The European Union and the global

financial crisis

Professor Nigel Healey

Pro-Vice-Chancellor (International)
Nottingham Trent University

10 July 2014
Southwestern University of Finance and Economics

Overview
What is the European Union?
What is the Eurozone? Whos in the Eurozone?
The institutional design of the Eurozone: guaranteed to
avoid inflation and printing money?
The performance of Eurozone 1999-2014
The global financial crisis
Moral hazard, bail-outs and monetisation of debt
The outlook for the Eurozone

What is the European Union?

European Union: a political and
economic union of 28 European states
Population: 0.5bn (China: 1.4bn)
Land mass: 4.4m km2 (China: 9.6m
km2)
Gross domestic product: US$18.4tr
(China: $10.0tr)*
GDP per capita: $36,393 (China:
$7,333)*
GDP per capita (PPP): $33,084
(China: $10.695)*

* IMF World Economic Outlook Database, April 2014

What is the Eurozone?

18 countries within the European Union
which share:
European Central Bank
A common currency (the euro)
Common monetary policy and short-term
interest rates

Mario Draghi, ECB

President
1November 2011 31
October 2019
4

ECB building (Eurotower),

Frankfurt

Whos in the Eurozone?

France, Germany, Italy, Belgium, Luxembourg, Netherlands, Ireland,
Spain, Portugal, Austria, Finland: January 1999
Greece: January 2001
Slovenia: January 2007
Cyprus and Malta: January 2008
Slovakia: January 2009
Estonia: January 2011
Latvia: January 2014
= 18 members at July 2014

Objectives of the European Central Bank (1)

The Maastricht Treatys Art. 105.1:
The primary objective of the ECB shall be to maintain price
stability. Without prejudice to the objective of price stability, the
ECB shall support the general economic policies in the Community
with a view to contributing to the achievement of the objectives of
the Community as laid down in Article 2.

Article 2:
The objectives of European Union are a high level of employment
and sustainable and non-inflationary growth.

So:
fighting inflation is the absolute priority
supporting growth and employment comes next

Objectives (2)
Making the inflation objective operational: does the ECB have
a target?
It has a definition of price stability:
The ECB has defined price stability as a year-on-year increase in
the Harmonised Index of Consumer Prices (HICP) for the euro area
of below 2%.

and it has an aim:

In the pursuit of price stability, the ECB aims at maintaining
inflation rates below, but close to, 2% over the medium term.

Central bank independence

Current conventional wisdom is that to
ensure price stability, central banks
should be independent:
most governments cannot resist the
printing press temptation
the Bundesbank set the pre-Eurozone
example

ECB set up to be independent of

national and EU government
What does independence mean?

Independence
Politically independent

Article 7: Independence
neither the ECB, nor a national central bank, nor any member of
their decision-making bodies shall seek or take instructions from
Community institutions or bodies, from any government of a
Member State or from any other body
Article 21: Operations with public entities
overdrafts or any other type of credit facility with the ECB or with
the national central banks in favour of Community institutions or
bodies, central governments, regional, local or other public
authorities, other bodies governed by public law, or public
undertakings of Member States shall be prohibited, as shall the
purchase directly from them by the ECB or national central banks of
debt instruments
Financially independent
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Fiscal complications in a monetary union

In a monetary union, fiscal policy

the only macroeconomic instrument left at national level
government borrows in recession and pays back in good times
government acts as a buffer in case of a negative shock

Automatic stabilisers:
tax receipts decline when the economy slows down
welfare spending rises when the economy slows down
rule of thumb: deficit worsens by 0.5% of GDP when GDP
growth declines by 1%

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But there are fiscal policy externalities

Borrowing cost externalities:
Country Xs deficit would boost growth in country X
But raise interest rate for everyone with wider negative longterm growth effects

Most serious is the risk of default in one member country:

Loss of confidence in other Eurozone members
Pressure on other governments to help out
..and on the ECB to monetise debt

Alert:moral
hazard!
The no monetisation / no-bailout clauses in Maastricht
Treaty

Answer to address risk:

Prevention procedure

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Maastricht Treaty
1.2. Monitoring of budgetary discipline
The Treaty prohibits the direct financing of public entities
deficits by national central banks (Art. 101), be it overdraft
facilities, other types of credit facility or the purchase of debt
instruments, except for the purpose of monetary policy. The
Treaty also prohibits public entities' privileged access to
financial institutions (Art. 102).
Moreover, the no bail-out clause in Article 103 stipulates
explicitly that neither the Community nor any Member State
is liable for or can assume the commitments of any other
Member State.

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Prevention procedure: pre-GFC attempts to

control government deficits and debt
The Stability and Growth Pact (SGP)
The SGP made permanent the 3% GDP deficit and 60%
GDP ceilings
SGP reformulated in 2005 to make it more flexible:
negative growth may be exceptional
take account of all relevant factors
no specific definition

Fines are automatic if approved

Funds withheld from EU payments to member
state

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The record of EMU so far..

