The turbulent adolescence of the euro and its path tomaturity by Gonzalo García Andrés

The turbulent adolescence of the euroand its path to maturity

* Member of the Technical Body of the Spanish Civil Services (Técnico Comercial

Economista del Estado) and Graduate of Economics at Universidad Autónoma de

Madrid. He has spent a large part of his professional career in the current General Office

of Treasury and Financial Policy in the Ministry of the Economy and Competitiveness

of Spain. He held the office of Deputy Director of Financial and Strategic Analysis, res-

ponsible for financial stability and crisis management issues, international financial

policy (EU, G20) and adviser to the Social Security Reserve Fund. In September 2009 he

was appointed Deputy Director of Funding and Debt Management, where within a few

months he was involved in the adaptation of the Treasury funding programme to the

instability generated by the Greek fiscal crisis and its contagion throughout the rest of

the euro region. From September 2010 to January 2012 he has held the office of Director

General for International Finance, which has enabled him to form part of the manage-

ment boards of the European Investment Bank and of CESCE. He has likewise been

Associate Professor in Economic Theory at Universidad Rey Juan Carlos and has publis-

hed several articles on regulatory, financial and monetary matters in Spanish journals.

/GONZALO GARCÍA ANDRÉS */

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1. Introduction; 2. Anatomy of the crisis: Greece, the contagion and the per-verse dynamics of debt; 2.1. Sovereign credit risk within the euro: from zeroto infinity; 2.2. A fiscal problem, not the fiscal problem; 2.3. Contagion: thefragmentation of the single monetary policy; 2.4 A particular manifestationof the global financial crisis; 3. The Eurosystem at a crossroads; 3.1. Intra-system balances as an expression of the fragmentation of monetary policy;3.2. Quantitative easing for banks only; 4. The definitive solution mustbegin in 2012; 5. Conclusion; Bibliography

The turbulent adolescence of the euro and its path to maturity

1. Introduction

The Monetary Union is a political construction, the boldest and

most significant step forward by the European project since the

Treaty of Rome. Its conception also had an economic basis, that of

completing the consolidation of the economic integration process

which was begun in 1985. However, its implementation was a great

adventure. The countries that use the euro are far from constituting

an optimal monetary zone. In addition to the evident initial diffe-

rences in the economic and institutional structure of the countries

and in their histories of stability, the euro was forced to make room

for disparate economic philosophies.

The European leaders elected to create a very light institutional

structure, with an independent federal monetary authority, an

apparently severe budgetary discipline (the Stability and Growth

Pact or SGP) and the rule of no mutual support (in order to rein-

force the individual fiscal stability of each State).

During its first ten years the euro appeared to be working relati-

vely well. Average real growth exceeded 2% and both the level and

the volatility of inflation improved in comparison to the previous

132

He is currently an adviser in the General Deputy Office of Financial and Economic

Matters of the European Union and the Eurozone which is part of the General Office of

the Treasury and Financial Policy. The opinions expressed in this article pertain to the

author and under no circumstance may be attributed to the Ministry of the Economy

and Competitiveness.

The Future of the Euro

decade, although the differences in the macro-economic and finan-

cial behaviour of the members were quite considerable. Although

the Stability and Growth Pact was reformed mid-decade, no signi-

ficant alterations were made to the institutional framework and the

number of members gradually grew. The onset of the financial cri-

sis in 2007 initially underlined this perception of the euro as somet-

hing imperfect but solid.

However, a little after its 11th anniversary, three interconnected

calamities fell upon the euro. Firstly, one of its members plumme-

ted towards insolvency in just three months. Secondly, the politi-

cal pact on which the single currency was built began to shake

when financial assistance within the area became inevitable. And

thirdly, the unity in regard to monetary policy fell apart with the

dislocation of the public debt markets.

Two years later, and despite having taken decisive steps in natio-

nal policies and in institutional framework reform, the crisis of the

euro has deteriorated to the point of calling its survival into ques-

tion; and a definitive solution is yet to be glimpsed. With the bene-

fit of hindsight, it is worth attempting to interpret was has happe-

ned, taking into account the extreme complexity both of the initial

situations (with accumulated imbalances and structural deficien-

cies in several countries), as well as the outbreak, contagion and

escalation of the crisis. And to do so moreover against the broader

backdrop of the global financial crisis, which has influenced eco-

nomic and financial evolution for five years, in order to identify

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which specific aspects of the euro have played a vital role. All the

above with the aim of helping come up with solutions, bringing

together the most urgent ones and those of a longer term basis.

2. Anatomy of the crisis: Greece, contagion and the perversedynamics of debt

2.1. Sovereign credit risk within the euro: from zero to infinity

The natural starting point of the analysis of the crisis is the

behaviour of sovereign debt markets. The creation of the euro gave

way to a number of markets for debt securities issued by sovereign

states but denominated in the same currency. This is an atypical

configuration with few precedents, given that sovereign debt secu-

rities are usually associated with the bond that exists between the

issuer and monetary sovereignty.

Until 2007 the markets considered that the very creation of the

Monetary Union had reduced sovereign credit risk to a very small

level. For example, the spread between the ten year Greek bond

and the ten year German bund fell within a range between 10 and

30 basis points between 2002 and 2007. In spite of GDP growing

at relatively high rates, the level and performance of the fiscal and

current account imbalances in Greece had justified a much higher

risk premium.

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With the outbreak of the global financial crisis, credit risk spre-

ads among Eurozone countries widened. But this trend – common

to all of the world financial markets –, was mainly due to risk aver-

sion and an increase in the demand of assets deemed to be safer

(Barrios et al, 2009). The spreads thus adopted a trend towards

moderation throughout 2009, all amid a context of low absolute

financing costs for the sovereign issuers.

Towards November 2009, an alteration in the behaviour of sove-

reign debt markets took place, which in hindsight can be conside-

red as a structural change. The almost perfect convergence since

the beginning of the Monetary Union1 therefore gave way to a

cumulative bifurcation, reflecting the binary behaviour of the mar-

kets. This is a dynamic system with two main features:

• Systematic inefficiency. Bond market prices do not reflect the

fundamental information on credit risk determining factors.

Until 2009, the spreads had been smaller than would be justified

by the main variables (debt stock, deficit, international invest-

ment position, real exchange rate); since autumn 2009, the spre-

ads have been systematically higher than would be justified by

the performance of the fundamental variables. This gap betwe-

en market prices and economic fundamentals has been noted in

several empirical studies (Aizenman, Hutchison & Jinjarak

(2011), De Grauwe & Ji (2012)).

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1 The average 10 year debt spread in Eurozone countries against Germany was of only

18 basis points between 1999 and mid-2007.

• Tendency towards instability. The euro sovereign debt markets

have shown themselves to be incapable of adjusting their credit

risk assessments in a stable manner. Their capacity for discrimi-

nation has been non-existent for years, with a high demand for

bonds from countries exposed to vulnerability, which were dee-

med to be almost perfect replacements for the German bund.

And in these last two years, the trend has been explosive. In

micro-economic terms, instability means that given an excess

supply of bonds, a drop in price does not bring it back to balan-

ce. But furthermore, we must point out that the explosive natu-

re of the sovereign debt markets since the beginning of 2010 has

become more noticeable than that reflected in market prices.

ECB intervention has lessened the trend towards increases

which are sharp and not related with new fundamental infor-

mation on the likelihood of default by various countries in the

region.

On the basis of this general outlook of the dynamics of debt

markets, a distinction must be made between the Greek market

and the rest.

2.2 A fiscal problem, not the fiscal problem

The Greek situation is special. In October 2009, the new Greek

government announced that the public deficit for the year would

be somewhat over double that which had been forecast (12.7% of

GDP versus the expected 6%). This setback of Greek public debt


136

was thus triggered by a fundamental fiscal surprise of considerable

dimensions.

Greece has systematically managed its public finances poorly

since joining the euro.2 It has taken advantage of the financial

benefits of belonging to the euro to increase expenditure, while

maintaining a pro-cyclical fiscal orientation during a clearly expan-

sive phase. The Hellenic country has thus made real one of the

worst fears of the founders of the euro in regard to the risk of free-

rider fiscal behaviours. The bad news is that neither the market dis-

cipline under the non-mutual guarantee clause nor the Stability

and Growth Pact have managed to correct this situation, which has

worsened further due to continuous problems regarding reliability

of public accounts.

The Greek public debt market has also followed a pattern of

inefficiency and instability. Gibson, Hall & Tavlas (2011) have

identified a systematic bias between the credit risk spread adjusted

to the main determining variables and the market spread.

Nevertheless, the collapse of the market is not difficult to explain.

The depth of the fiscal crisis and its structural nature, added to the

uncertainty and lack of confidence generated by the handling of

accounts, spread the perception among investors of inevitable

insolvency with a certain risk of loss of principal.


137

2 In fact, its public deficit has never been below 3% since it joined the monetary union.

What is hard to explain is why the Greek crisis spread to the rest

of the public debt markets in the area. Firstly, the weight of Greece

in the GDP of the Eurozone (around 2.3%) does not justify that its

fiscal crisis should become a systemic problem. Secondly, no other

Eurozone member country is anywhere near this level of systema-

tic poor management of public funds and continuous breach of

the rules of the Monetary Union.

