This document provides an overview of a lecture on European monetary policy, fiscal policy, and the global financial crisis. It discusses the monetary unification of the EU, fiscal coordination in the eurozone, the Stability and Growth Pact, EMU performance 1999-2012, and strains within the eurozone. It also covers the objectives, instruments, and strategy of the European Central Bank, fiscal policy externalities, and the Stability and Growth Pact.
European monetary policy, fiscal policy and the global financial crisis
1. ECON339
EURO339
Lecture 4: European monetary
policy, fiscal policy and the
global financial crisis
January 2013
2. ECON339 / EURO339
Overview
The monetary unification of the EU
Monetary and fiscal coordination in the euro zone
Fiscal policy and the Stability and Growth Pact
The performance of EMU 1999-2012
The global financial crisis
Moral hazard, bail-outs and strains within the eurozone
The outlook for European monetary union
2
5. ECON339 / EURO339
The Maastricht Treaty (2)
A firm commitment to launch the single currency by
January 1999 at the latest
A list of five criteria for admission to the monetary union
A precise specification of central banking institutions
Additional conditions mentioned (the excessive deficit
procedure)
5
6. ECON339 / EURO339
The Maastricht convergence criteria
Inflation:
not to exceed by more than 1.5 per cent the average of the three lowest
rates among EU countries
Long-term interest rate:
not to exceed by more than 2 per cent the average interest rate in the
three lowest inflation countries
ERM membership:
at least two years in ERM (now ERM-2) without being forced to devalue
Budget deficit:
deficit less than 3 per cent of GDP
Public debt:
debt less than 60 per cent of GDP (or declining satisfactorily)
All observed in 1997 for decision in 1998
6
7. ECON339 / EURO339
Interpretation of the convergence criteria:
inflation
10.00
Straightforward
fear of allowing in
unrepentant
inflation-prone
countries
5.00
0.00
1991 1992 1993 1994 1995 1996 1997 1998
France Italy
Spain Germany
Belgium Portugal
Greece average of three lowest + 1.5% 7
8. ECON339 / EURO339
Interpretation of the convergence criteria:
long-term interest rates
Easy to bring inflation down in 1997 – artificially or not – and then
let go again
Long interest rates incorporate bond markets expectations of long
term inflation
So criterion requires convincing markets
Problem: self-fulfilling prophecy:
if markets believe admission to euro area, they expect low inflation
and long-term interest rate is low, which fulfils the admission criterion
conversely, if they don‟t, all is lost
8
9. ECON339 / EURO339
Interpretation of the convergence criteria:
ERM membership
Same logic as the long-term interest rate: need to
convince the exchange markets
Same aspect of self-fulfilling prophecy
9
10. ECON339 / EURO339
Interpretation of the convergence criteria:
budget deficit and debt
Historically, all big inflation episodes born out of runaway
public deficits and debts
Hence requirement that house is put in order before
admission.
How are the ceilings chosen?
deficit: the German „golden rule‟
debt: the 1991 EU average
Problem No 1:
a few years of budgetary discipline do not guarantee long-
term discipline
Need Stability and Growth Pact
Problem No 2: artificial ceilings 10
11. ECON339 / EURO339
The deficit and debt criteria in 1997
Maastricht fiscal criteria 1997
120
100
80
Public Debt (%GDP)
60
40
20
0
-3 -2 -1 0 1 2 3 4 5
Deficit (% GDP) 11
12. ECON339 / EURO339
A tour of the acronyms
National Central Banks (NCBs) continue
operating but with no monetary policy
function
A new central bank at the centre: the
European Central Bank (ECB)
Jean-Claude
Eurosystem/ECB independent of national Trichet, ECB
governments President
The European System of Central Banks
(ESCB): the ECB and all EU NCBs
The Eurosystem: the ECB and the NCBs
of euro area member countries (N=17)
12
13. ECON339 / EURO339
How does the Eurosystem work?
Objectives:
what is it trying to achieve?
Instruments:
what are the means available?
Strategy:
how is the system formulating
its actions?
