Off the Target: The Stagnating Political Economy of Europe and Post-Pandemic Recovery 3030881849, 9783030881849

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Off the Target The Stagnating Political Economy of Europe and Post-Pandemic Recovery Muhammad Ali Nasir

Off the Target “Muhammad Ali Nasir has written a remarkable book full of new insights in the difficult process of European integration and the financial crises of recent times that resulted in a lost decade for the continent. This book is a must-read for anyone who is seriously interested in understanding the mechanisms that led to the problems Europe encounters and in the potential ways ahead.” —Hans-Werner Sinn, Professor Emeritus of Economics and Public Finance, University of Munich, Germany “After providing insightful accounts of the moves to union and integration in Europe, this impressive book provides detailed analyses and critiques of the macroeconomic policies of the euro area institutions in the ‘lost decade’ of the 2010s. It also evaluates the prospects for a post-pandemic recovery and whether a second ‘lost decade’ can be avoided, fully cognizant of the major challenges faced by the euro area.” —Malcolm Sawyer, Emeritus Professor of Economics, University of Leeds, UK “This is a timely book on European economic and social policy. As we have seen during the Euro Crisis, the European integration has weakened nation states without the Union stepping. EU policies had deepened the economic crisis. The Covid Crisis requires the EU to change course and develop its capacity to support its citizens. Off the Target is a useful guide through current debates.” —Engelbert Stockhammer, Professor of Political Economy, King’s College London, UK “At this time of grave ecological insecurity and dangerous imperialist rivalries, a democratic and social European Union could emerge as a progressive, green, stabilising power in world politics. This detailed and authoritative account of the emergence of the European Union’s political economy is both timely and an invaluable resource for diplomats, scholars and politicians. It already has a significant place on my bookshelf.” —Ann Pettifor, Director of Policy Research in Macroeconomics (PRIME) “This book gives a fascinating history of the European Monetary Union and the role of Target2 mechanism in internalizing the financial and economic fissures

within the Eurozone area. At the heart of the Euro experiment is the question whether a single currency will be the bonding glue for fiscal, security and political union or instead, a formula for stagnation or Lost Decade2.0. Read this book to find out the answers.” —Andrew Sheng, Distinguished Fellow at University of Hong Kong, Adjunct Professor Tsinghua and Peking Universities “This book does a fantastic job assessing the European Union’s decade in turmoil – the 2010s – when it plunged from one crisis to another including the Eurozone debt crisis, austerity and Brexit. In accounting for the ‘lost decade’, politics and economics are beautifully woven together, combining topics ranging from European identity and politics of convergence to the intricacies of monetary, fiscal and financial policies in the Eurozone. This is also an ambitious and forward-looking account, tackling green finance, digital transformation and potential trade wars – key policy issues of our time.” —Gulcin Ozkan is Vice Dean and Professor in Finance at King’s Business School, King’s College London

Muhammad Ali Nasir

Off the Target The Stagnating Political Economy of Europe and Post-Pandemic Recovery

Muhammad Ali Nasir Huddersfield Business School University of Huddersfield Huddersfield, UK Research Fellow at University of Cambridge Cambridge, UK

ISBN 978-3-030-88184-9 ISBN 978-3-030-88185-6 (eBook) https://doi.org/10.1007/978-3-030-88185-6 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover credit: Vectorios2016 Cover design by eStudioCalamar This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Dedicated to my grandmother Evelyn Servant that she has been a source of great inspiration and the best grandma ever. To my mother Nasim and father Imdad Hussain.

Preface

Leaving the European Union will be the best thing that can ever happen to the UK, we must leave and take back control from Brussels, somebody said in a voice full of emotions. No, that would be disastrous, it is economically and geopolitically suicidal, we must stay, somebody else said equally passionately. Membership of the EU was the talk of the town and there was not a day when somebody did not mention the word Brexit. But the debate was not just limited to and focusing on the geographical boundaries of the UK, there were longstanding and even tougher questions on the membership of the European Union and particularly on those countries that had signed up for a common currency formulating the Eurozone. Debate on the European Sovereign Debt Crisis, bailouts, austerity and associated tragedies was anything but over yet, the historic announcement by the British prime minister in February 2016 on Brexit Referendum had profound significance and the events that followed overshadowed everything in both UK and EU for the years to come. There were many questions, more than we can find answers to. What is the European Union, is it something which is defined by the EU treaties and regulations that are not always easy to comprehend by a layman? or is it something a lot deeper? Are the foundations of the European Union underpinned by economic necessity or is it all about politics? Politics, that is not always very clean! But is there something there in European history that is even more profound, yet often condoned? My grandma

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PREFACE

who has lived through the second world war says there is nothing new under the sun! well, does it mean that all the developments and ideas of European Integration are not very new and if they aren’t, why they have not been applied before and what it is that makes the European Union, and everything associated with it the way it is at present? Again, a lot of questions, perhaps more than the number of problems and issues the European Union is faced with. Through the lens of an economist, this book is an endeavour to dig deeper into the development of the European Monetary Union, issues it faces, the influence of politics, historical events in shaping and defining what is now. It is also a critical analysis and reflection on an unfortunate Lost Decade of economic progress in one of the oldest, historically and culturally richest continent of the world. Why and where it went OFF The Target ! and how we can put it right. In the self-inflicted, stagnating political economy of the European Union that was not short of challenges to start with, the Pandemic is just another one, yet existential. God forbid, if Europe does not get it right this time, it could be a Lost Decade 2.0 at least or to our fears, it could be the timber plank that will definitely break the back of the camel of European integration. In a world that is changing more rapidly than ever before and the centre of gravity of the global economy is shifting eastward, the margin of error for Europe is very slim. Nobody takes lessons from you if your economy is stagnating. European ambitions of global leadership on climate change, sustainable development and geopolitical issues will remain wishful thinking if we do not get it right this time. It’s Europe’s last shot. Huddersfield, UK

Muhammad Ali Nasir

Contents

1

Wrong Intentions and Flawed Foundations European Identity and Integration in European Blood From Fall of the Berlin to the Rubble of Berlin Wall German Unification and Road to Maastricht Maastricht Treaty—Conception of Tragedy Maastricht to Amsterdam Politics and Economics of Convergence Euro—The Birth of Tragedy

1 1 5 20 23 30 35 38

2

Great Moderation Let the Party Going Treaty of Nice and Eastward Expansion Treaty Establishing a Constitution for Europe (TCE): Rome to Lisbon Berlin Declaration and Treaty of Lisbon Steroid-Enhanced Economic Development Post-Euro

47 47

Global Financial Crisis—Tip of the Iceberg First Test and Longest Battle of ECB Long-Term Refinancing Operations (LTROs) and Whatever It Takes! Stabil Wie Die Mark Conventional to Non-conventional and Asset Purchase Programme Refinancing Operations but This Time They Are “ Targeted”

65 65

3

51 53 57

80 85 87 91

ix

x

4

5

CONTENTS

Asset Purchase Programme (APP) Going Below Zero Forward Guidance

96 115 119

Flawed Fiscal and Stimulus Plans: A World Beyond ECB A European Economic Recovery Plan Fiscal Manoeuvres in Limited Space German Fascination with Balancing French Finance for Financial Sector Spanish Stimulus Generosity with Design Flaw Italy Wrong Side of Business Cycle Netherland’s Robustness but Not Rapid Recovery Britain’s Early Withdrawal and Austerity

123 123 130 130 134 137 139 141 143

A Jigsaw of Financial Institutions and Unions Within Union European Financial Stabilisation Facility/Mechanism (EFSF/M) European Stability Mechanism (ESM) Outright Monetary Transactions (OMT) Financial Stability in the EMU and the European System of Financial Supervision (ESFS) Single Supervisory Mechanism (SSM) Single Resolution Mechanism (SRM) European Deposit Insurance Scheme (EDIS) Union of Compromises and Completion of the Banking Union Unions Within the Unions Capital Requirements Regulation and Directives Markets in Financial Instruments Directive (MiFID) EU Reforms Plans of Four Presidents Five Presidents Plan A New Commissioner a New Plan: Junker Plan COVID and Europe: ESM, EIB and SURE Fiscal Union or Framework for Fiscal Policies Fiscal Stability Treaty or Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG) European Fiscal Compact

147 147 153 163 164 169 173 177 179 182 186 187 187 190 194 195 198

200 202

CONTENTS

xi

European Fiscal Board Learning from Good Practices

204 207

6

Stagnation in Europe: A Lost Decade Europe Will Above All Be Judged on Results

211 211

7

TARGET2: Off the TARGET Eurozone Monetary system—A Hub with Many Spokes Trans-European Automated Real-time Gross Settlement Express Transfer System (TARGET2) OFF the TARGET Secret Bailout, Is It or Isn’t? Stagnation & Settlement of TARGET2 A Settlement Mechanism

225 225

Europe: The Way Forward Seven Decades of Integration: A Work Still in Process COVID-19 Mother of All Crisis for EU ECB’s Response: Another Battle to Pick Fiscal Measures: Death of Debt Break EU and European Commission’s Response Green New Deal, Digital Agenda and Ambitions for Global Leadership A Europe Without UK Rising Asia, New Trade and Cold Wars Can Europe Be a Good Example? Closing Remarks

267 267 269 270 272 275

8

228 231 238 243 257

282 285 289 293

Appendix “A”

297

References

299

Index

311

List of Figures

Fig. 1.1

Fig. 1.2

United States’ reaction to the slow negotiations for the establishment of a European Payments Union (Source Evening Standard. 28.12.1949. London. “Time, Gentlemen, please!”, auteur: David Low) Joining the European Payments Union (EPU) (Source Daily Herald. 28.03.1950, n° 10 625. London. “Slightly mixed bathing”, Auteur: David Low. On 28 March 1950, the British cartoonist, David Low, illustrates the hesitations of Ernest Bevin, British Foreign Secretary [left], and Hugh Gaitskell, British Chancellor of the Exchequer [right], at calls from Paul Hoffman, US administrator of the Economic Cooperation Administration [ECA] given the task of managing the distribution of funds under the Marshall Plan, for them to join the future European Payments Union [EPA])

8

9

xiii

xiv

LIST OF FIGURES

Fig. 1.3

Fig. 1.4 Fig. 1.5 Fig. 1.6

Fig. 1.7 Fig. 1.8 Fig. 2.1 Fig. 2.2 Fig. 2.3 Fig. 2.4 Fig. 2.5 Fig. 2.6 Fig. 2.7 Fig. 3.1

Fig. 3.2

Maastricht European Council (9 December 1991) (Source Horst Haitzinger. Copyright: “Horst Haitzinger, München”. Maastricht open-air swimming pool: “Follow me! Let us know if there’s any water in the pool!”’ On 9 December 1991, on the eve of the Maastricht European Council, German cartoonist Horst Haitzinger takes an ironic look at the commitment [“follow me!”] of German Chancellor Helmut Kohl to Economic and Monetary Union [EMU] and to the Treaty on European Union. French President François Mitterrand, second in line, seems more reluctant to take the plunge [“Let us know if there’s any water in the pool!”], while British Prime Minister John Major seems to be about to climb down from the diving board) Pillars of the European Union The Europa 1928 Inflation, consumer prices for EMU 12 in % (1990 to 2002) (Source FRED, Federal Reserve Bank of St. Louis 2019) Exchange rates; purchasing power parities (PPPs) national currency per $US (Source OECD) Long-term interest rates (Government bonds maturing in ten years) Consumer price index percentage change on the same period of the previous year (Source OECD) Economic activities—Domestic producer prices—Manufacturing (Source OECD) Purchasing power parities for GDP Deficit to GDP ratios (Source OECD, authors calculations) Debt/GDP ratios (Source OECD) Government bonds yield maturing in ten years (Source OECD) Unit labour cost (Source OECD) Annual consolidated balance sheet of the Euro system 1999–2020 (Source ECB, https://www.ecb.europa.eu/ pub/annual/balance/html/index.en.html) Lender of last resort (Source Bankers-banking)

25 29 39

40 42 44 58 59 60 61 62 63 63

68 73

LIST OF FIGURES

Fig. 3.3

Fig. 3.4

Fig. 3.5

Fig. 3.6

Fig. 3.7

Fig. 3.8

Fig. 3.9 Fig. 3.10

Fig. 3.11 Fig. 3.12

Fig. 3.13 Fig. 4.1

Long-term Ratings of Euro Area Sovereigns (Source Barthélemy et al. [2018]. Note The vertical lines show [1] the first three-year LTRO of 21 December 2011, [2] the second three-year LTRO of 28 February 2012, [3] the announcement of the OMT programme on 2 August 2012, [4] the decision to launch the PSPP on 22 January 2015) Variation in the value of Euro Area Collateral (Source Barthélemy et al. [2018]. Note Haircut and Price contributions are compared to their average values between Jan and June 2014) Eligible marketable assets (Euro Billion) (Nominal amounts, averages of end of month data over each time period shown. Source ECB, https://www.ecb.europa.eu/ paym/coll/charts/html/index.en.html) Number of Euro-system Counterparties (Note The vertical lines show [1] the first three-year LTRO of 21 December 2011, [2] the second three-year LTRO of 28 February 2012, [3] the announcement of the OMT programme on 2 August 2012. Source Barthélemy et al. [2018]) President Mario Draghi pledge to “Whatever it takes” and Eurozone bonds yields (Author’s calculations. Source OECD) ECB’s asset purchase programme with average monthly target 2015–2021 (Source ECB. *Governing Council set the monthly average APP targets in March 2015 with the start PSPP) Cumulative net asset purchases 2015–2021 (Source ECB) Fed, Bank of England and ECB Balance sheets (Source https://voxeu.org/article/ltro-quantitative-easing-disgui se. Note The Asset side of balance sheets of ECB, Fed and BoE have been decomposed into five categories) ECB’s key interest rates (Source ECB) European Countries below zero by October 2019 (Source European Central Bank, Swiss National Bank, Riksbank, Danmarks Nationalbank) Timeline of ECB’s non-standard measures (Source ECB) Government Consolidated Gross Debt as a Percentage of GDP (Source Eurostat)

xv

74

75

77

81

83

97 99

108 115

116 118 125

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LIST OF FIGURES

Fig. 4.2

Fig. 4.3

Fig. 4.4

Fig. 5.1

Fig. 5.2

Fig. 5.3

Fig. 5.4

Fig. 5.5 Fig. 5.6

Fig. 5.7

Fig. 5.8

Fig. 6.1 Fig. 6.2

Loss of Confidence. High frequency indicators were rescaled to range between 0 and 100 (Source IMF https://www.imf.org/en/News/Articles/2015/09/28/ 04/53/socar012209a) German Export-Led Growth (Index: 1995 = 100) (Source IMF https://www.imf.org/en/News/Articles/ 2015/09/28/04/53/socar012209a) Rescue Plan for UK Banks Unveiled, How Big is the Bailout? (Source BBC http://news.bbc.co.uk/1/hi/ business/7658277.stm) The three pillars of the banking union (Source The Oesterreichische Nationalbank [OeNB], https://www. oenb.at/en/financial-market/three-pillars-banking-union. html) Single resolution fund (Source Single Resolution Board, https://srb.europa.eu/en/content/single-resolution-fun d) Evolution of EDIS funds compared to the funds of a participating DGS (Source European Commission, https://ec.europa.eu/info/sites/info/files/graph-151 12014_en.pdf) European system of financial supervision (Source Council of the European Union https://www.eiopa.europa.eu/ file/esfs-0_en) Building of Eurozone—Unions within Unions (Source Cagle cartoons) Size of capital market as percentage of GDP of 2018—Q3 (Source European Commission, https://ec.europa. eu/finance/docs/policy/190315-cmu-communica tion_en.pdf. EU Top-5 is obtained as GDP-weighted average for Netherlands, Sweden, Ireland, Denmark and Luxembourg with weights of 41, 25, 17, 15 and 2%) Stages towards a genuine EMU (Source European Council https://www.consilium.europa.eu/uedocs/cms_ Data/docs/pressdata/en/ec/134069.pdf) “Numerical compliance with EU fiscal rules. The compliance database of the Secretariat of the European Fiscal Board”, May 2020 (Source Larch & Santacroce, 2020) Real GDP from 2008 to 2019 (constant 2010 US$: 2008 = 100) (Source World Bank) GDP recovery path in euro area (Source CEPR)

131

132

144

169

175

178

181 183

185

190

206 213 215

LIST OF FIGURES

Fig. 6.3

Fig. 6.4

Fig. 6.5 Fig. 6.6 Fig. 6.7 Fig. 6.8 Fig. 6.9 Fig. 6.10 Fig. 6.11 Fig. 7.1 Fig. 7.2

Fig. 7.3

Fig. 7.4 Fig. 7.5 Fig. 7.6

Euro area and EU GDP growth rates % change over same quarter of the previous year, seasonally adjusted data (Source Eurostat) GDP level from Global Financial Crisis to COVID-19 (Source OECD. Seasonally Adjustment: Chain linked volumes, index 2010 = 100 [2008Q1 to 2021Q1]) Eurozone unemployment rates from Global Financial Crisis to COVID-19 (Source Eurostat) Price stability in Eurozone, all-items harmonised index of consumer prices (Source Eurostat) Dynamics of current-account balance 2010: Q1-2020: Q2 (Source OECD) Labour cost index percentage change period on period (Source Eurostat) Average annual inflation, growth and unemployment during the Lost Decade—2010–2019 (Source OECD) Real labour productivity per person employed (2010–2019) (Source Eurostat) COVID-19 and real labour productivity per person employed (Source Eurostat) TARGET2 payment system, a simple illustration TARGET2 imbalances over two decades—Net claims on Euro system (Source Euro Crisis Monitor, Institute of Empirical Economic Research, Osnabrück University) Destination of German savings a decade after Euro—2002 to 2010 (Source Sinn [2011a] *The TARGET claims of the Bundesbank amounted to e325.6 billion at the end of 2010; at the end of 2001 they were minus e30.9 billion. By end of September 2020, they have reached over e1.1 trillion) Current account as % of GDP, Germany, France, GIPS & Eurozone (Source [OECD]) Saving rate Germany, France, GIIPS & Euro area (Source [OECD]) Net Capital Stock (1995–2017), Germany compared to other EU countries (Source European Commission [2018], https://www.bruegel.org/2018/06/unders tanding-the-lack-of-german-public-investment/. Notes Measured in 2010 prices; 1995 values indexed to 100; Germany in red, all other EU28 countries in grey colours, European Union in black)

xvii

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216 218 219 219 220 221 223 223 230

232

238 245 245

247

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LIST OF FIGURES

Fig. 7.7

Fig. 7.8

Fig. 7.9 Fig. 7.10

Fig. 7.11

Fig. 7.12

Fig. 8.1

Fig. 8.2 Fig. 8.3 Fig. 8.4 Fig. 8.5 Fig. 8.6 Fig. 8.7

Fig. 8.8

Fig. 8.9

Public investment of Germany and selected EU countries—Public net fixed capital formation (Source European Commission [2018]) Germany gross & net fixed capital formation, private & public sectors (as a % of GDP) (Source Destatis [2018a]. https://www.bruegel.org/2018/06/understanding-thelack-of-german-public-investment/) Real gross fixed capital formation to GDP ratios (%) US & Eurozone (Source European Commission) Infrastructure investment by region, (2008 = 100) (Source EIB Infrastructure Database [IJ Global, EPEC, Eurostat]. Note Data missing for Belgium, Croatia, Lithuania, Poland and Romania. The EU average excludes the United Kingdom) Actual and potential GDP in the Eurozone (obtained from Summer, 2014) (Source IMF World Economic Outlook Databases, Bloomberg) Money supply among Germany, GIIPS, & Eurozone standardised, seasonally adjusted, year on year % (Source Eurostat) Projected change in the euro area and euro area countries’ budget balances relative to the preceding year (% of GDP) (Source European Commission’s Autumn 2020 Economic Forecast) General governments debts 2019 and 2020 (Source Eurostat) EU coronavirus response (Source European Commission) Council approval of SURE for 18 EU states (Source European Commission) The European Green Deal (Source European Commission) Brexit: what the European Union loses (Source Statista) Changing share of world GDP (PPP) from 2016 to 2050 (Source IMF estimates for 2016 and PWC projections for 2050) Real GDP growth Eurozone and emerging world (constant 2010 US$, Year 2010 = 100) (Source Authors’ calculations using data from World Bank) 2020 a year of uneven economic losses total, percentage change, same period previous year, Q4 2020 (Q3 for Greece) (Source OECD)

248

249 251

252

254

262

274 275 276 281 282 288

290

291

292

List of Tables

Table Table Table Table Table Table Table

1.1 1.2 1.3 1.4 2.1 2.2 2.3

Table 2.4 Table 3.1 Table 3.2 Table 3.3 Table 3.4 Table 3.5 Table 3.6 Table 5.1 Table 5.2 Table 5.3

Stages of Economic and Monetary Union (EMU) General government debt as % of GDP, 1995–2002 General government deficit as % of GDP, 1995–2002 Maastricht criteria, A snapshot European Parliament composition Votes in council and population Voting weights in both the Council of Ministers and the European Council PPPs for GDP, National currency per US dollar appreciation/depreciation (%) since 1995 Consecutive changes in collateral criteria Euro-system asset purchase programme holdings (e, millions) Breakdown of CBPP3 portfolio by rating and country of risk 2021Q1 Breakdown of ABSPP portfolio by rating, country of risk and collateral type: 2021Q1 Breakdown of debt securities under the PSPP: May 2021 Breakdown of CSPP portfolio by sector, rating and country of risk (semi-annual): 2021Q1 ESM: Lending toolkit Towards a genuine economic and monetary union roadmap: Stages and elements Roadmap towards a complete economic and monetary union

20 41 41 44 48 49 56 60 72 99 103 104 111 114 156 188 192

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LIST OF TABLES

Table 6.1 Table 8.1 Table 8.2

Growth rates of GDP in volume up to 2020Q2 Multiannual Financial Framework (MFF) 2021–2027 total allocations NextGenerationEU breakdown

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CHAPTER 1

Wrong Intentions and Flawed Foundations

European Identity and Integration in European Blood Built on flawed and uneven foundations a building can be raised to the Pleiades and it will still be neither strong nor straight. As the ancient wisdom says, the loftier the building, the deeper must the foundation be laid. The same logic holds for the architect of the Economic and Monetary Union of the European Union (EMU) which is the longest economic and political integration project with still work in process and no ending in sight. Nothing is new under the sun, so does the idea of the European Unity and Integration which is at least five centuries old. One can track at least as far back as the year 1464 when following the fall of Constantinople in 1453, the proposal of the League of Christian Nations (The Tractatus pacis toti Christianitati fiendae, or Treaty on the Establishment of Peace throughout Christendom) was made by the Czech King George of Podˇebrady to the French King Louis XI.1 This was a manifestation of the need and desire for peace and security in Central 1 See, V. Havel, “Dreaming Aloud” in J. Coleman (ed), The Conscience of Europe (1999, Strasbourg: Council of Europe Publishing), at 89–97. Treaty on the Establishment ˇ CEK ˇ of Peace throughout Christendom. Edit. Kejˇr J., Transl. Dvoˇrák I. In VANE V., The Universal Peace Organization of King George of Bohemia a fifteenth Century Plan for World Peace 1462/1464. Prague: Publishing House of the Czechoslovak Academy of Sciences 1964, pp. 81–90. Also see Smith (1992).

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6_1

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Europe which can be achieved through cooperation among states. The idea of European integration was further pruned by the English philosopher William Penn (founder of the province of Pennsylvania) into the United States of Europe by the establishment of a European Parliament.2 The reason was to prevent wars and establish peace among Europeans. However, the seeds of European identity were spread long before the suggestion of the European Parliament and even the League of Christian Nations, perhaps this was the historical relationship in the form of different empires including the Roman and Holy Roman Empires which resonates in the sub-conscious of Europeans. They cannot run away from their history. Whether it was a voluntary or forced relationship, the common citizenships and love–hate history have some sort of Stockholm syndrome effects that some affection and respect for the Europeanism always prevailed in the Europeans blood.3 Hence, after George of Podˇebrady and Willam Penn, Abbot Charles de Saint-Pierre’s proposal on the creation of the European League of Sovereign States were all the manifestation of nostalgic past and history of Europeanism written in blood and sweat.4 In this, we cannot forget to acknowledge Immanuel Kant’s proposal and sketch for the Perpetual Peace in which there are interesting and explicitly parallels ideas of mutual respect and cooperation among sovereign states.5 A desire also expressed by Napoleon6 that the “Europe thus divided into nationalities freely formed and free internally, peace between States would have become easier: the United States of Europe would become a possibility”. This dream was passed on by other scholars and philosophers such as Polish Wojciech Jastrz˛ebowski7 and Italian Giuseppe Mazzini 1843, to French Victor Hugo and who felt

2 “An ESSAY towards the Present and Future Peace of Europe by the Establishment of an European Dyet, Parliament, or Estates” year 1693. 3 A manifestation of this factor is evident and clearly observable in almost all of the historical political unions including united India or former soviet states. In the case of former, despite the hostile relationship and wars between India and Pakistan, both suffer from the nostalgia of being a one country under different rules. 4 See Hont (2005). 5 See Kant (1795). 6 See Markham (1966), as quoted in Matthew Zarzeczny, Napoleon’s European Union:

The Grand Empire of the United States of Europe (Kent State University Master’s thesis) visit https://www.napoleon-series.org/research/napoleon/c_unification.html. 7 On About eternal peace between the nations, published 31 May 1831.

1

WRONG INTENTIONS AND FLAWED FOUNDATIONS

3

no stigma in say that “A day will come when all nations on our continent will form a European brotherhood … A day will come when we shall see … the United States of America and the United States of Europe face to face, reaching out for each other across the seas ”. In fact, to live his legacy Hugo planted a European Tree called Hugo’s United States of Europe Oak in Guernsey Island.8 Later Giuseppe Garibaldi, and John Stuart Mill joined Victor Hugo at a congress of the League of Peace and Freedom in Geneva. To Mikhail Bakunin reason of putting their weight to Hugo’s side was “That in order to achieve the triumph of liberty, justice and peace in the international relations of Europe, and to render civil war impossible among the various peoples which make up the European family, only a single course lies open: to constitute the United States of Europe.”9 Hugo’s idea was nurtured and some form of practical proposal in 1885 by Theodore de Korwin Szymanowski as L’avenir économique, social et politique en Europe—The Future of Europe in Economic, Political and Social Terms.10 The proposal provided the blueprints or hints of a parliamentary system, a customs union, centrally collected statistics, financial contributions from all the participating European states for deposit and lending via a central bank with a common currency, for preference, though not necessarily Euro.11 As obvious the proposal did not get much fame, never mind an influence that could have shaped European relations and prevented the first world war and its misery. Counterfactual does not exist, so we do not know if the implementation of the Theodore de Korwin Szymanowski proposal could have avoided the painful events of the first half of the twentieth century, but what we know for sure is that the ideas entailed in the proposal are prima facie evident that the plans of integration postWWII and hitherto are not something nobody thought of before. There is nothing new under the sun! Mistakes and blunders are often good teachers though can be too harsh, WWI did teach Europeans something and that was the importance of cooperation and peace. After WWI the movement of European unity and cooperation remerged with even more vigour. Austrian Richard von

8 Visit https://www.visitguernsey.com/victor-hugo-garden for Victor Hugo’s garden. 9 See the Anarchist Sociology of Federalism at http://library.nothingness.org/articles/

anar/en/display/334. 10 Szymanowski (1885/8). 11 Szymanowski (1890).

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M. A. NASIR

Coudenhove-Kalergi hosted the first pan-European conference and also founded the Pan-Europa moment.12 Similarly, a Pro-European group “Federal Union” was launched in Britain.13 Nonetheless, it also led to the proposal on economic integration coming from not merely poets and philosophers but from the statesmen and politicians. Most prominently, Aristide Briand in the form of a proposal for a new economic union in Europe in the interwar period.14 Briand made his proposals in a speech in favour of a European Union in the League of Nations and his “Memorandum on the Organization of a Regime of European Federal Union”.15 The idea was to contain the future threats from Germany while still endeavouring to avail the settlement of the Treaty of Versailles . Perhaps, this was the subtle flaw, however as the plan was never implemented this flaw was not apparent or hindered its success. The political and economic failure to maintain peace led to the success of misery in the form of WWII. Yet, during the war, there were sentiments of Europeanism even among Nazis. German ministers Joachim von Ribbentrop and Cecil von Renthe-Fink proposed “European confederacy”. It entailed the idea of a single currency, a central bank, a regional principle, a labour policy and economic and trading agreements, however, could not get Hitler’s approval.16 The first half of the twentieth century with two great wars and a great depression was so painful that no European ever wanted to have anything similar for the remaining half of the century, and in fact never again. In the Post-WWII, the idea of a united Europe became more powerful. Despite not much in favour of British absorbent and dissolvement in the European continent, Winston Churchill was also in favour of European cohesion and put his weight by saying that “We see nothing but good and

12 In its Soviet form Trotsky also proposed the idea of “United States of Europe”. 13 Visit http://federalunion.org.uk/ for details on Federal Union. 14 Navari (1992). 15 At the annual meeting of the Assembly of the League of Nations in September

1929, Foreign Minister Aristide Briand of France proposed the establishment of a federal European union to coordinate economic and political policies. Briand believed that the proposed union should be created within the framework of the League and promised to submit a detailed plan for a federal union to the 27 European states that were League members. Visit https://www.wdl.org/en/item/11583/ for details. 16 See Lipgens (1985).

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hope in a richer, freer, more contented European commonality”.17 After the war, Churchill became an even greater vocal of the idea of the European Unit. In his famous speech at the University of Zurich, he strongly expressed his feelings “We must build a kind of United States of Europe. In this way only will hundreds of millions of toilers be able to regain the simple joys and hopes which make life worth living ”.18 To some Churchill’s approach to European integration was cautious, some scholars define the approaches from a cautious approach (“the unionist position”) to a more closer Federalists approach (full integration with a constitution).19 While the view and model of the European integration and coordination may vary in its design and shape the underlying rationale is embedded in the European brotherhood. The wars and depressions have just strengthened and highlighted the need for European unity roots of which are centuries deep. The idea of European Identity and Integration which led to the creation of the European Union is not new, it prevailed before and shall exist with and without European Union, it is in European Blood.

From Fall of the Berlin to the Rubble of Berlin Wall In the post-WWII period, it was clear that there should be something different done than the failed strategy of the interwar period which led to depression, hyperinflation and further destruction. Concomitantly, Henry Morgenthau Jr.’s plan to deindustrialise Germany by dismantling its industrial capacity did not go very far.20 Economic realities led allies to see the sense, an economically weak Germany was not in the best interest of anyone including Western Allies.21 James F. Byrnes with his “Restatement of Policy on Germany” expressed the firm commitment of 17 See Ponting (1996). 18 For Churchill, Winston (19 September 1946). Speech to the Academic Youth.

Zürich, Switzerland. Visit https://archive.is/20100820031147/http://www.europa-web. de/europa/02wwswww/202histo/churchil.htm. 19 See Dinan (2005). 20 Visit https://web.archive.org/web/20130531235410/http://docs.fdrlibrary.marist.

edu/psf/box31/t297a01.html for Suggested Post-Surrender Program for Germany. The plan entailed proposal to remove and destroy all the key industries which are important to military strength. The plain was set out in his booked titled “Germany is Our Problem”. 21 See Petrov (1967).

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a military presence in the Germany and Potsdam Agreement, but he also expressed the importance of economic recovery and stabilisation of Germany.22 This led to first the European Recovery Program that is commonly known as the Marshall Plan. Restrictions on the German industrial production were also relaxed or if put more appropriately, they have to be relaxed. In General Lucius Clay words, “there is no choice between being a communist on 1,500 cal a day and a believer in democracy on a thousand”.23 However, German exports prices were set below the international market prices and there were also restrictions on what Germany can export and how much.24 This also led to a major malnutrition and starvation crisis in Germany. It was Allied legal obligation to feed the occupant Germans,25 but of course, it was a big take. Particularly when you have imposed restrictions on the economy. This was not all; Germans were yet to pick more bills in coming years and decades to re-establish their political system and economy. The first was the Ruhr Agreement which led to establishing the Federal Republic of Germany, but not due to the benevolence of the French and Allies. The resourcerich Ruhr region was put under International Authority for the Ruhr.26 The French were allowed to extract the German resources, including from the Saar region (Saar Protectorate).27 On the other hand, the USA and UK were rather more interested in intellectual property and “intellectual reparations ”.28 At the same time, the threat from the Soviet Union or perceived threat from the Soviet Union, and American wishes29 to establish a stronger western block led to the change of stance from teaching

22 See Gimbel (1972). 23 For Speech by J.F. Byrnes, United States Secretary of State “Restatement of Policy

on Germany” Stuttgart September 6, 1946, https://www.linkedin.com/pulse/hoffnungs rede-restatement-policy-germany-speech-hope-francisco-cruz/. 24 Balabkins (1964). 25 Article 43 of the 1907 Hague Rules of Land Warfare. 26 Yoder (1955). 27 Milward (1984). The Saar was returned to Germany in 1957 though French was allowed to extract resources till very late. 28 Smith (1993). Also see How T-Force abducted Germany’s best brains for Britain, available at https://www.theguardian.com/science/2007/aug/29/sciencenews. secondworldwar and Jacobsen (2014). 29 American Committee on United Europe.

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a harsh lesson to Germany and containing and extracting its resources to contain the immediate threat the Soviet Union.30 The Organisation for European Economic Co-operation (OEEC) which we now known as the Organisation for Economic Co-operation and Development (OECD) came into existence in the April 1948 and the Council of Europe in May 1949 for the legal and human rights aspects.31 In mid-December 1949, a memorandum was submitted to the Secretariat of OEEC by the UK which emphasised the importance of the introduction of a new scheme that will govern the future of intra-European payments.32 There was also an urge from the USA for the establishment of a European Payment Union so that the aid can be channelled as well as the trade between the OEEC members can be revived and promoted. An illustration of this is evident in the cartoon by David Low (Fig. 1.1). One of the earlier decisions of OEEC (or OECD as we know it) that it took in July 1950 was to replace the bilateral payment agreements between European countries which were prevailing post-WWII with a new multilateral system, the European Payment Union (EPU)33 The issue was that the bilateral payments agreement preceded EPU entailed exchange-rate controls which implied that the payments had to be made based on fixed official exchange rates. Nonetheless, there were also modest credit limits, hence, the rationale of EPU was to revitalise and enhance European trade and economy. The EPU delivered by first setting exchange rates that were deemed to reflect the reality of each country’s economic situation and second, facilitating the convertibility of European currencies. Yet the currency restrictions were maintained visà-vis the dollar area. EPU by its functioning helped to compensate and balance the accounts of each European country with those of its neighbours. Therefore, it can be perceived as an international clearing house. Member countries used to set a parity between their currency and the unit

30 Milward (1999). 31 Visit https://www.coe.int/en/web/portal/home for details. 32 British memorandum on the future of intra-European payments (15 December

1949), available https://www.cvce.eu/en/obj/british_memorandum_on_the_future_of_ intra_european_payments_15_december_1949-en-04f98523-70bc-446c-bae9-5d9194728 66b.html. 33 For details on the European Payments Union, visit https://www.cvce.eu/en/edu cation/unit-content/-/unit/02bb76df-d066-4c08-a58a-d4686a3e68ff/ab473e40-d7d8419b-b507-ac6d7a7ffe76.

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Fig. 1.1 United States’ reaction to the slow negotiations for the establishment of a European Payments Union (Source Evening Standard. 28.12.1949. London. “Time, Gentlemen, please!”, auteur: David Low)

of account, which was fixed in grams of gold based on the gold value of the dollar, as well as a single exchange rate. The EPU also had a settlement mechanism as the settlement of trade was carried out partly in gold and partly via the granting of credits to the EPU at the end of each month. In this regard, it was a very important system and with some good features that were ignored in the design of the current TARGET2 system. I will revert to this point later as at this point, we are talking about the 1950s. The USA subscribed to the initial capital of EPU which was used to settle with the creditors as soon as the debtors made their payments. The Bank for International Settlements (BIS) managed the settlement transactions, and the National Central Banks also made their currency available to their partners. Each month the balance (credit or debit) for each country was calculated in relation to all the other countries in the Union. There was also a quota that was set for each member representing the maximum amount of its account balance can grow to. On the monthly basis, the adjustments (partially calculated in gold) were made depending on the monthly credit or debit balance of the country. As it proved to be up and

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running the EPU had been made a bit more flexible. Flexibilities include the introduction of bank arbitrage procedure, decentralisation and greater flexibility in the intra-European payment arrangements (Fig. 1.2). The EPU was successful in delivering the exchange-rate stability and promoting inter and intra trade among the member states, however, it was criticised for price fluctuations and not enabling convertibility between individuals as the convertibility was only limited to the issuing banks. To

Fig. 1.2 Joining the European Payments Union (EPU) (Source Daily Herald. 28.03.1950, n° 10 625. London. “Slightly mixed bathing”, Auteur: David Low. On 28 March 1950, the British cartoonist, David Low, illustrates the hesitations of Ernest Bevin, British Foreign Secretary [left], and Hugh Gaitskell, British Chancellor of the Exchequer [right], at calls from Paul Hoffman, US administrator of the Economic Cooperation Administration [ECA] given the task of managing the distribution of funds under the Marshall Plan, for them to join the future European Payments Union [EPA])

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some critics, EPU also caused fear of being a competitor to the International Monetary Fund (IMF), this led to the replacement of EPU in December 1958 with the European Monetary Agreement (EMA) which was signed in August 1955. It also led to the creation of reserve funds for those states which were running a balance of payment deficit. Nonetheless, there was a multilectal settlement and equalisation system which was based on the exchanges rates which were to large extent kept stable. Unlike its predecessor, settlements and granting of lands under the EMA system were not compulsory or automatic. In nutshell, salient features of the agreement included the features of exchange-rate margins, interim finance, bilateral payments agreements, balances held in the currency of other participating countries and monthly settlements. Once again, the Bank for International Settlements (BIS) was managing the financial transactions in the EMA. On the economic front, soon after the creation of OEEC, the French foreign minister Robert Schuman put forward a plan known as the Schuman Declaration of 9 May 1950. In a nutshell, it proposed the creation of a European Coal and Steel Community (ECSC) whose members would pool coal and steel production. The logic was that “the solidarity in production thus established will make it plain that any war between France and Germany becomes not merely unthinkable, but materially impossible”.34 Later, with the Treaty of Paris in 1951, Germany had to agree to the European Coal and Steel Community in exchange of some economic and political freedom. This also led to the creation of institutions such as the High Authority and the Common Assembly which have now taken the form of the European Commission and European Parliament , respectively.35 Reports by the WikiLeaks suggest that there were 34 For the Schuman Declaration—9 May 1950, visit https://europa.eu/europeanunion/about-eu/symbols/europe-day/schuman-declaration_en. 35 Jean Monnet who proposed the Monnet Plan became the first President of the High Authority of the European Coal and Steel Community. Some of the relaxation to Germany for instance return of Saarland to Western Germany was more a matter of people’s will than French benevolence as the referendum held on 23 October 1955, the people of the Saar voted against this European statute, and instead opted for the return of the Saar to the Federal Republic of Germany from 1 January 1957. For details visit https://www. cvce.eu/obj/en-26859090-52d0-4850-9019-92748182042a, though the West Germany would still have to agree to channelisation of the Moselle. In addition to a High Authority and a Common Assembly, ECSC was composed of a Special Council of national ministers and a Court of Justice, somewhat similar to Council of the European Union and the European Court of Justice.

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serious discussions among some of the influential think tanks such as the Bilderberg Group which entailed the issues around a single currency and more economic and political integration of European states.36 To what extent reports such as these are credible is another question, however, as the events unfolded, hindsight tells us that it was the direction Europe evolved. Starting with the six initial signatories (Belgium, France, West Germany, Italy, the Netherlands and Luxembourg), the European Coal and Steel Community was just the steppingstone towards further integration which led to the contemporary European Union (EU). In fact, there was a clear expression of these intentions in the Schuman Plan. For instance, that the “By pooling basic production and by instituting a new High Authority, whose decisions will bind France, Germany and other member countries, this proposal will lead to the realization of the first concrete foundation of a European federation indispensable to the preservation of peace”. At the same juncture, it was also acknowledged by Schuman that there is no single plan leading to the final form of the European project as he stated: Europe will not be made all at once, or according to a single plan. It will be built through concrete achievements which first create a de facto solidarity.37

Concomitantly the next step was the establishment of a customs union. The ideas of the European Political Community (EPC) and European Defence Community (EDC) could not sail through the tides of nationalism at that time.38 Yet on the economic front, the integration seemed to be rather easier. Perhaps, seemingly easier political integration was more difficult than economic integration. Countries are less reluctant to hand over their economic sovereignty than political sovereignty. After the 36 For details visit https://file.wikileaks.org/file/bilderberg-meetings-report-1955.pdf. 37 For details visit https://europa.eu/european-union/about-eu/symbols/europe-day/

schuman-declaration_en. 38 Although, there was also proposed to form European Political Community (EPC), however, the refusal of the French National Assembly on 30 August 1954 to ratify the Treaty establishing the European Defence Community (EDC) automatically led to the plan for a European Political Community, of which it was the institutional corollary, being abandoned, for details visit https://www.cvce.eu/obj/the_european_political_communityen-8b63810a-e5bd-4979-9d27-9a21c056fc8d.html. This led to resignation of ECSC 1st President Jean Monnet in protest. Also see Mikesell (1958).

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Messina Conference in 1955, the Spaak Committee, prepared the Brussels Report on the General Common Market (a.k.a. Spaak report)39 which led to the Treaty of Rome in March 1957 and the creation of the European Economic Community (EEC) and the European Atomic Energy Community (EAEC or Euratom). The crux of the EEC and EAEC/Euratom was economic integration by removal of trade barriers and development of the nuclear energy sector while sharing the cost. It is worth noting and remembering that the UK delegation represented by Russell Frederick Bretherton, pulled out from the Spaak Committee and did not commit to the EEC and EAEC/Euratom, same as they stayed out from the ECSC,40 if the question is that has the UK always been a reluctant bride of EU? the answer is Yes! The European Economic Community (EEC) started to work and as obvious, the opposition, differences of opinions and conflicts which are the integral elements of national as well as supranational intuitions started to emerge. These differences were particularly explicit in the Heseltine Commission as it started to work, and its functioning led to the Empty Chair Crises.41 French under General de Gaulle was not very happy about the increasing powers of the Commission mainly the arrangements for voting in the Council of Ministers and budgetary arrangements. The economic realities however brought the French back to the table after the Luxembourg Compromise.42 Thanks to prime minister of Luxembourg Pierre Werner, the crisis was resolved by giving the veto power to the member states for the matters which were of the profound importance of national interest. If a member state believed that its vital interests are at stake, then the negotiations had to continue until a universally acceptable compromise was reached.43 Slow but steady, the progress

39 Spaak (1956). 40 See Maclay (1999) and Stokes (1999). 41 For De-Commissioning the Empty Chair Crisis visit https://web.archive.org/web/

20071025203706/http://eprints.lse.ac.uk/2422/01/Decommisioningempty.pdf. 42 For The Luxembourg Compromise (January 1966), visit https://www.cvce.eu/ en/education/unit-content/-/unit/d1cfaf4d-8b5c-4334-ac1d-0438f4a0d617/a9aaa0cd4401-45ba-867f-50e4e04cf272. 43 This aspect led to overreaction and frequent use of veto power, and resistant to even small changes. However, it was rectified in Single European Act, July 1987.

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continued on the economic integration, specifically the Common Agriculture Policy (CAP).44 The Common Agriculture Policy (CAP) is not the main focus of this treatise, yet it has a very subtle yet important aspect that is worth paying attention to. That is the support to the sector of the economy (Farming) against open and brutal international competition and market failures. Taking into account not only the economic but moral and social values. Moving forward, the three executive bodies or “European Communities”, i.e. European Coal and Steel Community (ECSC), European Atomic Energy Community (Euratom) and the European Economic Community (EEC) were combined into a single intuitional structure by the Merger Treaty. Being singed on April 1965 and enforced on July 1967, the Merger Treaty replaced the Commission and Council of Euratom and the High Authority and Council of the ECSC by the Commission of the EEC and the Council of the EEC. Expansion and enlargement of the EEC were slower in the initial years, partially due to the opposition and veto of President Charles de Gaulle to the British membership. But after Georges Pompidou becoming the President of France in 1969 and reapplication by Denmark, Ireland, Norway and the UK, negotiations began on further enlargement. It led to the 1973 enlargement of the European Communities where Denmark, Ireland and the UK joined but the Norwegian public opted to stay out of the EEC. Similarly, the development on the political front by democratically electing the members of the European Parliament also became a bit more convenient after De Gaulle. Budgetary treaties of the European Communities became possible in 1970 and 1975 which gave more budgetary power to the parliament and council. In its brave endeavour to enhance monetary integration and exchange-rate stability, the Pierre Werner report45 in 1970 explicitly produced the blueprints of the great plan of monetary union. As it stated: A monetary union implies inside its boundaries the total and irreversible convertibility of currencies, the elimination of margins of fluctuation in exchange rates, the irrevocable fixing of parity rates and the complete liberation of movements of capital. It may be accompanied by the maintenance of

44 Fennell (1997). 45 For Report to the Council and the Commission on the realisation by stages of

Economic and Monetary Union in the Community (Werner Report) visit http://aei.pitt. edu/1002/1/monetary_werner_final.pdf.

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national monetary symbols or the establishment of a sole Community currency. From the technical point of view the choice between these two solutions may seem immaterial, but considerations of a psychological and political nature militate in favour of the adoption of sole currency which would confirm the irreversibility of the venture.

Furthermore that: It is indispensable that the principal decisions in the matter of monetary policy should be centralized, whether it is a question of liquidity, rates of interest, intervention in the foreign exchange market, the management of the reserves or the fixing of foreign exchange parities vis-a-vis the outside world. (Werner Report, 1970, p. 10)

The Werner plan was not fully implemented in a proposed time framework, yet the progress was steady and eventually resulted in the “adoption of sole currency” about three decades later. First attempt towards monetary integration and cooperation was the Snake in the Tunnel. This involved creating a single currency band for the European Economic Community (EEC) members and pegging their currencies. In the Basle Agreement on April 1972, members of the EEC established a snake tunnel which was an intervention system of the central banks to limit fluctuation between currencies of members to a maximum of ±2.25% or a maximum change of 4.5%. Considering the facilities available by the IMF to facilitate the issues around the balance of payment, in 1972 the OECD announced that the EMA would be terminated. The European Monetary Cooperation Fund (EMCF) was established in April 1973 to stabilise the exchange rate. To provide the necessary administrative and technical support, with the Bank for International Settlements (BIS), the EMCF was operated from Basel.46 In November 1975, nine prominent European economists47 put forward a proposal what they called “All Saints’ Day manifesto for European Monetary Union”. They recommended that instead of sudden drastic move a gradual approach to monetary integration is preferable. 46 For details on The European Monetary Cooperation Fund (1973–93), https://www. ecb.europa.eu/ecb/access_to_documents/archives/emcf/html/index.en.html. 47 These included, Michele Fratianni, Giorgio Basevi, Herbert Giersch, Pieter Korteweg, David O’Mahony, Michael Parkin, Theo Peeters, Pascal Salin and Niels Thygesen. All the signatories gathered at the round table discussion at the Katholieke Universiteit te Leuven.

