5. Monetary Policy Crisis in the Eurozone

These included (in alphabetical order) Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and, eventually, Greece, which entered on January 1, 2001.

European Commission white papers are documents containing proposals for European Union action in a specific area aiming to launch a debate on the relevant topics with the public, stakeholders, the European Parliament, and the Council in order to arrive at a political consensus. They are currently published on the Commission’s “Have Your Say” web portal (retrieved from https://​eur-lex.​europa.​eu/​EN/​legal-content/​glossary/​white-paper.​html).

To illustrate trade diversion, consider a scenario where the most efficient producer of a certain good is located in the United States and sells its product to French buyers. Additionally, there is a higher-cost producer in Italy. However, due to the dismantling of intra-EU trade barriers, the Italian producer becomes the lowest-priced option for the French market. If there were no trade barriers, both within and outside the EU, the US firm would remain the lowest-priced producer for the French buyers. However, the combination of high external EU trade barriers and the removal of intra-EU barriers results in the Italian product being delivered to the French buyers at the lowest price (Viner, 1950). In this hypothetical example, the process of unification leads to a decrease in global welfare if the loss incurred from switching to the less efficient Italian producer outweighs the gain derived from removing intra-EU trade barriers (Hunter, 1991, p. 20).

If these countries were to become discouraged, the process of unification may have slowed or even ceased. Many different economic variables were to determine potentially which areas were to be the greatest winners from unification and which areas might incur problems. An article in The Economist (1990, p. 72) ranked the then European Community (EC) member countries by estimated growth in the 1990s. The ranking included the effects of Europe 1992, German unification, and economic reforms in Eastern Europe. Table 5.1 lists the economic variables that determine the pattern of growth of EC member countries from Europe 1992. The Economist ranking which takes into account exports to West Germany as a share of total exports and exports to Eastern Europe as a share of total exports found West Germany to be the greatest winner in the 1990s and Spain the country with the lowest growth rates in the 1990s, according to the analysis.

The advantages of committing to a policy of low inflation, rather than continuously setting policy in a discretionary manner, are demonstrated in seminal research antecedent to the signing of the Maastricht Treaty, such as Kydland and Prescott (1977) and Barro and Gordon (1983a, 1983b).

For a discussion on the implications of such heightened uncertainty for economic prospects in the euro area during that era, see ECB Monthly Bulletin, August 2009, Box 6.

The “Great Moderation,” a term coined by Stock and Watson (2002), refers to the reduction in the volatility of the business cycles of many advanced economies that started in the mid-1980s.

With the 10-year German bond (known as the Bund) yielding 2.26% at the time, the bond yields of other countries within the euro area reveal a significant spread. Italy, with a gross debt of 120% of GDP, had a bond yield of 7.28%. Spain’s bond yield stood at 6.62%, Belgium’s at 5.65%, and France’s at 3.63%. This indicated a spread of 137 basis points over the Bund. It is worth noting that prior to 2008, this spread was close to zero for most of the period from 1999 to 2008. Consequently, only Germany’s Bund had been considered a risk-free “safe asset” among the Eurozone government bonds. However, even the credit default swap (CDS) premium for Germany had risen to 110 basis points, compared to 40 in July 2011. Even though the CDS market may not provide a reliable indicator of default risk, it does nevertheless offer insights into sovereign bond prices. The signal transmitted had been rather cautious over the next 3 years as Italy had a CDS spread of 535 basis points, Spain at 466, Belgium at 344, and France at 225.

Euribor, although still below levels seen in 2008–2009, kept rising, making it difficult for banks to access market funding, particularly in dollars. Reports indicated evident shortcomings in the functioning of the repo market. The European Financial Stability Facility (EFSF) faced challenges in selling some of its bond issues and acknowledged limited leverage possibilities. France was at risk of losing its AAA rating, and all euro area banks were under review by rating agencies. Greek banks experienced a steady decline in deposits, and similar but slower trends were observed in other vulnerable countries, indicating concerns among depositors. The reliability of the sovereign CDS market itself was questioned as authorities sought to restructure Greek debt without triggering CDS contracts, raising doubts about the effectiveness of CDS as insurance. On a positive note, ECB monetary policy was still deemed credible based on market inflation expectations, with inflation projected at 1.79% over a 5-year horizon and 2.04% over a 10-year horizon. However, the underlying issue was that ECB policy rates had been too high. The prime ministers of Greece and Italy at the time were experienced and capable, understanding the necessary steps for restarting economic growth in their respective countries. However, as they were not elected politicians, their legitimacy and authority were limited (Portes, 2014, p. 424). Considering that implementing the necessary measures did remain challenging irrespective of popular support, indeed, the effectiveness of technocratic governments in carrying out such measures had been put into severe scrutiny.