ECB building, Frankfurt
13
14. ECON339 / EURO339
Objectives (1)
The Maastricht Treaty‟s Art. 105.1:
‘The primary objective of the ESCB shall be to maintain price
stability. Without prejudice to the objective of price stability, the
ESCB shall support the general economic policies in the
Community with a view to contributing to the achievement of the
objectives of the Community as laid down in Article 2.’
Article 2:
‘The objectives of European Union are a high level of employment
and sustainable and non-inflationary growth.’
So:
fighting inflation is the absolute priority
supporting growth and employment comes next
14
15. ECON339 / EURO339
Objectives (2)
Making the inflation objective operational: does the
Eurosystem have a target?
It has a definition of price stability:
‘The ECB has defined price stability as a year-on-year
increase in the Harmonised Index of Consumer Prices
(HICP) for the euro area of below 2%.’
…and it has an aim:
‘In the pursuit of price stability, the ECB aims at
maintaining inflation rates below, but close to, 2% over
the medium term.’
15
16. ECON339 / EURO339
Instruments
Main channels of monetary policy:
longer run interest rates
credit
asset prices
exchange rate
These are all beyond central bank control
Instead it can control the very short-term interest rate:
European Over Night Index Average (EONIA)
EONIA affects the channels through market expectations
16
17. ECON339 / EURO339
The ‘two-pillar’ strategy
The monthly Eurosystem‟s interest rate decisions (every
month) rests on two pillars
Economic analysis:
broad review of economic conditions - growth,
employment, exchange rates, economic
developments abroad (eg, oil prices)
Monetary analysis:
evolution of monetary aggregates (M3, etc)
17
18. ECON339 / EURO339
Comparison with other strategies
The US Fed:
legally required to achieve both price stability and a high level
of employment
does not articulate an explicit strategy
Inflation-targeting central banks (NZ, Czech Republic,
Poland, Sweden, UK, etc):
announce a target (eg, 3 per cent in NZ), a margin (eg, 1%)
and a horizon (2–3 years)
compare inflation forecast and target, and act accordingly
18
19. ECON339 / EURO339
Taylor Rule interpretation (1)
i = i* + a( - *) + b (y - y*)
i* = equilibrium interest rate
= inflation
* = inflation objective (eg, 2%)
y = GDP growth
y* = trend GDP growth
a = aversion to inflation
b = aversion to cyclical fluctuations
19
20. ECON339 / EURO339
Taylor Rule interpretation (2)
i = i* + a( - *) + b (y - y*)
By Fisher equation,
i* = r* + *
(eg, r* = 2%, then i* = 4%)
and y* = 1.2%
ECNB weights are estimated at:
a = 2.0
B = 0.8
20
22. ECON339 / EURO339
Independence and accountability
Current conventional wisdom is that central banks
ought to be independent:
governments tend not to resist to the „printing press‟
temptation
the Bundesbank has set an example
ECB set up to be independent of national and EU
government
What does independence mean?
How does accountability work?
22
23. ECON339 / EURO339
Independence
Article 7: Independence
…neither the ECB, nor a national central bank, nor any member of
their decision-making bodies shall seek or take instructions from
Community institutions or bodies, from any government of a Member
State or from any other body…
Article 21: Operations with public entities
…overdrafts or any other type of credit facility with the ECB or with
the national central banks in favour of Community institutions or
bodies, central governments, regional, local or other public
authorities, other bodies governed by public law, or public
undertakings of Member States shall be prohibited, as shall the
purchase directly from them by the ECB or national central banks of
debt instruments
23
24. ECON339 / EURO339
Accountability: redressing the
democratic deficit
Misbehaving governments are eventually punished by voters
What about central banks? Independence removes them from
such pressure - a democratic deficit?