There are two factors in the Greek collapse during the first

semester of 2010 which became important for the operation of the

rest of the Monetary Union. To begin with, the fragility of the

domestic debt markets within the Eurozone became clear.

Secondly, the political tension generated by the intra-zone finan-

cial aid revealed a considerable institutional weakness. Discussions

prior to the approval of the loan to Greece brought to light that the

politics of the countries in the zone were about to take on a hard

line of fiscal adjustments and onerous conditions in the financial

aid defended by creditor countries, in stark contrast with the posi-

tion of countries which were beginning to feel the effect of the tur-

bulence in Greece as of January.

Even so, it seems impossible to explain how the Greek crisis

became a euro crisis in light of only these two factors. Particularly,

following the creation in May 2010 in response to the explosive

market situation, of the European Financial Stability Facility and

the start of the intervention by the Eurosystem via the Securities

Market Programme.


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2.3 Contagion: the fragmentation of the single monetary policy

The strategy we have chosen to explain the spread from Greece

throughout all of the Monetary Union is a two-phased approach.

The first phase attempts to define the morphology of the crisis,

which may help, at a second phase, to get to the bottom of its

nature.

These are the main morphological characteristics of the crisis:

• Systemic for the entire Eurozone. The crisis is often discussed

as if it only affects part of the Monetary Union; along the same

lines, it is argued that this is not a crisis of the euro, on the

grounds of exchange rate levels or price stability. In fact, since

the generalised dislocation of the debt markets was sparked off

towards the end of April 2010, the crisis has indeed become a

euro crisis. It affects all member countries, albeit in opposite

way. There has been a flow of capital from the more indebted

countries to the creditor countries, which has been reflected in

the yields of public debt and other securities. Thus, the impact

of the fiscal irresponsibility of one of the members has not

resulted in a generalised increase in interest rates as was expec-

ted (Dombret (2012)). It has had an asymmetric impact, punis-

hing countries with greater financial vulnerability and benefi-

ting the stronger ones.

• Specific to the Eurozone. The financial bifurcation movement

has been limited to the member states, despite having some


139

effect on the rest of the world.3 There is no sovereign debt glo-

bal crisis; on the contrary, public debt yields in the main deve-

loped countries have reached historic minimal levels. Thus, the

main non Euro indebted countries (United Kingdom, United

Sates) have seen an increase in the demand of sovereign debt as

a result of the euro crisis. For instance, at the start of 2010, ten

year British debt securities traded at levels similar to the Spanish

ones. The worsening of the crisis in the Eurozone has meant that

the British debt is just a few basis points away from the German

debt. The negative contagion has therefore only affected euro

members, whereas the positive contagion of public debt has

managed to reach other markets.

• Its dynamics are financial and autonomous, not defined by

fundamental economic variables. This statement calls for an

explanation because… doesn’t Ireland have a serious solvency

problem in its banking system? Isn’t Portugal undergoing a

current unsustainable imbalance? Doesn’t Spain have a high

public deficit and an excess of private debt? How will Italy

manage to sustain a public debt stock of 120% of the GDP and

a GDP growth trend below 1%? … and we could move on to

Belgium and then to France. All the euro countries which have

suffered the restriction of their external financing terms in the


140

3 The Euro crisis has become the main factor threatening the recovery of the world eco-

nomy and the consolidation of the progress made in restoring financial stability after

the global crisis. However, at this point only direct spreading via debt markets is dis-

cussed.

last two years are facing serious problems. But the existence of

such problems does not make them causes for the dislocation of

the debt markets and the consequences thereof. In fact, in all

cases we are dealing with problems with which the markets have

been well acquainted for years. There are two ways of illustrating

the secondary role played by economic fundamentals in the cri-

sis. One is to compare euro countries affected with other non-

euro countries with similar fundamentals. Aizenman et al (2011)

have done this by matching Spain with South Africa and con-

cluding that the greater risk spread in Spain cannot be explained

by the worse levels in the variables which have determined cre-

dit quality ratings. The other is to verify whether an improve-

ment in the fundamentals (including economic policy measures

required to achieve this) has had a positive impact on the finan-

cing terms. For example, affected countries have considerably

reduced their primary deficits adjusted to the cycle, although

this has not helped to improve the perception of the fiscal situa-

tion. This does not mean that the fundamentals are not impor-

tant when determining the vulnerability of a country, or that

the economic policies adopted in response to the crisis have not

proven vital in halting or slowing down the impact of the crisis.

But it is important to stress that the crisis is essentially not a pro-

blem of fundamental economic variables.

• It has become apparent through the inversion of the capital

flow pattern within the euro. For years, the economies with

lower rates of savings (such as Greece or Portugal) or higher


141

investment rates (such as Spain) comfortably financed their

large deficits via private flows of capital from countries with hig-

her rates of savings and lower investment rates. As of spring

2010, many of these countries have been forced to face an inte-

rruption, and in some cases a sudden inversion, of external

funds, as shown by the performances of their financial accounts

(see Graph 1 for Spain). Part of that capital has been diverted to

creditor countries. From this perspective, the crisis can be

understood as a series of sudden stops (with their pertaining

sudden goes) in capital flows within the Monetary Union. The

most acute episodes of the crisis have thus coincided with an

intensification of the external financial restriction. In short, it is

about a crisis in the balance of payments within the particular

framework of the Monetary Union, whose adjustment variable

is not the amount of reserves but the net funding of the

Eurosystem.

By combining these characteristics, the crisis can be defined as

a cumulative coordination failure, with a positive feedback.4 The

key mechanism underlying this failure is the effect that the dislo-


142

4 The concept of coordination failure arises as part of an alternative interpretation of

Keynes’ analysis to that of the Neoclassical Synthesis, which considers there is a deeper

explanation for unemployment and instability problems than salary rigidity. In a first

formulation, it can be associated with the Macroeconomics of imbalance. Subsequently,

within the framework of New Keynesian Economics, this is analysed with different

models which have strategic interdependence and multiple balances in common

(Cooper and John, 1991). In the context of the financial crisis, the coordination failu-

res have played a core role, linked to uncertainty and the effect thereof on expectations.

cation of the operation of the public debt market has over the

mechanism of monetary transmission and, in the last resort, on

the financing conditions of the non-financial private sector.

Indeed, the public debt markets, in addition to procuring state

funding, play a central role in the operation of the monetary and

financial systems. The yield curve of public debt, considered to be

the risk-free asset, serves as the main price reference for the rest of

the credit and securities markets, acting as a floor for financing

costs for all other agents. On the other hand, the implementation

of monetary policy traditionally uses government securities as asset

guarantees. And financial institutions, and credit institutions,

UCITs and pension funds in particular, often keep a considerable

amount of sovereign bonds in their portfolios.


143

Graph 1Net Loan and Financial Account balance of Spain

Source: Bank of Spain

The dislocation of the public debt markets has had a devastating

effect on the affected economies. The increase in volatility (see

Graph 2 for the Spanish market) and the upturn in the credit risk

spread without any underlying new fundamental information

have restricted funding for the non-financial sector in various

ways. Directly, insofar as market-funded companies must pay more

for issues. And indirectly, and more importantly given the finan-

cial structure of the euro economies, it operates via the banking

system. Bank access to market funding is restricted in terms of

volume and prices, whilst the value of both their public debt hol-

dings and other market shares continues to fall. The result is a res-

triction in funding available to businesses and households.


144

Graph 2Historical volatility of Spanish debt

Source: Bloomberg

This situation gives rise a contracting spiral which generates a

perverse dynamics in the sustainability of public debt. The first reac-

tion from countries suffering from a financial restriction mainly of

their debt markets is the acceleration of fiscal adjustment which, in

principle, appears to be a logical and reasonable response. The pro-

blem is that a combination of a strong contractive fiscal approach

and financial restriction weakens the nominal GDP. This leads to

an increase in the nominal fiscal adjustment required to achieve a

deficit target in relation to the GDP. Unemployment rises, disposa-

ble income falls and the creditworthiness of businesses and house-

holds deteriorates. The result is a deterioration of the Debt/GDP

ratio, with a feedback effect.

In summary, the dislocation of public debt markets generated an

endogenous monetary restriction, equal to a drastic toughening up

of monetary policy in the most affected countries. The transmis-

sion mechanism of the policy established by the ECB no longer

works in a fairly uniform manner, upset by the intensity of the pri-

vate funding flows and the effect thereof on expectations. The

result is the breakdown of the single monetary policy.

2.4. A particular manifestation of the global financial crisis

The symptoms of this disease afflicting the Monetary Union

seem very familiar by now: debt markets which no longer work nor-

mally, spreads with an explosive tendency, asset liquidation at dis-

counted prices (fire sales), banks in the grip of liability restrictions


145

and falling asset values, gaps between the financial sector and the

real economy. In fact the mechanism is identical to that which led

to the subprime mortgage debacle in the systemic crisis of develo-

ped economies in 2007-2009. The main difference is that both the

source and the means of contagion were in that case the private

debt markets, whereas in the Eurozone the dislocation has mainly

taken place in public debt markets. But the analogy is valid in

analytical terms and can prove quite useful when considering the

regulatory implications which will result from the crisis resolution.

