stressed by De Grauwe (2012)

• And sovereign’s health depends on its support of banks.• range of vulnerability to multiplicity is therefore larger• creates “doom loop,” which becomes more severe as growth slows

Trilemma for Members of Currency Unions with Big Banking Systems

One cannot enjoy all three at same time:

1. Financial integration with partner countries.2. Fiscal independence.3. Financial stability.

This is the financial/fiscal trilemma.

With National Currency, a QuadrilemmaOne cannot enjoy all four at same time:

1. Financial integration with partner countries.2. Fiscal independence.3. Financial stability.4. Price-level stability.

Capital Flows in the Euro Zone• Two salient features of the euro’s first decade:• Bigger current account deficits of poorer countries.• Much bigger intra-euro area flows and positions.

• Authors such as Blanchard and Giavazzi (BPEA, 2002) identified an appropriate “downhill flow of capital” in Europe, absent elsewhere in the world, which was promoting convergence.• Others praised creation of a bigger unified financial market,

allowing reductions in home bias, greater liquidity, cross-border bank M&A.• Two potential issues:• Current accounts driven by demand and housing investment.• Portfolio diversion and risk concentration, pricing distortions.Costs have been evident in euro zone and earlier in CEE countries.

Three Destabilizing MechanismsEuro’s first years coincided with low world real interest rates, a global liquidity and credit boom, asset (especially real estate) appreciation, looser collateral constraints, but low inflation. Euro crisis does grow directly out of the 2007-09 banking crisis.

Against this worrisome backdrop, three interrelated mechanisms (along with scale of banking) within EMU added to its fragility:

1. Sovereign yield compression.2. Helping to drive the preceding, increasing intra-EMU financial bias at the expense of diversification 3. Real interest rate dispersion, credit growth, demand growth, competitiveness loss, external imbalances.

10-year Spreads against Bund (basis points)

Causes and Consequences• ECB applied equal collateral haircuts to all sovereigns

regardless of rating or fiscal fundamentals (as stressed by Buiter and Sibert in 2005)• Quasi-automatic financing through ECB standing facility.• Bailout expectations? Buiter and Sibert argued not, but their

case appears quaintly naive in retrospect.• Zero risk weightings for sovereign euro zone debt (EU’s CRD).• Strong empirical evidence in Acharya and Steffen (2013)• Implications:• Banks had more incentive to hold sovereign debt.• All countries faced rates of most creditworthy sovereigns.• This helped drive aggregate demand.

Banks Shifted Foreign Lending toward GIIPS

How Did Banks Shift Lending?• Dramatic lending shift from north Europe favoring Ireland, Spain.

• Banks outside euro zone (including US and Japan) raised lending shares to the northern euro zone, where gross banking assets therefore rose.

• These extra-EMU banks also lent to GIIPS, likewise favoring Ireland and Spain.

• Swiss banks lent heavily to Greece.

• Concentration of north-EMU bank risks in GIIPS. Supported housing bubbles and sovereign debt bubbles (esp. Greece).

Residential Real Estate Price Behavior

Domestic Credit to Private Sector

Percent of GDP

Competitiveness of GIIPS (HCI indexes)

Index, euro entry year = 100, increase = real appreciation

Real Interest Compared to Germany

Peripherals’ Current Account Imbalances

The Maastricht Treaty’s Maginot Line• Monetary policy geared to low, stable inflation via central bank

independence and treaty remit to preserve “price stability.”• Fiscal policy constrained by EDP (as implemented through SGP).• Treaty’s no-bailout clause; ECB statute on monetary financing.• National discretion over structural reform – reform promoted by

inflexibility of exchange rate?• National discretion over deposit insurance, supervision, regulation,

resolution; LLR role of ECB left vague (Begg et al., 1991; Vives 1992).• To have gone further in the treaty would have raised intractable

issues of fiscal union, democratic deficit.• These defenses were easily circumvented.

The Case for Fiscal Rules (1)• It was based largely on the fear that governments with large

debts could pressure the ECB to inflate them away.• With no-bailout, it was hoped that markets would factor in

sovereign default, and charge appropriate (real) spreads, disciplining governments that transgressed fiscal rules.• Begg et al. (1991), Kenen (1995), Eichengreen-Wyplosz (1998),

others worried sovereign default could hit banks.• Given the interconnections between national banking systems in

EMU, such a development creates big bailout incentives and undermines discipline.• Begg et al. suggested, impractically, that banks should be

restricted from holding sovereign debts of EMU countries.

