Economic Integration - ECB MP and Fiscal Policy Coordination

How well did the European Central Bank’s Monetary Policy Perform?

• Supporters

• Critics

  • How it couldve been prevented

• Good - kept inflation stable and clsoe to target level, reputation of competence but caution

• Critics (e.g. de Grauwe) ECB failed to control growth of bank credit and price bubbles.

  • Property Bubbles as credit too cheap, Banks offered risky mortagaes, banks had a lot of money to lend

  • Could differentiated banks reserves to maintain.

• One size fits all: Economic conditions between countries varied, with MU would set diff IR.

• What is the Taylor Rule

• Example of how this shoudlve been used (but wasn’t)

• Taylor Rule: formula to find out optimal IR based on macroecon data.

  • Desired interest rate as a function of: Weighted output gap | Weighted inflation deviation | Target inflation rate | Long-term interest rate.

• 2002 Germany desired IR was 2.75%, Ireland’s was 7.5% (Irealands economy was overheating). Actual rate was 3.25% until December.

What caused the 2008 Recession?

• 2007 - failings in world financial systems - US subprime mortgages defaults and securitised loans spread across continents.

• Dec 2007 - US Recession

• Sep 2008 - Lehman Bank failure, fears of total collapse of banking system.

What were the immediate impacts of the 2008 recession.

• Demand fell quick, unsold stocks increased.

• Output down 4% 2009, Unemployment rose 7.2 → 10%, mid 2009 deflation.

How did the ECB respond to the Crisis and Aftermath.

List 4 ways explain 2.

• Cut IR - Trichet cut 4.75% to 1%, Draghi more cuts Nov 2011 onwards 0.05%.

  • June 2014 - standing overnight IR negative to increase bank lending.

  • Cut banks’ reserve ratios.

• Boost banks’ liquidity - inter-bank lending dried up due to fears of bank solvencies, 2001 weekly tenders, fixed 1% IR unlimited amout.

  • Draghi 3 year refinancing - 1 tril, euro at 0.75%.

  • Draghi accepted lower grade bonds as collateral (as long as banks have collateral they can access liquidity)

• Bought weak gov. bonds.

• New European Systemic Risk Board: Dec 2010 ‘macro-prudential oversight’ monitoring risks and advising actions. Prevent another crisis. Independent but no binding power.

How did buying weak gov. bonds (SMP) help the ECB after the recession.

• Worries about nation solvency / eurozone breakup after 2008 caused some national bond prices to fall (and rise in those countires longer term interest rates), this undermined a single monetary policy (e.g. Spanish firsm borrowing at a higher IR than German)

• Trichet ‘Securities Marketing Programme’

• ECB and nation CBs buy problem bonds from com. banks (steralise the effect on mone supply) but didnt work: interest gaps continued to widen.

What is the ‘Outright Monetary Transactions’

How it worked

ECB refrained from QE. Strongly opposed in GER - mutalisation of debt.

2012 Draghi do whatever it takes to save Euro. → OMT annoucned:

• OMT - buy government debt in secondary markets, massive firepower. (Never actually implimented)

IR on SPA/ITA bonds fell sharply. BUT Eurozone crisis continued - stagflation and Inflation rates falling below target.

Arguements for fiscal policy rules in an MU

• National borrowing on capital marktets increases interest rates for all. Increases cost to other countries of servicing their gov.debt.

• Borrowers might but pressure on ECB to lower interest rates.

• Conserns over consequences if a country were to default (gov cant fund interest on nation debt).

  • Maastricht Treaty includes a ‘no-bail-out’ clause - others no required to help. Unrealistic though as gov bonds are widely held in the EZ - default would damage the whole financial system

    • Hence aid to Greece, Ireland, Portugal.

Arguments against fiscal policy rules in a MU

• Economies in MU may differ so need national control of tax (can’t use MP)

  • BUT could be differentated but co-ordinated across the MU

• Capital markets will attach risk premium on lending to debt-burden country = curbs excess borrowing and risk.

  • BUT premium will be lower if markets believe others will bail them out.

How were national budget deficits controlled before and after crisis.

Before: Stability and Growth Pact: agreed 1997 pre-MU. SGP reformed 2005

After: Six-pack plan 2011: Medium term budgetary balance and Current budgetary balance.

What did the SGP involve before crisis

SGP - Stability and Growth Pact

• A) Medium term budgetary balance (preventative arm - meant difference between gov spending and income) aimed to eliminate budget deficit over the years, in a downturn fiscal pol. could be eased without a crisis.

  • Most EU countries failed pre 2007.

• B) Excessive deficit procedure (EDP), in excess if > 3% GDP. Monitored by a commission which proposed actions to the council. If council agreed the deficit was excesive country had 10 months the act (e.g. cut by 0.5%/year) if not sanctions.

What happened to / within the SGP pre-crisis (2003, 2005, 2006)

2003 - Crisis, small countries made to take action (Portugal) but big countries refuse and say EDP rules too strict (France)

2005 - reform - made SGP more flexible and added Merdium Term Objective for budget balance.

2006 - widespread deficits: 12 more countries subject to EDP.

How did the Crisis impact Gov finances and why

Why?

• Massive increase in spending to try offset recession | Cost of rescuing banks.

By 2010 -

• budget deteriorated by 5% points.

• Budget deficits averaged 6%

2012

• 23/27 countries subject to EDP - had to suspend SGP requirments.

How did the EU control national budget deficits post-crisis

• Six pack

• European Semester

• Fiscal Compact (TReaty)

What was the six pact policy

2nd reform of the SGP - correct inability to prevent build-upp of fiscal imbalances.

• Enforcment of rules stricter. ‘Reverse Qualified Majority’ new voting system for sanctions - Commision proposals adopoted unless majoirty of Council votes against them.

• Extra EDP - if debt >60% GDP, reduce by 5%/year for 3 years.

• Stricter fiscal rules - ‘expenditure benchmark’ defined - cap on annual growth of public expenditure accoriding the a medium-term rate of growth.

• More reporting requirments,

What is the European Semester 2011

Coordination and Surveillance.

Jan-July national policies reviewed before enacted.

• Structural Reforms: MS present SR as part of National Reform Programes.

• Budgetary Surveillance: national Stabilit and Convergence Programmes in framework of strengthened SGP, member state submit detailed budget plans.

• Macro-Econ imbalances surveillance

Rigorous enforcment via interest-bearing fines.

What was the 2013 'Fiscal Compact’

• A) Treaty Obligation: balanced budget rule for medium term: budget deficit must not exceed 0.5% GDP (1% if total debt below 60% GDP)

  • Auto sancations of 0.1% GDP (need a qualified majority in council to reject)

• National debt >60% GDP must be cut by 1/20th of excess yearly. Applies to all Eurozone members.