The effect on monetary policy was similar, although at that time

the public debt markets carried on as normal and could continue to

be used to tackle the endogenous restriction in the financing con-

ditions of the private sector with firm and innovative measures.

Several studies on the nature of the global financial crisis have

highlighted the importance of the increase in uncertainty when

seeking to understand and resolve it. Caballero (2010) considers

that the financial crisis, which appears similar to a heart attack, is

the product of a combination of uncertainty as defined by Knight

and the complexity of the structure of the financial system. These

two factors amplify the initial shock effect, with forced sales of

assets and liquidity strangulations which drive a wedge between

the financial sector and the real economy, preventing the proper

operation of the economy and the markets.5 The solution requi-


146

5 This then leads to large scale coordination failure, in the sense mentioned at the end

of the previous note.

res the State to become an insurer of last resort, providing insurance

against uncertainty to persuade the agents that the less likely nega-

tive scenarios will not take place. This enables the coil to snap, thus

coordinating agents at higher comfort levels.

This financial crisis model can be applied to the Eurozone. The

Greek fiscal surprise and its rapid decline towards insolvency

would be the initial shock, generating confusion among agents and

leading them to reconsider their perception of sovereign risk wit-

hin the euro. The complexity of the financial interrelations within

the area, along with the emergence of political differences, disse-

minates lack of confidence to all other markets. And the rapid dis-

location of the debt markets increases uncertainty, hits the banks

in affected countries and ends up by paralyzing the workings of

their financial system and depressing the real economy. The inten-

sity of self-fulfilling prophecies in the markets increases the uncer-

tainty regarding the outlooks for the countries and for the

Monetary Union as a whole. Investors fear the possibility that the

market dynamics should cause solvent countries to lose access to

new funding.

Definitive uncertainty appears when the disintegration of the

Monetary Union, which seemed like a bad joke even at the start of

2010, becomes a scenario deemed likely by main investors. In fact,

the persistence of such huge spreads between the public debt of

member countries is an unequivocal indicator that the market is

taking the possibility of disintegration very seriously. Investors


147

accept negative real returns in the short term and no return in the

medium and long term of the German public debt because they

believe that, given a break-up scenario, these assets are the ones

which will guarantee the security and continuity of the euro.

It is a fact that certain partial insurance mechanisms to deal

with the effects of the crisis have been implemented in the

Eurozone. On the one hand, the Eurosystem has performed the

role of lender of last resort for the banking system with force, adap-

ting its role to perceived needs. On the other hand, the creation of

a system of financial aid as a component of the institutional fra-

mework of the Monetary Union also constitutes a significant

collective insurance item. But as we pointed out in the introduc-

tion, for the time being these instruments, along with the steps

taken at a national level, have not managed to prevent crisis relap-

ses. The relapse of summer 2011 was particularly serious, as it

underlined its systemic nature and struck both Italy and Spain,

with an ensuing financial strangulation that has led to a new reces-

sion in the region.

3. The Eurosystem at a crossroads

The ECB and the 17 National Central Banks (NCB) comprise the

most powerful institution in the Monetary Union. Its legal inde-

pendence is greater than that of other central banks in developed

countries and, like them, it has the essential power of unlimited cre-


148

ation of money. In contrast with the rest of Monetary Union bodies,

the Eurosystem is capable of making decisions and of expediently

executing them. Even so, it is not a central bank like all the others.

During its first decade of life, the difficulty entailed in setting a sin-

gle monetary policy to be applied to a group of economies with dif-

ferent fiscal policies and economic and financial cycles became

patently clear. But since the Greek crisis, the task has become extra-

ordinarily complicated: on the one hand, due to mix of the fiscal

origin of the problem and the financial nature of the contagion;

and on the other, as a result of the tension which the solutions con-

sidered has produced between the Bundesbank philosophy and that

of the more pragmatic (and closer to Federal Reserve and Bank of

England standards) monetary policy of the all the others.

The Eurosystem has been in the eye of the storm for the last two

years and its performance has been the target of criticism from all

angles: there are those who resent it not having acted in a suffi-

ciently forceful way and there are others who believe that the SMP

and the Long-Term Funding Operations are causing it to deviate

from its mandate and endanger price stability.

With our sights set on the search for a definitive solution to the

crisis, let us attempt to better understand the implications of what

has happened for the single monetary policy and the response

given by the Eurosystem.


149

3.1. Intra-system balances as an expression of the fragmentation of

monetary policy

It would have all been simpler if the impact of the Greek fiscal

debacle would have been a generalised increase in public securities

interest rates in all other euro members. The Eurosystem would

have been able to counteract this effect by adjusting the tone of its

monetary policy. However, the contagion has driven a wedge wit-

hin the euro-debt financial markets, where capital is flowing

towards creditor countries and away from debtor countries.

The dislocation of the debt markets has endowed the net fun-

ding of the private sector in each country with strongly endoge-

nous dynamics, as can be observed in Graph 3. Despite the expan-

sive tone of the monetary policy of the ECB, in Ireland, Portugal,

Greece and Spain, businesses and households have had to face a

drop in the supply of funds, which in recent months has also affec-

ted Italy. In countries such as Finland, the net capital inflow has

magnified the expansive tone of the monetary policy.

The Eurosystem has thus had to face the most difficult problem

since its foundation, in that it directly questions the unity of the

monetary policy within the area.

The alteration in the pattern of financial flows within the

region has substantially modified the geographical distribution of

balances within the Eurosystem. As we have already mentioned,


150


151

within a monetary union a deficit in the domestic balance of pay-

ments is best funded with a greater appeal made by the banking

system of the country to the Eurosystem. If we take a close look at

the evolution of the financial account balance of Spain, excluding

the Bank of Spain and the Net Eurosystem Loan granted to the

Spanish banking system (Graph 1), we can conclude that deficits

in the balance of payments have been offset by an increase in

appeals to funding via monetary policy operations.

The result of this is that the counterparts of the monetary base

(which can be calculated from the Eurosystem consolidated balan-

ce sheet) are now more concentrated in those countries which

Graph 3Bank Funding of the non-financial private sector

Source: Bank of Spain

Interannual Growth ratein Feb 2012

have experienced the dislocation of their debt markets and the res-

triction of private sector funding.

The accounting reflection of these financial dynamics can be

found in the sharp increase of the so-called intra-system balances.

The monetary policy decided by the Eurosystem is applied in a

decentralised fashion, in that it is carried out via national central

banks. The net balance of the operations of a given country with all

other countries in the area generates a book entry shown as the

balance variation between each national central bank (NCB) and

the ECB. These intra-system balances, required to ensure the iden-

tity between assets and liabilities in the NCBs and an appropriate

distribution of seigniorage, disappear when the balances are aggre-

gated in the consolidated balance sheet of the Eurosystem, as the

sum of positive balances is equal to the sum of the negative ones.

The component of these intra-system balances which explains its

sharp increase during the crisis is the one that relates to the varia-

tions in the net balance of outstanding operations settled via TAR-

GET2, whose counterpart entity is the ECB.6 These operations can

be either private inter-bank transactions or monetary policy opera-


152

6 The other basic component of intra-system balances is that related with the issue of

euro banknotes. Both the ECB and the NCBs issue euro banknotes in accordance with

a key (8% allocated to ECB and an adjusted allocation by the NCBs). Then the NCBs

release them based on demand. The difference between the allocated issue of bankno-

tes and the release thereof into real circulation generates an intra-system balance,

which is required for a fair distribution of seniority associated with banknote issue.

Germany has the highest negative balance under this heading.


153

tions between a NCB and a private counterparty. To a large extent,

the sign and amount of the balance depend on the relationship bet-

ween the public or private source of the money of commercial

banks in the central bank. When commercial banks increase their

deposits in the central bank as a result of an increase in private fun-

ding received (deposits, loans or security issues), they tend to redu-

ce their appeal to central bank funding (as we assume that they seek

to limit their reserve surplus). The counterpart of this increase in

liabilities and decrease in assets as a result of the net loan is a posi-

tive balance held by the central bank with the Eurosystem, accruing

at the reference interest rate. On the contrary, a drop in private fun-

ding makes the banks increase their appeal to the central bank. In

this case, the counterpart of the increase in assets is a negative

balance in the liabilities with the Eurosystem.

Germany, which had a very moderate positive balance before

the outbreak of the global financial crisis, has gone on to have over

half a billion euros of positive balance by the end of February 2012

(see Graph 4). The German Banks have reduced their appeals to

the Eurosystem, as they receive funding at very favourable terms

from the market and have furthermore reduced their asset posi-

tions in other euro member countries.

On the contrary, Greece, Ireland, Portugal and, more recently,

Spain and Italy, have experienced an increase in their negative

balances to very high levels, due to their banks having had to off-

set the loss of private funding.

The growing trend of intra-system balances was interpreted by

Sinn (2010) as a stealth bailout by Germany of countries with nega-

tive balances, going as far as proposing correction measures there-

of. Although it found some support among German academic

media (see Declaration of Bobenberg, 2011), Sinn’s interpretation

was subsequently refuted in several articles which have attempted

to shed light on the nature and significance of intra-system balan-

ces (Bindseil & König (2011), Jobst (2011), Borhorst & Mody

(2012)). The debate saw a later resurgence, to a large extent due to

the concern expressed by the Chairman of the Bundesbank in a let-

ter addressed to the Chairman of the ECB.7 Sinn (2012) suggests


154

7 Shortly after this letter was made public, the Chairman of the Bundesbank published

an article in the press which explained the position of his institution in this debate.