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Concomitantly, the central banks of EEC should issue European money of constant purchasing power “Europa”. In this Europe-wide and supposedly stable system, the nationals of EEC countries should be allowed to purchase Europa with their national currencies at a flexible exchange rate. In later stages, it could be issued to the banking system through open market operation (rediscounting of bills and loans). A crawling peg approach was to be used for adjustment of the exchange rate between national monies and Europa. They argued that the Werner report whose recommendation had been adopted as a goal of the European Community in March 1971, suffers from excessive idealism. Furthermore, that the Werner report identifies the monetary union with a number of factors, including, (i) total irreversible convertibility of currencies; (ii) elimination of margins of locution in the exchange rates; (iii) irrevocable fixing of parities; (iv) elimination of restrictions on capital movements; and (v) coordinated macroeconomic stabilisation or aggregate demand policies. Criticising these underlying principles of Werner’s monetary union, authors of the All-Saints’ Day Manifesto argued that the premature implementation of rigid exchange-rate regimes and lack of monetary policy coordination will lead to balance of payment crises, misallocation of resources and unemployment which will then have economic as well as political consequences. I think they were not wrong as it turned out to be that way. Furthermore, they also cautioned that the non-automatic nature of coordinated decision-making and the required political discretion in such coordination measures is also a weakness in the Werner Plan. The authors of Manifesto argued that the flexible exchange-rate system is better than a fixed exchange-rate regime and a single-valued monetary system is better and a system of multiple currencies with the flexible exchange rate. Interestingly, they urged that the natural rate of unemployment doctrine shall be accepted as any effort to reduce the unemployment below the natural rate will be self-defeating and will harbour more inflation. The loss of unemployment as cost of monetary unification was labelled as “transitional ”. Hence, as in the long-run unemployment is not related to inflation and monetary union cannot be regarded as a cause of unemployment. With the hindsight of decades, we can see that the monetary union has large disparities in terms of unemployment and some parts of the Union, particularly in the periphery it is astronomically high. It was recognised in the manifesto that the capital may move to the high productivity areas and there could be an increase in the unit labour cost in the periphery making investment less attractive. There would also be potential

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for the movement of labour from peripheral to central areas. However, for the sake of regional diversity, it was urged that the monetary union should not be permitted to encourage the movement of labour and capital from the periphery to the core. To solve this issue, they urged on the interim income transfers and raising productivity levels. It was also acknowledged that the transition to European Monetary Unions requires a considerable deflationary stance which may accompany prolonged periods of recessions, but as the price stability is desirable, reducing inflation is good anyway, never mind for the sake of EMU. The introduction of a new stable currency will in fact minimise the transitional cost and will not be subject to inflation expectations. The proposed approach was advocated to be based on gradualism and automaticity and respects the interplay of market forces. They urged that this will entail governments putting explicit and instead of implicit taxation (inflation). Lastly, they suggested that the monetary authorities should be given the same level of independence from political power as the judicial system which I think remains a debatable issue across the world. The All Saints’ Day Manifesto had some interesting aspects which I will revert to in the later part of this treatise, with the benefit of hindsight, but in a nutshell, there was an acknowledgement of some of the difficulties though the language of the manifesto remained over-optimistic. What in prevalence was the European Monetary Cooperation Fund (EMCF) and the Snake in the Tunnel which was proven to be difficult to contain! To support the balance of payment issues of the member states, the EMCF also administrated community loans since 1976. Alas, the Snake did not live very long and proved unsustainable due to the free float of the US dollar, leaving and joining of members and difficulty to keep the exchange-rate fluctuations (snake) in the tunnel. This led to its successor, the European Monetary System (EMS) and European Currency Unit (ECU) which were established in 1979 under the Jenkins Commission. EMCF took on the burden of carrying out the tasks related to the creation, use and remuneration of the ECUs. The EMS was an exchangerate arrangement where the currencies of the EEC members were fixed against each other’s currencies to gain exchange-rate stability and its benefits. Although, there was no currency officially designated as an anchor, under their own steam the Deutsche Mark and the Bundesbank proved to be the leaders. The initial range of bands was a narrow band of ±2.25% and a wide band of ±6% which after the speculative attacks on the French Franc and resulting Brussels Compromise in August 1993 was

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revised to 15%. The European Currency Unit (ECU, abbreviated as CE or XEU) was the unit of account and in some cases medium of transaction. In their essence, EMS and ECU were the forerunners of the Euro system and Euro (e). In terms of external trade, a major milestone was the Lomé Convention. A trade and aid agreement between the European Economic Community (EEC) and 71 African, Caribbean and Pacific (ACP) countries, signed in February 1975 in Lomé, Togo. This had symbolic importance in terms of EEC countries coming together in the form of a political-economics block to deal with the rest of the world in terms of trade as well as aid. There is a desire which is often explicit in the language of the European Commission and European leaders to have some global economic, political and influence. For instance, most recently, there have been claims made in terms of the EU being the leader in efforts to tackle climate change or on the financial front, the EU as an attractive destination for global savings (a place traditionally held by the USA). There is nothing wrong with wishful thinking and dreaming about global leadership, but for the EU that day is not in the sight48 ! On the political front, 1979 saw the achievement of a crucial landmark when the first European Elections were held in the 9 members states of the EEC. New members of European parliaments (MEPs) were democratically elected by an electoral process and hence had the power or element of people’s power, i.e. public mandate. Despite some reluctance from French President Francois Mitterrand and concerns on the readiness of the Greek and Spanish to join, the expansion continued southwards to the Mediterranean.49 In January 1981 Greece and then in January 1986 Spain and Portugal joined as well as Turkey applied for the membership. Though Greenland left in 1985 but did not go too far and is still considered as an Overseas Countries and Territories (OCT).50 On the legal front, an important event occurred which then became a precedent.

48 On this aspect, Dominguez (2006) argued that “The slim margins by which the Maastricht Treaty passed and the wide margin on which the European Constitution failed are reminders that Europeans are still wary of giving up their national sovereignty. This wariness also influences the ability of the ECB to efficiently take over monetary policy and limits the ability of the euro to become a true rival of the dollar in global financial markets”. The fact of the matter is “wariness” Dominguez pointed out still prevails. 49 For European Stability Initiative visit https://www.esiweb.org/index.php?lang=en& id=156&document_ID=74. 50 Article 17 of European Union Treaty as of 1999.

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The European Court of Justice (ECJ) ruled on the non-discrimination by nationality. Mr. Cowan, a citizen of the UK, was mugged while on holiday in France (exercising his EU free movement rights). French law was only permitting criminal compensation to be given to French nationals. In order to not breach the concept of the free movement of services, Mr. Cowan should be treated like every other (French) citizen. This was a crucial judgement and one of the biggest success for the Federalists or Pro-Europeans. As an effort towards further integration by making the movement of people more flexible, the Schengen Agreement was signed (West Germany, Belgium, France, Luxembourg and the Netherlands) to abolish the border checks and harmonisation of visa policies. The European flag, which was around since 1955, was approved by the European Council in June 1985 and raised outside Berlaymont. In the flag, we see that against the background of blue sky, there are stars form a circle, symbolising union. Number of stars is fixed, twelve being the symbol of perfection and completeness, one may draw parallel with the apostles, the sons of Jacob, the labours of Hercules and the months in the year.51 However, besides the completeness of stars on the blue sky, on the ground the things were neither complete nor perfect. Therefore, under the Jacques Delors presidency of the European Commission, the expansion and integration continued and as a step towards further integration, despite some opposition, the Single European Act (SEA) was signed in February 1986 and enforced in July 1987.52 With some delays in the case of Italian, Danish and Irish, eventually all the twelve members states of EEC signed and ratified the treaty. The Act entailed intuitional reforms, single market and political, social and scientific cooperation.53 More specifically, it was hoped that by the end of 1992 an objective of the single market would have been achieved after necessary legislative reforms. In its true spirit, it was a major step towards the creation of the world largest market or trading area in the coming years. So, on

51 For detail on The European flag visit https://www.coe.int/en/web/about-us/theeuropean-flag. 52 For details on the signing of the Single European Act visit https://www.cvce.eu/ obj/the_signing_of_the_single_european_act-en-d29e6c74-ba4d-4160-abc0-1f1d327bf aae.html. 53 For details on the provisions of the Single European Act visit https://www.cvce. eu/obj/the_provisions_of_the_single_european_act-en-243555aa-d219-4525-9978-343 25bb5e17a.html.

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one hand, where the Single European Act (SEA) confirmed and legitimised the discrete documents and procedures that had been taken till that point, on the other hand, it provided a time frame and direction for the future which had psychological significance. European foreign policy was and is till date a subtle but crucial aspect and when to speak to the rest of the world as a European foreign policy spokesperson, you got to speak in one voice which comes from the concrete unity. Concomitantly, the common foreign policy implies the pre-requisite of unity in foreign affairs and a preliminary to that unity in domestic affairs. Nonetheless, it was not the creation of a mere single market, but the objective was the Economic and Monetary Union (EMU) as confirmed by the European Council in June 1988. A committee led by Jacques Delors was mandated to propose the plan for the achievement of this great objective. The committee was composed of the governors of the then European Community (EC) National Central Banks, General Manager of the Bank for International Settlements (BIS) Alexandre Lamfalussy, Danish professor Niels Thygesen (the father of the Euro and signatory of the All Saints’ Day Manifesto and the only academic on the Delors Committee) and President of the Banco Exterior de España Miguel Boyer. The Delors committee prosed that the EMU should be achieved in three stages (Table 1.1). I will revert to the Delors Plan, but let’s first discuss the most important and significant event of the second half of the twentieth century. The fall of the Berlin Wall. At his Brandenburg Gate speech in June 1987, President Reagan made an open plea to President Gorbachev, saying “Mr. Gorbachev, tear down this Wall!” It took another two years before the wishes of President Reagan could come true. The change came from within East Germany and in November 1989s Alexanderplatz demonstration. Despite the anxiety of the French and British and the Plea of Margret Thatcher to stop the collapse of the wall as a symbol of German unification, the fall of wall war destined, and its destiny was rubbles.54

54 According to reports by the Hindu newspaper “Margaret Thatcher pleaded with Gorbachev not to let the Berlin Wall fall out of London” See Suroor (2009). The times also reported that “Thatcher told Gorbachev Britain did not want German reunification” See Binyon (2009).

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Table 1.1 Stages of Economic and Monetary Union (EMU) Stage One: Starting from July 1990 Complete freedom for capital transactions; Increased cooperation between central banks; Free use of the ECU (European Currency Unit, forerunner of the e); Improvement of economic convergence; Stage Two: Starting 1 January 1994 Establishment of the European Monetary Institute (EMI); Ban on the granting of central bank credit; Increased coordination of monetary policies; Strengthening of economic convergence; Process leading to the independence of the national central banks, to be completed at the latest by the date of establishment of the European System of Central Banks; Preparatory work for Stage Three; Stage Three: Starting 1 January 1999 Irrevocable fixing of conversion rates; Introduction of the euro; Conduct of the single monetary policy by the European System of Central Banks; Entry into effect of the intra-EU exchange-rate mechanism (ERM II); Entry into force of the Stability and Growth Pact; Source ECB (2018). For details on three stages of Economic and Monetary Union (EMU) visit https://www.ecb.europa.eu/ecb/history/emu/html/index.en.html)

German Unification and Road to Maastricht Change in the German Democratic Republic’s (GDR) leadership from Erich Honecker to Egon Krenz and changes in the regulations on the movement of people created the environment for the unification of Germany.55 On 9 November 1989, the wall was opened, and the East Germans were greeted by their Western counterparts. These greetings were not only a lip service but as the events unfolded, the cost of German unification and development of East Germany was transfers of e100 billion to e140 billion a year to prop up and overhaul the economy of the defunct communist state of East Germany. It piled up to an approximate bill of around e2 trillion.56 Funded by taxation on income such as solidarity surcharge (Solidaritätszuschlag). In the Solidarity Pact II, an amount of e156 million ($203 million) was agreed to 55 See Sebetsyen (2009). 56 For “Germany starts recovery from e2000 billion union” visit http://archive.li/

ahXRd#selection-677.25-677.166. Also see Hunt (2008).

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be spent on supporting the infrastructure in the East (including, Brandenburg, Mecklenburg-West Pommerania, Saxony, Saxony-Anhalt and Thuringia).57 Germany was paying through nose for sovereignty, as it has been since WWII. Despite the fall of the Berlin Wall, the unification was not formally achieved until 3 October 1990. Elections of March 1990 held in the German Democratic Republic (GDR) brought favourable results for the unification as the Alliance for Germany (German: Allianz für Deutschland) supporting rapid unification appeared to be the most successful party. In about six months time, the unification treaty was accepted by a clear majority in GDR (299–80) before it was also approved by even a greater majority (442–47) in the Bundestag Federal Republic of Germany (FRG). However, these few months were of profound importance and contained events that had significant implications for the years and decades to come. The negotiations between the GDR and FRG led to the Unification Treaty signed by both parties in Berlin on 31 August 1990. Besides this, the main negotiations were on the Treaty on the Final Settlement with Respect to Germany (Vertrag über die abschließende Regelung in Bezug auf Deutschland), or the Two Plus Four Agreement (Zwei-plus-Vier-Vertrag).58 The two were the GDR and FRG whereas the four were France, the Soviet Union, the UK and the US, the four were to renounce all the rights on Germany so that it could gain its sovereignty. According to the Potsdam Agreement section 1.3.1, “The Council (composed of the Foreign Ministers of the UK, the USSR, China, France, and the US) shall be utilized for the preparation of a peace settlement for Germany to be accepted by the Government of Germany when a government adequate for the purpose is established”.59 The treaty was signed in September 1990 which led to the German unification on 3 October 1993. Interestingly, there are no signatures from the Chinese side in the German Unification though in the Potsdam Agreement it was stated that China shall be part of the Council accordingly. Does this mean German Unification is illegal? Anyway, let’s not go there! Germany 57 For “Solidarity Pact II to Be More Effective” visit https://www.dw.com/en/solida rity-pact-ii-to-be-more-effective/a-1474273. 58 For details on “Treaty on the Final Settlement with Respect to Germany September 12, 1990” visit https://usa.usembassy.de/etexts/2plusfour8994e.htm. 59 For Potsdam Agreement visit https://www.nato.int/ebookshop/video/declassified/ doc_files/Potsdam%20Agreement.pdf.

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was allowed to have full sovereignty with effect from 15 March 1991. There was a question of “too much German land which had been stuffed to Polish goose” as Winston Churchill had cautioned. Germany had to agree to the border changes as a result of WWII including the area in the east of the Oder-Neisse line which had been its part for centuries. German–Polish Border Treaty60 on 14 November 1990 reaffirmed the German–Polish border as it stood at the time, effectively relinquishing these once historically German provinces in eternity to Poland. Germany was also required to amend its constitution so that it will not accept any application for incorporation into Germany from lands beyond the territories of what was then East Germany, West Germany and Berlin. Germany had to agree to the limitations on the size of the military, types of armament, deployment and use of force in future. There should be only German troops deployed in the former East German states, however, this aspect of the Treaty has been violated by the deployment of NATO and non-German troops. Some of the Central and East European (CEE) nations have joined NATO which changes the facts and political landscape, though not without discontentment from Russia.61 As the USSR collapse came without much anticipation, Germany had to pay another bill of $60 billion to the Russian Federation, for the resettlement of Soviet troops. In these politically high times, the efforts on the economic development continued an example was the European Bank for Reconstruction and Development (EBRD) established to preliminary support the eastern bloc countries, though with time it widened its scope of operations. The Schengen Convention in June 1990 supplemented the Schengen Agreement by proposing the complete abolition of internal border checks and having an external common visa policy. Similarly, in 1992 the European Community Humanitarian Aid Office (ECHO) was established under the Delors (second) Commission to support humanitarian causes globally. This is was also a manifestation of the European Union reviving its international position and impact. In terms of internal progress and integration, the big leap was to the Maastricht. 60 For “Treaty between the Federal Republic of Germany and the Republic of Poland on the confirmation of the frontier between them, 14 November 1990”, visit https://www.un.org/Depts/los/LEGISLATIONANDTREATIES/PDFFILES/TRE ATIES/DEU-POL1990CF.PDF. 61 See Cohen (2005) and Zoellick (2000).

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Maastricht Treaty---Conception of Tragedy Committee for the Study of Economics and Monetary Union in the chairmanship of Jacques Delors and under the mandate of the European Council presented their report in April 1989 and had proposed three-stage achievement of EMU (Table 1.1). Stage one entailed steps of complete freedom for movement of capital; increased cooperation between central banks, Free use of the ECU (European Currency Unit, the forerunner of the euro) and improvement of economic convergence. Additional responsibilities were given to the committee of the central banks of EEC members, these include consultation on the price stability by coordination of monetary policies in member countries. To achieve the required institutional framework in place which can lead to the EMU, it was also required to revise the Treaty of Rome which established the European Economic Community (EEC). This led to the occurrence of the Intergovernmental Conference (IGC) on the EMU and on the Political Union in 1991. The Intergovernmental Conference (IGC) on the EMU benefited from the solid start and context provided by the Delors report on the single currency and a central bank. This was a particularly important point in the monetary history of the EMU as well as what later followed till day. Germany was to make more concessions and by that, I mean giving up its sovereign currency, Deutschmark. Assurance was provided by the French that the European Central bank (ECB) will be independent of governmental influence, although their own proposal was to rather strengthen the Council of Finance Ministers of the Unions (Ecofin). Compromise is an important element of EU functioning was to have an independent central bank with a single currency but on the fiscal side, each country would have its only fiscal policy with some coordination among the council of economics and finance ministers or more precisely the Economic and Financial Affairs Council (ECOFIN). This implied a flaw or crack in the design which became explicit in the crisis and resulted in failure of coordination. The time told this was a major issue as the events of Global Financial Crisis 2008, succeeding European Sovereign Debt Crisis and most recently COVID-19 unfolded. Another issue that required agreement was the conditions for participation in the single currency. Economic and most importantly the budgetary outlook of the member countries was fairly uneven. Contrary to the Germany, France in the presidency of François Mitterrand was keen to have a stricter fiscal

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rule where the government budget deficit should not exceed 3% of the national income, a threshold which was already put in place in France. German suggestion to account for the investment expenditure was not taken into account by the French who wanted a simple and stricter fiscal rule. Perhaps it was easy for France which was running a deficit of less than 2% of GDP while for Germany it was around 3.5%. Undoubtedly, Germany had very hot unification invoices on hand. In most of the other member states (exception of Denmark, Ireland and Luxembourg) the budget deficit was in excess of 3% of national income and in fact in Italy it was approaching double-digit. There was a notion put forward by the Italian that the membership of a single currency should not be contingent on economic criteria as it is a political project (where the economic logic and even logic is condoned). However, this honest view was bitter and ended up under the carpet. Britannia was clearly not a rider of the single currency and why it should lose something which was its trademark for something that is half-baked. This reluctance and anxiety of departing from their sovereign currencies was obvious and explicit and nicely depicted by the German cartoonist Horst Haitzinger (Fig. 1.3). Under the presidency of Jean-Claude Junker (Luxemburg) and later under Wim Kok (Netherlands), in the Intergovernmental Conference (IGC) on the EMU, finance ministers of member states and their respective treasury representatives continued to negotiate through 1991. It is worth noting that at that point, the first stage had been implemented to some extent as on the 1 July 1990 with the liberalisation of movement of capital. What was to be settled was the convergence of the economies and even before that convergence of the economic policies. These negotiations were in isolation from the Intergovernmental Conference (IGC) on the Political Union and negotiations among foreign affairs ministers. To achieve the aim of creation and management of a single currency, the European System of Central Banks (ESCB) was established. This included the European Central Bank (ECB), and the central bank of members states, i.e. National Central Banks (NCBs). The ESCB was independent of national governments, similar to the other institutions of the Community. There was only and only one goal “Price Stability” something utterly myopic but yet seldom achieved. I will reflect on the failure to consistently achieve this goal in the later parts of this treatise. There were concerns raised by Germany on the convergence and independence of monetary authority, however, despite these concerns which later proved to be right,

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Fig. 1.3 Maastricht European Council (9 December 1991)62 (Source Horst Haitzinger. Copyright: “Horst Haitzinger, München”. Maastricht open-air swimming pool: “Follow me! Let us know if there’s any water in the pool!”’ On 9 December 1991, on the eve of the Maastricht European Council, German cartoonist Horst Haitzinger takes an ironic look at the commitment [“follow me!”] of German Chancellor Helmut Kohl to Economic and Monetary Union [EMU] and to the Treaty on European Union. French President François Mitterrand, second in line, seems more reluctant to take the plunge [“Let us know if there’s any water in the pool!”], while British Prime Minister John Major seems to be about to climb down from the diving board)

there were some assurances that nothing to worry about. In the Maastricht European Council meeting on 9 and 10 December 1991, French and Italian pushed for the decision that the EMU would inter into force of 1 January 1997 if most of the member countries satisfy the conditions, otherwise, on 1 January 1999, those members which meet the criteria

62 For details visit https://www.cvce.eu/en/obj/cartoon_by_haitzinger_on_the_maastr icht_european_council_9_december_1991-en-d0cac658-02e1-46ae-bd50-ed279c5a9244. html.

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would be able to join irrevocably. Convergence criteria included an inflation rate measured in terms of consumer price stability which should not exceed 1.5% more than the average of the three best-performing member states. Similarly, the long-term interest rates should not exceed more than 2% of the average of best-performing member states. The candidate currency of the candidate member states was required to participate in the European Monetary System (EMS) for at least two years and during this period it should not exceed the margins. In terms of fiscal criteria, the deficit of central, regional and local governments as well as social security funds should not exceed 3% of the GDP whereas the debt should not exceed 60% of the GDP. Core principles were stated in the Treaty on the European Union (Aka Maastricht Treaty) in the article 109j, the relevant periods over which they are to be respected are developed further in the protocols (Nos. 5 and 6) which were amendable by a unanimous decision of the Council of Ministers. It was also agreed in the Maastricht European Council that the prerequisites to accede to EMU would also be dependent on the technical as well as political criteria and trends would be taken into account. The decision to allow a member to join EMU would be taken by the Head of states/government levels and would require a qualified majority in the council. This meant that there would be room for the politics to overwrite and overrule the economic criteria and principles, what followed is prima facie evidence that it was so! Parallel to the IGC on the Economic and Monetary Union of the European Union, rather more stringent negotiations were continued on the Political Union, there was no Delors report to provide the foundation of Political Union, though there was a European Parliament and European Commission in place which had been calling for the extension of powers. In March 1990, it declared the intention of rapid integration and conversion of the European Community into a Federal type of European Union which goes beyond a single market and EMU to foreign policy. In that environment, Belgium sent an Aide-mémoire on 20 March 1990. It urged on the strengthening of the institutional system of the community by adopting a qualified majority voting system in Council, reduction in the number of commissioners, the President of the Commissions to be investiture by the Parliament, reinforce of legislative co-decision between Council and Parliament and cooperation enhancement in the security and foreign policy aspects. Belgium proposal was not explicitly and fully implemented yet it had its impact rather more implicitly and by and large the direction the politics of the European Union was steered.

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As it often happens, push came from the big guys, i.e. France and Germany in the leadership of President Francois Mitterrand and Chancellor Helmut Kohl. In their letters on 19 April before the Dublin European Council planned on 28 April 1990, they urged the European Council to expedite and convene an Intergovernmental Conference for integration efforts and work towards the achievement of four objectives. These included (a) enhancements of democratic legitimacy of the Union (b) increase in the effectiveness of institutions expanding role of European Council and by extending majority voting in the Council of Ministers (c) ensuring the coherence and unity in the activities of the Union in economics, monetary and political terms and make these activities comprehensible to the layman and (d) establish a common security and foreign policy. How much of these four objectives have been achieved till date is debatable, yet at that time the response by Britain in the Premiership of Mrs. Thatcher was cautious asking for clarifications and sureties, so does the Danish and Portuguese leadership. On the other hand, without much surprise, President of the Commission Jacques Delors was supportive of the proposal by Belgium as well as France and Germany. And why would he not be? We cannot recall a single incident where anybody from the European establishment would object to any effort towards closer integration. Anyway, the Ministers of Foreign Affairs in conjunction with the European Commission and Parliament drafted a report setting out the objectives analogous to what was the German, French and Belgian proposals. It was decided to hold the Intergovernmental Conference on the Political Union in parallel to the one on EMU on 15 December 1990. However, the differences among the member countries were profound. Federal Republic of Germany (FRG) and France were interested “in the common foreign and security policy and this viewed was shared by Belgium, Luxembourg, Spain and Greece. Germany, Italy, Belgium and Netherland were also in favour of extending the powers of the European Parliament, so support towards the element of democracy. Similarly, some countries were focusing on social policy (France, Germany, Italy and Benelux states) whereas southern states were keen on economic and social integration with the northern countries. In this scenario the UK was less ambitious about further integration and it required a change of Premiership from Mrs. Thatcher to Mr. John Major in November 1990 before the UK could make some steps forward. European Commission put its weight in favour of a single community constituting political, economic and monetary union to ensure the

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economic and political coherence though on the foreign policy front there were some limitations. The European Parliament also expressed the desire for the extension of powers in the conference held at the end of November 1990. In December 1990, the French and German steered the process and provided the outline of future Political Union which entailed the extension of the Community’s power in the areas of health, energy, social policy, research and technological developments, environment and consumer protection, immigration and visa policy and international crime. The institution of “European Citizenship” proposed by Spain was also agreed upon by France and Germany who were in favour of strengthening community and integration to a common foreign and security policy. Agreeing to the spirit of common security the member states declared that the Atlantic Alliance would be reinforced with enhanced responsibility of European states. Though there were some concerns on the mandate of the Intergovernmental Conference through 1991, it continued under Luxembourg and Netherlands presidencies and a plan was submitted by April which entailed extending the powers of the EEC, European Parliament, the introduction of Justice and home affairs and inclusion of common foreign and sectary policy in the structure of the Union. In nutshell, it was a “pillar” structure with the first pillar as European Community including EMU, second foreign and security policy and third justice and home affairs. The Commission was not supportive of the pillar structure but a tree-like structure with the different decisionmaking processes, however, this opposition went in vain. Pillars stood their ground until they were abolished in 2009 as a consequence of the Treaty of Lisbon (Fig. 1.4). On the issue of security and defence, France and Germany suggested a Common Foreign and Security Policy (CFSP) under the Western European Union (WEU) which cooperates with the Atlantic Alliance. The proposal had support on both sides of the Atlantic. The UK was reluctant to sign-up for the social policy as it refused to for the Social Charter in 1989 which it was opposing to include in the Treaty on European Union. As a special provision, the UK was granted exemption or opting-out from the Social Protocol. There were also some concerns on the common defence policy (UK, Netherlands, Denmark and Portugal) versus common defence (France, Germany, Belgium, Luxembourg and Greece). Diplomatic jugglery led to the agreement that “all the questions related to the Union’s security shall be included in the common foreign and security policy and this will include the eventual framing of a common

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Fig. 1.4 Pillars of the European Union

defence policy, which in time might lead to a common defence”. On the question of qualified majority vote in the Council of Ministers, UK and France agreed that on foreign policy aspect the joint action shall require unanimous approval and only in the implementation the majority voting could be excised which would also be subject to Council unanimous agreement. It seemed all cleared for the road to Maastricht! Negotiations in the Intergovernmental Conferences on the EMU and Political Union led to the Treaty on European Union (TEU) often known as the Maastricht Treaty which was agreed in December 1991 and later signed in Maastricht on 7 February 1992. Ratification of the treaty was rejected by Denmark in a referendum held in June 1992. This led to amendments and the Edinburgh Agreement where Denmark was given four opt-outs namely on the citizenship of the European Union, Common Security and Defence Policy, Justice and Home Affairs and most prominently on the Economic and Monetary Union (EMU). The UK also secured an opt-out from the EMU and it was not required to move to

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the 3rd stage of EMU and introduction of the Euro. Concomitantly, the UK retained its monetary policy under national law, it was not subject to the Provisions of Treaty related to the fiscal deficit. UK was also not under the provisions of the Treaty relating to the European System of Central Banks (ESCB), the European Central Bank (ECB) or the regulations and decisions adopted by those institutions. In return, the UK weighted votes were excluded from the calculation of the qualified majority and its rights were suspended to vote on the acts of Council related to the decision on the irrevocable fixing of the exchange rates between the currencies of the member states that move to the third stage and adopted the Euro (e). It was also not allowed to participate in the appointment of the President, Vice President and Executive Board of ECB. Fair enough, if you don’t join the club, you can’t have your say in its affairs! After the prolonged ratification the Treaty came into force in November 1993. It introduced the protocol on the Statute of the European System of Central Banks (ESCB) and of the European Central Bank (ECB) and the Protocol on the Statute of the European Monetary Institute (EMI). Single Market Act guaranteeing the free movement of goods, services, capital and labour was already enforced from January 1993. The European Economic Area (EEA) agreement also came into force from 1 January 1994 and members of the European Free Trade Association (EFTA) countries were allowed to participate in the common market without being a member of the EU. Though Switzerland failed to ratify what followed was the enlargement of the European Union as Austria, Finland and Sweden acceded, but Norway electorate decided otherwise. With further enlargement, the EU-12 became EU-15 while Poland and Hungary formally applied for membership.

Maastricht to Amsterdam The second stage of EMU started with the establishment of the European Monetary Institute (EMI). Based on the mandate given by the Treaty, EMI undertook the following specific responsibilities: • Preparation of a range of instruments and procedures to conduct the single monetary policy in the future euro area and to analyse potential monetary policy strategies;

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• Promoting the harmonisation in collection, compilation and distribution of properly articulated euro area statistics in respect of money and banking, balance of payments and other financial data; • Development of the framework for conducting foreign exchange operations as well as for holding and managing the official foreign exchange reserves of the member states participating in the euro area; • Promotion of the efficiency of cross-border payment and securities settlement transactions in order to support the integration of the euro money market, notably by developing the technical infrastructure (the TARGET system) for the processing of cross-border payments in euro to be as smooth as that of domestic payments; and • Preparation of the euro banknotes, including their design and technical specifications. At this juncture, I must point out that the EMI was established postMaastricht Treaty, so the commitments were made before getting into the technical nitty-gritty of a single monetary policy. This raised some of the issues which emerged Post-Global Financial Crisis including the emergence of TARGET2 imbalances. I will discuss this aspect later. Anyway, in preparation for the establishment of the ESCB EMI took the following tasks: • Elaborated harmonised accounting rules and standards to make it possible to construct a consolidated balance sheet of the ESCB for internal and external reporting purposes; • Putt in place the necessary information and communications systems support for the operational and policy functions to be undertaken within the ESCB; and • Identified the possible ways in which the ESCB would contribute to the policies conducted by the competent supervisory authorities to foster the stability of credit institutions and the financial system. With the beginning of the second stage of achievement of EMU, the European Monetary Cooperation Fund (EMCF) was dissolved on the 1 January 1994 as the European Monetary Institute (EMI) took over its role, although during the transitional period, BIS continued to operate as an agent until May 1995. Following the broad guideline by the council,

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the economic policies of the member states were influenced to bring the public deficit in line with the criteria. The rationale for the establishment of the EMI was to strengthen the coordination among National Central Banks and monetary policies. In so doing, it was intended to do the preparatory work for the European System of Central Banks (ESCB), by laying the foundation for the transition to the third stage which entailed a single currency and establishment of ECB. However, the EMI was not involved in the conduct of monetary policy which remained the remit of National Central Banks and nor it was involved in the foreign exchange market interventions. This implied that the EMI was not directly involved in the price and exchange-rate stability which were also two of the convergence criteria and perhaps the core ones. Rather, it provided a consultation and discussion forum for debate on policy issues. Nonetheless, it provided the regulatory, institutional and logistical framework required for the ESCB to function when it comes to the third stage of the establishment of EMU. Delivering on its mandate, the EMI presented a report to the European Council in December 1996. This report provided the foundation to the Resolution of Council on the principle and basis for Exchange Rate Mechanism (II) which was followed in June 1997. At the same time, EMI provided the design of the Euro Currency notes first to the Council and then to the Public which were to be put in circulation from 1 January 2002. European Council adopted the Stability and Growth Pact (SGP) in June 1997 with the notion to complement and specify the provisions of the Treaty on EMU, specifically the fiscal discipline. The declaration of the council in May 1998 and reforms and in 2005 and 2011 supplemented SGP. I will revert to the reforms as they occurred in chronological order. Council of the European Union unanimously decided on the 2nd of May that 11 of the member states, including Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland have met the requirements for the adoption of Euro and third stage of EMU. Decision on the members of the Executive Board of the European Central Bank was also reached by the respective governments. A consensus was also reached among EMI, European Commission, NCBs and finance ministers of the member states that to determine the irrevocable conversation rates for the Euro, the current ERM bilateral central rates of the currencies of the participating member states would be used. In May 1998, the President, Vice President and four members of the ECB’s Executive Board were appointed by the member states and their appoints were to be effective

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from 1 June 1998 which was an important date as the establishment of ECB and liquidation of the EMI which had done its job. How well the job was done, I won’t go into the debate on that, but the EMI worked according to its remit. On the political front, Post-Maastricht, the European Committee of the Regions was established in 1994. Its underlying principles were Subsidiarity, Proximity and Partnership, and in a nutshell, the idea was to increase the participation of regional bodies so that the EU and European integration could be as much as possible get “close to the citizens”. Though the membership reflects the size of each EU country’s population but not very precisely and the smaller countries, for instance, Malta has greater per capita representation than Germany. In order to go to the micro-level in terms of economics and finance, to facilitate the small and medium enterprises (SMEs) the European Investment Fund (EIF) was established in 1994. Although it did not lend money directly to SMEs, as it claims, it acts as an intermediary. Shareholders are the European Investment Bank (EIB), the European Commission (representing the European Union) and a number of public and private banks and financial institutions. I would say EIF had done some work in facilitating Venture Capital (VC) investments in the EU. Though the Maastricht Treaty was a huge leap, but on the political front there was also some further progress required and this need was fulfilled by the Treaty of Amsterdam amending the Treaty on European Union, the Treaties establishing the European Communities and certain related acts, it was as its names suggest and was signed in the Amsterdam on the 2 October 1997. It particularly enacted the areas of foreign and security policy (CFSP), civil and criminal laws and immigration issues by giving more powers to the European Parliament and institutions. Agreement on Social Policy and Schengen Agreements were made part of the Treaty and incorporated in the legal system of the EU. This is an intuitive step as the free movement of labour and the notion of European Citizenship requires security, safety and rule of law at the European level for which the enhanced cooperation and institutional arrangements between the governments were a precondition. There was also an aspect of establishing a mechanism for coordinating employment policies of member states. Putting it plainly, Article B suggested that the Union set herself to the objectives and the first is:

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to promote economic and social progress and a high level of employment and to achieve balanced and sustainable development, in particular through the creation of an area without internal frontiers, through the strengthening of economic and social cohesion and through the establishment of economic and monetary union, ultimately including a single currency in accordance with the provisions of this Treaty.

As it stands and by the writing of this para, it seemed that the EU failed tremendously on this objective more than anything else. I will revert to this in the later part of this book by reflecting on the socio-economic progress including the state of employment and decade of economic stagnation. Anyway, coordination was also required on the external issues and specifically for the security and foreign policy and hence it led to the establishment of a High Representative for the EU foreign policy who with in coordination with the European Commission and President of the Council present EU foreign policy. The high representative was supported by the office of the Secretary-General of the Council for the CFSP, and Policy Planning and Early Warning Unit were established. The President of the Commission was to be nominated by the European Council and approved by the parliament, which was intended to make it more democratic, how much it is democratic is debatable and Eurosceptic in and outside the European Parliament are among those who think it isn’t very much! Third stage of EMU began on the 1 January 1999 where 11 members states started to participate in the Monetary Union with irrevocably fixing the exchange rate of their currencies and the ECB started to conduct a single monetary policy for these states. The UK had already notified the Council on 30 October 1997 that it has no intention to adopt the single currency on 1 January 1999. The window of single currency however remained opened for the UK subject to the fact that the UK Government and Parliament wish to do so (either with or without the referendum that would have been subject to the domestic law, though for any political party it would have been disastrous to take such a step without public vote). The second requirement would be of meeting the convergence criteria laid down in the Maastricht Treaty. A request by the UK government to join the single currency would have been considered by the Council which would have consulted Commission, ECB and Parliament to decide whether the conditions are met, and the decision would have been made by a qualified majority. Till date there has been no step made

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by the UK towards Euro and after Brexit, that possibility is gone. But at that point, the UK rather tied the membership of Euro with the requirement of the UK meeting five economic tests. These included, first, the convergence business cycle in the Eurozone and the UK and specifically, with a long-term view of convergence in terms of inflation, interest rates, output gap and real effective exchange rates. Second, the UK should have been flexible enough in terms of fiscal policy and labour market flexibility and mobility that it can absorb any asymmetrical shock. Third, the membership of the single currency must promote both domestic and foreign investment in the UK. Fourth, the membership must also increase the competitiveness of the financial series industry and the City of London. Lastly, the membership of EMU must have positive effects on economic growth, stability and employment and should also have a positive impact on the UK foreign trade, price differentials. These criteria were the domestic self-imposed conditions, in addition to the Maastricht criteria. It is interesting in the way and raises an intriguing question that what if the other members of the EMU including those who had actually opted for the Euro could have met these criteria! Perhaps not many. Though after Brexit UK has left the EU but till date, the UK has not met the criteria to a satisfactory and more importantly sustainable manners that it could have borne the brunt of any difficulties it might have faced if it had joined the EMU! But it was Greece who being the 12th Member of EMU joined in on 1 January 2001, just a year before the Euro ship set the sail.

Politics and Economics of Convergence An important aspect of the Maastricht Treaty which had been prone to debate is the convergence criteria which is important to keep in context as whatever followed has crucial political and economic significance around it. Specifically, according to Article 121(1) of the Treating Establishing the European Community, these four criteria are price stability, government finances, exchange rates and long-term interest rates. On the price stability, it was associated with the rate of inflation which should have been close to the three best-performing members states. Objectively, it required that the inflation rate in a member state must not exceed by more than 1½ percentage points that of the three best-performing member states in terms of price stability during the year before the examination. This

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was indeed a very short-term assessment of price stability for an irrevocable arrangement of exchange-rate fixing or putting it better Monetary Union. It merely meant that one can deflate for a short assessment period, check the box and get yourself a ticket to the EMU. Similarly, on the public finances and financial discipline, it was required that the member state in question should not have an excessive deficit. Excessiveness of deficit or fiscal outlook was then gauged by two measures. First, the ratio of fiscal deficit to the national GDP must not exceed 3% at the end of the preceding finical year. Nonetheless, if it is not the case, then the ratio must have declined substantially and continuously to reach a level close to 3% and only in an exceptional situation and temporarily accede the 3% reference value. Second, the ratio of government debt to GDP must not exceed 60% at the end of the preceding year and if that is not the case this ratio must have significantly decreased and on the path to 60%. In a nutshell, on the deficit and debt, despite the clear 3 and 60% of GDP benchmark, the trends were taken into account. Perhaps once again, the only very short-term trends. So, if you are showing a decline in the high levels of debt and deficit and may approach the benchmark if you continue, then besides historically poor fiscal performance, you have ticked the box. Furthermore, where a member state does not fulfil the requirements under either deficit or debt or both benchmarks, the Commission shall prepare a report taking into account all other relevant factors including public investment and medium-term budgetary outlook of the member state in question. Though Commission could also report despite the fulfilment of criteria if in her judgement there is a risk of excessive fiscal deficit. In the end Council by a qualified majority taking into account the Commission view as well as the member state, decide on the excessiveness of deficit. The Council could make recommendations to a member state to reach the desirable fiscal outlook which shall not be public. But not fulfilment of these recommendations Council could make them public. This was quite an interesting deal as the blame can be put on the member states for not complying with the recommendations and counterfactual is fascinating whether it would have worked or not. Card of public humiliation and favour to the opposition party! If a member state persistently fails to take into account the recommendation of the Council, it may serve a notice from the Council to take specific measures on deficit reduction within a specified time limit and also report the Council on its progress. In case of non-compliance the Council may intensify its pressure take further measures which may include:

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• Publication of additional information specified by the Council before issuance of bonds and securities, • Urging European Investment Bank to revisit the lending policy towards the noncomplying State, • A non-interest-bearing despite of appreciate size by the member state to the Community until the correction of deficit and • Fines and penalties of appropriate size. The parliament is to be informed by the President of the Council. Council can repeal the pressure as it feels that the member states council has made some progress on deficit reduction. Nonetheless, if the recommendation had been made public, it shall make a public statement that an excessive deficit has been rectified. Decision on the measures was taken by the Council with the recommendation from the Commission by a two-third majority (excluding the votes of the member state in question). This is supposedly a system of reward and punishment and enforcement of fiscal discipline in which the politics and bureaucracy are intended to define the rules of the Economic game. But did these measures on fiscal convergence worked is an interesting question and if so, how much was put under the carpet? With hindsight, it is prima facie evident that it was a lot that was condoned. I will revert to it but before that let’s first look at the other criteria of convergence. Third criterion of convergence was the exchange rate where the fluctuation was to be observed as normal and within the margins of the Exchange Rate Mechanism (ERM) of the European Monetary System for at least two years. Preceding the examination on the convergence, the member state in question should have continuously participated in the ERM for a two-year period and it should have not unilaterally devalued against any other member state. The European Monetary System was replaced by the Exchange Rate Mechanism (ERM II) after transition to the 3rd Stage of EMU. The fourth and last criterion was the long-term interest rates and in practice, the long-term interest rates for the member state in question should have not more than 2 percentage points than the three best member states in terms of price stability. So, it was rather a comparative analysis which might be appropriate for the convergence assessment but then there were three member states which may also differ from each other to a large extend. Nonetheless, the period to review was only and only one year preceding the examination which was undoubtedly a very short period for the analysis of long-term interest rates. Particularly the long-term interests of the stressed countries have skyrocketed

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during the crisis. It was stipulated in the Treaty that long-term interest rates may reflect the durability of the convergence by the member state. To some extent, one can be sympathetic to this view as if the member states have converged on the fiscal discipline, price stability and exchange rates then there shall not be much divergence on the rate of interest one shall charge them. Though with the benefit of hindsight we can say that was not the case as the preceding criteria were not perfect per see neither of them was a condition to perfectly reflect on the achievement of the fourth criteria. Anyway, for the third stage of the Economic and Monetary Union and in order to introduce the Euro, a member state was required to meet all of the criteria of convergence which with the underlying limitations of criteria and political will on both sides, was not too difficult. The Commission and ECB were obliged to submit the convergence reports to the Council at least once every two years or at the request of member state a derogation. As the Denmark and UK had opted out, they were not obliged to worry about the convergence criteria either.

Euro---The Birth of Tragedy Like the idea of the United States of Europe, the notion of a single currency is not new either and as I discussed at the beginning of this treatise, a common currency was the part of the idea put forward by William Penn. In 1928 the French man Joseph Archer minted the Europa coins in the name of “Federated States of Europe” (États Fédérés d’Europe) depicting famous French biologist and chemist Louis Pasteur and the map of Europe. This currency was never adopted by any of the European sovereign states, and it took another 71 years before the birth of its successor, the Euro (e) (Fig. 1.5). The year 1999 has a unique significance as EU–Japan, EU–Canada, EU–countries of Latin America and the Caribbean, EU–US, EU–Central and East European countries, African, Caribbean, Pacific (ACP)–EU, EU–Russia summit and EU–China summit took place. In that essence, it was a year of profound importance where the EU countries were coming as a block speaking in one voice one economic, political and security issues. Although, there was a mishap as there was a collective resignation of the Commission in March 1999 in response to the report by the Committee of Independent Experts on the allegations regarding fraud, mismanagement and nepotism in the Commission. It led to the establishment of the European Anti-Fraud Office in June 1999. Nonetheless, in

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Fig. 1.5 The Europa 1928

terms of economic and monetary integration 1999 was is also important as on the 1 January 1999 the exchange rate of 11 participating countries including Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal and Spain were irrevocably fixed as they officially adopted Euro as their currency. It replaced the European Currency Unit (ECU) and analogous to its predecessor was not immediately available for public use and was rather used by the financial institutions. As it stands, Euro is the second-largest reserve currency in the world used by approximately 350 million people and there are over 22 billion notes in circulation amounting to a value of over 1.2 trillion. Comparable with its nearest counterpart and king of global currencies, the US dollar $.63 In January 2002 Euro entered into circulation and in the next quarter of 2002, it replaced the currencies of the member states. In addition to the 11 member states which were participating on 1 January 1999, Greece also joined or to say sneaked in EMU on 1st of January 2001, while the UK and Denmark had already got the exemption while the Swedes turned down the Euro in a referendum in 2003. The banknotes are issued by ECB and NCBs where the former only issues around 8% of the total issuance and later issues 92 of the total issuance where each NCB issues on the basis of its capital key. Capital Key is based on the population size and GDP of the EU member states. It is a “key” 63 There was approximately $1.70 trillion in circulation as of 23 January 2019, of which $1.66 trillion was in Federal Reserve notes.

