“How to regain confidence in the euro area?” contribution by Vítor Gaspar 1to a panel
discussion at the Conference “The Euro Area and the Financial Crisis”, 6-8 September,
Bratislava, hosted by the National Bank of Slovakia.
I thank the organizers, especially Ludovit Ódor, for inviting me for this Conference and for
giving me the opportunity to participate in this panel to discuss “How to regain confidence in
the euro area?” As Athanasios Orphanides said, in his opening keynote address, the Global
Crisis revealed fault lines in the governance of the euro area. He focused on the new
architecture for financial stability in Europe. In my brief introduction to this panel I want to
focus on public finances; specifically I want to focus on budget discipline.
1. Demographic transition, the global crisis and debt levels.
Before focusing on the specific case of the euro area I want to very briefly comment on a
crucial evolutionary trend that shapes the context in which budgetary policy will be conducted
in the next decades: demographics. Developments are the more surprising as the world is
experiencing a fundamental demographic transition. According to the latest demographic
projections, made available by the United Nations 2, World Population will stop growing by
2050, when it will have reached about 9 billion people (compared to almost 7 billion in 2010).
This will interrupt a trend of pronounced population growth recorded for centuries. This
constitutes an epochal transition with profound impacts on economic, political and social
balances.
The transition will happen first in advanced countries. For example for the 27 Member States
of the European Union the population is projected to decline slightly in the four decades from
2010 to 2050 (notwithstanding significant migration flows). The share of EU27 in World
population is projected to decline from 7.2% to 5.4% 3. The transition has far-reaching
implications for social, political and economic trends. It has, in particular, strong influence on
the sustainability of public finances. All other things equal, a slowdown in population growth
increases the implicit public debt burden associated with the operation of health and pension
systems. At the same time demographic transition raises very difficult issues of equity across
generations. Public debts in OECD countries have doubled since the mid-seventies. The Global
Crisis accelerated the trend. The evolution was marked by the functioning of automatic
stabilizers, discretionary expansion and the costs of intervention to stabilize the financial
1
Special Adviser Banco de Portugal. I am grateful to Isabel Gameiro and Paul Hiebert for comments and
corrections. The remaining errors are my responsibility. The views expressed are my own and do not
necessarily reflect those of the Banco de Portugal or the Eurosystem’s.
2
An authoritative source is provided by United Nations, 2009.
3
In 1950 the relevant percentage was 14.8%.
system 4. Such accumulation of public debt is unprecedented in peace time. Therefore,
sustainability of Public Finances is a central challenge that the Global Crisis has made even
more pressing.
2. Budgetary rules and procedures in the euro area.
The economic constitution of the euro area reflects the view that stability-oriented
macroeconomic policies provide the groundwork for the proper functioning of a market
economy with unfettered competition leading to sustainable growth. The primary goal of
monetary policy is price stability and the conduct of monetary policy was entrusted to the
independent European Central Bank. The Lisbon Treaty includes provisions protecting the
central bank from encroachment from the fiscal authorities. Article 123 prohibits monetary
financing and Article 124 rules out privileged access to financial institutions. Moreover, Article
125 excludes the responsibility of the Union or of other Member States for financial
commitments assumed by one Member State; and Article 122 limits financial assistance for
cases in which a Member State “is in difficulties or is seriously threatened with severe
difficulties caused by natural disasters or exceptional occurrences beyond its control …”
Notoriously, article 143 of the Treaty does not foresee mutual assistance for the case of
members of the euro area 5.
A fundamental question is whether, given the prohibition of monetary financing, privileged
access and bail out, market discipline can be expected to be sufficient to ensure fiscal
discipline. The question was addressed more than twenty years ago in the Delors Report (page
24):
“To some extent market forces can exert a disciplinary influence … However, experience
suggests that market perceptions do not necessarily provide strong and compelling signals and
that access to a large capital market may for some time facilitate the financing of economic
imbalances … The constraints imposed by market forces might either be too slow and weak or
too sudden and disruptive.”
In a companion piece, Lamfalussy (1989) argues that there is indeed reason to be skeptical
about the effectiveness of market-imposed discipline for countries participating in a monetary
union 6. The conclusion in the Delors Report was that participation in the single market and in
the single currency implied that Member States had to accept corresponding policy
constraints. This view is reflected in relevant provisions in the Lisbon Treaty. Specifically
Articles 120 and 121 prescribe that Member States conduct their economic policies as a matter
of common concern and with a view to achieve the objectives of the Union. In case a Member
4
As Trichet stressed, in his address to the 2010 Jackson Hole Conference, in the euro area, public debt
to GDP shot up by more than 20 percentage points in a period of just four years starting in 2007 (see
Trichet, 2010).
5
The point is made by Marzinotto, Pisani-Ferry and Sapir (2010).
6
Empirical evidence and further discussion are provided in Restoy (1996) and Bernoth et al. (2006) and
Schuknecht et al (2008).