Graph 4TARGET2 Balanace

Source: Whitaker, Central Bank of Ireland, Bank of Spain, Bank of Greece, Bank ofPortugal, Deutsche Bundesbank

the establishment of a system for annual settlement of intra-system

balances with liquid assets with guarantees from each country (on

real estate assets or on future tax income). In his opinion, it would

be a system similar to that which exists in the United States within

the Federal Reserve System.

In order to adequately interpret the evolution of intra-system

balances it is worth remembering the following points:

• Balances are the result of the normal execution of monetary

policy. These are therefore flows between the Eurosystem and

the banking systems (in no case bilateral between central

banks), of a monetary nature (these are not real flows of cash or

fiscal transfers) and resulting from the use that the Eurosystem

counterparts make of monetary policy operations.

• Under present conditions, the greater appeal to the Eurosystem

Net Loan by the banking system of a country does not reduce

the funding available to the banking system of another country.

• The risk of loss assumed by the NCB on the assets of the

Eurosystem balance is in line with its allocation of the ECB capi-

tal and does not depend on the size of its intra-system balance.

• Proposals to limit the maximum volume of these balances are

equal to calling into question an essential principle of the opera-

tion of the Monetary Union, and the adoption thereof would pro-

bably lead to the disintegration of the area. It is not appropriate to

use the example of the United States, as the Federal Reserve System

operates within a fully integrated banking and capital market.


155

In summary, the accumulation of intra-system balances is the

normal result of an asymmetrical crisis in the balance of payments

within the area. As is pointed out by Pisany-Ferry (2012), the evo-

lution of the intra-system balances is only a symptom of the dise-

ase afflicting the Monetary Union: the best expression of the frag-

mentation of the monetary policy.

As we discussed earlier, access to Eurosystem funding has acted

as a security valve to prevent a generalised problem of illiquidity

eventually leading to situations of default. However, to date, this

insurance mechanism has proven incapable of correcting coordi-

nation failure. And on many occasions, the appeal of a country’s

banking system to the Eurosystem has been interpreted by the

market as a risk factor, so that it has become an additional compo-

nent of the self-fulfilling prophecy process. The greater the increase in

funding via monetary policy, the greater the restriction on funding

from the market. Bear in mind the aberrant nature of this sequen-

ce and its lack of sense in an environment other than that of the

Monetary Union. During the shutdown of the wholesale financial

markets at the end of 2008 and beginning of 2009 nobody thought

to judge that a greater appeal to the credit of the Fed or of the Bank

of England was an act of weakness.8


156

8 Among other reasons because the names of the institutions that most used these faci-

lities were not known, and because the geographical distribution of the use (in the case

of the districts of the Federal Reserve system) was not significant

During spring of 2011, it seemed that the combination of the

SMP, the maintenance of the full allocation in monetary policy

operations and start of financial aid programmes in the cases dee-

med to be more vulnerable (Ireland in November 2010 and

Portugal in May 2011) allowed the Eurosystem to take on a less lea-

ding role in the crisis resolution.

The position of the ECB, as explained by Trichet (2011), was

based on the diagnosis that this was not a crisis of the euro, but rat-

her a problem of poor macro-economic management, linked to an

insufficient budgetary discipline and the persistence of real and

financial imbalance. The solution could only come about from a

combination of fiscal adjustment and structural reforms at a natio-

nal level, and the strengthening of the institutional framework of

the Monetary Union. Much emphasis was placed on the impor-

tance of the full activation of the EFSF and the future European

Stability Mechanism (ESM). As for monetary policy, this supported

the principle of separation between the setting of the interest refe-

rence rate and the maintenance of unconventional measures to

deal with the distortions in the financial markets and the trans-

mission mechanisms. As an unequivocal example of application of

this principle, the Governing Council decided to raise interest rates

on two occasions in response to the inflationist risk associated with

the rising price of fuel and raw materials.

But the deterioration of the crisis since the end of June 2011

once again placed the ECB at a crossroads. The dislocation of the


157

Italian public debt market, the second largest in the euro region,

triggered a new and virulent bifurcation dynamics which severely

punished the banking system. Although the negative balance of its

international investment position is moderate, Italy underwent a

sudden restriction of external funding which led to the liquidity

crisis of its banking system. The value of traded stocks of the banks

in the region plummeted and the perception of default risk, reflec-

ted in the credit derivative contract premiums, shot up. During

those weeks of August and September, the euro crisis reached its

most dangerous systemic repercussions since its onset.

The Eurosystem was forced once again to react in order to con-

tain the spiralling instability which threatened to spread the rest of

the world. It reactivated and expanded the SMP, by purchasing

Italian and Spanish public debt for the first time. The bloodbath

was successfully avoided, but throughout the month of October, in

the debates held prior to the European Council and G20 meetings,

the need for the ECB to adopt a firmer and more efficient strategy

to solve the crisis was the main topic. And the Eurosystem finally

took a new step.

3.2. Quantitative easing for banks only

The central banks of the main developed economies have had to

revolutionise the implementation of monetary policy in order to

respond to the financial crisis. At a first phase, they modified the

conditions of liquidity provision, both in regard to terms and types


158

of counterparties and guarantees, maintaining a relatively stable

balance. When the crisis became systemic in autumn 2008, it beca-

me clear that the cut in the interest reference rate to its minimum

level (zero or close to zero) would not prove enough to halt the spi-

ralling contraction between the financial conditions and the real

economy.

Henceforward, the monetary policy of the Fed, the Bank of

England and the ECB was implemented mainly through unconven-

tional measures, which was the start of the stage in which we remain

to date. Despite the sudden departure from the practice of the last

two decades, this was not a totally untraveled path. The Bank of

Japan had spent years trying unconventional measures in an attempt

to overcome the persistent deflation generated by the financial crisis

at the end of the eighties. And the Japanese experience, not very suc-

cessful, brought about a debate on how to implement an efficient

monetary policy in a context of a liquidity trap, distortions in the

transmission mechanism and a banking crisis.

The Fed paid special attention to the problems of Japan and the

conclusion of its analyses served as the basis for the deflation pre-

vention policy of 2002 and 2003. Bernanke & Reinhart (2004) iden-

tify three categories of these measures: i) the use of communication

to influence agent expectations ii) quantitative easing via the incre-

ase in the size of the balance sheet and iii) the alteration of the com-

position of the balance sheet in order to directly affect the prices of

certain financial assets. Each of the aforementioned central banks


159

has applied the unconventional approach in its own way, but all

have coincided in having significantly expanded the balance sheet.

Both the Fed and the Bank of England have carried out a three-

fold increase of the weight of their balance sheet in regard to the

GDP (see Graph 5). And both have done so by the mass acquisition

of financial assets, which traditionally made up the main compo-

nent of the assets in their balance sheets. The US monetary autho-

rity began by concentrating its purchases on mortgage bonds,

having subsequently moved on to Treasury bonds. The Bank of

England has mainly purchased significant volumes of short and

medium term public debt securities (around 14% of GDP and 30%

of the amount of securities in circulation). The objective in both

cases has been to have a direct influence on the nominal expendi-

ture in order to reduce the risk of deflation and help the economy

to reabsorb idle resources.

Although it is too early to carry out a full evaluation, the evi-

dence suggests that the unconventional strategies of the Fed and

the Bank of England have proven successful. Estimates indicate a

significant positive effect on asset prices, both of those assets

which have been directly purchased and those with higher risk and

greater impact on the funding terms of the non-financial private

sector (See Meaning & Zhu (2011)). The evolution of the nominal

demand has also been positive, although in this case it is harder to

estimate the impact of unconventional measures. We must also

highlight the credibility of the strategy and its contribution to the


160

reduction of uncertainty, given that the forceful and voluminous

interventions and the communication thereof have managed to

modify agent expectation and to coordinate these towards balan-

ces equilibria which are at some distance from more catastrophic

scenarios. It has not been a magical solution for all problems, but

they have managed to stabilize the operation of the financial sys-

tem, to lend strength to the recovery of the economy and to crea-

te conditions so that the correction of the structural problems of

public and private indebtedness is carried out at a moderate cost.

From the start, the Eurosystem elected to concentrate its uncon-

ventional measures on the provision of funding to the banking sys-

tem, in line with the financial structure of the area, particularly in

terms of full allotprent and the performance of unusually long term

operations. The purchase of assets has been more modest in relative

terms and has now become sterilised. In December 2011 this stra-

tegy was reaffirmed, by deciding to enter into two special financing

operations for a three-year term, along with other credit support

measures designed to favour bank lending and the money markets

in the region.

The demand for liquidity of both operations was very high, with

a very high participation of entities compared to the average num-

ber of previous long term financing operations. The total amount

granted was 1.018 trillion euros. The distribution of liquidity follo-

wed a concentrated geographical pattern reflecting the effect of

funding restrictions on the banking system. The percentages of


161

Spanish and Italian banks were much higher than their respective

allocations in the ECB, whereas the banks from creditor countries

were granted much lower percentages, and further increased their

resources in the Deposit Facility.