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aspect of this book and I will revert to it in the latter parts. An important aspect which required to be discussed at this juncture is that whether joining the Euro was a good thing for these countries? One may argue that they have met the convergence criteria, supposedly, so why not! But have they really met convergence criteria? Though itself the criteria was not the panacea for all the problems in the world. Let’s start by look at each criterion. First, the price stability as measured by the consumer price index (Fig. 1.6). In the run-up to 1 January 1999 that’s the date of irrevocably fixing the currencies, there was a sharp decline in the underlying measure of inflation, i.e. consumer price index in almost all of the countries, but specifically for Greece, Ireland, Italy, Portugal and Spain, GIIPS as we know them now for a reason. Undoubtedly, it was a very short-term assessment of price stability focus on the recent period, just one year before the examination of criteria. The second criterion was the fiscal outlook and specifically, the debt and deficit to GDP ratios (Table 1.2). The fiscal outlook was clear. Most of the countries were not meeting the criteria of a national debt of less than 60% of national income (GDP). In fact, Greece, Italy and Belgium were over 100% of their national income. At this juncture, if one takes the trends into account, we need to not only look at the trajectory of the debt in the last few years but also the second part of the fiscal criteria. Yes, the deficit ratios (Table 1.3). 25.0 20.0

Austria Greece

Belgium Finland

15.0

Portugal

10.0 Spain 5.0 Netherlands 0.0

France Germany Greece Ireland Italy Luxembourg Netherlands Portugal

Fig. 1.6 Inflation, consumer prices for EMU 12 in % (1990 to 2002) (Source FRED, Federal Reserve Bank of St. Louis 2019)

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Table 1.2 General government debt as % of GDP, 1995–2002 Countries Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain

1995

1996

1997

1998

1999

2000

69.17 140.37 62.91 67.29 54.12 97.84

69.71 142.24 63.76 73.29 57.2 98.98

65.37 136.83 62.17 75.95 58.66 95.69

121.23

127.13

128.67

67.12 138.02 59.12 77.61 60.55 94.08 61.28 129.58

84.78 67.49 67.53

83.5 68.04 73.86

78.14 66.03 73.05

75.97 65.31 73.47

70.73 126.67 53.02 74.02 60.46 96.75 50.48 123.74 16.15 67.44 62.46 67.95

71.07 120.54 51.01 72.43 59.52 111.7 38.72 118.99 15.76 61.13 62.02 65.17

2001

2002

72.12 74.03 119.24 118.42 48.41 48.24 71.47 75.16 58.76 61.2 115.3 116.63 35.55 34.05 118.14 116.96 16.15 16.22 57.12 57.63 63.46 66.81 60.57 59.25

Source OECD

Table 1.3 General government deficit as % of GDP, 1995–2002 Countries

1995

1996

1997

1998

1999

2000

2001

2002

Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain

−6.1 −4.4 −5.9 −5.1 −9.4 −9.7 −2.1 −7.3 2.7 −8.7 −5.2 −7

−4.5 −3.9 −3.2 −3.9 −3.5 −8.2 −0.2 −6.7 1.6 −1.8 −4.7 −5.4

−2.6 −2.1 −1.2 −3.7 −2.9 −6.1 1.3 −3 2.8 −1.6 −3.7 −3.9

−2.7 −0.9 1.6 −2.4 −2.5 −6.3 2 −3 3.2 −1.4 −4.4 −2.9

−2.6 −0.6 1.7 −1.6 −1.7 −5.8 2.4 −1.8 3.5 0.3 −3 −1.3

−2.4 −0.1 6.9 −1.3 0.9 −4.1 4.9 −2.4 5.9 1.2 −3.2 −1.1

−0.7 0.2 5 −1.4 −3.1 −5.5 1 −3.4 5.9 −0.5 −4.8 −0.5

−1.4 0 4.1 −3.2 −3.9 −6 −0.5 −3 2.4 −2.1 −3.3 −0.4

Source OECD

As it shows, the deficit in most of the countries was within the 3% rule prescribed by the Maastricht Treaty, however, it is important to see that (a) this development was very short term as just four years ago in 1995 it was only Luxembourg and Ireland which was below 3%. In fact it was as high as 9.4 and 9.7% for Germany and Greece, although Germany was picking the unification invoices so understandably it was bound to be high

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in a transitional period. Besides that, the German deficit had been historically low, so this was really a short-term blip. But for the countries which had high levels of debt like Greece and Italy, it should have raised some alarms and bells. In the case of Belgium, there was a persistent decrease in the deficit and with the benefit of hindsight, we can see that it never increased despite the period around Global Financial Crisis and European Sovereign Debt Crisis. One may argue that there was convergence if we take the trend into account, but that will be a bizarre argument because (a) you need to take into account long-term trend and (b) if we go by the trend, we shall expect a negative deficit (surplus) in the coming years which did not happen and would be silly to expect it to happen anyway. As the data shows, Post-1999 the deficit started to increase again for a number of countries. The third criterion was the exchange-rate stability, and in order to be deemed stable, it was required that the exchange-rate fluctuation was to be observed as normal and within the margins of the Exchange Rate Mechanism (ERM) of the European Monetary System for at least two years. Preceding the examination on the convergence, the member state in question should have continuously participated in the ERM for a twoyear period and it should have not unilaterally devalued against any other member state (Fig. 1.7). The figure on the exchange rates in terms of purchasing power parities (PPPs) for each of the national currencies of EMU-12 countries per 1.2

Austria

1.1

Belgium Finland

1

France 0.9 0.8

Germany

Netherlands

Greece Ireland

Ireland

0.7Portugal 0.6

Italy

Italy Spain

Luxembourg Netherlands

0.5 0.4

Portugal

Greece 1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Spain

Fig. 1.7 Exchange rates; purchasing power parities (PPPs) national currency per $US (Source OECD)

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US dollar ($) suggests that there was convergence in the value of currencies. In the run-up to the irrevocable fixing of the exchange rates by 1st of January 1999, every currency appreciated until they all merged. This was even more for Greece, Spain and Italy who also saw more than 100% appreciation in their currencies. On the morning of January 2002 as the Euro started to roll out, it priced more than a unit in parity. This was obviously a blow to the competitiveness of these economies, though the convergence was achieved, at what cost? Erosion of competitiveness of these economies already holding a large amount of debt and no currency in future to depreciate either. The option of gaining competitiveness through external or currency devaluation was no more available! The fourth criterion as I mentioned earlier was that the long-term interest rates and in practice the long-term interest rates for the member state in question should have not been more than 2 percentage points than the three best member states in terms of price stability. So, it was rather a comparative analysis which might be appropriate for the convergence assessment but then there were three member states which may also differ from each other to an extent. Nonetheless, the period to review was only one year, preceding the examination which was undoubtedly a short period for the analysis of long-term interest rates. It was stipulated in the Treaty that long-term interest rates may reflect the durability of the convergence by the member state. But that was not really the case, rather it was putting the things under the carpet making it difficult for the markets to price the risk associate with lending to the fiscally fragile states. Among others, most prominently Professor Hans-Werner Sinn has appropriately and adequately reflected on this aspect64 (Fig. 1.8). Element of convergence was evident in the long-term interest rates criterion more than any other proxy. As it clearly shows, the long-term rates on the government bond maturing in ten years converged so swiftly that where there was over 600 basis points difference in the mid-nineties, by the morning of 1999, it has been almost impossible to clearly distinguish among EMU 11 members. Of course, Greece was still on the way to the convergence of rates, and it did not take her very long to join the others. It came to the point that before the rolling out of the Euro, Greek sovereign bonds were almost as good as German. Of course, the examination period was not the historical average, it was the snapshot of limited time duration. As shown in Table 1.4.

64 See for instance, the Euro-Trap by Sinn (2014).

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M. A. NASIR

Spain

Austria

Italy

Belgium

Finland

12 Ireland 10

Finland Greece

France Germany

8

Germany

Greece

6

Ireland

4

Netherlands Italy

2

Luxembourg 1990-01 1990-06 1990-11 1991-04 1991-09 1992-02 1992-07 1992-12 1993-05 1993-10 1994-03 1994-08 1995-01 1995-06 1995-11 1996-04 1996-09 1997-02 1997-07 1997-12 1998-05 1998-10 1999-03 1999-08 2000-01 2000-06 2000-11 2001-04 2001-09

0

Portugal Spain

Fig. 1.8 Long-term interest rates (Government bonds maturing in ten years) Table 1.4 Maastricht criteria, A snapshot Maastricht criteria

Debt as % of GDP

Deficit as % of GDP

1997 60.0

1997 3.0

1998 3.0

1997 3.2

1998 3.2

7.7

Austria 66.1 64.7 2.5 Belgium 122.2 118.1 2.1 Britain 53.4 53.0 1.9 Denmark 65.1 59.5 −0.7 Finland 55.8 53.6 1.1 France 58.0 58.1 3 Germany 61.3 61.2 2.7 Greece 108.7 107.7 4.0 Ireland 66.3 59.5 −0.9 Italy 121.6 118.1 2.7 Luxembourg 6.7 7.1 −1.7 Netherlands 72.1 70.0 1.4 Portugal 62.0 60.0 2.5 Spain 68.8 67.4 2.6 Sweden 76.6 74.1 0.8

2.3 1.7 0.6 −1.1 −0.3 2.9 2.5 2.2 −1.1 2.5 −1.0 1.6 2.2 2.2 −0.5

1.1 1.4 1.8 1.9 1.3 1.2 1.4 5.2 1.2 1.8 1.4 1.8 1.8 1.8 1.9

1.5 1.3 2.3 2.1 2.0 1.0 1.7 4.5 3.3 2.1 1.6 2.3 2.2 2.2 1.5

5.6 5.7 7.0 6.2 5.9 5.5 5.6 9.8 6.2 6.7 5.6 5.5 6.2 6.3 6.5

1998 60.0

Inflation*, %

Long-term interest ratesł

ERM membership

Yes Yes No Yes Yes} Yes Yes Yes§ Yes Yes** Yes Yes Yes Yes No

* Within 1.5% of average of lowest three. ł Within 2% of average of inflation’s lowest three, Jan 1998. } Since October 1996. § Since March 1998. **Since November 1996

Source European Commission

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Apparently, it was not all that bad! But unfortunately, it was! The criteria of convergence were fundamentally flawed, and they provided a very limited view of the world. On the fiscal and monetary discipline, the historical record of the EMU-12 was not the same, tweaking and twisting that involved taking into account the trends was not even fulfilling the criteria, to reiterate, taking short-term trends into consideration was not helpful either. The adoption of the Euro at this level and state of convergence was giving birth to a major tragedy.

CHAPTER 2

Great Moderation Let the Party Going

Treaty of Nice and Eastward Expansion Launch of the Euro was just the beginning not an end to an infinitely perpetual project of integration. The period that proceeded the rollout of the Euro was the reign of treatise and the readers may find treaty-related section a bit tedious read,1 for which I can express my sympathy. Less focus was given to building the economic resilience than the regulatory jugglery, which remains the case in the EU till date, but I think that was more so in the duration between rolling out of Euro and Global Financial Crisis. The Amsterdam Treaty entered into force in May 1999, but it was not ample either and in December 1999, it was agreed to convene an Intergovernmental Conference (IGC) to revise the Treaties. In order to facilitate the eastward expansion of the EU and to bring in some of the institutional changes, the Maastricht Treaty (1992) and Treaty of Rome (1957) were to be amended in the form of the Treaty of Nice signed in February 2001 and came into force two years later in February 2003. There were changes in the decision-making by adopting qualified majority voting, changes in the composition of the Commission and changes to the European Parliament. But the voting system was indeed a significant and

1 Readers not interested in the Treaties can skip to the section on Steroid-Enhanced Economic development Post-Euro.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6_2

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important element of the Treaty of Nice. The Intergovernmental Conference (IGC) had proposed an increase in the number of MEPs (from 700 to 735), though the number of seats allocated to the existing members came down from 626 to 535. This adjustment did not affect the number of MEPs from Germany and Luxemburg which retained the number of MEPs. I must mention here that Germany on per capita basis was already and has been underrepresented, therefore it was not an unfair favour to Germans. Nonetheless, the reduction was to come into force from the 2009 elections. IGC had the prospective of 27 EU members (EU-27), however, as the membership had not increased to that level in 2004, it was agreed that the number of MEPs in the current and new member states signing the accession treaties will be increased on a pro-rata basis reaching to the target of 732. In so doing, it was also taken into account that the number of MEPs to be elected in each member state cannot be higher than the current number. The expansion of 2004 was a major one, as ten states including Czech Republic, Cyprus, Estonia, Latvia, Lithuania, Hungary, Malta, Poland, Slovenia and Slovakia joined. Indeed, the UK as left now, but at that point, the number of MEPs was as follows (Table 2.1). Member states were to sign the accession treaty after the 2004 European election it was expected that the number of total MEPs may temporarily exceed the maximum number agreed in Nice. The scope Table 2.1 European Parliament composition

Member states Germany United Kingdom France Italy Spain Poland Netherlands Greece Czech Republic Belgium Hungary Portugal Sweden

Seats

Member States

Seats

99 78 78 78 54 54 27 24 24 24 24 24 19

Austria Slovakia Denmark Finland Ireland Lithuania Latvia Slovenia Estonia Cyprus Luxembourg Malta Total EU

18 14 14 14 13 13 9 7 6 6 6 5 732

Source Europa.eu http://europa.eu/rapid/press-release_MEMO03-23_en.htm

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of co-decision and responsibilities of the European Parliament were extended. It was also decided that the Parliament will be called upon and asked for advice when the Council faced a situation where there is a threat to breach of fundamental rights. There were also changes in the definition of qualified majority and associated co-decision process. The qualified majority is obtained if. a. The decision receives at least a specified number of votes (the qualified majority threshold) and b. The decision is approved by a majority of member states. What would be the qualified majority was a crucial and debatable issue! There were compromises made and it was decided that the qualified majority threshold will be fixed in the successive accession treaties on the basis of principles determined by the Treaty of Nice, particularly by the declaration on the qualified majority threshold. The qualified majority would have required at least 232 votes. There were also changes in the number of votes and the proportion of votes to each state. Consideration of population size was taken into account. The share of votes for the five most populous countries was increased from 55 to 60% (Table 2.2). Table 2.2 Votes in council and population Member states Germany United Kingdom France Italy Spain Poland Netherlands Greece Czech Republic Belgium Hungary Portugal Sweden

Votes

Population in millions

Member states

Votes

Population in millions

29 29 29 29 27 27 13 12 12 12 12 12 10

83 60 57 41 38 16 11 10 10 10 10 9

Austria Slovakia Denmark Finland Ireland Lithuania Latvia Slovenia Estonia Cyprus Luxembourg Malta

10 7 7 7 7 7 4 4 4 4 4 3

8 5 5 5 4 3 2 2 1 0.7 0.4 0.4

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There was also a provision that a member state can request verification that the qualified majority represents at least 62% of the total population of the European Union. In such a scenario where that is not the case, the decision would have not been adopted. It was also decided that from November 2004 each member state will have a national in the Commission and hence the bigger states lose the ability to propose the second member for Commission. It was also agreed that as the membership reaches to EU-27, there will be fewer commissioners than member states which will be selected by rotation given a fair chance to every member state. This obviously means the under-representation of more populous states. It was left to the Council and its unanimous decision on the number of commissioners and system of rotation after the membership of the Union reaches to 27. There were also changes in the nomination of Commission and the nomination of President was to be by the Commission with a qualified majority which would have required approval by the European Parliament. Thereafter, the Council was to appoint the commissioners by drawing upon the proposal made by each member state. This is to be done with the agreement by a qualified majority appointed President. Notion was to ensure that the member state whose national is appointed as commissioner is on board. Allocation of responsibilities and portfolios to commissioners were in the President’s hands and that meant the President of European Union bureaucracy. Governing Council of the ECB and its composition was not influenced much by the Treaty of Nice and as I said earlier, the focus was not building resilience for what was going to hit the Titanic of the world and Eurozone economy. Instead, there have been changes in the decision process. Governing Council was expected to submit the proposal on such changes which were to be ratified by the member states after unanimous approval by the European Council. For the European Investment Bank, the Treaty of Nice allowed potential alternation in the composition of the board of directors and decision process and roles, subject to a unanimous decision by the Council. The Treaty of Nice relaxed the decision-making and about 27 provisions were changed from the unanimity to qualified majority. These included areas around, international trade and finance agreements, freedom of movement, industrial policy and legal matters particularly the Court of First instance, statue of political parties and legal cooperation in civil matters among states. However, five keys remained more towards unanimity including taxation where unanimity is required for all measures. Similarly, for the social policy, the Council was allowed

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to apply the co-decision procedure with unanimity, though this was not be used as a bridge for social security matters. For the Cohesion policy, the qualified majority was decided to be adopted but post-adoption of multiannual financial perspectives. Application of qualified majority on asylum and immigration policy was also postponed. In terms of common commercial policy, which entailed areas like negotiation and conclusion of international agreements on trade in services and the commercial aspects of intellectual property, the qualified majority was required. Except, in a situation where the underlying agreement required unanimity or includes areas where the EU has not exercised its responsibilities yet. Treaty of Nice also touched upon the issue of enhanced cooperation,2 particularly on issues around common foreign and security policy as well as judicial matters. The treaty of the European Coal and Steel Community (ECSC) was about to expire on 23 July 2002, the Commission put forward a draft decision for the allocation of ECSC funding to the European Community which were then to be used for the research in the coal and steel sectors. This matter was also decided to be settled through the Treaty of Nice. In nutshell, the Treaty of Nice was an important steppingstone in the journey towards enlargement.

Treaty Establishing a Constitution for Europe (TCE): Rome to Lisbon In December 2001, European Council held at Laeken, Belgium and among various other aspects on the enhancement of integration, it led to the Laeken Declaration on the Future of Europe. The declaration established the European Convention which was tasked with the drafting of the Treaty Establishing a Constitution for Europe. In this regard, a

2 The procedure of Enhanced cooperation is where a minimum of 9 EU countries are allowed to establish advanced integration or cooperation in an area within EU structures but without the other EU countries being involved. This allows them to move at different speeds and towards different goals than those outside the enhanced cooperation areas. The procedure is designed to overcome paralysis, where a proposal is blocked by an individual country or a small group of countries who do not wish to be part of the initiative. It does not, however, allow for an extension of powers outside those permitted by the EU Treaties. Authorisation to proceed with the enhanced cooperation is granted by the Council, on a proposal from the Commission and after obtaining the consent of the European Parliament. As of February 2013, this procedure was being used in the fields of divorce law, and patents, and is approved for the field of a financial transaction tax.

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parallel can be drawn with the Philadelphia Convention which was held in September 1787 and led to the US Federal Constitution. A European Constitution was also necessary after a European currency Euro. Under French chairman and Italian and Belgian vice chairmen, The European Convention finished its task by July 2003. However, at the same time, Penelope Project issue arose which involved the preparation of a parallel Constitution for then the President of Commission Romano Parodi. The Penelope was the code word from the Greek mythology where faithful to her husband Odysseus who has gone to fight Trojans, Penelope delays re-marrying proposals by announcing that she will remarry after the completion of a funeral canopy of Laertes, Odysseus’s father. But in fact, she never completes it. President Parodi was indeed more enthusiastic in speeding up the integration process as well as the reforms and expansion of the Qualified Majority Voting system. The Penelope project did not get much appreciation from the Chairman of the convention Valéry Giscard D’Estaing, and rather to some extent undermined the credibility of the Commission.3 The final draft of the European Constitution was agreed in June 2004 and signed in October 2004 by 25 member states. The European Parliament voted and ratified the Treaty by a majority, no surprise! But it was to go through the ratification by member states which was a difficult task. Sailing through the tides of nationalism at the national level! Despite the ratification by a number of countries including, Spain, Italy and Germany it faced a backlash as the French and Dutch voters rejected it in a referendum held in May and June 2005. This led to the cancellation of further ratification by a number of countries, among others, Portugal, Poland, Ireland and UK were the significant ones. The rejection led to the start of a period of reflection in which it was to be decided what to do next. A group of high-level European politicians led by former Italian Prime Minister Giuliano Amato officially named Action Committee for European Democracy (ACED) a.k.a. Amato Group was set up which met in September 2006. The Amato Group reported in June 2007 and proposed an IGC with the aim of rewriting and amendments to the Maastricht Treaty and Treaty of Rome.4 In the same month, during

3 For details visit https://ecpr.eu/Filestore/PaperProposal/57c5a117-ae26-49e9-a350c9d6adcf7a5b.pdf. 4 For details visit https://web.archive.org/web/20070708034933/http://www.eui. eu/RSCAS/e-texts/ACED2007_NewTreatyMemorandum-04_06.pdf.

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the European Summit, the member states agreed to amend the treaties. This paved the path to Lisbon via Rome.

Berlin Declaration and Treaty of Lisbon In March 2007 on the 50th Anniversary of the Treaty of Rome, the Berlin Declaration or the Declaration on the occasion of the 50th anniversary of the signature of the Treaty of Rome was signed in Berlin.5 This was under the German Presidency being in the first half of 2007 and to be precise under Mrs Angela Merkel chancellorship. The purpose of the declaration was to provide a new impetus to reforms after the failure in the ratification of the Treaty Establishing a Constitution for Europe. Declaration was signed by the three presidents including the President of the European Parliament (Hans-Gert Pöttering), President of the Council of the European Union and the European Council (Angela Merkel) and President of the European Commission (José Manuel Barroso). Member states of the EU did not sign the Declaration which led to some criticism. Error in translation added to it. Nevertheless, the Declaration still went ahead, though being non-binding, too short and full of nice words and enthusiasm there was not much one can disagree to. Most importantly, it showed the intent by stating that: The European Union will continue to thrive both on openness and on the will of its Member States to consolidate the Union’s internal development. Furthermore, that “With European unification a dream of earlier generations has become a reality. Our history reminds us that we must protect this for the good of future generations. For that reason we must always renew the political shape of Europe in keeping with the times. That is why today, 50 years after the signing of the Treaties of Rome, we are united in our aim of placing the European Union on a renewed common basis before the European Parliament elections in 2009.

Clearly there was intent to move on before the next European elections and this led to the European Council meeting in June 2007 at Brussels, again under the presidency of Chancellor Markel. The issue of accession of Malta and Cyprus into the Eurozone was brought into consideration, 5 For Declaration on the occasion of the 50th anniversary of the signature of the Treaties of Rome visit https://publications.europa.eu/en/publication-detail/-/pub lication/e3c0969c-59fe-4bcf-877a-4bcd2628c2e6.

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but the more crucial issue was on the voting in Council of the EU and insistence by Poland for the adoption of Penrose or square-root method. It was agreed that the double majority voting system, as agreed in the 2004 IGC, will take effect on 1 November 2014, until which date the present qualified majority system (Article 205(2) TEC) will continue to apply. After that, during a transitional period until 31 March 2017, when a decision is to be adopted by qualified majority, a member of the Council may request that the decision be taken in accordance with the qualified majority as defined in Article 205(2) of the present TEC.6 There were also concerns by the UK and Poland on the Charter of Fundamental Rights. So according to the Unilateral Declaration by Poland “The Charter does not affect in any way the right of Member States to legislate in the sphere of public morality, family law, as well as the protection of human dignity and respect for human physical and moral integrity”. Similarly, for the UK, it was left to the interpretation by the UK courts as well as only those parts (rights) of the charter were applicable on the UK which were recognised in law by the UK. To Valéry Giscard d’Estaing (VGE) the Treaty of Lisbon was not very different from the TCE which was rejected and to which he had made a significant contribution. Yet, the Treaty of Lisbon went ahead and was signed in December 2007 amending the Maastricht Treaty (Treaty on European Union 1992) and Treaty of Rome (or Treaty on the Functioning of the European Union 1957) to 2007. For this reason, it was also referred to as the Reform Treaty, although later it’s called the Treaty of Lisbon for being signed in Lisbon. A half a century since the Treaty of Rome, a lot had changed, from the size of membership to members themselves. These changes were to be reflected in the new Treaty which could also weather the future. It included about 45 policy areas of the Council. Prominent changes were made in the calculation of majority, powers of Parliament, Presidential term and High Representative of the Union for Foreign Affairs and Security Policy, Charter of fundamental rights and most interestingly the explicit legal right to the members to leave the EU. The well-known Article 50 that was triggered by the UK in 2016. I will revert it in the later part of this Treatise. In nutshell, the notion of the Treaty of Lisbon was to add to the developments of the Treaty of Amsterdam (1997) and Treaty of Nice (2001). To its opponents the 6 For details visit https://www.consilium.europa.eu/ueDocs/cms_Data/docs/pressD ata/en/ec/94932.pdf.

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Treaty of Lisbon was an effort to transfer more power to the EU from the local democracies while to its proponents it was a system of more check and balance and more power to the European Parliament and institutions so that they can discharge their duties more efficiently and effectively. Despite the signatures by the member states the Treaty of Lisbon was to be ratified by the European Parliament as well as each member state and the plan was to get it done by the end of 2008. However, the rejection by the Irish voters led to a re-referendum and it was ratified in the second referendum which led to some delay and concessions to Ireland. No other country held a referendum which was indeed safer than trying to be more democratic asking the public for their opinion. Irish experience showed things could go the other way! Hence, the ratification was done by the Parliament. In fact, France was one of the first country to ratify it without a referendum and when the French Socialist Party had boycotted the vote in the Parliament.7 The Czech Republic was the last member to submit the ratification and the Treaty of Lisbon came into force in December 2009. In the Treaty of Lisbon, ECB was officially given the status of a European institution, whose President was to be pointed by the European Council through a qualified majority. The qualified majority has been extended to various areas in the Treaty of Lisbon. Qualified majority (a.k.a double majority) was considered to be met when a proposal by the Commission or the High Representative of the Union for Foreign Affairs and Security Policy receives: • 55% of member states vote in favour (practically 15 out of 27) • Member states representing at least 65% of the total EU population support the proposal. Blocking majority will require at least four-member Council members with a population representing more than 35% of the EU. Adjustments are made for opt-out members for instance on monetary affairs where only the participating members can vote. For the matter not proposed by the Commission or the high representative, it would require the support of 72% to be approved with supporting members that constitute at least

7 For details on Ratifying the Treaty of Lisbon visit https://www.euractiv.com/section/ future-eu/linksdossier/ratifying-the-treaty-of-lisbon/.

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Table 2.3 Voting weights in both the Council of Ministers and the European Councila Nice Member state

Population

Germany France UK Italy Spain Poland Romania Netherlands Greece Portugal Belgium Czech Rep Hungary Sweden Austria Bulgaria Denmark Slovakia Finland Ireland Lithuania Latvia Slovenia Estonia Cyprus Luxembourg Malta EU

82.54m 59.64m 59.33m 57.32m 41.55m 38.22m 21.77m 17.02m 11.01m 10.41m 10.36m 10.20m 10.14m 8.94m 8.08m 7.85m 5.38m 5.38m 5.21m 3.96m 3.46m 2.33m 2.00m 1.36m 0.72m 0.45m 0.40m 484.20m

Penrose

Lisbon

%

Votes

%

%

Population

%

16.50 12.90 12.40 12.0 9.00 7.60 4.30 3.30 2.20 2.10 2.10 2.10 2.00 1.90 1.70 1.50 1.10 1.10 1.10 0.90 0.70 0.50 0.40 0.30 0.20 0.10 0.10 100

29 29 29 29 27 27 14 13 12 12 12 12 12 10 10 10 7 7 7 7 7 4 4 4 4 4 3 345

8.40 8.40 8.40 8.40 7.80 7.80 4.10 3.80 3.50 3.50 3.50 3.50 3.50 2.90 2.90 2.90 2.00 2.00 2.00 2.00 2.00 1.20 1.20 1.20 1.20 1.20 0.90 100

9.55 8.11 8.09 7.95 6.78 6.49 4.91 4.22 3.49 3.39 3.38 3.35 3.34 3.14 2.98 2.94 2.44 2.44 2.39 2.09 1.95 1.61 1.48 1.23 0.89 0.70 0.66 100

82m 64m 62m 60m 46m 38m 21m 17m 11m 11m 11m 10m 10m 9.2m 8.3m 7.6m 5.5m 5.4m 5.3m 4.5m 3.3m 2.2m 2m 1.3m 0.87m 0.49m 0.41m 498

16.50 12.90 12.40 12.00 9.00 7.60 4.30 3.30 2.20 2.10 2.10 2.10 2.00 1.90 1.70 1.50 1.10 1.10 1.10 0.90 0.70 0.50 0.40 0.30 0.20 0.10 0.10 100

a Approximate population figures in 2003 and 2008

65% of the EU population.8 The voting procedure was to be applied from 2014, though till 2017 it was considered to be the transition period (Table 2.3).

8 Abstention is considered as vote against.

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The weights are undoubtedly not very democratic in the sense that the small states had a larger share as compared to their population. One European One Vote shall not be perceived as under-representation of small states because if you are going for Union then you have to put that aspect of nationalism behind and there should be equality among Europeans. If that would not be in the European institutions, where else it would be? A big change in the decision-making between Nice and Lisbon was the move from Unanimity to Qualified Majority. Although, it is endeavoured to achieve unanimity among the members and the record shows that in most cases the decisions are reached in unanimity. Among others, the issues around the European Central Bank are also decided by a qualified majority in Lisbon. Group of Finance Ministers of Eurozone countries or Eurogroup was formalised in the Treaty of Lisbon under the Presidentship of JeanClaude Juncker. The Economic and Financial Affairs Council (ECOFIN) composed of economic and finance ministers of EU member countries was also formalised. Commission of the European Communities was also renamed (officially) as the European Commission and the Three Pillars were merged into European Union. The Passerelle clause also opened the doors of changes in legislative procedures without Treaty change. But despite all these regulatory changes and work long tail of treatise there was little done with respect to increasing the competitiveness of the EU economies, particularly those which have signed up for the Euro. All seemed to be going well!

Steroid-Enhanced Economic Development Post-Euro In the run-up to Lisbon and all the legal jugglery of Treaties, there were also expansions of the Economic and Monetary Union of the European Union (EMU) to accommodate and integrate the new members, not only politically but also monetarily. I must acknowledge here that political and monetary integration does not mean economic integration. Political integration needs political and monetary integration needs monetary institutional changes, but economic integration means integration of economic fundamentals which is a very difficult task not always successful. Anyway, coming back to the expansion of the monetary union, it occurred when Slovenia joined the Euro club as the 13th member on 1 January 2007, followed by Cyprus and Malta who joined a year later and Slovakia

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which Joined in January 2009. Although the expansion was continued and there were some so-called convergence criteria, it might be cogent to do a post-Euro-rollout assessment and reflect on those criteria at this point. To reiterate, these four criteria were price stability, government finances, exchange rates and long-term interest rates. On the price stability, it was associated with the rate of inflation which shall be close to the three best-performing members states. Objectively, it required that the inflation rate in a member state must not exceed by more than 1½ percentage points than that of the three best-performing member states in terms of price stability during the year before the examination. As I discussed earlier, this was a very short-term assessment for an indefinite membership (Fig. 2.1). There were indeed major differences in the inflation in the run-up to the Euro but after that the differences remained small. Hence, apparently, it seemed that the Euro proved to be a good thing in terms of bringing the price stability from its roll out to the end of 2008. Inflation was well tamed a couple of percentages plus–minus but broadly synchronised. However, the harmony and synchronisation were only in the consumer price index, the domestic producer prices were telling a completely different story. There were huge disparities among the member countries (Fig. 2.2). These differences in the consumer and producer prices are crucial to understand from the perspective of competitiveness of these economies. There was up to 9% difference between consumer and producer prices in 25.0 20.0

%

15.0

Greece

Portugal

10.0 Spain 5.0 0.0

Netherlands 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Austria

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Luxembourg

Netherlands

Portugal

Spain

Fig. 2.1 Consumer price index percentage change on the same period of the previous year (Source OECD)

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15.0

59

Luxembourg

13.0 11.0

Greece

9.0 5.0

Netherlands Spain Portugal

3.0

Germany

%

7.0

1.0 -1.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

-3.0 -5.0 Austria

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Luxembourg

Netherlands

Portugal

Spain

Fig. 2.2 Economic (Source OECD)

activities—Domestic

producer

prices—Manufacturing

some of the members, furthermore, there were also up to 15% differences in producer price index among some of the member states, it implies that the producers in different regions were facing very different level of price increases, causing produce price instability and competitiveness imbalances. Similarly, the exchange rate was fixed in nominal terms but in real terms, there were major disparities. Looking at the purchasing power parity terms, the national currency per US dollar ($) was showing clear differences which prevailed pre- and post-Euro membership. While all the EMU-12 member currencies were lower than unit against the US dollar ($) in this period, there were clear variations within and between the member states from the mid-1990s to 2008 (Fig. 2.3). There was a clearly significant appreciation for Greece and Ireland, while France and particularly Germany showed significant depreciation. These changes since 1995 to 2007 and 2008 and differences among states are summarised in the Table 2.4. It suggests that country Greece and Ireland had appreciations of over 25 and 19% since 1995 while Germany, France and Austria had significant deprecation. Italy, Portugal and Spain also had comparative appreciation from 1995 till 2007 which to some extent diminished as the end of 2008 saw depreciation due to the Global Financial Crisis. The erosions of these countries’ competitiveness due to such massive appreciation is beyond any doubt. While the exchange rate was fixed in nominal terms, what really matters in the relative terms is the real depreciation and appreciation of

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M. A. NASIR 1.050000

NaƟonal Currency Per US$

1.000000 0.950000

Ireland

0.900000

Luxembourg France Belgium Netherlands Germany Italy

0.850000 0.800000 0.750000

Spain Greece

0.700000 0.650000

Portugal

0.600000 0.550000 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Austria Germany Luxembourg

Belgium Greece Netherlands

Finland Ireland Portugal

France Italy Spain

Fig. 2.3 Purchasing power parities for GDP

Table 2.4 PPPs for GDP, National currency per US dollar appreciation/depreciation (%) since 1995

Country Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain

2007

2008

−7.46 −5.04 −5.15 −9.80 −14.99 25.74 19.51 4.20 −5.32 −5.45 4.88 2.83

−9.02 −6.43 −7.55 −10.59 −16.79 23.81 17.73 0.80 −7.60 −6.90 3.05 1.81

Source OECD, authors calculations

these economies. There is an economic theory of relativity as strong as Einstein’s notion and in relative terms the competitiveness of appreciating economies had been significantly eroded. In terms of other proxies and convergence criteria’s, particularly on the fiscal discipline, there were consistent violations of Maastricht. On

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the deficit, although there seems some synchronisation among the EMU12, but despite the similarity of trajectory, there were massive differences that prevailed. Between two member states, such as Netherlands and Portugal, at some points there could be a difference of more than 6% in surplus/deficit to GDP ratios, suggesting them to be completely at different pages and requiring different strategies. There was no help from monetary policy in such a scenario as the monetary policy was to be formulated and implemented by the single monetary authority ECB (Fig. 2.4). On the measure of sovereign debt stock, there was not much compliance with the criteria either. The debt to GDP ratios in most of the countries increased and they took on more debt post rolling out of Euro. Upward trajectories of the debt stock as a proportion to their annual national income or GDP clearly show that in the decade post-Euro, the idea of taking the trend into account was bizarre. There was obviously a moral hazard involved as once you are in the Euro club, you are in, and hence, post membership discipline was not much practised. Particularly, when there is no strong enforcing agency to deter the countries from 7.00 5.00

Deficit/GDP RaƟo %

3.00

LUX NLD ITA

1.00 -1.00

IRL GRC FIN BEL

-3.00

AUS PRT

-5.00 -7.00 -9.00 -11.00 1998 AUS

1999 BEL

2000 FIN

2001 FRA

2002 DEU

2003 GRC

2004 IRL

2005 ITA

2006

2007 LUX

2008 NLD

Fig. 2.4 Deficit to GDP ratios (Source OECD, authors calculations)

PRT

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M. A. NASIR 160.00

Debt/GDP Ratio (%)

140.00 120.00

GRC ITA BEL

100.00

PRT AUT DEU NLD

80.00 60.00

ESP FIN LUX

40.00 20.00 0.00 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

AUT

BEL

FIN

FRA

DEU

GRC

IRL

ITA

LUX

NLD

PRT

ESP

2008

Fig. 2.5 Debt/GDP ratios (Source OECD)

doing so, and above all, who would like to be a bad guy trying the bring the fiscal discipline when everything is seemingly going fine (Fig. 2.5). In the absence of much fiscal discipline and lack of an effective institutional framework to enforce such a discipline, what fuelled the fire were the extremely attractive rates of interest. If there had been any convergence in anything, that was the rate of interest on the sovereign debt issuance by the Eurozone members. It also explained the ballooning of the debt stock of these nations and the allocation of capital to less efficient sectors (Fig. 2.6). This increase in the sovereign indebtedness was channelled to the increasing unit labour cost (Fig. 2.7). For Ireland, Spain, Greece, Portugal and Italy there has been a massive increase in the unit labour cost from ranging between 25 and 36% from the irrevocable fixing of currencies to the sunset of 2007. This significant increase in the unit labour cost was not supported by any significant increase in the productivity of these economies by any measure. In fact, the largest economy of the Eurozone, Deutschland had a significant decrease in the unit labour cost as compared to 1998, the unit labour cost was −0.47% lower at the end of 2007. This was on top of the real exchange-rate depreciation in Germany. Despite the erosion of competitiveness and external deficits, the cheap credit at the union level as well as

2

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9 8

Greece

7 6

%

5 4 3 Luxembourg

2 1 0 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Austria

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Luxembourg

Netherlands

Portugal

Spain

Fig. 2.6 Government bonds yield maturing in ten years (Source OECD) 140

Unit Labour Cost, 2010=100

IRL

AUT

130

BEL

120

DEU ESP

110 PRT & GRC ESP

100 90

ITA DEU LUX

80

FIN FRA GRC IRL ITA

70

LUX

60

NLD

50 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

PRT

Fig. 2.7 Unit labour cost (Source OECD)

global level, increased indebtedness and the Great Moderation had kept the economies of the periphery on steroids and let the party going! Who had known what the new year of 2008 was going to bring?

CHAPTER 3

Global Financial Crisis—Tip of the Iceberg

First Test and Longest Battle of ECB Global Financial Crisis of 2008–2009 which is declared as once in a century crisis by the IMF still has its scars on the global economic and financial systems. A crisis that will never be forgotten was the first test for the young ECB, it was also the tip of the iceberg that hit the Eurozone Titanic in the form of the European Sovereign Debt Crisis later on! In specific to the European Union, there are two aspects and contexts in which we shall see the Global Financial Crisis, and which shall be of our prime interest (a) how the Europeans responded to the crisis and (b) what impact the crises had on the European integration. Let’s start with the response of the Europeans. As in the former President of ECB Mr. Jean-Claude Trichet’s words, the dramatic shift in focus in large parts of the financial sector, away from facilitating trade and real investment towards unfettered speculation and financial gambling lead to the crisis. This harboured a specific type of economic system which Hans-Werner Sinn called “Kasino-Kapitalismus ”. On the causes and consequences of the Global Financial Crisis, there has been a lot written and I would not go into the details of them. The crisis did emerge from the US sub-prime mortgage market and the filing of Bankruptcy by the New Century, an American Real Estate Investment Trust in August 2007. But soon the hit was felt in the heart of Europe as the biggest French bank BNP Paribas froze funds of worth around Euros e1.6 billion © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6_3

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($2.2 billion). In response to the financial turbulence, the ECB started to cut interest rates. These included a) the rates on the deposit facility which banks may use to make overnight deposits with the Euro system and the rate on the marginal lending facility which offers overnight credit to banks from the Euro system. The rates on the deposit facility dropped from 3.25% in July 2007 to 0.25% in March 2009 while the rates on the marginal lending facility dropped from 5.25% in July 2007 to 2.25% in March 2009. Similarly, the interest rate on the Main Refinancing Operations (MRO), which provides the bulk of liquidity to the banking system was reduced from 4.25 to 1.25% in the same period. It is worth noting that since January 1999 the deposit facility rates had never been more than 3.75%, the rates on the marginal lending facility never increased more than 5.75% and the rates on the Main Refinancing Operations (fixed rates)1 never exceeded 4.25%. This implies that when the Global Financial Crisis hit the interest rates or so-called conventional and most frequently used monetary policy tool was already too accommodative and there was little room for further easing by using policy rates instrument. Hence, in addition to the interest rate tool, the ECB did adopt for some of the less frequent or less conventional measures. It provided liquidity to the stressed banks in August 2007. These measures were intensified as the Global Financial Crises reached to its full bloom with the collapse of Lehman Brothers in mid-September 2008. According to Mr. Jean-Claude Trichet, then the President of the ECB, there were five “building blocks ” or lines of action taken by the ECB to deal with the Global Financial Crisis. These included the standards and non-standard or so-called unconventional measures which putting together formed the “toolkit ” for the ECB’s policy of enhanced credit support. The enhanced credit support entailed a set of measures and policies which focus particularly on the banking sector due to its importance and sheer size in the euro area with the intention to support credit provision. Definition suggested by Mr. Trichet was: Enhanced credit support constitutes the special and primarily bank-based measures that are being taken to enhance the flow of credit above and beyond what could be achieved through policy interest rate reductions alone.

1 For details on Key ECB interest rates visit https://www.ecb.europa.eu/stats/policy_ and_exchange_rates/key_ecb_interest_rates/html/index.en.html.

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To our interest, the first aspect to look at is the response of the Guardians of the Euro system to crisis and that can be categorised in the following overarching measures: Refinancing Operations: There were significant changes made in the regular refinancing operations as a part of liquidity management measures. In the pre-crisis period, ECB monetary policy operations were carried out through the lending of central bank money (reserves) to commercial banks at fixed maturities, i.e. one week for the Main Refinancing Operations (MRO) and three months for the Long-Term Refinancing Operations (LTRO) and at a variable interest rate against collateral. But as the crisis hit with full blow halting the trading in the interbank lending market in September 2008, push came to shove, “fixed rate full allotment ” tender procedure was adopted with significant expansion of the maturity of operations. At an initial maturity of six months, the banks were granted access to unlimited liquidity at the policy rates. The Euro system started to offer credit with extended maturity date through Longer-Term Refinancing Operations (LTROs) which started with three and six months, followed by a year, three years and more recently Targeted Longer-Term Refinancing Operations (TLTROs) with four-year maturity. This was a major change in the ECB’s refinancing operations as before the crisis the usual practice was to auction a given amount of central bank credit and let competition between the bidders determine the interest rate. These liquidity operations called “Lending to euro area credit institutions related to monetary policy operations denominated in euro” were the main component responsible for the increase in the size of the ECB balance sheet until March 2015, of course for which the collateral used as the guarantee was needed. But after that, we witnessed the sharp expansion of ECB’s balance sheet with Securities of euro area residents denominated in euro as the largest asset class resulting from the ECB’s asset purchases. From 2016 to 2019, there was no significant expansion rather a marginal contraction from the end of 2018 to 2019, nevertheless, the COVID-19 led to a significant and sharp expansion of EBC’s balance sheet and took it over e6.9 trillion by the end of 2020 (Fig. 3.1). In Mr. Trichet’s words, in its response to the Global Financial Crisis, the ECB was acting as a “surrogate for the market ” both in terms of liquidity allocation and price setting. A free marketeer may argue that it was market distortions, but can we imagine a world without it. A world that would have led to many banks seize to remain liquid? what would have been the financial, economic and social cost of that? Indeed, in its

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Fig. 3.1 Annual consolidated balance sheet of the Euro system 1999–2020 (Source ECB, https://www.ecb.europa.eu/pub/annual/balance/html/index.en. html)

first crucial challenge, the young ECB was acting as the Lender of Last Resort ! Collateral Requirements: significant changes were made in the quantity and more so in the quality of assets which were accepted as a collateral. Acting in the boundaries of its statute, the Euro system provides credit only against supposedly adequate collateral. Typically, collateral refers to marketable financial securities, such as bonds, or other types of assets, such as non-marketable assets or cash. The term “eligible asset ” is used for assets that are accepted as collateral by the Euro system. What is eligible and what is not, is debatable and for a very good reason. Just by mere common sense, good collateral shall be something worth pledging and can compensate the creditor in the event of a default. So, in principle, it got to be good as gold! The National Central Banks assess the eligibility of assets according to the criteria specified in the Euro-system legal framework (general framework and temporary framework) for monetary policy instruments. Contrary to its counterparts such as Federal Reserve System, the core principals of the Euro-system collateral were not clearly stated, though as stated by the ECB,2 they can be somewhat derived from the EU Treaty and the ESCB Statute3 as follows: 2 See for details on framework visit https://www.ecb.europa.eu/paym/coll/html/ index.en.html. 3 All Governing Council decisions on refinancing operations are documented in the “General documentation on Euro-system monetary policy instruments and procedures”. Specifically, Chapter No. 6 entails the details on criteria used to determine the eligibility

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• Collateral must protect the Euro system from incurring losses in its credit operations. • Volume of collateral available to counterparties must ensure that the Euro system can effectively conduct monetary policy operations and promote the use of the TARGET payment system. • Euro-system operations should be equally accessible to a broad set of counterparties. • Eligible collateral should offer cost-efficient transfer and mobilisation conditions, credit risk evaluation and monitoring possibilities. • Euro system shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources. • Collateral framework should be simple and transparent. In the ECB’s or to be precise, in Mr. Trichet’s own words the list of the assets accepted as collateral was already very long before the crisis, yet this long list was further stretched, and even wider range of securities was started to be accepted as collateral. That simply meant one thing, cutting the corners! Commercial banks were allowed to use a larger set of corporate loans as well as lower-rated assets as collateral when they borrow from the Euro system. This increase in quantity had been criticised on the basis of compromise on quality. Though, there is also an argument that there were higher haircuts applied in these instances to insure the central bank against liquidity risk and the potentially volatile prices of the lower-rated assets. Furthermore, that the lower valuations and rating downgrades due to the crisis and financial stress also require to revisit and adapt to the new financial realities. Given the fact that the ECB was conducting its liquidity operations at fixed-rate and full allotment, therefore the only limit for access to funding was the amount of eligible collateral which was provided in a quantity sufficient enough to cater the demand of commercial banks and satisfy the ECB collateral requirements. But this line of of assets accepted as collateral. An asset must be a fixed income debt security, for instance, a debt or a security representative of a debt or an Asset Backed Security (ABS), In order to be eligible as a collateral in monetary policy operations. It must also be denominated in euros and meet a minimum quality requirement corresponding to a maximum probability of default of 0.4% within the meaning of the Basel rules. Debt issued by the non-euro zone resident is unacceptable for posting as collateral. These requirements can be temporarily condoned/exempted by the authority of Governing Council. visit https://www.ecb.eur opa.eu/ecb/legal/pdf/02011o0014-20130103-en.pdf for details.

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reasoning is a bit difficult to follow and add up, where is the principle of competition and efficient allocation of resources? or is the efficiency of allocation is contingent on the demand condition. What is the point of standards, when you lower them and if and when required? In the crisis, everybody is Keynesian driven by the animal spirit, doing something was better than doing nothing, and if there is anything that comes in the way of that something, it shall better be condoned. So, if you ask well, was this the Return of the Master, John Maynard Keynes? Perhaps it was! To reiterate, compared to its counterparts, the ECB was already accepting a wide range of assets even at a lower-quality range which includes market traded assets such as sovereign bonds. However, ECB also accepted non-marketable assets, for instance, bank loans or credit loans to firms. These credit claims constitute a large chunk of the Euro system’s collateral and in fact, in the period between 2007 and 2011, the proportion of non-markable assets in total collateral increased from 3 to 23%.4 It is worth mentioning that the Federal Reserve mostly considers the government and public sector institution’s bonds as collateral while the Eurozone banking system is rather bigger in size and heterogeneity. Type of the assets as well as their ratings are taken into account while considering them as collateral. There are also haircuts applied to the market value of the assets put forward as collateral for liquidity requests by the banking sector. The size of the haircut depends on the rating of the collateral as the high default and value risks imply higher haircuts to hedge against these risks. Concomitantly, assets such as sovereign debt with three-year maturity and AAA rating is subject to about 2% haircut, whereas one with the BBB rating is subject to a haircut of around 10%. The collateral framework pre-crisis had been subject to criticism with the main objection that it has led to a reduction in the liquidity risk premium and a lack of differentiation in sovereign risks. In simple words, the risk of the sovereign debt of Germany was treated equally as sovereign debt issued by the periphery. This equivalent treatment of the debt issued by Eurozone members is held responsible for the low spreads in the Eurozone sovereign yield, despite some differences in the credit rating (triple to single-A) and fiscal stance.5 Euro system viewed the debt of

4 See Barthélemy et al. (2018) also see Tamura and Tabakis (2013) for details on the use of Credit Claims as collateral for Euro-system credit operations. 5 Buiter and Sibert (2005).

