Institutions for EMU Economic Governance Francesco Saraceno
OFCE-Research Center in Economics of Sciences Po Luiss School of European Political Economy Jakarta School of Government and Public Policy
Where were we? The Eurozone
19/09/2016
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Outline
•The Maastricht Treaty
•Macroeconomic Governance §Monetary Policy -
The Eurosystem Objectives Instruments The Two Pillar Strategy International Comparison Issues
§Fiscal Policy
- What is Fiscal Policy - The role of Fiscal Policy - Some Definitions - Fiscal Policy in the EMU: The Stability and Growth Pact - From Maastricht to the reform of 2005 - The rationale for a fiscal rule - The debate on the SGP http://fsaraceno.wordpress.com 19/09/2016 @fsaraceno
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The Long Road to Maastricht and the Euro
2015: Lithuania
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The Maastricht Treaty (1992)
•A firm commitment to launch the single currency by January 1999 at the latest. •A list of five criteria for admission to the monetary union. •A precise specification of central banking institutions.
•Additional conditions added later on (e.g. the excessive deficit procedure).
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The Maastricht Convergence Criteria •Inflation:
not to exceed by more than 1.5 per cent the average of the three lowest inflation rates among EU countries.
•Long-term interest rate:
not to exceed by more than 2 per cent the average interest rate in the three lowest inflation countries.
•ERM membership:
at least two years in ERM without being forced to devalue.
•Budget deficit:
deficit less than 3 per cent of GDP
•Public debt:
debt less than 60 per cent of GDP
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Convergence Criteria: Inflation
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Convergence Criteria: Interest rates and ERM •Long-Term Interest Rate:
§Necessity to guarantee an uniform investment environment §Easy to bring inflation down in 1997 and then let go again. Long term rates embed future inflation expectation
•ERM Membership: need to convince the exchange markets and to anchor exchange rates before fixing the parity.
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Convergence Criteria: Budget Deficit and Debt •Historically, all big inflation episodes born out of runaway public deficits and debts.
•Hence requirement that house is put in order before admission. •Problems:
§A few years of budgetary discipline do not guarantee long-term discipline §Artificial/arbitrary ceilings § Controls were not particularly effective (just one exemple: Grece, twice!)
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Debt and Deficit in 1998
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Macroeconomic Governance: Monetary Policy
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A Tour of the Acronyms
•N countries with N National Central Banks (NCBs) that continue operating but with no monetary policy function.
•A new central bank at the centre: the European Central Bank (ECB). •The European System of Central Banks (ESCB): the ECB and all EU NCBs (N=28). •The Eurosystem: the ECB and the NCBs of euro area member countries (N=19).
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The System
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How Does the Eurosystem Operate? •Objectives: What is it trying to achieve?
•Instruments: What are the means available?
•Strategy: How is the system formulating its actions?
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Objectives
•The Maastricht Treaty’s Art. 105.1:
‘The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community […].’
•Article 2. The objectives of European Union are a high level of employment and sustainable and non-inflationary growth.
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Objectives
•Does the Eurosystem have a target?
“In the pursuit of price stability, the ECB aims at maintaining inflation rates below, but close to, 2% over the medium term.” Peculiarities:
•Decided by the Governing Council •Leaves room for interpretation: § where below 2 per cent? § what is the medium term?
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Instruments
•What are the channels of monetary policy? §long run interest rates §credit §asset prices §exchange rate.
•These are all beyond central bank control.
•Instead it can control the very short-term interest rate: European Over Night Index Average (EONIA).
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Instruments
•The Eurosystem controls EONIA by establishing a ceiling, a floor and steering the market in-between.
•The floor: the rate at which the Eurosystem accepts deposits (the deposit facility - REPO).
•The ceiling: the rate at which the Eurosystem stands ready to lend to banks (the marginal lending facility). •In-between: weekly auctions (main refinancing facility).
•Besides technicalities, what is important is that the ECB only directly affects interbank rates
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The Two-Pillar Strategy
•The Eurosystem’s interest rate decisions (every month) rest on two pillars. •Economic analysis:
§broad review of economic conditions: growth, employment, exchange rates.
•Monetary analysis:
§evolution of monetary aggregates (M3, etc.).
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Comparison With Other Strategies •The US Fed:
§legally required to achieve both price stability and a high level of employment §does not articulate an explicit strategy (this changed later with forward guidance)
•Inflation-targeting central banks (Czech Republic, Poland, Sweden, UK, Hungary):
§announce a target (e.g. 2% HICP in the UK), a margin (e.g. ±1%) and a horizon (2–3 years) §compare inflation forecast and target, and act accordingly.
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Independence and Accountability •Arguments for central bank independence:
§governments tend not to resist to the ‘printing press’ temptation §Independence removes central banks from such pressure. §the Bundesbank has set an example.
But…
•Misbehaving governments are eventually punished by voters. •Nobody punishes Central banks ⇒ A democratic deficit?
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Redressing the Democratic Deficit
•In return for their independence, central banks must be held accountable: §to the public §to elected representatives.
•The Bank of England for example is given an inflation target by the Chancellor. It is free to decide how to meet the target, but must explain its failures (the ‘letter’)
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The Eurosystem’s Weak Accountability •The Eurosystem must report to the EU Parliament.
§The Eurosystem’s President must appear before the EU Parliament when requested, and does so every quarter.
•Nevertheless,
§The EU Parliament cannot change the Eurosystem’s independence and has limited public visibility.
•The American Congress and Senate have more power over the Fed
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Macroeconomic Governance: Fiscal Policy
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What is Fiscal Policy
•The set of macroeconomic policies aimed at impacting the macroeconomic outcome of the economy through: §Revenues of the government (tax policy) §Expenditures of the government
•The Role of Fiscal Policy
§Macroeconomic stabilization §Collective insurance §Provision of public goods §Redistribution
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Some Definitions (Do not fall asleep, please!)