Following these two operations, the consolidated balance sheet

of the Eurosystem reached 32% of the GDP for the region, excee-

ding the percentages of the Fed and Bank of England. However, the

impact of the unconventional strategy in the balance sheet of the

central banks has been somewhat lower in the ECB that in the other

two, due to the increase in total weight over the GDP, as well as

having only used assets related to monetary policy, which account

for a lesser percentage of the balance sheet in the European case.


162

Graph 5Balance fo the Central Banks during the crisis(in % of the GDP)

Source: ECB, BoE, FED

The immediate impact of the three year funding operations was

very positive. The coverage for a three year period of the liquidity

requirements of the banks considerably reduced the uncertainty

which had frozen the workings of the banking system. The percep-

tion of bank credit risk improved with significant drops in the pre-

miums of credit derivatives and increases in the value of capital.

The money markets and bank debt markets underwent a revitalisa-

tion, with new flows of funds and the return of European and

foreign institutional investors. At the same time, the public debt

market spreads also experienced a significant narrowing down,

returning in the case of the Spain and Italy to around 300 basis

points. The disabling of the loop-shaped coordination failure bet-

ween sovereign debt and bank risk also had some effect on the

monetary and credit performance, as well as on the real economy.

Towards the end of the first quarter, both the European

Commission and the ECB stated that the M3 and private sector

loans exhibited positive – albeit very low – expansion rates, where-

as activity stabilised after the drop in the last quarter and first

months of 2012.

Beyond its short term efficacy as an insurance mechanism in the

face of the systemic deterioration of the crisis, the full effect of the

quantitative easing for banks only in the Eurosystem will only be

assessable over time. Nevertheless, the strategy adopted has some

weak points, among which we highlight the following:

• It emphasises the Eurosystem’s tendency towards geographi-

cal concentration of net funding. The net amount and the dis-


163

persal of the net lending volumes by country and of intra-sys-

tem balances have increased substantially. The Eurosystem has

thus decided to carry on its clearing role for private funds move-

ments, directly avoiding having to deal with the underlying

causes of such movements in order to modify them. The side-

effect is the increase in the risk volume of the Eurosystem and

in its geographical concentration, assumed by member coun-

tries in proportion to their share of the capital.

• It fails to put an end to the fragility of the public debt markets

in the face of dislocation, and might even increase it.

According to BIS figures, Spanish Banks have increased their

public debt holdings by over 40,000 million between December

2011 and January 2012, whereas the Italians did so at around

15,000 million euros. This evolution, which is due to the entities

taking advantage of the possibility of generating margin by borro-

wing from the Eurosystem and buying public debt, might end up

being counter-productive for two reasons. In first place, because

these are not resources geared towards credit for the non-financial

private sector (which is the main objective behind it). And

secondly, because it might even intensify the means of contagion

towards the banking system if the public debt spreads widen once

again. A demand has therefore been generated for the more casti-

gated public debt securities, but nothing can guarantee that the

market evolution will not suffer further dislocation episodes

which will increase volatility once again and widen the gap bet-

ween market prices and prices based on fundamental variables.

• The SMP might be relegated an amortised instrument. It


164

seems logical that the Programme activity was interrupted

almost at the time when the positive impact of long term fun-

ding operations became evident. The problem is that, within the

Governing Council, the opposition to the reactivation of the

SMP is likely to increase in the event of a new dislocation of the

markets, arguing that both the levels of risk in the balance sheet

and degree of geographical concentration are way too high. This

eventually would be cause for grave concern, given that the SMP

was the instrument which had succeeded in preventing a syste-

mic collapse of the euro region both in May 2010 and in August-

September 2011.

There is an alternative, which the Eurosystem has ruled out,

which might prove more effective as a contribution towards a defi-

nitive solution to the crisis. It would involve directly tackling the

source of the problem, which is the instability that the dislocation

of some public debt markets have brought upon the core of the

economy’s funding system. The aim would be to ensure that a limit

is established on the deviation between the market prices and pri-

ces adjusted to fundamental economic variables which must not be

exceeded. Although there are various ways of implementing this

type of measure, they all involve direct intervention in the market

in a plausible way. Only the central bank, with its power to create

unlimited money, will be able to successfully carry out such a task.

A reasonable option would be to publicly commit to ensuring

that the spread between short term sovereign debt in euro countries


165

does not surpass a certain value threshold. Given the arbitrage rela-

tionship between the various terms of a country’s public debt yield

curve, the application of this stability limit on the shorter part of the

curve (bills and bonds up to 2 years) would suffice, for this then to

be applied to longer terms. In fact, the epicentre of the dislocation

episodes in the public debt markets can be found in the shorter part

of the curve, where volatility increases and exorbitant probabilities

of default emerge, which in turn adversely affect the repo market,

which is crucial for short term financing of the banking system.

The stability limits should be defined for each country on the

basis of its vulnerability and adapted as the case may be to take into

account potential default in commitments of fiscal consolidation

and structural reform. By way of illustration, for Spain and Italy the

stability limits might be around 200 basis points: this level would

be clearly above what can be considered a fair value spread. But

what is important is not to compress the spreads as much to ensu-

re the stability thereof to enable the transmission mechanism of the

monetary policy to operate under relative normality.

The Eurosystem should purchase public debt when the price rea-

ches the stability limit. But if this proposal is viable, the volume of

debt eventually purchased by the Eurosystem is likely to be more limi-

ted than that already in place in the SMP. Moreover, the volume of

purchase of public debt could be sterilised, as is already done now. The

problem is less about amount of money, and more about price struc-

ture and risk, as well as market operation.


166

This type of initiative would enable to transform the perverse

dynamics of debt into a virtuous circle. The recovery of monetary

and financial stability in the more adversely affected countries

would establish the conditions for fiscal consolidation and structu-

ral reform measures to have the positive impact that they should

have had on the confidence of agents and markets.

It is not about the Eurosystem taking on a new role as lender of

last resort to the States, which would be entirely inappropriate.9

The idea would be to preserve the good operation of the debt mar-

kets as a key component in the transmission mechanism of mone-

tary policy and funding of the economy. We are speaking of a

public good of great economic value, the protection of which is an

essential (albeit not explicit) task of any central bank. But as we

recalled earlier, the Eurosystem is not a central bank like the rest.

The rejection by the Governing Council of a plausible intervention

in the public debt markets designed to limit the instability seems to be

related to a number of economic and legal objections. It is argued that

this type of action does not pertain to a central bank and that it carries

inflationist risks in that it would be assuming a quasi-fiscal role,

attempting to solve problems of lack of budgetary discipline and/or


167

9 De Grauwe (2011), after performing a thorough analysis of the crisis, uses the notion

of lender of last resort for sovereign debt markets. Subsequently, this idea has been used

by others to assimilate a plausible intervention in the debt markets with State funding

via the central bank.

competitiveness by means of creating money. It is also argued that it

may violate section 123 of the Treaty, or at least the spirit thereof.

Despite having the seal of respectability granted by the

Bundesbank, such arguments are questionable. It is true that the

Eurosystem should not intervene in public debt markets if the

widening of the spreads is due to irresponsible fiscal policies or an

impairment of fundamental variables (a drop in the GDP, an incre-

ase in the external deficit). For this reason it is highly probable that

a mistake was made when in May 2010 the Eurosystem purchased

Greek public debt. But when the market dislocation begins via con-

tagion and, furthermore, is endogenous and subject to feedback, if

the central bank does not act, it is opening the door to monetary

restriction which would endanger price stability not only of the

country but of all the region. As for inflation, this type of uncon-

ventional measure would carry lesser inflationist risk than the

other two long term funding operations unanimously approved by

the Governing Council. The argument to intervene becomes even

stronger when the affected countries have reacted to contagion by

accelerating their fiscal adjustment plans and implementing signi-

ficant structural reforms.

On the other hand, a more plausible and decisive intervention

in debt markets would not only not violate what is set forth in sec-

tion 123, but would in fact be fully coherent with the spirit there-

of. The text of the section refers to the direct purchase of public

debt securities in the primary market, excluding from the ban the


168

purchase of bonds on the secondary market. The ban on monetary

funding seeks to ensure the independence of monetary policy in

regard to the needs imposed by the fiscal policy. The public indeb-

tedness requirements (arising from treasury deficits, net asset varia-

tion and the refinancing of debt maturities) must be covered by

appealing to the market, without resorting to the expansion of the

monetary base, which ends up generating an inflationist bias.

However, compliance with this healthy principle requires the exis-

tence and proper operation of a liquid and deep public debt mar-

ket. A lack of action in the face of the dislocation of public debt

markets means accepting the gradual destruction of one of the

basic foundation stones of the separation between fiscal policy and

monetary policy.10

In our opinion, the reason why the Eurosystem has not chosen

this solution, more in line with the practice of other comparable

central banks, is not economic but political. This is difficult to belie-

ve, in that it is a fiercely independent institution managed by qua-

lified professionals. But as was pointed out in the first sentence, the

Monetary Union is a political construction; and the euro crisis

carries, as is natural, a very influential political dimension. The

governments and central bank authorities of Germany and all other


169

10Within the monetary union, the loss of access to the market as a result of contagion

does not mean resorting to monetary funding of public debt, but the use of official fun-

ding on a temporary basis. However, this situation quickly leads to some to request to

exit the euro and the recovery of monetary sovereignty as a means of escaping the per-

verse dynamics of debt.

countries benefiting from the positive contagion of the Greek crisis,

have viewed the crisis as a vindication of their economic philosop-

hies and an opportunity to reconsolidate the Monetary Union in

accordance with their principles. And as part of this process, they

understand that market pressure is an efficient discipline that must

not be neutralised. In their opinion, the markets may exaggerate,

but in the end they reflect the fundamental economic problems.