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the Eurozone sovereigns dominated in Euro as equivalent, i.e. highest liquidity category (Tier One, Category 1) and subject to the lowest “valuation haircut”. Furthermore, the debt with longer maturity was subject to greater haircuts which encouraged the issuance of debt with the shorter maturity, implying that the bills will be due to pay in the shorter timehorizon and under financial stress short-term insolvency can have a drastic impact. This aspect was picked by Willem H. Buiter and Anne Sibert as they proposed that the size of the haircut on each debt instrument be related inversely to its credit rating. Furthermore that, the sovereign debt of nations that violate the conditions of the Stability and Growth Pact should be declared ineligible as collateral in Euro-system Repos. The suggestions have to be weighed and with the benefit of hindsight if these steps would have been taken while lying the foundations of the Euro system, might have led to different results. The collateral framework and criteria were helpful in facilitating the flight of capital from periphery to the core in the crisis as it was keeping the banks liquid during and PostGlobal Financial Crisis. No doubt, it was not in the hands of to ECB to change the collateral framework overnight or refusing the bank of any specific Eurozone member, particularly during the financial stress. Preventive measures are very often better than corrective measures and during the financial crisis refusal of the liquidity requests could have caused a crisis bigger than any processor in financial history. Therefore, in crisis, the approach was rather pragmatic and lenient, and the list of eligible collateral was rather extended by reduction in the required rating standards increase in the haircut for the low ratted newly eligible collateral to seemingly safeguard ECB against excessive risks which were bound to emerge due to change in framework. But can any hair cut justify allocation of liquidity to collateral that has no market value? So, the collateral was anything but collateral that can be sold in the market to cover the losses. Where would you have sold it when there was no market for it? The summary of consecutive changes is in Table 3.1. As the result of successive revisions in the collateral framework, most of the assets with above BBB ratings were deemed as eligible collateral. These changes were vital to accommodate the sovereign debt issued by the Eurozone members whose ratings had been downgraded. Again, the criticism of market distortion was fair, though the harsh facts on the ground were providing the rationale for this strategy. Intentionally or unintentionally, this was giving markets the message that the ECB which has a monopoly over the issuance of liquidity in the Eurozone still accepts

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Table 3.1 Consecutive changes in collateral criteria Before the crisis 15 October 2008 8 April 2008 8 December 2011

20 June 2012

9 July 2014

Credit rating threshold at A− for all eligible collateral (except ABS for which the credit rating threshold is at AAA) Credit rating threshold of all eligible collateral (except ABS) lowered to BBB− “temporarily” (ECB/2008/13) The previous measure is made permanent (ECB/2011/14) Credit rating threshold of ABS based on residential mortgages only or loans to SMEs only decreased to A− (ECB/2011/25). Often referred as to the Additional Credit Claims (ACC) framework Credit rating threshold of ABS based on auto loans, leasing, commercial mortgages, consumer finance, residential mortgages and loans to SMEs decreased to BBB Credit threshold of ABS based on auto loans, leasing, commercial mortgages, consumer finance, residential mortgages, loans to SMEs or credit card receivables reduced to BBB (ECB/2014/31)

the debt issued by the stressed Eurozone members as collateral. So why should not they? and if they don’t you can always take it to the Lender of the Last Resort (Fig. 3.2). In addition to the changes in the collateral standards, there were changes in the haircut applied to various forms of assets put forward as collaterals. In September 2010, the haircuts for high-rated bank bonds and Asset-Backed Securities (with residual maturity of 5–7 years) were, respectively, increased to 12.5 and 16%. The hair cut for some of the lowrated bonds with ratings of BBB+ to BBB− almost exceeded 1/3rd of their value. However, for the sovereign bonds, there were mild changes in the haircut. In the pre-crisis period, only the high-rated sovereign bonds with the minimum rating of A− were accepted as collateral and for residual maturity of 5–7 years and a haircut of 3% was applied. But in October 2008, even the lower-rated sovereign bonds were considered as eligible collateral after an 8% haircut. Well, will the markets consider 8% haircut ample? we don’t know. In fact, the Greek government bonds were eligible even below the BBB- minimum rating subject to a special haircut in December 2012. Further expansion in the list of eligible assets occurred with the Additional Credit Claims (ACC) and suspensions of rating criteria for countries struck by the crisis which had caused the ratings to drop below the threshold of BBB−. There were further changes in the haircuts in September 2013 when for highly rated and low-rated sovereign bonds, the haircuts were change to 2 and 10% respectably (Fig. 3.3).

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Fig. 3.2 Lender of last resort (Source Bankers-banking)

The value of the underlying assets used as collateral is fundamentally important in terms of how much liquidity it can secure. A large part of the collateral had been the sovereign bond valuing in trillions of euros (e14 trillion in 2011) which implied that the shifts in the valuation such as the witnessed during the European Sovereign Debt Crisis in 2011–2012 can have drastic consequences. This risk materialised during the Global Financial Crisis and European Sovereign Debt Crisis which hugely diminished the values of the sovereign bonds issued by the periphery. Particularly, Greece, Italy, Ireland, Portugal and Spain (Fig. 3.4). According to the estimations by the Banque de France staff, there was an approximate reduction of e200 billion on the valuation of eligible collateral. This entailed a large share for banks situated in the periphery due to the fall in sovereign bonds prices associated with the sovereign debt crisis. Furthermore, their estimates showed that relative to the Eurozone refinancing, the price shock was equivalent to 16% of the e1.265 billion refinancing peaks reached in June 2012. This implied that for the

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Fig. 3.3 Long-term Ratings of Euro Area Sovereigns (Source Barthélemy et al. [2018]. Note The vertical lines show [1] the first three-year LTRO of 21 December 2011, [2] the second three-year LTRO of 28 February 2012, [3] the announcement of the OMT programme on 2 August 2012, [4] the decision to launch the PSPP on 22 January 2015)

stressed countries, the maximum price variation corresponded to a reduction of e150 billion in posted collateral, equivalent to 40% of the total refinancing of peripheral countries or 27% of total post-haircut collateral posted by the banks of these countries. The expansion of collateral as well as the large use of collateral provision before the crisis, for instance, the ability to pledge specific loans as collateral cushioned the shock to some extent. Out of the total collateral posted in May 2013 (post-haircut), the overall credit claims account for about 26.7% which implies that in addition to the new expansion measures, the flexibility of the existing operational framework, i.e. acceptance of most illiquid assets eligible as collateral for Euro-system refinancing made it possible to cushion the price and overarching financial shock.

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Fig. 3.4 Variation in the value of Euro Area Collateral (Source Barthélemy et al. [2018]. Note Haircut and Price contributions are compared to their average values between Jan and June 2014)

The extension or more precisely, lowering of the collateral standards can be interpreted as a violation of Bagehot’s Rule, according to which the central bank should only accept good collateral.6 Though the counterargument is that the good collateral is the one that is good in ordinary times, not in the face of crisis when the financial stress has occupied everything. So, in Bagehot’s words: The great majority, the majority to be protected, are the ’sound’ people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security on what is then commonly pledged and easily convertible the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse. 6 See Eberl and Weber (2014) for details on ECB Collateral Criteria: A Narrative Database 2001–2013.

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Walter Bagehot (1873), in Lombard Street, Chapter 7, paragraphs 57–58.

To be fair, the Bagehot has two Rules for the Lender of Last Resort,7 the first rule suggests that the loans are made at and a higher rate of interest with the notion that increasing the interest rates which operate as a heavy fine on unreasonable timidity and will prevent the large number of applications by persons who do not really require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible. The second rule

7 Chapter 7: Walter Bagehot on the Lender of Last Resort: Nothing, therefore, can be more certain than that the Bank of England has in this respect no peculiar privilege; that it is simply in the position of a Bank keeping the Banking reserve of the country; that it must in time of panic do what all other similar banks must do; that in time of panic it must advance freely and vigorously to the public out of the reserve. And with the Bank of England, as with other Banks in the same case, these advances, if they are to be made at all, should be made so as if possible, to obtain the object for which they are made. The end is to stay the panic; and the advances should, if possible, stay the panic. And for this purpose, there are two rules: First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible. Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse someone who has good security to offer. The news of this will spread in an instant through all the money market at a moment of terror; no one can say exactly who carries it, but in half an hour it will be carried on all sides and will intensify the terror everywhere. No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected. The great majority, the majority to be protected, are the “sound” people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse. For Walter Bagehot on the Lender of Last Resort visit https://www.bradford-delong.com/2011/03/walter-bagehot-on-the-len der-of-last-resort.html?asset_id=6a00e551f0800388340147e3963795970b.

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was that at this high rate, advances should be made on all good banking securities, and as large as the public asks for them to be. In the light of these two rules by Bagehot, we can intuitively argue that to some extent ECB did follow them. The collateral, which was considered as collateral in the ordinary times, remained eligible, though not by the market standards. However, there was no increase in interest rates and rather the haircuts were introduced which I would say are not the perfect substitute for the interest rates, rather a constraint on the amount of liquidity one may avail. Nonetheless, the introduction of such a constraint is contrary to the first rule which suggests that advances should be made “as largely as the public ask for”. Therefore, the increase in the Eligible Marketable Assets was inevitable and it is evident that the Bagehot principle was not followed in true spirit. It is an interesting thought to entertain that what if the principle had been followed. That would imply that the ECB would have not been considering rate cuts rather exceptionally high rates, without any haircuts. This would have led to a very different outcome for employment, inflation and the trade balances of the Eurozone economies. Perhaps, what the ECB did was cogent but was it enough of good thing? Seemingly not as the changes in collateral requirement were just one of the series of measures (Fig. 3.5).

Fig. 3.5 Eligible marketable assets (Euro Billion) (Nominal amounts, averages of end of month data over each time period shown. Source ECB, https://www. ecb.europa.eu/paym/coll/charts/html/index.en.html)

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Additional Credit Claims (ACC) and Emergency Liquidity Assistance (ELA): The adoption of the Additional Credit Claims (ACC)8 programme by the ECB after the introduction of the “long-term refinancing operations ” (LTROs) of three-year maturities resulted in improvement in the value of disposable collateral as the list of assets considered as eligible collateral was extended. No surprise most of the liquidity flew to the periphery during the crisis to support its banking system. This is evident in the share of liquidity provided to the banking system of Greece, Italy, Ireland, Portugal and Spain which constituted about 80% of the total liquidity provided by the ECB. Nonetheless, ECB was still not able to extend the liquidity to desired levels due to the sharp drop in the credit ratings of the assets held by the banking sector in these countries. This issue was resolved by the Emergency Liquidity Assistance (ELA) programme according to which the liquidity was also provided by National Central Banks with the approval of the ECB against collateral that does not meet the ECB’s eligible collateral criteria. The aim of the ELA was and is to provide central bank money to solvent financial institutions that are facing temporary liquidity problems, outside of normal Euro-system monetary policy operations. According to the Agreement on ELA,9 it must be in line with and must be in compliance with the prohibition of monetary financing (Article 123 of the Treaty of the Functioning of the European Union [TFEU]). The National Central Banks (NCBs) were able to provide liquidity to banks resident in the country against lower-quality collateral after the approval of the ECB Governing Council. This raised the issue of potential losses. Undoubtedly, the decision to lend against riskier collateral or to weaker counterparties increased the risk borne by the national

8 The Governing Council of the European Central Bank (ECB) first approved for seven

and then for the nine National Central Banks (NCBs) that have put forward relevant proposals, specific national eligibility criteria and risk control measures for the temporary acceptance of additional credit claims as collateral in Euro system credit operations. These NCBs included the Central Bank of Ireland, the Bank of Greece, the Banco de España, the Banque de France, the Banca d’Italia, the Central Bank of Cyprus, the Oesterreichische Nationalbank, the Banco de Portugal and Banka Slovenije. For Nonmarketable assets Eligibility criteria visit, https://www.ecb.europa.eu/mopo/assets/standa rds/nonmarketable/html/index.en.html. 9 For details on Agreement on Emergency Liquidity Assistance (ELA) visit https:// www.ecb.europa.eu/pub/pdf/other/Agreement_on_emergency_liquidity_assistance_2017 0517.en.pdf?23bb6a68e85e0715839088d0a23011db.

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central bank. Nonetheless, it is difficult to comprehend that how it was not monetary financing if you are valuing the collateral well above the market value. According to the agreement, the ELA occurs when a Eurosystem national central bank provides central bank money and/or any other assistance that may lead to an increase in central bank money to a financial institution or a group of financial institutions facing liquidity problems, where, in either case, “such operation is not part of the single monetary policy”. This clearly implies that the NCBs are taking a solo flight which is clearly inexplicable as there is no reason for them to do anything which is not part of a single monetary policy. Any scenario other than a single monetary policy would imply that each NCB is running a “parallel monetary policy”. Though, I must acknowledge here that the NCBs were bound to notify the ECB within a couple of business days about the ELA with more details to follow. Institutions under ELA were also required to report its capital adequacy and recapitalisation plans as well as the exit strategy was to be provided to the ECB President by the concerned NCB, if the ELA exceeds six months. The ELA in excess of e2 billion were also liable to be considered by the Executive Board that if they interfere with the single monetary policy of the Euro system, if so, they shall be passed to Governing Council with the request to take a position. Governing Council could allow or prohibit the ELA, meanwhile, the NCBs are good to go ahead unless they have been prohibited in the 24 hours of notifications. If there is a systemic risk, the NCBs could also take overnight operations where the Executive Board should be immediately informed. Solvency criteria were based on the capital ratios which if falls short, there was then consideration of “credible prospect of recapitulation” or in other words, room to cut the corners. The NCBs could communicate the public on some broad information on ELA, though the Governing Council could even restrain the NCBs from doing so if it feels appropriate, however, who would have dared to do so in the face of a freezing interbank market and financial crisis threats. The ACC and ELA did lead to the euro area banking system remaining liquid, nonetheless to some scholars it also led to a decrease in the cost of borrowing and supported the lending to the SMEs.10 Though the increase in the haircut also negatively affected the price of sovereign bonds, these effects were trivial given the fact that the same assets were 10 Mésonnier et al. (2017) provided empirical evidence, though they were only drawing on French dataset.

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continued to be used as collateral and were on the balance sheet of Euro system. It is interesting that an asset that is on the balance sheet of the central bank may lose its value but given the fact that the central banks don’t go bankrupt and have a monopoly over the issuance of currency, they can continue to operate with full confidence. Nonetheless, the collateral that got possessed in the event of insolvency by the counterparty can be resold as the Bundesbank received payment from German Lehman insolvency proceedings.11 Though, in the case of sovereign bonds, if the underlying collateral is good enough to be considered as eligible for issuance of liquidity, there is no reason to expect that the issuer of such collateral would go bankrupt. Particularly, considering the fact that the issuers of this collateral do exceed the limits suggested by any fiscal rule, quite often! Hence, despite the fact how dull, unfair and undesirable they look at first glance, the changes to the collateral standards were of course need of the hour and necessary to keep the system afloat and keeping the collateral eligible. In the midst of a major crisis, a strict stance could have been disastrous. Extension of Counterparties: In addition to the changes in the refinancing operations from limited quantity and bidding to the full allotment as well as the collateral criteria, the number of counterparties which can participate in the refinancing operations was also revisited. In simple words, the list of participants which was already quite exhaustive was further extended in October 2008. So much so that the European Investment Bank (EIB) also became and an eligible counterparty in the Euro system’s monetary policy operations. The notion was that it will complement the EIB’s financing initiative by accommodating EIB’s demands to support its lending programmes. Later in 2011, the number of counterparties taking part in refinancing operations was almost doubled from around 500 to over 1000s counterparties (Fig. 3.6).

Long-Term Refinancing Operations (LTROs) and Whatever It Takes! Changes in the refinancing operation framework discussed so far including fixed-rate full allotment, lowering the bar for eligible collateral 11 For “Bundesbank receives final payment from German Lehman insolvency proceedings” visit https://www.bundesbank.de/en/press/press-releases/bundesbank-rec eives-final-payment-from-german-lehman-insolvency-proceedings-666694.

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Fig. 3.6 Number of Euro-system Counterparties (Note The vertical lines show [1] the first three-year LTRO of 21 December 2011, [2] the second three-year LTRO of 28 February 2012, [3] the announcement of the OMT programme on 2 August 2012. Source Barthélemy et al. [2018])

and expansion of counterparties list were very significant but not ample for the challenges faced by the EMU. A union that was expanding even in the midst of an existential crisis as Slovakia join the EMU in January 2009 followed by Estonia in January 2011. Initially, the Long-Term Refinancing Operations (LTROs) were started with the maturity of three, six and twelve months and it was intended to carry out purchases of about 60 billion euro-denominated covered bonds from private security markets which were affected by the Global Financial Crisis. One aspect which we must acknowledge here is that the financial system in euro area is dominated by the banking sector which adds up to 70% of non-equity external finance in the euro area (contrary to 30% in USA). Due to the importance of the banking system, the initial focus was obviously to keep the banks liquid. Still, the changes in the Main Refinancing Operations (MROs) as discussed hitherto were not ample. Therefore, the framework

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of the Long-Term Refinancing Operations (LTROs) was also revisited and revised to support the financial system of the Eurozone. In December 2011, the Governing Council of the European Central Bank (ECB) decided to conduct two Longer-Term Refinancing Operations (LTROs) with the maturity of 3 years and the option of early repayment after a year.12 The reason was to provide additional enhanced credit support to support bank lending and liquidity in the euro area money market. The counterparties which had received 12 months LTROs in October 2011 were allowed to shift all outstanding amounts into the first 3-year LTRO allotted in December 2011 by notifying the respective NCBs. Furthermore, at the same time the reserve ratios were reduced from 2 to 1% with the given reason that after the adoption of the full allotment policy in the ECB’s Main Refinancing Operations, the reserve requirements of higher-level were not really needed. Nonetheless, it was decided by the Governing Council that the availability of collateral should be increased by (a) reducing the rating threshold for certain Asset-Backed Securities (ABS) and (b) by allowing National Central Banks (NCBs), as a temporary solution, to accept as collateral additional performing credit claims (i.e. bank loans) that satisfy specific eligibility criteria. The NCB authorising the use of collateral was to bear the responsibility entailed in the acceptance of such credit claims. It was also explicitly declared that the Governing Council aims to enhance its internal credit assessment capabilities as well as, it encourages potential external credit assessment providers (for instance, rating agencies) and commercial banks that use an internal rating-based system, to seek Euro-system endorsement under the Euro-system Credit Assessment Framework. Of course, qualifying for the eligible collateral to a central bank like ECB in itself is an achievement in terms of credibility and trust in an asset. But in the light of shifting the bar or lowering the collateral standards through the lens of the Euro system’s eligible collateral, this is clear that Euro-system Credit Assessment Framework would have been the most flexible rating system. Despite the changes in the Main Refinancing Operations (MROs) and the introduction of three years LTROs, the markets were still suspicious. This suspicion and lack of appetite for risk and distaste for the sovereign debt of periphery was prima facie evident in the increased spreads between core and periphery sovereign bonds yields (Fig. 3.7). 12 For “ECB announces measures to support bank lending and money market activity” visit https://www.ecb.europa.eu/press/pr/date/2011/html/pr111208_1.en.html.

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Whatever it takes

8 7

Spain

6

%

5 Italy

4 3 2 1

France Germany 2007-01 2007-04 2007-07 2007-10 2008-01 2008-04 2008-07 2008-10 2009-01 2009-04 2009-07 2009-10 2010-01 2010-04 2010-07 2010-10 2011-01 2011-04 2011-07 2011-10 2012-01 2012-04 2012-07 2012-10 2013-01 2013-04 2013-07 2013-10 2014-01 2014-04 2014-07 2014-10

0

Whatever it takes

Germany

Italy

France

Spain

Fig. 3.7 President Mario Draghi pledge to “Whatever it takes” and Eurozone bonds yields (Author’s calculations. Source OECD)

This situation was posing challenges to the Guardians of Euro, the currency in which bonds of all the Eurozone member states were denominated. Currency club whose membership required convergence, there was nothing, but continuous divergence and trajectories were alarming. This required more actions and nobody else but the Gaudian of Euro, i.e. the ECB was not able to condone this fact. So, Mr. Mario Draghi the President of the European Central Bank in his famous speech at the Global Investment Conference in London in July 2012 shared the view from of the ECB, as the things look from Frankfort13 : And the first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So, the euro was a bumblebee that flew very well for several years. And now – and I think people ask, “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing.

13 For Verbatim of the remarks made by Mario Draghi visit https://www.ecb.europa. eu/press/key/date/2012/html/sp120726.en.html.

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Mr. Draghi contradicted the doubts about the weaknesses in Euro arguing that the Euro is a lot stronger than people acknowledge. He based his argument on the fact that the “inflation, employment, productivity, the euro area has done either like or better than US or Japan”. Mr. Draghi went on: Then the comparison becomes even more dramatic when we come to deficit and debt. The euro area has much lower deficit, much lower debt than these two countries. And also not less important, it has a balanced current account, no deficits, but it also has a degree of social cohesion that you wouldn’t find either in the other two countries.

While that might have been the case during the ten proceeding years from July 2012 but with the benefit of hindsight what we saw and so did Mr. Draghi that the Eurozone had a lot higher unemployment and worst output and productivity growth than the USA, Japan and UK. I will revert to and explain this point at length in the next chapter. In all fairness, Mr. Draghi, acknowledged that there are differences within the euro area and among Eurozone members which are neglected when we look at the overall average of the Eurozone. Still, he also hoped that in the coming days the countries like Portugal, Italy, Ireland and Spain will rapidly converge. There was no objective evidence to warrant this claim, but he did refer to the last summit and labelled it as a real success. The reason for the title of success was that “all the leaders of the 27 countries of Europe, including the UK etc., said that the only way out of this present crisis is to have more Europe, not less Europe”. Well, as we now know that one of the largest economies of the European Union whose size is more than a dozen smaller states coming together, has signed up for the exit, Brexit! This means the appetite of more Europe is not shared by every European. Anyway, I will revert to it again but at that moment Mr. Draghi declared Euro irreversible despite the fact that he acknowledged that the interbank market across the countries and even within the countries was not functioning smoothly. Yet: Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

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The message of “whatever it takes ” gained a lot of intention and debate. It was Verbal Easing or a combination of Quantitative and Qualitative Easing (Q. Q. E.). There was a clear intention to recalibrate the financial regulations as well as have a single supervisor for the banking union or financial markets union. The issue of a single supervisor was also deemed important as during the crisis the national supervisor had attempted to keep the banks in their national boundaries withdraw from the activities reducing the cross-borders liquidity flows, exacerbating the crisis. This would have to be started by the European Commission which was going to present a proposal for the supervisor in early September 2012. The half trillions worth of net liquidity injected in the system in the form of LTROs was to overcome the counterparty risk. Nonetheless, one of the most crucial aspects Mr. Draghi or him representing ECB was the acknowledgement of the risk prima on sovereign states borrowings. At the time of the “whatever it takes” pledge, the risk prima was widening so considering the aspect of this divergence in terms of default, liquidity, convertibility and transmission of monetary policy, it was declared that “they come into our mandate. They come within our remit ”. Yes sir, the yield on sovereign bonds of euro member became the mandate and remit of ECB! Was it a good thing or a bad thing as a violation of some rules? Who cares! Push had come to shove, and ECB was to do whatever it takes to save the Titanic of Euro on which it was boarded including its captain and crew.14 Stabil Wie Die Mark In his speech at the University of Munich in July 2009, the Predecessor of Draghi, Mr. Jean-Claude Trichet had claimed the credit by arguing that, since the crisis began, not one systemically important financial institution has collapsed in the euro area. This is no small achievement, given the damage we

14 Epstein (1992) introduced a Marx-Keynes-Kalecki model of the political economy of comparative central banking in which he had suggested that monetary policy is determined by four key factors: capital–labour relations; industry–finance relations; the degree of central bank independence; and the position of the economy in the world economy. He argued that there exists a relationship between political-economic structure and central bank policy. I think one can’t agree more on the political-economic nexus of monetary policy, not only in USA and UK but also in ECB where the central bank shall be “supposedly” independent of political pressure.

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have observed as a result of such events.15 Furthermore, that I am therefore pleased to report that the policy toolkit of the European Central Bank – a young institution albeit benefiting from a very solid legacy – has been up to the challenge. the euro is a very stable currency and all the institutional requirements are in place to preserve its solidity in the future. This is what defines success in monetary affairs. Being here in Munich, I would say that the promise that the euro will be “Stabil Wie Die Mark” has been kept. A glance at the inflation rates makes this clear.

These strong words in the support of the Euro and drawing a parallel with the Deutsche Mark is slightly difficult to comprehend and seemingly focused on only and only one measure, i.e. price stability as seen through the lens of inflation index in the last few years since rolling out of Euro. Inflation rate was undoubtedly comparable with the inflation rate prevailing in Germany during the 1990s and for this, there was not much sacrifice made in terms of employment, at least until the Global Financial Crisis. In My Jean-Claude Trichet comparison, the first decade of the Euro led to more jobs than the total job creation in the proceeding 10 years in Eurozone and the job creation in the USA during 1999–2008. But the question bigger question is the decades succeeding the Global Financial Crisis. Experience suggests that the wages and prices of goods and services are slower to change in the euro area than in the USA. Sluggishness of the prices means that the crisis would be prolonged as the prices won’t adjust promptly to the new proximal equilibrium or optimal level. This was acknowledged by Mr. Trichet in July 2009, though this also has an implication that the economic slowdown in the Eurozone should have been dealt with more aggressively. To maintain the Stabil Wie Die Mark moto and basing the success on keeping inflation rate and the aggregate Eurozone level around the 2% target was obviously not the broad enough benchmark. However, the realisation came quite late, and it took 3 years July 2009 to July 2012 before the Stabil Wie Die Mark changed into Whatever it takes. It’s not only that the prices are sluggish in the Eurozone the response to the crisis had also been sluggish and this means half measures and requiring to do a lot more than what was actually done. Small problems changed into large problems and long-term

15 For Keynote address “The ECB’s enhanced credit support” by Jean-Claude Trichet, President of the ECB at the University of Munich, 13 July 2009 visit https://www.ecb. europa.eu/press/key/date/2009/html/sp090713.en.html.

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problems, for which it required to conduct the new and long-term operation. A stitch in time saves nine but the focus was not on stitching and rather on Stabil Wie Die Mark!

Conventional to Non-conventional and Asset Purchase Programme In the so-called “toolkit ” of the ECB, there are conventional and supposedly unconventional measures. Whatever is conventional and nonconventional is debatable as nothing is new under the sun! Very often labelled as an unconventional measure of Large-Scale Asset Purchase (LSAP) or Quantitative Easing (Q.E.) is not really so unconventional either. In fact, the Roman Emperor Tiberius in his rule spanning 14A.D. to 37A.D., used Quantitative Easing to overcome the Financial Crisis of 33A.D.16 An amount of 100 million sesterces were to be taken from the imperial treasury and distributed among reliable bankers, to be loaned to the neediest debtors. This injection of liquidity in today’s prices was approximately about $2 billion. No interest was to be collected for 3 years. Measures were somewhat similar to those taken by the ECB, Fed, Bank of England, Bank of Japan and almost all the other central banks in response to the Global Financial Crisis of 2008–2009.17 Between Emperor Tiberius and the President of the ECB, there have been other cases of Quantitate Easing. For instance, Michael D. Bordo did drew some parallels between the Q.E. in the USA Post-Global Financial Crisis of 2008–2009 and the measure taking by the Federal Reserve in the 1930– 1940s. Nevertheless, it is well known that the Bank of Japan has been carrying out credit or monetary easing operations since the 1990s, so shall we call it unprecedented or unconventional only because it was a new thing ECB did? In fact, no. The ECB itself, though not at the large scale, was keeping financial assets as well as Gold on its balance sheet

16 For “Tiberius Used Quantitative Easing To Solve The Financial Crisis Of 33 AD” visit https://www.businessinsider.com/qe-in-the-financial-crisis-of-33-ad-2013-10?r=US& IR=T. 17 The effectiveness of Q.E is also debateable and interestingly in the study “Fifty Shades of QE” Fabo et al. (2021) reported a divergence between the findings of central bank researchers and academic economists regarding the macroeconomic effects of quantitative easing (QE). They found that the report by centrals suggests a more favourable outcome of Q.Es in terms of enhancing economic growth.

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before it rolled out the large-scale asset purchases. Nonetheless, it has been involved in accepting government securities as well as private papers as collateral. One may argue that it is just collateral for a short period of time, but if you take that view, is the asset purchases are not with the explicit or implicit intention/promise of an exit strategy? or has the ECB put assets on its balance sheet forever? Anyway, whatever we may call it the ECB did start large-scale asset purchases and undoubtedly the size and scale was and in fact has been phenomenal to the day. Before dipping into the details of the Quantitative Easing and Asset Purchase Programme by the ECB, it is worth acknowledging one of the significant measures taken by the ECB to provide liquidity in the foreign currencies. These are part of fine-tuning operations with the participation of a limited number of counterparties. Following the decision by the Governing Council, the Euro system National Central Banks (NCBs) were allowed to conduct operations that entailed the provision of US dollar (USD) funding to Euro-system counterparties against collateral that is also eligible for Euro-system monetary policy operations.18 The dollar Euro swipes lines are maintained with the Federal Reserve. Similar, swipe lines were open between various other central banks to keep their banking sector liquid in the face of liquidity as well as foreign exchange risks. Though, the share of these operations is undoubtedly not comparable with the Asset Purchase Programme which has been more than fine tuning. It started to gather momentum in May 2009 with the purchases of covered bonds which are essentially the debt securities issued by banks to obtain funding with a maturity longer than the refinancing operations carried out by ECB. In so doing, the notion was to overcome the issue of maturity mismatch, an issue banks have to face when they borrow for short term and lend for the long term. There are a number of reasons given for the intervention in the covered bonds market. First, it was due to the reason that as I said earlier, this market is vital for the banking sector to meet its liquidity requirements. Given that the Global Financial Crisis also hit this market, the intervention by the ECB was to kickstart the covered bonds market. Secondly, referring to the German covered bonds Pfandbriefe which are around for about 200 years, it was argued

18 For details on “Tender Procedure for the Provision of US Dollar to Eurosystem Counterparties” visit https://www.ecb.europa.eu/mopo/implement/omo/pdf/ EUR-USD_tender_procedure.pdf?1e47c84c4ac17c543f58acb3e0e4dcd7.

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that argued by Mr. Trichet that the covered bonds are safe assets. Particularly in comparison to the other Asset-Backed Securities, the credit risk is not transferred from the issuer to the investor in the covered bonds. In fact, it stays with the originator and hence leads to prudent credit risk evolution as well as monitoring which puts the covered bond in the class of safe assets. It was also argued that the outright purchases of covered bonds and in line with the realm of fiscal policy and entails a significant transfer of credit risk from financial institutions to the taxpayer. Besides that, it still does not burden the Euro system with excessive credit risk. It’s hard to see how one can add all this up, where it says that the role of fiscal policy is to buy covered bonds? in fact, the monetisation of Eurozone sovereign debt was against the principles of EMU and clearly against Article 104 of the Maastricht Treaty. As there was no provision for the overdraft facilities or any other type of credit facility with the ECB or with National Central Banks in favour of community institutions, central, regional and local public authorities under the Maastricht Treaty. So why there is an exception for the covered bonds. Well by very simple logic, if you got to do the asset purchases you can buy assets either issued by the public or private assets. The ECB for the outright purchases of covered bonds went with the latter. There was however acknowledgement of this aspect by Mr. Trichet as he gave his rationale for not involving the outright purchases of the sovereign bonds, based on the three “P”, i.e. pragmatism, principles and preparations for exit. On the aspect of Pragmatism, the rationale was based on the contrast between the American and European Tradition. Specifically, it was argued that it has been traditionally US monetary policy routine to outright purchase and sell short maturity treasury bonds. Hence, in the USA, the monetary policy just extended its scope to longer maturities. On the contrary, in the Eurozone the repurchase agreements and collateralised loans to the banking sector had been the bread and butter of monetary policy operators. Hence, expanding on this tradition the path ECB took was to extend the maturities of its refinancing operations and bring more leniency in the collateral criteria. The second aspect of Principle, it was argued that there is a separation of responsibilities in the Eurozone which means that the ECB has to act in its boundaries its mandate and hence the enhanced credit support respects that Principle. Time is the best judge and despite all the stress on the “Principle” as the events unfolded and once again the “push came to shove” the Principle went down the drain and the large-scale purchases of sovereign debt were carried out. I will

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revert to it but before that, the third “P” of Preparations for exit. It was stated that the Governing Council will ensure that as the macroeconomic environment improves the measures taken and the liquidity created due to these measures have been absorbed. It was also argued that the longterm operations will run their course and in the foreseeable future ceased to exist, though in the case of covered bond purchases there will be questions on selling or holding. In specific to the exit strategy, it is yet to be implemented or at least set out, although it was urged that the policymaker should be “sangfroid” in envisaging the exit strategy while making a decision. Furthermore, that the existence of exit strategy should not be denied by confusing the existence of strategy with the decision to embark on the strategy. This was an interesting point advocated by Mr. Trichet as if there was a strategy and the question was its implementation, there should have been some blueprint of it, somewhere? To the best of my knowledge, there is no plan or blueprint of any sort and with the arrival of Pandemic and state of Eurozone economies, I have strong doubts if there would be one. On the fiscal policy, the position by Mr. Trichet in July 2009 was and it won’t be wrong to argue that the position of the ECB at that time was that the “fiscal policies lack a similarly strong built-in mechanism when it comes to the unwinding of stimulus ”. Hence, it was prescribed that Discretionary policies need to be invoked to engineer an exit from the current degree of fiscal expansion. A return to sound, sustainable public finances, thus strengthening overall macroeconomic stability, must be ensured. Euro area governments should prepare and communicate ambitious and realistic fiscal exit and consolidation strategies within the framework of the Stability and Growth Pact. (Jean-Claude Trichet, July 2009)

This state of distaste for fiscal expansion was a manifestation of the mood in the Post-Global Financial Crisis world where the hopes from the monetary policy were still very high, particularly in Europe where the ECB was titled as the anchor of stability and confidence in challenging times. It was argued that as the Europeans are by and large, “Ricardian”, they save more and cut consumption if they lose confidence in the soundness of future public finances. This turned out to be not the case as if such a behaviour was prevalent in the countries where the public finances were in mess, most notoriously Greece, the household should have been running

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huge savings? or in the case of Germany, the strong fiscal discipline should have led the German household to not save at all? A decade of Austerity was to follow, and I will cover the consequences of fiscal biasness which prevailed and negatively affected the Eurozone economies, societies and even European integration, but before that, an important aspect to look at is the monetary efforts. In its endeavour to leave no stone unturned, the ECB did not limit to the covered bonds and extended its operation to those purchases of those assets which were allowed in the Maastricht Treaty. But first on the refinancing operations as the faith in the refinancing operations and their effectiveness as the monetary policy tool had not shaken yet.

Refinancing Operations but This Time They Are “Targeted ” After June 2014, a further set of measures were taken to ease the credit condition and smooth the “monetary transmission”. This included negative interest rates on the deposit facility and targeted refinancing operations or more precisely the “Targeted longer-term refinancing operations (TLTROs)” and new Asset Purchase Programmes. I will revert to the negative interest but first on the Targeted Longer-Term Refinancing Operations which contrary to their predecessors were “Targeted” at least in the name. The notion was that the banks borrowing would be linked to their credit extension to the household and non-financial firms. There have been series of TLTROs announced first in June 2014, thereafter in March 2016 (TLTRO II) and then in March 2019 (TLTRO III). Decision to launch the Targeted Longer-Term Refinancing Operations (TLTROs, hereafter) was taken in June 2014 with the announcement to follow in July 2014.19 As it reads: In pursuing its price stability mandate, the Governing Council decided to introduce measures to enhance the functioning of the monetary policy transmission mechanism by supporting lending to the real economy. One particular measure announced by the Governing Council in relation to this objective was its decision to conduct a series of targeted longer-term refinancing operations

19 For details on “Decision of the European Central Bank of 29 July 2014 on measures relating to targeted longer-term refinancing operations”, visit https://www.ecb.europa.eu/ ecb/legal/pdf/oj_jol_2014_258_r_0006_en_txt.pdf.

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(TLTROs) over a period of two years. In conducting TLTROs, the Governing Council aims to support bank lending to the non-financial private sector, meaning households and non-financial corporations, in Member States whose currency is the euro. This measure does not propose to deal with lending to households for the purposes of house purchases. Eligible lending to the nonfinancial private sector in the context of this measure thus excludes loans to households for the purpose of house purchases.

Participation in the TLTROs was also possible for the eligible institutions on the individual as well as group basis with some formalities including mutual in writing consent of all the group members. There were also limits put on the borrowing and the initial borrowing allowance on the two TLTROs aimed to be conducted in the last quarter of 2014 was contingent on the total outstanding amount of eligible loans extended the participants to the non-financial private sector as on the 30th April 2014. Specifically, the counterparties were entitled to an initial borrowing allowance equivalent to 7% of the total amount of their outstanding loans to the euro area non-financial private sector (excluding loans to households for house purchase). The limits were to be rounded up to the next Euro 10,000/-. Regardless of the participation in any of the initial TLTROs, the participants were also allowed to avail additional allowance in the following six TLTROs in 2015 and 2016. Once again, the amount participants can avail was contingent on her eligible net lending to the non-financial private sector. Although in these TLTROs they would have been allowed to borrow up to an additional amount cumulatively reaching up to three times each counterparty’s net lending. Whereas the net lending was to be measured based on the transactions concept of the BSI statistics (i.e. new loans minus loan redemptions, adjusted for the impact of loan sales and securitisations). Reference dates for these later TLTROs were based on the latest date for which the net lending data in excess of a benchmark would be available. The underlying benchmark would have been each counterparty’s net lending to the euro area nonfinancial private sector during the 12 months preceding 30 April 2014. For the Bank that demonstrate positive net lending during this period, the benchmark was to be set at zero. In the case of groups, the calculation of borrowing allowance and for the group and its benchmark would have been based on aggregated loan data for the group. There was a fixed interest rate equivalent to the Euro system’s Main Refinancing Operations (MROs) plus a surcharge of 10 basis points was to be payable at the

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time of repayment of borrowing. But, in order to further the effectiveness of the targeted longer-term refinancing operations (TLTROs), this surcharge or premium of 10 basis points was eliminated after the initial two TLTROs. The notion and rationale given were that the Governing Council seeks a meaningful impact in terms of the monetary policy transmission mechanism. At the time of elimination of 10 basis points premium over Main Refinancing Operations rates on TLTROs, it was announced that the operations have been effective in reducing risks premium on term premia on market-based funding instruments for banks. Why would they not be for such lucrative lending and in an ultra-low-interest rate regime? Anyway, after the two-year periods, participants were allowed to repay the allocated amount. There was also an enforcement mechanism through a mandatory early repayment by September 2016, if eligible net lending of a participant that has borrowed in the TLTROs fall below the benchmark. For the sake of monitoring and valuation, it was also required that the participating institutions fulfil the reporting requirements which is not a big ask for what they were getting. In the official press release, it was stated that the “ECB announces monetary policy measures to enhance the functioning of the monetary policy transmission mechanism” where it was announced about the TLTROs, it was also declared that the Governing Council has decided to “intensify preparatory work related to outright purchases of asset-backed securities (ABS)”. The reason for this intention and intervention in the ABS market was given that it will enhance the functioning of the monetary policy transmission mechanism through the facilitation of new credit flows to the real economy. From the earlier mention purchase of covered bonds in the early summer of 2009 to the declaration of intervention in the AssetBacked Security (ABS) market in June 2014, there was a period of 5 years. This was a ridiculously long period in the face of a crisis where you have to react very very promptly. Eurozone had to pay the huge economic and social cost before the ECB could have come to the decision. I will cover these economic costs in terms of loss of output, employment and productivity in the later part of this treatise. However, it was still too little and too late. Under the ABS purchase initiative, it was declared that the purchase of simple and transparent ABS with underlying assets consisting of claims against the euro area non-financial private sector. This was also acknowledged that such a policy would have required changes in the regulatory and institutional framework. Most crucial, as I said before, we were

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in Summer 2014 and the still the discussion was on the rules and regulations which can justify the purchase of Asset-Backed Securities, while the counterparts of Eurozone including the USA, UK and other countries which participated in the Quantitative Easing were well ahead on this path. Before we get to the Eurozone version of Quantitative Easing or more precisely the Asset Purchase Programme, I must acknowledge that we are not done with the TLTROs, yet! The first round of TLTROs was not ample enough, so it was decided that we need more of it. In March 2016 it was announced that “In order to reinforce the ECB’s accommodative monetary policy stance and to strengthen the transmission of monetary policy by further incentivising bank lending to the real economy, the Governing Council decided to conduct a new series of four targeted longer-term refinancing operations (TLTROs-II)”. Additional voluntary repayment options for all outstanding TLTROs were made available and there were also no additional reporting requirements for the participants who had submitted the data for mandatory early repayment by September 2016. TLTROs-II was to be conducted at a quarterly frequency from June 2016 to March 2017 where each operation has a maturity of four years and an early repayment option of two years. Nonetheless, any counterparty which exceeds the lending benchmark would have been allowed to borrow at a rate as low as the deposit facility. Just to remember that the rate on despite facility has been negative since June 2014. This was exceptionally generous lending by any measure, comparable with the benevolence of the lender under Islamic Finance instrument Qardh al-Hasan (translates as benevolent lending). Analogous to the TLTROs, its predecessor was with the same hope that supposedly attractive long-term funding conditions which are provided to the Bank will result in easing credit condition and credit creation. Furthermore that the TLTROs-II will help to steer the inflation rate back to its target of just below 2% over the medium term. Participation was by the individual counterparty as well as in the group form as in TLTROsI. They were allowed to borrow up to 30% of the eligible loans or the loans they have extended to the Eurozone non-financial corporations and households excluding loans to households for house purchase (as of 31 January 2016). This allowance was, however, to be adjusted again for the outstanding TLTROs. Fixed-rate of interest equivalent to the prevailing Main Refinancing Operations (MROs) rate at the time of allocation was applicable to each TLTROs-II. There were two reports require, one

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to document the benchmark and borrowing allowance and second to monitor the lending performance over a two-year time. In an effort to get the third time lucky, in March 2019, the Governing Council decided to conduct a new series of seven targeted longerterm refinancing operations (TLTROs-III) to support the credit creation through bank lending in Eurozone. There was no change in the Euro system’s lending operations mechanism which were to be continued at fixed-rate tender procedures with full allotment. An intention to continue to reinvest the principal payments from maturing securities purchased under the Asset Purchase Programme, in full, was expressed by the Governing Council. There was no date given where this practice would have been terminated. In other words, there was no Exit Date or Exit Strategy. The Targeted Longer-Term Refinancing Operations (TLTROsIII) were to be launched from September 2019 to March 2021. In March 2019, it was also decided to keep the interest rates unchanged on the main refinancing operations, marginal lending and deposit facility at 0.00, 0.25 and −0.40% to with an expectation of no change in the remainder of the year. The interest rate on the TLTRO III was decided to be at 10 basis points above the average MRO rate over the life of each operation. But once again, for the counterparties which exceed their net benchmark lending, it can be as low as the average deposit facility rate plus 10 basis points. Yet, six months later these 10 basis points either on MRO rate or average despite facility rates were also abolished. Another drop in the ocean! It is hard to comprehend what difference 10 basis points can make. Particularly when it is coming with the other restrictions, in terms of the limit on the borrowing. The counterparties were allowed to borrow up to 30% of the stock of eligible loans (adjusted for outstanding borrowing under TLTRO II) as of 28 February 2019. Due to the short-term maturity, as compared to its predecessors, there was no early repayment option under TLTRO III. However, similar to going back on the 10-basis points decision, six months later, in September 2019 the Governing Council decided to extend the maturity to three years. The reason given was that the longer maturity is aligned with the Bank loan extension for the investment projects and that the economic outlook has deteriorated since the initial decision on TLTROs-III was taken in March 2019. Well, it was an interesting explanation as one may question the economic wisdom of the honourable Governing Council who did not know that the twoyear maturity is too short! It says in the name, the Targeted Long-Term

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Refinancing Operations. Nonetheless, if the economic outlook was worsening, will such a marginal difference of 12 months extension in maturity will be ample? Will the bank lending channel work as the banks will also see the slowing economy which will obviously imply more risky lending? Interestingly, the extension from two to three years also brought back the option of earlier repayment. But why a bank would be repaying early unless there is a better offer? TLTRO-IV perhaps! By the writing of this treatise, there is no official announcement, but as will not be surprised if the Governing Council would do another one, TLTRO-IV. But as the COVID-19 Pandemic hit the euro area, in March 2020, the interest rates on TLTRO III were reduced and the borrowing limit was also increased. We are yet to see TLTRO-IV but a newish version of TLTROs with Pandemic flavour, i.e. Pandemic emergency longer-term refinancing operations PELTROs was launched on 30 April 2020 when the ECB’s Governing Council decided to conduct a series of seven PELTROs followed by additional four PELTROs announced on 10 December 2020. In addition to these refinancing operations, there are also other exotic and ambitious measures that had been taken by the ECB in its commitment to whatever it takes! Among them is the ECB’s gigantic Asset Purchase Programme (APP).

