The Euro Area Crisis
Athanasios Orphanides
MIT
March 2013
The management of the crisis in the euro area
What crisis?
What crisis?
What crisis?
What crisis?
Real GDP Per Capita (1999=100)
GDP per person in the US vs the euro area
120
120
115
115
110
110
105
105
100
100
1999
2001
2003
2005
Euro Area
I
2007
2009
2011
2013
United States
February EC forecasts for 2013 and 2014 shown with dots.
Percent
Unemployment in the US vs the euro area
13
13
12
12
11
11
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
1999
2001
2003
2005
Euro Area
I
2007
2009
2011
2013
2015
United States
February EC forecasts for 2013 and 2014 shown with dots.
Percent
Divergence in unemployment in the euro area
30
30
25
25
20
20
15
15
10
10
5
5
0
0
1999
2001
2003
France
I
2005
2007
Germany
2009
Italy
2011
2013
2015
Spain
February EC forecasts for 2013 and 2014 shown with dots.
Percent
The disintegration of sovereign markets
8
8
6
6
4
4
2
2
0
0
2007
2008
2009
France
I
2010
Germany
Ten year government bond yields
2011
Italy
2012
2013
Spain
Percent
The disintegration of sovereign markets
8
8
6
6
4
4
2
2
0
0
2007
2008
2009
France
I
2010
Germany
Two year government bond yields
2011
Italy
2012
2013
Spain
Basis Points
The most troubled member states so far
2000
2000
1750
1750
1500
1500
1250
1250
1000
1000
750
750
500
500
250
250
0
0
2010
2011
Spain
I
Greece
2012
Cyprus
2013
Ireland
Portugal
Five-year CDS on sovereign, as of end February
How did the crisis reach the euro area?
I
August 2007: A disturbance in money markets in the USA
I
September 2008: The collapse of Lehman
I
Caused a global banking crisis and recession in 2009
I
Morphed into a sovereign debt crisis in the euro area
Symptoms, contributing factors and causes
I
Fiscal?
I
Competitiveness?
I
Growth?
I
Banking?
I
Economic governance?
I
Politics?
A fiscal problem?
Euro Area
U.S.A
Japan
U.K.
Deficit (%GDP)
2008
2009
2010
2011
2012
2013
-2.1
-6.4
-6.2
-4.1
-3.3
-2.6
-6.7
-13.3
-11.2
-10.1
-8.7
-7.3
-4.1
-10.4
-9.4
-9.8
-10.0
-9.1
-5.1
-10.4
-9.9
-8.5
-8.2
-7.3
Debt (%GDP)
2013
94.9
111.7
245.0
93.3
IMF Fiscal monitor, October 2012
Percent of GDP
Fiscal?
100
100
90
90
80
80
70
70
60
60
50
50
40
40
30
30
20
20
1999
2001
2003
Germany
I
Debt to GDP ratios
2005
2007
Spain
2009
2011
United Kingdom
2013
Percent
Divergent government financing costs
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
1999
2001
2003
2005
Germany
I
Ten year sovereign yields
2007
Spain
2009
2011
United Kingdom
2013
The governance problem of the euro area
I
The first phase of the global crisis uncovered weaknesses
in the construction of the euro area
I
The incomplete design of the euro area
I
Lack of a crisis management framework
I
Mismanagement of the problem since 2009 has turned it
into an existential threat for the euro area.
I
At least half a dozen euro area member states currently
under stress: Greece, Ireland, Portugal, Spain, Italy,
Cyprus, Slovenia ...
How could things get so bad?
I
Mismanagement of the crisis by euro area governments
damaged sovereign markets of euro area member states
perceived to be “weak”.
I
As a result, some euro area member states face much
higher government bond yields than countries with worse
public finances that are not in the euro area.
I
Holdings of government bonds by banks weakened the
capital position of banks in member states perceived to
be weak.
I
Negative feedback loop between banks and sovereigns
continues to damage the economies of several euro area
member states.
How was the damage done?
I
The incomplete design of the euro area
I
The lack of a crisis management framework
I
The politics of delayed resolution
Economic governance problems in the euro area
I
In a monetary union, strong economic governance,
including a clear crisis management framework is a
prerequisite for stability in all states of the union.
I
When the European Union was created, countries joining
committed to follow rules that limited fiscal profligacy by
member states
I
Member states agreed to a Stability and Growth Pact
that should have ensured sound fiscal policy.
I
I
Deficits should stay below 3 percent of GDP
Debt should stay below 60 percent of GDP, and if it
exceeded that, member states should follow policies to
reduce it.