In summary, the Eurosystem has proven to be essential in con-

taining the crisis at the times of greater systemic danger, but it has

not done what any national central bank would have done to tac-

kle the perverse dynamics of debt which threaten the survival of

the euro. In a way, it cannot be blamed. It has acted in accordance

with its nature.

4. The definitive solution must begin in 2012

After the bad omens with which 2011 came to an end, the first

few months of 2012 have seen the danger of a systemic collapse of

the euro fade into the distance, and it even seems that certain sig-

nificant steps have been taken towards a definitive solution to the

crisis. The insurance provided by the Eurosystem has brought

about time and tranquillity.

But the situation is still critical, if we look beyond the financial

tension gauges and we measure the situation of the real economy


170

and political cohesion within the area. The deterioration of the cri-

sis in the second half of 2011 has come at a very high cost in terms

of a fall into recession for Spain and Italy and other member coun-

tries, as well as the worsening outlook for countries with a pro-

gramme. To the rise in unemployment we must add new fiscal

adjustment measures, required to meet the targets in a context of

lesser growth of tax bases and higher cyclical expenditure. At the

same time, the detachment towards the Monetary Union is on the

increase, both in countries punished by financial pressure as well

as in creditor countries.

Given such conditions, the definitive solution to the crisis, this

being understood as the one allowing recovery of sustained

growth throughout the region and a reduction and stabilisation of

the credit risk spreads, cannot take as long as the refund of the

money by the banks to the ECB. It is urgent and the effect of

Eurosystem long term funding operations should be harnessed in

order to implement it.

In our opinion, the definitive solution is made up of 4 compo-

nents. Two of them are already well on track. The third is the key:

the one requiring greater effort due to its political and technical

complexity. And the last is fundamental to prevent future crises and

to encourage the stable operation of the Monetary Union; but this

can be taken more slowly, as it is not a pressing need and will even-

tually happen when the time is right.


171

A SUITABLE HANDLING OF THE INSOLVENCY PROBLEM IN

GREECE. Immediately after the approval by the States in the euro

region of the Loan to Greece which gave rise to the first adjust-

ment programme carried out jointly with the IMF in April 2010,

the prevailing opinion in the financial markets was that Greece

had a solvency problem which required debt restructuring.

However, among the European authorities, including the ECB, the

overriding idea was that any measure generating losses for inves-

tors had to be avoided at all costs. It was believed that this appro-

ach might exacerbate contagion to other public debt markets.

But the delay in recognising this problem undoubtedly was very

onerous. In the Deauville Declaration of October 2010, the leaders

of France and Germany, guided by the healthy aim of involving

private investors in the assumption of losses as a result of their

decisions, extended the potential risk beyond Greece, moreover

projecting it to the future. And in spring 2011, it became clear that

the first Greek programme was not in line with the assumption of

return to the market expected for 2012.11 Finally, the Heads of

State and Government of the Eurozone countries decided in

October 2011 that the restructuring of Greek debt had to allow suf-

ficient reduction of its stock and that this solution was meant

exclusively for the exceptional case of Greece.


172

11 The alarm bell was sounded by the IMF, given that the approval of program disbur-

sements requires a reasonable guarantee that the financing needs of the country are

A year and a half after the outbreak of the crisis, one of the most

decisive conclusions was thus reached: the problem of Greece is

special and requires special handling. And a series of questionable

decisions that had amalgamated, consciously or unconsciously, the

Greek situation with that of other vulnerable countries in the

region, was thus left behind.

Greece has continued to be a source of uncertainty which has

affected the crisis dynamics. Its economic depression (a 13% drop

in real GDP between 2009 and 2011, a 30% drop in deposits in the

banking system during the same period) and the proof of its insti-

tutional frailty have led to a situation of clear unsustainability of

its public debt,12 calling into question the viability of its perma-

nence in the euro. And the risk of Greece’s departure is a very dis-

turbing scenario, as this is not contemplated in the Treaties and it

is difficult to imagine the consequences it may lead to.

The Private Sector Involvement (PSI) Operation in the reduction

of debt, a prior condition for the approval of the second program-

me by the Eurogroup and the IMF, was quite successfully executed

throughout the month of March. The operation is a sophisticated


173

met for the following year; and given the market situation, the IMF considered that

Greece could not be expected to return to the market in 2012 as expected.

12 The deterioration of the sustainability analyses of the Troika since the start of the

programme has been overwhelming. At the start of the program the public debt vs.

GDP was expected to reach its peak in 2012 with 158% of GDP and no reduction. In

autumn 2011, this peak was changed to 186%; finally, the sustainability analysis carried

out after the PSI operation suggests a peak of 164% of the GDP.

and European version of the Brady Plan,13 which has used bonds

issued by the European Financial Stability Facility (EFSF) to soften

the drop in present value of over 50% in exchange for new ultra

long term bonds. The credible threat of a disordered bankruptcy

and the retroactive introduction of Collective Action Clauses in

the issues subject to Greek legislation managed to achieve a per-

centage participation in the exchange above 95%. The operation

has succeeded in reducing the debt load and Greek state’s refinan-

cing needs very substantially.

From a liquidity approach and at punitive rates at the start of

2010, reality has taken over through an operation in which priva-

te investors rightly take on a part of the cost of bankruptcy pre-

vention14 and Eurozone countries assume greater risks, for longer

periods and in exchange for lower interest rates.

Despite the magnitude of the debt reduction (100,000 million

euros, which would allow it to reach a ratio over GDP of 116.5% in

2020, according to the sustainability analysis of the Troika), the


174

13 Name of the Plan used at the end of the 1980s to solve the foreign debt crisis of deve-

loping countries, mainly Latin American. It consisted in exchanging outstanding bonds

for new bonds with a lower present value and longer terms, guaranteed by US Treasury

issued securities.

14 The policy of loss avoidance for investors led to a perverse dynamics whereby priva-

te investors reduced their exposure, in many cases with substantial gains, thanks to the

ever increasing involvement of official creditors. Taken to the extreme, this logic would

have led to a process whereby private investors would not suffer any losses whereas the

official lenders were left funding the entire Greek debt.

prevailing opinion seems to emphasise the main risks facing the

second Greek programme.15 After the last two years, any glimpse

of a positive assessment in regard to what is going on in Greece

seems completely off the wall. It is true that the sharp drop in the

GDP, the fiscal adjustment and the reforms carried out have not

achieved sufficient reduction in the primary budgetary balance or

in the current deficit (which is still around 10% of GDP). However,

in our opinion, the PSI operation and the approval of the new pro-

gramme, which supports devaluation via the reduction of labour

costs, the gradual continuation of the fiscal adjustment and the

50,000 million euros to ensure the solvency of the banking system,

will be able to restore certain stability to the Greek economy.

Taking into account the reduction in uncertainty, the moderate

deflation of costs and the effort invested in structural reforms,

there is a very clear potential for economic recovery. This stabiliza-

tion would exert a positive impact on expectations, leading in turn

to a virtuous circle. All this depends on the country being able to

maintain a stable political leadership which is committed to com-

pliance with the second programme.

In any event, the value of the PSI operation and the second pro-

gramme for the definitive solution of the euro crisis arises from the

reduction in uncertainty. Despite the need to continue to adopt

policies which require sacrifices on the part of the citizenship for


175

15 See for instance the IMF report on the request for a new program, which emphasizes

the risk of new accidents and the importance of Euro members undertaking to continue

to finance Greece in concessional terms whilst the appropriate policies are implemented.

some time, the reduction of the debt and the funding of the long

term needs of the State render the option of staying in the euro

much more attractive than the option of departure (although the

latter will continue to have its supporters both in and outside of

Greece).

A FISCAL PACT TO STRENGTHEN POLITICAL CONFIDENCE.

The Greek experience clearly justifies a reinforcement of the fiscal

regulations of the euro, so that these are more efficient during the

expansive stages of the cycle, therefore obliging member states to

internalise the external cost of unbalanced public finances.

The European Union already approved in 2011 a substantial

toughening of the Stability Pact and Growth, as part of the reform

of the macro-economic governance known as Six Pack, which also

broadens the multilateral supervision of macro-economic imbalan-

ces of a non-fiscal nature. The preventive section includes the quan-

titative definition of what is understood to be a substantial deviation

from the Medium Term Objective of structural budgetary balance or

from the path established to achieve it. The corrective section brings

about the Excessive Deficit Procedure due to the non-fulfilment of

the public debt criterion and introduces the reverse qualified majo-

rity rule for decision-making, which will make it harder for member

states to put a stop to a Commission proposal. Minimum require-

ments are also established for the budgetary frameworks of the coun-

tries, in terms of coverage of all administrations, multiannual natu-

re and quality of the public accounting systems.