Asset Purchase Programme (APP) Started in the summer of 2009, the Asset Purchase Programme (APP) by the ECB has been one of the largest schemes in the history of central banking. The reason given for these outright asset purchases was and has been to sustain the economic growth and keep the inflation below but close to the 2% target. Did that happen? I will revert to it but let’s first look into the details Asset Purchase Programme that consisted of four main programmes including: • • • •

Corporate Sector Purchase Programme (CSPP) Public Sector Purchase Programme (PSPP) Asset-Backed Securities Purchase Programme (ABSPP) Covered bond purchase programme (CBPP3)

There have been large-scale asset purchases under these programmes at varying paces. There seemed to be an inverse relationship between

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the speed of the economy and the Asset Purchase Programme! From March 2015 to March 2016, the average monthly pace of the net asset purchase had been e60 billion. Asset purchasing increased its pace in the following year to a monthly average of about e80 billion. Thereafter it did continue at a steady pace at an average of about e60 billion from April 2017 to December 2017 and slowing to e30 billion monthly on average from January to September 2018. In the last quarter of 2018, the average monthly purchase slowed down to about e15 billion. In the first three quarters of 2019, the cumulative net purchases size was maintained and the principal payments from maturing securities were reinvested. However, the strategy of holding the line was not ample, in the face of deteriorating economic outlook, where there were some marginal changes in the TLTROs-III maturity and interest rates, the pace of the Asset Purchase Programme was also increased even before the outbreak of the Pandemic. In September 2019, the Governing Council decided that (Fig. 3.8):

Fig. 3.8 ECB’s asset purchase programme with average monthly target 2015– 2021 (Source ECB. *Governing Council set the monthly average APP targets in March 2015 with the start PSPP)

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net purchases will be restarted under the Governing Council ’s asset purchase programme (APP) at a monthly pace of e20 billion as from 1 November 2019. The Governing Council expects them to run for as long as necessary to reinforce the accommodative impact of its policy rates, and to end shortly before it starts raising the key ECB interest rates.

From the statements made by the Governing Council, it was clear that there is no date in sight to roll back the monetary expansion carried out so far. There is an intent to carry on the reinvestment of principal payment from maturing securities past the date when the interest rates are started to rise. Hence, the first indicator of such a rolling back would be the interest rate rise. As acknowledged by the ECB at the time of the announcement, there was continuously expected redemption ranging between e2 and e35 billion each month, through the year 2020. Nonetheless, as the year 2019 taught us, the temporary halting of net asset purchasing decision had to be withdrawn and the net asset purchase restarted in the last quarter of 2019, i.e. just a bit before the Pandemic. But this restarting business was not smooth either and caused tensions in the Governing Council. On 25 September 2019, Sabine Lautenschläger, the German member of the Executive Board, resigned after the public sector purchase programme (PSPP) was reactivated on 13th September following a (simple) majority decision of the Governing Council. Several other ECB members had also voted against, and the governors of the German, Austrian and Dutch central banks openly criticised this decision. The argument on this particular case of restarting PSPP was that the longterm rates are already unprecedentedly low. But that was not the first time, the Bundesbank had routinely voted against the ECB’s decisions, criticised them publicly, even joined legal actions against them. So there had been tensions and conflicts at the heart of Euro system, in the Governing Council of ECB. Besides these tensions, as of April 2021, the Eurozone asset purchase programme was holding total assets in excess of e3.017 trillion with a fresh purchase of over e20.645 billion worth of assets in June 2021 (Table 3.2). There is a clear increase in the asset purchases and among them, the Public Sector Purchase Programme (PSPP) seems to hold the lion share making about 80% of the purchases. Yes sir, the “Public Sector” whose issued assets were particularly seen as undesirable since Maastricht. As I discussed earlier, the speech by Mr. Trichet in summer 2009 at Munich did acknowledge this undesirability and favouritism for

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Table 3.2 Euro-system asset purchase programme holdings (e, millions) Monthly change in holdings

ABSPP

CBPP3

CSPP

PSPP

APP

Holdingsa in May 2021

28,520 −314 −10

290,104 2037 −377

276,469 5602 −340

2,407,212 13,320 −5201

3,002,305 20,645 −5928

28,196

291,764

281,731

2,415,331 3,017,022

Monthly net purchases Quarter-end amortisation adjustment and redemptions of coupon STRIPS Holdingsa in June 2021 a End of the moth amortised cost

Fig. 3.9 Cumulative net asset purchases 2015–2021 (Source ECB)

the covered bonds. But what happened now? ECB had to awake to reality! Accumulation of assets portfolio under Asset Purchase Programme shows a consistent increase at varying pace. Just after the restart of net purchasing in September 2019, the Pandemic came as a catalyst that led to an increase in the pace of purchasing and Euro system holding assets in excess of e3.169 trillion by the end of June 2021 (Fig. 3.9).

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In the foothill of the mountain of accumulated asset purchases, the Asset-Backed Securities under the Asset-Backed Securities Purchase Programme (ABSPP) and Covered Bonds under the Covered bond purchase programme (CBPP) were the initial items. In the summer of 2009 the purchase of Covered bonds, specifically, the first round of covered bond purchase programme (CBPP1) started, leading to the purchase of assets worth e60 billion over the next 12 months. The second round covered bond purchase programme (CBPP1) started in November 2011 and ended in October 2012 resulting in purchases of about e16.4 billion. Between these two rounds of covered bonds purchases, in order to support the particular segments of financial markets, the ECB did start. Securities Markets Programme (SMP) in the summer of 2010. Under the SMP, there were interventions in the private as well as in public debt markets. The objective of the programme as stated by the ECB was to: Address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism.

This was a very interesting logic “transmission mechanism of monetary policy”. It was a blunt intervention in the fiscal policy and a poor attempt to disguise it as a monetary policy measure. In the press release issued by the ECB,20 it was stated that the Governing Council had taken note of the fact that the euro area governments were committed to accelerating the fiscal consolidation and will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures.

It was also declared by the ECB that the Sterilisation operations will be carried out to absorb the excessive liquidity created by the Securities Markets Programme (SMF). However, as in September 2012, the Governing Council started the Outright Monetary Transactions (OMTs), the SMP was terminated. The decision of OMT was opposed by the President of the Bundesbank who was the only opposition and worried about monetary policy crossing the lines to fiscal policy territory. Anyway, the German opposition went in vain. It was also decided that the 20 For details on ECB’s measures to address severe tensions in financial markets, visit https://www.ecb.europa.eu/press/pr/date/2010/html/pr100510.en.html.

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security will be held till maturity, hence, the reabsorption of liquidity created by the SMP is understandability not moped up. By December 2019, i.e. seven years after the termination, the holdings under SMP still stand for over e47 billion. The OMT entailed intervention in the sovereign debt secondary market and came with the conditionalities attached to the European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. The condition of EFSF/ESM was to show that it is not the ECB but the ESM programme which is facilitating a country in reforming its economy. It could have been either a full EFSF/ESM programme or a precautionary programme, i.e. and enhance Enhanced Conditions Credit Line. I will revert to the OMT and EFSF/ESM later on and in more detail but interestingly, for monitoring country-specific conditionality, the room for IMF involvement was created. This is a strange phenomenon because in the other monetary unions such as the USA and UK there is no precedence of any state or country approaching IMF. What was the role of IMF in a European matter? The involvement of IMF meant two things, the European Union and its institutions were not mature enough and the member countries problems were national problems not of the Union. Interestingly, it was also declared the Governing Council will be seeing the OMTs in the context of monetary policy transmission and may terminate the programme if the conditionalities/macroeconomic adjustments (mainly fiscal consolidation) have been not respected. Again, it was monetary financing of sovereign debt with the disguise of the monetary policy transmission mechanism. There was no limit set on the scale on OMTs and it was intended to focus on maturities between one and three years, hence, efficient the shorter part of the yield curve. The intention to fully sterilised the liquidity created by the OMTs was also expressed. In another interesting aspect, the ECB positioned itself side by side to the private creditor or holders of sovereign bonds by accepting the pari passu treatment. This might be a good and kind gesture but would the private creditor if he had such monetary power as the ECB would have reciprocated this kindness? Definitely not! I will revert to the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) programme but before that, it is vital to look at the mountainous pile of Asset Purchase Programme which has no end in sight. The covered bonds purchases which started over 10 years ago are still on the move and CBPP3 which was launched in October 2014 as been restarted in November 2019, ECB’s Christmas

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shopping. By the time of its launch, it was hoped that in conjunction with the Targeted Longer-Term Refinancing Operations (TLTROs) and ABS purchase programme (ABSPP), the CBPP3 will lead to “enhance the transmission of monetary policy, facilitate credit provision to the Euro Area economy, generate positive spill-overs to other markets ”. The covered bonds which do not achieve the CQS3 rating in Greece and Cyprus were also allowed after some formalities and demonstration of commitments. Purchases under CBPP3 have exceeded e291 billion in May 2021. So, in comparison, the programme has dwarfed its predecessors where most of the purchasing is also done in the secondary market. With the aim to support the liquidity in repo and bond markets the securities held under Asset Purchase Programmes, including public sector purchase programme (PSPP), covered bond purchase programmes (CBPP, CBPP2 and CBPP3) and corporate sector purchase programme (CSPP) have been made available for lending against security and cash collateral. Though the lending under CBPP3 and ABSPP was not made mandatory due to the associated costs with the establishment of a security lending facility, lending of PSPP and CSPP was made mandatory by the Governing Council (Table 3.3). Looking at the breakdown of assets held under CBPP3, it is clear that by rating they were AA and AAA-rated. The distribution has not been exactly in line with the size of economies in Eurozone as France has superseded Germany while Spain and Italy share of holdings had been more than the benchmark. Purchase of the Asset-Backed Securities under the Asset-Backed Securities Purchase Programme (ABSPP) was also started in November 2014. The programme is still on the go and by May 2021 the asset holdings have crossed e28.7 billion with a slightly more ratio (about 58.98%) from the primary market (Table 3.4). Most of the ABSPP holdings are of AAA ratings and from Netherlands, Germany and Italy. The universe is a theoretical measure of the purchasable senior tranche securities eligible as Euro-system collateral outstanding which of course also shows the degree of intervention in the market. The residential mortgages also take a lion share of the ABSPP holdings although it is interesting that the TLTRO operations were excluding this segment. Coming towards the public sector purchases which was the nightmare for the fiscally strong members of the Euro family since beginning, in the first quarter of 2015, this nightmare became reality.

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Table 3.3 Breakdown of CBPP3 portfolio by rating and country of risk 2021Q121

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Credit ratinga distribution of CBPP3 holdings and benchmark Credit rating bucket AAA AA A BBB

CBPP3 holdings (%)

CBPP3 benchmark (%)

72 28 0 0

80 20 0 0

Country of riskb distribution of CBPP3 holdings and benchmark Country of risk France Germany Spain Italy Netherlands Finland Austria Other (euro area)

CBPP3 holdings (%)

CBPP3 benchmark (%)

29 23 18 10 7 4 4 5

32 23 13 7 8 4 5 6

a Note “AA” contains credit ratings from AA− to AA+, “A”

contains credit ratings from A− to A+, “BBB” contains credit ratings at or below BBB+ . The credit ratings are first-best asset ratings. The rating distribution is based on all bonds with an asset rating b Internal classification of country of risk Sources ECB, FitchRatings.com, Moody’s Investor Service, S&P Global, DBRS

21 The distributions are by nominal values as at end of Q1 2021. The numbers may not sum to 100% due to rounding. The benchmark is constructed using the universe of eligible securities pertaining at the end of Q1 2021. The weights of certain covered bond classes have been adjusted lower to reflect their lack of availability and illiquidity. The CBPP3 benchmark has evolved over time leading to some deviations between the country and credit rating distribution of CBPP3 holdings and the distribution of the quarterly CBPP3 benchmark (for further information please see Box 2 entitled “Providing additional transparency on aggregate APP holdings”, Economic Bulletin, Issue 2, ECB, 2019, pp. 79–81). Only bonds with an asset rating are included in the data for the credit rating distribution. The ratings are first-best asset ratings.

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Table 3.4 Breakdown of ABSPP portfolio by rating, country of risk and collateral type: 2021Q1

Credit ratinga distribution of ABSPP holdings Credit rating bucket

ABSPP holdings (%)

ABSPP universe

86 14 1 0

80 18 2

AAA AA A BBB

Country of riskb distribution of ABSPP holdings Country of risk

ABSPP gross purchases (%)

ABSPP holdings (%)

ABSPP universe (%)

Netherlands Germany Italy Spain France Ireland Portugal Finland Belgium

34 24 18 9 9 2 2 1 1

42 21 11 12 10 1 2 1 0

39 19 13 12 12 1 2 2 0

Collateral type distribution of ABSPP holdings and universe Collateral type Residential mortgages Auto loans Consumer loans Leasing contracts Credit card receivables Loans granted to SME

ABSPP holdings (%)

ABSPP universe (%)

59

54

29 9 1 2

32 10 1 2

0

1

a “AA” contains credit ratings from AA− to AA+, “A” contains

credit ratings from A− to A+, “BBB” contains credit ratings at or below BBB+ . Credit rating distribution based on second-best rating consistent with collateral eligibility b Internal classification of the country of risk Sources ECB, Bloomberg, company publications

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On 22 January 2015, the Governing Council decided that asset purchases should be expanded to include a secondary markets public sector asset purchase programme (hereinafter the ‘PSPP’). Under the PSPP the NCBs, in proportions reflecting their respective shares in the ECB’s capital key, and the ECB may purchase outright eligible marketable debt securities from eligible counterparties on the secondary markets. This decision was taken as part of the single monetary policy in view of a number of factors that have materially increased the downside risk to the medium-term outlook on price developments, thus jeopardising the achievement of the ECB’s primary objective of maintaining price stability. These factors include lower than expected monetary stimulus from adopted monetary policy measures, a downward drift in most indicators of actual and expected euro area inflation both headline measures and measures excluding the impact of volatile components, such as energy and food towards historical lows, and the increased potential of secondround effects on wage and price setting stemming from a significant decline in oil prices. (ECB, 4 March 2015)

The decisions clearly state or in other words confess the shortfall in the monetary policy and measures taken to the day. It was acknowledged that the key ECB interest rates are at their lower bound, and purchase programmes focussing on private sector assets are judged to have provided measurable, but insufficient, scope to address the prevailing downside risks to price stability. This was awakening by the guardians of Euro! As with the hindsight, we can see that even the zero lower bound had been defied and that did not help either but also the other measures of monetary policy and asset purchases other than PSPP had not helped much either. I will revert to it. But with the announcement of PSPP there was a clear change of mind as well as change of tune, it was argued in the decision by ECB that “it is necessary to add to the Euro-system’s monetary policy measures the PSPP as an instrument that features a high transmission potential to the real economy”. This line of reasoning was clearly contradicting Mr. Trichet speech at Munich in the summer of 2009. Now the intervention is supposed to have a higher potential and all the benefits. Though the decision on PSPP was seemingly in the context of lack of monetary measures ability to even avoid deflation, there was now an intent to enter into the public sector debt market. The PSPP linking to the ECB’s capital key was in somewhat an effort to be fair and equitable. Though, one point here was that the country which has the largest capital key, i.e. Germany, did it really require intervention in its public

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debt market? This was an inherent flaw in basing the PSPP on the capital key, but in a counterfactual what measure could have been used which can then be fair? Members with a smaller share in the capital key cannot have preferential treatment. If you hold fewer numbers of shares in common stock, you will have a smaller proportion of any dividend sharing. Fair enough! But there was also some provision left in the decision as it was stated that “In exceptional circumstances, where the envisaged purchase amount cannot be attained, the Governing Council may decide to purchase marketable debt securities issued by other entities located in the euro area” implying that there could be changes in the policy and stance as and if the things do not work. Yet, what was most striking was the sugar quoting it was stated in the decision that The PSPP complies fully with the obligations of the Euro-system central banks under the Treaties, including the monetary financing prohibition, and does not impair the operation of the Euro-system in accordance with the principle of an open market economy with free competition.

Well, if it was not monetary financing what else it was, buying the public sector debt and putting it on the balance sheet of the central bank of corresponding nations is monetary financing. It will certainly lead to the gains being distributed to the issuer of debt through the central banks. Nonetheless, the yield on the debt will also be affected by it. On the point of “open market economy and free competition” there is no market and competition here. There is only one seller the sovereign and one buyer the central bank, so which textbook will call it an open free market? The fact of the matter was that the guardians were interpreting their bible differently as they were trying to justify their stance. Decision and announcement of PSPP also came with a lot larger dose. It was decided that the size of combined purchases including PSPP, ABSPP and CBPP3 could be as large as e60 billion and it would be continued until September 2016 and as long as the Governing Council feels appropriate. The portfolio was to be 88% eligible central governments and recognised agencies and 12% eligible international organisations and multilateral development banks. Where 92% share of the PSPP securities to go towards NCBs and ECB was decided to have remaining 8%. Each NCB was to purchase the eligible securities of issuers of its own jurisdiction where it also purchases the securities issued by eligible international organisations and multilateral development banks. The ECB itself

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was to purchase the securities issued by recognised agencies and central governments of the whole Eurozone. This is interesting in a way that each NCB was still allocated a “jurisdiction” a confined territory to operate, an element of parallel monetary policy or a joint monetary policy rather than a single monetary policy. Distribution of purchases was to be based on capital-key subscriptions. Once again, the pari passu treatments were agreed upon, meaning that the ECB will be happy to be treated as the private investor or buyer of the public debt. This was obviously setting the ceiling as if the largest and in some cases only customer does not want the preferential treatment, then who else can insist on? The minimum remaining maturity on the debt securities purchased under PSPP at the time of purchase was the Euro-system central bank was required to be two years and a maximum of 30 years. This is called the “Blackout period” with the idea of letting the market set the price, the purchase of newly issued and tapped securities was not permitted. This decision was again implying that there would be no effect of purchases between 2- and 30years maturity of an asset on the price of its stock which has less than 2 years of maturity. Of course, when you mop up assets amounting to over Euro 2.4 trillion from the market, there got to be some impact. Nonetheless, the short-term rates are already low anyway. Anyway, this was the rationale for choosing a blackout period. One word which appeared in the decision of ECB is the exceptional circumstances. Seemingly the Governing Council was realising that there could be “exceptional circumstances which can lead to doing exceptional things” being done, including the reinterpretation of rules and treaties. Response time is an important factor when it comes to the ability to tackle any emergency or crisis. This is true from defence and security to the medical and fire services. If we look at the response time of the guardians of the Euro, it is prima facie evident that the responsiveness or reaction function is pathetically slow and hesitant to cushion the financial markets including the public debt market (Fig. 3.10). In the Pre-Global Financial Crisis period, to some there were no great striking differences in terms of monetary policy implementation among the Federal Reserves, ECB and Bank of England.22 In specific to US Fed and ECB it was also perceived that they both share same conviction of neutrality of money in long run and perhaps it’s the fiscal policy where

22 See Gerdesmeier et al. (2007).

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Fed Balance sheet as % of GDP

Bank of England balance sheet as % of GDP

ECB balance sheet as % GDP

Fig. 3.10 Fed, Bank of England and ECB Balance sheets (Source https:// voxeu.org/article/ltro-quantitative-easing-disguise. Note The Asset side of balance sheets of ECB, Fed and BoE have been decomposed into five categories27 )

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the differences are more significant.23 But the comparison of Fed, Bank of England and ECB clearly suggests some differences and the way these central banks reacted Post-Global Financial Crisis. As pointed out by Jean Pisani-Ferry and Guntram Wolff,24 the Repo lending in the UK and USA by the Bank of England and Fed was short-lived and mostly to overcome the shock by the collapse of Lehman Brothers. At the end of first quarter of 2010, Fed has almost withdrawn its Repo activities while the Bank of England also significantly reduced them. Nonetheless, they also started the purchase of government sectaries soon after the crisis and the size of these purchases was comparatively many folds larger than other assets. However, in the case of ECB, this did not happen, it took ECB well over 5 years to start the PSPP programme.25 This is was due to the earlier discussed affection with the bank credit channel. Perhaps, it took six years for ECB to learn that in the face of a massive slump, the bank credit channel does not work. Who is willing to lend to the private sector and household for investment, in the middle of a major economic crisis? In the Eurozone, the challenges to ECB increased by many folds 23 See Sardoni and Wray (2006). 24 For “Is LTRO QE in disguise?” visit https://voxeu.org/article/ltro-quantitative-eas

ing-disguise. 25 On the comparative central banking, Ferreira (2015) compared the response of US Fed and ECB and argued that “the Fed was more effective and prompter in taking action against the crisis. In addition, the Fed was also more successful in its communications, with a better management of expectations, capacity to adapt to the markets’ response to quantitative easing and faster implementation of forward-looking guidance, a feature determinant to the success of monetary policy”. Similarly, On the comparison between Fed and ECB to the Great Recession, Kang et al. (2016) also argued that US approach was much more proactive and aggressive. Furthermore, that the ECB failed to provide intime stimulus which may result in the Eurozone slipping into a low-inflation trap. With the hindsight we can see that their fears real. Similarly, in regard to the Global Financial Crisis and European Sovereign Debt Crisis, De La Dehesa (2012) argued that the monetary policy responses to the crisis by the US Fed, Bank of England and the ECB were different due to large differences in institutional set-up, structural differences in the financial markets and other economic differences. He argued that underlying differences among them also influenced the use of the non-conventional or non-standard monetary policy measures. While Pronobis (2014) also argued that the ECB response to GFC was more cautious comparing to Fed, BoE or BoJ and the reason was constant disagreement among European politicians, defragmentation of European sovereign debt market and different pattern of financing in Europe (more bank-oriented and less market-based— unlike in US or UK). For further insight, one may see Agostini et al. (201) comparative study of central banks Quantitative Easing Programs by ECB, Bank of Japan, US Fed and Bank of England in which they drew on a number of existing studies.

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due to the distaste for intervention in the sovereign debt market, absence of a banking and fiscal union and the strong heterogeneity within the Eurozone economies. The increase in the commercial bank deposits at the ECB was indeed an indication of a dysfunctional interbank market for which the MRO and LTROs used as a remedy. Much of the liquidity through MRO and LTRO did go to the southern countries, though it did not alter much in terms of kick-starting their economies. Hence, ECB had to dip into public sector asset purchases. The purchases continued from March 2015 to December 2018. In the first three quarters of 2019, the net or new purchases were halted and only the principal payments from the maturing securities were reinvested to sustain the stock at its prevailing levels. But not too long, the economic outlook of the Eurozone led to the change in the stance and PSPP purchases restarted in November 2019. The PSPP included central government bonds (nominal and inflation-linked) and bonds issued by recognised agencies, regional and local governments, international organisations and multilateral development banks located in the Eurozone. The bonds issued by the governments and recognised agencies constitute about 90% of the PSPP holdings.26 It has been declared by the ECB that the purchases of nominal marketable debt instruments at a negative yield to maturity are permissible. There was no hint about the negative yield given in any of the Treaty but as I mentioned earlier, the economic realities are not always aligned with the regulatory frameworks. In January 2017 ECB elaborated on its decision by announcing that purchases of assets with yields below the Deposit Facility Rates (DFR) will only occur under the PSPP, while no such purchases will be carried out under the CBPP3, ABSPP and CSPP. Nonetheless, for each jurisdiction, priority will be given to PSPP purchases of assets with yields above the DFR. It implied that the purchases that were to be made at a yield below DFR will vary among jurisdictions. By May 2021 the purchase of the assets under PSPP had exceeded e2.4 trillion (Table 3.5). Breakdown of securities under PSPP so far clearly reflects that the lion share of German, French and Italian public sector debt. Among these, which sovereign really needed this support? and the problem with this approach has been the contrast between being fair and hence basing purchases on the capital key while at the same time not being sensible at 26 For Implementation aspects of the public sector purchase programme (PSPP) and list of agencies see https://www.ecb.europa.eu/mopo/implement/omt/html/pspp.en.html.

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Table 3.5 Breakdown of debt securities under the PSPP: May 2021

Austria Belgium Cyprus Germany Estonia Spain Finland France Ireland Italy Lithuania Luxembourg Latvia Malta Netherlands Portugal Slovenia Slovakia Supranationals Total

Cumulative net purchases as of end December 2020a

Monthly net purchases April 2021

Cumulative net purchasesa

WAM of PSPP portfolio holdings end December 2020b

Current WAM of PSPP portfolio holdingsb

68,160 86,392 3277 580,224 281 292,880 35,897 488,536 37,522 411,197 4586 2987 2802 1215 118,662 45,891 9084 14,614 258,911 2,463,117

669 831 86 6000 21 3141 −918 −231 318 3181 134 72 102 4 1618 −1374 −92 304 319 14,186

70,653 89,126 3611 598,996 372 296,991 36,318 494,566 38,881 424,762 4927 3301 2808 1229 122,372 46,005 9112 15,494 261,517 2,521,042

7.70 8.22 9.95 6.52 9.44 8.05 7.04 7.22 8.72 7.28 9.97 5.41 10.04 9.74 7.57 7.05 9.35 8.18 7.43 7.29

7.47 7.90 9.72 6.62 9.11 7.93 7.31 7.22 8.42 7.09 10.32 5.56 11.16 9.36 7.66 7.41 10.17 8.14 7.87 7.3

a Cumulative monthly net purchases figures represent the difference between the acquisition cost of

all purchase operations and the redeemed nominal amounts b Remaining weighted average maturity (WAM) in years

Source ECB

buying the debt of sovereign which had strong fiscal position, specifically the Germany and Netherlands. 27 See Jean Pisani-Ferry, Guntram Wolff (2012) as they formulated following five categories: Lending to financial institutions, mainly through repos; Government securities held within the framework of Asset Purchase Programmes; Non-government securities held within the framework of Asset Purchase Programmes; Foreign-exchange swaps with other central banks (for the Fed)/foreign currency lending to domestic institutions (for the Bank of England and the ECB). Other assets.

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Last but not least, the Corporate Sector Purchase Programme (CSPP) which was started in June 2016. This came after the decision by the Governing Council in March 2016 which entailed the expansion of Asset Purchase Programmes by adding corporate sector purchases issued in Euro denomination with credit rating at least BBB or equivalent by the issuers incorporated in the Eurozone. Reason for the CSPP was the same as the other PPs in the Asset Purchase Programme umbrella. Purchases were intended to run till the end of March 2017, though the continuity was subject to the Governing Council wishes which of course were to be affected by the state of the economy. Maturity was to be between six months and about 31 years. Six Euro-system National Central Banks (NCBs), including the Nationale Bank van België/Banque Nationale de Belgique, Deutsche Bundesbank, Banco de España, Banque de France, Banca d’Italia and Suomen Pankki/Finlands Bank were given the responsibility to carry out the outright purchases of investment-grade euro-denominated bonds issued by non-bank corporations. At the time of the decision, it was also declared that the necessary safeguards will be put into place for risk management and purchases are subject to the limits consistent with the PSPP. Interestingly, it was also stated in the decision that the CSPP should fully comply with the obligations of the Euro-system central banks under the Treaty, including the monetary financing prohibition in relation to the purchase of eligible marketable debt instruments issued by public undertakings. Though, the public sector debt was also being purchased. Furthermore, it was also stated that the CSPP should respect the principle of an open market economy with free competition, while giving due regard to the formation of market prices and the functioning of markets. Once again, such a large intervention in the market would have some implications for the market, in fact the ECB was acting as the market marker so where was the “Free market”? It was decided that as the underlying debt instruments mature, principal payments of the eligible marketable debt instruments purchased under the CSPP should be reinvested. Purchases were allowed through the primary and secondary markets for the corporate bonds, though the public sector corporate bonds were only allowed to be bought in the secondary market. The issuer should have not been a credit institution or institution whose parent company comes under banking supervision. It should have not been an issuer of ABS or covered bonds or PSPP, in a nutshell the CSPP was intended to be focused on those areas where the other elements of the Asset Purchase Programme have not poured their liquidity. An issue

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share limit per international securities identification number (ISIN) was applied which was 70% per ISIN for all corporate bonds other than public sector corporate bonds. Though this limit could have been lowered. The securities purchased under CSPP were also made available for lending. Initially, the Purchases of nominal marketable debt instruments at a negative yield to maturity (or yield to worst) above the deposit facility rate were permitted. Later it was changed into the “purchases of nominal corporate bonds at a negative yield to maturity (or yield to worst) equal to or above the deposit facility rate are permitted. Purchases of nominal corporate bonds at a negative yield to maturity (or yield to worst) below the deposit facility rate are permitted to the extent necessary”. Nonetheless, in its later decision, the Governing Council in September 2019 decided to extend this possibility to the private sector elements of the Asset Purchase Programme including the asset-backed securities purchase programme (ABSPP), covered bond purchase programme (CBPP3) and the corporate sector purchase programme (CSPP). By the end of May 2021, the purchases under CSPP exceeded e275 billion with around of over 78% of them in the secondary market (Table 3.6). As clearly suggested in the table, most of the holdings under the CSPP programme were in the rated A to BBB, French and German and falling in the sectors of utilities, infrastructure and transport as well as automotive parts and telecommunications. There was also the real estate sector being part of it for which in the TLTROs there was the aspect of not including credit to the housing as a benchmark for eligibility. There is a notion that the CSPP did lead to some reduction in the borrowing costs for the firms as the yields went down,28 but the yield did go down on the other assets as well, most prominently the sovereign bonds. The Asset Purchase Programme and it’s all constituents are of unprecedented scale in the short history of the European Monetary Union. But, the Asset Purchase Programme is not a silver bullet for all the evils in the face of European monetary and economic integration. This reality and difficulty have been realised and also evident in the policy stance of the ECB from the beginning of the year 2019 to its end with the worsening economic outlook the tone has also become less confident. It is important to remember that due to the worsening outlook of the economy, 28 For “How ECB purchases of corporate bonds helped reduce firms’ borrowing costs” visit https://www.ecb.europa.eu//pub/economic-research/resbull/2020/html/ ecb.rb200128~00e0298211.en.pdf.

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Table 3.6 Breakdown of CSPP portfolio by sector, rating and country of risk (semi-annual): 2021Q1 Credit ratinga distribution of CSPP holdings and the eligible bond universe Credit rating bucket AA A BBB

CSPP holdings (%)

Eligible CSPP bond universe (%)

10 40 49

11 41 48

Country of riskb distribution of CSPP holdings and the eligible bond universe Country of risk France Germany Italy Spain Netherlands Belgium Switzerland Other (euro area) Other (non-euro area)

CSPP holdings (%)

Eligible CSPP bond universe (%)

31 23 10 9 6 3 3 6 8

31 25 8 8 6 3 3 7 9

Economic sectorc distribution of CSPP holdings and the eligible bond universe Economic sector Utilities Infrastructure and transportation Automotive and parts Telecommunication Real estate Energy and basic resources Construction and materials Technology Beverages Health care and life science Chemicals Food Insurance Other sectors

CSPP holdings (%)

Eligible CSPP bond universe (%)

15 11 9 8 6 8 5 8 4 7 4 4 2 9

15 12 10 6 8 8 5 8 3 6 3 3 2 9

Sources ECB, FitchRatings.com, Moody’s Investor Service, S&P Global a Note “AA” contains credit ratings at or above AA−, “A” contains credit ratings from A− to A+, “BBB” contains credit ratings at or below BBB+. The credit ratings are first-best asset ratings. The rating distribution is based on all bonds with an asset rating b Internal classification of country of risk. c Internal classification of economic sector Note Nominal CSPP holdings as at end of Q1 2021. CSPP holdings with a remaining maturity below 6 months are excluded. The numbers may not sum to 100% due to rounding. The eligible CSPP bond universe contains all bonds that are currently eligible

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the ECB had to restart the APP before the outbreak of the Pandemic. The Pandemic has obviously made it worst, but the situation was not great even before the Pandemic. In addition to the AAP one exceptional and unprecedented measure taken by the ECB was to go below zero or so-called zero lower bound on nominal interest rates.

Going Below Zero

interest rate levels in % per anum

Since June 2000 the Main Refinancing Operations of the Euro system were conducted by the ECB at a variable rate tender. In the wake of the crisis in October 2008, a fixed-rate full allotment policy was adopted. The rates were already quite low by historical standards and were also comparable with the other developed economies including the USA and UK. Hence it is fair to argue that in terms of policy rates there was much scope or room as the dawn of crisis broke. Keynes had cautioned on the ineffectiveness of low-interest rates in the General Theory but as the crisis hit and well over decades afterwards, it seems they have not delivered much (Fig. 3.11). The rates on the ECB deposit facility remained close to zero in the period succeeding the Global Financial Crisis of 2008–2009 and from July 2012 they touched what was perceived to be the zero lower bound. It has been thought for decades that interest rates cannot go below zero. The traditional view on the nominal interest rates has been predominantly to consider them as a nonnegative entity. As Hicks (1937, pp. 154–155) famously stated 7 6 5 4 3 2 1 0

Deposit facility

Fig. 3.11

MRO (Fixed Rate)

MRO Variable rate

ECB’s key interest rates (Source ECB)

Marginal lending facility

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[I]f the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently, the rate of interest must always be positive.

In essence, this argument was drawn on the logical foundations laid by Keynes (1936) while emphasising the liquidity preference of economic agents and that the utility of holding money is always positive, even if more money is held than required by the transactions or precautionary motives. But looking at the practices in the recent history of monetary policy formulation, it is witnessed that in order to stimulate economies further, Riksbank in July 2009 chosen to defy the zero lower bound and enter into an uncharted negative interest rates territory. The Riksbank, the world’s oldest central bank, pioneered the negative interest rate policy by charging the commercial banks to hold deposits rather than pay them interest. ECB followed the suit in June but once again it took her five years to copy the Riksbank (Fig. 3.12).

Fig. 3.12 European Countries below zero by October 2019 (Source European Central Bank, Swiss National Bank, Riksbank, Danmarks Nationalbank)

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Negative interest rates have been debatable, and policy was not adopted by the US Fed and in his remarks Mark Carney then the Governor of the Bank of England did not show much interest in negative interest rates. In his speech at the G20 conference in Shanghai in 2016, Mark Carney reflected on the limitations of negative interest rates and their implications. Similarly, the former US Fed, Chairperson Janet Yellen, did not show much interest in going below zero. She wrote to the US Congress that “while the idea of negative interest rates is not completely ruled out, it would require a lot of consideration and could be only as a last resort ” (Posen, 2016). To some it is an unfair wealth tax and which can affect the vulnerable member of society, it could lead them to either keep hold of savings or move to risky assets which may have further implications (Coeure, 2015). Nevertheless, ultra-low-interest rates may lead to situations where agents borrow and invest in assets with a limited and inflexible supply like real estate which then poses risks to financial stability (Claeys & Darvas, 2015; Palley, 2016). In fact, in my own writing on “Zero Lower Bound, Negative Interest Rates & Choices for Monetary Policy in the UK ”, I have empirical showed that it is not the nominal but real rates that matter. It was argued that the real rates have significant implications for the real growth, labour market and price stability even when in the nominal sense the monetary policy was constrained at the zero lower bound. Furthermore, that the effectiveness of the real rate did not diminish due to the Global Financial Crisis or nominal rates being close to zero which has important implications in terms of policy setting and allowing for the other measures and perhaps more emphasis on coordination with fiscal policy than pushing on negative rates. Coming back to the ECB’s affair with the negative interest rates, although it came quite late, almost five years after the Riksbank had taken this step, the approach was also slow. There was not a massive cut below zero. From June 2014 to September 2019, the interest rates on the deposit facility changed from −0.10 to −0.50%. It is hard to comprehend that what on earth ECB was aiming to achieve by dropping the interest rates by 1/10th of a percentage and going negative? Nonetheless, there is an acknowledgement of the fact by the ECB that the negative interest rates are harmful to the banking sector which has opposed the policy. Savours and pensioners are also negatively affected, the so-called “euthanisation of the rentier”. Therefore, the ECB introduced a “tiering” system to partly shield a portion of their reserves and where the banks are allowed to hold excess cash of up to six times their mandatory reserves

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without having to pay the penalty charge in the form of negative interest which by the writing of this passage stands at the −0.50%. Although these negative interest rates can be passed to the customer in the form of a fee, yet one question, one simple question which we shall ask ourselves in the debate on negative interest rates on deposits is that “What is the purpose of banks?” and if I rephrase this question, “What is that banks love to do?” The raison d’etre of the banking sector as taught in any of the banking textbooks is to lend money and in so doing make a profit. So why is that the ECB had to push banks that instead of parking their money for nothing at the zero-deposit rate (Even if we ignore the cost of inflation and opportunity cost) they lend it somewhere to somebody and make a profit? There is something wrong, fundamentally wrong that the banks are reluctant to lend. Never mind the bank lending channel with which the ECB has this crazy fascination from the day of the Global Financial Crisis. Timeline of non-standard measures or so-called unconventional measures which are still in place with no end in sight summarises ECBs over a decade long struggle (Fig. 3.13). Negative deposit facility rate TLTRO I TLTRO TLTRO III PELTROs

APP Third Covered Bond Purchase Programme (CBPP3)

Asset-backed Securities Purchase Programme (ABSPP)

Public Sector Purchase Programme (PSPP)

Corporate Sector Purchase Programme (CSPP)

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Fig. 3.13

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Timeline of ECB’s non-standard measures (Source ECB)

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Forward Guidance In addition to all the quantitative measures, including Asset Purchase Programmes, Long-term and Targeted Long-Term Refinancing Operations, Emergency Liquidity Assistance, negative interests as well changes in the institutional framework including collateral requirements, policy of fixed-rate full allotment, etc., the ECB also started to provide the Forward Guidance. As defined by the ECB, the Forward Guidance entails provisions of the information about the monetary policy “intentions” based on the assessment of the outlook for price stability/inflation. In its true essence, the Forward Guidance was provided in the “whatever it takes ” statement by Mr. Mario Draghi in the summer of 2012. The intention to save the Euro at any cost with leaving no stone unturned was indeed the best possible form of Forward Guidance. However, a bit more formally and in the context of monetary policy, in July 2013, the Governing Council expressed its attention and expectations to keep the interest rates low for foreseeable future. In the press conference at Frankfurt when the question was raised to Mr. Draghi that Mr. Carney, then the Governor Bank of England has provided the Forward Guidance “if [he would] put aside the pre-commit barrier to more detailed and specific forward guidance?” Mr. Draghi replied, If you are asking this question, you have not really listened to my statement.

Furthermore that: The Governing Council has taken the unprecedented step of giving forward guidance in a rather more specific way than it ever has done in the past. In my statement, I said “The Governing Council expects the key…” – i.e. all interest rates – “…ECB interest rates to remain at present or lower levels for an extended period of time.” It is the first time that the Governing Council has said something like this. And, by the way, what Mark Carney said in London is just a coincidence.

It might be a coincidence, but on the positive side, unlike the other measures, at least the ECB was not lagging years behind on the Forward Guidance. There was an emphasis on the “extended period of time” with advice that one shall look at the inflation, economy and monetary dynamics to understand the duration of an extended period of time. Hence, it can be argued that the Forward Guidance was more like a

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Qualitative forward guidance conditional on a narrative.29 In terms of its rationale, the reason for providing Forward Guidance is that if the ECB suggests that the interest rates are expected to be low, the commercial banks will take this into account, and they will extend the credit to households and firms and lower rates expecting that the ECB will not increase the rates in “extended period of time”. Hence, it’s a way of influencing the banking sector expectations and giving banks more confidence in the maturity transformation. But do the banks really bothered about it? if so, they should have been reluctant to lend at the beginning of every economic boom as the inflation as well as the interest rates can be expected to go up on the upswing of the economy. Therefore, the logical reason given by the ECB does not hold much water. Although there were some changes in the EONIA (Euro Overnight Index Average) forward rates over six months maturity which declined about 5 basis points or 1/20th of a percentage. Furthermore, some estimations showed that the EURIBOR (Euro Interbank Offer Rate) options which were used to gauge expectations of the Overnight Indexed Swap Forward Rates also showed some decline. But these reactions from the market and the underlying proxies for the expectations were a little bit farfetched. To reiterate, the assurance that the interest rates will not be increased unless the inflation starts to pick up and the economic outlook improves is not really required when you are facing risks of deflation and stagflation. As the questions had been raised on the Asset Purchase Programme and its future, including the exit strategy, the ECB extended its Forward Guidance to provide some information on APP. Indeed, it has also be argued that the Forward Guidance is more useful when the central bank is carrying out large-scale asset purchases.30 Well, ECB has been doing both of them, so did it hit the target? we will have a deep look into

29 The is different to the Pure qualitative forward guidance which has no explicit end-date or numerical thresholds that provide information about the likely evolution of policy interest rates in the future and no explicit reference to a configuration of underlying conditions, including regarding the objectives of policy, which would justify this evolution. Other forms can be Calendar-based forward guidance which can entail making a conditional commitment based on the explicit date after which the stance of monetary policy is expected to change and/or Outcome-based forward guidance with explicit numerical conditions or thresholds that link central bank actions to a selected set of observed or projected economic variables. 30 See Coenen et al. (2017) for Communication of monetary policy in unconventional times.

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that but one obvious thing was that with the expansion of monetary measures and toolkit, the monetary union was also expanding as Latvia on 1 January 2014 and Lithuania on 1 January 2015 joined the Euro family. On the day each country joined the euro area, its central bank automatically became part of the Euro system. The notion of the currency union was working, whether the currency union was working ! We have to see the functioning of the currency union in the light of some facts but before that, it is also vital to not miss the fiscal and state-level support that was provided to kick start the Eurozone economy.

CHAPTER 4

Flawed Fiscal and Stimulus Plans: A World Beyond ECB

A European Economic Recovery Plan While the Global Financial Crisis reshaped the functioning of the Economic and Monetary Union of the European Union and European Central Bank, it also affected the fiscal side and the other intuitions and pillars of the Union, including the European Commission. Monetary policy on its own has not and shall never be enough to deliver the mandate of mere price stability never mind the stability of macroeconomy and financial system. Therefore, it was obvious that sooner or later the fiscal policy and the public policy will have to play their parts. So, to start with, under the Presidency of Mr. José Manuel Durão Barroso, the European Economic Recovery Plan was announced in November 2008, wrapped in thick layers of passion, which of course was very much needed, as well as the action.1 The aim of the Plan in the European Commission’s own words was to “restore consumer and business confidence, restart lending and stimulate investment in the EU’s economies, create jobs and help the unemployed back into work”. It was urged that the European Heads of States which were going to meet in December of 2008, shall agree to adopt the Plan which was constructed after their agreement on 1 For Communication from the Commission to the European Council—A European Economic Recovery Plan visit https://eur-lex.europa.eu/legal-content/EN/ALL/?uri= CELEX:52008DC0800.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6_4

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the joint efforts and notion of having a plan in the meeting they had in early November 2008. Plan entailed setting out the actions on the investment in the infrastructures and key sectors of economies including automobile, construction and green technologies. Emphasis was on the coordinated fiscal measure by the EU member states so that the impact of fiscal expansion can be maximised and optimised. In numbers, it amounted to a sum of e200 billion which at that point was about 1.5% of EU annual GDP. Out of this e170 billion was to be funded by the member states while e30 billion was planned to be through the EU funding. Although, the emphasis was on the joint fiscal stimulus, but it was clear, and the Commission was aware that there is a different starting point for each member state. Putting it simply, each member state had an idiosyncratic fiscal outlook and hence a different fiscal capacity and room to manoeuvre. Italy and Greece were already holding the government debt in excess of their annual national income or GDP. To be specific, for Italy it was about 106% and for Greece, it was about 112% of annual GDP. Between Greece and Finland, there was a difference of 120% in terms of their debt to GDP or national income ratios. So, it was clear that the fiscal authorities in Greece and Italy would not have much room to start with. Nonetheless, with the economic difficulties, it was also obvious, but I am not sure if it was accounted for that the fiscal deficit would have been increasing for all the members of the Eurozone in the coming years (Fig. 4.1). Suggestions by the Commission were to take timely, targeted, temporary and coordinated actions which should also take into account the flavour of structural reforms. This fiscal expansion and structural reforms as we know them and commonly understand are often seem to be mutually exclusive. Structural reforms mean fiscal discipline or if I dare to explain the word discipline, in plain English it means “Austerity”. Austerity at the same time when you are thinking of fiscal stimulus! how this adds up? This exclusivity and contrast may have the element of confusion or differences of opinion and competing interests in the Union, so any plan got to have something for everything or was supposed to have something for everybody. Therefore, in the language of the European Economic Recovery Plan, there is clear contrast and tension between being fiscally simulative and expansionary and at the same time fiscal consolidation and discipline/austerity. European Investment Bank (EIB) was also responding by increasing its annual investment by e15 billion over the

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180.0 160.0

Greece

% of GDP

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Fig. 4.1 Government Consolidated Gross Debt as a Percentage of GDP (Source Eurostat)

next two years, which was obviously a very small fraction of EU annual GDP. Not too late but perhaps too little! In the opening lines of the Plan, it was argued that the European governments and institutions need to show that they are in tune with the needs of families and communities across the European Union. Most interestingly, it was also acknowledged that “Europe will above all be judged on results ”. Fair enough, this is the self-selected criteria and benchmark set by the Commission and in the following parts of this book we will look into the “results ” and I will leave the reader to make the judgement. But let’s revert to the Plan first which in Commission’s words had two pillars and one principle: First pillar was to stimulate the economy by injection of purchasing power and for this purpose, the above mentioned e200 billion were to be used. Second pillar was to increase the competitiveness of European economies, by smart investment, increasing efficiency, clean and green technologies. Lastly the single “fundamental principle” as told by the Commission was social justice and solidarity. For this purpose, the European Globalisation Adjustment Fund and European Social Fund were put in place. The purpose of the European Social Fund (ESF) with e10 billion financing a year was to help all the EU citizens getting job by funding the local, regional and

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national employment-related project and aiming at education systems and skill development.2 On the other hand, with a budget of e150 million for six years (2014–2020) the European Globalisation Adjustment Fund (EGF) was to provides support to people losing their jobs as a result of major structural changes in the world trade patterns due to globalisation.3 It could only fund up to 60% of the cost of projects designed to help workers made redundant find another job or set up their own business. The size of these programmes and their effectiveness at the Union level can be debatable but the judgement can be made based on the “results” which did not turn out to be great. Anyway, there were all the nice things one can think of in the European Recovery Plan. The strategic aims included swift stimulation of the economy, containing the impact of economic downturn particularly due to the unemployment and its social consequence, increasing competitiveness (in line with the Lisbon Strategy for Growth and Jobs ) through innovation and structural reforms and low corban energy-efficient green economy. The notion was to exploit synergy by coordinated efforts as well as fiscal measures, structural reforms and financial market reforms and last but not least, to be part of international efforts to meet the global challenges of the economic and financial crisis. The last one, that the contribution to the international growth and stability agenda, with the benefit of hindsight we can say that instead of contributing, Europe put a drag on the growth of the global economy. Most of the growth was shouldered by the emerging economies in the Post-Global Financial Crisis world. However, the cause of the failure to the international contributions was due to the failure of the European Union on its home ground. The European Recovery Plan was proposing a countercyclical approach and was intended to be anchored on the Stability and Growth Pact and Lisbon Strategy for Growth and Jobs. The Lisbon Strategy started in 2000 with various modifications and it entails the idea of “the most competitive and dynamic knowledgebased economy in the world, capable of sustainable economic growth with more and better jobs and greater social cohesion”. It was later expanded to

2 For details on European Social Fund visit https://ec.europa.eu/esf/main.jsp?catId= 35&langId=en. 3 For details on European Globalisation Adjustment Fund for Displaced Workers (EGF) visit https://ec.europa.eu/social/main.jsp?catId=326.