Governance problems in the euro area: 2010
I
The crisis revealed significant gaps in monitoring and
enforcement and insufficient respect for the rules by euro
area governments.
I
Greece proved to be the worst offender. The realization
of the fiscal problems in Greece at the beginning of 2010
made it necessary to consider in a hurry:
I
How to complete the monetary union.
I
How to design a crisis management framework.
Was the Greek problem insurmountable?
I
Evidence of misreporting certainly damaged trust among
govenrments and people
I
But Greece only about 2 percent of euro area
I
And debt was sustainable by usual criteria.
I
Problem should have been manageable in 2009, 2010, ...
I
How did it become a crisis for the euro area as a whole?
EC debt sustainability analysis—June 2011
Graph 1. Debt sustainability assessment
(baseline and alternative scenarios)
180
% of GDP
170
160
150
140
130
120
110
Baseline scenario
Baseline + lower growth (-1p.p.)
Partial consolidation
Baseline + unsuccessful privatisation
Baseline + higher interest rate (+2p.p.)
Baseline + higher growth (+1p.p.)
100
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Constraints in managing the crisis
I
The Treaty prohibits member states from assuming the
debts of other member states and prohibits monetary
financing by any central bank in all member states.
I
As a result, a crisis management framework should be
designed to ensure that any assistance would not transfer
resources from other states to the state in need. It should
be temporary and should be repaid in full.
I
But how could the framework avoid moral hazard? If
governments knew that whenever they needed assistance
other states would easily provide financing, they might
again break the rules.
Political constraints
I
Europe is not a federal state—there is no single
government that can enforce solutions.
I
Solutions on key issues that may involve adjusting the
Treaty, require unanimous agreement by governments of
the member states.
I
But governments of member states must face their own
electorate and some element of any solution may be
unpopular to the electorate in some state.
I
Election cycles vary from state to state and at any given
moment some government may prefer to postpone
decisions.
Two approaches to moving forward
I
The cooperative approach: Strengthen governance so
that future governments of all member states are bound
to respect the rules and show solidarity when needed.
I
I
I
Only legitimate “accidents” could cause a liquidity crisis.
But the required strengthening in governance should
imply constraints, potentially limiting sovereignty—e.g.
restricting a government’s ability to increase spending.
The non-cooperative approach: Make temporary
assistance extremely costly to the government requesting
help as a deterrent.
I
I
I
Raise the cost of financing of weak governments that
have high debts or deficits so nobody wants to be in that
situation.
No moral hazard issues would be present.
But it shows poor solidarity and is inefficient.
A wrong turn in 2010
I
During 2010, governments tried to improve governance.
I
But some could not accept imposing stricter rules on their
conduct. Cooperative approach seemed out of reach.
I
In October 2010, the governments of Germany and France
moved the euro area to the non-cooperative approach.
I
The idea was to raise costs on weak governments.
I
ECB objected and voiced concerns but was ignored.
I
Unfortunately, other governments went along.
Four damaging government meetings
I
October 18, 2010: PSI concept introduced
I
July 21, 2011: PSI, up to 21% haircut on Greek debt
I
October 26, 2011: PSI 50% haircut
I
February 21, 2012: PSI, “53.5%” haircut (about 80%)
October 18, 2010: Deauville
I
Private Sector Involvement (PSI) doctrine introduced.
I
Whenever a euro area member state faced liquidity
pressures (not necessarily solvency concerns), the
imposition of losses on private creditors would be
demanded before euro area governments agreed to
provide any temporary assistance.
I
Message to potential investors: Euro area sovereign debt
should no longer be considered a safe asset with the
implicit promise that it would be repaid in full.
I
Implication: Raise the cost of financing for euro area
governments perceived to be relatively weak.
Five-year CDS on sovereigns
Basis Points
Oct−18
Jul−21
Oct−26
Feb−21
700
700
600
600
500
500
400
400
300
300
200
200
100
100
0
0
2010
2011
France
2012
Germany
Italy
Spain
July 21, 2011 Summit Statement
“We reaffirm our commitment to the euro and to do whatever
is needed to ensure the financial stability of the euro area as a
whole and its Member States.”
“The financial sector has indicated its willingness to support
Greece on a voluntary basis through a menu of options further
strengthening overall sustainability.”
“As far as our general approach to private sector involvement
in the euro area is concerned, we would like to make it clear
that Greece requires an exceptional and unique solution.”
October 26, 2011 Summit Statement
“The euro is at the core of our European project of peace,
stability and prosperity. We agreed today on a comprehensive
set of measures to restore confidence and address the current
tensions in financial markets. These measures reflect our
unwavering determination to overcome together the current
difficulties and to take all the necessary steps towards a deeper
economic union commensurate with our monetary union.”
