FINANCE AT CENTER STAGE - University of California, Berkeleywebfac/obstfeld/e280c_s14/Finance at...
Transcript of FINANCE AT CENTER STAGE - University of California, Berkeleywebfac/obstfeld/e280c_s14/Finance at...
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FINANCE AT CENTER STAGE Some Lessons of the Euro Crisis
Maurice Obstfeld University of California, Berkeley, NBER, and CEPR April 2014
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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
• At the same time, financial regulation missed macro aspect.
• These are also lessons of the euro zone crisis, which grew
directly out of the 2007-2009 global crisis. • Financial markets must be at center stage in any discussion of
the future of EMU.
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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 most 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.
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Source: Krugman, Obstfeld, and Melitz, International Finance: Theory & Policy.
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Bank and Sovereign Solvency Now Closely Linked • Sovereign debt markets are subject to multiple equilibria; but
analogous liquidity risk characterizes financial institutions.
• Financial system depends on sovereign’s fiscal health in at least 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 euro 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 • expectations can trigger “doom loop,” a.k.a “lethal embrace” and “vicious
circle,” which becomes more severe as growth slows, heightening bank/fiscal weakness (cf. Brunnermeier et al. 2011; Mody and Sandri 2012)
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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. Indeed, fiscal independence implies segmentation, impaired stability. With own currency, add price stability: quadrilemma.
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Capital Flows in the Euro Zone • Three salient features of the euro’s first decade:
• Bigger current account deficits of poorer countries. • Much bigger intra-euro area flows and positions. • Sovereign yield convergence.
• Authors such as Blanchard and Giavazzi (BPEA, 2002) identified an appropriate “downhill flow of capital” in Europe, absent elsewhere in the world, and promoting real 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.
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10-year Spreads against Bund (basis points)
-50
450
950
1450
1950
2450
2950
3450
3950
01/0
7/19
9505
/20/
1995
09/3
0/19
9502
/10/
1996
06/2
2/19
9611
/02/
1996
03/1
5/19
9707
/26/
1997
12/0
6/19
9704
/18/
1998
08/2
9/19
9801
/09/
1999
05/2
2/19
9910
/02/
1999
02/1
2/20
0006
/24/
2000
11/0
4/20
0003
/17/
2001
07/2
8/20
0112
/08/
2001
04/2
0/20
0208
/31/
2002
01/1
1/20
0305
/24/
2003
10/0
4/20
0302
/14/
2004
06/2
6/20
0411
/06/
2004
03/1
9/20
0507
/30/
2005
12/1
0/20
0504
/22/
2006
09/0
2/20
0601
/13/
2007
05/2
6/20
0710
/06/
2007
02/1
6/20
0806
/28/
2008
11/0
8/20
0803
/21/
2009
08/0
1/20
0912
/12/
2009
04/2
4/20
1009
/04/
2010
01/1
5/20
1105
/28/
2011
10/0
8/20
1102
/18/
2012
06/3
0/20
12
Belgium
France
Greece
Ireland
Italy
Portgual
Spain
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Domestic Credit to Private Sector
0
50
100
150
200
250
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Greece
Ireland
Italy
Portugal
Spain
Germany
Percent of GDP
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Residential Real Estate Price Behavior
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Real Exchange Rates in the Euro (relative CPIs)
80
90
100
110
120
130
140
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Re al appre c iation (e uro e ntry = 100)
S pain
P ortugal
Ireland
G reec e
G ermany
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Real Interest Compared to Germany
-5
0
5
10
15
20
25
30
199519961997199819992000200120022003200420052006200720082009201020112012
Greece
Ireland
Italy
Portugal
Spain
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Peripherals’ Current Account Imbalances (percent of GDP)
-15
-13
-11
-9
-7
-5
-3
-1
1
3
5
GreeceIrelandItalyPortugalSpain
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Banks Shifted Foreign Lending toward GIIPS
5
10
15
20
25
30
1999
-Q4
2001
-Q4
2003
-Q4
2005
-Q4
2007
-Q4
2009
-Q4
2011
-Q4
Perc
ent o
f tot
al fo
reig
n cl
aim
s allo
cate
d to
GIIP
S Austria
Belgium
Germany
France
Netherlands
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Causes and Consequences • ECB applied equal collateral haircuts to all sovereigns regardless
of credit 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 weights for sovereign euro area debt (still in CRD IV). • Implications:
• Banks had more incentive to hold sovereign debt.