176

This exhaustive reform of the fiscal rules culminated with the

signature on 2 March 2012 of the Treaty on Stability, Coordination

and Governance. This new Treaty:

• Has been signed by 25 of the 27 EU member countries, alt-

hough it will only be legally binding for euro members.

• It shall come into force on 1 January 2013, provided it has been

ratified by 12 euro member states, thus avoiding the uncer-

tainty associated with the ratification process of a modification

of EU Treaties. Even so, its content is expected to be added to

community legislation within five years.

• It introduces the rule of budget balancing. This will be unders-

tood to be met when the structural deficit reaches its Medium

Term Objective (MTO) with a maximum deficit of 0.5% (which

can reach 1% if the debt is significantly below 60% and the sus-

tainability risks are low).

• Any significant deviation from MTO or from the path of adjust-

ment towards the MTO that is observed will trigger an automa-

tic correction mechanism, defined in the national legislation

but inspired by the principles established by the Commission.

The foregoing shall be of application unless in the event of

exceptional circumstances.16

• Both the rule and the correction mechanism must be added to

the national legislative systems, preferably at a constitutional

level, within the year subsequent to the entry in force of the


177

16 This refers to i) An unusual event outside of the control of the country which has a

large impact on the financial position of the public administrations or to ii) periods of

Treaty. And the transposition shall be subject to verification by

the EU Court of Justice, which shall be empowered to take dis-

ciplinary action in the event of infringement.

• The euro countries undertake to support Commission propo-

sals within the framework of the excessive deficit procedure

concerning any of them, except in the event of a qualified

majority thereof against it.

The new Treaty is consistent with the system of fiscal regula-

tions established in the revised SGP and actually uses its basic com-

ponents (the MTO, the significant deviation and the exceptional

circumstances). What it does is to toughen these rules and increa-

se the legal rank thereof within the internal legal system. The two

most important items are the rule of budget balance and the auto-

matic correction mechanism.

In technical terms, the new framework of fiscal rules for the

euro is reasonable from a medium to long term perspective, inso-

far as:

• It reinforces the discipline mechanism during the expansive

phases of the cycle, which will oblige budgets to be kept in

balance or with surplus.


178

serious economic contraction as this is defined in the revised Stability and Growth Pact

and, in both cases, provided the temporary deviation does not endanger medium term

fiscal sustainability.

• It increases control at a European level on the quality of the

public accounts as a basis for multilateral supervision of the fis-

cal policies.

• It increases the credibility of the prevention and sanctioning

mechanisms, assisting in non-discretional decision-making and

toughening sanctions.

• It obliges national legal systems to fully incorporate both the

fiscal rules and the minimum requirements of quality and coor-

dination of budgetary frameworks.

In the medium to long term, the application of such rules, assu-

ming a trend nominal growth of 3% per annum, would lead to a

public debt stock of 17% of GDP (Whelan, 2012). The key for such

rules to generate anti-cyclical fiscal policies is that they are able to

impose tough discipline during the expansive phases, that the

reliability of the fiscal information is assured and that the sanc-

tions are applied in rigorous and equitable way for all.

The use of a non-observable variable such as the structural

balance in order to assess compliance with the deficit rule makes

sense, but it complicates the practical application thereof due to

uncertainty in regard to the correct estimate of potential GDP. The

case of Spain during the phase prior to the crisis is paradigmatic:

during the period 2005-2007, the Commission estimated the struc-

tural budgetary balance to be very close to the nominal balance,

given that the growth estimate for potential GDP was around 3%.

The subsequent performance of the economy and of the public


179

income and expenditure has shown that in the years previous to

the crisis, Spain was growing over and above its potential and that

the structural balance was much worse than that indicated by the

nominal surplus.

In reality, the value of the Treaty on Stability, Coordination and

Governance is above all political, as it helps to bring about once

again a new political understanding among the euro member

countries. Several countries have interpreted the financial aid as a

breach, at least in spirit, of the non-mutual guarantee clause in the

Treaty. It was hard for Germany and other countries in the D-mark

area to bring their monetary sovereignty in line with that of coun-

tries with a lesser tradition of stability. And the non-guarantee

clause was one of the essential conditions to do so. Part of the atti-

tude of governments and central bank authorities in these coun-

tries in the last two years could be explained by this feeling that

rules have been broken.

The new Treaty, with its reflection in the Constitutions of several

countries, is one more step for countries in the north and centre to

believe that the countries which are currently more vulnerable are

adopting a longstanding commitment to fiscal discipline, beyond

the adjustment forced upon them by the markets. And this confi-

dence is essential to the creation of political conditions which will

enable decisions to be taken with a view to solving the crisis. The

Fiscal Pact is therefore a necessary condition, but in no way is it

enough to make 2012 the year of the start of the end of the crisis.


180

The Treaty will strengthen the policy of firm advancement in fis-

cal consolidation in the most vulnerable countries, which has been

applied for the last two years. But we are already aware that the per-

verse dynamics can make a steadfast programme of fiscal adjustment

which lacks a complement to help restore growth fail in its objecti-

ve of stabilising public debt. Without nominal growth and financial

stability, the efforts made in regard to deficit reduction not only fail

to reduce the debt/GDP ratio, but actually increase it.

THE GRADUAL AND FLEXIBLE CONSTRUCTION OF A SIN-

GLE PUBLIC DEBT MARKET. The key to doing away with the per-

verse dynamics of debt is to restore the good working order of the

public debt markets, so that the spreads are more in line with eco-

nomic fundamentals and more stable. This is an essential condition

for relaxing financial terms in vulnerable countries and for allowing

growth to benefit from the positive effects of the reforms adopted.

We have already pointed out that there is no confidence that the

Eurosystem will adopt the strategy required to achieve this objecti-

ve. A second alternative on the table is the EFSF/ESM. In theory, the

EFSF/ESM, with the set of intervention instruments which it

currently contains, has the effective capacity to stabilise the public

debt markets. However, in our opinion, financial aid is not an effi-

cacious solution to the perverse dynamics of debt. Under current

conditions, the preventive funding facilities would soon become

ordinary adjustment programmes; the result would be the exten-

sion of the loss of access to market funding and the escalation of the


181

political tension arising from the concentration of funding in the

area from only a few contributor countries. On the other hand, the

design of the secondary market intervention instruments has too

many political and operational limitations to even appear plausible.

In our opinion, the most suitable way is the creation of a new

public debt market with jointly and severally guaranteed securities.

This is a very important and delicate political decision, as it involves

the pooling together of sovereign risk, which is an essential part of

fiscal sovereignty. Countries with higher credit rating have been hit-

herto reluctant to share the issue of debt with those of a lower cre-

dit quality. This attitude is fair and understandable; to ask Finland,

Holland or Germany to pool together all the debt issued with more

indebted and vulnerable countries is politically unrealistic.

But given the current crossroads of the Monetary Union, this

step must be taken, and the way to do it is to design it in such a

way that it is politically feasible. This design should abide by the

following principles:

• The construction of a single public debt market in euros must

be done gradually. The first stone must be solid but of a mode-

rate size. The next stones shall be placed little by little and on

the basis of experience.

• At the first stage, the percentage of public debt pooled together

must be limited. This requirement should be in line with the

doctrine of the German Constitutional Court, which requires

bonds issued by the State to have a clear quantitative limit.


182

• The pooled debt must be senior to the national debt, in order to

reduce the risk of the joint and several guarantee.

• Incentives restricting moral hazard must be introduced, taking

in account the strengthened governance framework of the

Monetary Union.

In the Eurobond debate, several specific formulae have been

considered which are compatible with such principles. The pione-

er was the blue bond/red bond proposal (Delpla & Weizsäcker,

2009), which suggested pooling together up to 60% of the public

debt over the GDP (blue debt), leaving the rest as subordinate

national debt (red debt). The Commission published a Green Paper

containing various different options of Stability Bonds which

aimed at feeding the debate. Lastly, the proposal of a European

Debt Redemption Fund from the Group of German Economic

Experts (2011), which advises the Federal Government, is also of

great interest, in that it considers the pooling together of the sur-

plus of the 60% of debt over GDP in exchange for real guarantees

in order to overcome the crisis. 17

In our opinion, the most attractive alternative would be the

Eurobills proposal made by Hellwig & Phillippon (2011) which

would consist of:

• The issue with a joint and several guarantee of all public debt

securities with initial maturities of up to 1 year (Eurobills).


183

17 The formula of the surplus over and above the 60% does not seem fair, as it rewards

the more indebted countries.

• The participation of each member country would be limited to

10% of the GDP. The Eurobill market would therefore have a

maximum size, based on the GDP for 2011, of 1 billion euros.

• The Eurobills would be senior to all other longer term debt, as

the short term debt is already de facto senior to medium and

long term debt.

• The loss of access to the Eurobills could be considered discipli-

nary action within the framework of multilateral supervision

of fiscal policies and macro-economic imbalances.

The Eurobills are a simple formula with many advantages:

• Efficacy. As we have already mentioned, the core of the dislo-

cation in economy funding mechanisms lies with the shorter

part of the debt markets and its connection to the money mar-

kets. The Eurobills would manage to directly tackle the failure

and the effect would be foreseeably transmitted throughout

the yield curve. They would thus represent an alternative to

stability limits.