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include environmentally sustainable growth.4 In the Plan, there was an acknowledgement of the fact that the fiscal stimulus may not be ample as it would require joint policy action on all fronts including the monetary and credit policies. It was also mentioned in the Plan that the European Commission will monitor the development in the Banking sector and the economic impact of the policies adopted with respect to easing the credit conditions. While it was hoped that the increased investment of e15 billion by the European Investment Bank (EIB) will generate a positive impact and influence the private sector to chip in and mobilise their resources, it was also urged that the member states reinforce the capital base of the EIB to the order of e60 billion. This measure was hoped to give the market a clear signal that the political will is there and hence the banks would respond positively. The European Bank for Reconstruction and Development (EBRD) was also expected to add an additional e500 million per year on top of the existing financing. In the Plan, it was clearly acknowledged that it’s time for the Budgetary Policy to play its part and stimulate the economy while drawing on the revised Stability and Growth Pact. Therefore, the governments should coordinate in stimulating the economy by a coordinated injection of e170 billion in the spirit of the Lisbon Strategy. Furthermore, that there should be a commitment that the stimulus is merely temporary and would be reversed in the medium term to avoid budgetary distortions and the countries with more fiscal space should do more, including those which have not opted for the single currency. A mix of revenue and expenditure instruments, in simple words cutting taxes and increasing spending, was suggested in the Plan, though indeed the latter is often considered as more appropriate in stimulating the economy. Emphasis was on temporary increased transfers to the household with unemployment and low income, lending to SMEs, provisions of guarantees and loan subsidies on financing and infrastructure projects with the green elements. While the revised version of the Stability and Growth Pact, i.e. the 2005 version was to be used as a framework for the budgetary policies. This implies taking into account the cyclical realities while keeping an eye on the long-term fiscal discipline. So, there was some room to breathe in the difficult times by temporarily being more tolerant to the fiscal deficit, though how long is the long term or how far is the long term is still a 4 The Lisbon Strategy in short, visit https://portal.cor.europa.eu/europe2020/Pro files/Pages/TheLisbonStrategyinshort.aspx.

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question for the European Union. A much-debated 3% arbitrary limit on the fiscal deficit was allowed to be condoned in the economic downturn with the view that as the economy recovers, the focus could be shifted to balancing the books. Member states which were going to undertake a fiscal expansion were asked that by December 2008, they shall submit an updated Stability or Convergence Programme entailing the intended measures to reverse the fiscal expansion. The Commission would then have gone through the details of these programmes and advised accordingly to bring the fiscal discipline in the medium to long term. It was quite interesting that while there was an acknowledgement of economic difficulty and emphasis on fiscal measures, there was also a huge emphasis on fiscal consolidation and withdrawal of the stimulus. In addition to the fiscal consolidation, there was an emphasis on the structural reforms so that the economies could become structurally strong ability to deal with the crisis. For structural reforms the solution suggested were improving the market functioning, competitiveness, linking wages with productivity, curbing inflation, reducing the regulatory and administrative burden on business. This was the definition of structural reforms and there was a fairly clear hint of what was coming. In the absence of exchange adjustment, all the burden was going to be pass through structural reforms and these market reforms would mean a cold-turkey solution. There were four areas of the Lisbon Strategy which were declared focus of the Plan these were people, business, infrastructure and energy, research and innovation. For People, the Commission proposed easing the criteria for European Social Fund (ESF) and advance payment setting up from early 2009 of the amount which could be up to e1.8 billion. This amount of staggering e1.8 billion which was a fraction of the EU’s annual national income was to be used for skill-upgrading, business start-ups, community financing, etc. There were also proposals by the Commission to revise the rules on European Globalisation Adjustment Fund with the rationale that it can co-finance training labour with the skills which might be needed when the economy recovers. On the one hand, it was a very forward-looking and future-oriented idea, but recovering the economy was the question and the biggest challenge. For the support of businesses, particularly SMEs and micro-enterprises, the European Small Business Act was intended to be implemented on urgent basis. The Plan urged that the state aid should be focused on R&D, innovation, ICT, transport and energy efficiency. The EIB put together a package of e30 billion for lending to SMEs which was an increase of about 10 billion.

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There was a billion here and a billion there for mid-size cooperation and through EIF’s mezzanine finance facility. There was some removal of barriers to start-up businesses, removal of preparation of accounts for micro-enterprises, the capital requirement of European private company to one euro; accelerating the adoption of the European private company statute so SMEs can operate cross-border under a single set of corporate rules, acceptance of e-invoice by the public bodies and paying the SMEs in one-month cycles, reduction in the patent fee of 75 and 50% reduction the EU trademark fee. As the numbers suggest it was clearly not a huge injection. There was an emphasis in the Plan on the Trans-European Networks (TENs), high-speed ICT networks, energy interconnections or European electricity grid and pan-European research infrastructure. An amount of e5 billion was proposed for the trans-European energy interconnections and broadband infrastructure projects. At the same time, the intention was to be within the budgetary limits and financial envelope. The European Investment Bank (EIB) was to increase its financing by e6 billion for investments in tackling climate change, energy security and infrastructure. Furthermore, the focus would also be on the Risk Sharing Finance Facility to support the R&D activities and the Loan Guarantee Instrument for Trans-European transport (TEN-T). The European Bank for Reconstruction and Development was also aiming to double its effort with mobilisation of private sector financing of about e5 billion to fund the climate and infrastructure projects. There was also an envelope of e5 billion jointly funded by the Community, the EIB, industry and member states were planned for the “European green cars initiative”. In addition to that, there was a CARS21 initiative for the procurement of clean buses and vehicles. The “European energy-efficient buildings” initiative has an envelope of e1 billion. Under the factory of the future initiative to support EU manufacturing particularly by SMEs, there was a planned envelope of e1.2 billion and for High-speed Internet, there were e1 billion by the Commission. So, in nutshell, a few billions here and a few billions there was too little in terms of the comparative size of these expansionary doses and aggregate economy of the European Union. There was also an expression of commitment to the WTO rules, but in a world, which is severely hit by the crisis, the aggregate demand was suppressed everywhere. For the candidates of the membership including Western Balkans, there was e120 million put in place under the “Crisis Response Package” and from International Financial Institutions an

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amount of e500 million in loans was to be leveraged. There was an intention to build neighbourhood partnerships, so integration in the form of a new Eastern Partnership and Union for the Mediterranean, close cooperation with USA, Japan, Canada as well as China, India, Brazil and Russia. There were also nice things in the Plan like Millennium Development Goals (MDGs) and helping the developing countries and doing things like food aid facilities and Overseas Development Assistance (ODA). The Commission called on the European Parliament as well as all the Heads of States to lend their support for the European Economic Recovery Plan. How much has been delivered on the four areas of priority (people, business, infrastructure and energy, research and innovation) since the Plan in 2008 till the date is crucial in terms of assessing the performance of the European Union. As it was agreed and accepted benchmark by the Commission itself. To reiterate, “Europe will above all be judged on results ”. But before we go to the result card of the Eurozone’s economic performance, we shall also look at the fiscal manoeuvres by the EU member states.

Fiscal Manoeuvres in Limited Space German Fascination with Balancing As in the European Recovery Plan, the emphasis was on the member states and the ECB to take stimulative actions. They both acted, fruitfully or not is debatable. I have covered the ECB’s actions at length in the earlier sections and also the stimulative plan by the EU, so let’s look at the country level response. Starting with the German economy which is the largest economy in Europe. IKB Deutsche Industriebank and Sachsen LB had become the victims of the sub-prime mortgages due to exposure to the toxic assets it had invested. It was bailed out mainly by the KfW bank which is state-owned and hence by the taxpayers who picked the bill. About 1/4th of the European bank’s write-downs were German by the end of September 2008. Among these were approximately 2/3rd of public or quasi-public sector banks. There were two large private banks Hypo Real Estate and Commerzbank which have also asked for assistance through the financial stabilisation package put in place by the government. There was a crisis not only the banks, but the German real economy was faced with the significant downgrade of its growth forecasts. From November 2008 to January 2009 the future outlook for the German

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economy turned out to be bleaker. The IMF projection was showing an economic contraction of about 2.5% in the year 2009 while arguing that still there was some room for fiscal stimulus. Particularly, considering the expected fall in the export demand of German products due to global slow down, cautious German household with the saving behaviour and drop in investment and most importantly the confidence which underpins all the decisions meant that there was a Keynesian moment. Germany, like many other economies, was going to be the victim of the Paradox of thrift, though it may not be the first in terms of succession (Fig. 4.2). Earlier in November 2008, Germany had announced a Mickymouse fiscal stimulus, where it was going to take some small stimulative steps by committing to e12 billion spendings which were expected to yield an investment of e50 billion investment over a couple of years. I think the expectations were a bit too optimistic with such a large multiplier effect. However, there was a slow awakening to the crises and in January 2009, there was a commitment to spend e50 billion. Again, too little too late. According to the Ashoka Mody (2009) from IMF:

Fig. 4.2 Loss of Confidence. High frequency indicators were rescaled to range between 0 and 100 (Source IMF https://www.imf.org/en/News/Articles/ 2015/09/28/04/53/socar012209a)

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Germany is going through a wrenching economic phase, and 2009 is now projected to be the most severe downturn that the German economy suffered in the last 60 years.

The suggestion by the IMF was that Germany shall have a stimulus of about 1½ to 2% of GDP which was a bit more than the German declaration but still with hindsight IMF suggested stimulus was not gigantic either. It is worth acknowledging that Germany was neither running a large fiscal deficit or a huge debt balance. In fact, it was running a large trade surplus which was giving it room to manoeuvre. But more than the room, it was the question of will! The structural reforms, wage restraint and fiscal discipline both at the private and public level in the pre-crises period had given the German economy competitiveness and strength. As the crises hit, it was time to use these muscles built in good times. But the coalition government of Mrs. Merkel’s Christian Democratic Union (CDU) in alliance with the Social Democratic Party (SPD) was more keen on achieving a balanced federal budget in the next couple of years than a huge fiscal stimulus (Fig. 4.3). The crisis increased the difficulty for the financial sector and particularly banks and their capacity to lend the Financial Market Stabilisation Fund was a useful tool, however, the issue was not mere lack of liquidity

Fig. 4.3 German Export-Led Growth (Index: 1995 = 100) (Source IMF https://www.imf.org/en/News/Articles/2015/09/28/04/53/socar012209a)

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in the domestic market. There were international repercussions for one of the most open economies in the world. The first was of course the lack of global demand which was going to hit the German exports but also the financial integration and exposure of the German financial sector to the rest of the world was posing severe challenges. According to IMF calculations, in the period from June 2007 to September 2008, German banking sector exposure to emerging markets via loans and credit derivatives increased about 100% reaching $450 billion which was equivalent to 4% of all German banking assets and 12% of all German banks’ crossborder claims. This is showing that it was not only the monetary and/or fiscal sides, but there were also issues on the financial regulatory side. I will revert to it in the latter part of this treatise. According to the former IMF Managing Director Dominique StraussKahn5 : “In Europe especially, they are still behind the curve,” Strauss-Kahn said. “There needs to be more done on the spending side, especially because the reaction of the economy to more spending is quicker than the reaction to a decrease in taxes ”.

German stimulus was slightly above the coordinated stimulus of 1.2% of GDP suggested by the Commission in the European Recovery Plan. But if we consider the leading indicators, it was not enough at all. German exports fell by about 10% in November 2008, it was the largest month on month drop in decades. There was also a contraction of over 1.6% of GDP in last quarter of 2008 which was followed by a contraction of 4.7% in the 1st Quarter of 2009. Of course, it is easy to criticise now but for an export-based economy, it was not rocket science to comprehend that unless the domestic demands substitute the shortfall in external demand, there is going to be a huge hit. The IMF forecast which has not been historically very impressive suggested a decline of German GDP by −2.5% in 2009.6 Later, it turned out to be −5.7%, the worst economic performance of the German economy since WWII. Basing on its forecast, the suggestion by the IMF staff was to have a stimulus of about 2% of GDP, i.e. equal to the 80% of the amount of contraction expected in 5 Dominique Strauss-Kahn (2009). 6 For “The German fiscal stimulus package in perspective”, visit https://voxeu.org/art

icle/german-fiscal-stimulus-package-perspective.

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the German GDP. By this matrix, with hindsight we can say that with a contraction of −5.7% the number would have been around 4.6% of German GDP or based on 2007–2008 GDP of US$ 3.752 trillion, stimulus should have been US$ 172.59 billion (approx. e127 billion) at that time. Anyway, the stimulus was even short of the amount proposed by the IMF staff with concerns about achieving fiscal stability. Nonetheless, designing a fiscal package that could be more stimulative was also an issue as the most effective and immediate response can be through public investment whereas measures to induce private investment and consumption do not work that well in a severe downturn. Sometimes in life, one has to take a step back to leap forward. This was something a bit difficult for Germans to comprehend. Putting the IMF advice aside, it was the German money to be spent on Germany by the German government, but unfortunately, Germany was hesitant to change the course due to the smooth sailing and achievements it had on the fiscal and economic front in the run-up to the crisis. But there was an iceberg and the Titanic of German fiscal discipline heading to the destination of a balanced budget was to be slowed down, but unfortunately, it did not, which resultantly led to damaging the real economy.

French Finance for Financial Sector Coming to the other European economies, France the second-largest economy of Eurozone also got affected by the first wave of the Global Financial Crisis and similar to the other developed economies it had the financial sector which was both the cause and the first casualty of the crisis. Franco-Belgian bank Dexia had to be bailed out to the tune of e6.4 billion. The French government agreed to a e10.5 billion to be handed over to the six largest banks in exchange for guarantees on lending to households and firms. A gigantic e360 billion banks rescue package was also announced. An amount of e40 billion was to be used for recapitalisation of the banks while e320 billion was to be used in the form of interbank loan guarantees to overcome the credit crisis. Mr. Sarkozy made it clear that the banks will be saved from collapse and savours will not lose a single Euro. Stock market and Cotation Assistée en Continu or CAC—40 index responded positively to the news. In that climate, an interesting development occurred as the European Commission intervened by blocking the French government’s efforts to recapitalise the six

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main retail banks.7 Initially, then the EU’s Competition Commissioner Ms. Neelie Kroes was unsuccessfully persuaded by Christine Lagarde to lift the Veto on e10.5 billion support package. But Ms. Kroes was adamant that the state aid cannot be used in a manner that can help banks prop up their lending. The French were not very happy about it as they were quite intuitively holding the view that in the presence of a frozen interbank lending market, the banks will reduce the lending to the real economy which will have a catastrophic impact. French intention was to provide support of e10.5 billion to BNP Paribas, Société Générale, Crédit Agricole, Caisse d’Epargne, Banque Populaire and Crédit Mutuel so that in 2009 they can increase their lending by 3–4% to households, businesses and local governments. Anyway, the push has come to shove and in the midst of crisis, the European Commission and the European Competition Commission and its commissioners were the last to be the package spoiler, hence, after some revisions, the support package was eventually passed. The revisions included the issuance of preferred stock by the banks as collateral to the monetary support they were getting, this was in addition to the subordinated debt and conversion of existing debt into equity. Despite this support and steering banks’ lending, the aspect of nationalisation of the French banks was avoided which is interesting and has an implication that as compared to the real economy the financial sector is rather more preferable to be dealt by the private sector in France.8 For the real economy, perhaps maybe not as generous, the government of Mr. Sarkozy chipped in and announced a stimulus of about e26 billion which did not even make 1.5% of the French economy. This was despite the fact that there was a recognition of a significant problem in France and the rest of the world. Then the French finance minister, later the Managing Director of the IMF and most recently the President of the ECB, Christine Lagarde as well as Prime Minister Francois Fillon clearly stated that there is going to be a significant contraction of Global, Eurozone and French economy. There was an obvious collapse in French industrial production. Yet, the measures taken were too little! Mr. Patrick Devedjian was appointed as the in-charge of the Recovery Plan or made Recovery Minister. It is worth noting that it was the time when

7 Brussels blocks French bank bail-out, available at https://www.ft.com/content/7e7 f0ec6-bd72-11dd-bba1-0000779fd18c. 8 See Ben Clift (2012).

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Mr. Nicolas Sarkozy from Union for a Popular Movement a centre-right party was in power so it shall not be surprising that the fiscal prudence and conservativeness in spending (even for the name’s sake) was to be the part and parcel of every policy. The choice of projects included in the Plan was not inappropriate. It included money for transport and energy, research and innovation, education, support industry particularly the auto sector. The stimulus package was expected to lift the economic growth by about 0.6% while there was an open recognition by the IMF and the Finance Minister Christine Lagarde that the growth is going to decline by −2%, so in a nutshell, there was still a gap of 1.4%. Logically, one should have done more to fill this gap. There were concerns that the increased spending would increase the deficit to about 3.9% of the GDP but it was worth every Euro as in the absence of stimulus the contraction of the economy was going to be larger and that would imply that the decrease in GDP will further exacerbate the deficit to GDP ratio. There was not much emphasis by anybody to stick to the 3% deficit limit and the EU has lenient on that in the midst of crisis. To facilitate the investment a package of e11.5 billion to the companies in the form of tax breaks and credits was released which would be investing in 2009. So, the notion was to encourage the companies to bring the investment plans forward. Logically, a very good thing, but when the times are bad the tax incentive is good but not good enough. One would rather like to make a profit and pay taxes than make a loss and not pay taxes. Hence, the supply-side reforms are helpful but when there is high uncertainty it’s difficult to lift the confidence unless the “investor of last resort ” the government with its fiscal instruments puts in. According to the report by the IMF in July 2009, in France, the policies had softened the downturn, yet the recovery was still expected to be sluggish. The banking sector was weathering the storm but there were crucial risks. In this environment, the fiscal policy was to play its part to counter the crisis, though once again the suggestion by IMF was to safeguard the sustainability of public finances. By that point, the forecast was downgraded downwards, so now instead of −2%, there was an expected drop of −3% in the GDP in 2009. Unfortunately, the IMF’s forecast accuracy was not too bad, and it turned out to be −2.9%. To Anne-Marie Gulde, then the IMF mission chief in France, “France’s generous social safety net has protected domestic demand, and the country’s limited reliance on exports has shielded it from the worst effects of falling global demand”. Of course, social security can protect the domestic demand to a level but that was not a solution, the solution is to

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kickstart the economy and put the people back in work. Not having too much dependent on export may shield you from harm but trade is not a zero-sum game, still, you would get hurt as there is no completely closed economy in the world, and particularly in the EU. Strong social security and lack of export can also put a drag when you want to recover, one will have to rely on domestic and foreign investment which may not come when the times are tough. So once again the buck stops at the fiscal policy. The financial system and banks were comparatively in better shape but still just in comparative terms. They were still adversely affected by both the bad outlook of the French and global economy and the global financial sector which was the very liberal French financial sector was exposed to.

Spanish Stimulus Generosity with Design Flaw Spain was not the largest economy in the Eurozone, but the Spanish government behaved more generously and still put in quite a bit in terms of fiscal efforts. Indeed, referring back to the fiscal space for the Eurozone countries in the beginning of the crisis, there was a reasonable amount of fiscal space for Spain to play. The debt to GDP ratio at the time of crises was below 40% and this was not only at the time of crisis since the year 2000 Spain had a very robust fiscal outlook. The fiscal deficit was also below 3% and hence Spain was ticking all the boxes on the list of fiscal stability. There was a huge room for the fiscal policy within the limit of the Stability and Growth Pact. A fiscal space of 20% of GDP without breaking the fiscal rule was in sight. Besides, this fiscal prudence of public finances, on the private side the things were slightly different and less promising. Indebtedness of Spanish household continued to increase in the years preceding the GFC, it increased from 80% of disposable income in 2003 to 130% in 2008. Nevertheless, the debt burden of non-financial cooperation as % of gross operating surplus also increased from four to seven hundred per cent in this period.9 In that environment, the fiscal policy was more or less the only game in the town. So, the stimulus came, but not 20% but 9% of the GDP in 2008–2009. This included 6% in the form of expenditure and 3% in the form of tax cuts. The other countries had a greater emphasis on expenditure than tax cuts, indeed cutting the taxes by 3% of GDP is a bit of a cut. This is just basic logic cutting the taxes cannot

9 Serrano (2010) for “The Spanish fiscal policy during the recent ‘great recession’”.

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be necessarily stimulative, one can simply put the money he got from tax cuts into the savings, particularly when the times are not good. In the difficult time and high levels of private indebtedness, the more probable scenario is deleveraging rather than expansion. Increased uncertainty also makes the household and business more risk-averse. Spanish stimulus was poorly designed. Tax reforms included corporate and income taxes which are obviously procyclical. When the profits and incomes are low, you don’t have as much to pay in taxes anyway. So, this was the one design flaw in the Spanish fiscal stimulus. An increase in the salary and wages of public servants was not a good way of doing it either. Particularly, when you have uncertainty and a highly leveraged household. So, in response to the fiscal stimulus, the increase in consumption was very modest, i.e. 0.1%, whereas the savings rate increased sharply by 3%, reaching 13%. The fiscal programmes to stimulate the aggregate demand were launched such as Fondo Estatal de Inversión Local and Fondo Especial para and la Dinamización de la Economía y el Empleo. Interestingly, in February 2009, the European Commission on its follow up of countries who have exceeded the deficit by more than 3% of GDP in 2008 including France, Spain, Italy, Greece and Malta, argued that the Spanish case is not exceptional as there was no economic deacceleration. Hence, Spain was to reduce its deficit by 2012 and in so doing, it shall have a rebalancing of 1.25% of GDP each year. The forecast the Commission was relying on was projecting −1% GDP contraction in 2010 and unemployment of about 20%. The forecast can be either wrong which happens most of the time or you are just lucky once in a blue moon! So, as we got the numbers now, the Spanish economy contracted by −3.8% in 2009. Therefore, the European Commission’s criticism of the Spanish violation of the 3% fiscal rule was simply wrong. The forecast was also wrong in 2010 where the economy started to show signs of recovery by growing 0.2% year on year basis. But this was not really the growth, it was a very modest recovery and not ample enough to fully compensate for the output losses in 2009. Yet, it gave a sense of euphoria, the crisis was over, and the economy was on the path to recovery. So, it was not really more fiscal dose but the fiscal restraint and there where the things started to go wrong. In the next three years 2011–2012 and 2013, the Spain economy contracted by −0.8, − 3.0 and −1.4%, respectively. The unemployment rate also increased to 21.4, 24.8 and 26.1% in 2011–2013. Having more than 1/4th of the workforce out of work means a lot. The OECD unemployment rate in this period remained around 7.9% which has always been lower than the

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Spanish unemployment rate but during this period 2011–2013, the gap widened unprecedently. In 2007 Spain had an unemployment rate of 8.2% while the OECD total was around 5.6%, so a gap of about 2.6%. But unfortunately, during 2011–2013 this gap increased where the Spanish unemployment was 13.5, 16.9 and 18.2% higher than the OECD total. In a nutshell, poorly designed Spanish fiscal stimulus which focused on tax cuts, slow response from the ECB and in cutting taxes, increase in the saving and increased uncertainty were the causes of high unemployment and economic contractions that prevailed in the later years. There was a fascination with fiscal discipline and the term discipline was meant to not freely flex the fiscal muscles. The faith was more in the monetary policy and monetary stance which as I discussed earlier, at the Union level could not fully compensate.

Italy Wrong Side of Business Cycle Coming to Italy, the third-largest economy of the Eurozone which was also carrying one of the largest burdens of sovereign debt as the Global Financial Crisis hit. Although the private sector was not highly leveraged, and the banks were relatively stable, the Italian government was holding the debt well in excess of 100% of its national income or GDP. Italian government had been running the deficit for a long time and in 2008, the deficit was about −2.6% of GDP which obviously got worsened with the crisis and in 2009 increased to −5.1%. But as the scale and intensity of the Global Financial Crisis increased as it unfolded in the last quarter of 2008, the intention of the Italian government wanted to be more fiscally prudent and reduce the debt level from over 100 to 95% of the GDP in the period 2009–2011. In August 2008, based on the projections suggesting that the following years will bring positive economic growth, it was expected that the deficit will almost be diminished by 2011. Unfortunately, the opposite happened. Italy which was just about to set up on the journey to fiscal discipline had to change its course very soon. Stimulus package was introduced in November 2008 which included transfers to low-income households and support to businesses, but these measures were financed through the increase in revenues rather than borrowing or cutting spending elsewhere. There were controversies about the exact amount of effective stimulus, although Mr. Silvio Berlusconi after the G20 meeting announced an e80 billion fiscal stimulus package, the critics argued that it is not the correct figure. In fact, this is the repackaging

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of old money where most of it consisted the comprised spending of EU funds for the environment, research and development and infrastructure. A further sum of e10 billion was expected in the form of investments by toll-road operators for which they were allowed to increase the toll charges. These were all pies in the sky! There were other estimations of the actual size of the Italian stimulus which ranged from e3 to e5 billion only. Minister Giulio Tremonti then the Italian finance minister, tried to send the message of confidence to the consumers and workers but there was so little in terms of real action. By the size of the Italian economy in 2008, there was a stimulus of over e35 billion need to meet the EU wish of 1.5% of GDP. But this was not the advice going to be followed. Mr. Tremonti was concerned that losing the tight fist of finances may lead to an increase government’s bond yields and higher borrowing costs. The yield on Italian sovereign debt has already started to increase and the gap with the German ten-year bond had been widened from 25 basis points in 2007 to 170 points in January 2009. This was a sign of deterioration of trust by the markets in the Italian sovereign and Mr. Tremonti wanted to improve it by signalling prudence. Later in February 2009 further stimulus was given in the form of a car scrapping scheme. Further actions were taken in the form of strengthening the social safety net and tax incentives on machinery purchases in the following year from June 2009. In the mid-year budget revision that occurred in July 2009, there was a temporary boost given to the consumption and public investment which was about 0.3% of GDP. This was the only deficit-increasing boost or stimulus as before this all the measures were intended to be financed through an increase in revenues. The budget of 2010 which was approved in December 2009 did include some increase in expenditure, however, it was supposed to be met by the increase in taxes. Taxes were voluntary capital taxes which included a substitute tax on asset revaluations (0.3 and 4% of GDP in 2009 and 2010, respectively) and a tax on assets held abroad illegally (0.5 and 0.2% of GDP in 2009 and 2010, respectively). Seemingly, these types of taxes do not cause much negative impact on the economy as compared to other forms of taxation. This is due to the reason that they have an aspect of compassion and voluntarily on the part of those who are already quite rich and does not cut their consumption due to paying these taxes. Yet, there shall be very little hope one should have attached to the impact of these measures in the face of crisis. As we got the numbers now, it is clear that despite the intended fiscal prudence, the Italian debt to GDP increase from 106% in 2008 to 127% in 2011.

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Deficit which was tried to be controlled by not increasing expenditure also increased from −2.6% in 2008 to −5.1% in 2009, −4.2% in 2010 and −3.6% in 2011. So, what was the point of being “so-called prudent in the midst of crisis ”. Notion of Expansionary Fiscal Cont raction was being debunked. Italians were on the wrong side of the economic cycle. Debt was exceeding the double of debt limit of 60% of GDP under the Stability and Growth Pact. There was no growth and no stability neither in the economy nor in the government finances. So, where it went wrong for Italy? It went wrong for Italy in the same way as it went wrong for the rest of the Eurozone countries. They did two things wrong. First, they underestimated the scale of the crisis which led them to do less than what was required at each step. This is what I have explained on the monetary front in the previous chapter and one by one failure of each trick the ECB tried. Second, Europeans forgot the simple lesson that the financial crises and recessions are sharp and free fall, but the recovery is a slow and steady process. Forgetting this lesson led them to jump the gun. As there were some minor signs of containing the economic downturn and financial instability, in the Stability Programme that the Italian government submitted to the EU Commission in April, it aimed to adopt a budget that entailed a deficit reduction of about 12 billion in 2011 and 25 billion in the year 2012 and 2013 each. As I explained in the last para, the projections about the deficit were wrong. On the sovereign debt, which slightly declined from 2009 to 2010, a drop of about 1% of GDP (125.6% to 124.4%), it was projected that it will be continually falling to 116.3% in 2014. But as it turned out, it continuously increased and reached 155.5% of GDP in 2014. The fiscal prudence backfired and instead of diminishing, the debt and deficit increased while the only thing which decreased was the economy.

Netherland’s Robustness but Not Rapid Recovery Coming to the other members of EMU, the Netherlands had a reasonable fiscal outlook at the time of crisis in 2008 with the debt to GDP below 60% of GDP. In November 2008, the Dutch government decided to launch an economic stimulus of e6 billion (about 1% of GDP) aiming at supporting the businesses. It also spared e13.75 billion to support the financial system, this was in addition to purchasing the Dutch part

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of Fortis Bank for e16.8 billion.10 Later in March 2009, the government proposed a further package of e6 billion for 2009 and 2010. This money was to be spent over six years. Dutch municipalities and provinces had additional e1.5 billion to invest. As obvious, the notion was that these plans will lead to boosting consumption as well as the economy by e50 billion. The focus was on the job market where the part-time unemployment benefits were expected to help saving against job losses. Plan included investment in sustainability, energy security, renewable energy and innovation. Proposals included scraping the old cars and home insulations, infrastructure and construction including schools and hospitals. the stimulus package was in addition to the e80 billion spent in September 2008 to support the banking sector. There was recognition by Prime Minister Jan Peter Balkenende that these measures were costly, but he also declared them “necessary and defensible given the economic situation”. However, similar to the other European counterparts, the Dutch showed an intention to recover this spending as soon as 2011. A commitment to reducing the deficit by 0.5% was intended to be stipulated in the act of Parliament. In addition, to the short-run expansionary and medium-run consolidatory fiscal plans, the reforms in the pension age with an increase from 65 to 67 years and more taxes on house purchases were announced. Despite the stimulus to the financial sector, the aspect of financial reforms was untouched. There were no changes announced in the supervisory functions of the De Nederlandsche Bank (Netherlands central bank) or the Autoriteit Financiële Markten (Authority for the Financial Markets) the financial watchdog. Despite the strength and competitiveness of the Dutch economy and fiscal stimulus, five years later, both the employment and household consumption were still about 5% below their pre-crisis peak and it took them a while before they started to recover at a very modest pace.11 A strong position in world trade can only be counted as a strength if your trading partner and customer are strong enough.12

10 For “Netherlands: New Stimulus Package”, visit http://www.loc.gov/law/foreignnews/article/netherlands-new-stimulus-package/. 11 For “Why is the Netherlands doing so badly?” visit https://www.ft.com/content/ 7a3f30dd-51ff-38c1-8a1a-bf0d8140f19f. 12 For “The Global Financial Crisis and its effects on the Netherlands”, visit https:// ec.europa.eu/economy_finance/publications/pages/publication16339_en.pdf.

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Britain’s Early Withdrawal and Austerity The UK, then the second-largest economy in the European Union and the reluctant bridge of Europe also took some expansionary measures and called upon other countries to take a similar stance. It included income tax cuts, reduction in the value-added tax (sales tax), Small Enterprise Loan Guarantee Scheme and bringing some investments forward from 2010. Plans were unveiled to guarantee up to £20 billion of loans to small and medium-sized firms, the Conservative Party which was in opposition at that time did oppose the scale of the plan suggesting a bigger package of about £50 billion. There was also a car scrap scheme where a subsidy of about £2000 was given on the purchase of a new car which involved scraping a car more than ten years old. There were also some investments in skills and training for the young and unemployed. The government plan included the Working Capital Scheme that was supposed to secure up to £20 billion of short-term bank lending to firms with a turnover of up to £500 million. The Enterprise Finance Guarantee Scheme was to secure up to £1.3 billion of additional bank loans to small firms with a turnover of up to £25 million and Capital for Enterprise Fund with £50 billion from the government, plus £25 million from the banks, to invest in small firms that need cash. However, all these schemes did not live up to the plans. I will not go into the details of these schemes, but the number of businesses failures was about 18% higher in 2008 and 2007 which manifested the lack of support and the difficulty of the economic climate. But besides the real economy, one of the biggest challenges for the UK was its gigantic financial sector. So, on the 8th October 2008 (on my birthday to be precise) a bank rescue package of £500 billion was announced by Alistair Darling, then the Chancellor of the Exchequer. This included the Bank debt guarantees, short-term loans by the Bank of England, treasure injection in addition to the support for the failing or falling Northern Rock which had already been brought in government ownership. At this juncture, I must acknowledge that by not joining the Euro, UK had preserved its monetary policy sovereignty so, unlike the ECB, the actions were swift and with unanimity (Fig. 4.4). British banks were required to increase their capital and for this purpose, the government agreed to provide the necessary support. Government established a Bank Recapitalisation Fund and the Bank of England Special Liquidity Scheme also started to reduce its policy rates the Bank Rate to 0.5% by March 2009. The UK’s rescue plan did not

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Fig. 4.4 Rescue Plan for UK Banks Unveiled, How Big is the Bailout? (Source BBC http://news.bbc.co.uk/1/hi/business/7658277.stm)

include only the provision of liquidity but guarantees and capital which in its true spirit was more supportive of addressing the problem of solvency and recapitalisation. Without much delay and controversy, the Bank of England also launched its assets purchased programme which by the writing of this para stands around £895 billion. Starting in March 2009, the stock of assets purchased reached £375 billion in July 2012, postBrexit it was increased to £435 in August 2016 and after the outbreak of COVID-19 it has been further increased to £895 billion. I will cover the aspect of COVID-19 and its devastating impact on Europe in the later part of this book. Coming back to the response of the UK to the Global Financial Crisis, it would be fair to give the UK the credit for being the most proactive in its response. Other countries including the USA and Eurozone followed, though as I said before, the response of EMU was slowest than its counterparts which led it to continuously undershooting of its targets of stimulating economy and employment growth, particularly in the periphery.

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While the UK did do quite well to stabilise its gigantic financial sector and keep the financial order, it did make a mistake on the fiscal front. The general election of 2010 brought the centre-right Conservative Party in government in coalition with the Liberal Democrats, this marriage led to years of fiscal consolidation and Austerity.13 The Conservative Party is known for its fiscally conservative agenda, so the emphasis was on balancing the books. In parallel, the events in the Eurozone and European Sovereign Debt Crisis also provided support to the political rhetoric of being fiscally responsible and cutting government spending. What followed was the decade of Austerity in the UK which to some led to very modest growth and increasing inequality while the fiscal deficit could not be completely diminished. Brexit or British exit from the European Union membership is also often associated with the Austerity and resulting sense of deprivation in some communities of Britain. I won’t go into the details of it as it is beyond scope of this treatise, but with hindsight, it’s clear that the too soon withdrawal of fiscal stimulus and Austerity in the UK neither helped her nor its European counterparts. In addition to the EMU and UK, other countries, including the G-20 members took a stimulative stance, but as soon the Global Financial Crisis smoke started to settle there were two more tragedies waiting to happen. On this side of the channel, it was the British plan of Austerity while on the otherwise it was the European Sovereign Debt Crisis. To recap, while there was not much done at the Union level except the Recovery Plan which was more passion than action, there was too little too late, poorly designed and the hesitant response of fiscal authorities in the EU to the Global Financial Crisis. Jumping the gun on withdrawal of stimulus, fascination with the balancing books and faith in Austerity did not help either!

13 For “Cutting the deficit: three years down, five to go?” visit https://www.ifs.org. uk/publications/6683.

CHAPTER 5

A Jigsaw of Financial Institutions and Unions Within Union

European Financial Stabilisation Facility/Mechanism (EFSF/M) In addition to steps taken by the European Central Bank and sovereign states that I discussed in previous sections, there was still more to be done as the existing apparatus to deal with the crisis at the Union level was almost non-existent and the ECB with its limited remit and internal tensions could only do so much. So, to start with, in May 2010, the Council of European Union agreed to European Financial Stability Facility (EFSF) to address the European sovereign debt problem and safeguard financial stability.1 In the press release by the Council of European Union, it was stated that The Council and the member states decided on a comprehensive package of measures to preserve financial stability in Europe, including a European Financial Stabilisation Mechanism (EFSM), with a total volume of up to EUR 500 billion.

Greece was condemned by the European Commission and the other members of the Euro family which were not happy about the falsification 1 Extraordinary Council meeting, details can be found at https://www.consilium.eur opa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/114324.pdf.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6_5

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of fiscal statistics by Greece. It was not the first time, previously Greece had cut corners and also at the time of joining the Euro, innovating accounting was done by massaging the statistics. I have covered this in the earlier parts of this book. While the Greek data was not factual, the fact on the ground was that the markets were shaking. As I once heard Canadian clinical psychologist Jordan Peterson quite rightly saying that trust is the most important factor in the economy, perhaps the same holds true for the society and world of finance. The Greek crisis was causing financial instability therefore it was deemed important to have a European Financial Stability Mechanism through which Greece can be supported so that the risk of financial contagion can be contained while the fiscal consolidation can also be accelerated. This was once again a very paradoxical and selfconflicting stance of the EU, similar to the European Recovery Plan. For some reason, there has always been this necessity to express the intention of being accommodative and at the same time consolidating. Anyway, following the approval of the Eurozone member states, the Commission signed the support agreement. The Council supported what was called the “ambitious and realistic” consolidation package. Commitment to fiscal sustainability and economic growth in all states was reiterated and it was emphasised that for this purpose fiscal consolidation and structural reforms should be accelerated. Council welcomed the commitment of Portugal and Spain to fiscal consolidation (Austerity) in 2010–2011 which they were intended to present on 18 May ECOFIN Council. This was interesting as on the one hand, the economies of these countries had not yet fully recovered from the Global Financial Crisis, but the emphasis was given on fiscal consolidation. The Council of European Union in its press release at the time of EFSF’s inception following the extraordinary meeting also emphasised the importance of progress on financial market regulations and supervision, fiscal reforms and crisis resolution framework. I will revert to these aspects later. Decision to establish the European Stabilisation Mechanism (ESM) was also announced by the Council of the European Union where it was argued the ESM is based on the agreement of Eurozone member states and Article 122.2 of the Treaty. The article reads as follows: Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the Member State concerned.

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The President of the Council shall inform the European Parliament of the decision taken. (Article 122.3: TEFU)

There was no natural disaster, but the occurrence was exceptional and at that point beyond the control of Greece. Initially, a volume of e60 billion was foreseen through the European Financial Stability Mechanism (EFSM) where the funds are raised on financial markets, guaranteed by the European Commission. While through European Financial Stability Facility (EFSF) a Special Purpose Vehicle, the euro area members states were to complement resources of up to e440 billion (in accordance with their share in the paid-up capital of the European Central Bank), later in June 2011, the scope of EFSF was widened by increasing the guarantee commitments to e780 billion. The notion was to achieve the highest possible rating by providing a guarantee of up to 165%. Enlarged EFSF also implied guaranteeing the capital as well interest payment which also implied that with the increase in coupon payment on bonds issued by EFSF the guarantees would also increase. In November 2011, it was decided that the EFSF can guarantee 20–30% of the bond issues of struggling peripheral economies. Furthermore, it was hoped that the money can be attracted from other investors to purchase bonds. There were concerns that even all this may not be enough. Management of EFSF has been under Mr. Klaus Regling, a German economist acting as the chief operating officer and board members from Eurozone member states. The EFSF has been able to issue bonds and debt instruments to finance the funding needs of sovereigns and recapitalise banks. The issuance was backed by the Eurozone member state in the share of their paid-up capital in the Euro system. This paid-up capital or capital key is something of extreme importance and can be a key to many ills of EMU , anyway I will revert to it later in the book. The IMF was also expected to participate in financing arrangements and provide fifty per cent of the EU contributions, so an additional around e250 billion implies a financial package of about e750 billion. What was the most interesting and somewhat strange aspect of the ESM was that its activation was based on conditionalities where it was linked to the EU/IMF joint support with terms and conditions similar to the IMF. A Eurozone member state facing hardships in borrowing from the market was to make a request after which a programme was to be negotiated with the European Commission and the IMF and unanimous approval

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was required by the Euro Group before the EFSF can act. Requirement of unanimity brought the EMU to an interesting juncture when Slovakia, a comparatively very small member of the Euro family voted down the EFSF, though, the share of Slovakia in the capital key and hence in EFSF was not even 1%, compared to Germany with over 27% contribution. Nonetheless, the majority of risk was on the shoulders of AAA-rated countries and their taxpayers for the original e440 billion. The question raised by the Mr. Richard Sulik President of Slovakian Parliament (National Council) was that: How can there be any justification for a state of affairs where a poor but rule-abiding euro-zone state must bail out a serial violator with twice the per capita income, and triple the level of the pensions — a country which is in any case irretrievably bankrupt? How can it be that the no-bail clause of the Lisbon treaty has been ripped up? 2

Compromise is name of the game that often happens in the EMU, hence after some internal politics and power struggle which led to the agreement on early elections, the EFSF was ratified. I will not go into the details of this incident as it is obvious that Slovakia could have not resisted the pressure from the other member states. Who wants to be the party spoiler? The interesting bit was that among all these Europeans, the involvement of IMF meant that it is was not a party where only Europeans were invited. But most crucially, this implied that the EU was not capable of handling crisis on its own and the treatment of Greece was not as a member of the United States of Europe but as a sovereign nation. I must acknowledge Lord Adair Turner here for raising this point and drawing a parallel with the United States of America where no state seeks help from IMF and neither the Federal government becomes a party. EFSF achieved the rating of AAA in September 2010 which made it qualified to be used in the ECB refinancing operation. Though, as I discussed earlier the bar of rating was lowered when the push came to shove, after Greece first bailout, Ireland became the recipient of financial assistance of about e85 billion in November 2010. Problems for Ireland were in its real estate sector where the prices quadrupled just in a decade

2 “Slovakia’s reluctant EFSF vote reflects deep unrest” available at https://www.market watch.com/story/occupy-the-euro-zone-bailout-fund-2011-10-14.

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from 1997 to 2007. This was a manifestation of sub-prime and aggressive lending and speculation. Of course, that meant that the Irish banking sector was also in hot water. The Irish government has to save the banking sector by providing guarantees but that was a bigger bite than it can chew. Unit labour cost and competitiveness had also been eroded and with the Global Financial Crisis and associated Great Recession, the international economic outlook was not great either. Therefore, it had to request for assistance. EFSF issued its inaugural bonds of five years amounting to e5 billion in January 2011 which were well received by the markets. Despite the return of less than 3%, the demand was more than supply, significantly from the Asian investors. The e5 billion issuances attracted orders of over e44 billion, this was a clear sign of demand for safe assets. The financial assistance is also an assistance in confidence, and it enabled Ireland to come back to the bond market with a 5-year issuance in July 2012. In April 2013 the loan maturity was extended from 14 to 21 years and by the end of the same year, the assistance programme was concluded after extending long-term loans and very low-interest rates. The total e67.5 billion entailed e17.7 billion from EFSF, e22.5 billion from EFSM, e22.5 billion from IMF and e4.8 billion in bilateral loans from the UK, Sweden and Denmark. Ireland had been a good boy and in Mr. Klaus Regling words, Irish determination is an inspiration for the other Eurozone countries. All the evaluations by Troika showed compliance. Not too long after Ireland, the Portuguese asked for assistance in April 2011. Due to weak economic performance, the Portuguese economy was not in a good shape to start with. A package of e78 billion was agreed in May 2011, through the EU/IMF. The EFSF was activated in June 2011 with first and second issuances of e5 and e3 billion. These issuances were also fairly well received. As I mentioned before, a month later, more room was created in the EFSF where the capital guarantees were agreed to be increased from e440 to e780 billion and the over-guarantees of 65% were given by the AAA guarantors. Given that the recipients of EFSF (Greece, Ireland and Portugal) were not qualified to act as guarantors, the total size of capital guarantees came down to e726 billion which was still substantial as for as the requirements of the periphery were concerned. In its essence, the pillar of confidence and capital guarantees were the six AAA-rated Eurozone countries (Germany, France, the Netherlands, Austria, Finland and Luxembourg). There were concerns about the size of the EFSF and European Commission President Jose Manuel Barroso did “urge a rapid re-assessment of all elements related to the EFSF, and

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concomitantly the ESM [the European Stability Mechanism], in order to ensure that they are equipped with the means for dealing with contagious risk”. The second round of bailout for Greece led to shifting Greek jurisdiction bonds of about e164 billion to EFSF. In the first round of assistance or First Economic Adjustment Programme for Greece which is a good name, Troika (European Commission, ECB and IMF) through the Greek Loan Facility (GLF) and Stand-By Arrangement (SBA). Following a request for international financial assistance from Greece, a joint EC/IMF/ECB mission visited Athens from 21 April to 3 May 2010. On the 2 May, a staff-level agreement for a joint euro area/IMF financing package of e110 billion was concluded. On the same day, the Eurogroup agreed to activate stability support to Greece via bilateral loans centrally pooled by the European Commission. On 9 May the IMF Executive Board approved a Stand-By Arrangement. On 18 May 2010, the euro area member states disbursed their first instalment of e14.5 billion of a pooled loan to Greece, following disbursement of e5.5 billion from the IMF. In May 2010 loans from Eurozone brought e52.9 billion and IMF provided support of about e20.1 billion in the form of loans. The EFSF was established a bit later therefore did not play the part in this assistance at that stage. The financial assistance came as usual in the form of tranches and the Greek government had to agree to the Austerity plan and balance the books. As the EFSF was established later on, in the second bailout it played its role which including remaining committed amounts from the first bailout, amounted to e172.6 billion (e144.6 billion from EFSF and e28 billion from IMF) making the total to around e245.6 billion. Payments from EFSF were used to finance the e35.6 billion of PSI (private sector involvement a.k.a private sector haircut) restructured government debt. A sum of e48.2 billion was used for bank capitalisation, e11.3 billion for debt buy-back and about e49.5 billion were to be used for government budgetary requirements. With the notion to lighten the debt burden of Greece, its debt held by private investors (mainly banks) was restructured in March 2012. About 97% of privately held Greek bonds (about e197 billion) took a 53.5% cut of the face value (principal) of the bond, corresponding to an approximately e107 billion reduction in Greece’s debt stock. This was a huge haircut, and a lot of burden was definitely taken off from Greece’s shoulders. The bond holders were encouraged by the EFSF to participate in the restructuring. As the part of two facilities, the EFSF bonds were provided to Greece. First, the PSI

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facility where as the part of the voluntary debt exchange, Greece offered investors 1- and 2-year EFSF bonds. These EFSF bonds, provided to holders of bonds under Greek law, were subsequently rolled over into longer maturities. Second, Bond interest (accrued interest) facility—to enable Greece to repay accrued interest on outstanding Greek sovereign bonds under Greek law which were included in the PSI. Greece offered investors EFSF 6-month bills. The bills were subsequently rolled over into longer maturities. In a nutshell, the Greek bailout involved debt restructuring and haircuts which meant investors and creditors agreeing to something rather than nothing.

