The turbulent adolescence of the euro and its path tomaturity by Gonzalo García Andrés

/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.

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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.

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The Future of the Euro

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

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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.

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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.

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• 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

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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.

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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

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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.

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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.

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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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