This document provides an overview of a lecture on European monetary policy, fiscal policy, and the global financial crisis. It discusses the monetary unification of the EU, fiscal coordination in the eurozone, the Stability and Growth Pact, EMU performance 1999-2012, and strains within the eurozone. It also covers the objectives, instruments, and strategy of the European Central Bank, fiscal policy externalities, and the Stability and Growth Pact.

1. ECON339
EURO339
Lecture 4: European monetary
policy, fiscal policy and the
global financial crisis
January 2013

2. ECON339 / EURO339
Overview
 The monetary unification of the EU
 Monetary and fiscal coordination in the euro zone
 Fiscal policy and the Stability and Growth Pact
 The performance of EMU 1999-2012
 The global financial crisis
 Moral hazard, bail-outs and strains within the eurozone
 The outlook for European monetary union
2

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The long road to Maastricht and the
euro
2011 Estonia joins 3

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The Maastricht Treaty (1)
4

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The Maastricht Treaty (2)
 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 mentioned (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
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 (now ERM-2) 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 (or declining satisfactorily)
 All observed in 1997 for decision in 1998
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Interpretation of the convergence criteria:
inflation
10.00
Straightforward
fear of allowing in
unrepentant
inflation-prone
countries
5.00
0.00
1991 1992 1993 1994 1995 1996 1997 1998
France Italy
Spain Germany
Belgium Portugal
Greece average of three lowest + 1.5% 7

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Interpretation of the convergence criteria:
long-term interest rates
 Easy to bring inflation down in 1997 – artificially or not – and then
let go again
 Long interest rates incorporate bond markets expectations of long
term inflation
 So criterion requires convincing markets
 Problem: self-fulfilling prophecy:
 if markets believe admission to euro area, they expect low inflation
and long-term interest rate is low, which fulfils the admission criterion
 conversely, if they don‟t, all is lost
8

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Interpretation of the convergence criteria:
ERM membership
 Same logic as the long-term interest rate: need to
convince the exchange markets
 Same aspect of self-fulfilling prophecy
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Interpretation of the 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.
 How are the ceilings chosen?
 deficit: the German „golden rule‟
 debt: the 1991 EU average
 Problem No 1:
 a few years of budgetary discipline do not guarantee long-
term discipline
 Need Stability and Growth Pact
 Problem No 2: artificial ceilings 10

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The deficit and debt criteria in 1997
Maastricht fiscal criteria 1997
120
100
80
Public Debt (%GDP)
60
40
20
0
-3 -2 -1 0 1 2 3 4 5
Deficit (% GDP) 11

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A tour of the acronyms
 National Central Banks (NCBs) continue
operating but with no monetary policy
function
 A new central bank at the centre: the
European Central Bank (ECB)
Jean-Claude
 Eurosystem/ECB independent of national Trichet, ECB
governments President
 The European System of Central Banks
(ESCB): the ECB and all EU NCBs
 The Eurosystem: the ECB and the NCBs
of euro area member countries (N=17)
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How does the Eurosystem work?
 Objectives:
 what is it trying to achieve?
 Instruments:
 what are the means available?
 Strategy:
 how is the system formulating
its actions?
ECB building, Frankfurt
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Objectives (1)
 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 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
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Objectives (2)
 Making the inflation objective operational: does the
Eurosystem 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.’
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Instruments
 Main channels of monetary policy:
 longer 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)
 EONIA affects the channels through market expectations
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The ‘two-pillar’ strategy
 The monthly Eurosystem‟s interest rate decisions (every
month) rests on two pillars
 Economic analysis:
 broad review of economic conditions - growth,
employment, exchange rates, economic
developments abroad (eg, oil prices)
 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
 Inflation-targeting central banks (NZ, Czech Republic,
Poland, Sweden, UK, etc):
 announce a target (eg, 3 per cent in NZ), a margin (eg, 1%)
and a horizon (2–3 years)
 compare inflation forecast and target, and act accordingly
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Taylor Rule interpretation (1)
 i = i* + a( - *) + b (y - y*)
 i* = equilibrium interest rate
  = inflation
 * = inflation objective (eg, 2%)
 y = GDP growth
 y* = trend GDP growth
 a = aversion to inflation
 b = aversion to cyclical fluctuations
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Taylor Rule interpretation (2)
 i = i* + a( - *) + b (y - y*)
 By Fisher equation,
 i* = r* + *
 (eg, r* = 2%, then i* = 4%)
 and y* = 1.2%
 ECNB weights are estimated at:
 a = 2.0
 B = 0.8
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The ECB’s ‘Taylor Rule’?
Inflation
3.50
3.00
7
2.50
2.00 6
1.50
1.00 5
0.50
0.00 4
1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1
Output gap
3
1
0.5 2
0
-0.5 1
-1 EONIA Taylor rule
-1.5 0
-2 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1
-2.5
1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 21

