Lorenzo Codogno LC Macro Advisors Ltd Founder and Chief Economist +44 758 3564410 lorenzo.codogno@lc-ma.com Visiting Professor in Practice at the London School of Economics l.codogno@lse.ac.uk Some reflections on governance and financial stability in the Eurozone Presentation at the Bank of Portugal Lisbon, 14 May 2019
GOVERNANCE AND FINANCIAL STABILITY IN THE EUROZONE Agenda (Eurozone focus, but equally valid for the EU) Eurozone at 20 : from crisis to crisis, amid growing divergence. A failure of governance? The fiscal framework and the policy mix. A failure of governance? Macro-economic imbalances. Financial stability issues: Risk sharing, mutualisation, fiscal capacity and safe bonds. The doom loop between the sovereign and the banks: Italy. A flows of fund approach to sustainability: The Italian case. Conclusions. 2
FROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE EU moving from crisis to crisis 2008/09 - The first leg of the crisis, i.e. global contagion and GDP collapse: Sharp drop in export and investment activity, markets turmoil. Economy in free fall until mid-2009. 2010/11 - The second leg, i.e. Greece + banking/debt crisis in Europe : Increase in public debt, widening in government bond spreads, interbank market closure, frantic policy reaction. 2011/12 - The third leg, i.e. Italy: Sharp widening of yield spreads, credit crunch. Eventually, accommodative monetary policy + softer fiscal policy, but also debt overhang and fallouts of the balance sheet recession. 2015 - The fourth leg: Greece again. 2018/19 - A fifth leg: Italy again?
FROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE Many shocks at once left political scars, i.e. lack of trust Initial exogenous shock: The trigger was the subprime crisis in the US, hitting through trade and financial markets contagion. Macroeconomic imbalances: Typical emerging market crisis, just within the Eurozone. Sudden stop of financial flows core/periphery. Banking crisis : Dis-integration and fragmentation in financial markets; re-nationalisation of the banking industry. Public debt crisis: Existing weaknesses come to the fore. A monetary/fiscal policy response failure: Political/legal constraints, mistakes and delays, lack of interpretation model. Above all, a governance failure? Political/institutional constraints.
FROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE GDP growth per capita: Divergence since EMU 5
FROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE GDP levels per capita: Divergence since EMU 6
FROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE Italy: Two lost decades, and still a 5% gap relative to 2008 7
FROM CRISIS TO CRISIS, AMID GROWING DIVERGENCE Labour market performances: Big divergence as well 8
A FAILURE OF GOVERNANCE? Governance measures taken since 2010 The European Stability Mechanism: Permanent crisis mechanism tool. Banking Union: Single Supervisory Mechanism (SSM), Single Resolution Mechanism (SRM) and Single Resolution Fund (SRF) and the bail-in rules of the BRRD framework. Yet to be completed. Macroeconomic Imbalance Procedure (MIP): Detection and correction of macroeconomic vulnerabilities and a way to enforce reform implementation. Reform of the Stability and Growth Pact and Fiscal Compact: Reinforced fiscal framework, monitoring of expenditure developments, numerical debt benchmark, reverse qualified majority voting. But how can governance cope with increasingly differing economic performance ? 9
A FAILURE OF GOVERNANCE? The ECB view: Draghi’s speech in Helsinki, 27 Nov 2014 MSs “have to be better off inside than they would be outside.” “The euro is – and has to be – irrevocable in all member states, not just because the Treaties say so, but because without this there cannot be a truly single money ” ( fungibility of money, redenomination risk). In the absence of permanent fiscal transfers among MSs: (1) all EA countries need to be able to thrive independently , (2) EA countries need to invest more in other mechanisms to share the cost of shocks , “ensuring that the conditions are in place so that all countries can retain full use of national fiscal policy as a counter-cyclical buffer .” 10
A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX IMF (2014): Fiscal rules are too complex and inconsistent Reforms of the SGP “have made the system increasingly complicated, creating risks of overlap and inconsistency between rules, as well as difficulties in public communication. […] Staff advised examining the complexity of the framework over the medium term, and looking into the possibility of reducing the number of rules.” “The SGP may limit the space to finance structural reforms that entail sizeable short- term budgetary costs”. “A second question is whether the MTO and, to a lesser extent, the 3 percent deficit cap, discourages public investment by limiting the capacity to borrow to fund projects that increase long- term growth potential.” 11
A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX Fiscal governance: Recent improvements/still-open issues Structural balances: Well-identified drawbacks mainly due to potential output and output gap measurement, volatility and deep revisions (levels, but not much about changes). Alternatives? Pro-cyclicality: Fiscal policy has turned pro-cyclical no matter the “true” level of the output gap. Are rules really working? Flexibility for reforms: Structural reforms increase potential growth and thus lower the structural part of the deficit , often imply either near-term recessionary effects or need to compensate losers. Public investments: Some flexibility for EU co-financed projects; need to incentivise investment by proper fiscal space. Bottom line: There are drawbacks, but it is not fair to argue that the framework is wrong. The problem is proper implementation . 12
A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX Is fiscal governance based on the output gap a problem? 13
A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX Fiscal rules are just part of the story Many other institutional features help strengthening the fiscal framework. Legislated broad principles that guide the formulation of fiscal policies. Effective budget mechanisms and procedures designed to minimise deficit biases. Strong transparency requirements and public oversight. The operation of independent fiscal agencies tasked with the monitoring and assessment of fiscal developments. Last but not least, politics …
A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX Fiscal policy: The Great Recession led to a change of views Before the crisis: Fiscal policy not appropriate for economic stabilisation , no significant effect on output, long time lags , risks of pro-cyclicality , challenging to rein the extra spending back when the cycle turned expansionary. Monetary policy is a more flexible and effective tool for stabilisation. Zero-lower-bound: Few now question the appropriateness of massive fiscal stimulus to rescue banks, companies and people in 2008-09. After 2008-09 : Can ‘austerity’ or ‘fiscal discipline’ (budgetary policies aimed to reduce the deficit, or increase the surplus, on a structural basis) be counterproductive or self-defeating ? Can expansionary policies be self-financing ? 15
A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX Now only mildly accommodative Eurozone fiscal policy 16
A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX Fiscal policy constraints: Would the ECB come to the rescue? Issuer’s limits: For the reactivation of the APP the ECB would need to first announce some loosening of the issuer limits. Feasable? Tiering system: Mitigating the costs for banks would likely be a precondition to further extend forward guidance and any lowering of the deposit rate. Would it produce further fragmentation? T-LTRO III rates decision: It will depend on the state of the economy in June. Rates will likely be closer to the deposit rate, although linked to the MRO. Changes in the Governing Council: Implementation risk for any accommodative measure. 17
A FAILURE OF GOVERNANCE? THE FISCAL FRAMEWORK AND THE POLICY MIX Lessons from the past China 1997-98: PBoC bought impaired assets and accelerated debt- for-equity swaps to clean the balance sheets of the commercial banks and restore their lending capacity (+Malaysia). No moral hazard. The economy stayed on the banks’ balance sheets, and grew. US 2008: Troubled Asset Relief (TARP): $426.4bn invested. The Treasury bought Preference Shares – bought franchise future, not legacy losses (+AIG bailout $182bn). GSEs (Fannie Mae, Freddie Mac) nationalised in 2008. Shares delisted in June 2010. By August 2012 they had drawn $190bn in aid. TARP closed in 2014, $14.3bn profit. AIG closed in 2012: $25.5bn profit. GSEs: profit $80.9bn (2017). 15% return. 2008 UK: Lloyds and RBS. More mixed results. 18
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