FINANCE AT CENTER STAGE
Some Lessons of the Euro Crisis
Maurice Obstfeld
University of California, Berkeley, NBER, and CEPR
March 2013
Introduction
• The crisis that followed the events of August 2007 have shown
conventional macroeconomic models were ill equipped to
capture the key role of financial markets:
• as a source of shocks
• in the transmission of shocks and policies
• This is also a lesson of the euro zone crisis, which grew directly
out of the 2007-2009 global crisis.
• But Maastricht Treaty focused on “conventional” macro.
• Financial markets must be at center stage in any discussion of
the future of EMU.
Growth of Global Banking
• Financial markets expanded worldwide after 1990s.
• Especially true given the low interest rates and liquidity
boom of 2000s; global trend toward deregulation.
• Banking expanded markedly in Europe.
• International financial integration made it easy for banks to
get big, even in small countries.
• In many, banking assets far surpassed GDP.
Banking Assets Relative to GDP
10.00
9.00
8.00
Austria
Belgium
7.00
6.00
Estonia
Finland
France
5.00
Germany
Ireland
4.00
Italy
Netherlands
3.00
Slovak Republic
Slovenia
2.00
Spain
1.00
0.00
Source: OECD
Bank and Sovereign Solvency Now Linked
• Sovereign debt markets are subject to multiple equilibria.
• Analogous liquidity risk characterizes financial institutions.
• Financial system depends on sovereign’s fiscal health in two distinct
ways, the first less discussed than the second:
• sovereign backstops financial system, but cannot maintain confidence in banks
if it has insufficient fiscal space – “too big to save” problem (modeled by
Acharya, Drechsler, Schnabl, “Pyrrhic Victory,” 2011)
• system holds sovereign national debt (absent a euro zone bond) but sovereigns
cannot print money, as stressed by De Grauwe (2012)
• Range of vulnerability to multiplicity is therefore larger.
• Creates “doom loop,” which becomes more severe as growth slows.
Trilemma for Members of Currency
Unions with Big Banking Systems
One cannot enjoy all three at same time:
1. Financial integration with partner countries.
2. Fiscal independence.
3. Financial stability.
This is the financial/fiscal trilemma.
With National Currency, a Quadrilemma
One cannot enjoy all four at same time:
1.
2.
3.
4.
Financial integration with partner countries.
Fiscal independence.
Financial stability.
Price-level stability.
Capital Flows in the Euro Zone
• Two salient features of the euro’s first decade:
• Bigger current account deficits of poorer countries.
• Much bigger intra-euro area flows and positions.
• Authors such as Blanchard and Giavazzi (BPEA, 2002) identified
an appropriate “downhill flow of capital” in Europe, absent
elsewhere in the world, which was promoting convergence.
• Others praised creation of a bigger unified financial market,
allowing reductions in home bias, greater liquidity, crossborder bank M&A.
• Two potential issues:
• Current accounts driven by demand and housing investment.
• Portfolio diversion and risk concentration, pricing distortions.
Costs have been evident in euro zone and earlier in CEE countries.
Three Destabilizing Mechanisms
Euro’s first years coincided with low world real interest rates, a
global liquidity and credit boom, asset (especially real estate)
appreciation, looser collateral constraints, but low inflation. Euro
crisis does grow directly out of the 2007-09 banking crisis.
Against this worrisome backdrop, three interrelated mechanisms
(along with scale of banking) within EMU added to its fragility:
1. Sovereign yield compression.
2. Helping to drive the preceding, increasing intra-EMU financial
bias, at the expense of diversification.
3. Real interest rate dispersion, credit growth, demand growth,
competitiveness loss, external imbalances.
01/07/1995
05/20/1995
09/30/1995
02/10/1996
06/22/1996
11/02/1996
03/15/1997
07/26/1997
12/06/1997
04/18/1998
08/29/1998
01/09/1999
05/22/1999
10/02/1999
02/12/2000
06/24/2000
11/04/2000
03/17/2001
07/28/2001
12/08/2001
04/20/2002
08/31/2002
01/11/2003
05/24/2003
10/04/2003
02/14/2004
06/26/2004
11/06/2004
03/19/2005
07/30/2005
12/10/2005
04/22/2006
09/02/2006
01/13/2007
05/26/2007
10/06/2007
02/16/2008
06/28/2008
11/08/2008
03/21/2009
08/01/2009
12/12/2009
04/24/2010
09/04/2010
01/15/2011
05/28/2011
10/08/2011
02/18/2012
06/30/2012
10-year Spreads against Bund (basis points)
3950
3450
2950
2450
1950
Belgium
France
1450
Greece
Ireland
950
Italy
Portgual
450
Spain
-50
Causes and Consequences
• ECB applied equal collateral haircuts to all sovereigns
•
•
•
•
regardless of rating or fiscal fundamentals (as stressed by
Buiter and Sibert in 2005)
Quasi-automatic financing through ECB standing facility.
