Christodoulakis (ed ) managing risks in the european periphery debt crisis (2015)

Managing Risks in the European Periphery Debt Crisis Lessons from the Trade-Off between Economics, Politics and the Financial Markets Edited by George Christodoulakis... 212 Adrian Blun

Managing Risks in the European Periphery Debt Crisis

Also by George Christodoulakis

Th e Analytics of Risk Model Validation (edited with Stephen Satchell)

Managing Risks in the

European Periphery Debt

Crisis

Lessons from the Trade-Off between

Economics, Politics and the Financial Markets

Edited by

George Christodoulakis

Editorial matter and selection © George Christodoulakis 2015 Remaining chapters © Respective authors 2015

All rights reserved No reproduction, copy or transmission of this publication may be made without written permission.

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The authors have asserted their rights to be identifi ed as the authors of this work

in accordance with the Copyright, Designs and Patents Act 1988.

First published 2015 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS.

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In the memory of my parents Aristotle and Georgia Christodoulakis, who

taught me about qualities versus quantities

Contents

List of Figures ix

List of Tables xii

Preface xiii

Notes on Contributors xvii

Part I: Genesis of the Crisis, Use and Abuse of Economic Policies 1 Th e Genesis of the Eurozone Sovereign Debt Crisis 3

Philippe d’Arvisenet 2 Th e Trade-Off between Fiscal and Competitiveness Adjustments 38

Daniel Gros with Cinzia Alcidi 3 Ireland and Greece: A Tale of Two Fiscal Adjustments 55

Jeff rey D Anderson and Jessica Stallings 4 Rating Agencies vs Sovereign Debt Markets: A Tale of Interacting Risk Preferences 78

George Christodoulakis 5 Th e 2012 Greek Debt Restructuring and its Aft ermath 87

Miranda Xafa 6 Economic Th eories that Infl uenced the Judges of Karlsruhe 101

Paul De Grauwe 7 Privatization of State Assets in the Presence of Crisis 108

George Christodoulakis Part II: Crisis Resolution, Prospect and Retrospect 8 How to Manage Public Debts in the Euro Area? 127

Catherine Mathieu and Henri Sterdyniak 9 Fiscal Risk Sharing and Stabilization in the EMU 148

Kerstin Bernoth and Philipp Engler 10 Sovereign Debt and its Restructuring Framework in the Eurozone 163

Ashoka Mody 11 Funding Risks for Corporates in the Periphery: Disintermediation to the Rescue for the Larger Ones, Challenges for the Others 198

viii Contents

Blaise Ganguin

12 On Solving Europe’s Financial Issues to Promote Sustainable Growth 212

Adrian Blundell-Wignall and Caroline Roulet

13 European Banking Union as a Response to the

Fragmentation of the Internal Market Resulting from the Financial and Sovereign Debt Crisis 237

