The European Union and the Global Financial Crisis

The European Union and the global financial crisis

Professor Nigel HealeyPro-Vice-Chancellor (International)

Nottingham Trent University

10 July 2014Southwestern University of Finance and Economics

Overview

• What is the European Union?

• What is the Eurozone? Who’s in the Eurozone?

• The institutional design of the Eurozone: guaranteed to avoid inflation and printing money?

• The performance of Eurozone 1999-2014

• The global financial crisis

• Moral hazard, bail-outs and monetisation of debt

• The outlook for the Eurozone

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What is the European Union?

• European Union: a political and economic union of 28 European states

• Population: 0.5bn (China: 1.4bn)

• Land mass: 4.4m km2 (China: 9.6m km2)

• Gross domestic product: US$18.4tr (China: $10.0tr)*

• GDP per capita: $36,393 (China: $7,333)*

• GDP per capita (PPP): $33,084 (China: $10.695)*

* IMF World Economic Outlook Database, April 2014

What is the Eurozone?

• 18 countries within the European Union which share:– European Central Bank– A common currency (the euro)– Common monetary policy and short-term

interest rates

Mario Draghi, ECB President

1November 2011 – 31 October 2019

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ECB building (Eurotower), Frankfurt

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Who’s in the Eurozone?

• France, Germany, Italy, Belgium, Luxembourg, Netherlands, Ireland, Spain, Portugal, Austria, Finland: January 1999

• Greece: January 2001

• Slovenia: January 2007

• Cyprus and Malta: January 2008

• Slovakia: January 2009

• Estonia: January 2011

• Latvia: January 2014

• = 18 members at July 2014

Objectives of the European Central Bank (1)

• The Maastricht Treaty’s Art. 105.1:

– ‘The primary objective of the ECB shall be to maintain price stability. Without prejudice to the objective of price stability, the ECB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2.’

• Article 2:

– ‘The objectives of European Union are a high level of employment and sustainable and non-inflationary growth.’

• So:

– fighting inflation is the absolute priority

– supporting growth and employment comes next

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Objectives (2)

• Making the inflation objective operational: does the ECB have a target?

• It has a definition of price stability:

– ‘The ECB has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.’

• …and it has an aim:

– ‘In the pursuit of price stability, the ECB aims at maintaining inflation rates below, but close to, 2% over the medium term.’

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Central bank independence

• Current conventional wisdom is that to ensure price stability, central banks should be independent:

– most governments cannot resist the ‘printing press’ temptation

– the Bundesbank set the pre-Eurozone example

• ECB set up to be independent of national and EU government

• What does “independence” mean?

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Independence

• Article 7: Independence

• …neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body…

• Article 21: Operations with public entities

• …overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments

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Politically independent

Financially independent

Fiscal complications in a monetary union

• In a monetary union, fiscal policy

– the only macroeconomic instrument left at national level

– government borrows in recession and pays back in good times

– government acts as a buffer in case of a negative shock

• Automatic stabilisers:

– tax receipts decline when the economy slows down

– welfare spending rises when the economy slows down

– rule of thumb: deficit worsens by 0.5% of GDP when GDP growth declines by 1%

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But there are fiscal policy “externalities”

• Borrowing cost externalities:

– Country X’s deficit would boost growth in country X

– But raise interest rate for everyone with wider negative long-term growth effects

• Most serious is the risk of default in one member country:

– Loss of confidence in other Eurozone members

– Pressure on other governments to help out…

– ..and on the ECB to monetise debt

• Answer to address risk:

– The no monetisation / ‘no-bailout’ clauses in Maastricht Treaty

– Prevention procedure

Alert: moral hazard!

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Maastricht Treaty

• 1.2. Monitoring of budgetary discipline

• The Treaty prohibits the direct financing of public entities’ deficits by national central banks (Art. 101), be it overdraft facilities, other types of credit facility or the purchase of debt instruments, except for the purpose of monetary policy. The Treaty also prohibits public entities' privileged access to financial institutions (Art. 102).

• Moreover, the “no bail-out” clause in Article 103 stipulates explicitly that neither the Community nor any Member State is liable for or can assume the commitments of any other Member State.

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Prevention procedure: pre-GFC attempts to control government deficits and debt

• The Stability and Growth Pact (SGP)

• The SGP made permanent the 3% GDP deficit and 60% GDP ceilings

• SGP reformulated in 2005 to make it more flexible:– negative growth may be exceptional– take account of ‘all relevant factors’– no specific definition

• Fines are automatic if approved

• Funds withheld from EU payments to member state

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The record of EMU so far…..