European Stability Mechanism (ESM) The EFSF was a special purposes vehicle that was agreed to support the troubled Eurozone countries. But there was a need for something more substantial and established with legal basis, a mutually agreed permanent mechanism. Therefore, the Treaty Establishing the European Stability Mechanism led to the establishment of the European Stability Mechanism (ESM) in September 2012. In this regard, Article 136 of the Treaty on the Functioning of the European Union (TFEU) provided the legal base for ESM. The article suggests that the Council shall adopt measures specific to those member states whose currency is the euro: (a) to strengthen the coordination and surveillance of their budgetary discipline, and (b) to set out economic policy guidelines for them, while ensuring that they are compatible with those adopted for the whole of the Union and are kept under surveillance. For these measures, only those countries whose currency is Euro were allowed to vote. The Article states that “the Euro members may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole”. Furthermore that “the granting of any required financial assistance under the mechanism will be made subject to strict conditionality”. Hence, the Article created legal room for a mechanism that can be used to provide financial assistance to member states in need. This was also somewhat necessary as the EFSF was based on Article 122 of the TFEU which as I stated earlier allowed financial support in case

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of “severe difficulties caused by natural disasters or exceptional occurrences beyond its control ”. The exceptional occurrence is somewhat vague and there was no natural disaster under which the support could have been extended. Therefore, it was open to debate if the EFSF was at odds with Article 125 and the “no bailout ” clause. Although there was no great appetite for another treaty which obviously means more integration by closing the loopholes in the existing arrangements, at least not in Britain. In my own view which is supported by the evidence on the evolution of the European Union, all the treaties and all the Articles are not only amendable and replaceable but also interpretable according to the convenience when and if required. This is what happened, and the Treaty was approved by the European Parliament, the European Commission played a central role, the European Court of Justice ruled that “the right of a Member State to conclude and ratify the ESM Treaty is not subject to the entry into force” of TFEU amendment. So, the treaty was concluded by the Eurozone member states where the UK stayed out of it. There was no requirement for the referendum, so the element of democracy was put under the carpet. There was some critique of ESM on the political level but given that the public engagement was limited to non-existent, it did not come across significant opposition due to no potential political loss to the governing parties of creditor nations. Treaty was to come into force if the member states constituting 90% of the capital requirements ratify according to their constitutional requirements. This implied that the German endorsement with lion share in capital contribution fulfilled the requirement. Doors of ESM were remained open to their members of EU and future Eurozone members subject to their acceptance in the Euro club. Starting its operation in October 2012 with a maximum lending capacity of e500 billion and located in Luxemburg, the purpose of ESM is to act as a rather more permanent source of financing to member states facing hardships. It replaced the EFSF and EFSM though they continue to handle the previously approved financing for Greece, Ireland and Portugal. Mr. Klaus Regling CEO of EFSF took over the responsibilities of ESM’s managing director. Any candidate state desiring financial assistance through ESM was to agree to a Memorandum of Understanding (MoU), entailing reforms to restore the financial stability or in simple words Austerity. Furthermore, requesting state is also required to ratify the European Fiscal Compact. Initially, the EFSF and ESM were focusing on providing financial support to the sovereign states, however, instruments have been put in

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place to directly support the financial institutions in need. The ESM has a toolkit with various instruments including Loans within a macroeconomic adjustment programme, Primary market purchases, Secondary market purchases, Precautionary credit line, Loans for indirect bank recapitalisation and Direct recapitalisation of institutions. The direct bank recapitalisation framework was put in place for the systemic banks which may require additional financial support after bail-in by the private investors and support by the Single Resolution Fund. Among these tools, loan as part of a macroeconomic adjustment programme has been used by Greece, Ireland, Portugal and Cyprus. Loans for indirect bank recapitalisation have been only used for Spain. By the writing of this passage, all other instruments remain unused (Table 5.1). After Greece, Ireland and Portugal, the small island country and one of the youngest member Cyprus was also facing assistance needs, but, instead of Troika, the first dose of assistance came from Russia in the form of e2.5 billion bilateral loans in December 2011. This support proved to be too little and in less than a year Cyprus was seeking further assistance from Troika. Cyprus had joined the Euro-club in 2008 and hence been lucky in a sense that it joined the family of wealthy members which could support him in the crisis. The Cypriot banking sector was in trouble and afraid of capital flight Cyprus put strict capital control. This was a clear violation of EU treaties that categorically abstain from capital controls. Anyway, very soon the help came, and the first dose of ESM financial assistance came in May 2013. The initial estimates of support were about e17.5 (e10 billion for bank recapitalisation, e6 billion for debt refinancing and e1.5 billion for budgetary requirements). However, closer of the Laiki Bank and bailin of the Bank of Cyprus lead to deal reaching at e10 billion where e1 billion from IMF and e9 billion from ESM. In return, Cyprus had to agree to structural reforms which included usually suspected remedies such as fiscal consolidation and measures to increase competitiveness. In June 2014 Cyprus returned to the bonds market and in April 2015 capital controls were fully lifted after two years of restrictions. Not before too long in March 2016, Cyprus concluded the ESM programme. Portugal had already concluded the EFSF programme in May 2014 after return to the bond market in January 2013. Its loan maturity was also extended by 7–21 years, though Portugal made an early repayment of e2 billion suggesting a stronger fiscal position. Despite being severely affected by the Global Financial Crisis, the request for financial assistance from Spain came a bit later than other

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Table 5.1 ESM: Lending toolkit Instrument Recipient Objective

Conditionality

Monitoring

Instrument Recipient Objective

Conditionality Instrument Recipient Objective

Conditionality Instrument Recipient

Loans within a macroeconomic adjustment programme Ireland, Spain, Greece, Cyprus To assist ESM Members in significant need of financing, and which have lost access to the markets, either because they cannot find lenders or because the financing costs would adversely impact the sustainability of public finances ESM loans are conditional upon the implementation of macroeconomic reform programmes prepared by the European Commission, in liaison with the European Central Bank and, where appropriate, the International Monetary Fund Same institutions are entrusted with monitoring compliance with the agreed programme conditions for economic reform. The ESM Member is obliged to cooperate with this monitoring and enable the ESM to perform its financial due diligence. If the country deviates significantly from the programme, disbursements may be withheld Primary market purchases Unused ESM may engage in primary market purchases of bonds or other debt securities issued by ESM Members at market prices to allow them to maintain or restore their relationship with the investment community and therefore reduce the risk of a failed auction. This can complement the regular loan instrument or a precautionary programme. The purchase will be limited to 50% of the final issued amount No additional conditionality beyond the underlying programme Secondary market purchases Unused To support the sound functioning of the government debt markets when lacking market liquidity threatens financial stability in the context of a loan either with a macroeconomic adjustment programme or without if the Member’s economic and financial situation is fundamentally sound For ESM Members not under a programme, specific policy conditions will apply Precautionary credit line Unused

(continued)

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Table 5.1 (continued) Objective

Two types of credit lines

Monitoring

Instrument Recipient Objective

Eligibility

Conditionality

To support sound policies and prevent crisis situations from emerging. It aims to help ESM Members whose economic conditions are sound to maintain continuous access to market financing by strengthening the credibility of their macroeconomic performance Both can be drawn via a loan or a primary market purchase, have an initial availability period of one year and are renewable: • Precautionary Conditioned Credit Line (PCCL): available to a Member State whose economic and financial situation is fundamentally sound, as determined by respecting six eligibility criteria such as public debt, external position or market access on reasonable terms • Enhanced conditions credit line (ECCL): access open to euro area Member States whose economic and financial situation remains sound but that do not comply with the eligibility criteria for PCCL. The ESM Member is obliged to adopt corrective measures addressing such weaknesses and avoiding future problems in respect of access to market financing. The ESM Member has the flexibility to request funds at any time during the availability period When an ECCL is granted or a PCCL drawn, the ESM Member is subject to enhanced surveillance by the EC. Surveillance covers the country’s financial condition and its financial system Loans for indirect bank recapitalisation Spain To preserve the financial stability of the euro area by addressing those cases where the financial sector is primarily at the root of a crisis, rather than fiscal or structural policies The beneficiary Member State should demonstrate an inability to: • Meet capital shortfalls via private sector solutions • Recapitalise the institutions without adverse effects for its own financial stability and fiscal sustainability. The institutions should be of systemic relevance or pose a serious threat to the financial stability of the euro area or its Member States. The ESM Member should demonstrate its ability to reimburse the loan Will apply to financial supervision, corporate governance and domestic law relating to restructuring or resolution

(continued)

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Table 5.1 (continued) Monitoring

Instrument Recipient Objective

Eligibility

Conditionality

The EC enforces compliance with EU state aid rules and also monitors other policy conditions with the ECB and the relevant supervisory authority Direct recapitalisation of institutions Used To help remove a serious risk of contagion from the financial sector to the sovereign by allowing the direct recapitalisation of institutions. The total amount available for this instrument is limited to e60 billion. The instrument is relevant for banks (systemically important credit institutions), financial holding companies, and mixed financial holding companies as defined in relevant EU legislation Eligible if the following situations apply: • They are or are likely to be in breach of the relevant capital requirements and are unable to attract sufficient capital from private sector sources to resolve their capital problems • Burden-sharing arrangements, such as bail-in (fully applicable in 2016), in the Bank Recovery and Resolution Directive, are insufficient to fully address the capital shortfall • They have a systemic relevance or pose a serious threat to the financial stability of the euro area as a whole or the requesting ESM Member • The institution is supervised by the ECB • The beneficiary Member State should also demonstrate that it cannot provide financial assistance to the institutions without very adverse effects on its own fiscal sustainability, and that therefore the use of the indirect recapitalisation instrument is infeasible Will apply, addressing the sources of difficulties in the financial sector and, where appropriate, the general economic situation of the ESM Member. Additional institution-specific conditions will also apply

Source ESM If the table can be used as at the source. https://www.esm.europa.eu/assistance/lending-toolkit#len ding_toolkit

recipients of EFSF/ESM. The real estate bubble burst came along the Global Financial Crisis 2008/09 led to huge losses to the Spanish economy and banking sector. The house prices which had almost tripled in the decade before the crisis were to adjust and this meant a huge cost to the economy and financial system. The Spanish government decided

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to support and restructure its banking sector. I have already discussed the stance of the Spanish government and its fiscal policy earlier. Initially, Spain was relatively in a better position and the years preceding the crisis had brought the bonanza. The Global Financial Crisis has ended the party. In July 2012 Spain requested assistance as the markets were asking for higher returns making it too expensive to borrow. A sum of e100 billion was made available to the Spanish government though it only needed e41.3 billion. Spain concluded the programme in December 2013 and in fact started to repay its loan in July 2014 which implied that it was rather in a stable position. Ireland, Portugal, Cyprus and Spain have been good boys’ bit better than Greece who was the largest recipient of the bailout money. With the Syriza party in power, in January 2015 Greece announced to change its stance on Austerity. But, they have to face the reality very soon as Greece failed to pay SDR 1.2 billion (about e1.5 billion) repayment to IMF. The bailout money runout as the Greek financial assistance programme of EFSF expired end of June 2015. Consequently, it implied that the last EFSF loan tranche of e1.8 billion will not be available and the e10.9 billion to cover the potential cost of bank recapitalisation or bank resolution in Greece will be cancelled. Mr. Klaus Regling, CEO of the EFSF expressed his disappointment declaring it regrettable that despite the good progress by Greece there was no follow-up programme agreed. Under the expiring programme, EFSF had disbursed e141.8 billion to Greece. It included e48.2 billion to cover the costs of bank resolution and recapitalisation. Out of this amount, e10.9 billion in EFSF notes was returned to EFSF, therefore, the outstanding loan was about e130.9 billion. Furthermore, it was not required to pay any interest until 2023 on a large part of its debt which according to ESM helped Greece saving e16 billion in 2013 and 2014. Yet, due to the expiry of EFSF and hence by not paying IMF and running an arrear, Greece joined Somalia, Sudan and Zimbabwe. This was the place Greece was, and the club Greece had to belong had it not been to the membership of an elite sovereign club, the Eurozone. Greece had to put its action in order before too long, the Euro Summit July 2015 associated further support to Greece and assistance from ESM

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with the Greeks taking responsibility.3 It was also emphasised in the statement that came out from Euro Summit that A euro area Member State requesting financial assistance from the ESM is expected to address, wherever possible, a similar request to the IMF. This is a precondition for the Eurogroup to agree on a new ESM programme. Therefore, Greece will request continued IMF support (monitoring and financing) from March 2016.

Troika was united and Greece was to go back to IMF and be a good boy. Greek authorities agreed to take measures without further delays. These included tax and pension reforms, independence of Hellenic Statistical Authority or ELSTAT, operationalisation of Fiscal Council, spending cuts, an overhaul of civil justice system, etc. This led to the ESM board of governor in August 2015 approving up to e86 billion in financial assistance to Greece over three years. First disbursement of e13 billion was immediately made available. The money was and has been abundant subject to Greece obedience. In December 2015, out of e10 billion kitty separately held at ESM to support the Greek banking sector e2.72 billion was released to recapitalise Piraeus Bank. This was after an assessment of four systemic Greek banks carried out by the European Central Bank’s Single Supervisory Mechanism (SSM) which suggested that there was a shortfall of e4.93 billion at Piraeus Bank. Out of this gap, Piraeus had raised e1.94 billion from private means and an additional e271 million from capital actions where the bondholders voluntarily exchange their bonds into equity. A few days later, ESM provided e2.71 billion to recapitalise the National Bank of Greece (NBG) which had a gap of e4.6 billion as identified by the SSM. Out of this gap, NBG had covered e1.5 billion by private means and e120 million through its operations. Furthermore, there was a bail-in of e302 million in the form of preference shares. In January 2017 short-term debt relief measures were approved by ESM and EFSF for Greece. Overarchingly, these measures entailed reducing the risks of interest rate rises for Greece. That is quite interesting as it implied that in future if the rates increase, Greek’s huge debt with long maturity would not cause her any burden. It was hoped that these measures would lead to a reduction in the debt to GDP ratio 3 Euro Summit Statement—Brussels, 12 July 2015, available at https://www.esm.eur opa.eu/sites/default/files/2015-07-12_euro_summit_statement_on_greece.pdf.

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for Greece being 20–25% lower than otherwise by the year 2060. Yes, 43 years later! That was a hell of a forecast but it’s obvious that benefits were for Greece. In August 2018, Greece successfully concluded the so-called ESM programme through which out of a maximum of e86 billion, a sum of e61.9 billion was distributed by the ESM over three years in support of macroeconomic adjustment and bank recapitalisation. The remaining e24.1 billion were not needed. To reiterate, Greece had already received e141.8 billion from the EFSF between 2012 and 2015. The total amounted to e203.77 billion which is exceptional and unprecedented as well as the long maturity of these loans and very modest interest rates which according to ESM saved Greece 12 billion in interest each year. Not to forget, between 2010 and 2012, Greece received e52.9 billion in bilateral loans to Eurozone member states under the Greek Loan Facility. For these treasures, Greece had to introduce Austerity which led to about a 25% decrease in public sector employment and a 30% fall in public sector wages. If we compare it with the amount of money made available to Greece in addition to over a e100 billion straight haircut or debt forgiveness, it seems quite generous and fair to Greece. At the time of leaving the ESM programme, Greece had enough cash buffers to manage itself for the next couple of years. However, the main question is if concluding the programme means everything is settled? In fact, no. The early Warning System of ESM implies that it will continue to monitor Greece’s progress and performance of its economy. For Greece, there is a long way to go though it seems that the debt relief programme will contribute to facilitating Greece as long as it behaves. There is no benefit from chest-beating! Greek debt is a problem of its creditors mainly ESM and those who hold the largest capital key. As of November 2011, EFSF approved medium-term debt relief for Greece which entailed conditional abolition of the step-up interest rate margin, a deferral of interest and amortisation by 10 years on e96.4 billion of EFSF loans and extension of the maturity of some of its loans. This implied that Greece will not start repaying most of its until 2033. The step-up margin of 2% which is related to e11.3 billion loan instalment of EFSF financial assistance used to fund a debt buy-back in 2012, under the short and medium-term debt relief measures, the margin had been reduced to zero since 2017. There have been reimbursements of step-up interest margins every six months of about e103 million and the total reimbursement and reduction of step-up interest margin for Greece amounted to a e1 billion in one package.

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Support to Greece and other recipients of the EFSF/ESM is generous and by no measure comparable with the Market lending. Markets are brutal! But here we have very long maturity dates and repayments of principle also start in far future, for instance, Cyprus was required to start paying in 2025 whereas Ireland in 2029. Similarly, other recipients were given extended dates for repayments at very generous rates. I don’t think any private investor would be that benevolent and patient as this implies starting to pay the principle on a date longer than a usual business cycle. According to the ESM’s own to claim, there were e18.2 billion accumulated savings for the 5 programme countries in 2019 as a result of EFSF/ESM financing. The average interest rate charged by ESM on loans (Q2 2020) is about 0.76% which is very modest. Furthermore, there was a targeted bond issuance of e11 billion in 2020 while about e410.1 billion i.e. over 80% of the ESM lending capacity still remains. As it stands, there is about 42.5 years maximum weighted average maturity of EFSF loans to Greece. About 70.6% percentage of the total external financial assistance for Greece is provided by EFSF/ESM. While by the end of the 2020 first quarter, 52.7% of Greek public debt was also held by EFSF/ESM, in December 2015, the longest ESM bond was issued with a maturity of 40 years. This would have not been possible with the creditworthiness of the member states which had been recipients of these funds in the open market. In fact, a developing non-eurozone country could not even dream of such a luxury. Nonetheless, those members of the EU who were not in the Eurozone had also been supported through other channels such as the Balance of payments (BoP) assistance facility. Under this facility Hungry, Latvia and Romania have been provided assistance from the European Community in collaboration with the IMF and other financial institutions. For instance, the agreement was reached to provide Hungary with e20 billion in multilateral financial assistance. This entailed, e6.5 billion from the European Community, around e12.5 billion from the IMF and e1 billion from the World Bank. Although Hungary received e14.2 billion in total including e8.7 billion from IMF and e5.5 billion EU and did not draw from World Bank, the support was there. The conditions were as usual fiscal discipline and structural reforms. In December 2008, a e7.5 billion package was agreed for Latvia where European Community was to contribute e3.1 billion, IMF around e1.7 billion and remaining from other countries and financial institutions like European Bank for Reconstruction and Development and the World Bank. In May 2009 an agreement was reached with Romania for

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e20 billion through the EU, IMF, EIB and the EBRD. Thereafter, the Balance of Payment precautionary assistance programmes have also been run to support Romania’s external balance. Indeed, there is a benefit for the small states in joining the Euro club. As we clearly witnessed in the case of Greece and other periphery countries, when the markets refused to lend the European institutions performed the lender of last resort role. But even when the membership of the European Monetary Union is not achieved, being a member of the EU certainly brings some benefits and easy money.

Outright Monetary Transactions (OMT) In addition to the EFSF/EFSM and ESM, there are a set of actions taken by the ECB which had direct and indirect bearing on the public finances of the Eurozone. I have covered these policies and actions in the earlier sections. Among these, Outright Monetary Transactions (OMT) and favourable view of sovereign debt as eligible collateral by ECB gave a significant cushion to the public debt of struggling economies. Particularly the OMT which entailed ECB buying sovereign bonds in the secondary market was with the view of lowering the yield of countries facing financial stress and seeking financial assistance through EFSF/EFSM. The country in question had to have access to the capital market funding through the new long-term debt issuance i.e. 10-year bond to private investors. Therefore, it was more a matter of lowering the yield than simply bailing out the state whose debt issuance attracts no investors. One may question that why a forward-looking investor would not be attracted knowing that if he buys the newly issued debt there will be a big buyer in the form of ECB. Hence, this factor was obviously important in terms of restoring confidence, though it may also put a question on the logic of conditionality of access to the capital market. But as the yield of the periphery, most significantly Greece was skyrocketing where Greek’s 10-year bond had a yield of over 33%, it was clear that markets were not trusting the creditworthiness of Greece. Therefore, the OMT was the selected tool to tell the markets that big buyer ECB is the town. Yet it was not until April 2014 when Greece returned to the bond market with a new issuance of e3 billion. The only opposition to the OMT was a vote by the President of the Bundesbank who raised concerns that the OMT implies crossing the lines between fiscal and monetary policies by intervening in the sovereign debt

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market. I think this was so, however, the Governing Council had different ideas and was emphasising on the linking of OMT with the conditionality of activation of a European Stability Mechanism (ESM) adjustment programme. Despite the German concerns, the European Court of Justice which is the European Court of Justification in my view justified the decision of the Governing Council. It ruled that the OMT “does not exceed the powers of the ECB in relation to monetary policy and does not contravene the prohibition of monetary financing of EU nations ”. An overarching view of the decisions of the European Court of Justice suggests that their decisions are always in favour of integration and more EU. Anyway, the OMT was adopted and conditions to qualify were to be a recipient country of financial support through ESM/EFSF which I said earlier also required conditions of its own. In its essence, the announcement of the OMT was an assurance that the ECB will stand ready to buy the debt of sovereign states struggling to borrow in the competitive market, so the private sector investors should be confident of the presence of a big buyer with no budget constraint in the market.

Financial Stability in the EMU and the European System of Financial Supervision (ESFS) The Global Financial Crisis and European Sovereign Debt Crisis magnified the fault lines in the EMU, its financial institutions and infrastructures. Besides the common monetary or single monetary policy, the financial policy which entails supervising and regulating financial institutions was very much left to the national authorities. Therefore, a high-level group chaired by the de Larosière reported in February 2009 (de Larosière report) and urged for the development of a more harmonised set of financial regulations. It was stated in the de Larosière group’s report (the “de Larosière report”) that, a Member State should be able to adopt more stringent national regulatory measures considered to be domestically appropriate for safeguarding financial stability as long as the principles of the internal market and agreed minimum core standards are respected.

So, there was a principle of at least meeting the minimum core standards on integration and harmonisation, if you go the extra mile that

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is even better. On the aspect of future European supervisory architecture, the European Council in June 2009 also emphasised the need to establish a “European Single Rule Book” applicable to all credit institutions and investment firms in the internal market. To fill the fault lines in European Financial architecture and achieve more harmonisation and integration, the framework of the European System of Financial Supervision (ESFS) was approved in September 2010 consisting of European Supervisory Authorities (ESAs), the European Systemic Risk Board (ESRB), Joint Committee of the European Supervisory Authorities, ECB and national level supervisory authorities in the EU. The reason to establish ESFS was to increase the harmony and efficiency of the single market functioning through a synchronised common regulatory and supervisory framework that is applied across the EU. There were three European Supervisory Authorities (ESAs) which started to work from 1 January 2011. These include (i) the European Banking Authority (EBA) which was to deal with banking supervision and issues around bank recapitalisation (ii) the European Securities and Markets Authority (ESMA) whose job was to supervise the capital markets and (iii) the European Insurance and Occupational Pensions Authority (EIOPA) to supervise the insurance industry. European Banking Authority (EBA) was created with the aim that it will identify the weaknesses in the European banking system and in so doing it will do its assessments and stress testing. It took over the role of the Committee of European Banking Supervisors (CEBS) which was established in 2004. Headquartered in London, CEBS consisted representation of national supervisory authorities and central banks of the European Union. The CEBS was mere an advisory group parallel to the Committee of European Securities Regulators and the Committee of European Insurance and Occupational Pensions Supervisors. It was part of Lamfalussy process legislation process which was a four-step framework of legislation. I will not go into its details but the scope of CEBS was very limited, hence, the EBA was brought to replace it in a hope that it will do a better job. Initially based in London as it replaced CEBS, the EBA was later moved to Paris in November 2017 after Brexit. The EBA has more authority in the sense that it can play a bit more active and influential role if the notional regulators do not do a good job in regulating their banking sector. Furthermore, EBA is expected to prevent regulatory arbitrage which can lead to a competitive banking sector in the EU. In so doing, EBA aims for the establishment of a single set of rules

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or Single Rulebook and these prudential/banking rules are applied across the EU in a transparent and harmonised manner. It was also mandated to conduct assessments and stress testing to explore the vulnerabilities in the European banking sector. EBA also promotes consumer protection in the area of financial products and services that are provided by financial institutions. In discharging its duties, EBA could produce Binding Technical Standards (BTS) which are endorsed and adopted by the European Commission. In terms of governance structure, EBA has two governing bodies. First, the main decision-making body i.e. Board of Supervisors (BoS) which takes all policy decisions including draft technical standards, guidelines, opinions and reports. It brings together the supervisors of all EU members states with the voting right but also non-voting members including the Chairperson of the EBA, representatives of the Commission, the ESRB, the ECB, EIOPA and ESMA as well as observers from Single Resolution Board (SRB) and supervisors from EEA (European Economic Area) and EFTA (European Free Trade Area) countries. In a nutshell, every stakeholder is taken on board. Second is the Management Board which ensures that the Authority carries out the tasks assigned to it. EBA also issued a Common Reporting (COREP) framework for Capital Requirements Directive reporting which have been adopted by a number of financial institutions. EBA has issued a significant number of directives and regulations including the capital requirements framework.4 All the directives and regulatory infrastructure applied across the EU contributes to the notion of the Single Rulebook as well pan-EU approach to banking supervision. The EBA is equipped with the technical resources to contribute to the EU-wide risk assessments and stress testing to identify the structural weaknesses in the banking sector of the EU, in so doing, it collaborates with the ESRB, ECB and the Commissions. The Supervisory Review and Evaluation Process (SREP) framework helps supervisors in

4 Consisting of the capital requirements directive (CRD IV) and the capital requirements regulation (CRR), the bank recovery and resolution directive (BRRD), the deposit guarantee schemes directive (DGSD), the revised directive on payment services (PSD2), the mortgage credit directive (MCD), the payment accounts directive (PAD), the regulation on key information documents for packaged retail and insurance-based investment products (PRIIPs), the fourth anti-money laundering directive (AMLD), the electronic money directive (EMD), the EU market infrastructure regulation (EMIR), the financial conglomerates directive (FICOD), the directive on central securities depositories (CSD), the markets in financial instruments directive (MiFID II) and the interchange fee regulation (IFR).

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the harmonised assessment of risk profiles of financial institutions across the EU. Lastly, the EBA also contributes to the harmonisation of the resolution framework through its Resolution Committee (ResCo), investigates alleged breaches or non-applications of EU law and mediates to settle disagreements between competent EU authorities in cross-border situations. Second European Supervisor Authority (ESA) created under the European System of Financial Supervision was the European Securities and Markets Authority (ESMA). It was based on the recommendation by the Frenchman de Larosière report in 2009. As of January 2011, the ESMA replaced the Committee of European Securities Regulators (CESR) which was established in 2001 and whose role as the name suggests was to coordinate among securities regulators in the EU along with advising the Commission and contributing to the implementation of legislation. Similarly, ESMA is what it says on the tin, its objectives are to protect the investor, smooth functioning of Markets and contribute to Financial Stability. To achieve these objectives, among others, ESMA is mandated to perform four crucial activities. First is the assessment of risks to investors, markets and financial stability. For this purpose, it capitalises on the European Supervisory Authorities (ESAs) and National Competent Authorities (NCAs) and contributes to the systemic work undertaken by the European Systemic Risk Board (ESRB). Second, it contributes towards completing a single rulebook for EU financial markets. For this purpose, it has been developing Technical Standards and provided advice on legislation to the EU. Third, it promotes supervisor convergence, to avoid regulatory arbitrage. In so doing, it collaborates with the NCAs and Central Counterparties (CCPs). Lastly, ESMA directly supervises financial entities such as Credit Rating Agencies (CRAs) and Trade Repositories (TRs). This is a necessary task due to the importance of credit rating agencies and their role in pricing risk which had come under severe criticism since the Global Financial Crisis. ESMA has made interventions to protect investors or avoid reckless behaviour in the markets, for instance, it has imposed some restrictions on retail investors participating in the spread betting contracts for difference. Third European Supervisor Authority (ESA) created under the European System of Financial Supervision was the European Insurance and Occupational Pensions Authority (EIOPA). It replaced its predecessor the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS). The CEIOPS was established in November 2003 and

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consisted of representatives from insurance and pension fund supervisory authorities in the EU. The representative from European Economic Area used to participate as observers. In January 2011 it was replaced by EIOPA which as the name suggests focused on insurance and occupational pensions. According to its own account, it is responsible for contributing to financial stability, transparency of markets and financial products and protect insurance policyholders, pension scheme members and their beneficiaries. Unlike other EBA and ESMA, the EIOPA is based in Frankfurt. So, Paris and Frankfurt are the financial and monetary capital of the EU. In addition to the European Supervisor Authorities (ESA), tasked with the Macroprudential foresight of the EU’s financial system, the European Systemic Risk Board (ESRB) was established in December 2010 to prevent the risk to the financial stability in the EU. Being a part of the European System of Financial Supervision (ESFS), the board is chaired by the ECB President and hosted as well as analytically, administratively and logistically supported by the ECB. It constitutes President and Vice President of the ECB, governors of NCBs, representative of European Commission, Chairpersons of EBA, EIOPA, ESMA. It also has the chair and the two vice-chairs of its own Advisory Scientific Committee (ASC) the Chair of the Advisory Technical Committee (ATC). Non-voting members included representatives from the competent national supervisory authorities and from European Free Trade Association (EFTA) States, President of the Economic and Financial Committee (EFC), Governors of NCBs of Iceland and Norway, representative of the Ministry of Finance of Liechtenstein. In a nutshell board is quite broad and high-level representative of all stakeholders. Board is responsible for the macroprudential oversight of the EU financial system and the prevention and mitigation of systemic risk. It has a broad remit, covering banks, insurers, asset managers, shadow banks, financial market infrastructures and other financial institutions and markets. In the overarching measures, Commission also proposed enhancing the capital requirements by increasing both quantity and quality of capital in the light of BASEL-III standards. This implied applications of the rules on over 8000 banks which holds over 50% of the global assets. In addition to these measures, as I discussed earlier, bank restructuring has also been carried out, particularly in the countries which obtained assistance under the EFSF and ESM. Deposit guarantees were also provided e100,000 per depositor if a bank fails. The area of shadow banking and credit

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Fig. 5.1 The three pillars of the banking union (Source The Oesterreichische Nationalbank [OeNB], https://www.oenb.at/en/financial-market/three-pillarsbanking-union.html)

rating agencies which has not been focused on before was also brought under attention. There are three crucial pillars of the Banking Union that the Commission envisaged these are a Single Supervisory Mechanism, a Single Resolution Mechanism and a common system for deposit guarantees (Fig. 5.1).

Single Supervisory Mechanism (SSM) The European Banking Authority (EBA) along with the other European Supervisory Authorities (ESAs) under the umbrella of the European System of Financial Supervision were established and since Jan 2011 been working to improve the coordination among supervisors of banks and creation of a single rule book in the EMU. EBA has also contributed to the agreement on the recapitalisation of major credit institutions in the Union. However, the supervision which was carried out by the national supervisory institutions not by the EBA needs to be carried out at the Union level. While the European Banking Authority (EBA), European Securities and Markets Authority (ESMA), and European Insurance and Occupational Pensions Authority (EIOPA) are to retain their powers and tasks, the Single Supervisory Mechanism (SSM) provided ECB with the legal and institutional framework to supervise the banks in its jurisdiction. It does so by directly supervising the large banks while indirectly supervising the smaller banks in collaboration with the national authorities. Eurozone member countries’ banks are required to participate while the

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non-Eurozone members of the EU can voluntarily participate in the SSM through “close cooperation agreement ”, though their rights and obligations would not be the same as Euro members, the participating non-euro member gets a seat on the ECB supervisory board. ECB is also to act as host supervisor for other banks active within the euro area. Responsibility of supervision in addition to the more traditional monetary authority role means that ECB has to draw a balance between two functions as also required by the SSM Regulations. In my personal opinion, this is rather a good thing for the sake of collaboration and inclusive policymaking. Since the Global Financial Crisis, the central banks have been performing the task of financial stability anyway. Drawing on the June 2012 Euro Area summit, the proposal for SSM was developed by the European Commission in September 2012 which was welcomed by the ECB declaring it as “an important step towards laying the foundations of a financial market union with the view to ensuring financial stability in the euro area and the European Union”. There was a question on the capacity of the ECB to supervise about six thousand banks single-handedly, but the reason and solution given was the joint and collaborative supervision by both the ECB and the national authorities. The ECB will have ultimate authority and responsibility of supervision to avoid financial instability and may directly supervise and intervene in even a small bank. In the Commission’s proposal, there was an acknowledgement of potential asymmetry between banks supervised by the local authorities and banks directly supervised by the ECB, but there was recognition of the importance of even small banks which can cause instability. Therefore, a two-tier system was the chosen option, considering the experience of national authorities. One of the reasons for the establishment of the SSM was to weaken the link between sovereign and national banks. Indeed, this was necessary to take the burden off from the shoulders of sovereigns and going beyond national interest, but the ground realities were not letting it become possible overnight. Supervision entails various tasks including, authorisation of all credit institutions, ensuring compliance with all prudential requirements, supervisory stress testing, imposing capital buffers when required, assessing governance arrangements, early intervention, etc. and the list goes on and on. Therefore, the national supervisory authorities are continued to assist ECB in the matters such as consumer protection, day-to-day affairs with the credit institutions and prevention of illegal activities such as money laundering of terror financing. Implementation of most of the decisions by the ECB was

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also through the national supervisory authorities. The supervised institutions are to bear the cost of supervision. How much of this collaborative approach will be successful in maintaining both resilience and efficiency is the question. Time will tell but there is also an aspect of efficient allocation of resources that can facilitate growth, but it does not seem to be the prime focus. Neither the notion that there could be differences in the socio-financial structure of different members states and whether one size will fit all? But these deep questions are hard to answer with a broad brush! There have been concerns raised about the participation of national supervisors in the board, however, the composition of the board of SSM can be viewed in a positive way. Having members from national-level supervisory institutions means sharing good or bad ideas and practices. Furthermore, there are also chair, vice-chair and representatives from the ECB which can ensure that the views of all stakeholders are heard. Given the fact that the final decisions are taken by the ECB’s Governing Council, the SSM draft decisions are crosschecked. In September 2013 European Parliament and a month later, European Council gave approval of SSM which led to the ECB starting its role in November 2014. In this capacity, ECB started to directly supervise about 130 financial institutions which hold about 85% of the banking sector assets in the Eurozone.5 Banks deemed significant or Significant Institutions (SIs) are directly supervised by the ECB and to be significant, it has to meet at least one of the five criteria: (i) value of assets exceeds e30 billion (ii) value of assets exceeds e5 billion and its 20% of the GDP of the country in which it is located (iii) it is among the 3 biggest banks in the country (iv) it has large cross-border activities (v) it has received or applied for assistance under EFSF/ESM. So basically, being a Significant Institution (SI) means being big, a new slogan could be too significant to fail ! There has been a gradual approach taken in the implementation of SSM. Supervision entails stress testing and assessments which if requires can lead to intervention. First comprehensive supervisory review was published by the ECB in October 2014. This covered the 130 institutions (including 3 Lithuanian institutions) with assets around e22 trillion constituting over 80% of assets in the eurozone banking sector. The report included the Asset Quality Review (AQR) and the capital shortfalls. Designed by the EBA, to pass 5 Regulatory Brief available at https://www.pwc.com/us/en/financial-services/regula tory-services/publications/assets/fs-reg-brief-eu-bonus-cap-crd-iv-emir-aifmd.pdf.

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the stress tests, a bank was required to maintain a minimum CET1 ratio of 8% in the baseline scenario and CET1 ratio of 5.5% in the adverse case. Results based on assets position as of 31 December 2013 suggested that most of the banks sailed through. Out of 25 banks that could not make it, there were 9 Italians, 3 Greek and Cypriots, 2 Belgian and Slovenians, whereas only 1 bank from Austria, France, Germany, Ireland, Portugal and Spain. These undercapitalised banks can pose substantial challenges to the financial stability therefore those which could not meet the criteria by the publishing of the report were asked to increase their capital buffers. In terms of its progress, the report by the Commission to the European Parliament and the Council in November 2017 concluded that “the establishment of the Single Supervisory Mechanism was overall successful ”.6 Furthermore, the Financial Sector Assessment Programme (FSAP) of the IMF, convergence checks by the European Banking Authority (EBA) and the reviews by the European Court of Auditors (ECAs) were also welcomed. The Commission’s Communication on Completing the Banking Union was aimed for by end of 2019. Though it was also acknowledged that there might be still organisational challenges ahead there was an expression of confidence that these challenges would be dealt with by the ECB and the national competent authorities. I think it was a fair assessment. Indeed, European integration is a long journey and profoundly challenging. Very acknowledgement of these challenges implies that the stakeholders are aware of them and may endeavour to address them. In the report, it was also hoped that the governance structure of the ECB would be further improved in terms of SSM through a new delegation framework which will allow intermediate level management at ECB. In simple words, with the passage of time, there would be more integration and harmonisation which in my personal opinion, whether somebody likes it or not, democratic or undemocratic, is the intended way forward. Indeed, for the Single Rulebook and harmonisation, you need integration and that involves decreasing the powers from national to union level. The issues such as around the scope of the European Court of Audit (ECA) to review ECB and the distinction between the role of ECB and NCAs were there but as on all other matters which had been settled with compromise and principle of giving and take, this 6 Report from the Commission to the European Parliament and the Council on the Single Supervisory Mechanism established pursuant to Regulation (EU) No. 1024/2013, available at https://ec.europa.eu/info/sites/info/files/171011-ssm-review-report_en.pdf.

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comparatively trivial matter was also to be settled. The SSM in its essence is a game of interaction between ECB/ESFS and National Competent Authorities (NCAs). In this interaction, the ECB/ESFS are to take over some of the NCAs in a smooth manner, they bite as much as they can chew. The concerns by any NCAs on ECB intervention in the Less Significant Institutions (LSI) shall not be a matter of surprise and hence there shall be no tension. Once you join a club you are bound by rules. But there were a few which did not have the official membership and hence the question of ECB jurisdiction remained. These were the investment firms, specifically investment banks providing “bank-like” services and/or EU branches of institutions having their head office in third countries which may pass through the loopholes and regulatory arbitrage. However, there was an acknowledgement of these issues with the hope that they will be picked up in the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR) reviews. Based on a common methodology, the application of a unitary Supervisory Review and Evaluation Process (SREP) to all Significant Institutions (SIs) merits some credit to ECB. The ECB was created well before the Global Financial Crisis and Sovereign Debt Crisis, the performance I have discussed earlier has not been extremely impressive. Well maybe it’s hard for a central bank to please one country, never mind 19, but by the narrowest mandate, the objective of price stability has hardly been achieved, though the implicit economic stabilisation is not in my view complete failure. Now if the apparatus of SSM works we will have to wait for an actual crisis. It will also be a test of the strength of the second pillar of the Banking Union i.e. the Single Resolution Mechanism.

Single Resolution Mechanism (SRM) The Single Resolution Mechanism (SRM) which is the second pillar of the Banking Union came into force in August 2014 with the notion of an orderly and efficient resolution mechanism for troubled financial intuitions supervised by the ECB and cross-border groups. At the time when the proposal for SRM was put forward by the European Commission in July 2013, the Internal Market and Services Commissioner Mr. Michel Barnier said that: the point of today’s proposal for a Single Resolution Mechanism is to ensure that supervision and resolution are aligned at a central level, whilst involving

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all relevant national players, and backed by an appropriate resolution funding arrangement, it will allow bank crises to be managed more effectively in the banking union and contribute to breaking the link between sovereign crises and ailing banks.

Global Financial Crisis had also highlighted the issues of “Too Big To Fail ” and the importance of orderly winding down of large financial institutions. This issue became a crucial part of the G-20 agenda with the key attributes for effective resolution regimes of the Financial Stability Board (FSB) in October 2011, an appropriate framework was required to orderly winddown i.e. resolution of the systemically important financial institutions. Hence, an EU’s established orderly cross-border resolution mechanism through the Bank Recovery and Resolution Directive (BRRD) provided resolution authorities with powers and tools to intervene if and when a bank meets the conditions for resolution. It required them to prepare resolution plans with details on how the underlying bank will be resolved while achieving the objectives of orderly resolution avoiding burden on taxpayers. The participants of SSM are also the participants of SRM or in simple words, those who have joined the SSM as the EMU member or as in “close cooperation” also joined the SRM. Overarchingly, the BRRD, the Deposit Guarantee Scheme Directive (DGSD), Technical Standards drafted by the European Banking Authority (EBA) and the EBA’s Guidelines form a kind of Single Rulebook for the EU for resolution planning and execution and the application of Deposit Guarantee Schemes (DGSs). The regulation SRM Regulation (EU) No 806/2014 provided regulatory justification for the establishment of SRM. But the date of 2014 does not tell the whole story as the SRM was enacted through the Intergovernmental Agreement (IGA) and quite a bit of time as the Commission put forward the proposal in July 2013 and obviously there was a significant amount of time which would have led to the proposal itself. The SRM was applied from January 2016 which is a prima facie manifestation of slow-moving European integration and Banking Union. The institutional hub or executive body of the SRM is the Single Resolution Board (SRB) which was established in 2015 and constituted of a chair, vice-Chair, four permanent members and the relevant national resolution authorities. The SRB aims to work closely with the Commission, ECB, EBA and national competent authorities (NCAs) and upon notification from ECB about a troubled bank, SRB is to adopt the resolution scheme.

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The Single Resolution Fund (SRF ) has also been established to provide the SRB with the necessary resolution tools or in simple words resources. It constitutes contributions from credit institutions and some investment firms from the EMU and hence, supposedly the financial industry contributes to financial stability. The intention has been that the SRF will be built gradually so that it could reach about 1% of total covered deposits (i.e. about e60 billion) in an eight-year time (2016–2023). This is once again a slow pace process; Rome was not built in a day neither was the SRF (Fig. 5.2). In July 2019, with cash injection of e7.8 billion from 3186 institutions for the year 2019, it reached e33 billion which is a reasonable amount of money if it is merely the matter of a single financial institution. Annual contribution to the SRF is based on a flat contribution determined based on an institution’s liabilities excluding own funds and covered deposits and a risk-adjusted contribution depending on the risk profile of that institution. This is fair in the sense that the institutions with larger liabilities may pose higher costs during its resolution. The use of SRF is only for the purpose of resolution and as last resort. Specifically, to guarantee the assets or the liabilities of the institution under resolution,

Fig. 5.2 Single resolution fund (Source Single Resolution Board, https://srb. europa.eu/en/content/single-resolution-fund)

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to make loans to or to purchase assets of the institution under resolution, to make contributions to a bridge institution and an asset management vehicle, to make a contribution to the institution under resolution in lieu of the write-down or conversion of liabilities of certain creditors under specific conditions and to pay compensation to shareholders or creditors who incurred greater losses than under normal insolvency proceedings. I must acknowledge that the purpose of SRF is not to recapitalise a bank or absorb losses. Contribution from the SRF could be made to the institution under resolution in exceptional circumstances where the eligible liability or class of liabilities is excluded or partially excluded from the write-down or conversion powers if two conditions of Bail-in of at least 8% and SRF contribution are only up to 5% of the total liabilities. Despite, the targeted hefty sum of e60 billion, there had been a consensus at the intergovernmental level that there might be times when the SRF is not enough. So, for a situation like that, a harmonised Loan Facility Agreement (LFA) was endorsed by the ECOFIN ministers in December 2015. It was agreed that the members states in the SRM will enter into the harmonised LFA with the SRB and provide a national individual credit line to the SRB to back its national compartment following resolution cases. In more simple words there is an acknowledgement that the SRF will not be ample and in fact it won’t be, in case of a systemic crisis faced by a number of European banks the sum of e60 billion which has been hoped to be accumulated by 2023 will not be ample. So, the idea the financial institutions will not have to be rescued by their corresponding national authority does not hold much water. If that is so what is the purpose of SRM? I think it will be very much down to the effectiveness of the Single Supervision Mechanism to ensure that the day does not come when a number of large financial institutions are in trouble. The history of finance is the history of financial turmoil, it is the same as hoping there will never be a political conflict in the world. Recent history shows at least some parts of the world have enjoyed peace since WWII, including Europe. But the financial stability is a luxury always found to be shortlived. Therefore, I will not be surprised if and when the day when the SRM is found to be insufficient comes in my lifetime. The other pillars of the banking union and financial stability that have been built since the Global Financial Crisis, including the European Deposit Insurance Scheme (EDIS), are hoped to be the earlier defences, but it would be sensible and less disappointing if we do not have our hopes very high.

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European Deposit Insurance Scheme (EDIS) The notion of deposit guarantees is not very new in the EU as in 1994 through a directive (94/19/EC), the European Parliament and the Council of European Union required members states to have the guarantees on up to 90% of deposits and up to an amount of European Currency Unit (ECU) 20,000/-. After the Global Financial Crisis, it was increased to e50,000/- in October 2008 as the agreement was reached among the finance ministers. Later the review of the directive (94/19/EC) carried out in 2010 on Deposit Guarantee Schemes declared e100,000/- as the optimal solution for deposit protection. In 2014, the directive (2014/49/EU) of the European Parliament and Council of EU was issued to further eliminate certain differences between the laws of the Member States as regards the rules on deposit guarantee schemes (DGSs) and achieve more harmonisation. It was deemed reasonable to set the harmonised coverage level at e100,000/-. The language of the directive was “member states shall ” which is a clear manifestation of the fact that most of the action part was required by the member states rather than the EU. Hence, the deposit guarantees remained a national subject and the states were to provide them at the state level. But the single supervision and single resolution also require singleness of deposit guarantees. Therefore, in November 2015 the Commission proposed to set up a European Deposit Insurance Scheme (EDIS) for bank deposits in the euro area. It did build on the existing system of national deposit guarantee schemes (DGS) which was already providing protection on all deposits up to e100,000/-. The notion of EDIS was to have more uniform system protection that would reduce the vulnerability of national DGS to large local shocks, ensuring that the level of depositor confidence in a bank would not depend on the bank’s location and weakening the link between banks and their national sovereigns. It is aimed that the EDIS will progressively develop and gradually take full responsibility for the deposit protection, though it was stated that this objective will be achieved through cooperation with the national DGS. It was proposed that the EDIS will be established in three stages: in the first 3 years period, there will be a reinsurance scheme for participating national DGSs, in the second period of 4 years a co-insurance scheme for participating national DGSs, and thereafter, in the steady-state, there will be full insurance for participating national DGSs. The Commission’s proposal on EDIS was in line with the Five Presidents’ Report that proposed the establishment of a

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European Deposit Insurance Scheme (EDIS). It proposed the expansion to SRB to administer EDIS and in terms of resources for administration, the contributions will be made from credit institutions affiliated to participating DGS. Deposit Insurance Fund which will be part of EDIS would be filled by contributions owed and paid by banks directly to the board and calculated and invoiced by participating DGSs. Total proposed EDIS fund was intended to be about 0.8% of the covered deposits of all banks in the Banking Union by 2024. Based on 2011 data this comes down to e43 billion which was to be built over the 8 years period. An annual contribution of about 12.5% of the target amount by the banking sector to the respective DGS and EDIS that is approximately e6.8 billion was required (Fig. 5.3). The gradual shift from national level DGS to EDIS was proposed to be in three phases. In Phase-I which is called Reinsurance, the National DGSs could access EDIS funds only after exhausting their own resources and EDIS funds would provide extra funds only up to a certain level. In Phase II, which was called Co-insurance, EDIS contributes from the first euro of loss, the share contributed by EDIS would start at a low level and progressively increase. In Phase III, by gradually increasing the share of

Fig. 5.3 Evolution of EDIS funds compared to the funds of a participating DGS (Source European Commission, https://ec.europa.eu/info/sites/ info/files/graph-15112014_en.pdf)

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risk that EDIS assumes to 100%, EDIS will fully insure national DGS as of 2024. Reason for the EDIS was given that the DGSs might be vulnerable to the large shocks, this implies the mutualisation of risks and contributions from the financial institutions of stronger states to lower the overall risks. Risk-weighted contributions are also an important issue as the banks which might be considered riskier should have comparative contributions in contrast with all the banks in the Union. There is also an element of operating costs associated with the insurance scheme. Nevertheless, what about the large institutions and the shock faced by the whole Union a less than 1% would not be able to provide enough funding to cover 100% of deposits. It might be right to say that the insurance is up to e100,000/(per bank and depositor) but that may still be a bigger ask given the fact that the total expected pot will be just e43 billion; that is just a fraction of total deposits in the EMU. Similar to the capacity of the Single Resolution Fund the EDIS may run short when the push comes to shove and once again the creditor nations and their taxpayers would have to pick the bill! The fancy term used for that is the last resort common fiscal backstop for the single resolution mechanism. But it in simple words, it means creditor nations will pick the bill. There seems to be no other way as the member states which are struggling to make the ends meet are last to expect to pay the depositors in a currency in which they do not have a monopoly!