Dimitris Tsibanoulis with Gerry Kounadis Index 273

List of Figures

1.1 Exchange rates 4

1.2 Exports of G & S, volume (index Q1/1991 = 100) 4

1.3 Real three-month interbank rates, % 6

1.4 Financial conditions in Germany 7

1.5 Eurozone: credit to non fi nancial corporate 8

1.6 Eurozone: credit to households 8

1.7 Debt of the private sector as % of GDP 8

1.8 Domestic demand volume 9

1.9 Goods and services balance, % of GDP 9

1.10 Structural budget balance as % of GDP 10

1.11 Ten-year government bond yield, % 10

1.12 Real interest rate and external imbalances 11

1.13 Current account balance as % of GDP 11

1.14 Eurozone: fi ve-year CDS by sector (basis points) 15

1.15 Eurozone trade (as % of total trade) 16

1.16 Eurozone: real growth dispersion 19

1.17 Eurozone: core infl ation dispersion 19

1.18 Eurozone: output gap correlation among eurozone countries (eight-year rolling sample) 20

1.19 Structural budget balance as % of GDP 28

1.20 Current account balance as % of GDP 28

1.21 Exports of goods and services in volume, index qi/2000=100 29

1.22 Nominal unit labour cost, country vs Germany (index 2005=100) 29

2.1 Government debt as % of GDP: sovereign debt ratios not yet under control 40

2.2 ECB competitiveness indicator, unit labour cost, index, 1999Q1=100 41

2.3 GDP defl ator, change between 1999 and 2012 (price index, 1999Q1=100) 43

2.4 Italy: selected governance indicators 52

3.1 Read GDP level 56

3.2 Ten-year government bond spreads vs German bund 56

3.3 Unemployment rate 57

3.4 Inward FDI, 2000–11 59

3.5 Employment 59

3.6 Fixed capital formation 60

3.7 Relative unit labour costs 61

3.8 Export volume 61

x List of Figures

3.9 Greece: output gap .62

3.10 Ireland: output gap .62

4.1 Ten-year European periphery bond yield .80

4.2 Five-year implied probability to default for Greece 82

4.3 Evolution of relative market and CRA pessimism 2008–11 84

5.1 PIGS: general government gross debt (% GDP) 88

5.2 PIGS: real GDP, 1999=100 88

5.3 PIGS: investment ratios, 2007–14 (% GDP) 89

5.4 PIGS: general government defi cit (% GDP) .91

5.5 Spreads over ten-year German bond yield (bps) .91

5.6 Distribution of PSI losses on €198bn of accepted bids (€bn) 93

5.7 Outcome of debt buyback targeting €62bn of new GGBs (€bn) 96

5.8 Greece: breakdown of public debt by creditor, 2013 (€bn) 96

7.1 Privatization activity in the EU – 15 110

8.1 Ten-year government interest rates .128

9.1 Output gaps “German bloc” 154

9.2 Output gaps “French bloc” 155

9.3 Output gaps France, Germany and Eurozone average 155

9.4 Standard deviations of output gaps and GDP: all eurozone countries but “big four” 156

9.5 Standard deviations of output gaps and GDP: the “big four” economies (GER, F, I, ES) .156

10.1 Trends in public debt ratios 170

10.2(a) Household debt/income ratios: eurozone vs USA 172

10.2(b) Corporate debt/GDP ratios: eurozone countries and USA 173

10.3 Sovereign bond market reactions to policy announcements (cumulative abnormal change (basis points)) 185

11.1 Funding mix by country 199

11.2 Loans to euro area non-fi nancial corporates 200

11.3 Sales growth GIPS vs Europe 200

11.4 Profi tability – GIPS vs Europe 201

11.5 Interest coverage – GIPS vs Europe .201

11.6 Cash balance – GIPS vs Europe 202

11.7 European default rate 203

11.8 National insolvency statistics 203

11.9 Average % of debt sourced from seven categories of debt for European non-fi nancial fi rms 205

11.10 Capital expenditures/sales (%) .205

11.11 US and European non-investment grade issuance 207

11.12 New speculative grade ratings 207

11.13 Disintermediation potential 2014–16 208

11.14 Funding preferences and investors’ appetite .209

List of Figures xi

12.1 Infl ation and defl ation risk 216

12.2 Unemployment rates across Europe 217

12.3 Central Bank QE, Europe lagging 218

12.4 Core Tier 1 capital versus IFRS assets of banks by country 219

12.5 Distance to default: US and European bank comparisons 221

12.6 Bank versus sovereign CDS spreads 223

12.7 Spreads before and aft er monetary union .225

12.8 Bank lending and the prime rate spread to cash and sovereign bonds .226 12.9 Policy problems in Europe 231

12.10 UK and Ireland currency union 1820–1920 .233

12.11 Unemployment 15–24-year olds in Europe 234

List of Tables

1.1 Correlations between supply disturbances 18

1.2 Size and speed of adjustment following supply shocks 18

2.1 Competitiveness-adjusted debt-to-GDP ratios (reference year 1999 for equilibrium price level) vis-à-vis EA-11 44

2.2 Competitiveness-adjusted debt-to-GDP ratios (reference year 1995 for the equilibrium level) vis-à-vis EA-12 44

2.3 Competitiveness-adjusted debt-to-GDP ratios (reference year 1999 for equilibrium price level) vis-à-vis Germany .46

2.4 Interest rate–growth rate diff erential (government debt), selected countries 46

2.5 Interest rate–growth rate diff erential for the non-fi nancial sector, selected countries 47

2.6 Average size of fi rms 48

2.7 A continuing squeeze on the non-fi nancial sector? 49

3.1 General government developments, 2007–15: Ireland and Greece 66

3.2 Relative eff ects of fi scal consolidation 67

3.3 Fiscal consolidation measures 67

7.1 Banks, credit institutions, gambling 115

7.2 Transport 115

7.3 Telecoms, energy, water 116

7.4 Defence, exhibitions, other 116

7.5 Real estate, state rights 117

8.1 Public debts in 2007 and 2013, as % of GDP 127

8.2 Public debt stability in 2007 130

8.3 Government balances in 2012 % of GDP 132

8.4 Ten-year government interest rates 133

8.5 Net position in the Target 2 system 137

9.1 Correlations of output gaps within eurozone 154

10.1 Fiscal solvency estimates: all advanced economies, 1995–2013 174

10.2 Fiscal solvency: how the euro area responded to the Great Recession 174

12.1 Alternative policies 214

12.2 Bank exposures by country to the sovereign debt of eight countries 225

12.3 Cross-border exposures of banks: millions of US dollars, 2013 Q3 228

12.4 Sovereign, household and corporate debt: % GDP averages 231

Preface

Th e origin of the European Periphery Debt Crisis is rooted primarily in the structural

characteristics of the European Union (EU) member state economies, trading-off

a number of European and international economic, regulatory, institutional and

political factors as well as the fi nancial markets Th e emergence and evolution of

the crisis can now be assessed both in prospect and in retrospect, learning lessons

on what policy measures could have been designed and introduced in order to

avoid or at least manage the crisis more effi ciently and what policy measures could

potentially minimize the risk of future crises

In late 2009 I was given the opportunity of participating in the government of Greece

as a secretary of state and chief executive for asset restructuring and privatization,

a role I kept until early 2012, thus spanning both the George Papandreou and the

Lucas Papademos governments Th e escalation of the crisis quickly turned this role

into a lifetime experience, triggering refl ections on the plethora of factors involved,

analysing problems and synthesizing solutions In the presence of a prolonged

crisis and extensive contagion and spillover eff ects, I was motivated to edit a book

that I hoped would contribute to its diagnosis and provide an analysis from a risk

management point of view of the available policy options, both prospectively

and retrospectively Th e group of contributors I have assembled comprises senior

policy makers, regulators, active policy advisors, bankers, and decision makers in

the markets, drawing experience from the peripheral EU member states, the EU

itself and other Western economies Th e book is intended to be a practical reference

source for all those involved in the decision-making process in banking, the fi nancial

markets, investment, business, policy making and regulation

Part I ‘Genesis of the Crisis, Use and Abuse of Economic Policies’, occupies

Chapters 1–7, while Part II, ‘Crisis Resolution, Prospect and Retrospect’, occupies

Chapters 8–13

Chapter 1, by Philippe D’Arvisenet, contributes an analysis on the genesis of the

crisis and its association with the divergent structural characteristics of member

state economies, institutional inadequacies and concurrent market conditions It is

argued that the EU policy steps that have been taken are insuffi cient and asymmetric;

defi cit countries have been invited to adjust but surplus countries have not, showing

up the lack of cooperation Although the possibility for mutualization of liabilities,

subject to conditions, could partially address the debt issue, stability would also

require a mechanism to help smooth the eff ects of the business cycle, thus raising

political trade-off s among member states

In Chapter 2 Daniel Gros and Cinzia Alcidi argue that the EU authorities have

failed to recognize the trade-off between these two recommendations for indebted

xiv Preface

countries, since internal devaluation would improve competitiveness, but that

lowering nominal GDP growth would also worsen the debt-to-GDP ratio Th erefore

one should look at the value of the debt-to-GDP ratio only aft er competiveness

adjustments

Chapter 3, by Jeff Anderson with Jessica Stallings, contributes a comparative study

of the diff erent fi scal adjustments of Ireland and Greece Th e authors show how fi scal

consolidation helped Ireland succeed in triggering the growth needed to restore

debt sustainability, while at the same time the far more severe adjustment required

of Greece has had a severe negative eff ect on its GDP, thus further undermining

its creditworthiness It is argued that applying the Irish example in Greece would

require some additional funding, but the fi nal cost would be much less than might

eventually be needed in the case of continuing output fall

In Chapter 4 George Christodoulakis presents a discussion on the role of rating

agencies’ and sovereign debt markets’ risk preferences for the evolution of credit

spreads in the fi ve EU periphery crisis countries It discusses the propagation

mechanisms of market attitudes towards sovereign risk, and describes how attitudes

to risk evolve during a period of crisis It is shown that a ranking of the relative

optimism and pessimism is present, revealing diff erent preference asymmetries for

countries of Hellenic, Latin and Celtic origin, with the striking result that although

the interaction between credit default swap and bond markets played a primary role

in the escalation of conservatism for all countries, this was overshot by the credit

rating agencies’ risk preferences in the case of Greece in particular

Chapter 5, by Miranda Xafa, contributes to the ongoing debate on the trade-off

between the need to ensure debt sustainability upfront, versus the risks of contagion

and euro area bank insolvency Th e author concludes that although the restructuring

was eff ective in achieving considerable debt relief, the subsequent underperformance

of Greece’s adjustment programme thwarted this result Moreover, Greece’s

enormous fi nancing needs and worse-than-expected growth path put the possibility

of improved debt sustainability at risk as a result of an earlier restructuring

In Chapter 6 Paul De Grauwe presents a discussion on the attitude of Germany

towards the European Central Bank’s Outright Monetary Transactions (OMT)

programme in the sovereign bond markets While the German constitutional court

has declared the OMT programme illegal according to EU law, De Grauwe argues

that this ruling is based on economic theories such as the effi cient market theory and

the central bank positive equity theory, and explains why that should be rejected