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Independence and accountability
 Current conventional wisdom is that central banks
ought to be independent:
 governments tend not to resist to the „printing press‟
temptation
 the Bundesbank has set an example
 ECB set up to be independent of national and EU
government
 What does independence mean?
 How does accountability work?
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Independence
 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
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Accountability: redressing the
democratic deficit
 Misbehaving governments are eventually punished by voters
 What about central banks? Independence removes them from
such pressure - a democratic deficit?
 In return for their independence, central banks must be held
accountable:
 to the public
 to elected representatives
 The Eurosystem must report to the EU Parliament
 The ECB‟s President must appear before the EU Parliament
when requested, and does so every quarter
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Fiscal policy in a monetary union
 In a monetary union, fiscal policy
 the only macroeconomic instrument at national level
 government borrows in recession and pays back on behalf of citizens in good
times
 government acts as substitute to inter-country transfers in case of asymmetric
shock
 Effectiveness depends on private expectations
 Slow implementation of fiscal policy
 Inside vs outside lags
 Result: countercyclical actions can have procyclical effects
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Automatic versus discretionary fiscal
policy
 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
 rule of thumb: deficit worsens by 0.5 per cent of GDP
when GDP growth declines by 1 per cent
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Automatic stabilisers
27

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Actual versus cyclically-adjusted
budget balance
 Discretionary actions: a voluntary decision to change
tax rates or spending
 Cyclically adjusted budget shows what the balance
would be if the output gap is zero in a given year
 Difference between actual and cyclically adjusted
budget = footprint of automatic stabilisers
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The Netherlands
6
Output gap
Budget balance
4 Cyclically adjusted budget balance
2
0
-2
-4
-6
1991 1993 1995 1997 1999 2001 2003 2005 29

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Fiscal policy externalities
 In a monetary union, should fiscal policy be subjected to some
form of collective control?
 Yes, if national fiscal policies are a source of externalities
 Externality #1 - income spillover via trade:
 important and strengthened by monetary union
 lack of co-ordination means that with a symmetric shock, too
much policy action can be used to counteract shock
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31. ECON339 / EURO339
Other externalities
 Borrowing cost externalities:
 one country‟s deficit would induce higher interest rate for everyone
 long-term growth effects
 capital inflows appreciate common currency and affect
competitiveness
 Most serious is the risk of default in one member country:
 capital outflows and a weak euro
 pressure on other governments to help out Alert: moral
 pressure on the Eurosystem to help out
hazard
 Answer to address risk:
 the „no-bailout‟ clause in Maastricht Treaty
 Prevention procedure
31

32. ECON339 / EURO339
Maastricht Treaty
 1.2. Monitoring of budgetary discipline
 As from Stage 2, 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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Arguments for/against fiscal policy
controls
 The arguments for:
 serious externalities
 a bad European track record on debt and deficits
 The arguments against:
 the only remaining macroeconomic instrument
 national governments know their domestic economic
circumstances best
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The Stability and Growth Pact (SGP)
 The SGP: meant to avoid excessive deficits upon entry into
euro area
 Excessive Deficit Procedure (EDP) makes permanent the 3%
GDP deficit and 60% GDP ceilings and calls for fines
 Final word remains with ECOFIN, and countries avoided fines so
far
 SGP reformulated in 2005 to avoid rigidity of Pact
 negative growth or accumulated loss of output over a period of low
growth exceptional
 taking account of „all relevant factors‟
 no specific definitions
 New reform makes fines automatic
34