“The Private Sector Involvement (PSI) has a vital role in
establishing the sustainability of the Greek debt. Therefore we
welcome the current discussion between Greece and its private
investors to find a solution for a deeper PSI. ... To this end we
invite Greece, private investors and all parties concerned to
develop a voluntary bond exchange with a nominal discount of
50% on notional Greek debt held by private investors.”
February 21, 2012 Eurogroup meeting
“The Eurogroup acknowledges the common understanding
that has been reached between the Greek authorities and the
private sector on the general terms of the PSI exchange offer,
covering all private sector bondholders. This common
understanding provides for a nominal haircut amounting to
53.5%. The Eurogroup considers that this agreement
constitutes an appropriate basis for launching the invitation for
the exchange to holders of Greek government bonds (PSI)”
March 2, 2012 Euro Summit
“[Euro area Heads of State or Government] welcome the
progress made on the new Greek programme, and notably the
agreement reached by the Eurogroup on the policy package
and the offer made to private creditors”
“Euro area Heads of State or Government recall their
determination to do whatever is needed to ensure the financial
stability of the euro area as a whole, and their readiness to act
accordingly.”
Five-year CDS on sovereigns
Basis Points
Oct−18
Jul−21
Oct−26
Feb−21
700
700
600
600
500
500
400
400
300
300
200
200
100
100
0
0
2010
2011
France
2012
Germany
Italy
Spain
The effect on the banks and the economy
I
As government debt holdings were branded “risky”:
I
First, banks needed to raise new capital to be considered
well-capitalized.
I
This meant a rentrenchment of credit expansion
equivalent to massive monetary policy tightening.
I
Second, banks needed to dump some of the government
debt they help (a firesale of government debt).
I
This meant yields on government debt of states perceived
to be weak rose even more.
The role of the ECB
I
The ECB cannot solve what is fundamentally a political
problem.
I
The ECB has the capacity to buy more time for
governments by ensuring the threat of immediate collapse
is averted for a while.
I
ECB intervention gives the option to governments to
postpone resolution of the crisis.
I
By postponing resolution governments raise the costs for
the euro area as a whole.
The role of the ECB: Four controversial decisions
I
May 10, 2010: SMP
I
August 7, 2011: SMP phase II
I
December 8, 2011: 3-year LTRO
I
September 6, 2012: OMT
Five-year CDS on sovereigns
Basis Points
May10
Aug07
Dec08
Sep06
700
700
600
600
500
500
400
400
300
300
200
200
100
100
0
0
2010
2011
France
2012
Germany
Italy
2013
Spain
The OMT-induced posponement
I
Words continue to suggest a strong desire for a solution.
I
Actions suggest continued bias towards postponement.
I
June 29, 2012—EU Summit: Significant progress in
improving governance, setting up a banking union to
break “the vicious circle between banks and sovereigns.”
I
December 14, 2012—EU Summit: Postponement of key
decisions that could resolve the crisis into the future.
Euro Area Summit Statement: 29 June 2012
”We affirm that it is imperative to break the vicious circle
between banks and sovereigns. The Commission will present
Proposals on the basis of Article 127(6) for a single
supervisory mechanism shortly. We ask the Council to consider
these Proposals as a matter of urgency by the end of 2012.
When an effective single supervisory mechanism is established,
involving the ECB, for banks in the euro area the ESM could,
following a regular decision, have the possibility to recapitalize
banks directly . . . We affirm our strong commitment to do
what is necessary to ensure the financial stability of the euro
area, in particular by using the existing EFSF/ESM
instruments in a flexible and efficient manner in order to
stabilise markets . . . ”
Towards a Genuine Economic and Monetary Union
“This report lays down the actions required to ensure the
stability and integrity of the EMU and calls for a political
commitment to implement the proposed roadmap. The
urgency to act stems from the magnitude of the internal and
external challenges currently faced by the euro area and its
individual members.”