In Chapter 7 George Christodoulakis reviews the importance of state asset

management, restructuring and privatizations for the control of government defi cit,

national debt and economic effi ciency It presents a discussion on the trade-off s

between economic rationality and the politics underpinning various European

privatization plans, especially those imposed on countries receiving Troika

funding It is shown why Greece constitutes a genuine special case, in which the

interconnection between economic events and European and national politics led

Preface xv

to massive underperformance Th e chapter concludes with international evidence

on the performance of privatization asset classes

Part II commences with Chapter 8 by Catherine Mathieu and Henri Sterdyniak,

who contribute an analysis of two main issues Th e fi rst concerns the sustainability

of high debt levels in developed countries and whether these countries should aim

for pre-crisis public debt levels Th e second question concerns the re-establishment

of public debt homogeneity within the euro area member states in the presence of

a single monetary policy and autonomous fi scal policies Th e authors contribute a

comparative discussion on alternative options for euro area governance as well as

public debt governance

Chapter 9, by Kerstin Bernoth and Philipp Engler, contributes an elaboration

on policy options for the stability of the European Monetary Union (EMU)

In the absence of monetary and exchange rate policies as stabilization tools, the

authors propose a system of compensatory payments between the member states,

and identify the degree of fi scal sovereignty that needs to be surrendered as a

requirement Higher compensatory payments could be a more eff ective stabilization

tool but require less fi scal sovereignty; therefore the optimal balance between the

two is left as a challenge for political debate

In Chapter 10 Ashoka Mody argues that in the presence of fi xed exchange rates

the eurozone needs fl exibility through a system of orderly debt restructuring, by

recognizing debt as an equity-like residual claim on the sovereign, which could

become operational by automatically lowering the nominal debt when it crosses an

agreed level Moreover, the author argues for the implications of this framework for

private deleveraging as well as its role in stability

Chapter 11, by Blaise Ganguin, focuses on the implications of the European

periphery crisis on corporate fi nancing He discusses empirical evidence showing

that rated corporates enjoy more diversifi ed funding sources than unrated ones,

and lower funding costs even in stress periods, signifying that information

asymmetries between the companies and the creditors are costly since the

creditors pay attention to rating assessments Moreover, while corporate fi nancing

in Europe is still bank-based, there is a recent trend in Greece, Italy, Spain and

Portugal where corporations are seeking ratings, thus raising expectations for

the development of corporate bond markets in Europe However, family-owned

businesses and SMEs are shown to be reluctant in sharing information outside the

traditional banking relationship

Chapter 12, by Adrian Blundell-Wignall and Caroline Roulet, provides a

comparative analysis and assessment of the main policy proposals that have been

made in Europe in the light of key economic constraints Th e authors provide

justifi cation and support for a mix of policies focusing on growth and structural

changes, thus giving a chance for Europe to resolve its problems without risking

the euro In the presence of the euro, the authors argue that Europe should choose

between either the costly path of monetizing its debts and adopting exchange rate

xvi Preface

management as a growth strategy, or a fi scal union which would trigger political

trade-off s on sovereignty

In Chapter 13 Dimitris Tsibanoulis and Gerry Kounadis identify a number of

institutional loopholes in the EU legislation which, in the presence of the sovereign

debt crisis, played a role in the fragmentation of the single market for banking

services Moreover, the chapter contributes an analysis of the European Banking

Union and its remedial implications for the institutional gaps in EU law and the

enhancement of the supervisory process, as well as a discussion of the single bank

resolution regime as a necessary step towards the restoration of the single market

Th e book constitutes a collective eff ort, providing analysis and understanding of

how to manage the European Periphery Debt Crisis and the associated risks from

both a prospective and a retrospective point of view Th e evolving nature of the

crisis and the institutional and structural complexities of the EU and member state

economies make such an eff ort diffi cult, but hopefully this book has contributed to

the advancement of our knowledge I would like to thank all the authors for their

excellent work and expert insights

George Christodoulakis

Notes on Contributors

Cinzia Alcidi is Head of the Economic Policy Unit at the Centre for European Policy

Studies (CEPS) in Brussels and a research fellow at the LUISS School of European

Political Economy Prior to joining CEPS in 2009, she worked at the International

Labour Offi ce in Geneva, and taught International Economics at University of

Perugia Since her arrival at CEPS she has worked extensively on the

macroeco-nomic and fi nancial aspects of crisis in Europe as well as on the policy response to

it During this process she has acquired a deep knowledge of the functioning of the

European Union, and the EMU in particular; she has written and lectured widely

on these topics She participates regularly in international conferences Her research

interests include international economics, macroeconomics, central banking and

EU governance She holds a PhD in International Economics from the Graduate

Institute of International and Development Studies, Geneva

Jeff rey Anderson has been with the Institute of International Finance (IIF) since

1984 He is Senior Director for European Aff airs, focusing on key issues arising from

the eurozone crisis, including implications for banks and impediments to fi nancing

for small businesses in Europe He was Director of the Institute’s European

Depart-ment from 1992 to 2012, where he followed the economic progress of central and

Eastern Europe, as well as Russia and Turkey, and led the expansion of the Institute’s

country coverage to the eurozone periphery Before that, he was Director of the

Comparative Country Analysis Department and Senior Economist in the Institute’s

Asia Department Prior to joining the Institute, he was part of the World Economic

Service at Wharton Econometric Forecasting Associates He received an MA in

International Studies from the Johns Hopkins University School for Advanced

International Studies in 1983

Kerstin Bernoth is Professor of Economics at the Hertie School of Governance, and

Deputy Head of the Macroeconomics Department at the German economic think

tank DIW Berlin She holds a PhD from the University of Bonn, and worked from

2004 to 2009 as a researcher in the economic policy and research department of the

Central Bank of the Netherlands Her research interests include empirical fi nance,

monetary and fi scal policy, and fi nancial stability Her articles have appeared in the

Journal of Banking and Finance and Journal of International Money and Finance.