With the benefit of hindsight, we may concisely address the case of the main four euro area periphery countries that faced the major challenges from the Eurozone crisis, namely, Greece, Ireland, Portugal, and Spain.

Greece stood as an exception to the aforementioned general statement due to its significant fiscal imbalances, which were partially concealed from statisticians. However, the issues faced by Greece are not solely attributed to fiscal matters but also stem from profound structural weaknesses, particularly within its institutions (Jacobides et al., 2011), high levels of political polarization, and irresponsible capital inflows that masked these fundamental flaws for a considerable period. As Portes (2014) remarks, it would be incorrect to simplify these factors as merely a lack of “competitiveness” that could have been resolved through currency devaluation if Greece were not a member of the Eurozone (Portes, 2014, p. 424).

Ireland encountered significant difficulties due to an unprecedented increase in the housing market, characterized by an inflated housing bubble. In Ireland, this surge was driven by irresponsible capital inflows into property development and mortgage financing facilitated by domestic banks, along with a culture of favoritism toward capitalists (crony capitalism) (Allen, 2000). However, the primary factor contributing to Ireland’s current difficulties was not solely the housing boom, but rather the government’s choice to guarantee the debts of the affected banks. This decision effectively transferred private debt onto the public sector, resulting in a substantial change in Ireland’s debt dynamics and causing the country’s public debt-to-GDP ratio to reach exceptionally high levels (Allen, 2009; Smyth, 2011).

Portugal faced several economic challenges, including inadequate education, an uncompetitive production system, and inflexible product and labor markets. However, Portugal’s main error was failing to utilize the substantial capital inflow it received in the precrisis era to modernize its economy (Portes, 2014). Spain also experienced a housing boom and an influx of capital into the construction sector. These issues were worsened by the reckless actions of politically influenced regional banks which faced significant challenges when the housing bubble collapsed.

As a result, Greece faced insolvency, while Ireland had excessive debt that needed restructuring (Portes, 2011). The IMF program in Portugal was deemed unworkable. Spain and Italy, on the other hand, were solvent under the condition that financial markets returned to normal and both countries implemented appropriate macroeconomic and structural policies. However, Spain, Italy, and even France faced market pressure. There were also concerns that Spanish banks would suffer further from the impact of bad real estate loans, leading to potential state bailouts. In Italy, political instability and indecisiveness exacerbated the contagion from weaker countries, resulting in a self-perpetuating vicious circle; rising costs of servicing debt weakened Italy’s fiscal position (despite being close to primary fiscal balance), eroding market confidence and causing a rise in borrowing costs that made debt service increasingly unsustainable. Confidence in French banks also diminished in the eyes of the markets, despite assurances of their soundness from the banks and regulators (Portes, 2014).

To illustrate the rationale behind this, we may simplify the process of euro area adjustment using the following model: Initially, there is a significant decline in output in the peripheral countries, which is large enough to roughly balance their current accounts. This is followed by an internal devaluation that occurs solely through increasing wages in the core countries and a gradual recovery in peripheral output. The duration of this process depends on the magnitude of the required internal devaluation and the rate at which core wages rise, which is directly linked to the inflation rate of the currency area. Let us consider a stylized but reasonably realistic numerical example. We assume that the euro periphery represents one-third of the euro area GDP and needs to achieve a 20% internal devaluation relative to the core. Furthermore, we assume that the inflation rate in the euro area equals the average wage increase minus 1%. Lastly, we assume that the initial output loss in the periphery compared to its potential, before internal devaluation can take place, amounts to 12% of GDP or 4% of the entire area’s GDP. As Table 5.3 depicts, the time required for adjustment and the cumulative output loss, measured in percentage years of GDP, are influenced by the underlying inflation rate. Evidently, a higher inflation rate smoothens the path of adjustment. Furthermore, this effect is significant even at between 3% and 4% inflation (Krugman, 2014, p. 117).

Inflation can have a “stall speed,” meaning that if inflation is too low during periods of economic stability, central banks may be unable to effectively counteract a downward spiral when faced with adverse shocks. The challenging task of combating such a downturn is often compounded by the political and economic dynamics associated with low inflation.

The significance of the banking sector in pre-economic and monetary union (EMU) discussions was minimal, but it became apparent that euro area countries were particularly susceptible to systemic banking pressures. The European Union’s free movement of capital allowed investors and depositors to withdraw their funds from struggling banks without incurring costs. Additionally, deposit insurance funding operated at a national level, meaning that concerns about a state’s ability to handle failing banks could further trigger deposit withdrawals. This interplay between concerns about bank and state solvency was most pronounced in Ireland in 2010 when the government’s attempt to rescue its banking sector raised concerns about potential sovereign default. Similar concerns have also impacted other countries, such as Cyprus and Greece, at different points over the past decade. Other issues related to the banking sector included the lack of harmonization in rules governing the resolution of banks and the complexities involved in dealing with failing cross-border banking entities.