Bailout expectations? Buiter and Sibert argued not, but their
case appears quaintly naive in retrospect.
EU Capital Requirements Directives – imply zero risk weightings
for sovereign euro zone debt.
Implications:
• Banks had more incentive to hold sovereign debt.
• All countries faced rates of most creditworthy sovereigns.
• This helped drive aggregate demand.
2011-Q4
2009-Q4
2007-Q4
2005-Q4
2003-Q4
2001-Q4
1999-Q4
Percent of total foreign claims allocated to GIIPS
Banks Shifted Foreign Lending toward GIIPS
30
Austria
25
Belgium
20
Germany
15
France
10
Netherlands
5
How Did Banks Shift Lending?
• Dramatic lending shift from north Europe favoring Ireland, Spain.
• Banks outside euro zone (including US and Japan) raised lending
shares to the northern euro zone, where gross banking assets
therefore rose.
• These extra-EMU banks also lent to GIIPS, likewise favoring
Ireland and Spain.
• Swiss banks lent heavily to Greece.
• Concentration of north-EMU bank risks in GIIPS. Supported
housing bubbles and sovereign debt bubbles (esp. Greece).
Residential Real Estate Price Behavior
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Domestic Credit to Private Sector
250
200
Greece
150
Ireland
Italy
Portugal
100
Spain
Germany
50
0
Percent of GDP
Competitiveness of GIIPS (HCI indexes)
120
115
110
Germany
105
Spain
Greece
100
Ireland
Italy
95
Portugal
90
85
80
1993
1995
1997
1999
2001
2003
2005
2007
Index, euro entry year = 100,
increase = real appreciation
2009
2011
Real Interest Compared to Germany
30
25
20
Greece
15
Ireland
Italy
Portugal
10
Spain
5
0
199519961997199819992000200120022003200420052006200720082009201020112012
-5
Peripherals’ Current Account Imbalances
5
3
1
-1
-3
-5
Greece
Ireland
Italy
-7
Portugal
Spain
-9
-11
-13
-15
The Maastricht Treaty’s Maginot Line
• Monetary policy geared to low, stable inflation via central bank
•
•
•
•
•
•
independence and treaty remit to preserve “price stability.”
Fiscal policy constrained by EDP (as implemented through SGP).
Treaty’s no-bailout clause; ECB statute on monetary financing.
National discretion over structural reform – reform promoted by
inflexibility of exchange rate?
National discretion over deposit insurance, supervision, regulation,
resolution; LLR role of ECB left vague (Begg et al., 1991; Vives 1992).
To have gone further in the treaty would have raised intractable
issues of fiscal union, democratic deficit.
These defenses were easily circumvented – by banks, not tanks.
The Case for Fiscal Rules (1)
• It was based largely on the fear that governments with large
•
•
•
•
debts could pressure the ECB to inflate them away.
With no-bailout, it was hoped that markets would factor in
sovereign default, and charge appropriate (real) spreads,
disciplining governments that transgressed fiscal rules.
Begg et al. (1991), Kenen (1995), Eichengreen-Wyplosz (1998),
others worried sovereign default could hit banks.
Given the interconnections between national banking systems in
EMU, such a development creates big bailout incentives and
undermines discipline.
Begg et al. suggested, impractically, that banks should be
restricted from holding sovereign debts of EMU countries.
The Case for Fiscal Rules (2)
• Begg et al. and others pre-1999 did not envision the other part of the
•
•
•
•
“diabolical loop”: that financial instability could endanger sovereign
solvency.
Even though this had been seen in Latin America, Asia, where
dollarized debts made depreciation problematic (Díaz-Alejandro).
“Too big to save,” coupled with cross-border contagion, undermines
the argument that stand-alone national fiscal policies can work
(financial/fiscal trilemma).
Also suggests a new argument for fiscal rules: a profligate
government undermines the credibility of its own financial backstop
powers, opening the door to possibly contagious instability.