Adrian Blundell-Wignall is the Special Advisor to the Secretary-General on

Finan-cial Markets and Deputy Director in the Directorate for FinanFinan-cial and Enterprise

Aff airs (DAF) at the OECD, eff ective from 14 February 2007 He is founder and

chairman of a charitable foundation (the Anika Foundation) that raises and invests

xviii Notes on Contributors

an endowment fund to provide scholarships in a critical area of healthcare An

Australian citizen, he obtained his PhD in Economics from Cambridge University

He is the author of numerous publications on fi nancial markets and monetary

policy in journals and books, as well as broker analyst studies and reports Senior

positions held in the past include Director and Head of Equity Strategy Research at

Citigroup (Australia, Ltd), Executive Vice-President and Head of Asset Allocation

at BT Funds Management, Head of Derivative Overlays and Levered Products at

Bankers Trust Funds Management, building a new $4 billion business, and Head

of the Research Department at the Reserve Bank of Australia, directing a

depart-ment and participating in monetary policy discussions at the internal pre-Board

meetings Early in his career he held economist positions in: the OECD Economics

Department, the Reserve Bank of Australia and the Economic Planning Advisory

Council of Australia

George Christodoulakis is Associate Professor of Finance at Manchester Business

School, University of Manchester, an active fi nancial advisor and entrepreneur

internationally, and a member of the Hellenic Corporate Governance Council He

served as the Secretary of State and Chief Executive for Asset Restructuring and

Privatizations of Greece between 2009 and 2012 He was formerly employed as

an Advisor to the Governor of the Bank of Greece, an academic at Cass Business

School, the University of Exeter, as well as an advisor in the international fi nancial

sector Dr Christodoulakis holds a PhD from the University of London His research

expertise concentrates on quantitative fi nance, credit and market risk, which has

applied in the market, to risk management, asset management and pricing, asset

privatization and restructuring transactions, forecasting, systemic fi nancial stability

and regulation Dr Christodoulakis is frequently invited as a speaker at international

professional conferences, expert panels and media He has published extensive

research work in leading international refereed journals and books He co-edited

the book Th e Analytics of Risk Model Validation and is Associate Editor of the Journal

of Risk Model Validation.

Philippe D’Arvisenet is currently an adviser to BNP Paribas From 1974 to 1977 he

was a research fellow at Lille Catholic University, where he also taught econometrics

From 1978 to 1982 he was with the French planning unit (Commissariat au Plan)

in charge of incomes policy He then joined the banking sector, was appointed chief

economist of BNP in 1994 and of BNP Paribas in 2000 He has been an associate

professor at Panthéon-Assas University since 1996 (economy and fi nance), and is a

member of the Commission Economique de la Nation chaired by the Minister of

Finance He is the author of nine books, including Finance Internationale (2nd ed,

2008), and Les Politiques Monétaires dans la Tempête (2014).

Paul De Grauwe is John Paulson Professor at the London School of Economics He

was a member of the Belgian parliament from 1991 to 2003 He is an honorary doctor

of the University of Sankt Gallen (Switzerland), the University of Turku (Finland),

the University of Genoa and the University of Valencia He was a visiting professor

Notes on Contributors xix

at various universities: Paris, Amsterdam, Berlin, Kiel, Milan, Pennsylvania and

Michigan He obtained his PhD from the Johns Hopkins University in 1974 He

is a research fellow at the Centre for European Policy Studies in Brussels and Area

Director “Macro, Money and Finance” at CESifo in Munich His research interests

are in the economics of monetary unions and behavioural macroeconomics Books

include Th e Economics of Monetary Union (9th ed 2012) and Lectures on Behavioral

Macroeconomics (2012).

Philipp Engler is Junior-Professor of Economics at Freie Universität Berlin and

he joined the University of Hamburg during summer 2014 He holds a PhD from

Freie Universität His research interests include monetary and fi scal policy, fi nancial

stability and European integration Philipp Engler has published several articles in

highly ranked international journals such as the Review of International Economics.

Blaise Ganguin is Head of Standard & Poor’s Corporate and Infrastructure Ratings

in EMEA, and Managing Director He coordinates a group of 170 analysts spanning

ten offi ces, and over 1500 credit opinions on corporate and infrastructure issuers,

and is part of the European Executive Committee Blaise joined Standard & Poor’s

in 1994 as a corporate analyst in Toronto, Canada, and previously worked in

bank-ing with UBS in Geneva, New York and Toronto He is the co-author, with John J

Bilardello, of Fundamentals of Corporate Credit Analysis (2005) He holds an MBA

from the University of Toronto, Canada; a post-graduate degree in International

Development and Cooperation from the University of Ottawa, Canada; and an MA

in History and International Aff airs from the University of Lausanne, Switzerland

Daniel Gros has been Director of the Centre for European Policy Studies (CEPS)

since 2000 He holds a PhD in economics from the University of Chicago In the

past, Daniel worked at the IMF, collaborated with the European Commission as

economic adviser to the Delors Committee that developed plans for the EMU, and

taught at several leading European universities He has been member of high-level

advisory bodies to the French and Belgian governments, and has provided advice to

numerous central banks and governments, including Greece, the UK and the US, at

the highest political level Daniel is currently an adviser to the European Parliament

and a member of the Advisory Scientifi c Council (ASC) to the European Systemic

Risk Board (ESRB) He has published extensively on international monetary aff airs

in scientifi c journals, is the author of several books and is the editor of Economie

Internationale and International Finance He contributes a globally syndicated

column on European economic issues to Project Syndicate.