•Output Gap: difference between actual and potential (full employment) output •Government deficit, or net lending: Difference between government expenditures and revenues •Public Debt: Stock of cumulated deficits.
•Primary deficit or surplus: government deficit or surplus net of interest payments
•Structural or cyclically adjusted deficit: what the balance would be if the output gap were zero
•Automatic stabilizers: Changes in revenues and expenditure that happen without discretionary action. 19/09/2016
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A Crucial Distinction: Automatic vs. Discretionary •Automatic stabilisers:
§tax receipts decline when the economy slows down, and conversely §welfare spending rises when the economy slows down, and conversely §no decision, so no lag: nicely countercyclical
•How large are automatic stabilizers?
§public sector size §progressivity of the tax and benefit system §levels of unemployment benefits §sensitivity of unemployment to economic fluctuations
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Automatic Stabilisers
•Percentage of fluctuations smoothed by automatic stabilization
Source: Creel and Saraceno (2010)
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The Maastricht Convergence Criteria: A Reprise •Inflation:
not to exceed by more than 1.5 per cent the average of the three lowest inflation rates among EU countries.
•Long-term interest rate:
not to exceed by more than 2 per cent the average interest rate in the three lowest inflation countries.
•ERM membership:
at least two years in ERM without being forced to devalue.
•Budget deficit:
deficit less than 3 per cent of GDP
•Public debt:
debt less than 60 per cent of GDP
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Fiscal Policy as a Stabilization Tool
•The perception of the role of fiscal policy has changed radically over recent decades.
• Discretionary fiscal policy to stabilize the economy has come to be regarded with great skepticism. •Instead, the conventional wisdom today is that monetary policy should be the main stabilization tool… •…At least until the last crisis!
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Criticisms against Stabilization Policies
•Decision lags are long: tax and expenditure changes have to go through a lengthy parliamentary decision-making process. Monetary policy is almost instantaneous. •The political character of fiscal policy decisions makes it much harder to revise decisions when circumstances change •Fiscal policy has other central goals than stabilization, e.g. income distribution.
•The risk of an expansionary bias is much larger for fiscal policy (political cycle) than for monetary policy, as the latter has been delegated to independent central banks, which can take a more long term view. 19/09/2016
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The Stability and Growth Pact (SGP) •Amsterdam Treaty (1997) and reform of 2005
•Meant to avoid discretion and to only allow automatic stabilization.
•Requirement to attain a position of close to balance or in surplus in the mid-run (which implies, in terms of structural balance?)
•Excessive Deficit Procedure (EDP) makes permanent the 3 per cent deficit and 60 per cent debt ceilings and foresees fines. •Final word remains with ECOFIN, and countries avoided fines so far. 19/09/2016
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How the Pact Works
•A limit on acceptable deficits: 3% of GDP •A preventive arm
§“Stability programmes” and peer pressure §Aims at avoiding reaching the limit in bad years §Calls for surpluses in good years
•A corrective arm
§‘Early warning’ when deficit is believed to breach limit + recommendations §EDP procedure for excessive deficit: recommendations, to be followed by corrective measures, and ultimately sanctions
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The SGP Fines
•The sum is retained from payments from the EU to the country (CAP, Structural and Cohesion Funds). •It is imposed every year when the deficit exceeds 3 per cent. •The fine is initially considered as a deposit:
•if the deficit is corrected within two years, the deposit is returned
•if it is not corrected within two years, the deposit is considered as a fine. •The fine starts at 0.2 per cent of GDP and rises by 0.1 per cent for each 1 per cent of excess deficit 19/09/2016
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The Debate on the Stability Pact
•To summarize the arguments against discretionary fiscal policy: §Voter myopia §Strategic government behaviour §Vested interests and bargaining §Dynamic inconsistency
•All reasons for fiscal discipline that nevertheless do not require supranational rules •Supranational rules can only be justified on two grounds §Spillovers §Credibility
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Fiscal Policy in the EMU
•The SGP has proven to have many flaws (we will see them during the debates) • Countries have often had deficits above 3% •Sanctions have never been imposed
•The reform of 2005 increased discretion and arbitrareness, making the imposition of sanctions even less probable •So, why bother?
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A Tale of Two Policy Approaches
Macroeconomic policy has been proactive in the US, and very inertial in the EMU Monetary Policy
Fiscal Policy
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The Crisis: Institutions Change
•After 4 years of crisis we have two major institutional innovations:
§A «European Stability Mechanism » (ESM), aimed at helping countries in trouble §A new fiscal rule, the « Treaty on Stability Coordination and Governance », or Fiscal Compact, effective since January 1st, 2013
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The European Stabilisation Mechanism •Established in October 2012
•Permanent mechanism for financial crises resolution
•Internationall financial organization that can raise funds on financial markets for up to €700 bn •It is an intergovernmental mechanism, limited to the 18 eurozone members •It can:
§Lend directly to countries in distress §Buy public bonds on primary and secondary markets §Directly finance recapitalization of financial institutions (once the single supervisory autority will be put in place §First intervention, aid to Spanish banks
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The Fiscal Compact
•Evolution/tightening of the 1997 Stability Pact: Budget balance and sanctions. Effective January 1st 2013 •It is an intergovernmental pact, introduced in the legislation of the 25 signing member at the constitutional level •Provisions :
§Structural balanced budget. Deficit net of cyclical components needs not to be larger than 0.5%. Attention: this has important consequences on debt ratios! §Contrary to the Stability Pact, sanctions are automatic. A majority of the Council can suspend them §Additional requirement of returning to 60% Debt/GDP in 20 years
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