The Case for Fiscal Rules (2) • Begg et al. and others pre-1999 did not envision the other part of the

“diabolical loop”: that financial instability could endanger sovereign solvency.

• Even though this had been seen in Latin America, Asia, where dollarized debts made depreciation problematic (Díaz-Alejandro).

• “Too big to save,” coupled with cross-border contagion, undermines the argument that stand-alone national fiscal policies can work (financial/fiscal trilemma).

• Also suggests a new argument for fiscal rules: a profligate government undermines the credibility of its own financial backstop powers, opening the door to possibly contagious instability.

• Financial instability risk implies austerity as a weapon against fiscal deficits can create far too much collateral damage.

Record on Austerity So Far

Financial Policy Approach (1)

Remedying the defects in the financial-market structure of the original blueprint. Ideally:

• Unified comprehensive regulatory structure (SSM).

• Universal deposit insurance scheme.

• Universal resolution regime (SRM).

Financial Policy Approach (2)Some questions:• Not only did mainstream macro downplay finance, the

practice of financial regulation downplayed macro.• Macroprudential role of ESRB? How does one handle

localized excessive credit expansion? Mandatory national LTV ratios, capital buffers imposed by center?• SSM must be strong to counter moral hazard. Role of legacy

national regulatory bodies?• More federal power requires commensurate governance

reform to ensure democratic accountability.

Financial Policy Approach (3)• There is push-back on euro area wide deposit insurance. But

this is needed to break the doom loop at national level, and address financial/fiscal trilemma.

• We see similar push-back against a joint SRM and the required joint fiscal backstop.

• But the case for taking resolution decisions out of national hands is super-strong:• National policymakers my exercise excessive forbearance in declaring

home banks insolvent. • They may devote insufficient resources to rescuing banks when much of

the benefit of rescue accrues abroad (Freixas, Schoenmaker).

Fiscal Policy Approach Thus Far• “Six-pack” tightens enforcement tools, e.g., RQMV, but adds flexibility.• Fiscal pact removes flexibility: pact calls for constitutional or equivalent

limits on deficits.• Do standard debt/deficit measures even make economic sense? • Fiscal pact may help to avoid situations such as Greece. • But not Spain or Ireland, where conventionally measured fiscal deficits

and debt were low prior to the crisis.• Defaultable debt, to instill market discipline and limit moral hazard,

provide disaster insurance to sovereigns. This is essential; CACs started January 2013.

• Facilities (ESM, ECB’s OMT) to prevent resulting liquidity flight, which can morph into solvency problems over time. ESM also still needed to counter convertibility risk, as it infects sovereign debt markets.

Financial/Fiscal Interactions• Banking union requires strong reliable fiscal backup, otherwise

government underwriting is not credible. Fees on banks not enough.• In turn, this requires healthy public finances … everywhere. This is

the new argument for something like fiscal pact.• Fiscal policy should make fiscal space by countering credit booms.• For now, direct bank recapitalization by ESM could help individual

sovereigns. (But when? March 2014? “Legacy” issues?) Will a permanent resolution regime (SRM) pre-empt this function of ESM?

• Nature of the resolution regime – do we bail in private wholesale creditors? (yes!) – affects the public finances, also changing market incentives and the volatility of private liquidity. ECB’s LLR role?

• Conversely, defaultability of debts not credible unless regulatory framework is strong.

• Authorities might go too far to avoid defaults if financial stability is at risk (banks’ sovereign debt holdings, CDS).

Three Trilemmas for EMU

EMU must cope with three trilemmas (at the least):

1. Padoa-Schioppa: single financial market, monetary independence, exchange stability.

2. Schoenmaker: single financial market, financial stability, national supervision/resolution.

3. Financial/fiscal: single financial market, financial stability, fiscal independence.

More Fiscal Centralization is Essential to Address Each of these Trilemmas

1. EMU fiscal federalism can partially offset lost monetary control. To reduce moral hazard, variable fees for access to banking union, ESM? GDP-linked debt (Obstfeld-Peri, Borensztein-Mauro, Drèze)?

2. Bank regulation, supervision, resolution must be EMU-wide, and this requires a shared fiscal backstop. Winding down insolvent banks must be a credible threat – endgame matters.

3. Only a centralized “big bazooka” can be a credible enough stabilizing force for EMU financial markets. But it can be less than full fiscal union.

EMU must have financial stability and integration. So: