The Future of the Euro (Brown book 2012)

BROWN BOOK
ANDRÉS DOMINGO AND DOMÉNECH VILARIÑO /

XXVIII EDICIÓN DEL LIBRO MARRÓN
The Future of the Euro
DÍEZ GANGAS / DONGES /
GARCÍA ANDRÉS / GROS Y ALCIDI /
MARTÍNEZ RICO / REQUEIJO GONZÁLEZ /
SÁNCHEZ FUENTES, HAUPTMEIER AND SCHUKNECHT /

BROWN EDITION BOOK XXVIII The Future of the Euro
El futuro del euro
The Brown Book in 2012 meets his XXVIII edition. Year after year since
1984, this flagship publication of the Círculo de Empresarios has offe-
red the most varied backgrounds a platform from which to contribute
their ideas and proposals on economic policy that requires our
country to its further development. The Brown Book contributes to one
of the founding objectives of the Círculo as the center of the view that
encourages and promotes debate on key issues for the benefit of
Spanish society as a whole.

JULIO 2012
CÍRCULO DE EMPRESARIOS
C/ MARQUÉS DE VILLAMAGNA, 3, 10ª. 28001 MADRID
TEL 915781472. FAX 915774871
www.circulodeempresarios.org
July 2012


Brown Book
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Index

Prologue 7

1. The future of the Euro
after the Great Recession 15
Javier Andrés and Rafael Domenech

2. Nature and Causes of the Euro crisis 63
José Carlos Díez

3. The European crisis and the challenge
of efficient economic governance 97
Juergen B. Donges

4. The turbulent adolescence of the euro
and its path to maturity 131
Gonzalo García Andrés

5. Breaking the common fate of banks
and governments 197
Daniel Gros and Cinzia Alcidi

5

6. The fiscal institution in the
Economic and Monetary Union:
the contribution of Spain 227
Ricardo Martínez Rico

7. The European Monetary Union:
the Never-Ending Crisis 265
Jaime Requeijo

8. Public expenditure policies during the
EMU period: Lessons for the future? 289
A. Jesús Sánchez Fuentes,
Sebastian Hauptmeier
and Ludger Schuknecht

6

Prologue

The crisis in Spain is, to a large extent, the crisis of the Euro. On
the one hand, the sustainability or otherwise of the monetary inte-
gration project hinges on Spain, as the fourth economy in the
Eurozone. On the other, Spain has no leeway available for fiscal sti-
mulus packages, and the success of its adjustments required stabi-
lity in the Eurozone. Hence, both crises are the two sides of the
same token.

The crisis faced by Euro economies and the adjustments made
and which will be made in the most vulnerable ones, are coming at
a high price which has not yielded tangible results to date. Círculo
de Empresarios believes that the current situation calls for an impro-
vement in European institutional architecture, in regard to greater
integration and, above all, more commitment to reforms in Spain.
The natural environment of our country is the Eurozone.

Over the last few weeks, citizens are beginning to live with the
different rescue modalities, as they had already done with the risk
premiums. Financial aid for troubled economies is quite diverse in
terms of implications, instrumentation, conditionality and scope of
application, therefore requiring detailed analysis for determination.
Although each carries its benefits and disadvantages, in the opi-

7

nion of Círculo de Empresarios, the greater scope and conditionality
scenarios – known as country-rescue – are not a desirable option.
This is why these must be avoided.

Indeed, an intervention or rescue, of its own accord, without
advancements made in the Eurozone architecture, shall not protect
any of its members from future scares. Domestic adjustment may
be less effective if no advancements are made in fiscal and banking
union, and in the European capacity to provide asymmetrical res-
ponses to national situations which are also different. The most
vulnerable countries in the Eurozone must no longer be perceived
as foreign currency debtors and it is imperative that the coordina-
tion of economic policies of Member States is improved. Without
such adjustments, a sustained growth path will not be possible to
achieve.

On the other hand, the crisis in Spain is the result of an accu-
mulation of imbalances due to a series of inadequate signals and
policies. Spain must face up to its responsibilities in terms of fiscal
consolidation and structural reform. All in the interest of recove-
ring competitiveness and encouraging a suitable environment to
attract growth-contributing investments.

In such circumstances, Círculo de Empresarios cannot help but
take part in the debate on the future of the Euro. The XXVIII edi-
tion of the Brown Book is dedicated to this matter and gathers a
varied number of authors, all with broad experience in the issue

8

and proven academic and professional records. Therefore, this
publication, with the sponsorship of BBVA as in previous years,
maintains its nature as a publication which is open to different
ideas and opinions, not necessarily shared by Círculo de Empresarios.

As in previous editions, the articles appear in alphabetical order
by the surnames of their authors, although these can be grouped
into three broad categories: the crisis of the sovereign debt in
Europe and the future of the Eurozone; the reform of economic
governance and operations of the institutions in order to solve the
sovereign debt crisis in Europe; and the integration into the
Eurozone, the fiscal coordination mechanisms, Eurobonds and the
assignment of sovereignty.

In their paper, Javier Andrés and Rafael Doménech analyse
the challenges faced by the Eurozone and the proposals to handle
them by improving economic governance. To this end, they begin
by reviewing the reasons underlying the accumulation of signifi-
cant imbalances in developed economies and among EMU coun-
tries, mainly from 2001 until the start of the crisis in 2007, as a
result of an unsustainable growth pattern in many developed eco-
nomies. Secondly, the magnitude and implications of such imba-
lances and the heterogeneity between EMU countries are closely
examined. Finally, the authors analyse the challenges involved in
the improvement of economic governance of the EMU on the fis-
cal, financial and economic integration fronts, which will determi-
ne its short and long term economic future.

9

José Carlos Díez analyses the Euro crisis. He reviews the histori-
cal background of the European and single currency projects, and
the theory of exchange rates to provide conceptual support to ena-
ble an understanding of the nature and the causes of the crisis.
According to him, this is an infrequent, but highly destructive, dise-
ase found in economics, especially in developed countries, since it
causes devastating damage to the employment and public debt of
the affected countries. For this reason, he believes it is essential to
come up with the correct diagnosis in order to define the economic
policy that will put an end to the crisis. The main causes analysed
are financial integration, the under-assessment of risk, local imba-
lances within the Eurozone and the Great Recession.

The aim of Juergen B. Donges is to bring the current debate on
the need for economic governance in the European Union, and par-
ticularly in the Eurozone, into the context of political realities. He
analyses the issue of governance from a historical and current pers-
pective, and highlights the significant fact that the Eurozone does
not constitute an optimal monetary area. He then moves on to
analyse the forms of governance to date and considers new approa-
ches to European governance. Finally, he ends his analysis with a
tone of moderate expectation. If the Governments of the Euro countries
understand that the solidity of public finances and the application of struc-
tural reforms are their responsibility and act in accordance, no State must
rush to the aid of another due to over-indebtedness and overspending, and
the ECB may stop indirectly funding the States and focus on its own duty,
which is to ensure the stability of the price levels within the Eurozone.

10

Gonzalo García Andrés highlights that, despite having taken
decisive steps in national policies and institutional framework
reform, the Euro crisis has worsened to the point of calling its sur-
vival into question; and no definitive solution is yet on the hori-
zon. In his article he attempts to offer an interpretation of what has
happened, assuming the extreme complexity both of the starting
point (with accumulated imbalances and structural deficiencies in
several countries), as of the outbreak, the contagion and the esca-
lation of the crisis. And he does so in the broader context of the
global financial crisis, which has affected economic and financial
development for five years, in order to determine which specific
aspects of the Euro have played a key role. All this with a view to
encouraging a reflection on solutions, bringing together the most
urgent and the ones with a longer term effect.

Cinzia Alcidi and Daniel Gros point out that the Eurozone cri-
sis encompasses different dimensions, from foreign debt and
current account balance problems, to the weak situation of the ban-
king sector. The document focuses on this last issue, the situation
of the banking system, and attempts to show the way in which
current characteristics of the regulatory framework of the financial
market have influenced the development of the crisis. In addition,
they express their concern about the false idea that the recently sig-
ned fiscal convention shall become the fundamental ingredient of
the recipe to overcome the crisis, when the banking sector conti-
nues to be heavily indebted and exposed to the vicissitudes of sove-
reign States. For this reason, they present a few ideas to break the

11

close ties between governments and banks, since these links them
in a common fate and constitute a clear impediment to recovery
from the crisis in the Eurozone.

Ricardo Martínez Rico, throughout his work, analyses the way
in which the sustainability of public finances requires a sold fiscal
institution and a firm political commitment by European govern-
ments. Subsequently, he tackles the close relationship between fis-
cal rigour, macroeconomic stability and growth, concluding that, in
order to achieve a positive inter-relation, the establishment of fiscal
rules which are simple, transparent, automatically applied and with
preventive control mechanisms for all Public Administrations, is
essential. All these items are key when designing a fiscal policy
which contributes to recovering the credibility required by Europe
along its route towards greater integration to handle the sovereign
debt crisis. Lastly, he examines the measures taken in Europe and
Spain since the start of the sovereign debt crisis, and reflects on the
next steps that should be taken towards a fiscal institution.

The work of Jaime Requeijo aims to provide a reasoned expla-
nation of the causes of the financial shocks affecting several
Eurozone countries, and which endanger the survival of the single
currency (the Monetary Union is a poorly built structure because
political urgency has prevailed over economic prudence; the fiscal
irresponsibility of many member state governments has translated
into the appearance of large public debt; such debts generate
doubts as to their holders; and, contributing factors such as the

12

effects of contagion or of the opinions of the rating agencies and
IMF predictions). In the article he also attempts to reply to three
questions on the measures taken, the results thereof, and the
impact of a potential decomposition of the euro. The article ends
with a brief final reflection on the solution to be applied in order
to maintain the Monetary Union.

A. Jesús Sánchez-Fuentes, Sebastian Hauptmeier and Ludger
Schuknecht state in their article that an ambitious fiscal reform
within a broader programme of reforms would have highly positi-
ve effects insofar as it would provide for a safer fiscal position, in
line with the requirements of the Stability and Growth Pact (SGP).
Expenditure control policies must therefore go hand in hand with
structural reforms, mainly focused on reducing rigidity in the
labour and product markets, on the correction of macroeconomic
imbalances, on the improvement of competitiveness and on sus-
taining potential growth. This becomes particularly key for the
most vulnerable countries in the Eurozone, which no longer have
the option of currency devaluation to increase competitiveness.

Finally, and on behalf of Círculo de Empresarios, I wish to thank
all the authors for their contributions to this new edition of the
Brown Book and I trust that these articles help to shed light on a
solution to the European trilemma.

Mónica de Oriol
President of Círculo de Empresarios

13

/JAVIER ANDRES * / RAFAEL DOMENECH**/

The future of the Euro
after the Great Recession 1

Summary; 1. Introduction; 2. From the Great Moderation to the Great
Recession; 3. The imbalances in Europe and in the EMU; 4. The new
European governance and the future of the Euro; 4.1. Changes in fiscal
governance; 4.2. Financial integration; 4.3. Economic integration; 5.
Conclusions.

Summary

In this chapter we shall analyse the challenges the Eurozone is facing and

proposals to deal with them via improved economic governance. To do so,

* Javier Andrés is professor of Fundamentals of Economic Analysis at the University of
Valencia and visiting professor of the University of Glasgow. http://iei.uv.es/javierandres/
** Rafael Doménech is Chief Economist of Developed Economies, BBVA Research and
Professor of Fundamentals of Economic Analysis at the University of Valencia.
http://iei.uv.es/rdomenec

1 The authors thank A. Deligiannido, A. García, M. Jiménez, and E. Prades for their assis-
tance and comments on this work, as well as the help from CICYT projects ECO2008-
04669 and ECO2011-29050.

15

The future of the Euro after the Great Recession

we shall first examine the reasons behind the accumulation of significant

imbalances in the developed economies and among the EMU countries,

mainly since 2001 until the crisis in 2007, as a result of a pattern of unsus-

tainable growth in many developed economies. Secondly, we shall offer an

in-depth analysis of the significance of such imbalances and the heteroge-

neity which exists between EMU countries. Lastly, we shall study the cha-

llenges presented by the improvement of the economic governance of the

EMU from a fiscal, financial and economic integration perspective, which

shall determine its economic future in the short and long term.

1. Introduction

The international economic crisis which begun in 2007 is
having an extraordinary impact on the European economy, and for
the coming decades, will leave a deep mark in many of its mem-
bers. The crisis has shown that the growth process undergone bet-
ween 1994 and 2007, particularly following the creation of the
Economic and Monetary Union (EMU) in 1999, had entered into
an unsustainable dynamics in the long term. The appearance of
important macroeconomic imbalances among EMU members was
taking shape within the framework of steady growth, inflation
under control, very low interest rates and a very reduced risk assess-
ment (partly as a result of the disappearance of currency risk) in the
context of a world saving glut. Although the Eurozone as a whole
presents smaller aggregate imbalances in terms of deficit and pri-
vate, public and foreign debt than, for instance, the US or the
United Kingdom, the expectations of economic convergence

16


among Eurozone countries and the appearance of financial bubbles
with the promise of high yields, led to very significant capital flows
among its members. This added to a spiralling increase in house-
hold debt and businesses in some of the member countries, gene-
rating very considerable and longstanding deficits in current
account balances. These expectations petered out sharply as of the
subprime crisis of 2007 and, since then, Europe has been experien-
cing different surges of financial crises, economic crises and sove-
reign debt crises, which have been following on and feeding off
each other over time.2 The result of this complex situation has been
that, albeit with differences in the intensity and the severity of the
problems (see, for instance, Doménech and Jiménez, 2010), a sig-
nificant number of European countries have experienced a situa-
tion similar to that of the sudden stops experienced in the past by
some emerging economies, leaving public and private sectors heavily
indebted and, in some cases, extremely high rates of unemployment.

The aim of this chapter is to analyse the changes required by the
EMU and proposals with which to face such challenges with suc-
cess. In order to understand what the problems are and, therefore,
their possible solutions, in the second section we analyse the rea-
sons why important imbalances accumulated in the developed eco-
nomies and among the EMU countries during one of the most sta-
ble periods of economic prosperity in the last decades (the Great
Moderation), which nevertheless gave way to an unsustainable

2 Shambaugh (2012) performs an excellent analysis of the interaction between fiscal,
financial and economic crises in the Eurozone.

17


growth pattern in many economies. In the third section, we offer
an in-depth analysis of the magnitude and implications of such
imbalances throughout the crisis, which are well summarised in the
Excessive Imbalance Procedure (EIP) recently implemented by the
EU, as well as the current heterogeneity among EMU countries. The
fourth section analyses the challenges of improvement of economic
governance of the EMU from a fiscal, financial and economic inte-
gration standpoint, which shall determine its short and long term
economic future. Lastly, the fifth section presents the main conclu-
sions reached in this paper.

2. From the Great Moderation to the Great Recession

In the period between the mid-1990s and 2007, developed eco-
nomies enjoyed one of the greatest economic growth periods,
known as the Great Moderation due to the low volatility of growth
rates in those years. Graph 1 shows evidence of this for the US and
the EMU in terms of GDP per person of employable age. As can be
seen, from the mid-1990s to 2007 there was sustained growth, with
levels well above the historical trend estimated since 1970 for both
geographical areas. In fact, the growth in GSP per person of emplo-
yable age was slightly higher in the EMU than in the US, although
not enough to bridge the gap between both economies.

The Great Moderation generated the perception that economic
cycles would have less volatility, as a result of better managed eco-

18


nomic policy (see, for instance, Galí and Gambeti, 2009, or the
references appearing in this article). In fact, these high growth rates
with low volatility came hand in hand with inflation under con-
trol and low interest rates across the board of financial assets, with
practically inexistent risk premiums in many cases as a result of the
underassessment of the risk. In light thereof, some analysts went as
far as to proclaim the disappearance of the economic cycle and the
capacity to avoid significant economic recessions. It was the com-
binations of these forces which fed the financial imbalances which,
for economists like Rajan (2005) or Borio & White (2005), among
others, are behind the crisis which began in 2007.

There are various economic factors which contributed to genera-
te this combination on which the Great Moderation was erected. In
the first place, the central banks of the developed economies carried
out a low interest rate policy or money glut, as a result of: i) the drop
in the inflation of sellable assets following the inrush of exporting
countries in the international economy with a very abundant and
cheap workforce and depreciated currencies; ii) the benign neglect
policy in regard to the high prices of financial and real estate assets
(Bordo & Jeane, 2002, or Bean 2004 & 2010); and iii) the attempt to
prevent the recession in the US, following the burst of the techno-
logical bubble, or in Germany, following the costly process of reu-
nification and the burst of its real estate bubble.

Secondly a savings glut took place on a worldwide level in
China, Japan, Germany, oil producing countries or the pension

19


funds of developed economies.

Thirdly, and as a response the savings glut in some countries
and sectors, a formidable increase took place in the demand of safe
assets, moving from the pre-eminence of individual savers to that
of large sovereign funds, investment funds or pension funds which
prioritize safety over yield and which seek to channel savings
towards fixed income rather than towards the acquisition of any
other kind of asset. At the same time that the demand for safe
financial assets (i.e. AAA) increased, there was a relative scarcity of
such assets in the case of sovereign debt, due to the fiscal consoli-

Chart 1
GDP per person of employable age in the US and in the EMU

Source: OEDC (2012) Economic Outlook Database.

20


dation taking place simultaneous in many developed economies as
a result of the high growth in GDP. This surplus demand for safe
assets created enormous pressure in the financial markets and in
certain types of assets, which in turn led to the appearance of bub-
bles in certain market segments. The pressure was such that finan-
cial deregulation and engineering came to the rescue, enabling the
response of the financial markets to this scarcity in AAA assets to
be the creation of multiple derivatives and the issue of huge volu-
mes of asset backed securities, as shown in Graph 2. In turn, this
generated enormous liquidity to fund those assets acting as the
underlying assets (for example, mortgages on homes), thus crea-

Chart 2
Issue of Asset backed Securities 1985-2011

Source: SIFMA

21


ting a circle in which asset demand stimulated supply, which in
turn was fed back into the process by boosting demand with the
creation of new assets.

As a result of this process, a specialization in asset production
took place on an international level, leading to enormous hetero-
geneity by country, sector and agents. Whereas some countries
generated a surplus in net savings, others (US, Spain or Ireland) res-
ponded to the very low interest rate incentive by generating the
real investments which served as the underlying assets for finan-
cial securities. The US produced assets on a world scale considered
safe by the markets, thanks to the specialization of its financial ser-
vices. Other countries, such as Spain and Ireland, carried out a
similar role, but on a European scale, producing assets backed by
safe collateral (homes) or with no collateral, but issued by financial
institutions deemed to be safe, which attracted savings funds or
large European banks.

In fourth place, the creation of the EMU meant the disappearan-
ce of exchange rate risk among its members. This removed an impor-
tant barrier to capital flows within the EMU and encouraged the pre-
viously described process. But its effects went even beyond the disap-
pearance of currency risk. In the international financial markets, as
well as in the EMU countries, expectations that the greater monetary
and economic integration ensured the economic convergence of its
members were generated, which justified the disappearance of any
type of risk premiums (see Ehrmann et al, 2011).

22


Graph 3 clearly shows the almost full disappearance of risk pre-
miums for countries becoming part of the EMU. Without doubt,
Greece was a paradigmatic example of this process, going from fun-
ding at 25% in 1993 to do at the same interest rate as Germany, follo-
wing its entry into the Eurozone.

Chart 3
10 year public debt interest rates in the EMU, 1995-2011

Source: ECB, Bloomberg

The implications of such expectations of economic convergence
were very important in terms of imbalances in the current balance.
Under the assumption that a real and economic convergence pro-
cess was taking place, well beyond the nominal, it seemed natural
that capital should flow towards the economies with lower per capi-

23


ta incomes, as economic theory predicts (see, for example, Barro,
Mankiw & Sala-i-Martin, 1995).

In fact, as the risk premiums were disappearing, the correlation
between the savings rated and investment rate were reduced. As
was already anticipated by Blanchard and Giavazzi (2002), since
1999 to the start of the crisis, the Feldstein-Horioka paradox disap-
peared completely, as shown in Graph 4. Coinciding with the
reduction in the typical deviation of risk premiums, which reached

Chart 4
Typical deviation of risk premiums and correlation between the rate of investment and
the rate of savings, EMU, 1993-2011

Source: Bloomberg

24


almost zero as of 1998, the correlation between the national invest-
ment rate and the savings rate was observed to have been nil or
even negative, compared to the positive and statistically significant
values of the beginning of the nineties.

In fifth place, a permissive regulation, together with reduced
interest rates and very high competition in the financial sector
generated the incentives required for the generation of profit to be
done via transaction volume instead of via price margins (mainly
interest rates), favouring a very important leveraging of broad seg-
ments of the private sector. One of the results of this process was
the intensification of a new banking business model, based on the
granting of collateral backed loans, the generation of financial
assets from such loans and the distribution thereof as asset-backed
securities in asset packages (originate to distribute) which transfe-
rred credit risk in full to the purchasers of these new generated
assets. Compared with the traditional bank business, in which
financial institutions that grant the credits keep the risk on their
balance sheets, this new business model led to greater intercon-
nection of the balance sheets among financial institutions all over
the world and a significant increase in contagion risk.

3. The imbalances in Europe and the EMU

The financial crisis was preceded by a period of economic prospe-
rity, measured by conventional indicators of growth, macroecono-

25


mic stability and inflation, during which enormous imbalances of a
financial and competitive nature have been created. However, a
glance of the macroeconomic picture of the EMU reflects a situation
of balance which we do not find in other important economic
regions of the world (Table 1). Both the deficit and public debt levels
and the net foreign positions and private indebtedness are generally
lower to those recorded in the United States or the United Kingdom.

However, the EMU has had other problems hanging over it which
have led the economy of the region – and that of the whole of the
EU by extension – to the situation of stagnation which it is currently
undergoing. Some of these problems are of a structural nature, and
others are related to the extraordinary disparities between member
states in their key indicators to which, until very recently, we had
paid little attention. Among the first are demographic evolution and
low productivity growth which in turn have provoked a limited rate
of growth in employment. But the disparities and the heterogeneity
within the EMU are the most outstanding imbalances, as they call
for a serious amendment in the operation of the Euro, whose main
objective was to accelerate convergence among countries who adop-
ted the single currency along with other common institutions.

The European Commission has recently implemented a pro-
gramme to monitor a number of indicators to detect and track
macroeconomic and financial imbalances in countries within the
EU (the EIP). One of these indicators summarises, over all others,
the nature of the main problem facing the European economy:

26


the gradual and persistent disparity in the current account of its
member countries. Although the EMU and the EU are economies
which can be described as economies which contribute (and
demand) little net savings to (and from) foreign savings, their
aggregate results is the sum of extremely disparate realities. As
Lane (2010) points out, in 2010 European countries accounted for
approximately one third of all current account deficits and sur-
pluses worldwide. As can be seen in Graph 5, the current account
deficits and surpluses of the EMU have gradually polarised from
levels ranging between the [-3%-, +3%] interval, in proportion to
the GDP to position itself outside of this range and even persis-
tently above it by 5%. The underlying causes and macroeconomic
implications of this type of imbalance are extremely complex.

Table 1
Debts and deficits in the EMU, US and United Kingdom (% GDP)

EA17 US UK

Budget balance of
2011 -4.4 -9.6 -8.9
public administrations
Debt of public
2011 87.6 100.0 84.8
administrations

Household debt 2010 67.3 92.1 106.1

Corporate debt 2010 119.1 74.6 123.7

Current account
2011 0.1 -3.1 -2.7
balance

Net international
2010 -7.2 -17.0 -13.9
position

Sources: AMECO, Haver, IMF, national sources and BBVA Research

27


It is true that this polarisation is not an exclusively European
phenomenon, as it happens in parallel with the so-called “global
imbalances” generated during the recent globalisation process.
However, in contrast to what is happening on a world scale and par-
ticularly in a series of developed countries (the Anglosphere) and
emerging countries (particularly China) in Europe there is a positi-
ve correlation between levels of income per capita and sales deficit,
so that the capital flows from the more advanced countries to the
less developed. This has rendered such imbalances less conspicuous,
as they have been associated with the real convergence process. The
traditional view considered foreign indebtedness as a natural con-
sequence of the catching up process during which the countries
undergoing rapid growth required foreign savings to fund strong
domestic investment in commercial goods. Thus, the availability of
savings and the Euro allowed for the funding of the productivity
convergence without financial and exchange rate strangulation.
The international allocation of savings was deemed to be optimal
(“consenting adults”, Obstfeld, 2012), and there was no reason for
public political intervention – what became known as “benign
neglect” by Blanchard and Giavazzi (2002) or Edwards (2002).

It is not easy to determine an optimal level, or even an adequate
one, for the current account deficit which already reflects the gap
between domestic savings and investment in a country which is
assumed to have been optimally determined by consumers and busi-
nesses, unless it is associated with high public deficit, in which case
we would be dealing with a fiscal problem. Moreover, a country may

28


have a deficit current account without having a serious foreign
financing problem, or may have it despite having a regularised
account, in this case because despite a reduced net capital flow, what
matters in the event of a financial crisis is the size of the gross flows,
as nothing guarantees that national savers are willing to fund
domestic liabilities should the international markets become una-
vailable. However, the evolution of the current account of EMU coun-
tries (EU) reflects more deep-rooted problems where the adjustment
role of the market mechanism has proven insufficient and in which
gross financial flows have grown in a fast and imbalanced way.

Chart 5
Current account balance (% GDP)

Source: BBVA Research with data from national sources

29


The deficits have not been linked with productivity convergen-
ce, as is evident in the cases of Spain, Portugal and, to a certain
extent, Ireland, which accumulated growing deficits despite the
slow growth of total productivity of the factors. As can be seen in
Graph 6, productivity grew by 1% on average, whereas the current
account balance varied between surpluses over 5% (the
Netherlands and Germany) and deficits of 10% (as in Portugal and
Spain). In fact, it has not only been the lure of investment but
mainly the fall in savings in peripheral countries which has caused
the gap in commercial deficit which has exceeded both in volume
– percentage of GDP – and in persistence, that observed in many
emerging countries prior to the crisis of the eighties and nineties.
Moreover, much of the foreign financing to the receiving countries
has not been channelled through direct and portfolio investment,
but by way of bank bonds, which increases the risk of bank crises
and ‘sudden stops’ (Jaumotte and Sodsriwiboon, 2010; Land,
2010).

However, the most worrying characteristic of the unequal per-
formance of the current account in Europe is its persistence. Far
from being a transitory phenomenon, the divergence between
commercial balances has sharpened until 2007 (see Graph 5). The
design of the Euro took into account that the absence of own
currency would hinder the traditional adjustment to which most
countries resorted in times of crisis in the balance of payments.
The impossibility of this recourse to devaluation has not come
hand in hand with the strengthening of real devaluation mecha-

30


nisms, that is, with a more flexible response by prices and salaries.
Between 2000 and 2010, enough time has lapsed to have expected
that the countries with most foreign debt and strong real apprecia-
tions should have begun a process of correction towards a surplus
in the commercial balance. Nevertheless, this has not been the
case. The correlation between the commercial deficit and the net
foreign position was positive in 2011 and in 2010 (Graph 7) as it
had been in the last decade, indicating that the private
savings/investment balance does not seem to respond to the cumu-
lative net foreign position.

Chart 6
Current Account Balance in 2007 (% of GDP) and average productivity growth bet-
ween 2000 and 2009.

Source: BBVA Research based on AMECO

31


In 2010 only four EMU countries had a net positive foreign posi-
tion – Belgium, Germany, the Netherlands and Finland – and only
Finland had managed it after correcting a very negative position in
2001 (that is, after a decade of foreign rapid growth and surplus).
Practically all other EMU countries saw their net indebtedness
increase substantially or, at best, such as in France or Austria, they
managed a moderate reduction thereof within the first ten years of
the single currency.

Therefore, the performance of the current account is a very use-
ful indicator – although naturally not infallible – of the way in
which a country responds to the commercial and financial globa-
lisation process and to the existence of other types of imbalances
associated with private sector debt, both financial and non-finan-
cial. Before reviewing these indicators for the EMU (EU), it is worth
asking why the (market) adjustment mechanisms have failed in
this case and what the risk of this situation is happening again in
the future.

The conventional current account approach indicates that
financial flows are a mere counterpart of commercial flows, so that
sustainability of foreign debt must be guaranteed by the expecta-
tion of future current account surpluses or, what is the same, by a
significant proportion of the commercial goods production in the
economy. Foreign financing is no at risk while foreign investors
consider the economy to be competitive. The domestic economy
must maintain a high productivity growth rate and competitive

32


labour costs, as the opposite would render the foreign deficit
unsustainable, foreign investment would drop, reducing prices and
salaries and improving the foreign balance. In this way, given rea-
sonable elasticity in the demand of exports and imports, the
periods of real appreciation and foreign deficit can be reversed wit-
hout deep structural changes.

However, this market mechanism has not worked in peripheral
Europe. Foreign funding has been used to a large extent to fund

Chart 7
Current account balance and net international position

Source: BBVA Research based on Eurostat

33


non-commercial goods, leading to strong expansion of demand, of
prices and of labour costs (see Graph 8). Despite the loss of com-
petitive capacity, the appeal for foreign lenders continues provided
the value of the asset with real guarantees – such as homes – con-
tinues, which is perceived as relatively safe. Thus, the worsening
competitiveness is the effect and not only the cause for the dete-
rioration of the current account. But the existence of high com-
mercial deficit is not corrected of its own accord nor is it done in a
smooth and orderly manner. When the bubble bursts and prices of
the assets used as guarantees plummet, foreign investors perceive
that the national economy is no longer able to guarantee their
debt, leading to the well-known processes of flight to quality,
increase in the cost of debt and, in extreme cases, to sudden stops.

This integration process has led to a number of other imbalan-
ces in the European economies. The objective of the EIP is to go
beyond the control of deficit and debt, and to follow a number of
economic indicators which enable the detection of inadequate
macroeconomic development in a country and can lead to locali-
sed financial crises and even contagion in the future. Such indi-
cators come hand in hand with a number of ‘limits’ that are con-
sidered to be security measures which, when exceeded by a
country, special tracking must be carried out by the Commission.
If an economy is showing imbalance in several of these indicators,
it must propose a plan of action for correction thereof which, if
not suitably applied, might result in some form of political or eco-
nomic penalty. The list of indicators is the following (the limits

34


above which a form of relevant imbalance is detected appear in
brackets): current account balance (% GDP, -4%, 6%); net inter-
national position (% GDP, -35%); real effective exchange rate
(variation rate, -5%, 5%); export market share (growth rate, -6%);
nominal unitary labour cost (growth rate, 9%); cost of housing
(growth rate, 6%); credit flow to private sector (% GDP, 15%); pri-
vate sector debt (% GDP, 1605); public debt (% GDP, 60%); and
unemployment rate (10%).

Chart 8
Growth of nominal salaries and real productivity

Source: BBVA Research based on Eurostat

35


The first report issued on the monitoring of these indicators
shows that in the third year since the start of the crisis (2010), the
imbalances accumulated in recent years are far from being correc-
ted, some of them having worsened since 2007 (Table 2). Greece,
Portugal, Ireland and Spain are the countries with worse qualitati-
ve results. They belong to the Eurozone periphery, where they fail
in at least five of the ten criteria.3

It is within the framework of such imbalances that we must
interpret the fiscal crisis that has been reflected in the general
growth of risk premiums of sovereign debt in Europe, especially in
peripheral countries – although not exclusively. The levels of public
debt in the EMU are comparable to those in the rest of the develo-
ped world, both if we consider the region as a whole or the coun-
tries within it separately. As is shown in Graph 6, only in 2008
three EMU countries (Greece, Italy and Belgium) had a public debt
above that of the US and in any case much lower than that of
Japan. The growth in public debt during the crisis period places
EMU countries – with the exception of Greece and Ireland – in the
realm of 20%, similar to what had happened in most of the deve-
loped countries. Therefore, behind the sovereign debt crisis there
are issues related to the economic governance of the EU in general
and the Eurozone in particular. But also, deeper reasons which have

3 The situation is worse if we take into account that indicators such as the growth rate
of housing prices and credit for the private sector are nowadays within the limits accep-
ted by the MIP as a result of the extraordinary restriction on credit suffered by most EU
economies.

36


become evident following the segmentation of the financial mar-
kets due to the crisis. On the one hand, we have the demographic
and structural characteristics of most of the countries, which
herald for the future a scenario of lesser growth than that before
the crisis. Graph 9 shows the growth rates up to 2007 and the fore-
casts made by the IMF up to 2015 for EMU countries, the United
Kingdom, Japan, and the US.

The aging population and its effects on participation in the
labour market, the low savings rates – with the ensuing difficulties
in funding investments – and the slow rate of productivity growth
explain such expectations, which in turn severely affect the capa-
city to absorb the strong increase in public indebtedness.

In second place, the economic crisis itself has generated an
additional burden on public finances by way of contingent liabili-
ties, the realisation of which shall depend on the performance of
the private debt and the need to apply measures to assist in the
reconversion of the financial sector. As stated by Reinhart & Rogoff
(2008 and 2009), one of the main consequences of financial crises
is that a large part of the private sector debt becomes public. Table
3 (ECB, 2012) shows the impact on public finances of the two
main contingent-type averages within the EMU: provisions for the
European Financial Stability Facility (EFSF) and the guarantees for
the banking sector. The sum of both would mean an additional
impact on the public debt in the EMU of almost 13% of the GDP.
It is true that such contingencies do not necessarily have to mate-

37

38
Table 2
Imbalances at the EMU

Source: European Commission (2012): First Alert Mechanism Report (moving averages, 3 or 5 years)


rialise, but it is also true that provisions have proven insufficient
and have had to be extended in successive programmes.

Chart 9
GDP Growth in 2007 and 2015

Source: IMF (2012)

Lastly, the aging of the population gives way to the generation
of implicit liabilities which are not considered in public debt figu-
res but should be taken into consideration when evaluating the
sustainability of public finances (Cecchetti, Mohanty and
Zampolli, 2010). In 2009 the IMF (IMF, 2009) calculated the sum of
implicit and contingent liabilities in securities exceed – in present
value – 400% of the average GDP of the G20. Of these, those of a
contingent nature associated with the crisis account for approxi-

39


mately one tenth, whereas that associated with an aging popula-
tion – pensions and social security – account for much higher
implicit obligations. As a whole, this type of liability will demand
a remarkable effort from public finances in the future. Cecchetti,
Mohanty and Zampolli (2010) place the additional permanent
financing required to meet such obligations at between 5 and 10
GDP points assuming a public debt at levels similar to the current
ones in developed countries.

In summary, some European economies may have reached debt
levels which exceed or are dangerously close to their fiscal limits,
defined as the maximum level of debt which a country is able to
fund. The fiscal limit depends on the political will of its citizens
and the capacity to increase income by means of tax rate rises (Bi,
2012 and Leeper & Walker 2011) which makes it specific to each
country. This might explain, at least in part, the differences obser-
ved in risk premiums between countries with similar levels of debt
or even that some countries pay a higher cost of financing that
others with much higher levels of debt. Moreover, the relationship
between the risk premium and the fiscal limit is non-linear, incre-
asing rapidly when fiscal performance places debt at such levels
that the likelihood of reaching the limit is significant (Bi, 2012).
That is to say, in order to observe significant risk premiums, it is
enough for investors to understand that the fiscal strategy of a
country leads it to a fair likelihood of reaching the maximum level
of debt financed, even if the probability of this taking place in the
short term is very small. This probability in turn grows over the

40


economic cycle, which obliges countries with greater volatility in
economic activity and unemployment to opt for stricter fiscal
rules.4

Table 3
Contingent Obligations of the governments 2008-2010

Banking sector
EFSF
guarantees
Belgium 7,3 12,7
Germany 8,22 3
Estonia 12,46 0
Ireland 42,8
Greece 25,8
Spain 8,61 6,2
France 7,97 3,1
Italy 8,78 2,7
Cyprus 8,78 15,7
Luxembourg 4,66 3,2
Malta 10,91 0
The Netherlands 7,32 6,1
Austria 7,19 5,7
Portugal 9
Slovenia 10,23 4,4
Slovakia 11,05 0
Finland 7,34 0
EMU 7,71 5,2

Source: BCE

4 When the economies reach this limit, the efficacy of the fiscal and monetary policy
is substantially reduced and both instruments no longer have the expected effects on
economic activity. The fiscal multipliers are reduced and the monetary authority loses
the capacity to control inflation, irrespective of the aggressiveness of its monetary
policy.

41


4. The new European governance and the future of the Euro

The economic crisis has highlighted the need to carry out
important changes in European governance. It is obvious that
there have been failures in coordination in the economic policy
and mistakes in the policies adopted by national government,
which have generated a sovereign debt crisis and a financial crisis.
And it is also obvious that Europe was not first resorting to the
supranational institutions and bodies to prevent the crisis and to
provide a rapid and efficient response once it had begun. The EU,
and particularly the EMU, need to improve their economic gover-
nance in at least three areas: fiscal, financial and economic inte-
gration. Below we shall analyse each of these aspects and the cha-
llenges faced in each by the EMU.

4.1. Changes in fiscal governance

In regard to fiscal integration, over recent months important
inroads have been made, among which are the Stability,
Coordination and Governance Treaty and the creation of the
European Stability Mechanism (ESM). The new Treaty, which shall
come into force on 1 January 2013, has been signed by all EU coun-
tries except for the United Kingdom and the Czech Republic, and
aims to make public finances sustainable and prevent the onset of
excessive public deficits, in order to safeguard the stability of the
Eurozone as a whole. In fact, this Treaty can be interpreted as a
second version of the Maastricht Treaty of 1992, with the differen-

42


ce that whereas the former determined the conditions to enter the
EMU, the new treaty can be said to detail the conditions to be met
by the members of the EMU to continue to belong to the Eurozone.
To this end, the Treaty introduces specific rules (the structural defi-
cit may not exceed 0.5% of the GDP, as of a date to be determined
by the European Commission, and a public debt below 60% of
GDP) and automatic mechanisms which enable the adoption of
corrective actions in the event of deviation from targets.

The rules introduced by the Treaty are in general well designed.
When establishing an objective in terms of structural fiscal balance it
allows for the influence of automatic stabilisers, the minimum being
between 0.5% of structural deficit and the deficit limit of 3%.
However, a good design does not necessarily guarantee a good imple-
mentation, as was the case with the Stability and Growth Pact (SGP).
It is true that the new Treaty entails a criterion of “reverse majority”:
from now on the adoption of corrective or disciplinary mechanisms
proposed by the European Commission must be rejected by a majo-
rity, whereas in the SGP the majority needed to be reached in order
to approve such proposals. It is also the experience of the current debt
crisis has led to an accumulation of collective knowledge which shall
prove very useful when adopting the right decisions in the future to
prevent new crises of this kind. Just as eighty years later the Federal
Reserve is currently preventing some of the well-known mistakes
which were made during the Great Depression of the 1930s, the
European Commission and the European Council shall endeavour to
prevent imbalances similar to those we are currently undergoing.

43


Available empirical and theoretical literature (see, for instance,
Andrés & Doménech, 2006, and the references included in this
paper), indicates that use of fiscal rules has proven useful in the
containment of public debt and the deficit, without the effective-
ness of the automatic stabilisers adversely affecting the effective-
ness of the discretionary fiscal policies. Therefore, the fiscal rules
like those included in the Stability Treaty do not have to be an
impediment for the fiscal policy to carry out its duty of stabilisa-
tion of economic cycles. Quite the opposite: when the economic
agents know, that as a consequence of the existence of such rules,
expansive fiscal policies in the short term shall be offset in the
medium term by counter-adjustment measures in order to prevent
the accumulation of public debt, the effectiveness of these discre-
tionary stabilisation policies increases, as has been proven by
Corsetti, Meier and Müller (2011).

In any event, it shall be very difficult to achieve an optimal
implementation of the Treaty. In the first place, because all govern-
ments are often too complacent when allocating probabilities to
possible risk scenarios which may render public finances unsustai-
nable. Secondly, because it is difficult that sanctions may come
about from the European Union Court of Justice on the basis of fai-
lure to meet the structural deficit targets, which depend of estima-
tes of the cyclical position of the economies and the elasticity of
public income and expenses to this cyclical position. Nevertheless,
what the Stability Treaty does provide is that, prior to reaching
sanctions, the Commission may exert much greater pressure on

44


national governments and alert markets about excessive imbalan-
ces, so that it is the markets themselves that impose discipline via
higher interest rates.

As for the ESM, at the ECOFIN on 30 March the decision was
taken to extend it to 500 thousand million euros, which shall be
provided over two years, and beginning on 1 July 2012. The extent
to which this fund will be sufficient is still unknown, in that it
shall depend on how it is used and whether it allows for fund leve-
raging. Without leveraging, the fund shall only be enough to cover
the financing needs of small or medium sized economies in the
EMU, but not of the big four. However, it may prove effective for
specific, selective but highly intensive interventions designed to
reduce risk premiums, that is, to replace the ECB in its Securities
Market Programme (SMP). In addition, if the ESM should obtain
liquidity from the ECB itself, each of these entities might be able to
separately specialise in the management of a risk: the SMP would
manage the ‘solvency risk’ of sovereign debt and the ECB would
managed the ‘liquidity risk’, thus enabling the central bank to resu-
me the natural role for which it was created, as it would be creating
an EU fund, with a joint and several guarantee, instead of sove-
reign debt with a national guarantee.

It is very important that the intervention of the SMP is as effi-
cient as possible. To this end, the Commission must be clear about
which countries are solvent, with adoption of any necessary adjust-
ment measures and structural reforms, and which countries need

45


some kind of debt restructuring. In the first case, which is clearly
applicable to countries such as Spain and Italy, SMP intervention
on risk premiums should be as intense as necessary until market
doubt and uncertainty have been obliterated. It would otherwise
be very difficult to convince sovereign, pension or investment
funds to purchase the public debt of such countries if Europe is not
the first to refrain from doing so.

Obviously, a more decisive intervention by the SMP, which
would lead to a rapid relaxation of the European sovereign debt
markets, requires the adoption and follow-up of the necessary
adjustments and reforms, but with sufficient time frame so as not
to asphyxiate the economic growth of the countries adopting such
policies. Specifically, the EU could change the fiscal consolidation
strategy which is currently being demanded from member states.
The obsession for nominal deficit targets should be replaced by a
more plausible, rigorous multi-annual fiscal policy strategy which,
in seeking to prevent a spiralling negative growth, truly contribu-
tes towards supporting sustainability in the long term of the public
finances of all countries. Specifically, the European consolidation
strategy should be based on the following principles:

1. Deficit reduction targets should refer to structural deficit inste-
ad of nominal deficit, as proposed by the new Stability Treaty.
This implies that countries should be asked to take specific and
detailed measures to ensure a certain amount ex ante in terms
of reduction in expenditure or increase in income in the

46


coming years. If, as a result of such measures, the economic
activity should be adversely affect with an impact on nominal
deficit (by the mere intervention of the automatic stabilisers),
the member states should not be obliged to take new savings
measures in that same financial year.

2. The pace of structural consolidation should be ambitious
enough to ensure sustainability in the medium to long term of
public finances, and gradual enough to prevent excessively
adverse effects on activity and employment in the short term.

3. The long term balance of public finances requires reforms
which guarantee the sustainability of public systems of pen-
sions and social protection.

Blanchard (2011) recently recommended that, in order to return to
prudent levels of public debt, it would be advisable to apply the pro-
verb of “slow and steady wins the race”. A similar recommendation to
that of De Long and Summers (2012), for whom a fiscal consolidation
which is too intense and too fast might endanger the very sustainabi-
lity of public finances instead of guaranteeing it.

In regard to the debate on Eurobonds, although not necessary
or sufficient, these can indeed become a useful tool in the con-
text of streamlined national finances. They are not necessary, as
the Eurozone can operate without them, if the Stability Treaty
and the mechanism for the prevention and correction of excessi-

47


ve imbalances work properly. And they are not sufficient to pre-
vent debt crises if the fiscal or current account imbalances are not
corrected. If growth is imbalanced (private indebtedness, current
account balance deficit), they imply a permanent transfer of
income from one country to another, which is unsustainable in
the long term. But they are convenient as an efficient mechanism
to ensure and pool risks in the face of asymmetric shocks and,
above all, as an element of political legitimacy of the European
project: European citizens must see that there are specific bene-
fits to belonging to the EMU. And Eurobonds are one of these
benefits, particularly now when many countries need to make
considerable sacrifices and carry out adjustments and reforms.

In this regard, the Eurobond proposal (blue and red) of Delpla
and von Weizsäcker (2010), has the advantage that it would allow
countries to benefit from risk pooling and the creation of a more
liquid asset (the blue bond) than that of the debt of each of the
EMU members, which would strengthen the euro as an internatio-
nal reserve currency, but with the benefit of preserving market dis-
cipline for national debt issued over and above 60% of GDP (red
bonds).5 This proposal consists of the EMU countries pooling their

5 Attinasi, Checherita and Nickel (2009) believe that this market discipline is behind
the increase in sovereign spreads between 2007 and 2009, as a result of the increase in
risk aversion and the concern for the sustainability of public finances. However, Favero
and Misale (2012) believe that this market discipline acts in an interrupted fashion over
time and, occasionally, in an exaggerated way, which in fact justifies the issue of euro-
bonds.

48


public debt up to 60% of their GDP as senior debt under the joint
and several responsibility of all members, whereas the issue of
national debt beyond such a limit would be junior debt under indi-
vidual responsibility. From this perspective, it is easy to conclude
that the decision of the European Council reached in December
2010 to ensure the solvency of the debt issued until June 2013, but
not that issued as of that date was a mistake, as the decision should
have been the opposite: ensure as of a given date all debt issued
under 60%, which would in effective terms be equal to the creation
of the Eurobonds proposed by Delpla and von Weizsäcker (2010).

4.2. Financial integration

As Pisany-Ferri and Sapir (2010) have pointed out, to date the
EMU has worked without a European institution able to rescue
transnational financial entities and without authentic European
stress tests for its banking institutions. Oversight duties have
remained with national authorities and coordination problems
have been managed by means of a combination of discretionary
cooperation and dependence on rules approved by the EU.

One of the lessons to be learned from the current crisis is that
it is difficult to manage a financial crisis on a European scale wit-
hout supranational regulators, supervisors and insurance mecha-
nisms. A large part of the head start that the US has over Europe
in terms of crisis management and resolution is precisely due to
the non-existence or the delay in creating such bodies. The US has

49


federal institutions to manage banking crises, whereas Europe
does not, which renders true the saying that banks are internatio-
nal when expanding and national upon demise. The problem is
that, for some governments (Ireland is a perfect example of this),
banks are too large in relation to their public budgets.

Likewise, the US has a federal regulation, whereas Europe has
enormous national dispersion of its regulations, despite the
efforts of the European Commission and regulators to homoge-
nise and converge towards a common financial regulation.
Occasionally, headways made in certain rules give rise to inequa-
lities among the agents who intervene in the markets, due to
other rules continuing to be different. This was the case, for ins-
tance, of the requirement of the European Banking Authority
that potentially systemic banks must exceed a capital ratio of 9%
before 30 June 2012, when the measurement of risk weighted
assets is regulated by different rules.

Banking oversight in Europe is furthermore carried out via
national supervisors instead of via a single European institution,
which introduces heterogeneity in oversight levels of the financial
system. The result of this financial fragmentation is that one can-
not speak of a single market, which generates the possibility of
regulatory arbitrage, different conditions of competency, ineffi-
ciencies and, in general, a disadvantage in regard to other world
financial areas.

50


In summary, financial integration requires an improvement to be
made in the mechanisms through which information is shared on
the financial systems of each country and the way in which their
activities are supervised, the harmonisation of the guarantees on
bank deposits and of consumer protection regulations, the creation
of European bank restructuring and rescue mechanisms, and the
advancement towards a Single Market not with more, but with a bet-
ter, European regulation which, instead of adding to and prevailing
over national legislation, should simplify and replace it.

4.3. Economic integration

With greater fiscal and financial integration the Eurozone could
operate with less tension in the future, without ensuring the economic
convergence among countries. Is convergence of income or welfare
levels in European countries necessary? Probably not, but it is still con-
venient, as has been stated earlier, to enable societies to believe that
being within an economic and monetary union has advantages well
beyond those which are provided by monetary stability. One of les-
sons to be learned from the Eurozone crisis is precisely that monetary
integration does not ensure economic convergence, as this requires an
advancement in convergence of the determining factors (economic,
social and institutional) of economic growth.

Table 4 shows that the differences in medium and long term
determinants of per capita income are very significant. The relati-
ve position of each country has been obtained on the basis of the

51


IMF analysis (2010), whereas the allocation of each country to one
of three groups under consideration has been carried out on the
basis of the criteria put forward by Hall and Soskice (2001). On the
basis of a number of criteria, both institutional and based on the
workings of economic relations, Hall and Soskice classify the varie-
ties of capitalism into liberal economies (the US being the pro-
totype) and coordinated economics (Scandinavian countries are
the paradigm). In both models (either with high or minimum
coordination), the economies can function efficiently. Market eco-
nomies which cannot be classified into either group are classified
as mixed economies.

In order to transform the qualitative IMF indicator into a quan-
titative one, such as analysing its correlation with per capita inco-
me, values of 1 to 3 have been allocated for each of the three levels
considered by the IMF, where a higher score suggests a greater need
for implementing structural reforms. This enables the obtention of
an average for each country and for each of the nine indicators
which are shown in Table 4. The differences shown in this table are
very marked, not only between developed economies, but also bet-
ween European ones. In light of this evidence it is not surprising
that, except in the case of Ireland, the countries which have accu-
mulated the most imbalances and which are suffering more form
the tensions in the debt market are precisely those which shown
greater structural weaknesses and the ones which must implement
the most reforms. Countries which in turn have been classified as
mixed market economies, presenting more inefficient institutions.

52

Table 4
Structural capacity of the developed economies

Source: BBVA Research (2010) based on IMF (2010) and Hall & Soskice (2010)

53


The changes in the regulations which affect the operation of the
labour, goods and services markets, trade, telecommunications
markets, are easier to implement in the short term, although the
changes thereof are felt in the medium term. An example of this
can be found in the recent reform of the labour market in Spain,
which is bringing its operation in line with that of countries like
Germany (in terms of internal flexibility mechanisms) or to that of
free market economies (by prioritising company agreements and
opt out clauses for collective bargaining agreements). Making
headway in these types of reforms (for example, linking salaries to
productivity) is crucial to remove the differences in competitive-
ness which exist between EMU countries, particularly bearing in
mind that the crisis may have had an effect on the potential
growth of these economies (see, for example, the European
Commission analysis, 2009).

However, in long term indicators such changes can take a lot
longer and, in some cases, even decades. This is the case with
human capital. Even in the event that the many younger workers
of countries such as Spain, Italy, Greece or Portugal should enter
into the labour market with the same human capital as in better
placed countries, 25 years would be needed to half the distance for
the whole of the population of employable age.

54


5.Conclusions

The economic crisis has highlighted the excessive complacency
of the markets, agents, supranational institutions and governments
when interpreting the imbalances which were being generated in
the previous expansion period and the absence of supranational
institutions and mechanisms, firstly to prevent the imbalances
which led to the crisis and secondly, to provide a fast and efficient
response once they had happened. Such institutions and mecha-
nisms are necessary because the evidence shows that the markets
react in a discontinuous way, and occasionally in an exaggerated
way, are pro-cyclical and do not generate of their own accord suf-
ficient disciplinary mechanisms in the short and medium term
whenever these are needed. Insofar as the current Eurozone crisis
has taken place mainly in three areas (debt crisis, banking crisis
and crisis in growth and competitiveness, with huge heterogeneity
between countries), the EU and, particularly the EMU, need to
improve their economic governance in at least three areas: the fis-
cal, the financial and that of economic integration.

As for the improvement in fiscal governance, the Treaty of
Stability, Coordination and Governance needs to be effectively
applies in a preventive way and that, during its transition towards
medium and long term structural deficit targets, this is done with
sufficient rigor and the right flexibility to prevent that countries
required to make the most efforts in the short term should enter
into a negative growth spiral. In this regard, intervention by the

55


ESM on risk premiums should be as intense as necessary until
market doubts and uncertainty have been removed, so that the
countries which are implementing fiscal adjustments and structu-
ral reforms have a sufficiently broad time period to enable such
measures to have positive effects on economic growth. As for the
Eurobonds, although they are not necessary or sufficient to ensu-
re the operation of the EMU, they are indeed convenient as an
efficient mechanism providing assurance and pooling risk in the
face of asymmetrical shocks and, above all, as a political legiti-
macy item in the European project: European citizens must disco-
ver that there are specific benefits to being part of the EMU.
Although it is difficult for such Eurobonds to become a viable ins-
trument in the current situation of divergence, they must become
an essential part of the future European Treasury when the main
imbalances are well under way to being corrected through the
decisive application of the reforms in the various countries in the
EU.

The second area where headway must be made is that of finan-
cial integration, in order to prevent future banking crises and to
manage them in a more efficient and rapid way. Europe must have
supranational financial institutions, regulators and supervisors, as
the current financial fragmentation prevents us from speaking of a
single market. An important limitation which gives rise the regu-
latory arbitrage, different competency conditions, inefficiencies
and, in general, a disadvantage in regard to other world financial
areas competing against the European entities.

56


Lastly, although greater fiscal and financial integration may suf-
fice to enable the Eurozone to operate with less tension in the futu-
re, it is worth establishing the bases for greater economic conver-
gence among its members, in order to increase the political legiti-
macy of the economic and monetary union project, with benefits
which go beyond those provided by economic stability. The diffe-
rences between the EMU countries in the workings of factor, goods
and services markets are very significant, as well as in long term
growth determinants. The structural reforms undertaken to enable
the markets to work more efficiently can bring positive effects in a
relatively reasonable period of time, enabling competitiveness to
improve and the imbalances accumulated during the expansion
and the crisis to disappear more rapidly. In this regard, it is essen-
tial to ensure the success of the Excessive Imbalances Procedure
and other imbalance monitoring mechanisms, ensuring a more
efficient preventive and corrective action than that provided by
the Stability and Growth Pact. However, in terms of long term
growth determinants, such changes can take longer and, in some
cases, even decades; it shall therefore be necessary for Europe to
boost the solidarity mechanisms required to accelerate this conver-
gence process in a more effective and efficient way than that done
in the past.

To simultaneous progress on all these fronts, both at suprana-
tional and national levels, is a necessary condition for the Euro to
overcome this crisis and for its members to continue to form part
of this project in the future. Insofar as the starting point is very

57


different in each country, the main challenge now facing the
EMU is to combine in a fair way the rigor and the ambition of the
adjustments and structural reforms, on the one hand, with an
appropriate time frame and solidarity with all other members of
the Eurozone, on the other.

If, on the contrary, the member states should fail to show such
determination, any attempt towards European economic gover-
nance will be due more an intention than a hard reality. The
Eurozone would have an uncertain future. The alternative of a
Political European Union, in which all necessary economic policies
could be implemented from a community Executive under the
control of a European Parliament and with all democratic rights, is
currently not expected for the time being.

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62

/JOSÉ CARLOS DÍEZ * /

Nature and Causes
of the Euro crisis

Summary; 1. Introduction; 2. Historical background of the Euro; 3. Nature
of the Euro crisis; 4. Fixed versus flexible exchange rates: a review; 5. Causes
of the Euro Crisis; 6. Conclusions; Bibliography

Summary

This work analyses the Euro crisis. It includes a review of its his-
torical background and the exchange rate theory to provide con-
ceptual arguments to help understand the nature and causes the-
reof. It is an infrequent pathology in economics, particularly in
developed countries, but with an enormous destructive capacity.

* José Carlos Díez is an economist who has combined his academic and corporate roles
throughout his professional career. His academic activity is linked to the University of
Alcalá, where he was an undergraduate and PhD student and now is Professor of
Fundamentals of Economic Analysis.
He is currently the Chief Economist at Intermoney, a company founded in 1979 and
leader in Spain in money market brokerage. He contributes with his forecasts to the
panel of experts of the ECB on European economy and the panel of FUNCAS on the
Spanish economy, and advises companies, financial entities and institutions both natio-
nal and international.

63

Nature and Causes of the Euro crisis

For this reason, it is important to get the right diagnosis when defi-
ning the economic policy that will solve the crisis. The main cau-
ses analysed herein are financial integration, the under-assessment
of risks, local imbalances within the Eurozone and the Great
Recession.

1. Introduction

The world financial crisis, whose first symptom was the collap-
se of the subprime asset-backed securities market at the start of
2007, has been changing. It is currently focused on Europe, and is
calling into question the future viability of the Euro and the
European project itself. This work aims to classify the nature of the
Euro Crisis and to identify the main causes thereof. Although the
objective is not to analyse potential economic measures designed
to solve the crisis, without an accurate diagnosis of the origin and
dynamics of the crisis, finding the right solution would be an exer-
cise in chance.

To this end, section 2 includes the history of the European pro-
ject and the single currency. Section 3 describes the nature of the
crisis, which is a seldom seen pathology in economics but which
causes devastating damage to unemployment and public debt of
affected countries. In order to provide the conceptual arguments
required to analyse the crisis, section 4 contains a review of the lite-
rature on exchange rates. Section 5 analyses the main causes of the
crisis, which are: i) financial integration and under-assessment of

64


risk; ii) local imbalances; and iii) the Great Recession. Finally, sec-
tion 6 includes the main conclusions reached in the article and
establishes the requirements to be met by the roadmap in order to
put an end to the Euro Crisis.

2. Historical Background of the Euro

The Euro is the first monetary experiment of the 21st century. It
is not the first in history and shall not be the last, but it affects an
economy like that of the Eurozone which accounts for 15% of the
GDP and for 40% of world exports. The European Union is a poli-
tical project designed to prevent a third world war in Europe. The
first assignment of sovereignty was control by a supranational
body of the coal and steel production in France and Germany, basic
raw materials to produce weaponry. Europe was not an optimal
monetary area; therefore, if a country suffered from an asymmetri-
cal disturbance which did not affect the rest and it saw the effects
thereof on tis unemployment rate, this could not be offset by wor-
kers migrating to other countries with lower unemployment rates.
The bubble in Spain is a good example of this. Spain created one
third of the jobs in the Eurozone during the boom years, but wor-
kers from Germany, where the unemployment rate was reaching
historical levels, did not come: instead, it was workers from outsi-
de the Eurozone who came. When the bubble burst, our unem-
ployment rate shot up, but very few Spanish workers have gone to
work in Germany.

65


The example of an optimal monetary area is always the US.
However, we tend to forget that in order to get there; they first
had to annihilate the original settlers and then have a civil war
which led to a default on payment of foreign debt. The European
project belongs to the 21st century and when in Asia, America or
Africa integration processes begin, they look to Europe for inspi-
ration. Nevertheless, the Euro was a risky headlong rush. Since the
end of the Bretton Woods agreement, Europe has tried to avoid
the unfair competition of competitive devaluations within a cus-
toms union. Germany, with the strongest currency in the system,
has always led the monetary agreements, as its companies suffe-
red the industrial delocalisation created by devaluations, mainly
that of the Italian Lira, a country a few hours away by lorry from
Bavaria. After the fall of the Berlin Wall, the acceleration of the
monetary union was decided so that it would become the striker
of the political union. However, the political union reached stag-
nation after the severe German crisis of 2000, and the single
currency project began to crack.

3. Nature of the Euro Crisis

The nature of the crisis which is hitting the European Union is
a classical debt deflation crisis (Fischer, 1933). Since the Great
Depression, this type of crisis had mainly taken place in emerging
countries and was associated with countries with financial vulne-
rability, with little tradition of macroeconomic stability and insti-

66


tutional fragility. Japan had suffered a crisis of this kind in the
nineties and its economy is today trapped under deflation and
liquidity, but it was viewed as an exotic case in the Far East. In
2008, the Great Recession led to an abrupt disruption of the paths
of growth in developed economies, and the ghost of the Great
Depression began to haunt the world. By contrast, the decisive and
coordinated action of global economic policies prevented another
Great Depression (Eichengreen, 2010). Since then, world trade and
industrial production are 10% higher to levels prior to the Great
Recession, although the MSCI world stock index continues to be
20% below the levels of spring 2008.

Nonetheless, the crash of Lehman Brothers led to the collapse of
world trade, and all countries and areas entered abruptly into reces-
sion, which favoured policy coordination. But the recovery from
2009 was asymmetric, and the coordination of world economic
policies was conspicuously absent. In the Eurozone, from summer
of 2008 to spring of 2009, the euphoria in support of an interven-
tion to avoid a depression gave way to exit strategies in autumn of
that same year and to begin implementing these in spring of 2010.
The debt crisis affected a country with huge imbalances in the
balance of payments and high level of indebtedness such as
Greece, which accounts for 2% of the GDP and population of the
Eurozone, and has extended first to Ireland, then to Portugal, and
now to Italy and to Spain. One third of the GDP of the area is alre-
ady affected, and it has thus become a systemic and global pro-
blem. This is a crisis in the balance of payments, but the existence

67


of a currency and the high level of indebtedness mean the lack of
any comparable historical precedents, which in turn makes the
diagnosis and the search for policies to solve it much harder. For
this reason, we must carry out a review of classical literature on
exchange rates in order to establish the conceptual bases for the
explanation of the crisis, without which the search for a solution
would become a random wander.

4. Fixed exchange rates versus flexible exchange rates: a review

An exchange rate is a relative price between two hypothetical
shopping baskets of two countries. However, exchange rates are
closely related to interest rates (Keynes, 1992), and we are therefo-
re speaking of a relative price which is essential when explaining
economic development. Probably for this reason and as a result of
the advance of globalisation, both commercial and financial since
the fifties, in recent decades economists have paid special attention
to exchange rates. Exchange rates can be:

i. Free floating: the exchange rate is set freely in the market on the
basis of supply and demand, without the intervention of the
central bank or the government of a country. The Euro and the
Dollar are the closest free floating currencies.

ii. Dirty or managed float: the government or central bank suppo-
sedly does not intervene but there are verbal interventions or

68


changes in monetary policy which attempt to alter the bases of
supply and demand in the currency market. At times of maxi-
mum volatility both the US government and the European ones
verbally intervene in the market. During the Great Recession,
the Federal Reserve, without expressly acknowledging this, has
applied a monetary policy which has significantly weakened the
dollar. The ECB has always followed in the footsteps of the Fed
but in 2011 it managed to exceed its action by weakening the
Euro, also without express recognition thereof. Japan is without
question the best example of dirty flotation. The country sup-
posedly enjoys free exchange rates but when there is tension in
the markets and the savers repatriate capital, the central bank
intervenes massively in the currency market to counteract the
pressures of appreciation on its currency, which would have a
very negative repercussion on activity and employment.

iii. Fluctuation bands: the European Monetary System or EMS, the
predecessor of the Euro, was the clearest example of this system.
A central parity and fluctuation bands were established. Whilst
the exchange rate in the market fluctuated within the bands,
the system behaved like a flexible currency rate, but if it reached
the bands then the central bank intervened to prevent these
being exceeded, therefore becoming a fixed Exchange rate.

iv. Fixed on a currency basket: equal to a fixed rate, but instead of
fixing the anchor on one single currency it is fixed on a basket.
It has been speculated for some time that China wants to apply

69


this system. It makes more sense that just fixing it against the
dollar, as the basket should replicate the composition of the
current account and financial balance and would allow for bet-
ter stabilisation of real exchange rates, which are the ones
which determine the impact on activity and employment.

v. Fixed adjustable: this is a fixed exchange rate which allows
for adjustments. These may be discretionary or else subject
to rules such as in the Bretton Woods system, or periodically
adjustable. The latter were used in emerging countries which
had sustained soaring inflation rates in the eighties and
nineties during their stabilisation programmes, especially in
Latin America.

vi. Non-adjustable or true fixed rate: the country fixes a nominal
anchor with a fixed rate relative to another currency with no
possibility of change. Middle Eastern countries have fixed
exchange rates against the dollar, which is justified by income
from oil being collected in dollars. China had a fixed exchange
rate against the dollar until 2005, when it moved onto daily
fluctuation bands which it has recently broadened to +/- 1%
daily.

vii. Cash conversion: the monetary supply of a country is determi-
ned by the level of currency reserves, and thus monetary sove-
reignty is subject to capital flows. This was the exchange system
in Argentina until 2001.

70


viii.Exchange Union: the countries waive their national sove-
reignty and assume a new currency. This may be a dollarization
as has been proposed in some Latin American countries, or else
a Euroization where the dollar would be adopted but without
representation in the central bank. Or else a monetary and
exchange union such as the Eurozone, where countries assume
the same currency and are represented in the central bank and
in monetary and exchange decision making processes.

The debate on fixed or floating exchange rates is as old as macroe-
conomics. During the happy twenties and then during the Great
Depression, capital movements were accused of being speculative due
to the extreme volatility of exchange (Nurkse 1942). Subsequently,
another school of thought argued that the volatility was caused by
destabilising economic policies and that freedom and speculation had
stabilising effects (Friedman 1953). Rudiger Dornsbush opened up a
new avenue of research according to which, even with investors with
rational expectations, there was volatility in exchange rates. An incre-
ase in the money in circulation by the central bank would increase
inflation expectations and lead to a depreciation in the exchange rate.
However, for investors to buy once again there should be expectations
of appreciation; the exchange rate should therefore over-react and
exceed its level of equilibrium to enable capital flows to return to the
country.

The truth is that neither the theory nor the empirical evidence
are conclusive in this debate. The problem facing the countries is

71


threefold: exchange rate stability, monetary independence and
financial aperture. Conceptually speaking, flexible exchange rates
are the optimal solution, but for these to be stable the country
must have monetary credibility. Flexible exchange rates provide
leeway to the central bank in terms of fiscal policy, whereas the
fixed exchange rate means this is lost and it becomes dependent on
the decisions made by the central bank to which it has anchored
its currency. The problem is that credibility takes a long time to
achieve and takes very little time to lose. Moreover, it cannot be
imposed; it is the society of the country in question which must
understand stability to be a public asset and to accept sacrifices and
limitations in order to preserve it.

Countries lacking monetary credibility have hardly any leeway in
monetary policy, and this reduces the costs of accepting a fixed
exchange rate. If the country has suffered from hyperinflation or a
spiralling inflation, a nominal anchor on a stable currency allows for
stabilisation of the prices of imported goods in the shopping basket
and, combined with a stabilisation plan, proves to be highly effecti-
ve to get the economy out of hyperinflation. This is what happened
in Argentina in 1990, but then the fixed exchange rate allowed imba-
lances to go beyond what was sustainable and ended up by explo-
ding in mid-air and amplifying the effects of the severe crisis of 2001.

During the nineties the debate in Europe prior to the creation of
the Euro was very intense (Rodríguez Prada, 1994). Most econo-
mists did not call into question the fact that Europe was an opti-

72


mal monetary area (Meade 1957 and Mundell 1961). Although
much progress has been made in the freedom of movements of
capital and people, the labour markets continue to be segmented,
mainly due to language and cultural differences, and when a region
suffers an asymmetric disturbance with an increase in unemploy-
ment, this is not offset by transferring workers from another region
as they do, for example, in the US. In this scenario, the country
needs to transfer capital and work to the sector of non-corporate
goods to the corporate goods sector and needs to depreciate the real
exchange rate. Without the capacity to devaluate the nominal
exchange rate, all the adjustment must be made via inflation or
productivity. When the central country has inflation rates close to
2% the strategy must be deflationist, which is where the problems
start, as many economists warned prior to the creation of the Euro
and has been proven since the Great Recession (Obstfeld 1998).

Nevertheless, the lack of an optimal monetary union is clearly a
downside to the creation of the euro, but in the nineties it was the
benefits that were highlighted (De Grauwe 2009). The main bene-
fit is that we Europeans already had a customs union and high
level of commercial integration. Nowadays, approximately 70% of
the Spanish exports are concentrated in the European Union and
60% of what we import comes from our partners. Therefore, natio-
nal exchange policies were very destabilising in this scenario, put-
ting the European project at risk.

73


The main benefits were concentrated in the financial area.
Integration would enable the removal of currency risk and risk pre-
miums, leading to a drop in real interest rates and therefore incre-
asing the potential growth of the Eurozone and of each of the
countries therein, in turn allowing for convergence in income per
inhabitant with the US, which experience a sharp boom in pro-
ductivity in the nineties. Chart 1 shows how the introduction of
the euro did not achieve the desired convergence, except in the
case of Spain.

Chart 1
Gross Domestic Product per inhabitant

Source: Eurostat structural indicators and own work

74


In the debate of costs and benefits prior to the creation of the Euro,
many economists warned of institutional problems in the design of
the monetary union. The main ones were the absence of a fiscal
union which would offset the asymmetric disturbances that might
take place in some states and, that in the absence of exchange rates
and monetary policy, the country would be left without economic
policy leeway to counteract them (Eichengreen 1998). The other
main limitation was the absence of a true lender of last resort which
the statutes imposed on the ECB (Obstfeld 1998).

5. Causes of the Euro Crisis

The Euro crisis is extremely complex like all debt deflation cri-
ses in history (Díez 2012), which is why we shall now review the
main events to enable us to understand the fundamentals of the
over-indebtedness without which we shall not be able to come up
with appropriate economic policies to help digest this.

5.1. Financial integration and under-assessment of risk

When a country adopts a fixed exchange rate and investors con-
sider it sustainable in the future, the risk premium drops. A rational
investor must choose between an infinite variety of international
assets in which to invest his savings, but his yield estimates are
made in local currency as the objective of purchasing financial
assets is to protect against the impairment of purchasing power

75


caused by inflation during the investment period. If an investor
purchases an asset in another currency that then appreciates
during the investment period, his yield will increase in the local
currency, but if it depreciates it will drop, which explains the direct
relationship between interest and exchange (Dornbusch 1976).

In the case of the Euro we are dealing with the exchange rate
with the largest commitment and greatest exit costs; therefore its
added credibility is also greater, just as the drop in risk premiums is
also highly intense. Chart 2 shows the intense process of financial
integration which took place in Europe following the creation of
the single currency. Investment funds and financial institutions in
the Eurozone went from having 20% of assets from other countries
in the region in their portfolios in 1998, to 45% and 40% respecti-
vely in 2007. This means a huge transfer of capitals from countries
with a savings surplus, mainly Germany, to countries with savings
deficits and especially those with higher risk premiums.

This arrival of capital flows, along with the credibility granted
by the investors to the Euro since its inception, help to explain the
intense convergence of interest rates between the public debt of the
various member countries that can be observed in Chart 3.
However, as is the case with all bubbles, at the beginning there are
fundamentals which justify investor behaviour, but usually, follo-
wing such sharp changes in financial flows, there is usually and
over-reaction and asset prices move away from the fundamentals.

76


Chart 2
Financial integration

Source: European Central Bank

Chart 4 shows how not only did convergence take place in
public debt interest rates, but that the process was more intense in
private debt. Covered bonds are the assets with the least likelihood
of default following the public debt of a country and it might even
be the case, in extreme cases, of default on Treasury bonds but not
on covered bonds, as has happened in Greece. The covered bond is
a bond with a senior guarantee from the financial institution that
issues it, but which also has a second guarantee. The issuing entity
selects its highest credit quality mortgages, those for the main resi-
dence, with a debt under 80% of appraisal and a monthly instal-
ment below 35% of the household income, and these are attached
as bond guarantees. Therefore, in the event of bankruptcy of the

77


Chart 3
10 years Public debt spread v. Germany

Source: Bloomberg and own data

entity, the buyers of the covered bond would prevail over the rest
of creditors to collect on such mortgages until recovery of their
investment, irrespective of whoever purchases the bankrupt entity.
This is what distinguishes them from asset-backed securities where
the investor assumes the direct default of the mortgages. In the
case of the covered bond, the risk belongs to the entity and, second
to the default of the mortgages, and thus they have a dual guaran-
tee and lesser likelihood of default. Moreover, the rating agencies
require the over-collateralisation of the issue, so that if an institu-

78


tion issues a covered bond worth 1000 million euros, they would
be required to provide between 1300 and 1500 in mortgage portfo-
lio as a guarantee. Hence, the entity would first have to be declared
bankrupt and then it should have to have a default in the mortga-
ge portfolio of over 50% for the investor not to recover 100% of his
investment. This helps one to understand that since 2007 no cove-
red bond issued by a European entity has experienced default.
These types of assets do not exist in the US, as the Fannie Mae and
Freddy Mac played the same role, but evidence has shown that the
European system, by maintaining the risk in each institution, was
more efficient and, in fact, there are legislative proposals under way
to develop a covered bond market in the US.

Until 1997, the companies of peripheral countries such as Spain
found it difficult to issue bonds on the international markets. The
Peseta was a currency which had experienced several devaluations
over the last few decades, its financial markets were very narrow
and were practically taken over in full by public debt. The entry of
the Euro enabled Spanish financial entities to access an organised
market of covered bonds with a longstanding tradition and depth
in Germany, which rapidly spread to all other countries in the area.
As we shall explain shortly, this coincided with a deep and complex
debt crisis in Germany, as a result of the excesses of its Unification,
which increased the savings rate in a structural way, and thus the
supply of top quality credit assets for its financial institutions, insu-
rance companies and pension funds, which in turn boosted the
rapid growth of this market as well as its (Díez 2012b).

79


Chart 4
Spanish covered bonds spreads

Source: Bloomberg and own data

In Chart 5 we can see how such structural changes in the fun-
damentals led to a credit boom in the Spanish economy. The ori-
gin of the boom was justified by the fundamentals, but in the end
the only fundamentals were the self-realisable expectations, lea-
ding to the bubble. In 1995, when the likelihood assigned by inves-
tors that Spain would form part of the founder members of the
Euro was very low, practically all of the Spanish bonds in the hands
of non-residents were public. Since then, the percentage of public
debt over GDP had become constant, but when our incorporation

80


into the single currency was approved in 1998, the international
issues market opened up for the private sector and grew exponen-
tially until it doubled that of public debt in terms of GDP. The hea-
ding “other resident sectors” includes the asset-backed securities
funds, rendering most of debt as pertaining to banks.

Chart 5
Spanish bonds in the hands of non-residents

Source: Bank of Spain, INE and own data

Covered bonds are purely a bank product, despite carrying a
second mortgage guarantee, and are accounted for as bank debt. The
most developed covered bond market in the world was the German

81


one of Pfandbrife but in Chart 6 one can see how in 2006 the
Spanish banks issued 70,000 million euros in covered bonds, 30%
less than the German banks which had a balance three times as
large as that of Spanish banks. In summer 2007, before the start of
the financial crisis, the outstanding balance of covered bonds issued
by Spanish banks exceeded 300,000 million euros, 30% of the GDP
and an amount equal to the outstanding balance of Spanish public
debt. In 2006, the issues of covered bonds and asset-backed securi-
ties by Spanish banks comfortably exceeded the current account
deficit which was approaching 100,000 million and were the main
financing instrument of our economic, without which it is not pos-
sible to explain the credit and real estate bubble.

The dynamics were straightforward. The Spanish banks used the
loans granted in retail banking as a guarantee for new issues which
allowed the granting of new credits. The issues of covered bonds
were carried out at variable interest rates of Euribor plus 10 basis
points and the mortgages were granted at Euribor plus 50 basis
points. A strong growth in credit, low rate of default and spreads
between stable asset and liability rates constituted the basis of the
demand for funds of Spanish banks. What were the fundamentals
of the supply of funds? The key lay in the Shadow Banking System
(FSB 2011, European Commission 2012). This consisted mainly of
vehicles created by international banks, based in tax havens and
not consolidated in their balance sheets and thus outside the peri-
meter of oversight by the central banks. The vehicles purchased
assets, mainly of high credit quality and were funded by the com-

82


Chart 6
Issues of Covered Bonds

Source: International Monetary Fund

mercial paper market using those assets as guarantees. Let us assu-
me that the vehicle bought a covered bond at Euribor plus 10 basis
points and was funded by Euribor commercial paper. This resulted
in a profit of 10 basis points per transaction. If the vehicle only had
5% of capital and 95% of debt, this meant a 20-fold leverage, such
that the yield over equity was Euribor plus 200 basis points.

The growth of the shadow banking system was exponential and
in 2007 in the US reached 20 billion dollars, whereas the non-sha-
dow banking system supervised by the Federal Reserve amounted

83


to 16 billion dollars. The asset-based leverage which used mortgage
guarantees already granted enabled the banking system to generate
liquidity in an endogenous manner without having to resort to the
central bank, leading to the loss of monopoly by the monetary aut-
horities of the issue of money in circulation. When in February
2005 Alan Greenspan, then President of the Federal Reserve,
announced that there was an enigma in the behaviour of the bond
market, he was responsible for this for allowing the development of
the shadow banking system. Until 2009, no statistics were publis-
hed on the shadow banking system but, once they became public,
it was much easier to understand the causes of the largest global cre-

Chart 7
Current account balance

Source: International Monetary Fund

84


dit bubble burst since the Great Depression and which was parti-
cularly severe in some Eurozone countries, including Spain.

5.2. Local imbalances:

Over the last few decades, the economic paradigm has analysed
the real economy and the financial economy separately. The Great
Recession has proven the failure of the paradigm and, as we were
shown by Luca Paciolo in the 13th century, when an economy is
analysed, the assets and liabilities cannot be separated. Therefore,
although it is evident that the hurricane began in the financial
realm, there are imbalances in the real economy which also help
to explain the crisis. Chart 7 shows the divergence between
current account balances among developed and emerging coun-
tries in the last decade. Several causes help explain this phenome-
non which the literature has called “global imbalances” (Caballero
2009).

The main cause was the aftermath of the Asian crisis of 1997.
The affected countries had large current account deficits and low
levels of currency reserves before the crisis, and subsequently they
geared their economic policy towards exports. This led to current
account surpluses and high currency reserves, and the ensuing
structural increase of the world savings rate (Bernanke 2005). The
accumulation of reserves was concentrated on sovereign funds and
central banks with a conservative approach, which significantly
increased the demand for fixed income funds of top credit quality,

85


known as AAA. Without understanding the Asian crisis and its con-
sequences it is not possible to understand the intense development
of the shadow banking system and the strong increase in leverage
in the world banking system which has been analysed in the pre-
vious section (Caballero 2008).

Chart 8 shows how the Eurozone was hardly affected by the
phenomenon of Global Imbalances, with a current account balan-
ce close to equilibrium since the Asian crisis. However, Chart 8
shows that there have indeed been huge differences between the
countries within the Euro and, for this reason, the phenomenon
has now been called Local Imbalances. In 2001 Germany suffered a
debt crisis similar to the one suffered at present in Spain, although
it hardly translated into a current account or foreign debt deficit.
Germany, as was the case in Japan in the eighties, suffered from a
problem of over-indebtedness of households and businesses, with
real estate bubble, burst and depression all thrown in to the packa-
ge. Following the burst of the bubble in 2000, German households
were reluctant to take on debt and structurally increased their
savings rate to reduce such a debt. Private consumption plumme-
ted and businesses sought the supply that was absent in the domes-
tic market in the export market. The fiscal revenue dropped dra-
matically and Germany failed to meet the Stability Pact and wat-
ched its public debt increase significantly until 2005.

The birth of the euro and the credit boom in peripheral coun-
tries enabled Germany to overcome the severe recession thanks to

86


the strength of its exports. Moreover, German savings found an
easy path without assuming exchange rate risk with its partners in
the Eurozone. The causes of the Euro crisis are focused on the
analysis of the imbalances of debtor countries, but it is not possi-
ble to understand and explain the crisis without analysing the
saver countries, particularly Germany. Debtor countries are facing
a prolonged period of debt reduction, which will ensure a weak
internal demand, and shall be obliged to show a current account
surplus as was the case in Asia in 1998 and in Germany in 2001.
But this will not be possible if the creditor countries reduce their
current account surpluses and boost internal demand.

Chart 8
Current account balance

Source: International Monetary Fund and own data

87


5.3. The Great Recession:

The European Monetary Union was born with institutional pro-
blems but these did not become evident and to put its viability at
risk until 2009. Chart 9 shows how the Great Recession which rava-
ged the world and Europe in 2008 has been the worst for seventy
years, although it did not reach the depth and length of the Great
Depression, which it is being called the Great Recession. Without
an earthquake of this force, it is possible that the institutional flaws
of the European project could have endured for longer, but the cri-
sis has highlighted them and the Euro is now at a crossroads.

In 2007 it was financial disturbances which anticipated the
recession. Chart 6 shows how the covered bond market practically
dried up for Spanish banks as well as for all other indebted coun-
tries. This brought the credit boom to a halt and acted as the trig-
ger for the recession. In 2008 the disorderly collapse of Lehman led
to the worst global run since the Great Depression. The investors
quickly resorted to short term public debt of the internal reserve
currencies, the money markets dried up as did the currency mar-
kets, and world trade collapsed in a matter of weeks. The coordi-
nated reaction of the G20 with the most expansive monetary, fis-
cal and financial policy in history prevented the world from ente-
ring into a depression and enabled a V-shaped recovery of world
economy and trade in 2009.

88


Chart 9
GDP EU 15

Source: Angus Maddison. University of Groningen

Economics is an empirical science but it is difficult to find
homogeneous experiments to compare policies, but this crisis has
provided one. The Great Recession was synchronized and most
countries entered into recession at the same time. However, the
recovery since 2009 has been disparate and the economic policies
have been very different between the US and the Eurozone, which
enables a comparison of its effects to be drawn. Europe began fis-
cal consolidation at the beginning of 2010, despite the boost
given in 2008 to get out of the recession, whereas the US has con-
tinued to renew its fiscal incentive plans. The ECB has been reluc-
tant to intervene and has only done so when the markets have
been on the edge of collapse and it even took the liberty of incre-

89


asing the interest rated in July 2011, making the same mistake as
in July 2008, anticipating the recession. The Federal Reserve has
kept its rates at 0% and has renewed its quantitative policies.

After two years of experimenting, what has the result been? The
growth in the US has been twice that of Europe, its inflation has
also doubled and its unemployment rate has reduced to 8.5%,
whereas in Europe it has exceeded 10%. In the US, several states,
among them California and Florida, burst their real estate bubbles
and California defaulted on payments and created its own
currency, what was known in Argentina as Patacones. Therefore,
the Euro crisis is not the cause of the problems in Europe but
simply the result of mistakes made in economic policy in Europe
since 2009. Neither is the argument of the greater rigidity of
European labour markets and the mobility problems between
countries valid. In the US, the unemployment rate increased with
equal intensity in states which did not have a real estate bubble,
thus confirming that the cause of the growth in unemployment
was a sharp drop in demand caused by an intense banking crisis
and credit restriction. But the most spectacular result of the expe-
riment is probably what happened with public finances. The US,
without resorting to raising taxes, without great cuts and simply by
freezing public expenditure has managed to increase fiscal revenue
by 12% and has reduced the deficit by four percentage points of
GDP. Europe, by raising taxes and cutting costs has managed a
revenue increase of 6% and a reduction of the deficit of two points
of GDP.

90


The emergence of almost ten points of public deficit in a new
Government in Greece was the spark which ignited the Euro crisis
which we currently face. The Greek Tragedy spread first to Portugal,
then to Ireland, and currently threatens Spain and Italy, thus
having affected one third of the GDP of the Eurozone, (Díez, 2012).
Chart 2 shows how the Great Recession began a process of finan-
cial disintegration in the Eurozone which was intensified by the
Greek Tragedy and the contagion of all other economies. In a
monetary union, the outflow of capital is equal to a contractive
monetary policy and, on the contrary, the inflow of capital is
expansive. This helps us to understand why the countries subjected
to financial tension entered once again into deep recession in 2011
whereas Germany, the main receiver of capital flows, has continued
to grow.

6. Conclusion

The European project is a political one and it is born out of the
need to end wars and conflicts which had ravaged Europe in the
20th century. The Euro was an attempt to accelerate the political
union but has ended up being a headlong flight.

· The Euro is the most extreme version of a fixed exchange rate.
Indeed, it is reinforced and with high cost of departure, which
renders it more credible, but while it lacks a political union there
will always be doubts as to whether it will be a single currency.

91


· In the nineties the benefits – and there were some which have
been clearly demonstrated – of the creation of the euro were
overvalued. But at the same time there was an under-assessment
of the costs which reality has proven were also there. The two
main institutional problems which must be solved are: i) the
absence of a fiscal union to complement the monetary union
and ii) the absence of a lender of last resort due to the limita-
tions imposed on the ECB in its bylaws.

· Financial integration and the undervaluation of risk, both glo-
bal phenomena, are essential to explain the credit boom and the
problem of over-indebtedness which are the origin of the Euro
Crisis. The case of the covered bonds is a good example that not
only were credit risks undervalued, but liquidity risk was likewi-
se under-assessed.

· The Local Imbalances, the high current account surplus in
Germany and the deficits in Spain and other countries forced
the transfer of financial flows and boosted the credit boom and
over-indebtedness. Countries subjected to financial tension are
implementing sharp reductions in their current accounts, but
Germany has hardly reduced its foreign surplus since 2007.

· The institutional problems of the Eurozone became apparent at
the Great Recession, as a result of the sharp drop in activity and
the collapse of the financial markets and credit channels which
have rendered many debts unsustainable and unpayable.

92


Without such a deep recession, the problems would have taken
longer to appear.

· The aim of this article was not to discuss solutions, but from the
analysis of the nature and causes of the Euro crisis, we can con-
clude that the solution must: i) dispel doubts as to the future via-
bility of the euro, ii) to do so we must work towards the fiscal
union and the creation of Eurobonds would be the precedent for
a future single European treasury, iii) we must change the bylaws
of the ECB so that it may act as a lender of last resort as the
Federal Reserve does in the US, iv) we must halt the process of
financial disintegration and ensure the return of part of the capi-
tal flows which have exited from peripheral countries, and v) we
must urgently reactivate growth in Europe. In order to do so, the
monetary policy must opt for quantitative strategies of debt pur-
chase, the fiscal policy must be less restrictive and the financial
institutions and countries with greater solvency problems must
be recapitalized in order to restore the credit channels as soon as
possible.

93


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96

/JUERGEN B. DONGES * /

The European crisis and the challenge
of efficient economic governance

1. Introduction; 2. The root cause of the problem: too much economic diver-
gence; 2.1. A suboptimal monetary area; 3. Attempted governance in an
indirect manner; 3.1. Breach of the fiscal rules; 4. Governance as activism
against the crisis; 4.1. Constituent principles, violated; 4.2. Financial assis-
tance, a never-ending story?; 4.3. Political pressure to impose discipline,
insufficient so far; 4.4. Financial markets, with capacity to persuade; 5. New
governance design: own responsibility as the key; 5.1. The euro Plus Pact, it
is not binding on anyone; 5.2. The Fiscal Stability Pact, a test of nine; 5.3.
The Macro-economic Governance Pact, with vague parameters; Conclusion

* Professor emeritus of economics at the Faculty of Economic and Social Sciences of the
University of Cologne (Germany). From 1969 to 1989 he managed several economic
analysis departments at the Kiel Institute for the World Economy, in which he was the
Vice-chairman for the previous six years until he took the chair in 1989 in Cologne. He
is currently a Senior Fellow of the Cologne Institute for Economic Policy. He was the
Chairman of the German Council of Economic Experts (the so-called “Five Wise Men”)
and the German Commission on Economic Deregulation. He is an economic advisor in
several academic institutions and foundations in Germany, Spain and in other coun-
tries. He is also a member of the Supervisory Board of several multinational companies.
He is the author of several books and articles published in academic journals on inter-
national economy and public policies in the field of macro and micro economy.

97

The European Crisis and the challenge of efficient economic governance

1. Introduction

The purpose of this article is to focus the current discussion on the
need for economic governance in the European Union (EU) and, in
particular, in the euro area, in the context of the political reality.
This is not such an easy task, as it may seem; in practice the rela-
tions between national governments, on the one hand, and these
and the European Commission and the European Parliament, on
the other, end up being profoundly redefined, with more European
powers and less national sovereignty.

This topic is not new; it has been on the table at the mee-
tings of the European Council of the Heads of State and
Government since the formation of the European Single Market 25
years ago (1986 Single European Act). We can interpret agreements
leading to a coordination of economic policies, as the initial step
towards “smooth” European economic governance, specifically to
(i) promote employment (1997 European Summit of Luxembourg),
(ii) apply structural reforms conducive to flexibility in the product
and factor markets (1998 Cardiff Summit), and (iii) institutionalise
macro-economic dialogue among the governments, the European
Central Bank (ECB) and social partners (1999 Cologne Summit).
Apart from the above steps we should add (iv) the agreement of the
European Council in 2010 to launch a strategy of structural reforms
that would make the EU at the end of that decade the most dyna-
mic economic area in the world.

98


These agreements which were then celebrated as a landmark in
the European integration process have not given the desired results.
The reason is very simple: over and above the rhetoric, the govern-
ments were not willing to co-operate if the alleged or true national
interests indicated otherwise. Such governance installed in the
European Council, the Ecofin and in other councils of ministers
involved, lacked any kind of power of management and supervi-
sion of the economic and fiscal policies of the member states.

At the current debate the great hope is that in the future
national interests will come second, giving way to the “More
Europe”, as the new political logo reads. The aim is to reach gre-
ater and efficient intra-European co-ordination of the economic
policy of the member countries. This aim was raised in 2011-
2012 in three basic agreements: (i) the Euro Plus Pact (to strengt-
hen the competitiveness and growth capacity of the economies),
(ii) The Fiscal Stability Pact (Fiscal Compact to guarantee in all
the countries the sustainability of public finances in the medium
and long term) and (iii) the Macro-economic Governance Pact
(Economic Governance Six Pack, to ensure economic and fiscal
policies compatible with the internal and external balance in the
economies). Now, the declarations of intent are one thing, put-
ting them into practice and applying the appropriate economic
policies, is quite another. Why should what politicians promise
today be believable, if in the past (and today, as many of them
are still around) did not fulfil their commitments?

99


I will now analyse governance in its past and present dimen-
sions. The following section emphasises the significant fact that
the euro area is not an optimal monetary area. In the third and
fourth sections the forms of governance relied on until now are
analysed. The fifth section deals with the new approach for
European governance. The last section concludes the analysis in a
tone of moderate hope.

2. The root cause of the problem: too much economic
divergence

The crisis of the sovereign debt in Europe has shown a serious
fault in the formation of the single currency: trusting that the
governments of the member countries would apply quality econo-
mic policies in accordance with the common interest of all the
partners, as set forth in the EU Treaty (articles 2 and 121), was
naive. In Germany, I together with many other economists noticed
this fault then, but political leaders took no notice or it was labe-
lled as “academic” and, therefore, irrelevant to take great historical
decisions. The leaders simply invoked the criterion of the so-called
supremacy of politics over economics, as they do today when they
run from one summit to the next to rescue certain countries from
bankruptcy and try to stabilise the euro area.

100


2.1. A suboptimal monetary area

The architects of the euro area, from the 1989 Delors Report,
knew that a monetary union would not be feasible in the long run
without a fiscal union, not to mention political union. The history
of the different monetary unions in Europe in the 19th Century
had left an unequivocal message: all of them failed because of
incompatibilities among the budgetary policies of the member
countries. However, during the negotiations of what would become
the Maastricht Treaty (of 1992) the prerogative of national budge-
tary policy was sealed. The then two main characters of the
European project, the German Chancellor Helmut Kohl and the
French President François Mitterrand, fascinated their counterparts
with their vision of the euro as a pacemaker to accelerate and to go
into greater integration. More than one will remember the famous
statement of the French Finance Minister, Jacques Rueff, ‘Europe
shall be made through the currency, or it shall not be made’ (1950),
and they took it literally. The French statesman could never have
imagined such a deteriorated environment of public finances as we
have today in many European countries.

It was also clear that the five convergence criteria set forth in the
Maastricht Treaty, even if they could be fulfilled (something that
not all countries have done), did not guarantee an optimal mone-
tary area (in terms of the theory of Robert Mundell and others). In
Europe, it would have been essential for the countries to be quite
homogeneous in terms of economic development and functioning

101


of the institutions or the prices and salaries in the various countries
should have been flexible enough (especially downwards in coun-
tries with weak growth and great structural unemployment), or for
European mobility of labour to be high (from backward regions
with high unemployment rates to dynamic regions with shortage
of workers). These conditions for an optimal monetary area did not
happen twenty years ago and do not happen today. The difference
between Europe and the United States in this is significant.

Only a group of countries in the euro area (in central and nort-
hern Europe) at least met then and meets now the condition of
homogeneity. The countries in the southern periphery were not,
strictu sensu, ready for their accession in 1999 to the monetary
union and, therefore, to waive a monetary and exchange rate
policy as adjustment facilities of internal imbalances (inflation)
and external imbalances (current account deficit) and to under-
take tax regulations that would restrict government deficit and
the level of government debt. It is not a coincidence that these
countries have had for the past two years a risk of insolvency (not
to have the capacity to re-finance the debt in the capital market
under affordable conditions), as only sovereign countries have, if
the State may not resort to the Central Bank to secure financing
and must get it by issuing bonds in a foreign currency. Greece
may be the most illustrative example of having done what the
German Council of Economic Experts has classified as an “origi-
nal sin”, in other words, having rushed into accessing the mone-
tary union in 2001, forced even through deceit (hiding the truth

102


of their fiscal statistics): the country is now at the mercy of the
international financial markets (rating agencies), after having
revealed the serious structural deficiencies in the economy and
the public institutions, which has led to a low growth potential
and low levels of productivity and competitiveness clearly insuf-
ficient at this time (globalisation of competition).

3. Attempted governance in an indirect manner

It was conceptually logical that with the creation of the single
currency the powers on monetary policy would be transferred
from the National Central Banks to the new ECB. However, as the
budgetary policy would carry on being a national responsibility,
two principles constituting the euro area were established in
order to guarantee the sustainability of the public finances in the
member countries and to ensure that the monetary union would
work as a price stability union.

• The two principles proclaimed in the Maastrich Treaty are the
prohibition to bail out insolvent partners, on the one hand,
and the prohibition imposed on the ECB to finance govern-
ment deficits (no monetisation), on the other hand. These
clauses are contained in the most recent version of the Treaty
on the European Union (the Treaty of Lisbon of 2007) in arti-
cles 125 and 123, respectively.

103


• The two provisions were supplemented with the Stability and
Growth Pact (SGP) approved in 1997 at the European Summit
in Amsterdam; in it a ceiling for national budget deficits (3%
of GDP) and government debt (60% of GDP) were established
under the assumption that the growth rate of the nominal
GDP in the euro area would be 5% in the medium term.1

With all this, indirect governance elements were created, in
other words, formally maintaining national powers in budgetary
policy, but controlling the use of the powers that could destroy
the feasibility of the euro area.

The monetary union was not designed to pay debts jointly and
generate financial transfers from certain States to others, as many
today think that that is the case, appealing to solidarity among
peoples. There was already solidarity, and there still is, in the
good sense of the concept: the more developed countries of the
EU must help the least developed for these to advance in real
convergence; the various European Structural Funds are for this.
But it is not compatible with the concept of solidarity; it rather
constitutes a “perversion” (Issing) of it, having to rescue a society
that underestimates saving, tends to consume ostentatiously,
tolerates waste by the public authorities, does not fulfil tax obli-

1 For a profound analysis see A. Brunila, M. Buti and D. Franco (ed.), The Stability and
Growth Pact: The architecture of fiscal policy in EMU. Houndsmills/Basingstoke (United
Kingdom): Palgrave, 2001 – Círculo de Empresarios (ed.), Pacto de Estabilidad y
Crecimiento: alternativas e implicaciones. Libro Marrón 2002. Madrid (December).

104


gations and claims social benefits beyond the means of the
country, given its own resources.

3.1. Breach of the fiscal rules

The architecture of indirect governance crumbled when it had to
pass the first real test, in 2002/03. In those days, Germany
(Schröder) and France (Chirac) violated the the fiscal rules of the
game. In Germany, government deficit had reached 3.7% of GDP
in 2002 and 3.8% in 2003; in France, it was 3.2% and 4.1% respec-
tively. In both cases, most part of the deficit was structural. The
European Commission had activated, according to the SGP, the
supervisory mechanism for ‘excessive government deficit’ against
these two countries. The German Chancellor explicitly rejected the
intervention from Brussels, the same as the French President. They
both imposed their criterion at the European Council in November
2003, which suspended the process (against the votes of Austria,
Spain, Finland and Holland). The then President of the European
Commission, Romano Prodi, had described the SGP in an inter-
view (on 18/10/02) as “stupido”, which is highly surprising coming
from the custodian of the European Treaties.

At the European Summit held in March 2005, the SGP was
amended, watering it down a great deal: with new exceptions for
breaking the rules, an assessment of the budgetary situation on a
case-by-case basis, considering the special circumstances of each
country, relaxing the periods to take the necessary adjustment

105


measures, the differentiation among countries as regards the goal
of budgetary consolidation in the medium-term and some com-
plex and non-transparent supervisory mechanisms.2 We must
remember this in order to understand the reason for the current
proposals to depoliticise (“automate”) the decisions on sanctions
in case of an infringement of the fiscal regulations.

With the erosion of the SGP, the factors that determined the cri-
sis of the current sovereign debt, put down roots, a crisis which
would have happened anyway, if the 2007-09 global financial and
economic crisis had not have appeared. If the governments of the
two main countries of the euro area are skipping the Treaty of
Europe and the SGP, why wouldn’t the rest do the same if this is
what is best for them and open the tap of non-productive public
expenditure? Structural government deficits increased conside-
rably and with this the volume of the government debt. With this
precedent, the supervision of national budgetary policies by the
European Commission was reduced to merely a rhetorical exercise
that did not scare the rulers much. Economic governance in an
indirect manner had failed. The ECB, however, fulfilled its role and
its first president, Wim Duisenberg, did not allow political leaders
to tie his hands, despite their attempts.

2 For this purpose, the European Commission adapted the original regulations No
1466/97 and 1467/97 of 7/7/1997; see COM (2005) 154 and COM (2005) 155 of
20/4/2005.

106


4. Governance as activism against the crisis

The threat of Greece’s suspension of payments two years ago
showed lack of efficient European economic governance. Instead,
a rare and disconcerting political activism appeared. The nume-
rous measures taken since May 2010 in Europe seem more like an
exercise of muddling through than implementation of a consis-
tent and long-term strategy.

4.1. Constituent principles, violated

It all started in the worst possible manner: the Governments eli-
minated in one fell swoop the two principles establishing the euro
area mentioned above.

The lifting of the non-rescue clause created the problem of
moral hazard for Governments with a tendency to excessive public
expenditure and for reckless banks when it comes to buying
government bonds. The Governments could pass the cost of exces-
sive indebtedness to taxpayers from other countries (who had no
right to speak or vote when the budgets of the State in question
were drafted). The banks started a tremendous communication
campaign to warn of the danger of the euro area (systemic risks) if
indebted countries were not rescued, efficiently concealing to the
public opinion that their true intention was to protect their share-
holders.

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Under the presidency of Trichet, the ECB was under pressure to
undertake a new role: the role of being a “repair shop” for the
faults in the fiscal and growth policies. It acquired in the Securities
Markets Programme, big sums of Treasury bonds from countries in
trouble which nobody wants. Here lies the difference with other
relevant central banks (the Federal Reserve, the Bank of England,
the Bank of Japan), they also buy government securities in the con-
text of their non-conventional monetary policies, but these are
assets with considerable profitability. Furthermore, the ECB
currently grants unlimited liquidity to banks for three years, at a
symbolic interest rate (1%) and it accepts low quality securities as
guarantee. But it is not in its hand to lead banks to proper granting
of credit to companies or households in the country under affor-
dable conditions; the ECB must resign itself to banks choosing
more profitable business in the short-term, as purchasing the debt
of the State; therefore, there is not much change in the scenario of
credit restriction in the private sector in several countries, like in
Spain. The European monetary entity is not only “a last resort len-
der” anymore, which in situations of financial emergency is justi-
fiable, but it has also become “a public debt buyer of last resort”,
which is more questionable, because it delays the fiscal adjust-
ments of the Governments (and it caused in 2011 the resignation
of two German senior members of the monetary authority bodies,
first the resignation of Axel Weber, President of the Bundesbank
and ex officio member of the ECB Governing Council and, subse-
quently, the resignation of Jürgen Stark, member of the Board of
the ECB and its chief economist). The role that the ECB is playing,

108


for the moment also under its new president (Draghi), may dama-
ge its reputation as an institution independent of political powers
and commited to price stability, which is what it has been entrus-
ted with in the European Treaty.

An additional problem is that the same standards of asset qua-
lity, which are used as collateral in the re-financing of commercial
banks by the National Central Bank itself (and, as such, part of the
Eurosystem), do not govern in the whole of the euro area anymo-
re. In several countries in trouble, especially with persistent current
account deficits which (already) do not finance in a conventional
manner import of capital or through financial assistance from
abroad, the respective National Central Banks, with permission
from the ECB, accept low quality securities as guarantee of loans,
more than what is allowed for emergency liquidity assistance. It is
as if they were using the money printing press. This somewhat
undermines the monopoly of the ECB to create money. What is
questionable from an economic perspective is hidden behind the
enormous increase in the amount of these operations in the
Eurosystem Target 2 in the past years, which has been vehemently
warned by the Ifo Institute of Munich for the last year.3 The
Bundesbank has become a gigantic creditor of hundreds of millions
of euros for the National Central Banks of the other countries, wit-

3 See H.-W. Sinn and T. Wollmershäuser, “Target Loans, Current Account Balances and
Capital Flows: The ECB’s Rescue Facility”, NBER Working Paper, No 17626 (November).
CESifo, “The European Balance of Payments Crisis”, CESifo Forum, Special Issue, January
2012.

109


hout protection and right to any kind of compensation if there is
any significant bankruptcy of banks and savings banks or if the
euro area collapses. The Governments of debtor countries have in
reserve a powerful argument to manage to get from others, espe-
cially from Germany, concessions in the negotiations over finan-
cial assistance.

4.2. Financial assistance, a never-ending story?

Political leaders believed, and some of them still do, that the
creation of a common rescue fund is the solution to the problems
of countries in trouble and it eliminates possible spillover effects.

The first rescue mechanism was created with the European
Financial Stability Facility (EFSF).4 This fund is provisional (three
years, until 2013) and at the beginning had a provision of 440,000
million euros in loans guaranteed by the euro countries; as the
Fund wanted to place their issues with the highest ranking ‘AAA’
to get attractive profitability, the real lending capacity would be
lower than the allocation, about 250,000 million euros. Ireland
(87,500 million euros) and Portugal (78,000 million euros) had to
resort to this Fund. Subsequently, in July 2011, the European
Council decided to increase the real lending capacity of this rescue
fund to 440,000 million euros and, in addition, increase their

4 EU Council of Ministers (Ecofin), EFSF Framework Agreement, 9/5/10 and 7/6/10.
Web page: http://www.efsf.europa.eu (Legal documents).

110


powers and relax the conditions for granting the loans to countries
in trouble. It even received leverage instruments (with a 4 factor)
and the so-called ‘special purpose vehicles’ (off-balance); such ins-
truments, applied by private banks, were exactly the ones that trig-
gered very harmful effects for the global financial crisis to break in
2008.

In mid-2012, six months in advance to the original schedule, a
new permanent rescue fund will come into force, the ‘European
Stabilisation Mechanism’ (ESM).5 This fund will have a provision
in nominal terms of 700,000 million euros (with capital contribu-
tions from the member countries amounting to 80,000 million
euros); the real lending capacity of this new Fund is 500,000
million euros. Provisionally, the amount of available resources may
amount to about 800,000 million euros, by transferring the unused
EFSF resources. The IMF, the OECD, the United States and China,
among others, recommend a higher firewall (up to 1.5 billion
euros).

In parallel with these events, a special treatment has been given
to Greece. After the initial financial assistance plan approved in
May 2010 (110,000 million euros, of which 30,000 million euros
came from the IMF), of which politicians said that it would enable

5 European Council, Treaty Establishing the European Stability Mechanism (ESM), 25/3/11.
Internet: http://www.efsf.europa.eu (Legal documents). – European Council, Treaty sig-
ned by the 17 euro area Member States, 2/2/12. Internet:
http://www.european.council.europa.eu.

111


the country to return to the capital market in 2013, in February
this year a second package was agreed (130,000 million euros,
including a contribution from the IMF, to which a further amount
of 24,400 million euros of the first package pending payment will
be added). The latest thing is that private creditors will undertake
(about 85.8% voluntarily and the rest will be obliged by law) a
deduction of 53.5% and will agree for the rest of their securities an
exchange for new Greek long-term treasury bonds and of the EFSF
Fund at a moderate interest rate (which will reduce the Greek
public debt in about 107,000 million euros of a total of 350,000
million euros). Greece’s main public creditor, the ECB, has escaped
this operation and the asset losses derived from it, by means of a
trick, quickly exchanging their former Hellenic bonds, which
would have undergone a reduction, for new exempt bonds under
the same condition.

The official aim is to get the public debt to be reduced from the
current 160% of GDP to about 120% of GDP in 2020. The Ecofin
believes that this level is sustainable, which is quite surprising for
three reasons: firstly, this level was what Greece had in 2008/09,
already in the increase and considered unsustainable then;
secondly, the tax authorities must improve a great deal in order to
promote the capacity to collect taxes and stop tax fraud and capi-
tal flight; and thirdly the IMF’s estimates of 2-3% economic growth
per year from 2014 must be fulfilled, which implies that the neces-
sary structural reforms must be quickly implemented and the eco-
nomy must reach considerable gains in international competitive-

112


ness by substantial salary and price reductions (according to the
estimates, about 50%). All of these points are question marks. The
most probable thing is that the announced aim of debt reduction
will not be attained and that the European governments sooner or
later will again have on the negotiating table Greece’s request for
further financial assistance.

4.3. Political pressure to impose discipline, insufficient so far

The European form of governance since the sovereign crisis star-
ted in Greece has always been “more of the same”: to want to solve
a problem of excessive indebtedness with more debt. The critical
public opinion, as in Germany, was calmed down by saying that no
cash was going to be paid from national budgets and, therefore,
from taxpayers (although there will be in the ESM), but that each
government “only” had to provide guarantees (distributed among
the countries according to the holdings of the national central
banks in the share capital of the ECB). As if guarantees could not be
enforced at the demand of the creditors, in other words, buyers of
the securities issued by the EFSF/ESM! The expectations to calm
down the markets, restore confidence and stabilise the euro area
were not met. The markets had noticed that, in the countries badly
affected by the sovereign debt crisis, progress in fiscal consolidation
and structural reforms that raise the potential of growth and com-
petitiveness, which there are, were too slow and incomplete.

113


This was caused from outside. The aided governments have not
forgotten the political messages launched from the beginning of
the crisis from Brussels/Paris/Berlin. The messages that are least for-
gotten and carry on being repeated with slight variations, are the
following: (i) “We will rescue the euro, no matter what it costs”
(Barroso); (ii) “We will not allow anyone to fall into insolvency”
(Sarkozy); (iii) “If the euro fails, Europe fails” (Merkel). There could
be no better invitation for irresponsible governments to blackmail.
That is how a government in trouble is tempted not to consistently
take pure and hard measures, therefore reducing the cost of loss of
political support, which any severe fiscal adjustment plan (with
unnavoidable cuts in salaries and social benefits and necessary rise
of taxes) would imply. In Greece it is already normal for the Troika
(the European Commission, the ECB and the IMF), each time that
it visits Athens to verify if Greece’s government has implemented
its commitments, to confirm that there is lack of forcefulness in the
policies applied, especially in relation to the structural reforms. But
as the President of the euro group, Juncker, and the Ecofin finally
have given the green light for new aid tranches to be given, the
government (after Papandreou, Papademos) could, after long nego-
tiations, according to the demands of his European partners, and
once at home, do half of it. He could even reject the proposals made
by his partners (Germany, the first) to provide administrative advi-
ce in situ, for instance, in order to create an efficient tax agency and
to design and manage infrastructure investment projects.

114


If with the aid programmes the idea was to buy time to imple-
ment structural reforms in the real economy, as the political leaders
repeatedly emphasised, time was not used productively in all the
countries involved, and Spain was no exception during the last
part of Zapatero’s government, when the crisis was not officially
denied anymore: fiscal and economic consolidation policies arri-
ved late and lacked consistency and force.

4.4. Financial markets, with capacity to persuade

One way of overcoming the reluctance of the governments to
inexorable political and economic changes in their respective
countries comes from the market, specifically the spreads of the
risk premiums included in the interest rates where the Treasury
may place their issues.

As mentioned above, the risk premiums of ten-year bonds, with
reference to the German bond, “bund”, reached rocket prices in
Greece in 2011 and also considerably in the other peripheral coun-
tries with debt problems, including Spain, where the interest rates
reached all-time highs of several hundred basis points. The same
happened with the credit default swaps (CDS) premiums. No mat-
ter how much the governments criticised financial agents for this,
not to mention also the three main rating agencies (Fitch, Moody’s,
Standard & Poor’s), we cannot understimate its deterrent effect
when it is intended to go into greater debt. The increase in price of
the debt convinced political leaders in the countries in trouble that

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the time of spending happily had gone and that they had to be
prepared for a future characterised by austerity. The new govern-
ment of Spain (Rajoy) is an example of strict action to modify
unsustainable habits in society and restore the economy. In Italy
there was a big change of direction since a government of techno-
crats (Monti) started in November last year. Ireland had already
started in March 2011, after early parliamentary elections and the
formation of the new government (Kenny). Three months after
that, the same happened in Portugal (Passos Coelho).

Therefore, any decision to artificially reduce the interest rates of
government bonds, as it has already been taken within the context
of rescue packages and as some governments claim, is counterpro-
ductive. Eliminating the mechanisms of the market that act, wit-
hout political interference, in favour of the quality of public finan-
ces, is pointless. Mutualisation of the sovereign debt, no matter
how much it is proclaimed by certain political circles (also Spanish,
irrespective of ideologies), as well as academic (including German,
Keynesian ideas) and financial (especially the most important
banks which are anxious to operate in capital markets with great
liquidity, comparable to the U.S. market) circles, is also pointless.
There is no reason why we should think that issuing eurobonds
would improve the quality of the economic policy in the euro area.
On the contrary, a reduction in the price of credit in the countries
in trouble, which the eurobond would entail, would deteriorate the
estimates of low cost, which all categories of public sector outlays
and any decision by the public authorities on loan finance, would

116


be subjected to; furthermore, it would be impossible to put pressu-
re on a government from outside to control expenditure and opti-
mise tax collection; and, in addition, restructuring processes in the
real economy, which are so important to raise the potential of
growth, would be postponed. It is far better for the financial mar-
kets to deploy their penalising effects and thus complement the
relevant mechanisms planned by the SGP and the coming Fiscal
Stability Pact.

5. New governance design: own responsibility as the key

It seems that European leaders got it into their heads that the euro
area needs another kind of governance different from what we have
had until now.

We will have to carry on thinking in the need for official assiss-
tance for certain countries, not only for Greece. As regards Greece,
maybe we must think of two options: one, exiting the euro, in
principle on a provisional basis (until the fundamental problems
have been solved) and continue as a EU member; two, exiting the
Economic and Monetary Union, also for a certain time, but kee-
ping the euro as dual currency circulation with their own currency.

Politicians now understand better than in the past that, for the
feasibility of the monetary union in the long term, we need robust
and resilient foundations to prevent external shocks of offer and

117


demand, both from outside and from inside (which in some way or
another will happen again). It is not enough to have a determined
common monetary policy dealt with by a competent European aut-
hority with aims of stability and orderly functioning of inter-bank
market. This is only one of the required conditions. Two further fun-
damental conditions are inexorable for the context of national eco-
nomic policies:
• On the one hand, there must be some rules on behaviour in bud-
getary and economic policy compatible with the efficiency crite-
ria in the allocation of production factors and with growth and
employment aims. The problem of “moral hazard” must be
totally eliminated.
• On the other hand, there must be unconditional willingness of
the governments to observe these rules and act according to
them. There must be a clear division of work and responsibility
between the governments and the ECB.

Indeed, efficient European governance means the transfer of the
national sovereignty to the European Union in budgetary matters
and in areas essential to the real economy. This would entail a qua-
litative leap in the process of integration.

The three pillars of the new architecture are:
• The Euro Plus Pact (approved at the European Summit of 24-25
March 2011, with immediate effect);
• The Fiscal Stability Pact (approved at the European Summit on
1st March 2012, with the exception of the United Kingdom and

118


the Czech Republic, and estimated to come into force, after rati-
fication by the national parliaments, on 1st January 2013);
• The Macro-economic Governance Pact (approved by the
European Parliament in September 2011 and ratified by the
European Council, which is in force already).

The three Pacts complement one another. Without quality of
public finances there will be no appropriate economic growth (“dis-
trust effect”), but without economic growth it will be impossible to
have organised public accounts (“tax collection weakness effect”),
and with no macro-economic balance growth will be slower (“effect
of inefficiency in the allocation of production factors”).

5.1. The Euro Plus Pact, it is not binding on anyone

This Pact is based on right diagnosis: the potention of growth in
southern countries and the capacity to create employment (to a gre-
ater or lesser extent) are low owing to the persistence of negative
national factors: non-qualified labour, insufficient technological
innovation in companies, over-regulation of the labour market and
of various services, inefficient bureaucracy, deplorable tax fraud and
corruption. For this reason, structural reforms in the economy and
the institutions are so necessary.

The governments of the countries of the euro area have under-
taken to implement it; other six countries of the EU have also

119


undertaken this commitment (for this reason the term “Plus” has
been added to the name of the Pact).6 The scope of action that the
Pact contemplates affects the labour market, the educational sys-
tem, the environment for research, the tax system and a long etce-
tera. All this is praiseworthy.

But the main problem of the Pact is that it gives full freedom to
the governments to take the measures that they deem appropriate
and not to take others that would also be necessary from an objec-
tive point of view. There is no sanction in case of lack of strictness.
Therefore, this pillar of economic governance of the euro area does
not offer security.

5.2. The Fiscal Stability Pact, a test of nine

Rightly, the inexorable key is the commitment from the govern-
ments to maintain orderly and balanced public finances in the
future.

This is no dogmatic approach (“neoliberal”, as some call it pejo-
ratively), but it is the consequence of an economic analysis, sup-
ported by theory and empirical experience. Government deficit
must be limited, owing to the “Domar condition”, according to
which, for reasons of assignative efficiency, long-term interest rates

6 European Council, Conclusions 24/25 March 2011, Annex I: The Euro Plus Pact –
Stronger Economic Policy Coordination for Competitiveness, Bruselas, 25/3/11 (EUCO 10/11,
CO EUR 6, CONCL 3).

120


must be higher than the economic growth rate. With no ceiling for
government deficit sooner or later we reach a point from which the
financial expenditure of the State (for servicing the debt) increases
substantially, which progressively reduces the room for manoeuv-
re of the government to seek its economic and social aims. The
level of public debt must be limited because of the
“Reinhart/Rogoff rule”, derived from econometric studies, which
establish a critical threshold of 90% of GDP, from which the secu-
lar economic growth rate may diminish at least half a percentage
point per year for three reasons: one, because public debt servicing
reduces the margin for productive investment of the State (infras-
tructures); two, because payment of interest to foreign creditors
reduces available national income and, therefore, the capacity of
consumption of households; and three, because the need to re-
finance sovereign debt makes financing of private companies in
capital markets difficult (“expulsion effect”).

The Ltmus test is characterised by strictness under which the
governments deepen in budgetary consolidation. Despite the fact
that in different countries of the euro area some measures invol-
ving tax adjustment have been taken already, public finances are
not consolidated at all. According to the European Office of
Statistics (Eurostat), government deficit is excessive (more than
3% of GDP) in most of the countries, also in Spain (2011: 8.5% of
GDP). Germany (1%) and four small countries (Estonia, Finland,
Luxembourg and Malta) are the few exceptions. Most of the
government deficits are structural, in other words, not cyclic but

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permanent, and, therefore, destructive for the good functioning
of the economy. The level of public debt is also too high (higher
than 60% of GDP) in almost all the countries, including
Germany (2011: 81.2%) and France (85.8%) and now also Spain
(68.5%), for the first time since 2011, Spain (68%). Where public
debt greatly exceeds all acceptable levels according to the
“Reinhart/Rogoff rule” is in the three countries that have been
rescued (Greece, Ireland and Portugal) and in Italy. For the latter
country, however, there is a differentiating factor in its favour,
most of the public debt is internal and, thus, its servicing may be
managed directly with its own instruments (by increasing fiscal
pressure on its citizens).

As mentioned above, the rules on sustainability of public finan-
ces as set forth in the Treaty of the European Union and in the SGP
have not been efficient to impose budgetary discipline. Its applica-
tion has been highly politicised. The mechanisms of penalisation
have never been implemented. The new Fiscal Pact has been arran-
ged in such a manner that it could put the screws, firstly, on the
euro countries on which the agreement is binding.7 The most
important advances as regards the SGP, for the moment only on
paper, are the following three:
• Firstly, the seriousness of government deficit is explicitly ack-
nowledged when it is structural. The explicit ceiling established

7 European Council, Treaty on Stability, Coordination and Governance in the Economic and
Monetary Union, 2/3/12, artículos 3-8. Internet: http//:eur-lex.europa.eu.

122


is 0.5% of GDP, maintaining the threshold of 3% for total defi-
cit. There is thus a large margin for the operation of “automatic
stabilisers” in the economic cycle and for discretionary govern-
mental measures if there is recession.
• Secondly, the aim of limiting the level of public debt at 60% of
GDP through a procedure which, if the debt exceeds this per-
centage, may activate the supervisory mechanism for “excessive
government deficit”, even if the deficit is below 3% of GDP. The
country in question shall be forced to reduce it at an average
rate of one twentieth per year as a benchmark (“1/20 clause”).
• Thirdly, the obligation for each member country to define its
medium-term budgetary objective (MTO), quantifying an indi-
cator for public expenditure evolution and making sure that the
estimated expenditure shall be financed by sustainable income
(“golden rule” of budgetary balance). If a country does not orga-
nise its budgets in a balanced manner it will be required by the
European Commission to submit new budgetary plans.

If the new rules are important, a mechanism to enforce them is
equally important. The most relevant three new elements are the
following:
• First, continuous supervision of the policies applied in both
summits of the euro area has been devised (two per year, at
least, called and chaired by the President of the EU, currently
Herman Van Rompuy).
• Second, there is a change in the decision process on financial
sanctions (of up to 0.2% of GDP) in case of breach and non-ful-

123


filment of the specific recommendations to remedy the situa-
tion in the sense that a proposal of the European Commission is
considered approved if the Council of the Heads of State and
Government of the euro area does not vote against it with a qua-
lified majority (until now such a majority was required for the
European Council to approve the sanction). Therefore, there will
be less room for political maneuvre to prevent the fine (as it was
normal in the past after the Schröder/Chirac precedent mentio-
ned above). The sanctions are not totally automatic as one
would like them to be, but they are moving in that direction.
Furthermore, they have a broader scope than before, because the
manipulation of fiscal statistics shall also be punished.
• Third, the obligation for each member country to transpose the
fiscal stability rule into its national legislation is established and,
therefore, be explicitly responsible for its fulfilment. The Court
of Justice of the EU shall ensure its fulfilment.

For the States to decide the medium-term budgetary stability
(equivalent to the economic cycle), the most credible formula is to
constitutionally estabish a ceiling for structural government deficit.
Germany has already done it (0.35% of GDP for the central govern-
ment, from 2016, and cero deficit for the federal states, from 2020).
Spain is moving in that direction after the reform of article 135 of
the Constitution at the end of the previous term of office and the
recent approval of the Budgetary Stability Law which will require
from 2020 cero structural deficit to the public authorities (which
could be up to 0.4% of GDP in exceptional circumstances). Other

124


countries are moving in that direction. The advantage of a consti-
tutional rule as regards de margin of debt of the government is that,
if a country incurs deficit and constitutional breach, it will need bet-
ter arguments for its society than if it only needs to be explained
before the Community authorities and take there the relevant war-
nings; Brussels is “far” and it is “under suspicion” of meddling in
national affairs.

The Fiscal Pact will only work if the euro area countries are
willing to do without most of its sovereignty in budgetary matters,
which will be transferred to Community institutions. Obviously,
this affects the main prerogative of national parliaments, which is
to shape the budgets of the State and decide how to finance expen-
diture. This will meet great opposition, in all the countries. It is not
a trivial matter that the Fiscal Pact must be institutionalised
through an inter-governmental agreement, that is to say, a level
lower than the Treaty of the EU, which reform would have requi-
red the unanimous approval of the twenty-seven, which was not
reached. This procedure has opened in the legal field a debate to
decide if the procedure chosen is compatible with Community
Law, specifically in relation to the mechanisms of sanctions for
excessive government deficit as set forth in article 126 of the
Treaty. For European leaders to have lowered the quorum required
for parliamentary approval of the inter-governmental agreement is
not a trivil matter either, to 12 of the 17 States that form part of the
euro area. Could it be that some partners are not reliable? It is true
that it has been decided that the countries that do not ratify the

125


Pact and transpose to their national legislation the ceiling of
government deficit will be excluded from possible financial bai-
lout. However, is this credible, especially if the stability of the euro
area is at risk? This being so, it would be better not to be too hope-
ful about this Fiscal Pact.

5.3. The Macro-economic Governance Pact, with vague
parameters

The same caution is advisable with regards to the solemnly
proclaimed Six Pack (so called because its content has been draf-
ted through a Community directive and five regulations).
Nodoby doubts that, for the feasibility of the euro area, macro-
economic stability is a necessary condition (although not enough
if the requirements for an optimal monetary area are not fulfi-
lled). Furthermore, it is true that macro-economic stability goes
beyond budgetary balance, as it has been proven with the recent
experience of different countries (inflationary pressure, property
bubble, excessive private sector debt, competitive weakness of
companies, current account imbalance, etc.). However, the
European Commission, the European Parliament and the
European Council seem to have faith in the capacity of economic
policy to handle crucial factors in the real economy. This is
highly questionable.

An alert mechanism scoreboard was created for the appearance
of internal and external imbalances in the countries, which will be

126


managed by the European Commission based on ten parameters,
as follows: 8
• Internal imbalance parameters: evolution of unit labour cost,
unemployment rate, private sector indebtedness, credit to the
private sector, evolution of property prices and government
indebtedness.
• External imbalance parameters: surplus and deficit of current
account balance, net international investment position, change of
export market shares and change of the real effective exchange
rates of the euro.

For these parameters, critical thresholds have been established,
from which the alarm would be triggered, and this would start a
procedure to analyse the causes in order to decide from Europe if
corrective measures need to be taken or not. For instance, for unit
labour costs the threshold is an increase of 9% in three years, for
unemployment rates it is 10% of the workforce as a three-year ave-
rage or for current account balance the threshold established is 3
year backward moving average of the current account balance as a
per cent of GDP, with a threshold of +6% of GDP (surplus) and -4%
of GDP (deficit). If there is excessive imbalance, the European
Commission will make the relevant recommendations for the
government of the country in question to remedy the imbalance; in
case of non-fulfilment, a fine may be imposed (up to 0.1% of GDP).

8 European Commission, EU Economic governance “Six Pack“ enters into force,
MEMO/11/898, 12/12/2011.

127


The thresholds set are not a consequence of a detailed economic
and empirical analysis that may indicate for sure when an imba-
lance is excessive for a country and negatively affects the euro area
as a whole. The numerical values rather represent the perception of
politicians of the recent events; therefore, they are, unavoidably,
arbitrary. But the fundamental question is different: How can a
government act efficiently?

We must remember that the EU proposes an open market eco-
nomy with free competition (article 119 of the Treaty of the EU). All
euro countries have this concept of economic system, some becau-
se of the Ludwig Erhard tradition (Germany), and others with reser-
vation in favour of the government (France). In a market economy,
the government lacks the instruments to control the variables con-
templated in this Macro-economic Governance Pact. Therefore, the
governments should activate a series of interventionist measures,
with no guarantee of their efficiency and with a high risk of distor-
ting efficiency in the allocation of production factors. In a market
economy, responsibilities are distributed in a different way: for level
of employment, social partners (unions and employers); for export
development, private companies (technology); or for granting
loans, commercial banks (based on the appropriate risk estimate).
The current account balance, among other things, represents the
saving trend rooted in society and objective conditions for fixed
capital investment (as explained by the “macro-economic equa-
tion” and the “Böhm-Bawerk theorem”). Unions will not accept
government interference in the negotiation of collective agree-

128


ments and companies will not stop being creative or innovative in
organisational management and product development for which
elasticity-income of international demand is higher than the unit,
and banks will not neglect their classical business, which is to pro-
vide credit to companies and households.

This economic governance project has no clear future. In the
best-case scenario, the new Summits of the euro area would have
matters to discuss. The countries in which the economy works well
could be taken as a benchmark for the others to rectify their struc-
tural deficiencies and improve their productive and competitive-
ness levels. In the worst-case scenario, the euro area would be expo-
sed to continuous political conflicts, which would not promote
economic growth with high employment. It is so easy, and espe-
cially politically profitable in countries with domestic problems, to
look for the villain abroad, maybe Germany?

Conclusion

The sovereign debt crisis has had a healthy effect in convincing
politicians that by providing liquidity to governments and banks
the stability of the euro area will not be attained in the medium
and long term. The quality of the economic policy must improve
in the countries, there must be impeccable follow-up by indepen-
dent institutions to weigh up the economic and fiscal situation and
it must be guaranteed that national accounts and other relevant
statistics are arranged under utmost scientific accuracy at all times.

129


If in all the euro countries the governments understand that
sound public finances and application of structural reforms is their
responsibility and if they act seriously according to them, no State
will have to rescue another State because of over-indebtedness and
waste, and the ECB may stop indirectly financing States and focus
more on its task, ensuring stability in price levels in the euro area.
The ESM fund would be reserved to emergency situations caused by
external factors beyond the government’s control. The Fiscal Pact
would have fulfilled its mission and the Euro Plus Pact would be
filled with efficient contents. We would not need to resort to mar-
ket interventionism as entailed with the Six Pack.

If, on the contrary, there is no determination in the member
countries, any attempt of European economic governance would
result more from proactive intentions than harsh reality. The euro
area would have an uncertain future. The alternative of a European
Political Union, in which all necessary economic policies could be
undertaken from a Community Executive under the control of the
European Parliament, with all democratic rights, cannot be seen on
the horizon.

130

/GONZALO GARCÍA ANDRÉS * /

The turbulent adolescence of the euro
and its path to maturity

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 zero
to infinity; 2.2. A fiscal problem, not the fiscal problem; 2.3. Contagion: the
fragmentation of the single monetary policy; 2.4 A particular manifestation
of 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 must
begin in 2012; 5. Conclusion; Bibliography

* 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.

131

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

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.

132


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

133


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 perverse
dynamics 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.

134


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)).

1 The average 10 year debt spread in Eurozone countries against Germany was of only
18 basis points between 1999 and mid-2007.

135


• 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.

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

137


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

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.

140


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-

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.

142


Graph 1
Net Loan and Financial Account balance of Spain

Source: Bank of Spain

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


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.

Graph 2
Historical volatility of Spanish debt

Source: Bloomberg

144


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-

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

146


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


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 3 Interannual Growth rate
Bank Funding of the non-financial private sector in Feb 2012

Source: Bank of Spain

151


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-

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.

152


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.

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Graph 4
TARGET2 Balanace

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

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

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.

154


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

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

156


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


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

Source: ECB, BoE, FED

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


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

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.

167


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

10 Within 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.

169


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.

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

172


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

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.

173


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

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.

174


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

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.

175


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

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

177


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.

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.

178


• 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).

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

183


• 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

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

184


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

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.

185


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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196

/DANIEL GROS * / CINZIA ALCIDI**/

Breaking the common fate of banks
and governments

1. Introducción; 2. Recent eurozone history: From bad to worse; 2.1. Recalling
the building blocks of the EMU construction; 3. A false solution to the crisis: the
fiscal compact; 4. Fiscal indiscipline versus financial regulation inconsistency;
5. A proposal for a new regulatory treatment of sovereign debt securities in the
euro area; 6. Conclusions; Bibliography

* Dr. Daniel Gros is the Director of the Centre for European Policy Studies (CEPS) since
2000. Among other current activities, he serves as adviser to the European Parliament
and is a member of the Advisory Scientific Committee of the European Systemic Risk
Board (ESRB), the Bank Stakeholder Group (BSG) of the European Banking Authority
(EBA) and the Euro 50 Group of eminent economists. He also acts as editor of Economie
Internationale and International Finance. In the past, Daniel Gros worked at the IMF
(1984-86), at the European Commission (1989-91), has been a member of high-level
advisory bodies and provided strategic advice to numerous governments and central
banks. Gros holds a PhD. in economics from the University of Chicago, has taught at
prestigious universities throughout Europe and is the author of several books and nume-
rous contributions to scientific journals and newspapers. Since 2005, he has been Vice-
President of Eurizon Capital Asset Management.
** Dr. Cinzia Alcidi holds a Ph.D. degree in International Economics from the Graduate
Institute of International and Development Studies, Geneva (Switzerland). She is

197

Breaking the common fate of banks and governments

1. Introduction

Since 2010 the news about Europe has gone from bad to worse.
In early 2012, it still cannot be claimed that the eurozone crisis is
solved, thought markets within the euro area seems to return
(maybe only temporarily) to more normal conditions.

Interestingly enough, the average of the fundamentals of the
euro area looks actually relatively good: compared to the US, the
eurozone as whole has a much lower fiscal deficit (4% of GDP in
2011 against almost 10% for the US) and unlike the US, it has no
external deficit. Its current account is close to balance, which
means that enough savings exist within the monetary union to
finance the public deficits of all its member states. This implies, in
turn, that potentially enough, domestic, euro zone’s resources exist
to solve the debt problem, without recurring to external lenders.
Whether these resources will be invested to finance eurozone
governments is a different question.

currently LUISS Research Fellow at Centre for European Policy Studies (CEPS) in
Brussels where she is part of the Economic Policy Unit dealing mainly with issues rela-
ted to monetary and fiscal policy in the European Union. Before joining CEPS in early
2009, she taught undergraduate courses at University of Perugia (Italy) and worked at
International Labour Office in Geneva. Her research interest focuses on international
economics and economic policy. Since her arrival at CEPS, she has worked extensively
with Daniel Gros on the macroeconomic and financial aspects of crisis in Europe and
at global level, as well on the policy response to it. She has published several articles on
the topic and participates regularly in international conferences.

198


In spite of this relative strength, eurozone policy-makers seem
incapable to solve the debt crisis. Meeting after meeting, heads of
state and Government or finance ministers have failed to convince
markets of the validity of their strategy, which has focused almost
exclusively on fiscal discipline and has repeatedly advocated the
need of financial help from outside investors, e.g. IMF and Asian
investors, regardless of whether resources exist within the eurozo-
ne. This approach has been both misguided and unconvincing.

Against this background, the paper emphasizes that while the
political agenda is almost obsessively focused on fiscal issues, the
euro zone crisis does not have a mere fiscal nature neither a simple
fiscal solution. It involves different dimensions running from
current account and external debt problems to the weak state of the
banking sector, which is still largely undercapitalized. This paper
will focus on the last element, the state of the banking system and
attempts at highlighting how features of the existing financial mar-
ket regulation framework which are inconsistent with main buil-
ding blocks of the monetary union have affected the course of the
crisis. We will argue that this inconsistency has crucially contribu-
ted to eurozone crisis and still remains unaddressed. The paper also
expresses concern about the misleading, prevailing view that the
just signed fiscal compact will work as crucial ingredient in the reci-
pe to overcome the eurozone crisis, while the banking sector
remains highly leveraged and exposed to the fortune and misfortu-
ne of sovereign governments. On this ground, the paper puts for-
ward some ideas about how to break the tight linkage between

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governments and banks. This is at the root of their common fate
and represents a decisive obstacle to overcome the eurozone crisis.

2. Recent eurozone history: From bad to worse

To understand why the euro crisis has gone from bad to worse,
one needs to develop a better understanding of the inconsistencies
in the setup of European Monetary Union (EMU) that caused the
problem in the first place. The official reading is that this is not a
crisis of the euro, but of the public debt of some profligate euro
area member countries. Therefore, tackling the causes of this crisis
and averting future ones requires only a new, tighter framework for
fiscal policy – which will be delivered by the new ‘fiscal compact’.

Yet, financial markets do not seem much impressed by a further
strengthening of fiscal rules: Portugal and other countries still have
to pay high risk premia while Greece has defaulted on its debt and
still teeters on the brink of a total collapse. This suggests that the
official approach captures only part of the problem and still misses
the full picture.

It is not only fiscal indiscipline in the periphery which turned
the public debt problems of a small country like Greece into a cri-
sis of the entire euro area banking system. The euro zone crisis is
the result of a constellation of vulnerabilities within the eurozone.
They include balance of payments problems, foreign debt, sudden-

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stops of crosser-border financing running from North to South
combined with a generalized undercapitalization of the banking
system.

This financial fragility has been the result of inconsistencies in
the setup of the EMU as well as a fundamental inconsistency in
financial market regulation that has yet to be addressed.

2.1. Recalling the building blocks of the EMU construction

The original design of EMU, as established by the Maastricht
Treaty in 1992, contained three key elements:

i) An independent central bank, the ECB, devoted only to price
stability.
ii) Limits on fiscal deficits enforced via the excessive deficit pro-
cedure (Treaty based) and the Stability and Growth Pact (SGP,
essentially an intergovernmental agreement, although still
within the EU’s legal framework).
iii) The ‘no bail-out’, or rather ‘no co-responsibility’ clause (art.
125 of the TFEU).

The treaty also contained other elements of economic gover-
nance,1 but this remained mostly declamatory as in reality

1 For instance, Article 121 of the TFEU contains the provision that member states
should regard economic policies as a matter of common concern and shall coordinate
them within the Council.

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Member States did not see any need to coordinate economic poli-
cies; at least, not before the crisis.

The first key element of the Maastricht Treaty, i.e. the very
strong independence of the ECB, was based on a large consensus
among both economists and policy makers that the task of a cen-
tral bank should mainly be to maintain price stability. The con-
sensus was based on a common reading of the experience of the
previous decades that higher inflation did not buy more growth
and independent central banks (with the Bundesbank as the most
prominent example) are best placed to achieve and maintain price
stability.2

Some academic economists and some observers at international
financial institutions worried already in the 1990s about financial
instability and advocate a clear role of the EBC in safeguarding
financial stability.3 Some also emphasized that a common currency
area also requires a common system of supervision of financial
markets.4 But the issue of financial stability did not attract the
attention of policy makers mainly for two main reasons. The first
one is theoretical: most prominent economic models before 2007
suggested that price stability delivers financial stability as by-pro-

2 A prominent paper of the period when plans for EMU were taking shape encapsula-
ted this insight in the title ‘The advantage of tying one’s hands’ (see Giavazzi and
Pagano (1988).
3 See for instance Garber (1992).
4 Among others Tommaso Padoa Schioppa (1994).

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duct, with no need to add another tool to achieve it. The second
one is much less sophisticated and relates to the fact that the two
key member states driving EMU, France and Germany, had not
experienced a systemic financial crisis for decades.

The second element of the Maastricht Treaty, namely the limits
on fiscal policy, did not enjoy the same consensus in the academic
profession (nor among policy makers) as central bank indepen-
dence. During the 1990s a wide ranging debate took place about
the sense or non-sense of the Maastricht ‘reference’ values of 3% of
GDP for the deficit and 60% for the debt level. Apparently the
advantage of tying one’s hands was much less recognized in the field
of fiscal policy. However, this debate did not need to be resolved as
long as benign financial market conditions prevailed and even the
core countries conspired to weaken the limits on deficits set by the
SGP in 2003.

The third element was only in the background and remained
untested until recently. Contrary to a widespread misconception,
Article 125 of the TFEU does not prohibit bail outs. It merely
asserts that the EU does not guarantee the debt of its member sta-
tes and that member states do not guarantee each other’s obliga-
tions. Germany had insisted on the no bail-out clause when the
Maastricht Treaty was negotiated about 20 years ago. Today, it is
clear that this clause does not provide the kind of protection that
was sought and widespread financial market turbulences threaten
to engulf Germany to agree to huge bail-out packages which would

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have been unthinkable only recently. However, instead of working
on averting the repeat of this situation in the future, German
policy makers are focusing exclusively on the need to ensure lower
fiscal deficits. This is the purpose of the Treaty on Stability, Coordination
and Governance in the Economic and Monetary Union also called the
‘fiscal compact’ under which euro area member countries agree to
adopt strict rules, ‘at the constitutional or equivalent level’, limi-
ting the cyclically adjusted deficit of the government to less than
0.5% of GDP. Will this fiscal compact work where the Stability Pact
failed?

The ‘original’ SGP already contained the engagement by mem-
ber states to balance their budget over the cycle. If implemented
since the onset of the monetary union, the rule would have led to
a continuous reduction of the debt-to-GDP ratio towards the 60%
target. But this did not happen. The promise or rather exhortation
contained in the SGP to balance budgets over the cycle was widely
ignored, given that the rule was not binding and financial markets
remained in a ‘permissive’ mood. All of the larger euro area mem-
bers ran budget deficits in excess of 3% of GDP threshold for the
first 4-5 years of the euro’s existence. Even Germany ran deficits
above 3% of GDP from 2001 to 2005. In 2003 a proposal put for-
ward by the Commission to ratchet up the excessive deficit proce-
dure to the point where fines might have been imposed on France
and Germany was defeated in the Council (of finance ministers,
ECOFIN). In the crucial vote the large countries (most of which
had excessive deficits, except Spain) colluded to water down the

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proposal and won the opposition of the smaller countries. The
’band of three large sinners’ (Germany, France and Italy) even
managed to put together a qualified majority to ‘hold the proce-
dure in abeyance’.5

This narrative is interesting in the light of the new ‘fiscal com-
pact’ which is supposed to radically strengthen the enforcement of
the fiscal rules by the application of the ‘reverse qualified majo-
rity’. Under this principle, an excessive deficit procedure launched
by the Commission is taken to be approved unless it is opposed by
a qualified majority. As past experience shows, despite the new sys-
tem makes the opposition harder, it does not ensure enforcement.

In 2005, following the 2003 episode, the SGP was changed. The
official justification was the need to improve its economic rational
and thus ownership,6 but it clear that it was necessary to avoid the
repeat of the embarrassing situation in which a literal application
of the rules would have led to sanctions for Germany and France
among others. The reaction in academia and among policy makers
was mixed: the SGP was ‘softened’ according to some, but ‘impro-
ved’ according to others. The very fact that professional opinion
on the merits of ’binding rules for fiscal policy’ was divided from
the start certainly facilitated the change in the SGP when it beca-
me politically opportune.

5 See Gros et al. (2004). 3 See for instance Garber (1992).
6 Annex to the 2005 Council conclusions
(http://register.consilium.europa.eu/pdf/en/05/st07/st07619-re01.en05.pdf).

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As matter of facts, shortly after the SGP was made less stringent,
the upturn of the business cycle allowed most governments to
reduce their deficits to below 3% seemingly vindicating the official
position that the ‘improved’ Stability Pact had led to a more res-
ponsible fiscal policy. But structural deficits (i.e. adjusted for the
cycle) actually improved very little even at time the boom reached
the peak in 2006-7 and, when the crisis hit, any remaining caution
was thrown overboard as deficits were allowed to increase again.

The euro area countries thus never lived up to the rules they gave
themselves. But even so, on average they remained relatively con-
servative in fiscal terms. In 2009, the average deficit peaked at 6.5%
of GDP, its highest level, whereas both the UK and the US went
above 11% during that year. Moreover, while the eurozone deficit
has brought back to 4% of GDP in 2011, it has remained at double
digits levels in both the UK and the US. In this limited sense, one
could argue that the Maastricht provisions against ‘excessive’ defi-
cits did have some influence after all, at least on average.

While the average deficits for the euro area appear today
‘modest’ by the standard of other large developed countries, one
euro area country, Greece, clearly violated all rules for years. But
mounting evidence that the Greek fiscal numbers did not add up
was never acted upon until it was too late. As long as financial mar-
kets provided financing at favorable rates any action was politically
inconvenient and was avoided.

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When the euro debt crisis started in early 2010 following the
discovery that Greece was running a deficit of 15% of GDP (and
that previous deficits had been misreported), some policymakers,
German in particular, started to call for tighter fiscal rules as essen-
tial to the survival of the euro.Despite Greece was an extreme case,
the case of Italy is widely seen as providing another justification
for tighter fiscal rules. However, the country seems to stand for
complacency rather than fiscal profligacy. Over the last ten years
the deficits of Italy have on average been lower than those for
France and even today its deficit is below the euro area average
(and declining rapidly).Yet, the incapacity of the country to redu-
ce its very high debt-to-GDP ratio has made it vulnerable to a loss
of investor’s confidence.

3. A false solution to the crisis: the fiscal compact

The new Treaty that was agreed upon in March 2012 has a long
title, Treaty on Stability, Coordination and Governance in the Economic
and Monetary Union, but upon closer examination it is long on
good intentions and rather short on substance in terms of binding
provisions.

The core of the new ‘fiscal compact’ is an obligation to enshrine in
national constitutions the commitment not to allow cyclically adjus-
ted deficits to exceed about ½ of 1% of GDP, which is roughly equi-
valent to balancing the budget over the cycle as in the original SGP.

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This should be done ‘preferable at the constitutional level’. The
European Court of Justice (of the EU) can be asked to pass a judg-
ment on these national rules, but the maximum fine that could be
assessed is capped at 0.1% of GDP – hardly a strong deterrent by
itself. This Treaty concerns only the framework for fiscal policy, i.e.
the rules setting up national ‘debt brakes’, not their implementa-
tion. This Treaty thus does not give any new powers to the Court
of Justice (neither to the Commission) to interfere with the actual
conduct of national fiscal policy. None of the provisions on eco-
nomic policy coordination are binding. Essentially they reiterate
the already often repeated statements of good intentions on struc-
tural reforms.

Among the provisions, the specification on governance institu-
tes regular meetings, at least twice a year, of the heads of state and
government of the euro area. However, since these meetings will
remain informal, in truth, there was no need for an international
treaty to establish them.

As far as the non-euro EU member states who signed the Treaty
are concerned, there is no obligation for them to do anything, but
the signature constitutes a political statement which gives them a
partial ‘seat at the table’ of the eurozone meetings, allowing them
to participate in most of the euro area summits.

From a purely legal point of view, this Treaty contains an inhe-
rent contradiction: it implies that its signatory countries agree on

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binding constraints for their constitutional order via an ordinary
international treaty. In most countries the national constitution is
of a higher in legal hierarchy than international treaties. This
means that even the provisions on the ‘fiscal compact’ constitute
essentially a political statement, unless the treaty is ratified with a
constitutional majority, as will be done in Germany.

The main value of this political statement coming from all euro
area member states is of course that it provides political cover for
the German government in its efforts to sell the euro rescue ope-
rations to a sceptical domestic audience. However, it is doubtful
that the ‘fiscal compact’ was really needed for this purpose. Data
on German support of the euro show that public opinion remains
much more constructive on the euro than widely assumed (see
Gros and Roth, 2011). Moreover even before the fiscal compact
existed, all votes in the Bundestag have resulted in very large majo-
rities in favour of the euro area rescue operations, even when they
contained large fiscal risks for Germany.

In judging the value of this Treaty one should also keep in mind
that, of the four large euro area countries, three have already natio-
nal debt brakes at the constitutional level: in Germany it is already
operational, in Spain has been adopted recently and in Italy is in
course of adoption. In the fourth country, France, it is already clear
that the Treaty will be implemented, if at all given the negative
attitude of the current opposition, via a so-called ‘loi organique’ and
that the French constitution will not be changed.

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All in all, the fiscal compact is probably useful in the long run
and may contribute to avert a future crisis. It forces Member States
to adopt stronger national fiscal frameworks at home. Some, per-
haps most, would have done so anyway under the pressure of the
markets, but it is unlikely that the new Treaty will make a signifi-
cant difference. The main danger is that that it has been oversold.

It is likely that the ratification process (e.g. the referendum in
Ireland) and then the implementation process in some difficult
countries (e.g. France) will receive a lot of attention and create a
distorted impression of the importance of the Fiscal Compact.

However, the initial excitement will be over once the national
fiscal rules have been put into place and this Treaty will quietly be
forgotten. Its only remaining impact will consist in the meetings of
the euro area heads of state which are likely to produce the regular
conclusions that ‘Member States commit’ to everything desirable
(structural reforms, etc.). Conclusions which become irrelevant
once the heads of state return to their capitals and their domestic
political realities.

The experience with the SGP suggests that how this new ‘fiscal
compact’ will be applied in future will depend on the degree of con-
sensus on the need to balance the budget over the cycle. If anything,
political will to follow this balanced budget rule will be even more
important for the new ‘fiscal compact’ since it will take the form of
an intergovernmental Treaty outside the legal framework of the EU.

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Today the consensus that only balancing budgets can solve this
crisis and allow the euro to survive seems strong and the position
of the German government seems particularly tough. This is cer-
tainly desirable to prevent future public debt problems but it
neglects the crucial role financial market fragility has played in this
crisis. The case of Greece is emblematic in this sense: despite
Greece accounts for less than 3% of the euro area’s GDP, the pros-
pect of the Greek government becoming bankrupt caused Europe’s
financial markets to go into a tailspin. The reason behind it was
the fragility of banks due to their undercapitalization and their
large holdings of government debt.

In this perspective, while for a creditor country like Germany it
might be important that other member states are forced to copy its
balanced budget rules, it should be even more important to ensu-
re that financial regulation helps to provide additional incentives
for good fiscal policy and that financial markets become more
robust and able to withstand a sovereign insolvency. This is what
would reduce the need for future bail outs by the German govern-
ment. German savers have over the last decade of current account
surpluses accumulated about one trillion euro worth of claims on
other euro area countries. Safeguarding the value of these claims
(which amount to about 50% of GDP) and ensuring the future
German savings surpluses are invested with minimal risk should
thus be a key policy goal for German policy makers.

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4. Fiscal indiscipline versus financial regulation inconsistency

The key insight that has been overlooked in the official circles
dominating EU policy making today is that today’s crisis is largely
due to an inconsistency in the original design of EMU, not in the
area of fiscal policy, but in the area of financial market regulation.
Even after the start of the EMU, financial regulation in general, and
banking regulation in particular, continued to be based on the
assumption that in the euro area all government debt is riskless.
This was from the start logically incompatible with the no-bail out
clause in the Maastricht Treaty, which implies that a euro area
member country can become insolvent, and the institution of an
independent central bank which cannot monetize government
debt. But it was adopted anyway, maybe because of the perception,
expressed recently in a spectacularly mis-timed paper from the IMF,
which proclaimed: “Default in Today's Advanced Economies:
Unnecessary, Undesirable, and Unlikely”.7

In the much more forgiving environment of the turn of the cen-
tury, it was quite natural for policy makers to ignore the logical
inconsistency between the no bail-out clause and maintaining the
assumption that government was really risk less. Yet this contra-
diction had two important consequences. First, banks did not (and
still do not) have to hold any capital against their sovereign expo-

7 Cottarelli, C., L. Forni, J. Gottschalk, and P. Mauro (2010) Staff Position Note No.
2010/12.

212


sure. Second, it was also deemed unnecessary to impose any con-
centration limit on the claims any bank can hold on any one sove-
reign. This lack of a concentration limit for sovereign debt is in
clear contrast to the general rule that banks must keep their expo-
sure to any single name below 25% of their capital. This exception
would make sense only if government debt is really totally riskless.

The main result of this special treatment reserved to govern-
ment debt securities on banks’ balance sheets has been that about
one third of all public debt of the eurozone is held by eurozone
financial institutions, which also tend to privilege the financing of
their own government. The fate of governments and banks is thus
tightly linked.

To the inconsistency of financial market regulation it must be
added that the ECB failed to apply differentiated haircuts to
government debt it accepted as collateral. Debt securities issued by
euro area governments ware accepted in indiscriminate fashion
provided that the country was rated at investment grade. This was
the case for all euro area member countries, of Greece as Germany.
When the Stability Pact was weakened by Germany and France in
2005, the ECB took member countries to court, but it did not
change its collateral policy. By doing so it would have given a con-
crete signal that it was worried about the long run sustainability of
fiscal policy and its consequences for the future of the single
currency. Alas, it did not do so, not even during the crisis, after it
was clear that it was changing its policy stance. Only now, the ECB

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applies a sliding scale of graduated haircuts which makes it less
attractive for banks to hold lower rated government debt.

The idea that governments provide the only safe assets even in
a monetary union where a no bail-out clause exists was also the
main reason for another omission: a common euro area (or EU)
deposit insurance scheme was never seriously considered. At EU
level, deposit insurance is regulated by the 1994 Directive on depo-
sit guarantee schemes, but the minimum harmonization approach
adopted at that time has proven largely insufficient and the ulti-
mate back up for all national schemes remains the national govern-
ment. A common European deposit insurance modeled on the US
approach of a fund financed ex-ante by risk based contributions
from banks like the Federal Deposit Insurance Company – FDIC-
would have had obvious advantages in terms of risk diversification.
But the preference for national solutions (based on the fear that a
European equivalent to the FDIC would lead to large transfers
across countries) and the bureaucratic interests of the existing
national deposit guarantee schemes ensured that such ideas do not
get a hearing even today.

The experience with Greece should have served to rest the idea
that government debt in the euro area is riskless. But so far no cri-
sis summit has drawn the conclusion from this experience for ban-
king regulation. Of course, it is true that once the crisis has hit it is
no longer possible to tighten the rules on government debt becau-
se this is pro-cyclical as the mayhem which followed the only

214


attempt to shore up the banking system in the context of the
recent EBA stress tests on government debt has shown.

However in order to illustrate the importance of thinking about
the larger benefits from a different kind of banking regulation it is
still worthwhile speculating what would have been different if
banking regulation had been ‘Maastricht’ conform, i.e. if it had
recognized that belonging to the European Monetary Union
implies that national government debt is no longer riskless.

One could thus consider how the crisis would have played out
if the following rules had applied since 1999:
i) Forcing banks to have capital against their holdings of euro area
government debt.
ii) Applying the normal concentration limits also to government
exposure.
iii) A different collateral policy of the ECB, for example with a sli-
ding scale of increasing haircuts on government debt in func-
tion of the country’s deficit and debt and its position in the
excessive deficit procedure.

One can only speculate what would have been different if this
kind of regulation had been in place during the boom years. But a
few conclusions seem certain.

215


Greece would certainly have encountered much more difficul-
ties selling its bonds to banks which would have had to hold capi-
tal against it would be less able to use them to access ECB funds.
The same applies to Italy, whose rating went already in 2006 below
the threshold at which under normal banking rules higher capital
requirements kick in. Both these countries would thus have seen
gradually increasing market signals, which would have most pro-
bably led to a more prudent fiscal policy.

Moreover, their problems would today have been much easier
to deal with because banks would have more capital and the con-
centration limit would have prevented Greek banks to accumulate
Greek government debt worth several times their capital. The
resources necessary to prevent the collapse of the Greek banking
system has increased considerably (by about 40 to 50 billion euro)
the size of the financial support Greece needed so far.

The negative feedback loop between the drop in the value of
banks and in the yields on government bonds which destabilized the
entire European banking system so much during the summer and fall
of 2011 would also have been very much mitigated if the concentra-
tion limit had been observed. Italian banks would have accumulated
less Italian debt and would have been able to offset some of the mark
to market losses on the Italian debt with their gains on German debt
holdings which they would have had to hold as well.

216


Common euro area wide deposit insurance would have contri-
buted in several ways to deal with the financial crisis from the
beginning. First of all, in 2008 it would have obviated the percei-
ved need for the competitive rush to provide national guarantees
for bank deposits. The Irish government would thus probably not
have had felt the need to provide the blanket guarantee for all lia-
bilities of its local banks which proved fatal once the extent of the
losses was revealed.

Ireland would still have suffered from a massive real estate bust
with all the consequences in terms of unemployment, but the Irish
government would not have been bankrupted by its own banks.
Paul Krugman has drawn attention to the parallels in terms of eco-
nomic fundamentals between Nevada and Ireland8 arguing that
explicit fiscal transfers and higher labour mobility within the US
constitute the main differences. However, Ireland has actually
experienced a degree of labour mobility which is quite similar to
that among US states like Nevada. During the boom it had immi-
gration running at over 1% of its population, which after the bust
turned into emigration of a similar order of magnitude. The wides-
pread held opinion that the euro could never work because there is
not enough labour mobility in Europe is not entirely correct.

In the case of Ireland the key issue was not one of a lack of labor
mobility, but of the absence of a common safety net for banks. A

8 See http://krugman.blogs.nytimes.com/2010/12/29/ireland-nevada/.

217


European deposit insurance would have provided stability to the
deposit base. It is also likely that the European Deposit insurance
would have been less complacent and less beholden to the inte-
rests of Irish banks and would thus have started to increase its risk
premium when the signs of a local real estate bubble were clear to
almost everybody outside the country.

Greece, where the national deposit guarantee scheme is now
practically worthless because it is backed up only by the Greek
government, which has just defaulted on its debt, provides anot-
her example of the potential importance of stabilizing the banking
system. With a European deposit guarantee scheme there would
have been no deposit flight, which has amounted so far to about
50 billion, or over 25% of GDP. There would have thus been much
less need for the ECB to refinance the Greek banking system, lowe-
ring again the cost of the Greek bail out.

The next crisis will be different from the current crisis, but it is
clear that different rules for the banking system could bring two
advantages: they would provide graduated market based signals
against excessive deficits and debts. Moreover, a better capitalized
banking system with less concentrated risks would be much better
able to absorb a sovereign insolvency, thus reducing the need for
future bail outs. Acting on this front seems a much more promi-
sing route to reduce the likelihood for future crises and minimize
the cost should they occur anyway.

218


Perceptions matter. Europe’s policy makers seem to be driven by
the perception that this crisis was caused by excessively lax fiscal
policy in some countries. In reality, however, the public debt pro-
blems of some countries have become a systemic, area wide, finan-
cial crisis because of the fragility of the European banking system.
The ‘euro’ crisis is likely to fester until this fundamental problem
has been tackled decisively.

5. A proposal for a new regulatory treatment of sovereign
debt securities in the euro area

The purpose of this section is to sketch a simple proposal for a
new regulatory treatment of sovereign debt securities in the euro
area which follows the arguments illustrated in the previous sec-
tions.
1. Any risk weights to be introduced after the crisis might better be
based on ‘objective’ criteria, rather than ratings.
2. Diversification of banks’ exposure; this is even more important
than risk weighting for sovereign exposure.

A simple way to attach a risk weight on government debt secu-
rities of a given country would be to make the weight function of
objective factors like the debt and deficit of the country. For exam-
ple, one could imagine that the risk weight could remain at zero if
both government debt and fiscal deficit relative to GDP remain
below 60% and 3% respectively. If the deficit and/or the debt ratio

219


exceed the ‘reference’ values of the Treaty, the risk weight would
increase by certain percentage points in a proportional or progres-
sive fashion. In addition the risk weights should be linked to the
stages of the excessive deficit procedure (EDP). When the procedu-
re is launched, the risk weight is increased and at each additional
stage of the EDP the risk weighting would be increased further. This
would provide the EDP with real incentives even without the need
to impose fines.

Introducing positive risk weights for government debt will not
be enough to prevent crisis because of the ‘lumpiness’ of sovereign
risk. Experience has shown that sovereign defaults are rare events;
but the losses are typically very large (above 50%) when default
does materialize. Even with a risk weight of 100% banks would
have capital only to cover losses of 8%. Risk weights would thus
have to become extremely high before they could protect banks
against realistic loss given default scenarios. This suggests that the
more important aspect is diversification.

All regulated investors, i.e. banks, insurance companies, invest-
ment funds, pension funds, have rules which limit their exposure
vis-à-vis a given counterpart to a fraction of their total investment
or capital (for banks). However, this limit does not apply to sove-
reign debt, especially within the eurozone for banks. The result of
this lack of exposure limits has been that, in the periphery, banks
have too much debt of their own government on their balance
sheet which has led to the deadly feedback loop between sovereign

220


and banks. In Northern Europe, investors, such as investment
funds and life insurance companies, which typically cannot avoid
government debt have also concentrated their holdings nationally.
This has led to a significant fall and in some cases even to negati-
ve value of government bond yields, not only in Germany but
throughout Northern Europe. From the point of view of core
Europe investors, today this might appear as being a prudent stra-
tegy, but this concentration increases the vulnerability of the sys-
tem to any reversal of fortunes. Moreover, if Northern investors
were required to diversify their holdings there would be a natural
demand for Southern European bonds, which would bring some
oxygen to those governments which have experienced a dramatic
surge in their borrowing cost.

Introducing exposure limits during a crisis period would be
much less pro-cyclical than introducing capital requirements. In
practical terms, the simplest approach would be to grandfather the
existing stocks, but apply exposure limits to new investments.

6. Conclusions

This paper has emphasized that while the political agenda has
been obsessively focusing on fiscal issues since the early onset of
the euro zone crisis; this crisis has neither a mere fiscal nature nor
an exclusively fiscal solution. Despite the Greek episode seemed to
point only to fiscal indiscipline, the reasons why the crisis did not

221


confined itself to Greece but spread out to the entire euro area assu-
ming a systemic nature should be sought in the state of the euro
area banking sector. European banks were, and still are, largely
undercapitalized and too tightly linked to the fortune and the mis-
fortune of governments.

The paper spots three contradictory building blocks of the EMU
construction: the no bail-out rule in the Stability and Growth Pact,
the independence of the European central bank and the provision
in the financial market regulation framework that government
bonds are considered as risk free assets. The combination of the no-
bail clause with the institution of an independent central bank
implies that fiscally undisciplined countries may have to face
default as no other country, nor the EU can take on its debt and the
central bank cannot monetize it. This definitely collides with the
principle that banks are not required to hold any capital against
government debt securities as it assumed that they do not carry
any default risk. In fact, Greece has proved this assumption wrong.

This contradiction was completely overlooked during the good
years in the turn of the new century and the politically more con-
venient approach suggested by financial regulation became the
dominant. The ‘risk free treatment’ of public debt securities has clearly
worked as incentive for banks to finance profitable government
spending and accumulate large amounts of government bonds.

222


This is at the root of the common fate of euro area banks and
governments. Alas, the crisis has made that fate an evil one.

Though these contradictory elements have now emerged clearly,
the issue has not been addressed and the regulator treatment of the
government bonds has not changed yet.

On this ground, the paper puts forward some concrete ideas
about how to break the tight linkage between governments and
banks, which represents a decisive obstacle to overcome of the
euro zone crisis.

We argue that positive risk weights for government debt securi-
ties must be introduced in the banks’ balance sheet, but alone this
measure will not be enough to prevent a new crisis. A clear pres-
cription to reduce concentration of the risk and impose diversifi-
cation is at least equally important and complementary to the risk
weighting.

While developing the arguments for the regulatory changes, the
paper expresses skepticism about the official, widespread view that
the just signed fiscal compact will have a crucial role in overco-
ming the eurozone crisis. As far as the banking sector remains weak
and highly exposed to governments, and the common fate of
government and banks is not broken, the crisis will be hard to die.

223


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in Today's Advanced Economies: Unnecessary, Undesirable, and
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Bank: A bank of a Monetary Policy Rule, NBER Working Paper
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hands: EMS discipline and Central Bank credibility”, European
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(http://www.sciencedirect.com/science/article/pii/0014292188900657).

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Stability Pact, Special Report of the CEPS Macroeconomic Policy
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225

/RICARDO MARTÍNEZ RICO * /

The fiscal institution in the Economic
and Monetary Union:
the contribution of Spain

1. Introduction; 2. Evolution of the fiscal policies in Europe and Spain;
3. Analysis of the relationship between fiscal rigour, macroeconomic sta-
bility and growth; 4. Next steps in the Fiscal Institution of the Economic
and Monetary Union: the necessary contribution of Spain; 5. Conclusion

1. Introduction

The current financial crisis in the European Union (EU) has
highlighted the importance of establishing a common framework

* Public Sector economist, on leave, and Founding Partner, President and CEO of Equipo
Económico, S.L. He has held office as Deputy Finance Minister Working inside the team
of the Deputy Prime Minister, Rodrigo Rato, and Finance Minister, Cristóbal Montoro.
Graduate cum laude in Business Administration at the University of Zaragoza, he stu-
dies in the Deutsche Schule of Bilbao and Valencia. He has attended postgraduate cour-
ses at the London School of Economics, Kennedy School at Harvard University and
Wharton Business School.

227

The fiscal institution in the Economic and Monetary Union:

which enables the economic agents to act in a macroeconomic sce-
nario of stability and confidence in the coming years.

In this crisis situation, once again the discussion has sparked
the debate in Europe of whether the necessary fiscal stability,
which will demand the rationalisation of public spending in the
member states, will be achieved at the expense of prolonging the
crisis and limiting economic growth possibilities. However, there
should be no dilemma between sustainability of public accounts
and medium term economic growth. The crisis of the European
sovereign debt is a consequence of overspending and debt which
the markets are not prepared to fund. In this regard, the only
recourse is a fiscal policy designed to mitigate the harsh effects of
the crisis and boost economic growth within the framework of
macroeconomic stability, continuous supervision over the sustai-
nability of public sector accounts and economic reforms.

Spain must cease to be a burden for Europe and once again
become a driver of growth. Compliance with a route of plausible
cuts in public spending in all Public Administrations is a necessary
condition to do so, though not the only. As previously shown, in
the case of the Spanish economy, stability and reforms make up the
formula required to revitalize investment, consumption and job
creation. Thus, economic reforms and budgetary discipline are
equally important.

228


The Spanish case is a clear example of a solid and plausible bud-
getary institution, where the principle of subsidiarity enables each
government with sound finances to tackle its internal decisions in
accordance with its economic and social reality (not only because
of its significance from a regulatory perspective but also because of
the parallels between the European scenario relative to the coun-
tries and the Spanish scenario relative to the Autonomous
Communities). At the same time, those who are forced to ask for
help must abide by the ensuing conditionality.

In Europe, likewise, the need for greater economic and mone-
tary integration must take us along the path of clear fiscal rules. But
it must also do so to encouraging income transmission mechanisms
between countries and regions, availability of financial resources
and support by way of providing the necessary liquidity to face
emergency situations and the pooling of risks, always in exchange
for strong sets of conditions to prevent moral hazard. Moreover,
within the monetary and economic union the imbalances must be
addressed, not only of highly indebted countries, but also those
with surplus balances. In some way, it must be recovered an incen-
tive system to ensure political commitment and compliance with
goals set. Nowadays, the fiscal institution1 is a basic component of
European and Spanish economic policy.

1 González Páramo defines it as "the rules which govern the preparation of the budgets, their
debate and approval in parliament, execution and subsequent control”. "Costs and benefits of fis-
cal discipline: the Law of Fiscal Stability in perspective” (Costes y beneficios de la disciplina fis-
cal: la Ley de Estabilidad presupuestaria en perspectiva), J.M. González-Páramo, 2001.

229


Throughout this work we shall examine, in first place, how the
sustainability of the public finances requires a solid fiscal institu-
tion and a firm political commitment by the different European
governments. Only on the basis of the conviction of the benefits of
this statement can one contribute towards the construction of a
stronger Europe.

Then we shall go on to examine the close relationship between
fiscal rigour, macroeconomic stability and growth, arriving at the
conclusion that the establishment of simple, transparent, automati-
cally applied rules with preventive control mechanisms for all
Public Administrations is essential for this ‘positive’ interrelation.
All these components are basic for the design of a fiscal policy
which helps to recover the credibility that Europe needs in its path
towards greater integration to face the sovereign debt crisis.

In the last chapter we shall examine the measures taken in Europe
and in Spain since the start of the sovereign debt crisis, and we shall
reflect on the following steps to be taken in support of the budgetary
institution. Then close with the appropriate conclusions.

2. Evolution of fiscal policy in Europe and Spain

The European political integration project came about in the
post World War years, as an extension of the economic integration
process. This was envisaged by one of the founding fathers of the

230


current Union, Jean Monnet. In 1950, he proposed the creation of
a space of peace and prosperity for Europe, via the formation of the
European Coal and Steel Community, which became a reality a
year later. His way of conceiving the European construction as a
project made up of very specific steps – beginning with the eco-
nomy – is the way to understand many of the milestones that
Europe has achieved in the last sixty years. Examples of this have
been the creation of the European Economic Communities, the
launch of the European Monetary System, the creation of the sin-
gle European market and the firm commitment that has led to the
Economic and Monetary Union (EMU).

During the first decades of the European unification project,
Spain was but a mere observer, although fully embraced the inte-
gration process along the same lines and endorsed the way of tra-
velling the path towards a united Europe. Thus, in the mid-1980s,
Spain understood that the current EU offered a chance to take a
decisive step in its integration into an international market which
would bring gains in efficiency, reinforce macroeconomic stability
and contribute to the increase of wealth and per capita income.
That would lead to the development and modernisation of the
country. And, indeed, this was the case in the first years, where eco-
nomic growth rate of Spain was positive over that of the EU, by a
maximum of 3pp in 1987 (see Chart 1). However, as of this time,
macroeconomic instability driven by an expansive fiscal policy,
became a burden for economic growth and job creation, and gene-
rated a fast and continuous rise in public debt. The importance of

231


having a solid fiscal institution in the economic development of
the Spanish economy became patently clear.

Chart 1
Year-on-year growth in real GDP in Spain and in the European Union

Source: Prepared by Equipo Económico with data from the International Monetary
Fund

After the repeated failures of the European Monetary System star-
ted up in 1979, and the progress of the approval of the Single
European Act (1986) in favour of an internal market, the EU mem-
ber states took an additional step in Maastricht. EU member states
support, via the adoption of the Treaty on the European Union
(TEU) (1992), the creation of an Economic and Monetary Union,
whose third phase would entail the launch of the single currency,
the Euro. Title VIII of the Maastricht Treaty set three main axes
around which the design of the EMU should be built around: sin-

232


gle monetary policy, fiscal policies subject to common rules and
coordination mechanisms for the remaining economic policies. A
clear view of establishing nominal convergence mechanisms based
on the fiscal institution was already existent at that stage, founded
on the following common rules: absolute ban on monetary funding
of public deficits, no liability held by the EU or by any other State
in regard to debts acquired by another member state, and the set-
ting of limits on deficit (3%) and public debt (60%). As of 1997, the
Stability and Growth Pact (SGP) introduce stricter rules with a defi-
cit target of balance or surplus, supported by an early alert system
and a disciplinary penalty structure designed to correct deviations.

For Spain the commitment to meet the convergence criteria esta-
blished in the TEU for eligibility for the third phase of the EMU
demanded a radical change to be made in our fiscal policy. Europe
then began to act as an anchor in Spanish budgetary policy.
However, even when the worst of the recession was over for Spain,
governments continued to face enormous difficulties in balancing
the budget in the pursuit of macroeconomic stability.

It would not be until the political change of 1996, and with the
reference and encouragement arising from the creation of the sin-
gle currency, when the necessary fiscal consolidation was finally
tackled, that macroeconomic stability was achieved and the bases
for a new economic growth phase were put in place. The starting
point was poor, in 1995 with a deficit around 7% of the GDP and a
growing public indebtedness which reached 67% in 1996.

233


Although the level of indebtedness was lower than the average for
the EU, in the case of Spain the combination of the primary defi-
cit, the high cost of financing of the debt and the recession had
rendered unsustainable the growing public debt. As of that time
there was a change in fiscal policy, which took on a markedly coun-
ter-cyclical approach. As shown in chart 2, an ambitious fiscal con-
solidation programme was implemented which allowed the annual
budgets to close with primary surpluses from 1996 until the end of
the period and to slow down the growth trend in public debt
which, after peaking in 1996, dropped by more than 20pp of GDP
until 2004.

Chart 2
Evolution of income and expenditure of Public Administrations and of their budget
balances

Source: Prepared by Equipo Económico with data from the Ministry of Finance and
Public Administrations

234


During the period, the fiscal consolidation drive contributed
towards a strong growth in GDP (average rate of 3.6 between 1996
and 2004), which helped reducing debt stock via the positive spre-
ad between the economic growth rates and interest rates. The suc-
cess in the change of direction in fiscal policy was due to a firm
political commitment, a well-designed fiscal consolidation pro-
gramme and a substantial reform of the fiscal institution.2

For countries that, like Spain, managed to take part in its foun-
dation and for others which joined subsequently – such as the case
of Greece which, with the support of Germany and despite not
meeting at the time the requirements established by the Maastricht
Treaty, became part of the Eurozone two years later – the incorpo-
ration to the euro meant the relinquishment of monetary policy in
favour of the European Central Bank (ECB). And this total integra-
tion in the establishment of monetary policy has fostered greater
price stability during these years. On the other hand, this relin-
quishment made budgetary policy, along with economic liberalisa-
tion policies, into the main economic policy instruments in each of
the Eurozone member countries.

We must highlight that, once the objective of forming part of
the euro was met in full, Spain took an additional step beyond what
was required in Maastricht. And, in line with the principles agreed

2 “The Spanish fiscal institution: from the Stability Pact to the rules of fiscal stability” (La
institución presupuestaria española: del Pacto de Estabilidad a las reglas de estabilidad
pre¬supuestaria), R. Martínez Rico (2005).

235


in the SGP, it rounded off the fiscal consolidation effort with a deep
reform of the fiscal institution. As a result thereof, the approval of
the fiscal stability laws (the General Law on Fiscal Stability and the
Organic Law additional thereto) brought about a change in the
budgeting process. This mainly consisted of: the definition of a fis-
cal stability target (fiscal balance) in the medium term for all Public
Administrations; for the State, a non-financial expenditure limit,
the so-called expenditure ceiling, was applied following parliamen-
tary approval during the first half of the year; as a novelty, the
Contingency Fund was added into the State budget, as a flexibility
component during the life of the budget which removes the need
for making fiscal adjustments, equal to 2% of the non-financial
expenditure ceiling approved by Parliament. The approval of the
Fiscal Stability Laws was further completed with a new General
Fiscal Law and a new General Subsidies Law. Specifically, the
General Fiscal Law aimed at achieving greater rationalisation of the
fiscal process, whereas the General Subsidies Law, on its part, aimed
at transferring the governing principles of Fiscal Stability Laws (effi-
ciency, transparency and multi-annual framework) to the expendi-
ture on subsidies (which would mean 20% of expenditure budget).

However, in 2005, the European process of integration and
reform came to a halt. The solution provided to the reiterated vio-
lations of the 3% limit on public deficit established at Maastricht –
and following the pressure exerted by Germany and France in this
regard, backed by the European Commission – was none other
than the SGP, introducing greater discretionary power and taking a

236


step back in the capacity of the fiscal institution to contribute to
growth.

Along the same lines, with a comfortable fiscal position and
with the same philosophy as that of the reform of the SGP, Spain in
2006 approved a reform to render the fiscal and Territorial
Administration funding processes more flexible, which is the sour-
ce of our current fiscal crisis. The relaxation of fiscal stability led to
a loss of transparency in its application as a result of the flexible
new rules.

With the outbreak of the international financial crisis as of 2008,
the primary surplus of the first years of the period quickly ran out.
Discretionary expenditure decisions, the impact of automatic sta-
bilisers and the major errors in revenue estimates led to a deficit
balance, which worsened over two years (from 2007 to 2009) by
13pp of GDP. This deterioration, which had also taken place in the
rest of EU members, was more notable in Spain due to its speed and
magnitude (see Chart 3), with few comparable examples within the
scope of the OECD (except for the cases of Iceland or Ireland). The
deficit fiscal position generated a fast increase in public debt, lea-
ding to doubts about sustainability thereof, and translating into
significant rises in the risk premium of the country.

At the start of 2010, given the lack of confidence displayed by
international markets, and in light of the fast deterioration of
public finances, the previous Government was forced to implement

237


Chart 3
Budget balance in 2006 and change in budget balance in 2007-2009

Source: Prepared by Equipo Económico with OECD data

a radical change in its fiscal policy and announce a fiscal consoli-
dation programme.

The sovereign debt crisis, which especially affects several of the
“peripheral” member states of the Eurozone (but which has also
affect countries such as France and Austria), has highlighted the
need to reinforce the budgetary coordination mechanisms within
the EMU. In the face of the problems arising from the sovereign

238


debt crisis and as a result of the fluctuations in the risk premiums
of the Eurozone member states, a double reinforcement movement
of the budgetary crisis has taken place from Brussels since the onset
of the crisis. On the one hand, that implemented by the European
Commission, the result of which is, for instance, the legislative pac-
kage comprising five regulations and one directive designed to rein-
force the preventive part and the disciplinary part of EC mecha-
nisms. On the other, that of the member states which, via the
European Council, have brought about agreements such as the
Fiscal Pact, which seeks to guarantee that all countries will commit
to fiscal stability under the highest level of regulation. The reform
enacted last year of the Spanish Constitution must be understood
within the framework of this new drive from Europe in support of
the fiscal institution. The reform, as we shall discuss further in this
paper, guarantees the principle of fiscal stability via the highest ran-
king law.

Despite efforts invested, and despite the positive effect of the
liquidity injections made by the ECB, the current economic scena-
rio in Europe continues to be marked by the risk premiums of EU
peripheral countries, which continue to be too high. The questions
as to the capacity of such countries to meet their debt commit-
ments have burdened economic European Union results over the
last two years. This has led the Commission to forecast a drop in
GDP for all of the EU of -0.5% for this year, which sets it back in
terms of the growth of the world economy. Although it must be
said, that all countries are not behaving in the same way. Germany,

239


for instance, closed last year with 3% growth, expecting to do so
this year at 0.6%, whereas Italy will experience a drop of around -
1.3% of GDP. From a growth perspective, there is an important dif-
ference between northern and southern European countries arising
from the financial crisis. However, it is worth remembering the
strong interdependence between all member states, including
Germany (second country in the world in terms of export volume,
of which 60% are directed to the EU).