35. ECON339 / EURO339
How the SGP works
 A limit on acceptable deficits: 3% of GDP
 A preventative arm
 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
35

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The SGP fine schedule
 The sum is retained from payments from the EU to the country
(CAP, Structural and Cohesion Funds)
 The fine 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
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Issues raised by the SGP
 It could make fiscal policies procyclical:
 budgets deteriorate during economic slowdowns
 reducing the deficit in a slowdown may further deepen the
slowdown
 a fine both worsens the deficit and has a procyclical effect
 In practice, the Pact encourages countries to:
 aim at surpluses (so public debts will disappear) in normal times,
to give them scope to use fiscal policy in a downturn
 reduce reliance on discretionary policy and just use automatic
stabilisers
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The record of EMU so far…..
 A difficult period:
 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
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Inflation: missing the objective, a little …until
2008 commodity boom, 2008-12 financial crisis
39
Source: European Central Bank

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The performance of the euro against
US$
40
Source: European Central Bank

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Current financial crisis
 “ 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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42. ECON339 / EURO339
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
 ECB would reduce interest rates and inject liquidity into
banking system
42

43. ECON339 / EURO339
Eurozone GDP growth
43
Source: European Central Bank

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Eurozone unemployment
44
Source: European Central Bank

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Eurozone one-year interbank rate
45
Source: European Central Bank

46. ECON339 / EURO339
Remember from Lecture 1:
government debt and the euro
 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
46

47. ECON339 / EURO339
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 EU treaties – note: bailout is
by EU national governments, not ECB, which cannot directly
monetise debt
47

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Eurozone budget balance (% GDP)
48
Source: European Central Bank

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Eurozone government debt (% GDP)
Ratio has never been below
60% GDP
49
Source: European Central Bank

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Government debt in key Eurozone
countries
50

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Deficits and debt
51
Source: Eurostat

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National long-term interest rates
52

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The bailouts
 In April 2010, bailout mechanism used - €30bn lent to Greece
 In May 2010, EU established a full fund of €750bn
 €440bn from eurozone states
 €60 billion from European Commission
 €250 billion from the IMF
 European Financial Stability Facility (EFSF) established
 issues debt on capital markets, backed by guarantees from the eurozone
states
 lends to indebted eurozone governments once recovery plan agreed
 Long-term solution is the European Stability Mechanism, agreed in
December 2010
 Replaces the EFSF and similar legal instruments
 Combined with a monitoring body
53

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Greece debates budget cuts
54

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Trying to make the SGP work
 In June 2010, the Council agreed that national governments
would present their budget plans to the Council and
Commission six months before budget time
 Governments would have to justify deficits
 Tougher scrutiny for deficits if debt > 60% GDP
 Sanctions still unclear – possibly having voting rights in the
Council suspended
55

56. ECON339 / EURO339
Is the medicine working?
 The EU has given bail-outs to five Eurozone members:
 G, IRL, P, E, I
 Loans have been conditional on budgetary cuts and
return to sustainable debt levels
 In some countries (Greece), budget cuts have deepened
the recession
 Long-term interest rates are coming down
 But indebted states still have poor credit ratings and
face many years of austerity and political unrest
56

57. ECON339 / EURO339
Conclusions
 The ECB set up with primary objective of price stability and
independent of national and EU governments
 May not directly monetise debt
 In EMU, national fiscal policy more effective, only
macroeconomic policy tool to adjust to asymmetric shocks
 But there are important external effects of fiscal policy
 EU has so far failed to design and enforce controls on national
fiscal policy
 EMU presently at risk of being destabilised by sovereign
default… but countries in crisis small and the EU has acted
decisively so far
57