A difficult birth and early teenage years:
an oil shock in 2000 and again in 2007
a worldwide slowdown in early 2000s
September 11, 2001
the stock market crash in 2002
Afghanistan, Iraq wars
the weak US dollar
the 2008 global financial crisis
the European (Eurozone) sovereign debt crisis
Bailouts and austerity

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Sources of Eurozone data

15

Source: http://sdw.ecb.europa.eu/home.do?chart=t1.6

Inflation: missing the objective, a little until

2008 commodity boom, 2008-14 financial crisis

Inflation
target

16

Source: European Central Bank

The performance of the euro against US$

17

Source: European Central Bank

Global financial crisis: the early days

The European Central Bank's main task is to keep inflation down.
But over the past month, it has thrown caution to the wind in trying
to prevent Europe's financial system and integrated economy from
falling apart.
The ECB has transformed itself into a crisis manager of the sort that
its architects could hardly have imagined when the bank took up its
work 10 years ago. The bank, charged with managing the euro, was
given a single mandate - to keep prices under control.
Lately, however, the central bank has cast aside worries about
inflation, cutting interest rates once already, with more cuts in the
pipeline. At the same time, it is lending ever more cash to
strapped banks.
International Herald Tribune
October 16, 2008

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Early stages of the recession

Eurozone entered recession in 2008Q3
European Council agreed package to avert financial meltdown
in October 2008
National governments (not ECB) would bail out commercial
banks: ie, buy shares to recapitalise them
ECB would reduce interest rates and inject liquidity into
banking system

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Eurozone short-term interest rate

20

Source: European Central Bank

GDP growth (% change year-to-year)

doubledip

21

Source: European Central Bank

GDP (2005 = 100)

Peak
GDP

22

Eurozone unemployment rate

23

Source: European Central Bank

Government debt in the Eurozone

Eurozone governments are effectively borrowing in foreign
currency
They cannot borrow from their own central banks,
monetise the debt and inflate away their debts (like US
and UK)
Financial markets demand ever-higher risk premium from
indebted governments
This increases debt service costs,
the deficit and so the need to
borrow more and eventually the
government will default

24

Source: European Central Bank

Eurozone government budget balance (% GDP)

SGP
Limit

25

Source: European Central Bank

Eurozone government debt (% GDP)

Never achieved
SPG ceiling

26

Source: European Central Bank

Government debt in key Eurozone countries

27

Deficits and debt

28

Source: Eurostat

From financial crisis to sovereign debt crisis

From 2010, growing concern about sovereign debt levels in Greece,
Spain, Ireland, Portugal and Italy
Bond yield differentials between this group and France and Germany
widened
March 2010, European Council agreed on a bailout mechanism for
Greece
Other countries could apply if needed
Widely believed bailout violates Maastricht Treaty the no bail-out
clause in Article 103 stipulates explicitly that neither the Community
nor any Member State is liable for or can assume the commitments
of any other Member State

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National long-term interest rates

30

Source: European Central Bank

The bailouts
In April 2010, bailout mechanism used - 30bn lent to Greece
In May 2010, EU established a larger fund of 750bn
440bn from eurozone states
60 billion from European Commission
250 billion from the IMF

European Stability Mechanism, agreed in December 2010:

issues debt on capital markets, backed by guarantees from the
eurozone states
lends to indebted eurozone governments once recovery plan (ie,
austerity) agreed
Combined with a monitoring body

31

Greece welcomes EU recovery plan

32

ECB bond purchases

The Treaty prohibits the direct financing of public entities
deficits by the purchase of debt instruments, except for the
purpose of monetary policy
From mid-2011, ECB forced to buy the bonds of weak
governments, especially Italy and Spain, to stop spirally bond
yield differentials
Could be seen as stabilising the market if yield differentials
fall back
but can be seen as monetising debt of weak governments

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ECB market stabilisation operations

34

Source: European Central Bank

Is the medicine working?

The ECB "...is ready to do whatever it takes to preserve the
Euro. And believe me, it will be enough Mario Draghi, July
2012
A combination of the bailouts and the bond purchases have
sent a strong signal to the markets that the EU is committed
to defending the Eurozone
EU has given bail-outs to five Eurozone members (G, IRL, P,
E, I) loans conditional on budget cuts
Long-term interest rates are coming down
But indebted states still have poor credit ratings and face
many years of austerity and political unrest

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A vote of confidence in the Eurozone from the

financial markets

36

Source: European Central Bank

Conclusions
The ECB set up with primary objective of price stability and
independent of national and EU governments it may not directly
monetise debt
In EMU, national fiscal policy is the only macroeconomic policy
tool to adjust to negative shocks
But there are important external effects of budget deficits - EU
has failed to effectively enforce controls on national fiscal policy
Between 2010-12, EMU was at risk of being destabilised by
sovereign default but countries in crisis small and the EU has
acted decisively
Some argue Maastricht Treaty has been breached and ECB has
increased future risk of moral hazard but deficit countries are
paying a high price for past overspending

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