On its part, the Spanish economy is clearly included in the “slo-
wer” group, at an extremely difficult time. In recent months, the
return to recession, which accumulates after four years of crisis, the
adverse effect on employment and on businesses, has led to a 24%
unemployment rate. At the same time, there is high external debt,
exceeding 160% of the GDP, with a high accumulation of public and
private debt maturities this year. All these factors have led to a risk
premium of around 340 basis points in the last few months and, more
recently, well above 450 basis points, and to be closely watched by the
markets, that is to say, our creditors. Given this scenario, in 2012, the
Spanish economy faces challenges associated with its macroeconomic
imbalances yet to be corrected, as well as the potential problems ari-
sing from a new challenge from international financial markets. In
this framework, we expect a drop in GDP during the first quarters,
and although its performance will improve towards the end of the
year, it will result in an overall drop in GDP of around -1.5% this year.
Meanwhile, the reality experienced by the rest of the world is diffe-
rent, with a world economy growth rate of around 3.5% of GDP.

240


Undoubtedly, the unemployment rate is our main negative dif-
ferentiating factor compared to all other EU members and the main
concern for Spanish society. As a result of the economic crisis, no
country in the OECD has experienced a downturn in the jobless
rate as negative as ours. Our rate of unemployment has gone from
8.3% of active population in 2007 to almost 24% at the end of
2011. The crisis has highlighted the problem with our employment
model, as our economy is adjusted by means of redundancies ins-
tead of by adding greater flexibility to employment conditions.

Despite the gradual correction of the external imbalance (the
current account deficit has been reduced from 10% of GDP recor-
ded for 2007 to less than 4% in 2011), Spain continues to be signi-
ficantly reliant on foreign funding (around 40,000M€ per annum).
The need for funds shown by the current account deficit, cannot in
fact be met by attracting foreign investment to our country.
Indeed, the opposite is the case, with recent years witnessing a
divestment process, particularly of portfolio assets. The forecast
drop in the GDP combined with the high level of debt, puts the
sustainability of our funding at risk. Given such conditions, the cri-
sis is requiring a must faster deleveraging process than that initially
expected.

Since the common denominator of the European sovereign debt
crisis is insufficient GDP growth, only by articulating the reforms
in Europe and in Spain in an expedient and firm manner can the
current increasing loss of confidence by financial markets be sta-

241


lled. In the case of the Spanish economy, this is a path which we
travelled successfully in the second half of the nineties, when
Spain took part in the foundation of the euro and then went on to
lead the fiscal consolidation process in Europe. The new govern-
ment seems to have understood this, having begun reforms in
three main areas: sustainability of the public finances and moder-
nisation of the public sector, the restructuring and reorganization
of the financial sector and the reform of the labour market. In the
coming years, political commitment to fiscal rigour, macroecono-
mic stability and growth must go hand in hand in Spain and
Europe, and happen in parallel.

3. Analysis of the relationship between fiscal rigour, macroe-
conomic stability and growth

In the context described in the previous section, fiscal consolida-
tion within the EMU is a fundamental tool for recovering macroeco-
nomic stability, the confidence of economic players and the path to
growth, leading in turn to job creation.

Moreover, the balance in public finances provides the econo-
mies participating in the monetary union, which therefore cannot
resort to instruments such as currency rates, with greater leeway to
deal with external shocks, enabling the implementation of anti-
cyclical policies and of automatic stabilisers.

242


At the same time, as has been amply studied in the literature,3
fiscal balance fosters a macroeconomic stability scenario which pro-
vides a more efficient framework for the development of economic
activity. The reduction in the deficit increases the confidence of
savers and investors. This translates into a stimulus for investment
and job creation, as well as allowing households and businesses to
plan the purchase of durable goods in the long term, thus leading to
sustained consumption, which is a key factor of economic growth.

One of the most relevant aspects is the stronger credibility of the
economic policy and the improvement in the funding terms of the
economies in the international markets, thanks to the reduction of
the risk premium, which in turn leads to a drop in financial costs,
as shown in Chart 4 in the case of Spain as of 1996. The subjection
of European monetary and fiscal policies to certain rules, and the
assumption thereof by Spain as a participant in the foundation of
the Euro, helped to provide additional credibility to the govern-
ment’s fiscal consolidation strategy. This strategy was strengthened
by the regulatory reforms introduced by said government as we dis-
cussed in the previous section. This positive impact4 on the expec-
tations and on the confidence of economic agents explains the
sharp drop in long term interest rates, compared to the 10 year
German bond. The spread in the Spanish risk premium was actually
zeroed as of 2003.

3 “Fiscal policy and long-run growth”, V. Tanzi and H. Zee, 1997.
4 “The Spanish economic model 1996-2004” (El modelo económico español 1996-2004), L.
Bernaldo de Quirós and R. Martínez Rico, 2005.

243


However, since 2008, with the arrival of the international finan-
cial crisis, the macroeconomic imbalances accumulated by the
Spanish economy led to the opposite effect. Furthermore, as a
result of the degradation of Spanish public finances between 2003
and 2009, as shown in the aforementioned graph 3, and the doubts
in regard to the sustainability of the Spanish public debt, the risk
premium increased once again in a significant way as of 2010, now
reaching the 450 base point mark.

The significance of fiscal consolidation as a tool for the recovery
of stability and long term growth has also been proven in practice
in many successful fiscal adjustment processes implemented in the
last decades in certain European countries, such as Spain (1996-
2004), Ireland (1982-1989) or Sweden and Finland (1993-2000),
some of which have been studied in depth in the literature.5

The most successful process was the one implemented in
Finland between 1993 and 2000, which managed to reduce pri-
mary expenditure by 14pp of GDP. This was mainly based on per-
sonnel cost containment, reduction in transfers from the Central
Administration to Local Corporations and the pursuit of efficiency
in social expenditure, particularly in health services, education and
pensions. Moreover, the fiscal institution underwent a reform with
the introduction of expenditure ceilings, which proved to be a key

5 "Fiscal expansions and adjustments in OECD countries", A. Alesina y R. Perotti, 1995. “An
Empirical Analysis of Fiscal Adjustments", C. McDermott & R. Wescott, 1996.

244


tool for cost containment. At the same time, the pension system,
the labour market and the financial system underwent a structural
reform. The only expenditure programme that was deliberately
maintained, thus keeping its 1% share of the GDP, was that of
Research and Development.

The Swedish experience between 1993 and 2000 obtained similar
results in terms of a reduction in primary expenditure (14% GDP),
which led to the attainment of fiscal balance in 1997, having closed
financial year 1993 with a deficit of 12.9%. In contrast with Finland,

Chart 4
Evolution of risk premium

Source: Financial Times

245


in Sweden the fiscal consolidation took place due to both the cut in
expenditure and the increase in revenue through a tax rise, while
also implementing simultaneous structural reforms such as the pri-
vatisation of public corporations and the liberalisation of the labour
market. Public spending was reduced by 16pp of GDP over a seven
year period, mainly through a reduction of the expenses in transfers
and benefits (including unemployment benefits) and a reduction in
personnel and current costs of all public administrations. The intro-
duction of three-year expenditure ceilings and annual productivity
targets must be added to such measures.

The starting point of all the above was the strict cut in primary
expenditure, as the basis for the adjustment process, mainly cen-
tred on personnel costs, transfers and health services.
Undoubtedly, a key factor in all such measures is that they were
done hand in hand with important structural reforms, particularly
those implemented in the labour market, the fiscal system and the
privatisations. Those allowed the adjustment process consolidation
and the increase in potential growth, on the basis of a firm politi-
cal commitment. Furthermore, it helped proved that fiscal consoli-
dation strategies based on spending cuts are more enduring and
promote a better economic performance than those based on reve-
nue increase.

Experience has likewise proven that fiscal consolidation cannot
be maintained in the medium term without a proper fiscal institu-
tion articulation. As shown in the previous section, from the start,

246


the construction of Europe has been evolving towards a greater
relinquishment of national policies in favour of European ones. It
is a slow and complicated process in which political divergences
often prevail over the overall view of what this process means. This
relinquishment has meant the need for greater autonomy in the
establishment of rules and objectives, as has been the case, for ins-
tance, with monetary policy. Aside from the current supervision
problems, it is clear that the role of the ECB in regard to price con-
trol has been a success. This example should be transferred to the
fiscal policy as a source of inspiration to maintain the necessary
political commitment and thus achieve effective fiscal coordina-
tion in the Eurozone.

We live in an open economy, where freedom of movement of
persons, goods, capital, information and technology are necessary
conditions for improvement of competitiveness and economic
development. A globalised market, with a high level of competi-
tion, but also great opportunities, requires a disciplined, foreseea-
ble and transparent behaviour by the countries, designed to gene-
rate confidence among economic agents. The EMU was born out of
this perspective although there have been mechanisms, or even
relevant design components, which have failed.

In general, The European construction has been preceded by the
establishment of rules seeking to limit the risks of integration. The
problem has arisen from the lack of rigour in compliance with such
rules, probably as result of the insufficient clarity of the rules and

247


of political leadership committed to integration. When this hap-
pens, it is easier to interpret the situation in one’s own favour, par-
ticularly when high political power is held. Therefore, it is impor-
tant to have clear and simple rules, in order to reduce the possibili-
ties of interpretation and to help control subsequent compliance.

At the same time, the establishment of preventing rules to ena-
ble the anticipation of sharp increases in public deficit, should be
articulated via a greater participation by the EU in the preparation
of national budgets, in line with the latest legislative proposals of
the European Commission on the matter. Preliminary control is a
guarantee of compliance and greater co-responsibility with Brussels,
which should in turn lead to better access to European funding.

According to economic literature,6 those countries exerting con-
siderable effort to achieve fiscal consolidation amid a context of
economic uncertainty, should design and announce the establish-
ment of a fiscal rule within a reasonable period of time designed to
improve credibility. In the case of Spain, this step has been taken by
way of the reform of section 135 of the Constitution, a historical
event of special political relevance.

In our case, constitutional reform has managed to raise to the
level of fundamental Law – a relevant issue in our highly decentra-
lised State – the commitment of all the Administrations to fiscal

6 “Fiscal Rules – anchoring expectations for sustainable public finances”, FMI, 2009.

248


sustainability. The approval of this reform has meant the recogni-
tion of the benefits of fiscal discipline, having assumed the flaws in
the relaxation of the Stability Laws in 2006 as well as the need to
provide a new common legal framework for all of the public sector.
Except for force majeure cases (natural disasters or emergency
situations), compliance with the limits on public debt and fiscal
balance set by the EU are guaranteed. Likewise, priority is given to
servicing the debt in the budget, a condition which helps build the
necessary confidence in lenders, and is an appropriate antidote for
preventing the loss of confidence in Eurozone countries.

The reform also established the need for articulation in a new
organic Law, designed, on the one hand, to regulate the distribu-
tion of deficit and debt limits between the various
Administrations, the exceptional cases of surpluses therein, and
the means and terms for correction of any deviations in one or the
other that might take place. On the other hand, it had to establish
the methodology and procedure for calculation of structural defi-
cit. It is important that the calculation methodology respects the
procedure used in the EU, to provide discipline and transparency
to the fiscal process and help in the statement of accounts. The cal-
culation rule must be clear, and serve to consolidate fiscal discipli-
ne, as a permanent long term commitment. Lastly, it must esta-
blish the responsibility of the Administrations in the event of fai-
lure to achieve fiscal stability targets. In this regard, the credibility
of the reform will depend on the existence of efficient systems
which encourage the Administrations to meet the fiscal targets. As

249


we shall mention in the next section, such principles have been
included in the Law on Fiscal Stability and Financial Sustainability
of Public Administrations.

4. Next steps in the Fiscal Institution of the Economic and
Monetary Union: the necessary contribution of Spain

The European debate on sustainability of public finances and
the future of the Euro is set at a time in which, following the con-
version of the international crisis into the crisis of the sovereign
debt of several Eurozone countries, we have witnessed myriad
European summits, each of which seeming to be the last chance to
tackle the doubts of the markets in relation to the viability of the
debt, in the first place, of Greece, Portugal and Ireland, and more
recently, of Italy and Spain.

It is true that the crisis is far from being resolved. The EU has not
always shown a capacity to react with the speed required by econo-
mic relations nowadays – until the tensions reached non peripheral
economies such as Austria or France, the pace in reaching consen-
sus had been much slower than necessary. Moreover, during the cri-
sis, it has become obvious that the institutional design of the
Monetary Union was incomplete and, above all, as we have men-
tioned in this paper, that there has been insufficient political com-
mitment to the application of the existing mechanisms of fiscal
coordination. But it is also true that in the last four years, a consi-

250


derable path has been travelled towards European construction,
towards an improvement in economic governance, so that in addi-
tion to a single monetary policy, Europe is also able to benefit from
greater integration of fiscal policies.

As such, it is worth highlighting the agreements reached, either
via the community procedure or via inter-governmental agree-
ments, in terms of strengthening coordination, supervision and
policing mechanisms of fiscal and macroeconomic policies.

In the first place, the European Semester establishes a new sche-
dule whereby, on the basis of the macroeconomic situation of each
member state and its growth forecast, the budgets and economic
policies required to meet the commitments undertaken in the Euro
Plus Pact and the 2020 Growth Strategy are discussed during the
first six months of the year in a coordinated fashion and in accor-
dance with common rules.

In the second place, the adoption of the so-called Six-pack (one
directive and five regulations) constitutes the greatest reform of the
SGP and of economic Governance since the Maastricht Treaty
which created the EMU. As of the adoption of the new legislation,
the European Commission may establish automatic penalties (of
up 0.2% of GDP) for those countries with excessive deficits which
do not follow the recommendations for correction. At the same
time, the public debt control mechanism and the required reduc-
tion are reinforced in the event of exceeding the 60% GDP level

251


assumed. It also introduces a mechanism designed to prevent
excessive imbalances such as unsustainable current account defi-
cits, loss of competitiveness and other macroeconomic imbalances.

Lastly, the signature of the new Treaty on Stability,
Coordination and Growth (by all member states of the EU except
for the United Kingdom and the Czech Republic) brings changes at
the highest legislative level to fiscal stability regulation. This must
be translated in each country in that the structural deficit of the
public sector may not exceed 0.5 GDP per annum, subject to auto-
matic penalties.

These steps will be followed in the months to come by impro-
vements seeking to fine-tune the mechanisms of economic con-
vergence, via two legislative proposals7 of the European
Commission, by establishing a clearer and more demanding sche-
dule for fiscal coordination in Europe and implementing fiscal
control and monitoring mechanisms in countries facing serious
difficulties in regard to their financial stability within the
Eurozone.

All these measures help towards the consolidation of economic
governance, and establish the bases to enable progress to be made

7 "Proposal for a regulation of the European Parliament and of the Council on common
provi¬sions for monitoring and assessing draft budgetary plans and ensuring the correction of
exces¬sive deficit of the Member States in the euro area" and "Proposal for a regulation of the
European Parliament and of the Council on the strengthening of economic and budgetary sur-

252


via other instruments, in order to provide funding and liquidity to
handle emergency situations, to the extent of including euro-
bonds, if necessary, as well as helping the ECB to have greater lee-
way when acting in the markets in pursuit of economic stability.
Without doubt, greater fiscal coordination broadens the funding
margin of these countries. But we must be clear that access to fun-
ding requires preliminary fiscal control, and not the reverse.
Conditionality in all these mechanisms is an essential requirement
when seeking to limit risk. Any funding requires certain minimum
guarantees of repayment of the loan, and this translates into
adjustments and reforms. This is nothing new, but something that
has cropped up on many occasions in IMF interventions.
Eurobonds might get to play a key role, but cannot be the only
item to support the fiscal union, which will drive the Eurozone
towards optimum monetary union, and for which to date there is
no more than a highly experimental road map.

Within this working programme so badly needed in Europe, and
supported by conditionality, greater mechanisms for EU income
transmission should be created to help countries facing serious pro-
blems – such as that of the sovereign debt crisis – in order to imple-
ment the structural reforms required by their economies, with the
support of Europe in driving growth. This can be done via the
encouragement of youth employment and entrepreneur program-

veillance of Member States experiencing or threatened with serious difficulties with respect to
their finan¬cial stability in the euro area", European Commission, November 2011

253


mes, the reinforcement of resources available, among other uses,
for structural funds or for the activity of the European Investment
Bank.

On their part, the Eurozone member states can and must con-
tribute to guarantee the future of the single currency, and to the
generation of the economic growth required to clear any doubts as
to the sustainability of sovereign debt, either via their contribu-
tions towards the establishment of common rules so that the EMU
becomes an optimum monetary zone, or via the reforms on a
national scale which constitute an example for all the others.

There is also a high degree of parallelism between the rules
required and which must be institutionalized in the Monetary
Union at a European level, and the process which must be follo-
wed in Spain in regard to responsibility, conditionality and subsi-
diarity of regional and local Public Administrations. In both cases,
the need for a political will capable of applying clear and straight-
forward rules, with prevention mechanisms, supported by coordi-
nation, monitoring and automatic sanction systems for those who
fail to comply with the targets undertaken, has become clearly evi-
dent. In this sense, the fact that the new fiscal pact at a European
level and the recent legislative changes in Spain seem to be going
in the same direction is a positive factor.

The case of Spain, where we have a very high degree of decentra-
lisation and where the Autonomous Communities and Local

254


Corporations manage approximately 50% of the public expenditure,
is a clear example of the need for coordination of fiscal policies to
ensure that the right signals are sent to markets and investors in
regard to the orientation of the fiscal policy. The consolidation efforts
made by some countries and regions are useless if there are others
which do not honour their commitments and destabilise the zone,
region or country. Europe and, of course, Spain have their own iden-
tity, and this applies to act as a unique body in order to establish the
aims. The scope of action of each government to achieve fiscal targets
undertaken, via the instruments deemed appropriate, is a different
thing altogether. The principle of subsidiarity must be respected pro-
vided that the principle of fiscal balance is observed. Each country
must have autonomy to define and design its fiscal structure so
long as the limits set for deficit, debt and growth in expenditure are
respected. Fiscal competition allows for improvement in revenue
collection efficiency and greater rigour in expenditure control, and
thus the greater fiscal coordination in Europe must not be envisaged
as a single fiscal policy. However, one of the main instruments at the
disposal of the governments when coordinating fiscal policies is con-
ditionality. In any regional funding system there are income transmis-
sion mechanisms and penalties aiming to fulfil the set fiscal targets.
Therefore, in the event that fiscal stability criteria are not met, be it at
a national level within the Eurozone or at a regional level within
Spain, the aid provided, as the case may be via special liquidity facili-
ties and even, if necessary, by way of eurobonds or hispanobonds, or
by way of larger revenue transmissions at a European level, cannot
take place without the acceptance of the conditionality it carries.

255


Spain has understood the need to contribute to the stability in
Europe and is leading, for the second time, a solid process of
reforms towards fiscal balance. Following the general elections of
November 2011, the new government and a reinforced political
capital constitute the main assets to bring about the necessary
reforms. The proof thereof is evident in the fiscal reforms: the
Royal Decree of non-availability, the reform of the Law on
Stability, the new system for payment to suppliers, the new bill on
Transparency or the bill of General State Budgets for 2012 (which
establishes an adjustment of 27,300 million euros to be made bet-
ween cost control and revenue increase).

The modification of section 135 of the Spanish Constitution
assumed its inclusion in a subsequent organic Law (the Law of
Budgetary Stability and Financial Sustainability of the Public
Administrations, recently presented), which specifies changes in
the preparation, execution and control of the Spanish fiscal insti-
tution. The recent approval of this bill means a return to the com-
mitment to the control of public finances and, more importantly,
it adds all of the Public Administrations to its scope of application,
which the previous Stability Law failed to do.

The three main objectives of this bill are to guarantee the fiscal
sustainability of all Public Administrations, to strengthen econo-
mic confidence and to reinforce the commits of Spain with the
European Union.

256


All Public Administrations must present a balance or a surplus
calculated according to EAS terms and none may incur in structural
deficit. However, there are two exceptions in the case of structural
reforms with long term fiscal effects (a structural deficit of 0.4% of
the GDP may be achieved) and in the event of natural disasters, eco-
nomic recession and extraordinary economic emergency.

In establishing the objectives of stability and public debt, the
recommendations of the EU in regard to the Stability Programme
must be taken into account, and all Public Administrations must
approve an expenditure ceiling in line with the stability target and
the expenditure rule. One of the most important aspects, in accor-
dance with European regulations, restricts the growth in expendi-
ture by the Public Administrations, as this may not exceed the GDP
growth rate.

Failure to comply with the targets shall require the presenta-
tion of an economic and financial plan to allow the correction of
the deviation for a period of one year. This plan must explain the
causes underlying the deviation and the measures which will
bring it back within the limit. In the event of non-compliance
with the plan, the responsible Administration must automatically
approve the non-availability of loans to guarantee compliance
with the set target and the meeting of the targets shall be taken
into account when authorising debt issues, granting subsidies and
signing agreements.

257


The Law, on the other hand, strengthens the preventive and
monitoring systems of stability and debt objectives. Therefore, a
debt threshold of a preventive nature is established, beyond which
the only debt operations allowed will be cash transactions.

In order to render all Public Administrations jointly responsible,
the penalties imposed in Spain in matters of stability shall be assu-
med by the responsible administration. In the event of failure to
produce an economic-financial plan, the administration in breach
must put of a deposit of 0.2% of its nominal GDP, which after six
months may be converted into a penalty in the event that the vio-
lations should continue. After nine months, the Ministry of
Finance and Public Administrations may send a delegation to
assess the economic and budgetary situation of the delinquent
Administration.

In order to strengthen the principle of transparency, each
Public Administration must establish the equivalence between
the budget and the national accounts. Prior to approval, each
Public Administration must provide information on its main
budget guidelines, in order to comply with European regulatory
requirements.

As was set forth in the new draft of section 135 of the
Constitution, the Law establishes a temporary period until 2020
for gradual compliance, until public debt is 60% of GDP. In order
to ensure compliance with this scenario, public debt must be redu-

258


ced whenever the economy experiences positive real growth. Upon
reaching a growth rate of 2% or net yearly employment is genera-
ted, the debt ratio shall be reduced each year at least by two GDP
points. On its part, the global structural deficit must be reduced by
0.8% of the annual average GDP.

Beyond the institutional importance of the reform, it is worth
considering the political capital that is allowing the deficit problem
to be addressed in an integral way and with long term vision. Doubts
as to possible deficit deviations in the current and following finan-
cial years should not lead us to lose perspective of the importance of
the reform. This reform set a trend designed to transform public bud-
gets into a reliable institution, with a simple structure, with no room
for interpretation, equal for all and with an automatic application
which allows it to be protected from temptations from other govern-
ments. In this regard, we also view the provisions included in the Bill
for the Transparency Law, which, undoubtedly, shall contribute
towards generating better knowledge of public finances.

The fiscal systems being approved in Spain matched with the
European model. There is a strong parallelism between the two,
and the construction errors of the European design and of the fis-
cal institution in Spain must be corrected by means of a coordina-
tion of fiscal policies in which the principles of regulatory equity,
subsidiarity, conditionality and sustainability should prevail above
all others.

259


Without doubt, the future of the euro requires more Europe.
The construction of Europe needs rules, adjustments and reforms.
Without growth the European model is doomed for failure. The
current crisis is but a result of the structural deficiencies of our eco-
nomy, of our excess indebtedness, of our lack of flexibility and our
lack of competitiveness in some aspects.

Once again, Spain, on its part, must become a role model of the
fiscal institution in Europe, and of the benefits which macroeco-
nomic stability brings to the economies, in terms of higher growth,
more wealth and greater employment. This is unquestionably the
best way to redistribute income. This is the only way we will mana-
ge to get Europe and Spain out of the sovereign debt crisis they
face, ensuring a solid future for the process of European construc-
tion, which is the greatest milestone in the search for peace and
prosperity in Europe.

5. Conclusion

Following the same pattern set since the inception of the
European integration project after the World War, the EMU came
about in 1999 as a result of the political aspiration of increasing
integration and as a European response to the globalisation pro-
cess. In reality, the integration via the monetary union which
makes up the Eurozone was not an objective in and of itself, but
rather a means to improve competitiveness and efficiency among

260


member countries. The ultimate goal, therefore, was growth, job
creation and the improvement of social welfare, while at the same
time making inroads in terms of political integration.

At that time the countries were aware of the need to set fiscal dis-
cipline targets as stability factors for Europe. However, those impor-
tant advances in the European construction process became diluted
over the years with the introduction of components carrying greater
flexibility and discretionality in the fiscal institution. The best exam-
ple is that the solution provided in 2005 to the violation of the SGP
by Germany and France was none other than the reform thereof
which included greater ambiguity in the search for fiscal stability, for
which they gained the support of the European Commission. The
diminishing political commitment with the fiscal institution and its
fragility in the face of the vicissitudes of the different governments
and ideologies became clear at that time. Therefore, with an institu-
tional design which was incomplete, and gradually declining over
the years, the EMU was far from representing an optimal monetary
area, and therefore the imbalances of the Eurozone economies incre-
ased, instead of decreasing, placing Europe in a difficult situation in
the face of the global financial crisis.

In this context, the current European debt crisis has highlighted
the urgent need for better coordination of the fiscal policies in
Europe. At the same time and particularly during the crisis, the
experience since the foundation of the euro has shown the impor-
tance of political commitment with the fiscal institution and the

261


need for preventive rules instead of penalties which are difficult to
apply. It is essential to ensure that the accumulation of excessive
deficits does not lead to unsustainable situations which call into
question traditional European security and seriously complicate
the capacity for funding growth and job creation. Rules are a
necessary condition to ensure compliance with fiscal targets. But
these rules must be of straightforward and automatic application.

Despite the difficulties, the present economic time obliges
Europe and Spain to make fast and efficient decisions in order to
straighten out the situation. It is important to take advantage of
current circumstances to tackle ambitious reforms designed to
correct some of the structural flaws of the Eurozone and of our eco-
nomy. It is important to face the current problems from a long
term outlook and to establish the rules of a fiscal institution which
ensure the viability of the European project.

The future and survival of the euro rests on all member states
being able to implement domestic reforms seriously, thus genera-
ting a sign of confidence for international investors and which
shall also serve, again in our case, as a calling card for our busines-
ses abroad. In Spain, one of the countries which has sustained the
most damage from the sharp budgetary deviations of recent years,
regional configuration shows evident parallelisms with Europe,
both in terms of the need to establish common objectives, and in
terms of the control systems or the transmission and penalty
mechanisms.

262


Spain, as a country which has already proven its ability to take
on this role at the end of the 1990s in the foundation of the Euro,
once again has an important role to play. In this regard, it is worth
mentioning that, thanks to the latest reforms implemented in sup-
port of the fiscal institution, Spain is once again contributing to
the European debate in pursuit of macroeconomic stability in the
Eurozone and its recovery. The challenge to be addressed, by means
of a change in the economic policy, is to recover confidence and
credibility of our economy, to enable businesses and consumers to
concentrate efforts in business, labour or consumer decisions, and
that macroeconomic issues, such as the risk premium, cease to be
cause for concern. Only in this way may Spain avoid lagging
behind like a second rate club, to which we have already said no a
few years back.

In order to move forward in building a fiscal union in Europe,
which succeeds in turning the EMU into an optimal monetary area
and ensures the good health of the euro and of the European eco-
nomy, the necessary mechanisms of income transmission, ensure
the availability of financial resources and required liquidity, to the
extent, if necessary, of creating risk pooling instruments, such as
eurobonds and, in parallel, the hispanobonds in the case of Spain.
These require, however, the establishment of prerequisites, that is,
economic adjustments and reforms to be implemented by the
countries facing the most difficulties. The rules are very important,
but without reforms it is impossible to grow, and without growth,
budgets become unsustainable. A different issue is, provided agre-

263


ed commitments are met, the respect for the autonomy of each
country to decide on its income and expenditure structure.
Subsidiarity must govern in Europe for those who are taking the
necessary steps, as is being done in Spain, in order to adapt the
budgets to the economic and social reality of each country.

The European construction has taken important steps since the
start of the crisis, but it needs to continue to progress via an incen-
tive system to ensure the political commitment with the fiscal ins-
titution in the medium and long term. The objectives of peace and
prosperity established by the founding fathers of the European
construction, on a long term horizon, once again depend on our
capacity to recover the growth and competitiveness of the eco-
nomy, and hence employment and the European welfare model.

264

/JAIME REQUEIJO * /

The European Monetary Union:
the Never-Ending Crisis

1. Introduction; 2. The Euro: a Badly Constructed Building; 3. The fiscal
Spillover; 4. The Consequences of the Doubtful Debt; 5. Contributing
Factors; 6. Main Measures Adopted to Solve the Monetary Union Crisis; 7.
Outcome of the Measures Adopted so far; 8. Consequences of the Breakup
of the Euro; 9. The Missing Link

* Ph.D in Economics, BA in Law, Former Civil Servant attached to the Ministry of
Commerce, Emeritus Professor of Applied Economics (UNED and IEB).Former positions
include : General Director for Imports and Tariff Policy at the Ministry of Commerce,
Chief Executive Officer of Caja Postal de Ahorros, Member of the Board of Banco
Zaragozano, Director of the School of Financial Studies (UCM) and Member of the
Board of Banco de España.
His fields of research focus on monetary and financial matters, international economics
and the Spanish economy. He has written seven books and published more then
seventy papers in Spanish economic reviews..

265

The European Monetary Union: the Never-Ending Crisis

1. Introduction

The constant financial trepidation afflicting different countries
of the Eurozone, and which threatens the survival of the single
currency, is not the result of random events. In our view, they can
be put down to four fundamental reasons. First, the Monetary
Union is a badly constructed building as political urgency prevai-
led over economic prudence. Second, there is the fiscal irresponsi-
bility of many member state governments, an irresponsibility that
has materialized as hefty public debts. Thirdly, the doubts being
generated among the debt holders, mainly institutional investors
and banks, and which has led to significant fluctuations in the
interest rates of those assets and, in general, to a cost hike for the
issuers. Four, what we could call the contributing aspects: the spi-
llover and contagion effects that batter the financial markets,
effects linked to the opinions of the rating agencies and, on occa-
sions, to the worst-case scenarios of the International Monetary
Fund regarding the medium-term performance of the European
Union economies and, particularly important, those of the
Monetary Union.

Faced with that panorama, and given the absence of clear solu-
tions, there are three questions raised by many observers of the cri-
sis. The first question is what the measures are that have been
adopted so far to try and avoid the recurring disruption. The
second question is whether those measures, or further ones
currently under debate, will be sufficient to solve the problem or,

266


on the other hand, will the fate of the Monetary Union be to totally
or partially break up? The third question is if the Monetary Union
proves to be totally unviable and the national currencies have to be
re-introduced, what will the consequences be of the failure of the
euro?

This paper seeks to provide a reasoned explanation of the cau-
ses underpinning the current major upheaval and it also aims to
answer the aforementioned three questions regarding the measu-
res, their outcome and impact of a possible breakup of the euro.
The paper ends with a short section considering the solution that
should be adopted to keep the Monetary Union in place.

2. The Euro: a Badly Constructed Building

Even though the dream of the single currency had been always
present since the Treaty of Rome, the definitive decision, contained
in the Maastricht Treaty, is the outcome of the political desires of
France and Germany. Of France as French governments believed
that having a single European currency would avoid the constant
pressures on the franc, pressures that usually led to the devaluation
of its currency. Of Germany as accepting the single currency meant
highlighting the European vocation of the most important
European economy after reunification in 1990, a process that ope-
ned up many raw wounds – particularly in France. Driven by those
dual interests, the currency unification project prospered, not wit-

267


hout significant frictions, until it became reality in 1999, the year
when eleven countries, including Spain, ceded their monetary
autonomy to the European System of Central Banks; Greece would
join in 2001, followed by other countries until it reached the
current seventeen members.1

Joining the Eurozone required the countries to meet the so-
called Maastricht convergence criteria, those rules aimed at ensu-
ring that the different economies had a certain nominal similarity.
During the year prior to the Compatibility Test, the inflation rate
could not be more than 1.5 points over the average of the three
most stable candidate countries; as the end of that year, the public
sector deficit could not exceed 3% of the Gross Domestic Product
or the debt be greater than 60% of that figure; the candidate
country had to have been part of the European Monetary System
during the two years prior to the test and without its currency
having experienced significant fluctuations; and, during the pre-
vious year, the long-term nominal interest rate had not exceeded
the average of the three most stable countries by more than 2
points.2 After the failure of the European Monetary System in
1993, only the other three criteria were required to determine
which countries could join the euro, and those criteria have conti-

1 Note that the countries that initially joined the Monetary Union were Germany,
Austria, Belgium, Spain, Finland, France, the Netherlands, Italy, Luxembourg and
Portugal. Greece joined later and, successively, followed by Slovenia, Cyprus, Malta,
Slovakia and Estonia.
2 Article 121 of the 1992 Maastricht Treaty.

268


nued to be applied to accept the application for entry of the suc-
cessive candidates.

Please note that those criteria were only required at the time of joi-
ning. The subsequent restrictions were laid down by the 1997
Stability and Growth Pact, aimed at maintaining budgetary stability
within the Union. Thus, the country could not exceed the annual
limit of the deficit and the debt: 3% and 60% of the GDP respectively.
Exceeding those limits meant that the European Commission would
implement the excessive deficit procedure, which would result in the
country in question having to face certain penalties. Subsequently, in
2005, the rules were reformed so that the deficits tested were not the
nominal but rather the structural ones. Therefore, not only the
current deficit, but also the sustainability of the long-term public debt
was taken into account in the supervision and monitoring process
entrusted to the European Commission.3 In short, and right from the
outset, the nominal similarities that a series of economies with clear
real differences had to offer were what seemed to matter to European
leaders. And, proof of that difference could be seen when, in 2002 –
Greece had already joined – the typical deviation of labour producti-
vity per hour worked, calculated as CWA was 29.46;4 which clearly
showed the different competitive capacity of the different countries,
right from the start. Those differences were a hint of the future sym-

3 See “The Stability and Growth Pact: Public Finances in the Euro Zone” of the Sub-
Directorate General for Financial and Economic Affairs of the European Union, SCI
Economic Gazette No. 2906, 16-28 October 2007.
4 Prepared using the Eurostat data for the twelve member countries.

269


metric upheavals to come in the zone, and that group of countries,
for different reasons, did not constitute – or constitutes – an optimum
monetary zone. And thus, the European Monetary Union was built
on quicksand, quicksand that would begin to overwhelm it as soon
as the fiscal irresponsibility of some of the governments made a sig-
nificant dent in the building overall.

3. The Fiscal Spillover

Can governments of countries with weak currencies issue debt in
their currency and ensure that attracts foreign investors? The like-
lihood is minimum as the potential investor will think that, at some
point, the currency will depreciate substantially, leading to a loss.

Can countries with a strong currency do so? They can because
the investors will not fear the losses following on from devalua-
tion. And proof of this is that institutional or private investors, resi-
dent in a wide variety of countries, have traditionally kept debts in
dollars, marks, Swiss francs or yens in their portfolios.