Gerry Kounadis started his studies at Athens Law School in 2004 and successfully

completed (cum laude) a Master of Laws (LLM) in Finance at the Institute for Law and

Finance (ILF) of Goethe University Frankfurt with a fi rst class LLM thesis (“Evolving

International and European Regulatory Regimes for Netting in Financial

Transac-tions”) Gerry has also recently graduated from the ICMA Centre of University of

Reading, where he completed a MSc in Capital Markets, Regulation and Compliance

xx Notes on Contributors

with a research project titled “OTC Derivatives Regulatory Reform: Current Topics in

Central Counterparty Clearing” He is currently studying for the Qualifi ed Lawyers

Transfer Scheme, with a view to qualifying as a solicitor in England and Wales From

a professional standpoint, he has spent more than four years as a legal and compliance

trainee, trainee lawyer and lawyer (Athens Bar) working for major banking institutions

across Europe, including the European Central Bank and Lloyds Banking Group He

is currently employed in Tsibanoulis & Partners, one of the largest Greek law fi rms, as

an associate (Banking and Finance, Capital Markets)

Catherine Mathieu is a senior economist in the Analysis and Forecasting

Depart-ment of the OFCE (Observatoire français des conjonctures économiques) Her

main research areas are the European monetary union, macroeconomic policies,

policy-mix, and macroeconomic forecasting She is a member of the AIECE

(Association of European Conjuncture Institutes) steering committee and Chair

of the Working Group on Longer Term Prospects and Structural Changes She is

currently President of the EUROFRAME group of research institutes Catherine

Mathieu co-edited with Henri Sterdyniak “Towards a better governance in the EU?”,

papers of the 10th EUROFRAME Conference, in the Revue de l’OFCE / Debates

and Policies 132 (2014); “Th e euro area in crisis”, papers of the 9th EUROFRAME

Conference, in the Revue de l’OFCE / Debates and Policies 127 (2013) She and

Henri Sterdyniak co-authored “Redemption?” in Revue de l’OFCE 132 (2014), “Do

we need fi scal rules?” in From crisis to growth? Th e challenge of debt and imbalances

(2012) “EU public fi nances in the crisis” in Stabilising an unequal economy? Public

debt, fi nancial regulation, and income distribution (2011).

Ashoka Mody is Charles and Marie Robertson Visiting Professor in International

Economic Policy at the Woodrow Wilson School, Princeton University, and a

non-resident senior fellow at the Bruegel think tank in Brussels Previously, he was

Deputy Director in the International Monetary Fund’s Research and European

Departments Earlier, he was at the World Bank, and at AT&T’s Bell Laboratories

He has advised governments worldwide on macroeconomic and crisis

manage-ment issues, as well as on developmanage-mental and fi nancial projects and policies He

has written extensively for policy and scholarly audiences He received his PhD in

Economics from Boston University

Caroline Roulet is currently an economist in the Financial Aff airs Division of

the OECD, which she joined in 2012 Her work covers issues related to banking,

fi nancial markets and monetary policy She has published various articles in books

and academic journals Previously, she worked at the JPLC, an advisory fi rm in

fi nancial markets, derivatives and credit risk She has a PhD in Economics from the

University of Limoges, France

Jessica Stallings is a research associate in the European Aff airs department at the

Institute of International Finance (IIF) She focuses on macroeconomic, fi nancial

Notes on Contributors xxi

and political developments in the euro area countries, particularly in the periphery

She also contributes to the IIF’s work on policy issues, and is part of the Institute’s

ongoing eff orts on access to fi nance for small and medium-sized enterprises (SMEs)

Prior to joining the IIF, Jessica served as the Special Assistant to the Ambassador at

the Embassy of the Republic of Korea Jessica received an MA from Johns Hopkins

School of Advanced International Studies (SAIS), with a concentration in

interna-tional economics and European studies, and a BA from the University of Virginia

Henri Sterdyniak is Director of the Economics of Globalisation Department at the

OFCE (Observatoire français des conjonctures économiques) He has published

many books and articles on macroeconomics, economic policy, monetary and

international economics, European economy, fi scal and social issues See entry on

Catherine Mathieu for recent publications

Dimitris Tsibanoulis is the managing partner of Tsibanoulis & Partners Law Firm

and legal adviser to the Bank of Greece He studied in Athens (1980 LLB) and in

Frankfurt am Main (1986 PhD) He practises banking, capital markets and

corpo-rate law He is member of the BoD of the Hellenic Deposit and Investment

Guar-antee Fund (since 2009), of the Hellenic European Law Association (FIDE-Greece,

since 2002) and of the European Society for Banking and Financial Law (AEDBF)

(since 2003 and from 1.1.2012 Chairman of the BoD) He has been a member of

the EFMLG since 1999 He was the legal Advisor to the Republic of Cyprus on

the implementation of the European capital markets legislation (2000–2004) and

to the Albanian Financial Supervisory Authority for corporate and capital market

issues (2006–2010) He participated in several legal groups in the ECB and the

European Commission advising on matters pertaining to the regulation of Banking

and Financial Markets, and in numerous legislative groups advising on the draft ing

of Greek Banking and Securities Laws (since 1988) He is the author of three books

and several articles published in Greek and foreign legal magazines on company

law, banking and fi nance law

Miranda Xafa started her career at the International Monetary Fund in Washington

in 1980, where she focused on stabilization programs in Latin America In 1991–93

she served as Chief Economic Advisor to the government of Prime Minister

Mitso-takis in Athens, and subsequently worked as a fi nancial market analyst at Salomon

Brothers/Citigroup in London Aft er serving as a member of the board of the IMF

in Washington in 2004–09, she worked as Senior Investment Strategist and member

of the advisory board of I J Partners in Geneva, and is now CEO of E F

Consult-ing in Athens She holds a PhD in Economics from the University of Pennsylvania,

and has taught economics at the Universities of Pennsylvania and Princeton She

has published several articles and papers on international economic and fi nancial

issues

Part I

Genesis of the Crisis, Use and Abuse of

Economic Policies

1 Introduction

The euro crisis is often said to have been the consequence of an excessive debt,

private or public, and finally both But that excessive debt would not have resulted

in such a serious crisis had the eurozone institutions properly ensured the correct

working of the mechanisms of a monetary union

The euro was seen as instrumental in eliminating the risk of competitive

deval-uations and possible protectionist pressures, obviously something that would not

be welcome in a deep integrated single market with freedom of trade in goods and

services and capital movements History shows that European countries have

re-peatedly shown little appetite for floating exchange rates Following the collapse

of Bretton Woods, they launched the “snake”, then the European monetary system

(EMS), a regime of fixed but adjustable exchange rates When the EMS collapsed

in the early 1990s, with huge exchange rate adjustments (Figure 1.1), considerable

changes in exports performances followed (Figure 1.2) Beside political

considera-tions, such disturbances were a good argument in favour of a single currency, a

much more robust arrangement than a classic fixed exchange rate regime

When the euro was launched, it did not comply with the requirements of an

op-timal currency area Some suggested that the features of an opop-timal currency area

that justify the adoption of a monetary union would progressively show up (the

so-called “endogenous currency area theory”) Until the crisis burst, the cycles

became more correlated, as we document below (regarding the rates of growth,

inflation, output gaps, etc), but simultaneously, labour costs diverged, and rates

of indebtedness were not kept under control, resulting in a widening of external

imbalances The conjunction of high debt together with the rise in risk aversion

resulted in “sudden stops”; the appetite of investors to finance external and public

deficits disappeared, and the crisis erupted In a true monetary union that would

not have happened, the deficits being automatically financed; the euro eliminated

exchange rate speculation, but not speculation in debt Things happened just as if