The ECB’s policies concerning collateral policies for refinancing operations and, specifically, Emergency Liquidity Assistance (ELA) to banks were deemed inadequate (Whelan 2014, 2015, 2016). There were instances of lending to banks with severe insolvency issues, a lack of transparency regarding the conditions for capping or withdrawing ELA by the Eurosystem, and a series of decisions where the provision or restriction of ELA seemed to be influenced by political developments in different countries (Whelan, 2019).

As highlighted in Portes (2014), the French president and German chancellor have made two significant mistakes that have had a disastrous impact on the markets. The Deauville statement in October 2010 introduced, in a poorly thought-out manner, the possibility of involving the private sector in addressing the debt of Eurozone countries. This had a detrimental effect on market confidence. Additionally, a year later, the Cannes statement explicitly suggested the potential for an EMU member country to exit the euro, which went against established norms and was considered a taboo. This proposal lacked any legal basis. Some have drawn a parallel with the statement made by the president of the Bundesbank in early September 1992, which allowed for the immediate exit of Italy and the United Kingdom from the EMS after he mentioned that “devaluations cannot be ruled out” (quoted in Portes, 2014, p. 427).

Regarding the fiscal union, the establishment of a complete fiscal union would require a corresponding political union or, at the very least, a political structure capable of addressing economic interactions that necessitate central-level intervention. This does not necessitate an immediate full fiscal union but rather requires progress toward empowering a European authority with legal powers and sufficient funds to address issues that require transfers among member countries. This could be achieved through dedicated taxes that are significantly larger than the current contributions to Brussels. To ensure full legitimacy, greater involvement of national political entities in the process, potentially through national legislatures, would be necessary. As for the banking union, progress has been occurring at a faster pace than anticipated, with the ECB preparing itself for supervisory responsibilities at the zone level. However, there are doubts among certain elements in European national central banks and governments regarding the desirability of locating Eurozone bank supervision within the ECB, as well as the feasibility of initiating zone-wide regulation (beginning of 2013). Nonetheless, efforts to establish uniform banking standards in Europe, particularly for systemically important banks, gained momentum, and the necessary work is underway.

In accordance with Article 105(1) of this Treaty, the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Community… . The ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system (Treaty of Maastricht (1992), Article 2 and Protocols Art. 105.5 (numbering changes in Lisbon Treaty, but no change in text). It would not violate the “no bailout clause” (which does exclude ECB purchases of Eurozone sovereign debt on the primary market). And in fact, the ECB has been purchasing member state bonds on the secondary market since May 2010, without any successful legal challenge. To stop self-fulfilling confidence crises, therefore, it has been suggested that the ECB should commit to capping yields for solvent countries through unlimited purchases in the secondary markets. This approach would lead to a decrease in primary issue yields as arbitrage brings them down to the capped level. Notably, this commitment would apply to solvent countries, as opposing such purchases for insolvent countries, like Greece in May 2010, would be justified (as proposed by then governor of the Bundesbank). Portes (2014) argues that this policy does not pose any significant inflation risk, as is the case for quantitative easing, as demonstrated in the case of the United States, the United Kingdom, and Japan. The ECB can always adjust its measures to tighten monetary policy as needed, retaining as its primary concern, however, the risk of incidents of moral hazard. The ECB strongly believed and still does that “market discipline” is the most effective way to encourage desired macroeconomic policies. This is evidenced by instances such as Berlusconi’s departure and the appointment of Mario Monti as Italy’s Prime Minister, as well as the technocratic government in Greece led by former ECB Vice President Lucas Papademos, which was willing to implement the stringent austerity measures demanded by the IMF-ECB-EC troika. Financial market pressures are intentionally utilized to compel governments to adopt austerity measures and reforms.

Moreover, fiscal contraction together with private sector deleveraging is not feasible without a current account surplus [CA = (Sp − Ip) + (T − G)]. The current account must equal the sum of private sector net saving and government net saving (Portes, 2014).

The classic trilemma of monetary policy emphasizes that when exchange rates are flexible and there is capital mobility, monetary policy can prioritize domestic goals. However, the trilemma does not directly address concerns regarding financial stability. In fact, relying solely on monetary policy may not be very effective in dealing with potential financial stability issues (Obstfeld & Taylor, 2017). In such cases, countries could face significant challenges from global financial shocks and economic cycles, which may be caused by monetary or other developments in the financial markets of industrialized countries. These challenges can overwhelm countries even if they have flexible exchange rates. If the latter outcome poses a risk, countries may wish to implement a combination of financial regulations or restrictions on international capital movement to better protect their economies. Rey (2013, 2016) forms the latter core argument, and on global financial cycles, see also Borio and Disyatat (2015), Avdjiev et al. (2016), and Reinhart et al. (2016).