The euro sought to be a strong currency right from the outset.
This strength was based on the monetary policy of the European
Central Bank, whose primary objective would be to keep prices sta-
ble.5 And which, furthermore, represented a series of important

5 Art. 2 of the Statues of the European System of Central Banks and the European
Central Banks.

270


economies, with Germany at the head. Moreover, the exchange
rate risk disappeared for member countries and it therefore facilita-
ted the setting up of a large financial market in euro.

The appearance of the euro, therefore, meant the disappearance
of the original sin experienced by countries with weak currencies:
the difficultly of leverage in other currencies, which meant that
they were at huge risk of financial fragility.6 The way was therefore
left clear for governments of euro countries that had found it diffi-
cult to finance themselves in other currencies prior to joining the
single currency, to easily raise leverage in the powerful financial
market of the euro. The only thing missing was the imperative need
to do so.

And that imperative need arrived with the economic crisis,
which began in 2007, and with the general downturn in the rates
of growth, a fall that is reflected in the following table.

It should be noted that even through the downturn in growth
was widespread, the countries with the sharpest recession were
Ireland, Italy, Portugal and Spain within the initial group of twelve
countries.

When the growth rate shrank, which was greatest in those cases
with the sharpest change in cycle, the budgetary revenue fell and

6 See Eichengreen, B. & Haussmann, R. “Exchange Rates and Financial Fragility”, NBER
WP 7418, 1999.

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Table No. 1. Average Growth of the Eurozone (17 countries)

Average Average
Country
2004-2006 2 0 0 7 -2 0 1 1
Germany 1.87 1.20
Austria 2.90 1.30
Belgium 2.57 1.12
Cyprus 4.07 1.68
Slovenia 4.73 0.74
Slovakia 6.70 3.80
Spain 3.67 0.26
Estonia 8.43 -0.14
Finland 3.70 0.80
France 2.20 0.52
Greece 4.07 -1.90
The Netherlands 2.53 1.14
Ireland 5.03 -0.82
Italy 1.27 0.52
Luxembourg 4.93 1.28
Malta 2.33 2.20
Portugal 1.27 -0.20
Source: Own preparation, using Eurostat data (Europe in figures, 2012)

the deficits appeared or increased and grew even further if the bud-
gets included automatic stabilisers, by virtue of which the fiscal
policy became expansive in periods of recession, and even more
expansive if the governments relied on additional fiscal stimulus to
overcome the economic crisis.

All of these are reasons have been given to explain the rapid
increase in the public sector debt, as can be seen in Table No. 2.

Given that panorama of slow growth, or decline, and of growing
public debts, it comes of no surprise that debt holders would soon
have greater misgivings – misgivings that particularly affected those

272


Table No. 2. Evolution of the public debt of the eurozone (% GDP)

Country 2007 2011 Growth
Germany 65.2 81.8 25%
Austria 60.2 72.2 20%
Belgium 84.1 97.2 16%
Cyprus 58.8 64.9 10%
Slovenia 23.1 45.5 97%
Slovakia 29.6 44.5 50%
Spain 36.2 69.6 92%
Estonia 3.7 5.8 57%
Finland 35.2 49.1 38%
France 64.2 85.4 33%
Greece 107.4 162.8 52%
The Netherlands 45.3 64.3 42%
Ireland 24.9 108.1 334%
Italy 103.1 120.5 17%
Luxembourg 6.7 19.5 191%
Malta 62.4 69.6 12%
Portugal 68.3 101.6 49%
Eurozone 66.3 88 33%

Source: Own preparation, with data from the Statistical Annex of European Economy,
autumn 2011. The data refer to the gross debt as they are the liabilities that the govern-
ment must face.

countries where the recession was combined with spiralling debt and
the few prospects for recovery. It was, therefore, foreseeable that any
event that affected the debt of a country would lead to a chain reac-
tion that would challenge the financial stability of the Eurozone.

That event was Greece going into virtual receivership on 23 April
2010: on that date the Greek government asked the International
Monetary Fund and the European Union for a 45,000 million euro
loan to meet their financial obligations, four months after Fitch, the
rating agency, had downgraded its debt.

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4. The Consequences of the Doubtful Debt

From then onwards, there were constant indications of concern
in different channels about the sovereign debts with a question
mark over them. First of all, the increase of the risk premiums of
certain securities; secondly, the increase in the cost of the credit
insurance for the same securities; third, the greater occasional cost
of the new issues by the countries under suspicion, the so-called
peripheral countries: Greece, Portugal, Ireland, Italy and Spain.

The three aforementioned reactions clearly moved in the same
direction. As is known, hikes in risk premiums on the secondary mar-
kets consist of discounts on the value of the securities, discounts that
are equivalent to an increase in the relevant interests and which are
compared to the interests of the benchmark debt, the German one,
for the same market. In its simplest version, credit insurance (Credit
Default Swaps) are contracts by virtue of which, and by means of
paying a premium, the bondholder is guaranteed the collection of
the nominal amount. And in increase of the risk premiums and the
price of the swaps affect, by definition, the cost of the new issues: the
more expensive the premiums and swaps become, the higher the
interest that the new issues should offer and the greater the cost for
the relevant governments. All of which tends to worsen the financial
situation of the governments, a situation that will enter a downward
spiral if the average interest rate of the outstanding debt is greater
than the growth rate of its economy.

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5. Contributing Factors

Current financial markets are markets of news and rumour
mills.7

The first report on how the turbulence develop and reflect veri-
fiable facts: the initial request for help by the Greek government;
the successive austerity measures demanded by the European aut-
horities and the International Monetary Fund for the bailout to be
granted; the social response to the austerity plans in different
countries or the downgrading of the sovereign debts of different
countries of the Eurozone, including France. All of the events show
the constant severity of an ongoing crisis.

The second are, in general, interpretations, opinions that are
usually transmitted through the different media, whether they are
journals, the daily press, television and radio programmes or news
spread online. Some are reasonably based opinions that are trying
to consider the difficult situation of the Monetary Union and to
offer some type of solution.8 Others are purely and simply seeking
to be alarmist, to the point of suggesting to their readers that they

7 An extensive study into the subject of rumours is by Mark Schindler: “Rumors in
Financial Markets”, Wiley&Sons, UK, 2007.
8 Examples of opinions of this type are “Beware of fallen masonry”, The Economist,
26/11/2011, and those expressed by K. Rogoff in the interview published by Spiegel on
27/2/2012, entitled “Germany Has Been the Winner in the Globalization Process”.

275


should stock up on food to survive the chaos that will reign, on the
world scale, when the euro implodes and triggers a financial tsu-
nami that will spread over the five continents.9

Furthermore, there are the constant threats of downgrading the
sovereign debt by the three major US agencies – Standard & Poors,
Moody’s and Fitch –, the three who were so optimistic when it came
to US mortgage junk bonds,10 and the doubts expressed, from time
to time, by the International Monetary Fund regarding the future of
the euro zone. There is also the risk that the whole set of views,
from the most founded to the most alarmist, will awaken many
fears and the prophecy will become self-fulfilling: the disaster will
occur because the avalanche of negative opinions will set it in
motion.

6. Main Measures Adopted to solve the Monetary Union
Crisis

At the time of writing (April 2012), these measures have invol-
ved setting up general bailout funds, the approval of a Greek Loan

9 Read “Will Greek Sovereign Debt Default on March 23” by Patrik Heller, Coinweck,
22/2/2012 (online).
10 In the opinion of John Kiff, from the International Monetary Fund, the opinion of
the agencies increases the uncertainties on the sovereign debt markets, due to the
importance that the participants on those markets seem to attribute to them. See his
article “Reducing Role of Credit Ratings Would Aid Markets” IMF Survey Magazine,
29/9/2010. Also Arezki et al: “Sovereign Rating News and Financial Markets
Spillovers”, IMF, WP/11/68.

276


Facility, the interventions of the European Central Bank and the
fine tuning of a new Treaty on Stability, Coordination and
Governance of the Monetary and Economic Union.

In 2010, the European Financial Stability Fund was set up,
whose aim is to facilitate resources to euro countries in financial
difficulties. It is a company whose headquarters are in Luxembourg
and its loan capacity is to the tune of 440,000 million euros.11 To
grant a loan to a Euro country, the government of the country has
to request it and sign an austerity programme. Part of the loans to
Ireland and Portugal were arranged through that Fund.

In 2011, the European Financial Stabilisation Mechanism was
created for a similar purpose. It is an institution, supervised by the
European Commission, which obtains its resources from the capi-
tal markets by means of issuing bonds underwritten by the
European Union budget. It may provide aid to members of the
European Union, whether or not they are members of the
Eurozone, is compatible with aid provided by other channels and
also requires the prior approval of an austerity package. Loans
have also been granted through this programme to Ireland and
Portugal.

The two aforementioned funds would duly be subsumed in the
European Stability Mechanism), agreed by the Eurozone countries

11 All the data referring to the bailout fund and to the Greek Loan Facility are taken
from European Commission official documents.

277


in February 2012 and which should begin to function in July of
that year. Its aid will not be limited to granting loans, but it will
likewise be able to acquire bonds issued by the member countries,
either on the primary or on the secondary markets, and facilitate
resources aimed at recapitalising financial institutions. In princi-
ple, it would have 80,000 million euros of capital and an initial cre-
dit capacity of 500,000 million euros. In May 2010, the members
of the Eurozone bilaterally decided to lend Greece 80,000 million
euros that, in addition to the 30,000 million from the
International Monetary Fund, meant that the first Greek bailout
totalled 110,000 million euros. At the end of 2011, and 73,000
million euros had been paid out from that fund, a payment that
required an austerity undertaking. On 14 March 2012, a new bai-
lout programme was approved, with substantial write offs for the
creditors and austerity obligations for the Greek Government, to
the tune of 130,000 million euros, an amount which includes the
International Monetary Fund contribution of 28,000 million
euros. The purpose of that financial support, which will last until
2014, is to bring the Greek public deficit under the 117% of its
Gross Domestic Product by 2020. Part of that bailout will be chan-
nelled through the European Financial Stability Fund.

A crisis intervention of particular importance is by the
European Central Bank, an intervention channelled in two lines.
In a non-recurrent way, the Bank acquires debt on the secondary
market, which reduces the risk premium and means that the issues
of new securities are at a lower cost. On the other hand, it lends

278


resources at a very low interest rate to financial brokers – its basic
rate has remained at 1% for some time – which means that the
banks of the worst hit countries acquire part of the new issues.
They, therefore, facilitate the placement of securities, securities that
are profitable for the financial institutions and less costly for the
issuers.

On 2 March 2012 and after many debates in the European
Council, the representatives of twenty-five countries of the
European Union – as neither the United Kingdom nor in the
Czech Republic wanted to sign up – signed the Treaty on Stability,
Coordination and Governance in the Economic and Monetary
Union. Even though the new Treaty was signed by members of the
European Union that are not part of the Monetary Union, its fun-
damental proposal is to force the euro countries to ensure that
their public finances are balanced. Further proof of that purpose is
that the Treaty will come into force when it has been ratified by at
least twelve euro countries.

A key aspect of the agreement is the so-called Budgetary
Agreement that forces those countries to tighten their budgetary
discipline and which introduces the balanced budget rule, a rule
that must be included in national legislation and, preferentially, in
the Constitution. The structural deficit must not exceed a specific
limit and cycle deficits are accepted, resulting from substantial
downturns in the economic activity, provided that they do not
alter the balanced budget rule in the medium term. And, in the

279


case that the deficit exceeds the permitted limit, a series of auto-
matic penalties are envisaged.12

7. Outcome of the Measures Adopted so far

Judging by the data that appeared in early April 2012, recovery
from the downturn has not yet started, in particular, as far as the
peripheral countries are concerned: volatility remains high both
on the sovereign debt markets and on the variable income ones –
in the case of the latter, the downward trend is reflected by the
drop in share prices of the most exposed banks to the sovereign
debt of those countries – and the doubts persist regarding the capa-
city of several of them to meet their obligations. Which is not at
all strange for several reasons.

The required restructuring to bring the debt back to more bea-
rable levels would hinder, in the short term, the growth capacity of
the five countries, as economic recovery would be further compli-
cated by the shrink in their tax revenue. And all of this would
occur in a climate of recession and economic stagnation that appe-
ars to have taken hold of the European Union, over all, and the
Monetary Union, in particular.13

12 The full text of the Treaty can be seen at the European Council website.
13 The forecasts can be seen at the European Economic Forecast, Autumn 2011 (online).

280


The situation of Greece is at the forefront of all the economic
analysis of the euro zone as very few believe so far that the recently
approved second bailout will result in the country solving pro-
blems and many believe that a third bailout will soon be on the
cards. And those doubts regarding the future of the Greek economy
are spreading to the rest of the peripheral countries and, to a great
extent, to the very future of the Monetary Union.

Despite the measures approved so far, the decision processes have
dragged on as an agreement needs to be reached by country repre-
sentatives, who are very aware of the opinion of their citizens, and
by representatives of community institutions. Long processes, where
multiple opinions, sometimes discrepancies, are mixed, that increa-
se the uncertainties regarding the future of the euro, even though
the disappearance of the single currency could raise much more
wide-ranging problems than the current ones trying to be solved.

8. Consequences of the Breakup of the Euro

The breakup of the Monetary Union could occur should one or
more member states decided to leave the single currency and rein-
troduce their own currency. That split could either be due to the
departure of one or more weak-economies or to one or more
strong-economies breaking. In either of the two cases, the Union
would be broken.

281


From the legal perspective, such a possibility does not currently
exist as the Maastricht Treaty does not include any clause that
opens up the way; only the 200714 Lisbon Treaty accepts the
voluntary withdrawal of a member state from the European Union,
but says nothing about the Monetary Union. This may be because
the architects of the common currency always thought that, given
that the single currency was an extremely important step in the
political and economic construction of Europe, the decision of
each country should be irrevocable.

Yet, leaving the legal aspect on one side, despite its importance,
the collapse of the Eurozone would lead to a series of disastrous con-
sequences for the country or countries that had left the euro, for the
Eurozone overall and for the world economy.

Let us first consider the departure of a weak economy. The mere
presumption by its citizens of leaving would result in a large-scale
transference of deposits from its banks towards other banks located
outside the country, given that nobody would want to see their euro
assets converted into balances in the devalued currency; the
Government in question would be forced to impose, as a preventive
measure and prior to the decision to abandon the euro, a limit on
withdrawing deposits and a strict exchange rate control. As it is to be
supposed that part of the private debt of the country would be held
by foreign institutions, individuals and companies would find them-
selves in the worrying situation of having to face such debts with a
14 Art. 50 of the Treaty regarding the voluntary withdrawal for a member country.

282


national currency of a lower value. With respect to the sovereign
debt, the problem would be the same: the Government would be
compelled to honour it at a higher cost. And the internal economic
adjustments would be of such a magnitude that the main purpose
sought by returning to the national currency – regaining the exchan-
ge rate policy and, thus, making the exportable goods more compe-
titive – would take many years to occur. Without even going into the
social and legal conflicts that would occur, in that country, as a seve-
re recession for an unforeseeable length would occur.

If the country decided to abandon the euro were a very strong
economy, would there be more advantages than disadvantages? It is
not easy to answer that question, for two reasons. First of all, becau-
se the foreseeable outcome is that its currency would appreciate,
which, even though it would mean an initial advantage, would also
raise problems. For example, and from that moment onwards, its
banks would have deposits in the new currency, but it is to be sup-
posed that part of its assets would be for operations with residents
in the euro zone and, therefore, the financial brokers would have to
face losses through that channel, and would moreover have to face
its fiscal obligations in the new currency. Second, and this is the
more important aspect, the appreciation of its currency would affect
its competitiveness in the remaining euro countries – the main mar-
ket of all the countries of the Monetary Union – which, undoub-
tedly, would hit its growth capacity for many years to come.15

15 On these aspects, see “Euro break-up: the consequences” of UBS Investment
Research, 6/9/2011 (online). Also the opinions of Eric Dior: “Leaving the euro zone: a

283


The departure from the Eurozone of any country, or several
countries, would break up the Monetary Union in both political
and economic terms. In economic terms, because the growing dis-
trust of all its citizens would lead to substantial capital flights and,
probably, to the collapse of different financial systems, which
would cloud the very limited economic perspectives of the zone
and would lead to a long recession. In political terms as its inter-
national clout would be considerably reduced, based on a situa-
tion, the current one, which is not particularly brilliant: its lack of
political unity and its indecisiveness, which characterises it as a
soft power area clearly reduce the international presence of a zone
that, we should not forget, is, taken overall, the second economy
and the second market of the world.16 Its breakup and the ensuing
recession would cloud the international presence of that group of
countries to unimaginable limits. And without taking into account
the likely decline of the European Union.

It is interesting to observe the distancing that many non-
European analysts show when considering the spasms of the
Monetary Union. Which is the equivalent, in many cases, to con-
sidering them as a local problem: the Eurozone is having to bear
great tensions, arising from the sovereign debt crisis, and there is
a question mark over its survival. And they go no further. They
forget that, in a world of fully integrated financial markets, the

user’s guide”. IESEG School of Management (Lille Catholic University), October 2011
(online).
16 With World Bank and World Trade Organisation data for 2010.

284


Eurozone crisis would have a global impact. For two reasons. First
of all, because a good part of the sovereign debt is in bank port-
folios; secondly, because the credit insurances (CDS) are, pos-
sibly, held by financial institutions around the world.

In December 2011, 513,000 million euros of public debt of the
five peripheral countries (Greece, Ireland, Italy, Portugal and Spain)
appeared in the portfolios of European banks.17 If we take into
account that the financial institutions around the world are linked
by a series of international transactions, it is not difficult to con-
clude that the breakup of the euro would have global repercussions.

In the March 2011, the CDS linked to European sovereign debt
stood at 145,000 million dollars.18 Neither of these two figures are
high but they are sufficiently important for the upheavals of the euro
zone, following on from the breakup of the currency, to be transferred
to other regions of the world with substantial multiplying effects.

It therefore can be supposed that the Monetary Union will
manage to overcome this crisis. Yet, from our point of view, the
current firewalls – the bailout funds, however they are called – and
the budgetary obligations, included in the Treaty on Stability,
Coordination and Governance, will not be enough to overcome

17 Jenkins, P. y Stabe, M: “EU banks slash sovereign holdings”. With European Bank
Association data (online).
18 ISDA: “The Impact of Derivative Collateral Policies of European Sovereigns and
Resulting Basel III Capital Issues”, 19/12/2011 (online).

285


the current problems and ensure that the Monetary Union is the
threshold to what, when all said and done, has been what they
wanted to achieve through the single currency: a certain degree of
Political Union. An additional link is therefore now needed.

9. The Missing Link

The endeavours aimed at solving the crisis have so far been along
two paths: creating financial instruments to avoid the bankruptcy of
some governments – the most worrying case is Greece – and strengthe-
ning the obligation of member countries to reach and maintain a rea-
sonable budgetary balance. Important steps, but which have not mana-
ged to eliminate the continuous tension that has been observed in the
financial markets, tension that the interventions of the European
Central Bank have only managed to soften. Soften, not eliminate.

Note that all the actions undertaken so far – bailout and rules –
do not imply any joint liability. It involves combining financial aid
and remembering that fiscal policy in a single currency arena must
be very similar and very prudent in all member countries. The lia-
bility therefore falls on the Government of each country.

Yet these measures will not be sufficient if the aim is to shore up
the badly constructed building of the Eurozone. It would be neces-
sary to show that the members of the Monetary Union are capable
of jointly and severally assuming liability of the problems of all its

286


members. And what is necessary, to affirm that joint liability, is to
issue the so-called Eurobonds or Stability Bonds; in other words,
bonds jointly issued that will replace, totally or partly, the current
sovereign debt. That measure, that would be a highly important
step forward in the construction of the common building that is
based on the single currency, would result in three far-reaching
consequences: the sovereign debt crisis of some countries would
be rapidly alleviated; the cost of future issues would be reduce as a
consequence of the overall solvency; and the financial system of
the Eurozone would be more resistant to any future upheaval, and
the overall financial stability would therefore be strengthened.
This decision necessarily implies the setting up of a common trea-
sury and likewise the application of a fiscal policy.

Clearly, that decision would entail many economic difficulties
and highly complex political problems, as the citizens of the most
prosperous and stable countries of the Union will be not very
willing to accept that type of shared liability which they would see
as the financial problems of others being placed on their shoul-
ders. Yet we should not forget that that possibility has already been
raised by the European Commission itself, precisely to attain those
objectives.19 And we should not forget, above all, that, as I have
attempted to explain in this paper, the end of the Monetary Union
is not a zero-sum game, where there are winners and losers; it is a
negative sum game, where everyone loses.

19 See European Commission: “Green Paper on the feasibility of introducing Stability
Bonds”, 23/11/2011.COM (2011) 818 final (online).

287


288

A. JESÚS SÁNCHEZ FUENTES * /SEBASTIAN HAUPTMEIER ** /
/LUDGER SCHUKNECHT *** /

Public expenditure policies during the
EMU period: Lessons for the future?1

1. Introduction; 2. Long-term public expenditure in industrialised coun-
tries; 3. The first decade of EMU period: a missed opportunity?; 3.1. A
disaggregated assessment of past expenditure policies; 3.2. Determinants
of the expenditure stance; 3.3. Implications for public debt; 4. Looking
backward to the past, lessons for the future? an episodes based approach;
5. The need for prudent expenditure rules; 6. Concluding remarks;
Bibliography

*He currently works as Ph. D Assistant professor at Complutense University of Madrid.
Before he worked as external consultant at European Central Bank, as (Ph. D) Assistant
professor at Pablo de Olavide University (Seville, Spain) and as research assistant at
Foundation centrA. He holds a Ph.D in Economics from Pablo de Olavide University
(with distinctions) and a Bachelor in Mathematics from University of Seville. His rese-
arch areas are mainly public economics and computational economics.
** He currently works as an Economist at the German Ministry of Finance. He was also
an Economist in the Fiscal Policies Division of the European Central Bank and worked
as a research assistant at the Centre for European Economic Research (ZEW). He holds
a Ph.D. in Economics from Munich University (LMU). His research focuses on empiri-
cal public finance and fiscal policy.
***Is heading the Directorate General Fiscal Policy and International Financial and
Monetary Policy at the German Ministry of Finance. Previously, he worked at the
European Central Bank, the World Trade Organisation and the International Monetary
Fund. His recent research mainly focuses on public expenditure policies and reform and
the analysis of economic boom-bust episodes.

289

Public expenditure policies during the EMU period: Lessons for the future?

1. Introduction

The outlook for public finances in the advanced economies for
the second decade of the 21st century is extremely challenging, not
least due to the substantial fiscal expansion that took place in the
context of the financial and economic crisis. Public deficits in 2010
averaged around 6% of GDP in the euro area and exceeded 10% of
GDP in the US and the UK (Chart 1, panels a, and b). At the same
time, public debt in advanced economies has increased signifi-
cantly between 2007 and 2010: by some 20pp of GDP to around
86% in the euro area and so far by 30pp or more in the UK (to 80%)
and in the US (to over 90% of GDP). When including Japan, public
debt in the G7 countries already averaged over 100% of GDP in
2010.

A closer look suggests that most of the deficit increase since the
start of the crisis in 2007 was due to an increase in public expendi-
ture ratios which have reached or approached historical highs. By
contrast, revenue ratio declines have been rather limited (panels c
and d). It is, therefore, logical to look at public expenditure when
striving to correct fiscal imbalances in industrialised countries. This
approach is in fact pursued already by a number of countries with
fiscal difficulties. It was also the approach used—successfully—by

1 The views expressed are the authors’ and do not necessarily reflect those of the authors’
employers. Correspondence to: A. Jesús Sánchez-Fuentes. Universidad Complutense de
Madrid. Campus de Somosaguas, 28223, Madrid (Spain). Tel: +34 913942542, Fax: +34
913942431. Email: antoniojesus.sanchez@ccee.ucm.es.

290


Chart 1. Developments in public finances, 1990-2011
a) Fiscal balance

b) Public debt

Source: Ameco.

291


Chart 1. (cont.) Developments in public finances, 1990-2011
c) Total public expenditure

d) Total revenue

Source: Ameco.

292


many advanced economies in the 1980s to return to sound public
finances and at the same time reinvigorate the economy.

The case of the euro area is of special relevance for a number of
reasons. While the crisis-related deterioration of public finances in
the euro area as a whole has not been as pronounced as for example
in the US or Japan (see Chart 1), heterogeneity at the Member State
level is substantial. A number of countries, in particular Greece,
Ireland and Portugal, recorded double-digit deficit ratios and expe-
rienced significant increases in government debt as a ratio to GDP.
Unsustainable fiscal positions coupled with structural economic
weaknesses and competitiveness deficiencies, in turn, fuelled market
tensions which - due to strong financial interlinkages – undermine
financial stability in the monetary union as a whole. Therefore, at
the time of writing, there is a particular urgency for euro area coun-
tries to regain market confidence through a swift return to sound
public finances. At the same time, euro area membership tends to
exacerbate adjustment efforts since the exchange rate mechanism is
not available, preventing an external devaluation. Therefore, fiscal
consolidation and the restoration of external competitiveness need
to strongly rely on internal adjustment processes.

Against the background, this study assesses expected public
expenditure developments of selected euro area countries for the
coming years. Based on the experience with expenditure reform in
the 1980s and 1990s, we argue that ambitious and high quality
expenditure reform as part of comprehensive economic reform pro-

293


grammes have the best chance of success. Furthermore, the role of
a prudent expenditure rule and the relevance of having a suitable
institutional framework are discussed.

Section 2 reviews public expenditure trends over the past 30
years. Section 3 reports on the main findings of earlier studies on
public expenditure policies during the first decade of EMU. Section
4 looks backward to the past to extract important conclusions on
the successful strategy exit of current crisis. Section 5 provides an
illustration on the preventive role of prudent expenditure rules
before section 6 concludes and draws some policy lessons.

2. Long-term public expenditure in industrialised countries

With a view to assessing recent developments in a broader his-
toric perspective, it is worth briefly taking stock of trends in public
expenditure and the size of the state over the past 30 years (Table
1).2 After a strong increase in the size of government in industria-
lised countries in the 1960s and 1970s, the average total public
expenditure ratio across OECD, G7 or euro area was broadly
unchanged in 2007 -just before the financial crisis- from 2000, 1990
and 1980. The average spending ratio for the euro area remained
around 45% of GDP and that of OECD and G7 around 40%.

2 See also Tanzi and Schuknecht (2000) for more details on historic expenditure deve-
lopments.

294


Table1. Total expenditure developments

Maximum Change
value
1980 maxi-
% of GDP 1990 2000 2007 2010
or nearest mum
Year Ratio to 2010

Austria 50,0 51,5 52,3 48,6 52,5 1995 56,4 -3,9
Belgium 54,9 52,3 49,1 48,3 52,9 1983 62,2 -9,2
Finland 40,1 48,1 48,3 47,2 55,1 1993 64,7 -9,6
France 46,0 49,6 51,7 52,6 56,6 2010 56,7 -0,1
Germany 47,4 44,2 47,6 43,5 48,1 1995 54,8 -6,7
Greece 27,0 45,2 47,1 47,6 50,2 2009 53,8 -3,6
Ireland 50,1 42,8 31,2 36,6 46,8 1982 54,2 -7,3
Italy 40,8 52,9 47,0 47,6 50,3 1993 56,3 -6,0
Luxembourg 48,4 37,7 37,6 36,3 42,5 1981 51,7 -9,2
Netherlands 55,2 54,9 44,8 45,3 51,2 1983 59,1 -7,9
Portugal 32,4 38,5 41,4 44,4 51,3 2010 51,3 0,0
Spain 31,1 42,1 39,3 39,2 45,6 1993 47,1 -1,4
Euro area (15) 4 5 ,4 4 7 ,9 4 6 ,2 4 6 ,0 51,0 1 9 9 5 5 3 ,1 - 2 ,1
Australia 32,5 35,4 35,5 33,4 38,5 1985 38,5 0,0
Canada 41,6 48,8 41,1 39,4 44,1 1992 53,3 -9,2
Denmark 52,7 55,4 53,7 50,8 58,5 1993 60,2 -1,7
Japan 33,0 31,6 39,0 35,9 41,1 1998 42,5 -1,4
Sweden 62,9 61,3 55,1 51,0 52,9 1993 71,7 -18,8
Switzerland 32,8 30,3 35,1 32,3 34,2 2003 36,4 -2,2
United
47,6 41,1 36,8 43,9 50,6 2009 51,5 -0,9
Kingdom
United States 34,2 37,2 33,9 36,8 42,5 2010 42,7 -0,2
G7 3 8 ,3 3 9 ,8 3 8 ,5 3 9 ,9 45,0 2 0 0 9 4 5 ,5 - 0 ,5
OECD 3 9 ,1 4 0 ,2 3 8 ,8 3 9 ,8 44,6 2 0 0 9 4 5 ,2 - 0 ,6

Source: Ameco, OECD.

295


However, this masks significant differences across countries.
The countries that undertook ambitious reforms in the 1980s and
1990s typically had much lower spending ratios in 2007 than in
1980 or at least than at their peak. A few countries, however, inclu-
ding many of those that we will refer to in the next sections (US,
Italy, Spain, Portugal, Greece, Ireland, UK) had significantly incre-
ased the size of government between 1980 and 2007 or least in the
2000-2007 period.3 This occurred notwithstanding an extended
economic boom in most of these when expenditure ratios should
have gone down.

With the start of the financial crisis, public expenditure ratios
went up everywhere by on average 5pp of GDP. This brought the
total expenditure ratio to about 50% in the euro area and 45% in
the OECD/G7 in 2010. For the euro area, the increase still consti-
tutes a decline in overall spending since the previous peak in 1995
but this was due to a lower interest bill. On the whole and for
many countries, public expenditure ratios are now at or near his-
torical peaks. This includes the European crisis countries, Portugal
and Greece and the UK and US.

These developments show that the challenge of containing the
size of the state is more present than ever. And together with deficit
and debt figures, the close link between rising public spending, defi-

3 See also Hauptmeier et al, 2011 for an assessment of the expenditure stance in euro
area countries since the start of EMU.

296


cit and debt figures is also obvious. But a number of countries mas-
tered the challenge of very large expenditure ratios with ambitious
reform programmes in the 1980s and 1990s. This experience will be
re-called in the next sections. These countries were typically not the
same that face such challenges now—except Ireland and the UK.

3. The first decade of EMU period: a missed opportunity?

In this section, we examine expenditure developments and plans
of a number of euro area economies, notably Greece, Ireland and
Portugal (programme countries), Germany, France, Italy and Spain
(large euro area countries) in comparison to the UK and US. The
common feature of most of these countries (except Germany and
Italy) for the period up to 2007 was a drawn out economic boom
characterised by significantly positive output gaps. In principle, this
should have allowed bringing down public expenditure ratios signi-
ficantly, firstly, due to the impact of automatic stabilisers and,
secondly, in some cases also due to lower interest spending thanks
to the euro.

However, this is not what happened. All countries pursued an
expansionary expenditure stance, of the order of 1-5pp of GDP
except for Germany (Hauptmeier et al, 2011).4 This basically “ate

4 One of analysing the expenditure stance of a country is to compare it with the expen-
diture levels that should have occurred if a country had followed certain fiscal rules.

297


up” the interest savings from introducing the euro. As a conse-
quence, total public expenditure only went down significantly in
Germany and even increased strongly in the three crisis countries
and the UK between 1999 and 2007 (Table 2). In the US, total spen-
ding grew by around 2pp of GDP between 2001 and 2006 but the
ratio remained well below 40% of GDP. Together with the US,
Ireland and Spain maintained the lowest spending ratios (below
40% of GDP), France’s public expenditure was the highest, at 52.4%
in 2007. The increase in public expenditure becomes even more
pronounced when looking at primary spending. For the crisis coun-
tries and the UK this went up by 3 to almost 6% of GDP between
1999 and 2007. As a result, most of the sample countries still had
significant deficits in 2007 while the debt ratio had hardly declined
or even increased between 1999 and 2007 (Schuknecht, 2009).

Expansionary expenditure policies during good times left most
of the countries “unprepared” when the crisis hit. As a consequen-
ce of the output fall and further expansionary programmes, public
expenditure ratios increased strongly between 2007 and 2009/2010.
Increases ranged from around 4pp of GDP in Italy and Germany, to
6-7½ pp in the UK and US to over 10pp in Ireland. The expenditu-
re increase was particularly strong in the countries where a credit-
fed real estate and financial sector boom had “artificially” inflated

Such an exercise was conducted by us last year (Hauptmeier et al, 2011). The study
found that most euro area countries had pursued expenditure policies that were more
expansionary than a reasonable expenditure rule would have proposed.

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Table 2: Recent total expenditure developments

% of G DP 1999 2007 2009 2010 Change Memoradum: deficit

1999-2007 2007-2010 2007 2010
Programme countries
Greece 44,8 47,6 53,8 50,2 2,8 2,6 -6,8 -10,8
Ireland 33,9 36,6 48,9 46,8 2,7 10,2 0,1 -11,3

Portugal 41,0 44,4 49,9 51,3 3,4 7,0 -3,2 -9,8

Large euro area countries
Germany 48,2 43,5 48,1 48,1 -4,7 4,5 0,2 -4,1
France 52,6 52,6 56,7 56,6 0,0 4,0 -2,8 -7,1
Italy 48,1 47,6 51,6 50,3 -0,5 2,6 -1,6 -4,5
Spain 39,9 39,2 46,3 45,6 -0,7 6,4 1,9 -9,3

Large non-euro area countries
United States 34,2 36,8 42,7 42,5 2,7 5,6 -2,8 -10,6
United Kingdom 38,9 43,9 51,5 50,6 5,0 6,7 -2,7 -10,3

Table 2: Recent expenditure developments for selected countries

% of GDP 1999 2007 2009 2010 Change
1999-2007 2007-2010
Programme countries
Greece 37,3 42,8 48,7 44,4 5,5 1,6
Ireland 31,5 35,6 46,9 43,7 4,1 8,1
Portugal 38,1 41,4 47,0 48,3 3,3 7,0

Germany 45,1 40,7 45,4 45,4 -4,4 4,7
France 49,6 49,9 54,3 54,2 0,3 4,3
Italy 41,5 42,7 47,1 45,9 1,2 3,2
Spain 36,4 37,6 44,5 43,7 1,2 6,1
Large non-euro area
countries
United States 30,4 34,0 40,2 39,8 3,5 5,9

United Kingdom 36,0 41,7 49,6 47,7 5,6 6,0

Source: Ameco

299


Table 2: Recent cyclically adjusted primary expenditure developments

% of GDP 1999 2007 2009 2010 Change

1999-2007 2007-2010

Programme countries

Greece 37,3 42,9 48,6 44,4 5,5 1,5
Ireland 31,7 35,8 46,6 43,5 4,0 7,7
Portugal 38,2 41,4 46,9 48,3 3,2 6,9


Germany 45,1 40,9 45,0 45,2 -4,1 4,3
France 49,7 50,1 54,1 54,0 0,4 4,0
Italy 41,5 42,7 47,0 45,8 1,2 3,1
Spain 36,5 37,7 44,3 43,4 1,2 5,7


United States 0,0 0,0 0,0 0,0 0,0 0,0
United Kingdom 36,1 41,7 49,5 47,6 5,7 5,9

Source: Ameco

GDP. When this reversed over the crisis, both higher spending and
lower GDP drove up the expenditure ratio. Virtually all of the
expenditure ratio increase was on public consumption and transfers
and subsidies; public investment went up only slightly in a few
countries. Greece, Ireland and Spain also reported higher interest
expenditure as the rapidly rising debt ratio and higher interest rates
started to affect public budgets.