• All countries faced rates of most creditworthy sovereigns.
• Helped drive aggregate demand, reinforcing global trends.
• In peripherals, real appreciation and delayed structural reform.
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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 (and fiscal responsibility) for deposit insurance,
supervision, regulation, resolution; LLR role of ECB left vague (Begg et al. CEPR report, 1991; Vives 1992).
• See Obstfeld (1997) paper. • To have gone further in the treaty would have raised intractable
issues of fiscal union, democratic deficit. • These defenses were easily circumvented.
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The Case for Fiscal Rules • In 1990s no one foresaw that banking troubles themselves could
cause sovereign weakness, even in seemingly fiscally prudent euro countries, or that the inability of weakened sovereigns credibly to protect banks would segment financial markets along national lines.
• The possibility for banking itself to undermine the sovereign had been seen in Latin America, Asia, where dollarized debts made depreciation problematic (Díaz-Alejandro on Chile, 1985).
• “Too big to save,” coupled with cross-border contagion, undermines the argument that stand-alone national fiscal policies can work (the financial/fiscal trilemma).
• Suggests a new argument for fiscal rules: a profligate government undermines the credibility of its own financial backstop powers, opening the door to market segmentation and contagious instability.
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Financial Reform to Break Doom Loop
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).
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Financial Reform State of Play • Imperfect SSM is being implemented (by November 2014). • Push-back on euro area wide deposit insurance with joint
funding. But it is needed to break the doom loop at national level, addressing financial/fiscal trilemma.
• On SRM: the case for taking resolution decisions out of national hands is super-strong: • National policymakers may exercise excessive forbearance in
declaring home banks insolvent. • They may devote insufficient resources to reorganizing insolvent
banks when much of the benefit of rescue accrues abroad. • ECB oversight though SSM cannot be effective unless there is a
credible end-game for financial institutions, including big ones. • But end-game threat is not credible, and does not weaken the
doom loop, unless there is sufficient joint funding for resolution.
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April 2014 European Parliament on SRM • Functions to begin 2016. • Recovery and Resolution Directive: EU rules, creditor bail-in. • Single resolution fund financed by ex ante & ex post bank levies. • National contributions with “progressive mutualisation over an
8-year transitional phase.” • Transitional bridge financing from ESM or national sources? • National budgetary processes required before “extraordinary
public support” from any member state. • Resolution and supervision for banks to be “at same level.” • Single resolution board of five full-time members (including
executive director) plus national resolution representatives; will have “broad powers in cases of bank resolution.”
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Private Creditor Bail-In • Under new common EU R & R framework, shareholders will lose and
unsecured, uninsured creditors will face haircuts – as they should. • Benefits of creditor involvement include:
• Reduced moral hazard. • Reduced taxpayer subsidy and therefore an attenuated doom loop. • Reduced subsidy to leverage – leading banks to hold more capital/assets. • Reduced subsidy to bank size.
• Higher funding costs for banks move us closer to social optimum! • Similarly, euro area sovereign debts are now issued with CACs, leading to
similar advantages if bank strength makes sovereign default is credible. • Disadvantages are possibly greater volatility and reduced liquidity in
sovereign and bank funding markets. • For former, need continuity of ESM and possibly OMT. • For latter, need continuing strong ECB last-resort lending presence. • Convertibility-risk genie is now out of the bottle.
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More Fiscal Centralization Is Needed – How Much? 1. Will bank fees be enough, even supplemented by ex post levies?
Not likely. Only a sufficiently large “bazooka” can be a credible enough stabilizing force for EMU financial markets, given bank size, and reverse market segmentation.
2. Variable national insurance contributions for access to banking union (beyond bank fees) can reduce policy moral hazard as well as partially offset asymmetric exogenous shocks.
3. But SRM fund can be far less than full fiscal union, which seems unlikely any time soon. Role for GDP-linked debt (Obstfeld-Peri, Borensztein-Mauro, Drèze)?
4. As fiscal mutualization rises, bigger democratic deficits?