December 5, 2012
Herman Van Rompuy, President of the European Council
Jose Manuel Barroso, President of the European Commission
Jean-Claude Juncker, President of the Eurogroup
Mario Draghi, President of the European Central Bank
Four presidents report towards a genuine EMU
Stages Towards a Genuine EMU
Ensuring fiscal sustainability and
breaking the link between banks
and sovereigns
Completing the integrated financial
framework and promoting sound
structural policies at national level
Establishing a EMU countrycountryspecific shock absorption
function
framework
Integrated financial
SSM and Single Rulebook
Harmonised national DGS
Harmonised national resolution
frameworks
Single Resolution Mechanism
with appropriate backstop arrangements
ESM direct bank recapitalisation
framework
Political
accountability
Integrated
economic
framework
Integrated budgetary
Six pack, Two pack, TSCG
Financial incentives linked to
contractual arrangements
Temporary/flexible/
targeted support
Conditional participation
based on entry
criteria/compliance
Country-specific shock absorption
Conditions of
participation depend on
ongoing compliance
Arrangements of a contractual nature
integrated in European Semester
Framework for exex-ante coordination of
economic policy reforms (TSCG, Art. 11)
Commensurate progress on democratic legitimacy and accountability
Stage I
Completed end 2012-2013
Stage II
Start 2013 – completed 2014
Stage III
Post 2014
Key elements needed to “break the vicious circle”
I
Common banking supervision
I
Common deposit guarantee scheme
I
Common resolution mechanism
December 14, 2012: Further postponement
”It is imperative to break the vicious circle between banks and
sovereigns. Further to the June 2012 euro area Summit
statement and the October 2012 European Council
conclusions, an operational framework, including the definition
of legacy assets, should be agreed as soon as possible in the
first semester of 2013, so that when an effective single
supervisory mechanism is established, the European Stability
Mechanism will, following a regular decision, have the
possibility to recapitalise banks directly. This will be done in
full compliance with the Single Market.”
Why is everything pushed beyond the end of 2013?
I
The german election in September 2013 has become a
constraint on action
I
Elements needed to make progress unpopular in Germany
I
Proposing solution now would compromise Angela
Merkel’s reelection
I
OMT provides safeguard in the meantime
Latest blunder? Cyprus
I
Cyprus: 0.2% of the euro area, entered euro in 2008
I
Large banking system with large Greek exposure
I
Stable currency and finances before euro entry
I
Communist government: March 2008—February 2013
I
I
I
I
I
Overspending government lost market access in May
2011
Avoided seeking help until banks needed temporary
capital
Avoided agreeing on help until election
Run election on a platform of bashing banks
Lost election but left huge problem behind
Basis Points
Could you see this coming?
2000
2000
1750
1750
1500
1500
1250
1250
1000
1000
750
750
500
500
250
250
0
0
2010
2011
Spain
I
Greece
2012
Cyprus
2013
Ireland
Portugal
Five-year CDS on sovereign, as of end February
Basis Points
Could you see this coming?
2000
2000
1750
1750
1500
1500
1250
1250
1000
1000
750
750
500
500
250
250
0
0
2010
2011
Spain
I
Greece
2012
Cyprus
2013
Ireland
Portugal
Markers show when assistance was sought and agreed.
Proposed solution by governments on March 16
I
Banks lost 25% of GDP due to write-down of Greek debt
I
Cypriot government agreed to “help” Greece in this
manner but left its banks exposed.
I
Eurogroup decided to impose haircut on all deposits,
insured and uninsured, in all banks rebardless of
capitalization, to replenish capital and solve problem.
I
The proposal is opposite to any known framework. For
example, bank bond holders were fully protected, only
depositors were targeted for a hit.
Another Deauville?
I
The PSI deal in Deauville (October 18, 2010) between
Germany and France generated the credit risk in
sovereign markets we still observe today.
I
European officials keep repeating (even after the
confirmation of the PSI concept with the haircut on
Greek debt) that Greece was a unique and exceptional
case, never to be repeated anywhere else in the euro area.
I
It took some time for the full effect to sink in, as seen
e.g. in the spreads between Spanish or Italian and
German debt.
I
Similarly, the confiscation of deposits decision (March 16,
2013) is described as a unique and exceptional case, never
to be repeated anywhere else in the euro area.
Why this particular solution was proposed?
I
Recall the German government faces reelection in
September!
I
Opposition party (SPD) signaled a tough stance on
helping other countries. Without SPD, Merkel cannot
pass anything.
I
To create political cost to Merkel, SPD claimed that
helping Cyprus is equivalent to “giving away German
taxpayer money to Russian oligarchs” who have deposits
in Cypriot banks.
I
So the German government had to insist that any
“solution” was an effective response to this argument to
avoid any potential political cost.
Outcome
I
Deposit haircut proposal rejected by parliament in Cyprus
I
Bank holiday imposed to avoid a run
I
Concern of contagion
I
Everyone involved denies ownership of confiscation
decision. A telling Bloomberg headline: “Europe Plays
I-Didnt-Do-It Blame Game on Cyprus Bank Tax”
I
Subsequent eurogroup meeting on March 25 changed
program but damage to banking system irreparable.
The European project today