Where did countries stand in the third year of the crisis, 2010?
None of our sample countries still featured a relatively small public

300


sector of below 40% of GDP (as defined by Tanzi and Schuknecht,
2000). Even the US, at 41.3% of GDP, featured a public sector that
was not much smaller than the euro area average before the crisis.
Greece, Portugal, France, Italy and the UK reported public spending
ratios of around to significantly above 50%.

It has been argued that the increase in expenditure ratios is not
very relevant as it presumably reflects almost solely the crisis and
should, thus, reverse itself over time as the economy normalises.
This reasoning implicitly assumes that output levels and growth
rates will more or less return to pre-crisis levels. As a large output gap
would be closed, public commitments should decline relative to
GDP. However, if the pre-crisis GDP was artificially inflated by boo-
ming sectors which have to shrink then both GDP level and growth
rates may be significantly lower post-crises. If the 2010 output gap
was only small, 2010 deficits and expenditure ratios would in fact
represent structural features of the examined economies. In any
case, significant fiscal adjustment is needed which in some cases
exceeds 10 pp of GDP in the coming years (IMF, 2011).

3.1. A disaggregated assessment of past expenditure policies

To assess in more detail what drove expenditure developments
since the start of EMU, this section provides an analysis the public
expenditure stance across the three main expenditure components
that governments can influence in the short term: government
consumption, transfers and subsidies and public investment. We

301


apply the same methodology as in Hauptmeier et al (2011): given
the existing levels at the start of the EMU (1999), actual public
expenditure developments are assessed against an expenditure
path that should have been taken if countries had followed a neu-
tral expenditure stance, i.e. if governments had aligned expenditu-
re growth to that of potential GDP. The latter is measured on the
basis of two expenditure rules: (a) nominal potential GDP growth
(NPG rule) and (b) real potential GDP growth plus the growth rate
of the GDP deflator capped at the ECB’s price stability objective of
below but close to 2% (RPECB) based either on real time or ex post
data. This counter factual analysis provides four measures of the
expenditure stance.5 Deviations are analysed by looking at margi-
nal (annual) and/or cumulative (total period) deviations (expressed
as percentage of GDP). According to this procedure, on the one
hand, marginal deviations help to identify the year(s) in which
expansionary/restrictive policies were implemented. On the other
hand, cumulative deviations measure the degree of expansio-
nary/restrictive policies in percentage points (pp) of GDP accumu-
lated over the period (1999-2010).

Firstly, to provide a general perspective, we focus on cumulati-
ve effects for the aggregate euro area (Chart 2), comparing actual
and rule-based expenditure developments (expressed as percentage
of GDP).

5 The earlier study applied six measures but the two additional ones did not provide
much additional insights.

302


Chart 2: Euro Area (12). Expenditures ratios as implied by a neutral expenditure
stance, across rules.
Primary expenditures

Public consumption

303


Chart 2: (cont.) Euro Area (12). Expenditures ratios as implied by a neutral expen-
diture stance, across rules.

Public investment

304


Looking at the primary expenditures stance - panel a - suggests
a co-movement with the NPG rules which indicates the absence of
a prudence margin to operate when difficulties appear. Looking at
the disaggregated developments, i.e. the main expenditure compo-
nents, gives a different picture: First, the results for public con-
sumption show an expansionary expenditure stance on this cate-
gory adding up to 0.5-2pp of GDP, depending on the respective
expenditure rule. Second, for the transfers and subsidies compo-
nent, a strong counter-cyclical behaviour is observed, as one would
expect. However, the decreases in economic good times were much
less significant than the increases during the crisis. Finally, the pat-
tern for public investment is clearly pro-cyclical. At the same time,
the adjustments carried out by some countries during 2010 can be
already observed (returning to 2004 levels).

To complement this general view, we briefly describe the
country pattern for the main expenditure components.6 As in
Hauptmeier et al. (2011), for primary expenditures, we observe a
restrictive expenditure stance for Germany whereas all other coun-
tries show an expansionary policy stance over the 1999-2010
periods, notably as regards public consumption as well as transfers
and subsidies. However, the degree of expansion is different among
components. On the one hand, in the case of public consumption,
the magnitude of cumulative expansion ranged from near zero for

6 For the sake of brevity, related country-specific results are not included in the main
text. They are available from the authors upon request.

305


France to up to 5pp of GDP for Ireland. On the other hand, for
transfers and subsidies, Germany is highly restrictive by 2-3 pp,
and the rest is expansionary by 1-7pp depending on the rule and
country.

Finally, for public investment, the development of the cumula-
tive expenditure stance is quite interesting: restrictive for Germany
and Portugal, neutral for Italy and expansionary for all other coun-
tries with a tendency of neutralisation in 2010. However, overall
magnitudes are small.

In a second step, we repeat this same exercise component by
component, in order to decompose the cumulative deviation
observed. This analysis provides a view of the respective stance of
each expenditure component. The list of indicators included is in
line with those presented so far; i.e. (i) public consumption, (ii)
transfers and subsidies, (iii) public investment, and (iv) other
expenditures. Moreover, we split our sample period into sub-
periods to show the role of (i)-(iv) before (1999-2007) and during
the crisis (2008 – 2009, 2009-2010).

First, looking at the expenditures stance, Chart 3 presents the
decomposition of cumulative effects observed for ex-post and real-
time rules. When compared real-time and ex-post rules behaviour
both similarities and differences are found. While on the one hand
the dynamics are very similar, quantitative differences emerge
especially during sub-period (II), i.e. 2007-2009.

306


Chart 3: Decomposition of cumulative changes to public primary spending ratios
compared to a neutral expenditure stance for selected periods

(I) Real-time NPG rule. 1999-2007
%GDP

(II) Ex-post NPG rule. 1999-2007
%GDP

307


Chart 3. (cont.) Decomposition of cumulative changes to public primary spending
ratios compared to a neutral expenditure stance for selected periods
%GDP

%GDP

308


Chart 3. (cont.) Decomposition of cumulative changes to public primary spending
ratios compared to a neutral expenditure stance for selected periods
%GDP

%GDP

309


An alternative way to look at these figures is going through the
different sub-periods. First, deviations in the pre-crisis period are
clearly dominated by public consumption. Moreover, if we leave
out Germany as the only restrictive country over this period, two
different country patterns can be observed: major deviations from
trend as regards public consumption in Italy, Spain and Ireland
while Greece and Portugal show strongly expansionary trends in
transfers and subsidies. Second, deviations from trend in transfers
become relatively more important with the start of the financial
and economic crisis.

3.2. Determinants of the expenditure stance

An empirical analysis of factors that influence countries’ expen-
diture stances can provide further information on the determinants
of expansionary expenditure policies in the past. Hauptmeier et al.
(2011) therefore applied standard fixed-effects panel estimation
techniques on a sample of 12 euro area countries for the 2000-2009
period using the measure for the expenditure stance described
above, i.e. the (marginal) deviations of actual spending growth from
rule-based or neutral spending (under the NPG and the RPECB rule
in ex-post terms), as the dependent variable.

The aim of this empirical exercise was to explain the govern-
ments’ expenditure stance on the basis of fiscal and macroecono-
mic factors, relevant institutional characteristics as well as political

310


economy variables. The results of the analysis are presented in
Table 3.

As one would expect, the macroeconomic environment measu-
red by the output gap (in % of potential GDP) constitutes an
important determinant of the expenditure stance. We find robust
support for a positive correlation between the output gap and the
expenditure stance across rules and estimations, suggesting a pro-
cyclical spending behaviour.

As regards fiscal factors, surprisingly the level of public indeb-
tedness does not seem to significantly affect our measure of the
expenditure stance. We also do not find robust evidence for an
effect of revenue windfalls that arguably could increase spending
profligacy. We capture such windfalls by including the excess reve-
nue growth in a given year relative to previous year’s Autumn fore-
cast by the European Commission. However, while we see the
expected positive sign the effect is not significant.

We find empirical support for the importance of political eco-
nomy factors. In particular, parliamentary elections at the national
level (Electoral cycle 1) tend to significantly increase the deviation
of actual from rule-based primary spending. The opposite holds true
for a second election-related variable (Electoral cycle 2) which cap-
tures the years left in the current election term. The negative sign on
this variable suggests that the incentives for fiscal discipline can be
expected to be higher at the beginning of the legislative period. We

311


Table 3: Determinants of expenditure stance
Dependent variable: Deviation of primary spending growth from rule-based growth rate
Panel A: Ex-post Nominal Potential GDP (NPG) rule

(I) (II) (III) (IV) (V ) (VI) (VII)
Output gap (based on Potential GDP) 0,525 0,476 0,401 0,463 0,274 0,374 0,476
[3.78]*** [3.01]** [2.50]** [3.04]** [1.65] [2.22]* [3.00]**
Public debt ratio (t-1) 0,054 0,056 0,035 0,071 0,042 0,033 0,057
[0.96] [1.04] [0.62] [1.20] [0.83] [0.67] [1.03]
Crisis dummy 3,946 3,649 4,028 3,138 2,241 2,34 3,341
[2.17]* [1.74] [1.64] [1.75] [1.08] [1.13] [1.22]
Strenght of expenditure framework *
Output Gap -0,262 -0,262
[2.09]* [2.08]*
Surprises in Revenues growth 0,09
[0.46]
Surprises in revenues growth -0,08
[0.86]
Electoral cycle 1 2,204
[3.64]***
Electoral cycle 2 -0,812
[3.66]***
Government Stability -2,699
[3.26]***
EDP 0,308
[0.16]
Constant -2,941 -2,998 -1,47 -4,148 -0,006 -0,512 -3,079
[0.72] [0.77] [0.39] [0.97] [0.00] [0.13] [0.78]

Observations 108 108 108 108 90 90 108
Number of countries 12 12 12 12 10 10 12
R-squared 0,1 0,11 0,11 0,14 0,13 0,11 0,11
corr u_i and Xb -0,76 -0,76 -0,57 -0,79 -0,52 -0,47 -0,77
adjusted R-squared 0 0,01 -0,01 0,05 0,01 -0,02 0

R-squared overall model 0,02 0,02 0,05 0,03 0,07 0,06 0,02
R-squared within model 0,1 0,11 0,11 0,14 0,13 0,11 0,11
R-squared between model 0,56 0,53 0,58 0,57 0,49 0,38 0,53
standard deviation of epsilon_it 4,52 4,51 4,54 4,42 4,15 4,2 4,53
panel-level standard deviation 2 2,13 1,43 2,55 1,24 1,05 2,17
fraction of variance due to u_i 0,16 0,18 0,09 0,25 0,08 0,06 0,19

312


Table 3. (cont)
Panel B: Ex-Post Real Potential GDP +ECB price stability objective (RPECB) rule

(I) (II) (III) (IV) (V) (VI) (VII)

Output gap (based on Potential GDP) 0,469 0,429 0,299 0,419 0,277 0,377 0,429
[3.92]*** [2.74]** [2.39]** [3.20]*** [1.94]* [2.58]** [2.72]**
Public debt ratio (t-1) 0,057 0,059 0,031 0,071 0,053 0,044 0,058
[1.19] [1.33] [0.64] [1.40] [1.18] [0.98] [1.33]
Crisis dummy 2,882 2,634 3,267 2,223 1,685 1,793 2,654
[1.56] [1.26] [1.26] [1.22] [0.74] [0.78] [0.90]
Output Gap -0,219 -0,219
[1.75] [1.74]
Surprises in Revenues growth 0,172
[0.91]
Surprises in revenues growth -0,044
[0.59]
Electoral cycle 1 1,798
[3.40]***
Electoral cycle 2 -0,798
[4.17]***
Government Stability -2,544
[3.48]***
EDP -0,02
[0.01]
Constant -2,808 -2,855 -0,747 -3,792 -0,392 -0,879 -2,85
[0.75] [0.82] [0.22] [0.97] [0.10] [0.23] [0.83]

Observations 108 108 108 108 90 90 108
Number of countries 12 12 12 12 10 10 12
R-squared 0,08 0,09 0,09 0,11 0,14 0,11 0,09
corr u_i and Xb -0,82 -0,82 -0,55 -0,83 -0,61 -0,58 -0,82
adjusted R-squared -0,02 -0,02 -0,02 0,01 0,01 -0,01 -0,03
R-squared overall model 0,01 0,01 0,04 0,01 0,07 0,06 0,01
R-squared within model 0,08 0,09 0,09 0,11 0,14 0,11 0,09
R-squared between model 0,61 0,61 0,58 0,62 0,4 0,37 0,61
standard deviation of epsilon_it 4,34 4,34 4,35 4,28 4,09 4,15 4,36
panel-level standard deviation 2,04 2,16 1,24 2,49 1,36 1,18 2,16
fraction of variance due to u_i 0,18 0,2 0,07 0,25 0,1 0,07 0,2

Notes: Baseline (I), Baseline + Institutional framework (II and III), Baseline + electoral
cycle and government stability , (IV - VI) and Baseline + European Institutions(VII).
Source: Hauptmeier, S., Sánchez-Fuentes, A.J. & Schuknecht, L. (2011)

313


also control for government stability as measured by the respective
index of the World Bank and find that the policy stance on the spen-
ding side is less expansionary if a government scores a higher value.

Most interestingly from a policy perspective, our results suggest
that the country-specific institutional framework exerts a significant
effect on the expenditure stance. In particular, we control for the
extent to which national expenditure policy faces domestic institu-
tional constraints using the expenditure rules index as developed by
Debrun et al. (2008).7 We interact this index with the output gap to
analyse to what extent strong institutions reduce spending profli-
gacy and find that, indeed, the strength of the national institutional
framework on the expenditure side significantly reduces the pro-
cyclicality of the expenditure stance. This finding is along the lines
of Holm-Hadulla et al (2010), Turini (2008) and Wierts (2008). At the
same time, the EDP dummy which is included to capture whether a
country is facing an excessive deficit procedure (EDP) due to deficits
above the 3% of GDP reference value of the Stability and Growth
Pact, does not turn up significantly in our regressions.

The results on the impact of fiscal institutions may be put into
the perspective of the recent efforts to strengthen the European fis-
cal framework. One of the lessons from past fiscal developments in

7 For a definition and a detailed description of the computation of this index see
European Commission (2006) and Debrun et al. (2008). The index takes into account
the share of public spending covered by the rule and qualitative features such as the
type of enforcement mechanisms and media visibility.

314


euro area countries is that the implementation of the Stability and
Growth Pact has not been effective in delivering sound and sustai-
nable fiscal positions in Member States. While one has to be care-
ful when interpreting the non-significance of the effect of the EDP
procedure dummy, the result is in line with this perception.
Moreover, the empirical analysis suggests that national budgetary
rules if well-designed can help to effectively reduce spending pro-
fligacy and therefore serve as important tools to promote sound
and sustainable public finances in line with the European fiscal fra-
mework. This reinforces the need for enhancing national fiscal
rules and frameworks as had been proposed by the European
Commission in the autumn of 2010.

3.3. Implications for public debt

Based on the analysis presented in Section 3.1, it is possible to
compute to what extent deviations of expenditure growth from
trend led to increases in government debt. Chart 4 shows alterna-
tive debt paths for the sample economies and across expenditure
rules. Consistent with the previous results, real time rules typically
lead to higher debt paths than ex-post rules. In the case of France,
for example, following a neutral expenditure path since 2000
would have resulted in a significantly lower debt ratio in 2010, i.e.
between 70% and 75% of GDP. If Italy had followed a neutral spen-
ding path, public debt would now stand roughly between 80% and
100% of GDP in 2010, rather than at around 120% of GDP.

315


For a second group of countries (Spain, Greece, Ireland and
Portugal), the difference becomes even more drastic. Neutral spen-
ding policies in Portugal would have led to debt ratios of 40-60% of
GDP in 2010 rather than over 80% of GDP in reality. Spanish debt
would have been at a trough of 10-40% in 2007-08 and would have
remained well below the reference value in 2009 under all rules.
Ireland would have just about eliminated all its debt in good times
and thus created significant room for the subsequent rise. Under all
rules, debt would have remained below 60% of GDP in 2010.
Finally, Greek public debt would have fallen to 60-80% of GDP (rat-
her than remain broadly constant around 100% of GDP until the
start of the crisis) and increased much more slowly in the crisis.

All in all, public debt positions in the euro area would have
been much sounder at the start of the crisis and in 2010, if euro
area countries had pursued at least a neutral expenditure stance on
average during EMU. Public debt could have been well around or
below the reference value in the euro area in most of its members
by 2010 and nowhere above 100% of GDP.

4. Looking backward to the past, lessons for the future? an
episodes based approach

In an earlier study, Hauptmeier, Heipertz and Schuknecht
(2007) looked at the experience with public expenditure reform in
the 1980s and 1990s. They found that there were basically two

316


Chart 4: Public debt ratios - actual vs. rule-based
Euro area (12)

Germany

317


Chart 4: (cont.) Public debt ratios - actual vs. rule-based
France

Italy

318


Chart 4. (cont.) Public debt ratios - actual vs. rule-based
Spain

Greece

319


Chart 4: (cont.) Public debt ratios - actual vs. rule-based
Ireland

Portugal

320


reform waves in industrialised countries. Moreover, they found
that there were three groups of countries: (i) ambitious, (ii) timid
and (iii) non-reformers. Ambitious reformers were those that
managed to reduce public primary (non interest) expenditure by
more than 5pp of GDP from their peak within 7 years. Timid refor-
mers were those that cut primary spending between 0 and 5pp and
non-reformers never undertook much of a cut at all. These coun-
tries and country groups, the time and size of the maximum expen-
diture ratio and the change in the expenditure ratio within years
(T7) as reported in Hauptmeier et al. (2007) are depicted in Table 4.

The study argued that conceptually, reforms needed to be ambi-
tious in order to make a significant difference for the resulting
public deficits and adverse debt dynamics. The more ambitious they
were the more they would even allow tax cuts. Already in the 1980s,
Ireland, Belgium, the UK, Luxembourg and the Netherlands had sig-
nificantly reduced their public expenditure ratio. The UK, Ireland
and the Netherlands did so again in the 1990s plus a number of
other countries: Finland, Sweden, Canada and Spain. Four countries
reduced public primary expenditure by more than 10% of GDP.
During this period, 10 countries undertook timid expenditure
reforms (amongst them the US, France, Germany and Italy at which
we will look again later). The three non-reformers included
Australia, which had always maintained a rather small government
sector, and Portugal and Greece.

321


Table 4: Expenditure reform phases 1980s and 1990s

Max. primary expenditure Change maximum
in year to T7
Ambitious' reformers
Finland 1993 -14,0
Sweden 1993 -14,0
Ireland (Phase 1) 1982 -12,4
Belgium (Phase 1) 1983 -12,3
Canada 1992 -9,5
United Kingdom (Phase 1) 1981 -8,2
Netherlands (Phase 2) 1993 -7,5
United Kingdom (Phase 2) 1992 -7,2
Spain 1993 -6,4
Ireland (Phase 2) 1992 -6,2
Luxembourg 1981 -5,7
Netherlands (Phase 1) 1983 -5,1

Timid' reformers
Austria 1993 -4,3
Denmark 1993 -3,9
New Zealand 1985 -3,8
United States 1992 -3,4
Italy 1993 -3,0
Japan 1998 -2,7
Belgium (Phase 2) 1993 -2,1
Germany 1996 -0,6
France 1996 -0,5
Switzerland 1998 -0,3

Non' reformers
Portugal 2004 0,0
Greece 2000 0,4
Australia 1985 0,4

It is, however, not just the magnitude of spending and reform
that is important but also the composition. The literature (e.g.,
Alesina and Perotti, 1995 and 1997) argues that reductions in
public consumption/wages and transfers and subsidies are particu-
larly “high quality”. They increase the chance of success of reform
by providing a strong signal of “willingness” and cuts tend to focus
on unproductive expenditure.

322


Table 5 illustrates that much of the expenditure cuts of
ambitious reformers came from transfers and subsidies and also
from government consumption. About two-thirds of the reduc-
tion in the total expenditure ratio and over 80 per cent of the
decline in the primary expenditure ratio occurred in these two
categories. Nine out of 11 reform episodes reported a decline in
public consumption by more than 2 per cent of GDP and eight
out of 11 featured a fall in transfers and subsidies by over 3 per
cent of GDP. At the same time, in most cases, government
investment and public education expenditure did not decline
disproportionately or in some cases even increased as a share of
GDP. Timid reformers did not report much of a decrease in
public transfers and subsidies and focussed on public invest-
ment in some cases and on public consumption including edu-
cation in others.

The study by Hauptmeier et al. (2007) also argued that public
expenditure reform needed to be part of a comprehensive overall
structural reform strategy. It was argued on the basis of the litera-
ture that this would allow the improvement in public finances not
only via less spending but also via better growth prospects. An
overview of the reforms undertaken by ambitious countries is
reported in Table 6. Most of the ambitious reformers undertook
major reforms that were complementary to expenditure retrench-
ment. Most countries strengthened their national fiscal institu-
tions. This not only facilitated fiscal retrenchment but also tended

323

324
Table 5: Composition of expenditure reform

Transfers
Total Interest Primary Government Government
Change T0-T7 and Health Education Pensions
expenditure Spending expenditure consumption investment
Subsidies

Ambitious'
reformers
Finland -15,7 -1,6 -14,0 -3,8 -0,3 -9,4 -1,3 -1,8 -1,5

Sweden -15,7 -1,8 -14,0 -2,8 -0,9 -8,0 -0,4 0,2 -1,7

Ireland (Phase 1) -13,3 -1,0 -12,4 -5,2 -3,2 -2,2 -1,7 -0,9 -0,7

Belgium (Phase 1) -10,9 -4,8 -6,2 -3,9 1,0 -4,7 -0,5 -0,9 -1,6

Canada -11,4 -1,7 -9,5 -5,3 -0,5 -3,3 -1,1 -1,9 -0,2

United Kingdom (Phase 1) -10,5 -2,3 -8,2 -2,5 -0,3 -2,0 -0,3 -0,8 -0,5

Netherlands (Phase 2) -9,8 -2,3 -7,5 -1,9 0,1 -6,5 -0,8 -0,4 -1,2

United Kingdom (Phase 2) -7,1 0,1 -7,2 -2,7 -1,1 -2,6 -0,1 -0,8 -0,4

Spain -8,2 -1,8 -6,4 -1,5 -1,0 -4,1 -0,4 0,0 0,2

Ireland (Phase 2) -10,9 -4,8 -6,2 -3,9 1,0 -4,7 -0,5 -0,9 -1,6

Luxembourg -5,9 -0,4 -5,7 -1,4 -2,1 0,0 0,1 -1,6 -0,8

Netherlands (Phase 1) -5,0 0,2 -5,1 -2,0 -0,2 -2,2 -0,1 -1,1 0,4


to make future budgetary control and thus the avoidance of fiscal
problems more likely.8 A number of countries devalued their
currencies. All ambitious reformers initiated significant labour
market reforms that improved work incentives. All but one
country reformed the tax system. And most countries reduced the

Table 6: Summary findings for ambitious reform episodes

Expenditure reform Structural reform

Institutional Other macroeco- Labour
Public
Transfers & reform nomic reform market
consumption Taxation Privatisation
subsidies 1/ incenti-
1/
ves

Ireland 1 XX XX X X X X X
Ireland 2 X XX X X X X
Sweden X XX X X X X X
Canada XX XX X X X X
Finland XX XX X X X X X
Belgium XX XX X X
Netherlands 1 X X X X X X
Netherlands 2 ~ XX X X X X
Spain ~ XX X X X X
UK 1 X X X X X X X
UK 2 X X X X X

All 9 11 10 6 11 10 8

8 For the importance of fiscal rules and institutions, see, e.g., Poterba and Von Hagen
(1999). Debrun et al. (2008) and Holm-Hadulla et al (2011) focus on the numerical fis-
cal rules in EU countries.

325


role of the state in the economy via privatisation.
Based on the fact that the reforming countries fulfilled the con-
jectures of ambition, high quality and comprehensive reforms it is
not surprising that the impact on public finances and the economy
were quite positive, compared to timid reformers (Chart 5). Panel
a) shows that ambitious reformers (here differentiating early and
late reformers) brought the public expenditure ratio down signifi-
cantly to levels similar or lower than those of timid reformers. This
was mainly achieved through cuts in public consumption and
transfers and subsidies while public investment did not change
much, at least for late ambitious reformers (see panels b)-d)). Panel
e) illustrates that public deficits were brought down very substan-
tially by ambitious reformers. The group of late reformers even rea-
ched sizable surpluses. As regards public debt developments (panel
f)), timid reformers did not achieve any significant reversal in debt
dynamics. Ambitious reformers, by contrast, managed to bring
debt down once fiscal balances had been sound enough.

Contrary to the concerns of vocal special interests and politi-
cians, ambitious expenditure reforms had very little (if any) adver-
se growth impact even in the very short run while the medium to
long term impact was very positive. Ambitious reformers experien-
ced a significant increase in trend growth by 1-2 percentage points
(panel g). By contrast, timid reformers experienced no such incre-
ase. Real private consumption started to recover as of the first year
of public expenditure reduction and accelerated more strongly
where ambitious reforms were undertaken (panel g). Private invest-

326


Chart 5: Ambitious vs. timid reforms, 1980s and 1990s.
a) Total public expenditures

b) Public consumption

327


Chart 5: (cont.) Ambitious vs. timid reforms, 1980s and 1990s.
c) Transfers and subsidies

d) Public investment

328


e) Fiscal balance

f) Public debt

329


g) Trend growth

h) Real private consumption

330


i) Private investment

Source: Hauptmeier, S., Heipertz, M. & Schuknecht, L. (2007)

ment initially declined or was flat and showed a relatively less
favourable trend than for timid reformers but this reversed in the
medium term. In the seventh reform year, the private investment
ratio of timid reformers had increased by 1pp of GDP while that of
ambitious reformers had increased by 2-3pp (panel i).

In a next step we assess recent and projected fiscal develop-
ments for 2012 and 2013 in selected euro area countries as well as
the UK and the US in the light of the evidence from past expendi-
ture reform periods described above. We do this on the basis of the
latest European Commission forecast (Autumn 2011) (see Table 7).
For the US we consider the latest IMF World Economic Outlook

331


projections. For all sample countries, the projections point to sig-
nificant primary expenditure reductions for the period up to 2013
(with the exception of France). This ranges from about 3-4pp of
GDP for Germany, Italy and the US to over 5pp in the UK and
Spain and to 7 to 10pp in the EU/IMF programme countries.
Expenditure reductions show a more or less linear pattern in most
countries. In the case of the US, the primary expenditure ratio
went down quite strongly in 2010. However, it is expected to decli-
ne only by another 1pp of GDP over 2011-13.

Table 7: Expenditure plans

% of GDP Primary expenditure

Actual Forecast
2009 2010 2011 2012 2013 2013 to max(0910)

Programme countries
Greece 48,7 44,4 43,6 42,4 41,7 -6,9
Ireland 46,9 43,7 42,1 39,6 37,0 -9,9
Portugal 46,9 48,3 44,9 42,0 39,9 -8,4

Germany 45,4 45,4 43,3 43,2 42,8 -2,6
France 53,8 54,2 54,0 54,3 53,9 -0,3
Italy 47,1 45,9 44,8 43,8 43,0 -4,1
Spain 44,5 43,7 40,8 39,8 39,3 -5,2

United States 42,1 39,3 39,6 39,0 38,5 -3,7
UK 49,6 47,7 46,8 45,3 43,9 -5,6

Sources: Actual and forecasts: EU Commission (Ameco), IMF for the US.

332


If projected spending developments materialise, primary expen-
diture ratios would decline to around 40% of GDP in most coun-
tries. The main exception is France where the ratio would remain
significantly above 50%.

Projected spending developments should also be assessed from
a longer term perspective. When comparing the 2013 figures to the
1999 primary expenditure ratios it is noteworthy that spending
would still be 1-7pp of GDP higher in 2013 than in 1999 for 8 out
of 9 countries. This relative increase would be particularly sizeable
for Ireland, the US and the UK and appears unwarranted in view of
the expected ageing-related increases in social security outlays in
the medium and long-term. Only Germany would post a signifi-
cantly lower primary expenditure ratio than at the start of EMU.

Coming back to the adjustment effort in countries’ expenditure
plans, it is noteworthy that five countries (Ireland, Greece,
Portugal, Spain and the UK) would meet the criteria of ambitious
reformers as applied in the earlier study by Hauptmeier et al. (2007)
whereas a second group of countries could be classified as “timid”
reformers (Germany, USA, and Italy).

5.The need for prudent expenditure rules

The evidence presented in this study supports the view that
public spending has been a major determinant of unsound public

333


finance developments in the past. Looking forward, it therefore
seems plausible to address this fact through the implementation of
prudent expenditure rules. Indeed, empirical studies suggest that
well-designed expenditure rules tend to limit the pro-cyclicality of
public spending (see, e.g. Holm-Hadulla et al (2010)). Recent policy
action in Europe goes in this direction. Notably, the EU fiscal sur-
veillance framework has been extended by a so called “expenditu-
re benchmark” which restricts the growth rate of public spending
net of discretionary tax measures to that of potential growth.
However, this new rule does not take into account some of the pro-
blems we identified in Section 3.1. Most notably, an effective rule-
based restriction of spending policies in real-time requires the
maintenance of a margin of prudence. This is necessary to account
for the tendency of overestimating potential GDP growth in real-
time. Given the past experience of systematic and persistent down-
ward revisions in potential growth, a margin of prudence of ½ pp
in expenditure growth per annum appears warranted. In addition,
excessive price developments should not automatically feed into
higher expenditure growth as expansionary fiscal policies may
accelerate an economic overheating. Therefore, the nominal com-
ponent of an effective expenditure growth rule should be capped,
e.g. at the ECB’s price stability objective (“close to but below 2%”).

Chart 6 shows that the application of such prudent expenditu-
re growth rules during EMU would have resulted in much safer fis-
cal positions. Primary expenditure ratios would have reached
much lower levels in 2009. As a result, also public debt ratios in

334


Chart 6: Actual ratios versus neutral expenditure policies-based ratios (based on
NPG – ½ pp and RPECB – ½ pp rules), 2009
Panel A: Primary expenditure ratios

Panel B: Public Debt ratios

Note: Includes GDP multiplier and compound interest effects.

335


2009 would have generally been much closer to 60% of GDP with
the highest ratio of around 90% in Italy. It is important to note,
however, that the proposed expenditure rules are intended to pro-
vide guidance for an appropriate, i.e. neutral, policy stance in the
absence of fiscal imbalances. Any fiscal adjustment, e.g. to regain
sound fiscal positions in the aftermath of the crisis, would of cour-
se require a restrictive policy stance, i.e. spending growth rates
below potential GDP growth.

6. Concluding remarks

What are the main findings of this study and what policy lessons
can be drawn? Public finances in advanced economies are at a cross-
roads. In the fifth year of the crisis, fiscal deficits remain high and
public debt has reached unprecedented peace-time levels in most
industrialised countries. Public primary expenditure stands at or
near historical peaks in many countries and therefore constitutes an
important determinant of the fiscal imbalances. It therefore seems
straight forward to focus on expenditure restraint when striving to
regain sound fiscal positions in the aftermath of the crisis.

In the 1980s and 1990s a number of countries undertook ambi-
tious expenditure reforms. Their experience, which was briefly
reviewed here, has been very positive. Within a few years from the
start of expenditure reform, public expenditure ratios went down
significantly, fiscal deficits largely or fully disappeared, public debt

336


was brought on a downward path, and economic growth and pri-
vate consumption resumed swiftly. We argue that this was because
ambitious expenditure reform was conducted in a growth-friendly
manner as part of comprehensive adjustment programmes.

Our study emphasises the key role of expenditure policies in
explaining fiscal developments during EMU in the euro area. It finds
that, almost all euro area countries (with the notable exception of
Germany) applied expansionary expenditure policies already before
the crisis. This resulted in much higher expenditure and debt paths
compared to a counterfactual neutral expenditure stance. Rules-
based spending policies could have led to much safer fiscal positions
much more in line with the EU’s Stability and Growth Pact (SGP).

The policy recommendations from these findings are obvious:
countries should focus on reducing public spending in the context
of ambitious reform programmes. Spending based consolidation
efforts need to be complemented by structural reforms, notably
with a view to removing rigidities in national labour and product
markets, to reduce macroeconomic imbalances, improve competi-
tiveness and support potential growth. This will be particularly
important for the vulnerable countries in the euro area which do
not have available the exchange rate mechanism to improve exter-
nal competitiveness. Latest projections suggest that governments’
consolidation plans in a number of countries indeed put a focus on
reducing government expenditure as a ratio to GDP in the coming
years. However, the benefits of reforms are only going to materia-

337


lise under one condition, namely that all these plans are fully and
adequately implemented. This is their main challenge.

In addition, the empirical evidence on the determinants of euro
area countries’ expenditure stance provide a number of policy
implications. First, strong national budgetary institutions seem to
limit expansionary spending biases. Second, the European institu-
tional framework needs to feature prominently expenditure moni-
toring and control. The incorporation of an expenditure bench-
mark in the preventive arm of the Stability and Growth Pact in the
context of the recent “Six-Pack” reform therefore constitutes a step
in the right direction. An effective enforcement of this rule should
help to limit overly expansionary spending policies in the future.

Furthermore, this chapter argues that a potential growth rule
with an extra ½ percentage point deduction from the resulting
annual expenditure growth targets would be a sufficiently prudent
and, thus, advisable expenditure rule for euro area countries. As
economic (e.g., population aging) and political economy reasons
suggest that overestimating potential growth could also occur in
the future, such a rule could provide a reasonably prudent bench-
mark for a neutral expenditure stance looking forward.

How does the debate on the overhaul of European economic gover-
nance fare against these conclusions? At the time of completing this
study (March 2012), EU member states have set up new EU economic
governance principles with a view to ensuring a tighter and more

338


effective surveillance of economic and fiscal policies at the European
level. At the same time, policy makers have agreed - in the context of
the new fiscal pact - to strengthen national fiscal frameworks.

All in all, a stringent implementation and enforcement of the
fiscal surveillance at European level could well ensure the necessary
break with past expenditure trends and thus also secure sustainable
deficits and debt dynamics in the future. However, it remains to be
seen whether the main obstacle of the “old framework”—lack of
incentives and enforcement—is really sufficiently remedied.

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