Financial instability risk implies austerity as a weapon against fiscal
deficits can create far too much collateral damage.
Record on Austerity So Far
Financial Policy Approach (1)
Remedying the defects in the financial-market structure
of the original blueprint. Ideally:
• Unified comprehensive regulatory structure (SSM).
• Universal deposit insurance scheme.
• Universal resolution regime (SRM).
Financial Policy Approach (2)
Some questions:
• Macroprudential aspect: Role of ESRB? How does one handle
localized excessive credit expansion? Mandatory national LTV
ratios, capital buffers imposed by center?
• SSM must be strong to counter moral hazard. Role of legacy
national regulatory bodies?
• More federal power requires commensurate governance
reform to ensure democratic accountability.
Financial Policy Approach (3)
• There is push-back on euro area wide deposit insurance. But
this is needed to break the doom loop at national level, and
address financial/fiscal trilemma.
• We see similar push-back against a joint SRM and the required
joint fiscal backstop.
• But the case for taking resolution decisions out of national
hands is super-strong:
• National policymakers my exercise excessive forbearance in declaring
home banks insolvent.
• They may devote insufficient resources to rescuing banks when much of
the benefit of rescue accrues abroad (Freixas, Schoenmaker).
Fiscal Policy Approach Thus Far
• “Six-pack” tightens enforcement tools, e.g., RQMV, but adds flexibility.
• Fiscal pact removes flexibility: pact calls for constitutional or equivalent
•
•
•
•
•
limits on deficits.
Do standard debt/deficit measures even make economic sense?
Fiscal pact may help to avoid situations such as Greece.
But not Spain or Ireland, where conventionally measured fiscal deficits
and debt were low prior to the crisis.
Defaultable debt, to instill market discipline and limit moral hazard,
provide disaster insurance to sovereigns. This is essential; CACs started
January 2013.
Facilities (ESM, ECB’s OMT) to prevent resulting liquidity flight, which
can morph into solvency problems over time. ESM also still needed to
counter convertibility risk, as it infects sovereign debt markets.
Financial/Fiscal Interactions
• Banking union requires strong reliable fiscal backup, otherwise
•
•
•
•
•
government underwriting is not credible. Fees on banks not enough.
In turn, this requires healthy public finances … everywhere. This is
the new argument for something like fiscal pact.
For now, direct bank recapitalization by ESM could help individual
sovereigns. (But when? March 2014? “Legacy” issues?) Will a
permanent resolution regime (SRM) pre-empt this function of ESM?
Nature of the resolution regime – do we bail in private wholesale
creditors? (yes!) – affects the public finances, also changing market
incentives and the volatility of private liquidity. ECB’s LLR role?
Conversely, defaultability of debts not credible unless regulatory
framework is strong.
Authorities might go too far to avoid defaults if financial stability is at
risk (banks’ sovereign debt holdings, CDS).
Three Trilemmas for EMU
EMU must cope with three trilemmas (at the least):
1. Padoa-Schioppa: single financial market, monetary
independence, exchange stability.
2. Schoenmaker: single financial market, financial stability,
national supervision/resolution.
3. Financial/fiscal: single financial market, financial
stability, fiscal independence.
More Fiscal Centralization is Essential to Address
Each of these Trilemmas
EMU must have financial stability and integration. So:
1.
EMU fiscal federalism can partially offset lost monetary
control. To reduce moral hazard, variable fees for access to
banking union, ESM? GDP-linked debt (Obstfeld-Peri,
Borensztein-Mauro, Drèze)?
2.
Bank regulation, supervision, resolution must be EMU-wide,
and this requires a shared fiscal backstop. Winding down
insolvent banks must be a credible threat – endgame matters.
3.
Only a centralized “big bazooka” can be a credible enough
stabilizing force for EMU financial markets.
Challenges for the (Near) Future
• Comprehensive banking union is urgent, and it requires some
•
•
•
•
•
sacrifice of sovereignty, along with an appreciable centralized
fiscal competence.
Some form of safe euro bond needed to underpin financial
system, weaken doom loop. ESBies?
Banking-cum-fiscal union requires change in EMU governance
institutions to ensure democratic decision making at the center
– more political union.
Centralized fiscal competencies would constrain national-level
taxation and spending more than they have been: big changes
in national aspirations and habits.
Convergence and competitiveness instrument (CCI)?
Could member states pay variable insurance premia into a
central fiscal fund?