1 The Genesis of the Eurozone

Sovereign Debt Crisis

Philippe d’Arvisenet

4 The Euro Zone Sovereign Debt Crisis

member countries had issued debt in a foreign currency without control over their

own currency by a central bank that could act as a lender of last resort Official

support, together with policies aiming at reducing imbalance became inevitable

At the beginning of the crisis, policies that were implemented aimed at reducing

fiscal deficits with the implementation of austerity programs, on a case-by-case

basis Delays and errors were made with respect to the distinction between

li-quidity and solvency, the involvement of the private sector, and the size and scope

Figure 1.2 Exports of G & S, volume (index Q1/1991 = 100)

Sources: Eurostats, OECD

170 160 150 140 130 120 110 100 90

Philippe d’Arvisenet 5

of the bailout mechanisms With the worsening of the crisis, contagion and policy

mistakes triggered a vicious circle between sovereign risks and banking risks It

became obvious that pan-European measures were required, hence the European

semester, the six pact, the two pact, the “fiscal compact”) and the banking union

(d’Arvisenet, 2012)

Beyond that, it can been stressed that in a monetary union with no exchange

rate risks, countries/ regions tend to specialize in activities in which they benefit

from comparative advantages That is welfare-enhancing, but does not come

without side effects Some will specialize in the production of tradables – industry

in the first place; others will specialize in non tradables (services) As a

conse-quence some will exhibit structural foreign trade surpluses, and others structural

deficits Such external imbalances are not the consequence of mistakes in

pol-icies; they result from the natural mechanism of comparative advantages Ruling

out such imbalances, in other words refusing structural transfers similar to those

that take place in any country/ federation, assumes that restrictive policies are

conducted repeatedly in countries that tend to exhibit deficits The alternative

would be a limit on the mechanism of specialization One might then question the

advantages of adopting a common currency

2 Without fiscal federalism, excess debt and widened

external imbalances triggered a sudden stop

2.1 Rising imbalances

The key objective of monetary policy, that is avoiding inflation (or deflation), can

be achieved through the reputation of the central bank, backed by its

independ-ence and its transparency When its reputation is solidly established, and the rate

of inflation moves above or below the central bank’s inflation target, such

devel-opments are seen as temporary and do not affect expectations, a key driver of

inflation in the medium term When its reputation is absent, however, building

it requires an investment that is costly in terms of growth and jobs (the Volcker

experience) In the eurozone, the central bank’s reputation was simply transferred

from the Bundesbank to the ECB, all countries enjoyed low short- and long-term

rates as a result, and real rates dropped to lower levels (Figure 1.3)

Countries that had previously experienced high interest rates benefited from

much friendlier financing conditions with real rates much below growth,

espe-cially in the south of Europe By contrast, financial conditions in Germany were

restrictive (Figure 1.4) So a borrowing binge erupted (Figures 1.5 and 1.6) This

resulted in elevated debt ratios, especially in the private sector (Figure 1.7), where

domestic demand was strengthened (Figure 1.8)

These conditions, which favoured certain sectors above others, led to a

mis-allocation of resources (particularly in residential construction), fuelling a

bub-ble rather than the development of the tradabub-bles sector In Spain and Ireland, for

6 The Euro Zone Sovereign Debt Crisis

6 5

4

3 2

1 0

–1

01 – 96 07 – 96 01 – 97 07 – 97 01 – 98 07 – 98 01 – 99 07 – 99

Figure 1.3 Real three-month interbank rates, %

Sources : Thomson Reuters, BNP Paribas

example, employment in construction as a proportion of total employment rose

to twice its long-term average In other countries, most notably Greece, capital

inflows helped finance government spending (starting with current expenditure)

For some time, this gave no apparent cause for concern, as shown by the extremely

low levels of sovereign spreads Growth was boosted well above potential and

above real rates, which supported the appetite for debt and risk, with finally

ad-verse consequences for both relative rates of inflation and competitiveness The

consequences were a slowdown in exports and soaring imports driven by strong

domestic demand In turn, this led to a widening of external deficits

The boom in activity and asset prices inflated the tax base (Ireland, Spain),

so the fiscal situation appeared sound External deficits resulting from a private

sector financing gap or from widened fiscal deficits were easy to finance Capital

flows were (rightly) expected to grow with the expansion of trade and financial

transactions resulting from the single market in a context where exchange rate

risks had disappeared In fact, the eurozone seemed to behave as an optimal

cur-rency area, which it was not

The widening of external deficits (Figure 1.9) and expansionary fiscal policies

in some “peripheral” ’ countries (Figure 1.10) continued for as long as investors

had an appetite to lend (Figure 1.11) That might not have been an issue had the

deficits been related to productive investment that would have generated income

in the future But in the case of many countries, the deficits were due to increasing

Yield on 5-Year Government bond Nominal GDP (y/y, %)

ECB refi rate

Yield on 5-Year Government bond Nominal GDP (y/y, %)

ECB refi rate

Figure 1.4 Financial conditions in Germany

8 The Euro Zone Sovereign Debt Crisis

–6 –3 0 3 6 9 12 15 18

0 60 120

180 Amount outstanding (yoy %)

Flows (bn EUR)

Figure 1.5 Eurozone: credit to non financial corporate

Source: BCE.

–6 –3 0 3 6 9 12

–30 0 30 60 90

120 Amount outstanding (yoy %)

* household + nonfinancial corporates

Figure 1.7 Debt of the private sector * as % of GDP

Sources: Eurostat, BNP Paribas.