• Political feasibility. The high level of political and legal com-

mitment to fiscal stability brought by the new Treaty should

allow for the more solvent countries to accept the Eurobills.

Given their term, the risk is limited; and in terms of cost if

issue, the loss would be small or non-existent.18

• Operating facility. The EFSF/ESM already issues bills, so it could

easily assumed the issue of Eurobills. A system would have to


184

18 The bills issued by the EFSF with proportional guarantees from euro member coun-

tries have a small spread compared to German bills. Taking as a reference the issue of

be established to consolidate the treasury needs for each State,

as Bills play a certain role as treasury management instruments.

• Additional benefits. Eurobills could be used to meet Basel III

liquidity requirements and would attract a strong demand from

institutional investors in and outside of the region.

The construction of a single public debt market in euros will be

a long and complicated process, likely to take decades. It is a basic

ingredient in the path of the euro towards institutional maturity,

which shall have to develop alongside advancements made in fis-

cal integration. But it must commence now, as it is the key to over-

come the crisis once and for all.

THE FEDERALISATION OF BANKING SUPERVISION IN THE

EUROSYSTEM AND THE CREATION OF A EUROPEAN DEPOSIT

GUARANTEE FUND. In hindsight, one of the most serious flaws of

the institutional framework of the first decade of the euro has to do

with banking supervision and crisis management. In order to reach

a definitive solution, this flaw must be corrected.

Despite having harmonised prudential legislation from the

start, the euro region has worked with banking systems which have

continued to be governed by an essentially national approach. On


185

March 6 month bills, the spread compared to the German bills is lower than 20 basis

points. The cost of issue of the Eurobills would naturally be lower than that of the EFSF

bills, thanks to the joint and several guarantees, closer to the levels at which bills are

currently issued by Germany and by other countries with a higher credit rating.

the other hand, despite the efforts begun following the Brouwer

Report (2001) to build a crisis management plan within the EU,

when the crisis was broke out weak in deposit guarantee and prac-

tically non-existent in the intervention and liquidation of credit

institutions.

One of the most illustrative indicators of this persistence of the

national approach in the realm of banking is that the integration

has advanced more between euro countries and non-euro coun-

tries than within the euro region itself. Among the problems asso-

ciated with this situation, we shall highlight two:

The absence of global overview of the funding structure of

the area and its relation with monetary policy. The creation of

the euro led to a strong expansion of gross and net flows within

the area. In a way, this was the reallocation of capital towards those

countries where it was scarce and could obtain better returns. But

in some countries this process ended up by creating bubbles in the

real estate sector, which reached hitherto unknown peaks partly

due to belonging to the Monetary Union (low interest rates, very

elastic supply of external funds). In light of the high short term

economic benefits in terms of extraction of income, employment,

fiscal activity and collection, the economic policy renders very dif-

ficult, as we have seen, the adoption of domestic measures to burst

the bubble. At the same time, given that monetary policy is exo-

genous to the authorities of a country, the effect thereof is not

internalised in regard to the creating or blowing up a bubble furt-

her. But it is not only about bubbles. The global crisis showed up


186

other weaknesses in the funding structure of the banks in the euro

region, such as its dependence on the liquidity of the US money

markets.

The possibility that a banking crisis might bring down a

country. National supervision goes hand in hand with the natio-

nal responsibility for covering costs in the event of a crisis. As we

have seen in Ireland, the bank solvency problems can overwhelm

the fiscal capacity of the country. Moreover, and continuing with

the Irish example, the potential effects of contagion within the

Monetary Union limit the capacity of the affected country to solve

the crisis by the assumption of losses by private creditors.

Since the start of the crisis, considerable progress has been made

in terms of coordination of bank supervision and crisis manage-

ment in Europe. Nevertheless, the maturity of the Monetary Union

still has a way to go. The essential public policies on the banking

system must be common within the euro area, in accordance with

a plan with two main cornerstones:

• Federal banking supervision within the Eurosystem. The time

has come to make use of a provision of the Treaty on the fede-

ralization of banking supervision within the euro area. Given

that only in 5 euro countries the banking supervisor is separate

from the central bank, and that the ECB is the most powerful

euro institution, the most natural approach to achieve this is by

awarding competencies to the Eurosystem. And the competen-

cies assumed must include micro-prudential regulation, macro-


187

prudential regulation and part of the crisis prevention and

management function.

• A European Deposit Guarantee Fund (EDGF). The crisis has

proven that the deposit guarantee systems are basic instruments

in the prevention and management of banking crises. During

the global crisis, the risk of having systems with insufficient

coverage (eg. Northern Rock) or the chaos generated by unilate-

ral decisions on levels of coverage within the euro (movements

of deposits between countries at the end of 2008) became

patently clear. With the generalized increase in coverage of

deposits up to 100,000 euros (which increases the cost of the

liquidation of the institutions), the guarantee funds, in princi-

ple, assume a crucial responsibility. However, the models of

deposit guarantee systems within the area as still quite different

from one another. For this reason an obligatory adhesion fund

should be created to assume the guarantee of all deposits in the

banks of the euro area and their branches in the EU. The fund

should be made up of the contributions from entities, determi-

ned on the basis of credit and liquidity risk and have a system

of governance similar to that of the Spanish guarantee funds,

presided over by the ECB and with broad representation of the

private sector in its Board of Governance. The functions of this

EDGF should include the resolution of banking crises, assisting

the mandate of the Eurosystem in early intervention and crisis

resolution at the lowest cost for the public treasury. As an addi-

tional and exceptional mechanism of funding, a system could

be established whereby the ESM could lend funds to the EDGF.


188

The improvement in the operation of the Monetary Union as a

result of the federalisation of banking supervision and crisis mana-

gement would be considerable in the medium and long term. The

following are among the possible positive changes associated with

this reform:

• The monetary transmission mechanism would become more

robust against national fiscal evolutions and the fluctuations of

the financial markets.

• A boost to cross-border integration and consolidation. The pro-

tection of domestic industry would become more difficult,

which would lead to benefits of risk diversification and econo-

mies of scale. And competition would gradually become more

intense, which is essential after the re-nationalisation of the

banking markets and the strong public support provided to cri-

sis- affected entities.

• Support for incentives to implement measures to prevent the

creation of speculative bubbles.

• The internalisation of external effects and public service provi-

sion problems associated with financial stability within the

area. This would allow for the creation of a structure where the

central bank and the Ministries (Eurogroup) work much more

efficiently towards preserving financial stability.

• It would support the introduction of measures to achieve grea-

ter involvement of the private sector in the solution of future

crises.


189

5. Conclusion

The adolescent crisis of the euro is extremely serious. European

and national authorities have taken courageous and significant

decisions in recent months, in many cases having learned from

previous mistakes. The restructuring of the debt and the new

adjustment programme are an intelligent and well executed res-

ponse to the serious solvency problem in Greece. Ireland and

Portugal are applying their programmes with excellent assessments

made by the troika. And an institutional framework is under way,

which will render the generation of a crisis in the future a lot less

likely.

Much political and social capital has been spent on implemen-

ting such measures. It is clear that the euro member countries are

willing to make great sacrifices in order to preserve the project. But

the truth is that the crisis has not yet been overcome, because the

root causes of the uncertainty and the instability generated by the

dislocation of the public debt markets have not been attacked.

The economy within the euro area will foreseeably face a second

recession three years after the sharp blow of 2009. Ireland and

Portugal are watching their expectations of recovery fade as a

result of lower foreign demand and maintenance of financial pres-

sure. And there are questions as to the likelihood of its return to

the markets within the timeframes set and even in regard to the

Greece and no more commitment. Spain and Italy are implementing


190

strong fiscal adjustments and deep structural reforms in an envi-

ronment of recession and financial vulnerability.

The euro cannot afford to undergo another episode like the one

in August-September 2011. It is imperative that a measure is taken

to protect us against that risk and removes, once and for all, the

devastating coordination failure of the global crisis of 2009. Having

assumed that the stabilisation of the debt markets cannot be pro-

vided by the central bank as in other countries, we have to choose

a new market. Eurobills are an efficient and balanced solution;

2012 should be their birth year. They will help reunify monetary

policy, by first restoring stability and establishing the foundations

for a solid economic recovery. These conditions are essential for the

programmes to work, for the debt to stabilize and for the consoli-

dation and reform policies to be effective and have continuity.

There is no future without stability and growth.

It is not necessary to search for great constructions or to come

up with solutions for all the problems. The Eurozone shall never be

an optimal monetary region. It does not need to be. For the time

being, we must concentrate on a series of efficient and plausible fis-

cal regulations, a single monetary policy based on debt markets

which are operating fairly and a stable banking system capable of

funding the economy. And to continue to learn and build an incre-

asingly closer union. The countries that are currently suffering will

learn from their mistake; one cannot prosper within the euro with

the same institutional framework that one had out of the euro:


191

foreign finances continue to be a restriction, the real exchange rate

and the flexibility in real salaries and mark-ups are important, cre-

dit excesses cost dearly… but we must allow some time for the les-

sons learned to be put into practice and produce good results.


192


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The turbulent adolescence of the euro and its path tomaturity by Gonzalo García Andrés

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