State does not behave in conformity with the Broad Economic Policy Guidelines or risks
jeopardizing the smooth functioning of economic and monetary union, it is subject to the
possibility of warnings from the European Commission and recommendations from the EU’s
Council. Moreover, Article 126 imposes on Member States participating in the euro area, the
legal obligation to avoid excessive deficits. The Treaty provisions were completed by the
Stability and Growth Pact 7. The Pact made clear a distinction between the preventive arm,
based on the surveillance of budgetary positions, and the corrective arm, based on the
excessive deficit procedure. The preventive arm is covered by Regulation EC 1466/97
(amended by Regulation EC 1055/2005). The corrective arm, in turn, is covered by Regulation
EC 1467/97 (amended by Regulation EC 1056/2005) 8. Paragraph 11, of article 126 of the TFEU
foresees the possibility of sanctions in the case of non-compliance.
3. Sovereign Debt Market Behavior.
The creation of the euro area has been associated with the emergence of an integrated market
for sovereign debt. Capiello, Engle and Shephard (2006) find that correlation between bond
returns issued by governments participating in the euro area approached unity shortly after
the start of the euro area in 1999. In most of the first decade of the euro area sovereign
spreads have been low (rarely exceeding 30 basis points and averaging much lower) 9.
The situation changed dramatically with the Global Crisis. Spreads widened slowly and
gradually and the process paced up after the bankruptcy of Lehman, in September 2008. In
2009 there was a period when the situation seemed on a path of gradual easing. However,
from the autumn onwards spreads widened again and CDS premiums increased reflecting
bond market tensions, driven, to a large extent, by idiosyncratic factors. Euro area bond
markets were in turmoil in early May 2010 and stabilized only after the announcement of
strong collective action at the European level. At the current time (September 2010) tensions
persist in bond markets.
Schuknecht, von Hagen and Wolswijk (2008, 2010) importantly show that bond yield spreads
can be largely explained on the basis of economic fundamentals before and after financial
market turmoil and the crisis. They are able to relate differentials to benchmark (the German
bunds for the euro area) with deficit and debt differentials. However, after September 2009,
the coefficient on deficit differentials has been multiplied by a factor between 3 and 4 and the
coefficient on debt differentials by a factor of 7-8. At the same time spreads have also
increased as a response to shifts in general risk aversion, with German ten-year bonds
assuming a safe haven role. The ability of these authors to find a systematic relation between
spreads and fundamentals before and after market turmoil and the crisis has important policy
7
For the genesis of the Stability and Growth Pact see Stark (2001) and Costello (2001).
A very useful source for the relevant secondary legislation texts is
http://europa.eu/legislation_summaries/economic_and_monetary_affairs/stability_and_growth_pact/i
ndex_en.htm.
9
As documented by, for example, Gerlach, Schulz and Wolff (2010).
8
implications. In particular market discipline has been present throughout the whole period,
albeit in a much stronger way in the recent past.
The evidence shows a clear pattern in which market discipline was “too slow and weak” before
the Global Crisis and became, more recently, “too sudden and disruptive”. The Stability and
Growth Pact and the other provisions in the Treaty and secondary legislation failed to prevent
the very pattern of market behavior they were designed to avoid. Such failure requires major
adjustments in the governance of the euro area. The issue is central for macroeconomic
stability, in general, and for financial stability, in particular.
4.
The work of the van Rompuy Task Force.
The problem identified above was already clear in March 2010. On 26 March the European
Council gave a mandate to the van Rompuy Task Force to examine the relevant issues and
proposed specific actions aiming at reinforcing economic governance in the euro area. The
approach of the Task Force includes three elements:
First, strong surveillance over national fiscal policies and more effective prevention and
correction of excessive levels of public deficits and public debt;
Second, effective monitoring countries’ competitiveness positions aiming at the correction of
macroeconomic imbalances;
Third, a crisis management framework.
In their contribution to the work of the van Rompuy Task Force, the Governing Council of the
ECB, stresses the importance of mechanism design to contain moral hazard associated with
the crisis management framework. As Jean Tirole said: in crisis, policy-makers often have their
options narrowed to choosing between “the bad and the ugly”. The only way around is to
design ex ante institutions to shape incentives to ensure prudent behavior. To do so it is
necessary to ensure that financial support will be made available only at penalty rates and
under strict conditionality. The rules that apply in extreme crisis situations are crucial to shape
incentives at all times.
The Task Force has met for the fourth time on Monday, September 6 and Van Rompuy will
report to the 16 September European Council. The Task force is due to complete its work and
to make concrete proposals before the end of October. Progress is being reported.
Nevertheless, it is important not to underestimate difficulties. The work of the Task Force is
made harder because we already have an extensive framework of rules and procedures
(described above in section 2) that failed to deliver as intended (as discussed in section 3).
The Global Crisis has demonstrated an unprecedented degree of international
interdependence. Nowhere are linkages stronger than in the euro area. An institutional
response is required, consistent with this increased interdependence. The construction of the
euro area is work in progress. If we are successful we will lay the stability-oriented economic
policy framework of the euro area on stronger institutional foundations.
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