• A “difficult” birth and early teenage years:– an oil shock in 2000 and again in 2007– a worldwide slowdown in early 2000s– September 11, 2001– the stock market crash in 2002– Afghanistan, Iraq wars– the weak US dollar– the 2008 global financial crisis– the European (Eurozone) sovereign debt crisis– Bailouts and austerity

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Sources of Eurozone data

Source: http://sdw.ecb.europa.eu/home.do?chart=t1.615

Inflation: missing the objective, a little …until 2008 commodity boom, 2008-14 financial crisis

Source: European Central Bank

Inflation target

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The performance of the euro against US$

Source: European Central Bank17

Global financial crisis: the early days

• “ The European Central Bank's main task is to keep inflation down. But over the past month, it has thrown caution to the wind in trying to prevent Europe's financial system and integrated economy from falling apart.

• The ECB has transformed itself into a crisis manager of the sort that its architects could hardly have imagined when the bank took up its work 10 years ago. The bank, charged with managing the euro, was given a single mandate - to keep prices under control.

• Lately, however, the central bank has cast aside worries about inflation, cutting interest rates once already, with more cuts in the pipeline. At the same time, it is lending ever more cash to strapped banks.”

International Herald TribuneOctober 16, 2008

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Early stages of the recession

• Eurozone entered recession in 2008Q3

• European Council agreed package to avert financial meltdown in October 2008

• National governments (not ECB) would bail out commercial banks: ie, buy shares to recapitalise them

• ECB would reduce interest rates and inject liquidity into banking system

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Eurozone short-term interest rate


GDP growth (% change year-to-year)

“double-dip”


GDP (2005 = 100)

Peak GDP

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Eurozone unemployment rate


Government debt in the Eurozone

• Eurozone governments are effectively borrowing in ‘foreign currency’

• They cannot borrow from their own central banks, monetise the debt and inflate away their debts (like US and UK)

• Financial markets demand ever-higher risk premium from indebted governments


• This increases debt service costs, the deficit and so the need to borrow more and eventually the government will default

Eurozone government budget balance (% GDP)


SGP Limit

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Eurozone government debt (% GDP)


Never achieved SPG ceiling

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Government debt in key Eurozone countries

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Deficits and debt

Source: Eurostat28

From financial crisis to sovereign debt crisis

• From 2010, growing concern about sovereign debt levels in Greece, Spain, Ireland, Portugal and Italy

• Bond yield differentials between this group and France and Germany widened

• March 2010, European Council agreed on a bailout mechanism for Greece

• Other countries could apply if needed

• Widely believed bailout violates Maastricht Treaty – “the no bail-out clause in Article 103 stipulates explicitly that neither the Community nor any Member State is liable for or can assume the commitments of any other Member State”

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National long-term interest rates

30Source: European Central Bank

The bailouts

• In April 2010, bailout mechanism used - €30bn lent to Greece

• In May 2010, EU established a larger fund of €750bn– €440bn from eurozone states

– €60 billion from European Commission

– €250 billion from the IMF

• European Stability Mechanism, agreed in December 2010:– issues debt on capital markets, backed by guarantees from the

eurozone states

– lends to indebted eurozone governments once recovery plan (ie, austerity) agreed

– Combined with a monitoring body

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Greece welcomes EU recovery plan

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ECB bond purchases

• “The Treaty prohibits the direct financing of public entities’ deficits by …the purchase of debt instruments, except for the purpose of monetary policy”

• From mid-2011, ECB forced to buy the bonds of weak governments, especially Italy and Spain, to stop spirally bond yield differentials

• Could be seen as stabilising the market if yield differentials fall back…

• …but can be seen as monetising debt of weak governments

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ECB market stabilisation operations


Is the medicine working?

• The ECB "...is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough” Mario Draghi, July 2012

• A combination of the bailouts and the bond purchases have sent a strong signal to the markets that the EU is committed to defending the Eurozone

• EU has given bail-outs to five Eurozone members (G, IRL, P, E, I) – loans conditional on budget cuts

• Long-term interest rates are coming down

• But indebted states still have poor credit ratings and face many years of austerity and political unrest

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A vote of confidence in the Eurozone from the financial markets


Conclusions

• The ECB set up with primary objective of price stability and independent of national and EU governments – it may not directly monetise debt

• In EMU, national fiscal policy is the only macroeconomic policy tool to adjust to negative shocks

• But there are important external effects of budget deficits - EU has failed to effectively enforce controls on national fiscal policy

• Between 2010-12, EMU was at risk of being destabilised by sovereign default… but countries in crisis small and the EU has acted decisively

• Some argue Maastricht Treaty has been breached and ECB has increased future risk of moral hazard – but deficit countries are paying a high price for past overspending

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The European Union and the Global Financial Crisis

Economy & Finance

Transcript of The European Union and the Global Financial Crisis