In return for their independence, central banks must be held
accountable:
to the public
to elected representatives
The Eurosystem must report to the EU Parliament
The ECB‟s President must appear before the EU Parliament
when requested, and does so every quarter
24
25. ECON339 / EURO339
Fiscal policy in a monetary union
In a monetary union, fiscal policy
the only macroeconomic instrument at national level
government borrows in recession and pays back on behalf of citizens in good
times
government acts as substitute to inter-country transfers in case of asymmetric
shock
Effectiveness depends on private expectations
Slow implementation of fiscal policy
Inside vs outside lags
Result: countercyclical actions can have procyclical effects
25
26. ECON339 / EURO339
Automatic versus discretionary fiscal
policy
Automatic stabilisers:
tax receipts decline when the economy slows down, and
conversely
welfare spending rises when the economy slows down, and
conversely
no decision, so no lag: nicely countercyclical
rule of thumb: deficit worsens by 0.5 per cent of GDP
when GDP growth declines by 1 per cent
26
28. ECON339 / EURO339
Actual versus cyclically-adjusted
budget balance
Discretionary actions: a voluntary decision to change
tax rates or spending
Cyclically adjusted budget shows what the balance
would be if the output gap is zero in a given year
Difference between actual and cyclically adjusted
budget = footprint of automatic stabilisers
28
30. ECON339 / EURO339
Fiscal policy externalities
In a monetary union, should fiscal policy be subjected to some
form of collective control?
Yes, if national fiscal policies are a source of externalities
Externality #1 - income spillover via trade:
important and strengthened by monetary union
lack of co-ordination means that with a symmetric shock, too
much policy action can be used to counteract shock
30
31. ECON339 / EURO339
Other externalities
Borrowing cost externalities:
one country‟s deficit would induce higher interest rate for everyone
long-term growth effects
capital inflows appreciate common currency and affect
competitiveness
Most serious is the risk of default in one member country:
capital outflows and a weak euro
pressure on other governments to help out Alert: moral
pressure on the Eurosystem to help out
hazard
Answer to address risk:
the „no-bailout‟ clause in Maastricht Treaty
Prevention procedure
31
32. ECON339 / EURO339
Maastricht Treaty
1.2. Monitoring of budgetary discipline
As from Stage 2, the Treaty prohibits the direct financing of public
entities‟ deficits by national central banks (Art. 101), be it overdraft
facilities, other types of credit facility or the purchase of debt
instruments, except for the purpose of monetary policy. The Treaty
also prohibits public entities' privileged access to financial institutions
(Art. 102).
Moreover, the “no bail-out” clause in Article 103 stipulates explicitly
that neither the Community nor any Member State is liable for or can
assume the commitments of any other Member State.
32
33. ECON339 / EURO339
Arguments for/against fiscal policy
controls
The arguments for:
serious externalities
a bad European track record on debt and deficits
The arguments against:
the only remaining macroeconomic instrument
national governments know their domestic economic
circumstances best
33
34. ECON339 / EURO339
The Stability and Growth Pact (SGP)
The SGP: meant to avoid excessive deficits upon entry into
euro area
Excessive Deficit Procedure (EDP) makes permanent the 3%
GDP deficit and 60% GDP ceilings and calls for fines
Final word remains with ECOFIN, and countries avoided fines so
far
SGP reformulated in 2005 to avoid rigidity of Pact
negative growth or accumulated loss of output over a period of low
growth exceptional
taking account of „all relevant factors‟
no specific definitions
New reform makes fines automatic
34
35. ECON339 / EURO339
How the SGP works
A limit on acceptable deficits: 3% of GDP
A preventative arm
Aims at avoiding reaching the limit in bad years
Calls for surpluses in good years
A corrective arm
„early warning‟ when deficit is believed to breach limit +
recommendations
EDP procedure for excessive deficit: recommendations, to
be followed by corrective measures, and ultimately
sanctions
35
36. ECON339 / EURO339
The SGP fine schedule
The sum is retained from payments from the EU to the country
(CAP, Structural and Cohesion Funds)
The fine is imposed every year when the deficit exceeds 3 per
cent.
The fine is initially considered as a deposit:
if the deficit is corrected within two years, the deposit is returned
if it is not corrected within two years, the deposit is considered as a
fine
36
37. ECON339 / EURO339
Issues raised by the SGP
It could make fiscal policies procyclical:
budgets deteriorate during economic slowdowns
reducing the deficit in a slowdown may further deepen the
slowdown
a fine both worsens the deficit and has a procyclical effect
In practice, the Pact encourages countries to:
aim at surpluses (so public debts will disappear) in normal times,
to give them scope to use fiscal policy in a downturn
reduce reliance on discretionary policy and just use automatic
stabilisers
37
38. ECON339 / EURO339
The record of EMU so far…..