Philippe d’Arvisenet 9

90 100 110 120 130 140 150 160

Ireland Greece

Spain Germany

Figure 1.8 Domestic demand volume, Indice Q1/2000=100

Source: Eurostat

–18 –15 –12 –9 –6 –3 0 3

Figure 1.9 Goods and services balance, % of GDP

Sources: Nationales

government expenditure and/or excesses in the private sector, especially in

resi-dential construction

Finally, access to external finance became a problem Countries that

experi-enced low real rates exhibited large current account deficits (Figure 1.12) When

the crisis erupted, countries with a large current account deficit were then affected

by high spreads (Figure 1.13)

10 The Euro Zone Sovereign Debt Crisis

Figure 1.11 Ten-year government bond yield, %

Source: Thomsan Reuters

–18 –15 –12 –9 –6 –3 0 3 6

Portugal Ireland* Italy

* excluding bank recapitalisation costs in 2009, 2010 & 2011

Figure 1.10 Structural budget balance as % of GDP

Source: European Comission (Ameco)

Philippe d’Arvisenet 11

Figure 1.12 Real interest rate and external imbalances

Source: European, BNP Paribs

0 0,5 1 1,5 2 2,5

AUS

Figure 1.13 Current account balance as % of GDP

Source: European Comission(Ameco), Thomsom Reuters

10-year bond rate: spread vs Bund (basis points) on 31/12/2011

GR PT

IR IT ES

FR

BG

NL DE

OE FN

10-year bond rate: spread vs Bund (basis points) on 31/12/2012

GR PT

IR IT

ES

FR

NL

FN DE

BG OE

12 The Euro Zone Sovereign Debt Crisis

2.2 Sudden stops, spreads, fundamentals and beyond

Debt is unfriendly to growth Herndorn et al (2013) have shown that over 1945–

2009, advanced countries with a government debt to GDP above 90% experienced

an average rate of growth of 2.2% against 3.2% with a ratio between 60% and 90%

During the period often referred to as the “great moderation”, when inflation,

un-employment and interest rates were all low, and demand for credit was stimulated

by favourable financial conditions and a lack of volatility in economic activity, it

became clear that external imbalances had to be reduced According to

conven-tional wisdom, that can be addressed with an effort to boost competitiveness and

reduce fiscal imbalances and therefore domestic demand That is a challenge in

countries where foreign trade elasticities are such that an internal devaluation is

not an easy solution

Until the financial crisis broke in the late 2000s, almost all analysis of

eco-nomic policy (BIS research was a conspicuous exception) attached little

import-ance to trends in debt and credit The health of the economy was supposed to be

guaranteed by an independent central bank aiming at price stability by using its

policy rate Debt was considered – rightly, up to a point – as a means of improving

the allocation of resources It helps households smooth their consumption over

bumpy income streams, and companies to insulate their investment and activity

from fluctuations in demand Similarly, government debt helps to spread taxes

and consumption between generations: if one assumes that future generations

will be richer and more populous, with more human capital and more efficient

productive capacity, they can finance a transfer to the present generation

Inter-temporal utility is thereby increased But beyond a certain level, debt has negative

effects Higher interest costs reduce the ability to cope with shocks, and increase

sensitivity to variations in activity and interest rates, and solvency can be affected

As far as governments are concerned, the scope to bolster activity or assist

eco-nomic agents in difficulty is reduced Ecoeco-nomic activity weakens and becomes

more volatile

Budget adjustments alone would undoubtedly suffice if spreads depended

solely on fundamentals Since 2008, however, as we have seen, panic behaviour

has driven spreads well above the levels justified by fundamentals alone This

jus-tifies the introduction of non-standard monetary measures to try to hold spreads

to reasonable levels, which by no means calls into question the need to clean up

public finances D Haugh et al (2009) showed that in addition to the effects of the

ratio of debt servicing over fiscal revenues and anticipated deficits, the dynamics

of spreads in the eurozone also depends on the degree of risk aversion (measured

by the corporate high yield spread) Along the same lines, L Schukenecht et al

(2010) show that since late 2008 the markets have been sanctioning deficit and

debt overruns much more severely than in the past The sensitivity of spreads to

deficit and debt overruns has increased, in addition to the general tendency for

spreads to rise in response to greater risk aversion P de Grauwe et al (2012) also

Philippe d’Arvisenet 13

show that sovereign spreads do not correctly reflect fundamentals (debt ratio) In

a period of excessive optimism, the markets ignored fundamentals until 2008,

which shows that contrary to the claims of the efficient market theory, the

mar-kets did not make use of all available information! As a result, spreads rose much

higher in the countries hit hardest by the crisis than the levels indicated by models

based on fundamentals Since 2008, the surge in spreads goes well beyond that

justified by the increase in the debt ratio, even after taking into account

non-linear effects Deviations between observed spreads and theoretical spreads (that

is, those based on fundamentals) are correlated over time, which is characteristic

of bubbles.1

Following the intensification of financial distress from 2008 and the recession

that followed, debt/GDP ratios rose sharply, as did yields and debt servicing costs;

yield spreads widened, but with important differences across countries

Factors behind these differences can be analysed with a model, with data up

to 2010 Q4 The period is not extended further, to avoid interference from the

consequences of the mounting concern regarding the exit of some countries or

the burst of the euro that affected the spreads beyond the liquidity and default

risk factors with a so-called “conversion risk” (in other words, we avoid structural

breaks caused by the intensification of the crisis, for instance the correlation or

vicious circle that showed up between banks and sovereign risks)

In a monetary zone, certain factors that are usually taken into account, such as

the exchange rate risk or the central bank credibility, are obviously absent; there is

just one currency and one central bank Both liquidity and default risks affect the

risk premium that market participants require to hold a risky asset relative to the

risk-free benchmark (the German Bund)

The endogenous variable is the spread between ten-year interest rates for ten

members of the EMU and the German Bund

Large bond markets come with low liquidity risks In such markets, it is easy to

find a counterpart willing to sell or buy securities, and a given trade on the market

will not have a significant impact on prices Everything being equal, higher

li-quidity is conducive to lower spreads As a measure of lili-quidity, we take the

cen-tral government debt of a given country as a proportion of the eurozone treasury

debt

In order to assess the default risk, we rely on a set of fiscal indicators: the debt/

GDP ratio, the debt servicing costs, the “fiscal effort” measured as the difference

between the actual fiscal balance and the fiscal balance that would be required in

order to stabilize the debt ratio at its previous year level, and the rate of economic

growth As is well known, these are the key variables of the debt dynamics:

dt = dt–1 (1 + r – g) + spt

14 The Euro Zone Sovereign Debt Crisis

dt = debt ratio, r real interest rate, g rate of growth (volume), sp primary balance

dt – dt–1 = 0 ≥ sp = dt–1 (r – g) measures the fiscal effort required to stabilize the

debt ratio

We control for the attitude regarding risk (appetite or aversion) by including a

corporate bond spread: at times of stress, a given level of debt or debt service ratio

can result in a higher spread than at normal times To avoid problems of

endog-eneity, we take the US (rather than eurozone) corporate bond spread

The annual data are modified to get quarterly observations that are smoothed

to avoid distortions due to seasonal factors GLS is used to take into account

cross-country heteroscedasticity and contemporaneous covariance of errors

Our preferred equation is:

Sit = –0.78 + 0.02Rt x DS2

it – 0.09 FE – 0.09 Yit – 0.102Lit + 0.25 Rt + 0.15 DSit (5.9) (1.74) (–6.91) (–3.55) (–8.99) (6.40) (3.43)

Sit = spread for country i, period t

Rt = general risk factor

DS = debt service ratio

FE = Fiscal effort

Y = growth

L = liquidity indicator,

Our estimates confirm that the liquidity factor reduces the risk premium

An increase in our measure of liquidity by 1% reduces the spread by 2 basis

points

Higher debt/GDP ratios, or the debt service ratio, indicate the magnitude of the

burden that the amount of debt imposes on fiscal flows Both variables are

obvi-ously correlated and cannot coexist contemporaneobvi-ously in the model

Everything being equal, 1 point of the debt service ratio leads to a widening

of the spread by 15 basis points Debt servicing ratios have non-linear effects on

spreads The interaction term between the general risk aversion and the debt

ser-vice ratio shows that, everything being equal, in times of market stress the risk

premium that is required to hold assets from countries with high debt service

ratios will rise

The coefficient of the fiscal effort indicator shows that if a country is doing

more than necessary to stabilize its debt ratio, the yield spread eases; a fiscal effort

equivalent to 1% of the GDP reduces the yield by 10 basis points

Obviously, economic growth helps in stabilizing debt Unsurprisingly, it affects

the risk spreads: 1 point in growth reduces the spread by 10 basis points

R2=0.67

Philippe d’Arvisenet 15

No more surprisingly either, in a period marked by tensions and

uncertain-ties the general risk aversion factor has a positive impact on spreads (by 20 basis

points)

Introducing a dummy variable for Greece, adding the debt/GDP ratio or

substi-tuting it to the debt service ratio, did not improve these estimates

From the beginning of 2008 until mid-2010, the evolution of the spreads is

replicated correctly by the model; in the following quarters, the residual between

the actual spreads and the spreads calculated by the model widened considerably

From compressed levels until mid-2010, they then reached 750 basis points in

Greece in 2010 Q4, and 300 in Portugal, 180 in Spain, 140 in Italy

Factors that are not taken into account by the model show up; the eurozone

experienced a sharp drop in confidence from the second half of 2010, and

sover-eign debt and banking sector debt were highly interacting, as shown by the CDS

(Figure 1.14)

3 The Eurozone is not an Optimal Currency Area (OCA)

3.1 The main features of an OCA

The euro was a political project; it was launched with little regard for the criteria

that would have to be complied with in order to make sure that the EMU would

work adequately

The criteria that define an OCA are the following:

– Strong trade integration, as shown by Figure 1.15; this criterion was undeniably

0 100

Figure 1.14 Eurozone: five-year CDS by sector (basis points)

Source: Thomsom Reuters

16 The Euro Zone Sovereign Debt Crisis

respected

– No (or little) exposure to asymmetric shocks: member countries cannot rely on

an exchange rate adjustment or on an autonomous monetary policy to cope

with a specific shock

– The flexibility of the labour market; the more flexible it is, the easier the

adjustment In case of a negative shock that results in a higher rate of

unemployment, downward pressures on wage costs would boost competitiveness

that would offset the adverse consequences of the shock for the economic

activity and then result in a reduction in unemployment, provided that prices

are flexible enough to reflect the moderation or reduction in wages In other

words, a real devaluation would take place instead of a nominal devaluation

that cannot be achieved, by definition, with a common currency

– Geographical mobility of labour: it enables an outflow of workers from a country

that is adversely affected by a shock towards other member countries; as a

consequence, the effect of the shock on unemployment is mitigated (In the

event, this mobility was extremely limited, due to differences in languages and

to the limited transferability of social rights such as pensions and unemployment

benefits.)

– Fiscal federalism: a country that is affected by an adverse shock will contribute

less to the central/ federal budget and benefit from higher fiscal expenditures,

so fiscal federalism acts as an automatic stabilization mechanism; the less well

correlated are the cycles/shocks, the more important is compliance with such

criteria

Obviously as we will document below, these criteria were not respected

Figure 1.15 Eurozone trade (as % of total trade)

Philippe d’Arvisenet 17

3.2 Convergence and divergence: is the OCA endogenous?

Before the euro was launched, the questions of whether the eurozone was an OCA,

or might become one, were frequently discussed Mundell’s (1961) concept of the

optimal currency area was based on the costs and advantages of the adoption of a

single currency

A single currency reduces the costs of transactions, and eliminates the

ex-change rate risks and therefore the costs associated with hedging But it also

eliminates the monetary policies of the member countries In case of common

or correlated shocks, a common monetary policy makes sense; it is able to deal

with two countries affected by the same shock In contrast, if shocks to which the

economies are exposed are different in nature or intensity or if economies respond

asymmetrically to common shocks or to the monetary policy, the outcome of a

common monetary policy can bring more inconvenience than advantages in its

wake Mundell also stressed the importance of the distinction between supply and

demand shocks and of the speed of adjustment of the economies to these shocks If

shocks are symmetric or show only a limited asymmetry, the loss of autonomous

monetary policies is of no great consequence The more a union complies with the

requirements of an OCA, the easier the adjustment to shocks

What can be said in that respect about the member countries of the EMU? In

order to answer that question, it is necessary to distinguish between the types

of shock (that is, supply shocks and demand shocks) Bayoumi and Eichengreen

(1994) suggested a framework based on Blanchard and Quah (1989) who

iden-tify the nature of shocks depending on their impact on output: supply shocks

have lasting effects, are persistent, and affect potential production; in contrast,

demand shocks are transitory by nature Obviously, asymmetric demand shocks

should not show up as a result of a monetary policy that is the same for everyone

Correlation between supply shocks is essential, as the monetary policy reaction

must be synchronized Demand shocks, not being lasting, cannot be the result of

divergences in monetary policy Based on this research, de Lucia (2011) conducted

a statistical test aimed at identifying supply and demand disturbances in the

eurozone He shows that supply shocks affecting Greece or Ireland are relatively

independent from those that affect the other economies Greek disturbances are

correlated with those affecting France and Italy, whereas Irish disturbances are

positively correlated only with those affecting Finland Shocks that affect Portugal

and Spain are correlated with 6 countries out of a sample of 11 As a consequence,

the countries of the periphery do not comply with the Mundell criteria: a high

and positive correlation that would justify a unique monetary policy Only the

six founding members of the EU and Austria pass this Mundell test (correlation

coefficient in Table 1.1)

What about the speed of adjustment to shocks? If these are limited in size,

macroeconomic variables (such as production and unemployment) remain close