The euro-area crises the next step Lucrezia Reichlin

The euro-area crises: the next step Lucrezia Reichlin London Business School & Now-Casting Economics Ltd Presentation at the Italian Parliament Rome 29 th September, 2014

Where are we now in the euro area crisis? • The economy is at best stagnating -- not out of the 2011 recession yet -- diverging from the US -- employment flat • Debt not stabilized • Financial fragmentation (and relatively high credit risk in the periphery) not over Ø The crisis is not over! Yet, low volatility … the market does not seem to price this risk … but the market has been wrong before! … an illusion of tranquility?

Recent new slowdown Now-casting Index (NCI) for the US and Euro Area US Euro Area

EA vs US since the crisis Since 2008 the Euro Area had a larger loss of income than the US. Although the initial income shock was of similar magnitude neither economy is back to trend, but the EA is further off Source: Buttiglione et al, 2014

Employment has not recovered and it is still below the second recession peak everywhere but Germany

Balance sheets ……

Credit deterioration after the second recession The second recession led to a deterioration of the stock of loans especially in the euro area periphery Non performing loans / total loans 25 20 15 10 5 No r Au way st ra lia Ja pa Tu n rk Be ey lg Ge ium Ne rm th an er y la n Un Es ds ite ton d ia St at Un e ite Fr s an d Ki ce ng d De om nm Slo ark va k Cz R. ec h Po R. la nd OE CD Sp Po ain rtu ga l Ita Slo ly ve Hu nia ng a Ire ry la n Gr d ee ce 0 Q 4. 2008 Source: OECD Q 3. 2012

Financial repression: banks buy government bonds

In particular their own

Diabolic sovereign-bank loop Euro-nomics. com Triggers: • Bank insolvency (Ireland, Spain, Cyprus) • Public debt and slow growth (Greece, Portugal, Italy)

Debt stabilization only just started – there is a long way to go In the euro area debt stabilization just started while it is well underway in the US

In particular in the public sector Total Debt as % of GDP Public Debt as % of GDP

But the market does not seem to care about debt … eg Italy … until when? Italy General government debt (% of GDP) Source: IMF, FRED 10 years i. r. (right) 2013 2012 2011 2010 2009 2008 2007 2006 2005 0 2004 0 2003 2 2002 20 2001 4 2000 40 1999 6 1998 60 1997 8 1996 80 1995 10 1994 100 1993 12 1992 120 1991 14 1990 140

Aggregate demand weak

Fiscal stance: Euro area and the US

Inflation declining dangerously towards zero – pushing up real interest rates HICP - Overall index, Yo. Y 5 4 3 2 1 0 -1 1999 Jan 2000 Apr 2001 Jul 2002 Oct 2004 Jan 2005 Apr 2006 Jul 2007 Oct 2009 Jan 2010 Apr 2011 Jul 2012 Oct 2014 Jan Euro area (changing composition) Source: ECB

Policies in the seven years of crisis Limits • Wrong sequence: no fiscal stimulus in 2009 and emphasis on fiscal consolidation since, aggressive ECB liquidity policy but no action on bank solvency until 2012/13 • Uncertainty in central bank policy with respect to the sovereign – impossible trinity of ‘’no bailout’’, ‘’no default’’, ‘’no exit’’ leading to messy solutions of debt crises: Greece, Cyprus, contagion … • De facto contractionary monetary policy since 2013 leading to declining nominal GDP growth – only recently reversed

Policies in the seven years of crisis But also … Not negligible progress: Ø Banking Union Ø ESM – firewall Ø Draghi’s pledge of doing “whatever it takes” to save the euro (but still untested) Ø Recent action on ABS-QE and other measures Ø …. and recent ECB communication perhaps leading to a new grand bargaining involving (i) conditioning further monetary policy action on commitment to reform (ii) framework for coordinating monetary and fiscal policy

Governance: how much progress? Problems Progress 1. Pre-crisis ex ante incentives weak: combination of common monetary policy with national fiscal and banking supervision leading to overborrowing/over-lending (private + public) Banking Union and launch of AQR 2. Ex post discipline excessive: no mechanism for crisis resolution, hence rules not credible ex ante None 3. No mechanism for resolving banking crises, hence diabolic loop between sovereign and banks Incomplete: the Banking Union has non credible resolution fund 4. No lender of last resort mandate for ECB Not clear: OMT untested, sovereign QE controversial

We need a “new bargain” • Any further progress requires a “new bargain” since needed new measures have fiscal implications • Including further ECB action Ø Need a mechanism that can enforce credible commitment of governments to policies aim at repairing balance sheets and putting the economies on a sustainable path Ø For credibility need a mix of rules and market discipline – tough rules are not credible

Key problems 1. Fiscal policy: need to allow changing fiscal stance overall and in countries over-burdened by debt overhang 2. Monetary policy: full mandate for sovereign QE 3. Dealing with financial segmentation (tendency to ring-fence balance sheets along national lines to cope with the risk of a collapse of the euro) Ø What do we need to achieve this goal?

Needed … • For problem 1 (fiscal): need a targeted – and sustained – effort to reduce sovereign debt The dilemma is how to do so without either pushing the Euro area back into recession (through a new bout of austerity) or endanger the progress that has been made in restoring financial stability • For problem 2 and 3 (QE and financial segmentation): need to establish incentives for the market to create a euro area safe/liquid asset

Dealing with the stock of debt • Need a “stock operation” to reduce sovereign debt, particularly in the highly indebted peripheral countries ü Several proposal on the table all involving partial debt redemption ü Prerequisite is to solve a time inconsistency problem via a new institutional mechanism – new grand bargain • Essential element is to build a sovereign debt restructuring regime, which: i. creates strong market-based incentives that will make it more difficult for Euro area countries to returning to excessive debt levels in the future ii. makes future debt restructuring – should if become necessary – less painful than is currently the case [Need market discipline – rules are not enough] CEPR REPORT IN PROGRESS

Dealing with financial segmentation: the safe asset problem • The euro area needs a pan-euro area liquid market for government bonds • In its absence what should the ECB buy if it decided to implement sovereign QE? • Flight to safety leads to home bias: italian banks hold italian govy and german banks hold german govy • Which in turn leads to correlation of banks’ and sovereign risk • Sovereign bonds unrealistically treated as risk-free in banks regulation and in the ECB collateral policy

Towards a solution: Garicano-Reichlin proposal • Impose as a rule that, for sovereign bonds to have a risk free weighting, they must be held by banks in certain constant proportions, for example relative to GDP. • such proposal would reduce the exposure of banks to their own sovereigns and therefore help to break the link between banks and sovereign risk. • We also anticipate that such a regulatory initiative bias could help to encourage the emergence of the market driven creation of a euro area safe asset • This asset is the natural target for sovereign QE – QE will in turn encourage a market for such assets CEPR REPORT IN PROGRESS

Conclusions • The crisis is not over • Notwithstanding market tranquility we are at a very dangerous juncture which find countries profoundly divided • Need a new bargain based on Ø a common narrative of the past (which is lacking) Ø a mixed of rules and market discipline to enforce commitment from all parties involved