A difficult period:
an oil shock in 2000 and again in 2007
a worldwide slowdown in early 2000s
September 11, 2001
the stock market crash in 2002
Afghanistan, Iraq wars
the weak US dollar
The 2008 global financial crisis
The European (Eurozone) sovereign debt crisis
38
39. ECON339 / EURO339
Inflation: missing the objective, a little …until
2008 commodity boom, 2008-12 financial crisis
39
Source: European Central Bank
40. ECON339 / EURO339
The performance of the euro against
US$
40
Source: European Central Bank
41. ECON339 / EURO339
Current financial crisis
“ The European Central Bank's main task is to keep inflation
down. But over the past month, it has thrown caution to the
wind in trying to prevent Europe's financial system and
integrated economy from falling apart.
The ECB has transformed itself into a crisis manager of the
sort that its architects could hardly have imagined when the
bank took up its work 10 years ago. The bank, charged with
managing the euro, was given a single mandate - to keep
prices under control.
Lately, however, the central bank has cast aside worries about
inflation, cutting interest rates once already, with more cuts in
the pipeline. At the same time, it is lending ever more cash to
strapped banks.”
International Herald Tribune, October 16, 2008
41
42. ECON339 / EURO339
Early stages of the recession
Eurozone entered recession in 2008Q3
European Council agreed package to avert financial
meltdown in October 2008
National governments (not ECB) would bail out
commercial banks
ECB would reduce interest rates and inject liquidity into
banking system
42
46. ECON339 / EURO339
Remember from Lecture 1:
government debt and the euro
Eurozone governments are effectively borrowing in
„foreign currency‟
They cannot borrow from their own central banks,
monetise the debt and inflate away their debts (like US
and UK)
Financial markets demand ever-higher risk premium
from indebted governments
This increases debt service costs, the deficit and so the
need to borrow more and eventually the government
will default
46
47. ECON339 / EURO339
From financial crisis to sovereign
debt crisis
From 2010, growing concern about sovereign debt levels in
Greece, Spain, Ireland, Portugal and Italy
Bond yield differentials between this group and France and
Germany widened
March 2010, European Council agreed on a bailout mechanism
for Greece
Other countries could apply if needed
Widely believed bailout violates EU treaties – note: bailout is
by EU national governments, not ECB, which cannot directly
monetise debt
47
53. ECON339 / EURO339
The bailouts
In April 2010, bailout mechanism used - €30bn lent to Greece
In May 2010, EU established a full fund of €750bn
€440bn from eurozone states
€60 billion from European Commission
€250 billion from the IMF
European Financial Stability Facility (EFSF) established
issues debt on capital markets, backed by guarantees from the eurozone
states
lends to indebted eurozone governments once recovery plan agreed
Long-term solution is the European Stability Mechanism, agreed in
December 2010
Replaces the EFSF and similar legal instruments
Combined with a monitoring body
53
55. ECON339 / EURO339
Trying to make the SGP work
In June 2010, the Council agreed that national governments
would present their budget plans to the Council and
Commission six months before budget time
Governments would have to justify deficits
Tougher scrutiny for deficits if debt > 60% GDP
Sanctions still unclear – possibly having voting rights in the
Council suspended
55
56. ECON339 / EURO339
Is the medicine working?
The EU has given bail-outs to five Eurozone members:
G, IRL, P, E, I
Loans have been conditional on budgetary cuts and
return to sustainable debt levels
In some countries (Greece), budget cuts have deepened
the recession
Long-term interest rates are coming down
But indebted states still have poor credit ratings and
face many years of austerity and political unrest
56
57. ECON339 / EURO339
Conclusions
The ECB set up with primary objective of price stability and
independent of national and EU governments
May not directly monetise debt
In EMU, national fiscal policy more effective, only
macroeconomic policy tool to adjust to asymmetric shocks
But there are important external effects of fiscal policy
EU has so far failed to design and enforce controls on national
fiscal policy
EMU presently at risk of being destabilised by sovereign
default… but countries in crisis small and the EU has acted
decisively so far
57