Union of Compromises and Completion of the Banking Union In his State of the Union address then the President Jean-Claude Juncker stated that: Democracy is about compromise. And the right compromise makes winners out of everyone in the long run. A more united Union should see compromise, not as something negative, but as the art of bridging differences. Democracy cannot function without compromise. Europe cannot function without compromise. (President Jean-Claude Juncker’s State of the Union Address 2017)

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So basically, democracy, Union and even Europe can’t function without a single principle of compromise. The question is who is compromising and on what. Monetary union is not complete with merely having a joint central bank or a common currency, there are also other aspects of “monetary affairs ”, these are not only the Banking Union but Union in any and every financial and monetary aspect one can think of. For instance, one of the aspects is the Capital Markets Union (CMU) and one of the important lessons the Global Financial Crisis 2008–2009 reminded us was the importance of financial stability for economic stability. This means the financial sector has a direct bearing on the real economy and monetary policy. In the case of EMU, it is the ECB whose policy is affected by financial instability. Furthermore, in order to break the nexus (doom loop) between the national financial institutions and corresponding sovereigns, it is considered vital to make the union stronger and integration deeper. That is giving the union more significance and nations less. Notion of having the European System of Financial Supervision (ESFS) has been based on the pillars of European Supervisory Authorities (EBA, EIOPA, ESMA) and European Systemic Risk Board (ESRB) and Nation Competent Authorities (NCAs) that provide the floor to this structure (Fig. 5.4). Noticeably, this structure is indeed very much reliant on the competency of the National Competent Authorities (NCAs). Furthermore, the degree of supervision, efficiency of resolution and resourcefulness and credibility of pan-European deposit guarantee is also not gone sail through the time testing. It would be unfair to make any judgement but there is no reason to not doubt the mere size of the resources which have been put forward for these tasks. The level of Non-performing loans (NPL) remains an issue that poses challenges to financial stability. Total Loss Absorbing Capacity (TLAC) and adequacy of bail-inable buffers/ Minimum Requirement for own funds and eligible liabilities, exposures to central counterparties (CCPs) are the standing issues that are not fully addressed hitherto. There are suggestions and proposals made, for instance, on the Sovereign Bond-Backed Securities (SBBS) which are securities backed by a diversified portfolio of euro area central government bonds. It is argued that it will help the banks diversify their sovereign exposures and further weaken the link with their home governments. The notion is that there is a doom loop between sovereigns and banks in their jurisdiction, a bank’s deteriorating finances put pressure on the fiscal outlook of its

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Fig. 5.4 European system of financial supervision (Source Council of the European Union https://www.eiopa.europa.eu/file/esfs-0_en)

home government and a Member State’s degrading public finances, in turn, weaken banks holding its bonds. So, the SBBS shall try to break this loop, but the point is that there are no restrictions on the bank in the Eurozone to hold high-quality assets, banks in the periphery can hold very high-quality assets if they wish to! So is this really breaking the loop or mixing the sovereign bonds into a portfolio that may help the states with weak fiscal outlook have their debt viewed by the markets in a more respectable manner, given that it is of use to the SBBS which themselves have favourable regulatory treatment. The SBBS is considered as a first step to contribute to the completion of the Banking Union and the

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enhancement of the Capital Markets Union, but it is small, slow and its significance is debatable.

Unions Within the Unions The Capital Market Union (CMU) is the intention of having a single market for Capital. The aim is “to get money, investments and savings flowing across the EU so that it can benefit consumers, investors and companies, regardless of where they are located”. This is an interesting fascination as the restriction on the movement on labour and capital have already been lifted decades ago. Efforts to a single capital market started with the Treaty of Rome 1958 and indeed the Maastricht Treaty 1992 was a major milestone. In its true essence, the Economic and Monetary Union of the European Union (EMU) should have already been the Capital Market Union with no restriction on the flow of capital among the member states. But this is something that does not seem to have occurred, otherwise, why would the CMU be required? It seems that even a time span of over 60 years has not been ample to reach the goal of CMU. Supposedly, the CMU should lead to easier access to funding for businesses and SMEs, support recovery, increase European competitiveness, new investment opportunities, facilities New Green Deal and Digital Agenda and financial stability post-Brexit (Fig. 5.5). In September 2015, the first Plan for CMU was laid by the European Commission under the Presidency of Mr. Juncker and in the form of a set of about 33 measures or actions to be taken. It was then declared as President Juncker’s top priority to build a CMU for all members of the EU. Furthermore, that despite the fact that the EU is an economy roughly equivalent to the US, its equity market was not even half in size of it’s counterpart. The debt market was also smaller and there were also significant differences among the member states. This results in comparatively less funding to the businesses and SMEs. Therefore, the 1st Plan argued for a more integrated and efficient CMU which can facilitate Europe’s funding needs and increase in the funding to the real economy and also in Green sectors reaching to boost of additional funding in hundreds of billions of Euros. This was also in line with the ambitions of the e315 billion Investment Plan for Europe a.k.a Juncker Plan. It was expected that the CMU will make it easier for companies to get listed and issue IPOs. A long list of regulations which generated various acronyms was expected to provide the regulatory infrastructure including the MiFID

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Fig. 5.5 Building of Eurozone—Unions within Unions (Source cartoons)

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II, European Long-Term Investment Fund (ELTIF) Regulation, Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD IV) European Markets Infrastructure Regulation (EMIR), Central Securities Depositories Regulation (CSDR) Securities Financing Transactions Regulation (SFTR). The target date for putting all member states in place for CMU was set out as 2019. However, the CMU plan was updated in June 2017 with a mid-term review. There was an acknowledgement of the fact that the UK which was the EU member with the largest financial sector had chosen to leave in June 2016. So, the European Council and Commission has urged on the “swift and determined progress on the CMU agenda”. They also agreed to the European Venture Capital Funds (EuVECA) Regulation and the European Social Entrepreneurship Funds (EuSEF) Regulation which are intended to relax the regulation for investors to invest in small and mediumsized innovative companies. It was communicated by Commission that

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the progress has also been made on the Companies entering and raising capital on public markets through ESMA. Steps have been taken towards Common Consolidated Corporate Tax Base (CCCTB) and Simple, Transparent and Standardised (STS) securitisation as well as amendments in the bank capital requirements so the lending capacity can be enhanced. The Solvency II delegated act was amended so that the insurance companies can invest in infrastructure projects. Proposals were also made on the legislative proposal on a Pan-European Personal Pension Product (PEPP) and European covered bonds as well as harnessing the opportunity that Fintech is offering e.g. investment-based and lending-based crowdfunding. There were challenges to start with which still prevails, these included heterogeneities in the level of financialisation among the member states, the saving behaviour of EU household which prefers saving in the bank than engaging in the capital market at retail levels. Not a great amount of investment is done by the insurance companies and pension funds in risk capital, equity and infrastructure. Global Financial Crisis and European Sovereign Debt Crisis have also left their scars and the credit creation had been constrained for a considerable amount of time. In March 2019, the Commission made the progress report in which it took the stock of progress made so far. By 2019 the Commission had tabled all the legislative proposals it committed to in the CMU action plan and midterm review. These included the proposals on Common corporate tax base (CCTB) and Common consolidated corporate tax base (CCCTB), the framework for the recovery and resolution of central counterparties, regulations Pan-European Personal Pension Product, creation of Simple, Transparent and Standardised (STS) securitisations, common rules on covered bonds and European Market Infrastructure Regulation (EMIR). A number of these proposals have been agreed upon through the political engagement by the European Parliament and Council. Work on regulations is still going and probably would remain a part and parcel of the EU as it started with regulations and treaties. Communication from Commission in March 2019 also suggested that the market capitalisation of listed firms in the EU has reached above precrisis levels and IPOs issued in EU are 30% of the global market. There was also growth in both the equity market capitalisation and debt securities as a proportion of the EU’s GDP. Increased cross-border investments were a sign of greater integration. However, as I said earlier and evident

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in the Figure, the capital market structure in the EU has idiosyncratic features and you start from a different base (Fig. 5.6). The CMU could have not been completed by the end of 2019, it is clear there might be a lot of legislation but what that really means? Mr. Junker left the office and as of the 1 December 2019, Ursula von der Leyen took over the presidency of the Commission, from the same day she emphasised the completion of CMU, finalising the common backstop to the Single Resolution Fund and agreeing on a European Deposit Insurance Scheme. The High-Level Forum (HLF) on Capital Markets Union (CMU) which constituted experts from various financial institution and bodies have made their commendation in the form of a report in June 2020, urging on the need of CMU in the post-COVID-19 world. There are various studies and feasibility reported produced on the feasibility of creating a CMU equity market index family and development of online tools for retails investment, etc. But as I said earlier it is work in process

Fig. 5.6 Size of capital market as percentage of GDP of 2018—Q3 (Source European Commission, https://ec.europa.eu/finance/docs/policy/190315cmu-communication_en.pdf. EU Top-5 is obtained as GDP-weighted average for Netherlands, Sweden, Ireland, Denmark and Luxembourg with weights of 41, 25, 17, 15 and 2%)

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and there is no final landmark in the sight. A new action plan is expected though it would be obviously getting old and replaced one day. The main question would be what are on the ground changes! While the ambition of CMU is clear and in the last few years, particularly since the first plan was put forward by the Junker Commission, there is significant progress made on the legislative front it is vital to not lose sight of a number of facts on the ground. These facts or more appropriately can be called difficulties are recognised by the Commission, particularly the differences among the member states. This has a crucial aspect which is the ability of local capital markets. In case you want a stronger union, it means you will have weaker localisation or local markets as the strength is concentrated at the centre. You can’t have your cake and eat it. Nonetheless, as we have seen the emergence of two financial sectors i.e. Paris and Frankfurt, it is very much possible that they will be the financial capitals of EU, given that London has left. There is one more aspect which is vital for the EU to recognise and that is the comparison with the USA and ambition to be like it. I think it is important for the EU to be careful what it is wishing for! USA has an exuberance privilege in the form of US dollar ($) which has been the world reserve currency and most of the world trade has been carried out in the US dollar ($). This Exuberance Privilege has led the USA to run a large trade deficit. Will Europe and particularly the strong exporting nations including Germany would like to be like that? Challenges of a gigantically large financial sector such as the one in the USA and costs of financial instability for the real economy due to the huge financialisation are the crucial issues the EU must think about. Be careful what you wish for, you just might get it!

Capital Requirements Regulation and Directives Notion of adequate capital requirements in the EU goes back to 1993 and the Capital Adequacy Directive that aimed to establish the uniform capital requirements for the financial services institutions. This was changed in the Capital Requirements Directives (CRD) 2006. With the revisions and further updating in July 2013, the Capital Requirements Directives (CRD-IV) were issued that manifested the BASEL-III in the European regulatory framework, specifically the Capital Requirements Regulation and Credit Institutions Directive. The BASEL-III is not a law; therefore, it was necessary to enshrine it into the EU regulations and also applied

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uniformly to all the financial institutions in the Union. In the implementation of BASEL-III in the EU, the aspects of capital, liquidity and leverage ratios have been considered. Furthermore, remuneration framework, corporate governance, diversity and board composition, systemic risk buffers, reliance on external as well as internal credit ratings and overarchingly the notion of “Single Rule Book” have been the significant element of CRD-IV.

Markets in Financial Instruments Directive (MiFID) In addition to the CRD/CRR, there is another piece of directives that is quite significant in the financial context. This is the Markets in Financial Instruments Directive (MiFID) which is binding in its entirety and directly applicable. It is what it says on the tin, it is a regulatory directive on the financial market and hence it regulates financial firms that provide services to clients linked to “financial instruments” (shares, bonds, units in collective investment schemes and derivatives), and the venues or markets where these instruments are traded. MiFID set out the conduct of business and organisational requirements for investment firms, authorisation requirements for regulated markets, regulatory reporting to avoid market abuse; trade transparency obligation for shares, and rules on the admission of financial instruments to trading. The MiFID was applicable since November 2007 but as there had been major changes in other directives, MiFID was also revised and upgraded. The MiFID-II and MiFIR have been adopted as of 2018 entailing new reporting requirements, product governance and tests to increase the transparency and efficiency of financial markets. European Securities and Markets Authority (ESMA) has played a crucial role in the implementation of MiFID-II/MIFIR. Going forward it is quite probable that the MiFID will continue to evolve, we shall see!

EU Reforms Plans of Four Presidents Handling of crisis by the EU was very poor and this among other factors was down to the institutional design and incomplete economic and monetary union. So, there was a need to have a better or the

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so-called “Genuine” economic and monetary union. This led to calls for reforms and the report titled “Towards a Genuine Economics and Monetary Union” was produced in July 2012 by the President of the European Council (Herman Van Rompuy) developed in cooperation with the Presidents of the Commission (José Manuel Barroso), the Eurogroup (Jean-Claude Juncker) and the European Central Bank (Mario Draghi). It urged on a strong and stable architecture in the financial, fiscal, economic and political domains. There were four building blocks for the vision Table 5.2 Towards a genuine economic and monetary union roadmap: Stages and elements Stage 1 2012–2013 Essential Elements

Stage 2 2013–2014 Essential Elements

Ensuring fiscal sustainability and breaking the link between banks and sovereigns I. The completion and thorough implementation of a stronger framework for fiscal governance (“Six-Pack”; Treaty on Stability, Coordination and Governance; “Two-Pack”) II. Establishment of a framework for systematic ex-ante coordination of major economic policy reforms, as envisaged in Article 11 of the Treaty on Stability, Coordination and Governance (TSCG) III. The establishment of an effective Single Supervisory Mechanism (SSM) for the banking sector and the entry into force of the Capital Requirements Regulation and Directive (CRR/CRDIV) IV. Agreement on the harmonisation of national resolution and deposit guarantee frameworks, ensuring appropriate funding from the financial industry V. Setting up of the operational framework for direct bank recapitalisation through the European Stability Mechanism (ESM) Completing the integrated financial framework and promoting sound structural policies I. The completion of an integrated financial framework through the setting up of a common resolution authority and an appropriate backstop to ensure that bank resolution decisions are taken swiftly, impartially and in the best interest of all II. The setting up of a mechanism for stronger coordination, convergence and enforcement of structural policies based on arrangements of a contractual nature between Member States and EU institutions on the policies countries commit to undertake and on their implementation. On a case-by-case basis, they could be supported with temporary, targeted and flexible financial support. As this financial support would be temporary in nature, it should be treated separately from the multiannual financial framework

(continued)

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Table 5.2 (continued) Stage 3 2014– Essential Elements

Improving the resilience of EMU through the creation of a shock absorption function at the central level I. Establishing a well-defined and limited fiscal capacity to improve the absorption of country-specific economic shocks, through an insurance system set up at the central level. This would improve the resilience of the euro area as a whole and would complement the contractual arrangements developed under Stage 2. A built-in incentives-based system would encourage euro area Member States eligible for participation in the shock absorption function to continue to pursue sound fiscal and structural policies in accordance with their contractual obligations. Thereby the two objectives of asymmetric shock absorption and the promotion of sound economic policies would remain intrinsically linked, complementary and mutually reinforcing II. This stage could also build on an increasing degree of common decision-making on national budgets and an enhanced coordination of economic policies, in particular in the field of taxation and employment, building on the Member States’ National Job Plans. More generally, as the EMU evolves towards deeper integration, a number of other important issues will need to be further examined. In this respect, this report and the Commission’s “Blueprint” offer a basis for debate

of future EMU identified. These were an integrated financial framework to ensure financial stability, an integrated budgetary framework to ensure sound fiscal policy at national and EU levels, an integrated economic policy framework and democratic legitimacy and accountability of decisionmaking. An extended report or roadmap was presented in December 2012 that suggested a timeframe and three stages-based processes towards the completion of the EMU and achieving four building blocks (Table 5.2). Six-Pack was the set of regulations on reforming Stability and Growth Pact and was tabled in September 2010 and enforced in December 2011. The macroeconomic imbalance procedure, a new macroeconomic surveillance tool was also introduced. The Six-Pack was followed by two additional regulations or Two-Pack which involved more intensive monitoring of the budgetary plans of the states receiving financial assistance. A graphical presentation of the 3 stages with the essential elements and four building blocks is also depicted as follows (Fig. 5.7).

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Fig. 5.7 Stages towards a genuine EMU (Source European Council https:// www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/134069. pdf)

Five Presidents Plan What is better than the Four Presidents’ Report? Five Presidents Report! Following from the “Towards a Genuine Economics and Monetary Union” report and its stages, the report entitled “Completing Europe’s Economic and Monetary Union” a.k.a Five President Report was issued in June 2015. It was reported by the President of the European Commission (Jean-Claude Juncker), President of the European Council (Donald Tusk), President of the Eurogroup (Jeroen Dijsselbloem), President of ECB (Mario Draghi) and President of the European Parliament (Martin Schulz). In the report, it was acknowledged that “Preventing unsustainable policies and absorbing shocks individually and collectively did not work well before or during the crisis ” and that the legacy of institutional shortcoming persists. Therefore, it was urged that “Progress must happen on four fronts: First, towards a genuine Economic Union that ensures each economy has the structural features to prosper within the Monetary Union”. This was a manifestation of the fact the so far Economic Union

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was not genuine or in simple words a union not working for everyone. Second, towards a Financial Union that guarantees the integrity of our currency across the Monetary Union i.e. completion of Banking and Capital Market Unions. Again, this was an acknowledgement that despite removing the restrictions on the movement of capital and a single currency, the union was a genuine Financial Union yet. Third, towards a Fiscal Union that delivers both fiscal sustainability and fiscal stabilisation. Indeed, on this front, there had been crucial challenges and major divergences among the member states excecated by the Global Financial Crisis and even more prominently by the European Sovereign Debt Crisis. And finally, towards a Political Union that provides the foundation for all of the above through genuine democratic accountability, legitimacy and institutional strengthening. Again, it was manifestation and recognition of the fact that the process of political integration and unity that started decades ago still lacks democratic accountability and hence legitimacy and the institutions are weak. It was urged in the Plan that all four unions are to be developed parallel due to the reason that their existence and success is interdependent. The report was a recognition of weaknesses and shortcomings and also a roadmap for further integration, and it entailed the following steps and stages (Table 5.3). To reiterate, the Five Presidents Plan reflected on the shortcoming of the EMU in a very honest manner; particularly the fact that the member states particularly those that share a common currency have major differences in the economic structures and policies. There were major differences in the ability of members states to use their fiscal policies and competitiveness differences in their economies make them stand apart from each other. Therefore, the need for the Competitiveness Authority was considered imminent. A stronger Macroeconomic Imbalance Procedure was required to adjust the imbalances and bring them under control. A stronger focus on employment and social performance was required but also acknowledged that one size does not fit all. It was urged that there should be better geographic and professional mobility. Stronger coordination of economic policies could help in gaining greater convergence. For the completion of the Banking Union, it was deemed necessary to establish and strengthen the Single Resolution Fund (SRF) and a backstop which could involve a credit line from the European Stability Mechanism (ESM) to the Single Resolution Fund (SRF). A European Deposit Insurance Scheme (EDIS) was proposed to be the third pillar of the banking

Immediate steps

Economic Union – A new boost to convergence, jobs and growth • Creation of a euro area system of Competitiveness Authorities; • Strengthened implementation of the Macroeconomic Imbalance Procedure; • Greater focus on employment and social performance; • Stronger coordination of economic policies within a revamped European Semester Financial Union – Complete the Banking Union • Setting up a bridge financing mechanism for the Single Resolution Fund (SRF); • Implementing concrete steps towards the common backstop to the SRF; • Agreeing on a common Deposit Insurance Scheme; • Improving the effectiveness of the instrument for direct bank recapitalisation in the European Stability Mechanism (ESM) – Launch the Capital Markets Union – Reinforce the European Systemic Risk Board Fiscal Union – A new advisory European Fiscal Board • The board would provide a public and independent assessment, at European level, of how budgets—and their execution—perform against the economic objectives and recommendations set out in the EU fiscal framework. Its advice should feed into the decisions taken by the Commission in the context of the European Semester Democratic accountability, legitimacy and institutional strengthening – Revamp the European Semester • Reorganise the Semester in two consecutive stages, with the first stage devoted to the euro area as a whole, before the discussion of country-specific issues in the second stage – Strengthen parliamentary control as part of the European Semester • Plenary debate at the European Parliament on the Annual Growth Survey both before and after it is

July 2015–June 2017

Roadmap towards a complete economic and monetary union

Stage 1

Table 5.3

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Stage 2

Stage 1

issued by the Commission; followed by a plenary debate on the Country-Specific Recommendations; • More systematic interactions between Commissioners and national Parliaments both on the Country-Specific Recommendations and on national budgets; • More systematic consultation and involvement by governments of national Parliaments and social partners before the annual submission of National Reform and Stability Programmes – Increase the level of cooperation between the European Parliament and national Parliaments – Reinforce the steer of the Eurogroup – Take steps towards a consolidated external representation of the euro area – Integrate into the framework of EU law the Treaty on Stability, Coordination and Governance; the relevant parts of the Euro Plus Pact; and the Intergovernmental Agreement on the Single Resolution Fund Completing the EMU Architecture Economic Union – Formalise and make more binding the convergence process Fiscal Union – Set up a macroeconomic stabilisation function for the euro area • Convergence towards similarly resilient national economic structures would be a condition to access this mechanism Democratic accountability, legitimacy and institutional strengthening – Integrate the European Stability Mechanism (ESM) into the EU law framework – Set up a euro area treasury accountable at the European level Final Stage at the Latest by 2025

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union. In parallel to the Banking Union, the capital market union was also deemed vital in the Five President plan. The lesson learnt or supposedly learnt from the Global Financial Crisis and European Sovereign Debt Crisis on the necessity of responsible budgetary policies made them the cornerstone of EMU. Establishment and effective functioning of the European Fiscal Board was therefore declared vital for a Fiscal Union. Lastly, democratic accountability which has been an area of concern and criticism by the EU critics was also aimed to be addressed in the Five Presidents Plan. This was to be done in a way that the European Parliament will strengthen parliamentary oversight where the “Economic dialogues” between European Parliament and the Council, the Commission and the Eurogroup were crucial to build the bridges. Well, I must say that those who hold powers do not let it go very often, therefore, the notion that the EU will become more democratic very smoothly is a bit of over-optimism! Date to complete the EMU was set as 2025. Something to look forward to, but with rational expectations and a grain of salt!

A New Commissioner a New Plan: Junker Plan In his first month in office, the European Commission’s Investment Plan for Europe (EC IPE) was announced by President Jean-Claude Juncker in November 2014. It aimed to deliver and mobilise private and public infrastructure investment of e315 billion over a three-year period (2015– 17), mainly through the efforts of the European Commission and the European Investment Bank (EIB) Group. Earlier in July 2014 at Strasburg, Mr. Jean-Claude Juncker gave his opening statement in front of the European Parliament as a Candidate for the Presidency of European Commissions. He put “A New Boost for Jobs, Growth and Investment ” at the top of his 10-point agenda of “Jobs, Growth, Fairness and Democratic Change”.7 In December 2014, Commission adopted the Work Programme for 2015 with a strong emphasis on making a real difference for jobs, growth and investment and bring concrete benefits for citizens. This was followed up and backed up with Latvia’s EU council presidency where the e315 billion investment plan became its “focal point ”. The 7 Jean-Claude Juncker Candidate for President of the European Commission, “A new start for Europe” opening statement in the European Parliament plenary session Strasbourg, 15 July 2014, available at https://ec.europa.eu/commission/presscorner/detail/ en/SPEECH_14_567.

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Juncker Plan was set to increase EU GDP by 1.3% and to create 1.4 million jobs by 2020. In July 2018, the Commission announced that the Juncker Plan is expected to trigger e335 billion in investment across the 28 EU member states. Furthermore that 898 operations (backed by a budget guarantee from the EU and EIB’s own resources) have been approved and 700,000 SMEs are expected to be the beneficiary with improved access to finance. Crisis-stricken economies of Cyprus, Greece, Ireland, Italy, Portugal and Spain, and some east European economies were expected to be the biggest beneficiaries. The European Council and the European Parliament had agreed to increase the capacity to e500 billion by the end of 2020. In Mr. Juncker’s own words: The Juncker Plan has proven to be a success. We have financed projects which without the EFSI would not have been possible, and all without creating new debt: two thirds of the investment come from the private sector. From financing job-training for refugees in Finland to renewable energy in Greece to farming in Bulgaria we will continue to use the EU budget for what it does best: to catalyse growth.

These claims of growth and jobs and effectiveness of the Juncker Plan in conjunction with the other plans should be judged on the basis of results. A matrix of assessment is chosen by the European Commission herself. We will look at the bleak progress report in the later sections.

COVID and Europe: ESM, EIB and SURE As the COVID-19 hit the EU economy, there has been some response from its newly established institutions. The ESM launched ESM Pandemic Crisis Support programme based on Enhanced Conditions Credit Line (ECCL). Under this arrangement, any member of the Eurozone had access to an amount up to 2% of its GDP to meet the health crisis expenses so if every country ask it was expected to reach e240 billion. There was no reason to expect that countries like Germany and the Netherlands with a very strong fiscal outlook at the beginning of the crisis would have to ask for such support. This ESM Pandemic Crisis Support programme was part of wider efforts on the creation of three safety nets for workers, businesses and sovereigns, amounting to a package worth e540 billion. Response of the EMU to the COVID-19 was relatively slower than other economies despite the fact that by March

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2020, Europe was the epicentre of the Pandemic, however, by the EMU standards and historical performance, I must say it was quite fast. The European Council invited proposals from the Eurogroup on 26 March 2020. It took Eurogroup two weeks to respond to the invitation and the reply came as a report on the comprehensive economic policy response to the COVID-19 pandemic. Initial fiscal stimulus was estimated to be around 3% of EU GDP, furthermore, the support to the businesses in the form of public guarantee schemes and deferred tax payment was claimed to be around 16% of GDP. Fiscal rules which were not always been followed anyway were officially relaxed and on 23rd March Ministers of Finance agreed with the assessment of Commission that it is the time. The EU budget was also brought into use to tackle the Pandemic. The Coronavirus Response Investment Initiative which brought e37 billion into use as of 1 April 2020 was approved by the European Parliament and Council. The scope of Solidarity Fund was extended to include major public health crises which implied that a member could get financial support of up to e800 million. To reiterate, the ECB also launched the e750 billion Pandemic Emergency Purchase Programme (PEPP) which exceeded the initially announced amount and by May 2021 reached e1.07 trillion. On the 2 April Commission proposed reactivation of the Emergency Support Instrument for COVID-19 which could provide support of e2.7 billion out of the EU budget. The EIB activities were also enhanced with the initiative to create a pan-European guarantee fund of e25 billion that could provide support to financing for companies of up to e200 billion with a focus on SMEs. The Balance of Payments Facility can also provide support to non-euro EU member states. On 2 April, the Commission also proposed a new instrument for temporary Support to mitigate Unemployment Risks in an Emergency (SURE) through which financial assistance up to e100 billion can be provided in the loans from the EU to affected the Member States. The e100 billion was backed by the e25 billion of guarantees voluntarily committed by the Member States to the EU budget to leverage the financial power of SURE. Proposed SURE is meant to be temporary until the COVID-19 crisis is over. They worked on establishment of a Recovery Fund which can provide funding through the EU budget for kick-starting the economy. Commission also expressed intention to adopt EU’s Multiannual Financial Framework (MFF) proposal for recovery. After the 4th video conference of the European Council, on 23rd April 2020, intentions of solidarity and cooperation to fight the Coronavirus

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were reiterated. The Joint European Roadmap to implement containment measures was welcomed. Agreement on three important safety nets for workers, businesses and sovereigns amounting to a package worth e540 billion was also endorsed by the European Council. In the same meeting, solidarity was expressed with Cyprus on so-called Cyprus’ Exclusive Economic Zone and the issue of Turkish drilling. An issue that is beyond the scope of this treatise but as interesting political-economic dimensions. On 8 May 2020, in the meeting of the Eurogroup details were agreed. The Eurogroup welcomed the decision by the Council on the SURE proposal, the EIB on the establishment of the pan-European guarantee fund and confirmed the agreement to establish the ESM Pandemic Crisis Support programme. Indeed, once the European Council had agreed there was only the issue of operationalisation of the wishes of states. In terms of ESM although all the states were deemed qualified the ask for assistance, a state seeking assistance under Pandemic Crisis Support would have to commit to using this credit line to support domestic financing of direct and indirect healthcare, cure and prevention related costs due to the COVID 19 crisis. Financing requests can be made till 31 December 2022 though there was the possibility of extending this date subject to approval by the ESM board of governors. The facility was to be available for 12 months period with the possibility of an extension of six months. Financing under this Pandemic support would be up to an average maturity of 10 years and with favourable pricing modalities. More specifically, the pricing structure under the Pandemic Crisis Support was to be comprised of a base rate and a commitment fee, reflecting the level of the ESM cost of funding, as well as the service fees to cover operating costs and an appropriate margin. The margin charged for the loans disbursed under the instrument will be 10 basis points annually, the upfront service fee will be 25 basis points and the annual service fee will be 0.5 basis points. Again, these were very marginal fees and indeed it implies that the real rates were not very high either. In a nutshell, the focus of ESM support is on Sovereigns states, EIB on businesses and SMEs and SURE on for the workers. Indeed, the response of Europe to the Pandemic was comparatively better than its response to the Global Financial Crisis, partly because both the Global Financial Crisis and European Sovereign Debt crisis have given Europeans some experience, but how much they learnt from their experiences is debatable. Nevertheless, the notion of contagion in the financial market and economy is bad enough, the contagion of the deadly disease is a lot worse,

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and no country is immune to it. As I said the response by Europeans to a pandemic is comparatively better, the questions remain whether it is good enough. I think the judgement should be based on the results. Pandemic might be over in a couple of years or so but the economic recoveries as we have experienced are always slow and steady. Time will tell how Europeans will progress, or more appropriately muddle through!

Fiscal Union or Framework for Fiscal Policies Along with the political, economic, monetary, banking and financial Unions, there is one more Union to go. Perhaps one of the most important of its kind, the Fiscal Union. The Stability and Growth Pact remained the point of concern and debate, but the fiscal stance and outlook of member states have persistently remained divergent. Member states more or less had been at completely different pages (if not books) in terms of their public debts and deficits. In his speech at Harvard University in October 2007, then the Present of ECB Mr. Jean-Claude Trichet called upon the EU member states to comply fully with the Stability and Growth Pact, an agreement which aims to ensure that they conduct prudent fiscal policies. He also acknowledged that in the US, there are inter-regional fiscal transfers that support integration, though transfers in the Euro area are almost exclusively domestic and not cross-border. Acknowledgement of this difference was the realisation of a fact by a top man in the EU bureaucratic structure and in charge of EMU’s money supply. Obviously, it means that this notion got to reflect somewhere in the policy. Fiscal Union in plain English means a fiscal policy at the union level, more simply, centralised collection of taxes which can create a centralised pool of revenues that can then be channelled, distributed and spent. Decisions on the revenue collection could be in the European Council. Eurobonds and Euro-bills can be issued to raise the finances and gap in the revenue and expenditures. There are various objections including the high degree of centralisation, lack of democratic value, “fiscal dumping ” i.e. keeping taxes predatory low to attract investment and free-loader problems. But the problem is that once you have monetary, political, economic, financial and banking union, not having a fiscal union is missing piece of the jigsaw, let me tell you that this is the most important piece. Yet it is also the most difficult one. In Chancellor Angela Merkel’s words “the most difficult chapter in the history of the euro, if not the most difficult in the history of the European Union”.

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The Global Financial Crisis, European Sovereign Debt Crisis and the fiscal constraint that the European member states faced made this caveat even more visible. There was no chance that a fiscal union can have been built overnight, either it would have been fair to the nations like Germany and others to mutualise the fiscal burden of the periphery. According to Chancellor Markel, there is “no quick and simple solution” and “Those who claim euro-bonds can currently be implemented as a rescue measure for the crisis have not understood this crisis ”. I think she was right. So, the path that was followed after Global Financial Crisis was to develop the crisis management framework and institutions, for instance, European Financial Stability Facility (EFSF) in 2010 as I discussed earlier, while this may lend sometime for the question on fiscal union, but how long we can kick the can for? German fascination with the balancing and order was manifested in the proposals in 2010–2011 on having a Balanced Budget Framework and Debt Break which was proposed to be integrated into the national laws of member states. Anyway, a set of reforms (part of “Six-Pack”) amending the Stability and Growth Pact entered into force at the end of 2011. This Economic Governance Package or “Six-Pack” amended the existing rules and provided instruments of surveillance of member states’ fiscal policies and as well as instruments for correction of their excessive deficits. In terms of surveillance, one of the important ones is the country-specific medium-term budgetary objectives (MTOs). The MTOs of each country have to be in a range of between −1% of GDP and balance or surplus, corrected for cyclical effects and one-off temporary measures. This objective must be revised every three years, or when major structural reforms are implemented which impact the fiscal position. In terms of prevention, the core instruments are the Stability and Convergence Programmes where each state has to submit a stability programme (Euro Member States) or a convergence programme (non-euro States) to the Commission and the Council. The stability programme shall contain details on the MTOs, the adjustment path thereto and scenario analysis on the effects of changes on the fiscal position. Member states that do not take suitable adjustment action could potentially face sanctions in the form of an interest-bearing deposit amounting to 0.2% of the previous year’s GDP. There was also a fine provision in case of manipulation of debt or deficit data. In terms of instruments of corrections there the Excessive deficit procedure (EDP) has been developed which can be triggered by the deficit criterion or the debt criterion. Specifically, a general government deficit higher than

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3% of GDP at market prices is considered to be excessive. Whereas, if debt levels are in excess of 60% of GDP and the annual debt reduction target of 1/20th the debt in excess of the 60% threshold has not been achieved over the last three years, it could trigger the EDP. There was however room for consideration of exceptional circumstances which has pretty much always been the case in the EU either written or not. The Commission is to watch and report on excessive deficit though the final decision rests with Council. Non-compliance with the EDP could result in a fine of up to 0.5% of GDP. So, in a nutshell, there was a procedure to comply with and reduce the deficit and in the event of non-compliance, the fines can be potentially imposed though that may result in outrage and a big dent in the notion of European unity. Fining a state that is struggling financially is the last thing you got to do to annoy its citizen. The regulations on assessing national draft budgetary plans (part of “Two-Pack””) entered into force in May 2013. In this regard, another set of reforms in the fiscal policy framework the intergovernmental Treaty on Stability, Coordination and Governance, including the Fiscal Compact, entered into force in early 2013.

Fiscal Stability Treaty or Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG) As things evolved in the EU, so did the Stability and Growth Pact, the new version of which is the Fiscal Stability Treaty or the fancy full name for it is Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG). Aimed to be the stricter and updated version of the Stability and Growth Pact, this intergovernmental treaty was signed by all member states on 2 March 2012, except UK and Czech Republic. This was of course following up on the earlier agreement among the Eurozone member states in December 2011. Intergovernmental treaty extended the existing legal formwork of the EU, mainly in three areas, Budget discipline enforced by Stability and Growth Pact (extended by Title III), Coordination of economic policies (extended by Title IV) and Governance within the EMU (extended by Title V). The Fiscal Compact was expected to be incorporated in the EU legal framework by January 2018, though the assistance through the European

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Stability Mechanism (ESM) was subject to the condition of embedding the fiscal rule in the national legal framework of requesting state. Later in November 2012, a blueprint for a deep and genuine EMU (full title A Blueprint for a deep and genuine Economic and Monetary Union: Launching a European debate) was adopted by the Commission. It provided a vision of developments in the financial, fiscal, economic and political domains. Commenting on this blueprint, José Manuel Barroso, the then President of the European Commission, said: We need a deep and genuine Economic and Monetary Union in order to overcome the crisis of confidence that is hurting our economies and our citizens’ livelihoods. We must give tangible proof of the willingness of Europeans to stick together and move forward decisively to strengthen the architecture in the financial, fiscal, economic and political domains that underpins the stability of the Euro and our Union as a whole.

In the intended, so-called genuine EMU , all major economic and fiscal policy choices by Member States would be subject to deeper coordination, endorsement and surveillance at the European level. The blueprint entailed three stages i.e. short, medium and long-term. The short-term was to last for 6–18 months which was to be focused on implementing agreed reforms (six and two packs) but the fiscal and budgetary subject was to be touched in medium terms (1 ½–5 years). Collective conduct of budgetary and economic policy—including tax and employment policies and enhanced fiscal capacity was considered to the objectives in the medium term. A redemption fund with euro-bills (maturity of 1–2 years) was also brought into consideration and management of fiscal capacity and instruments was proposed to be carried out by an EMU Treasury within the Commission. Lastly in the long-term (beyond 5 years), it was stated in the blueprint that contingent on pooling of sovereignty, responsibility and solidarity at the European level, it was expected to establish an autonomous euro area budget providing for a fiscal capacity for the EMU to support Member States affected by economic shocks. This is an interesting point as it is an expression of pooling the sovereignty that has been the case so far with some resistance from some member states. But the reward and prize promised is solidarity with nice word of responsibility, being responsible here means transferring your sovereignty to the EU. Furthermore, the proposed fiscal capacity was to be used in case of support to the EMU member state affected by and adverse shocks. Well in that case,

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it could be just an organisation that can support crisis-struck countries, but the ESM is already here. Anyway, it was also argued that a deeply integrated economic and fiscal governance framework could allow for the common issuance of public debt, which would enhance the functioning of the markets and the conduct of monetary policy. This would be the final stage in EMU . Clearly, that means once you transfer the sovereign power of raising taxes and spending there cannot be any further economic and monetary integrations.

European Fiscal Compact The Fiscal Compact is considered as an important step towards “Fiscal Union”. It requires transposing the provisions of the Fiscal Compact in the national legal frameworks of the member states and fiscal surveillance by an independent national watchdog. In so doing, the number states are to follow the balanced budget rule which had its interesting definition. A member state shall run a balance or surplus budget and the fiscal rule was deemed respected if the general government deficit does not exceed 3% of GDP. The structural deficit should not exceed the Medium-Term Budgetary Objectives (MTOs) of a country which at most can be 0.5% of the GDP for a country exceeding 60% debt to GDP ratio, while a state which has debt to GDP less than 60% can have the structural deficit of 1% at most. At the time of enforcement if a state is found to be in the breach of Treaty it was still ok as long as the improvement it was making annual was sufficient, so again the aspect of short-term trajectory “adjustment path” than the ex-post assessment is a criterion to meet. Such an adjustment path was to be outlined by the Council on the proposal by European Commission that shall take into account the country-specific sustainability risks into consideration. Temporary deviation from the adjustment path was allowed under exceptional circumstances. As we witnessed and I have discussed at length earlier that short-term assessments and flexible criteria with room to cut corners allow members states to sail through by hook and crook. But in the long term, fault lines re-emerge. Another aspect of the Fiscal Compact is the Debt Brake Rule or a Benchmark for government debt reduction. It suggested a numerical benchmark for debt reduction for the Member States with government debt exceeding 60%. The excessive debt (above 60% of GDP) shall be reduced to an average rate of 1/20th or 5% per year. There was also an automatic correction mechanism for non-compliance with the fiscal rule.

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Member states having the Excessive Deficit Procedure (EDP) were required to submit Economic Partnership Programme (EPP) to the Commission and Council for approval. The EPP is to provide details on the structural reforms that can lead to the correction of the excessive deficit. Progress on such deficit correction programme or EPP was to be monitored by the Fiscal Advisory Council of the underlying state but also the Commission and Council. The National Reform Programme report that is submitted to Commission in April each year is the main tool for monitoring compliance. However, it is not required if the country is a recipient of the sovereign bailout and submitting Economic Adjustment Programme (EAP) report. Abrogation from the EDPs is allowed under exceptional circumstances for instance severe economic downturn. Compliance can be reviewed more frequently as suggested by Six-Pack regulations and “Program Reviews” of the recipient of bailout funds. It is worth noting that the Stability and Growth Pact criteria have been frequently violated by almost all of the member states at different time horizons. On the aspect of Embedding the “Balanced Budget Rule” and “Automatic correction mechanism” into domestic law, a non-compiling state can be potentially fined up to 0.1% of its GDP by the Court of Justice. Though the implementations of rules have not been very strict and there have been occasions where the fines have been condoned, fining a country that is already running and deficit due to the weak economic outlook is making the state and its citizens annoyed which would obviously fuel the anti-EU sentiments, so what are these rules for and the notion of punishment? It’s a stick not to be used may be depriving one of carrot is more politically affordable! In the light of facts on the ground and the current state of Eurozone economies, particularly post-COVID19, the expectation to bring the debt and deficit down to the benchmark is the flight of fancy! The debt to GDP ratio in the Eurozone has crossed the 100% milestone and still increasing, the economies are yet to recover from the COVID-19 shock, so running surpluses to bring debt levels down requires imagination beyond reality! In that environment, the old fiscal rules on debt and deficit may seem to be more useful for history of fairy tale books than for real-world economics. Interestingly, the Fiscal Stability Treaty or Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG) also included the aspects of Economic policy coordination and convergence. It implied each state shall aim for coordination of policies that

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can lead to improving competitiveness, employment, public fiscal sustainability and financial stability in the Eurozone. Easy said than done! Furthermore, they should coordinate and debate economic reform plan ex-ante where appropriate and have enhanced fiscal coordination and enhanced cooperation. The Fiscal Stability Treaty also included the aspects of governance, specifically the provision for Euro summit to take place twice a year. I think there is no doubt that the need for coordination among the EU countries is more than ever before. This is manifested in the immense fiscal disparities where in 2020, Estonia had a debt-toGDP ratio of 17.2% and Greece 207.1% and every other country laying between these two ends of a large fiscal spectrum. The burden of the debt servicing is also huge where countries like Italy had a public debtto-GDP ratio of 159.6% and annual interest expenditure of about 3.6% of GDP. This simply means that the Eurozone is facing challenges to public finances greater than ever before, and the situation is worse than the dawn of the European Sovereign Debt Crisis. Coordination will remain a challenge, I doubt that the fiscal rules will come in way of fiscal policies, they better not! But most importantly, there is a huge difference between coordinated fiscal policy and a Single Fiscal Policy which in principle shall be the case in a Fiscal Union.

European Fiscal Board The European Fiscal Board (EFB) an independent advisory board on fiscal matters was established in October 2015 with a mandate to advise the Commission on the fiscal affairs in the Eurozone and evaluate the implementation of the fiscal rule. It was also a follow-up from “the Five Presidents’ Report Completing Europe’s Economic and Monetary Union”. Upon request, the EFB was to provide ad-hoc advice to the Commission of fiscal policy matters. It consisted of a Chairman and four members with expertise in fiscal policy, public finances and macroeconomics and experience in European economic governance and the EU’s fiscal rules. The inaugural Chairman was Niels Thygesen who was an independent member of the Delors Committee and also one of the co-authors of The All-Saints’ Day Manifesto for European Monetary Union, hence

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well versed with the European Monetary and Fiscal ills.8 Appointments were by the Commission through advice and consultation with the other officials and bodies of EMU. In April 2019, the European Commission decided to renew the mandate of the European Fiscal Board for a second and final three-year period taking effect on 20 October 2019. Scope of work of the European Fiscal Board is at the EU level which means its role is more challenging than national level Independent Fiscal Institutions (IFIs). There is undoubtedly some method to this madness manifested in the provision of independent, rigorous and nonpartisan advice on matters pertaining to fiscal positions. But this is not always the case that the IFIs can work without political influence and their work does not always lead to evidence base debate in political circles. In the case of EFB indeed it is an organisation that is at the union level and therefore there is an element of fiscal unity of some sort. Nonetheless, something is better than nothing! But EFB has not got teeth to enforce the fiscal rules. It is not mandated to interfere with the work of national fiscal councils. Due to the nature of its work, it is obvious that the EFB may come under political pressure and there is also a somewhat unattended aspect of coordination with the national fiscal authorities and fiscal oversight bodies. Due to being independent, limited resources and not a properly EU institution that has its roots in the EU treaties, the EFB has limits to which it can bite and chew. Perhaps, therefore, it can at most be an advisory body and that is what shall be expected from it. The EFB secretariat has collected data on budgetary policies in the EU Member States vis-à-vis the rules of the Stability and Growth Pact (SGP) (Fig. 5.8). Compliance Tracker is its database that assesses numerical as opposed to legal compliance with the rules of the SGP. Furthermore, abstracting from legal interpretations or margins of discretion allowed by the letter or spirit of the law, it assesses whether in pure quantitative terms the relevant fiscal aggregates—the budget balance, the debt-to-GDP ratio or government expenditure—evolved in line with the main course of action implied by the rules or not.9 I am not sure what is the difference between legal and numerical is when you have explicit fiscal rules and SGP criteria. Perhaps, it is a disclaimer on the legal judgement which may have a backlash. But 8 Other members included, Roel Beetsma (The Netherlands), Massimo Bordignon (Italy), Sandrine Duchêne (France) and Mateusz Szczurek (Poland). In September 2020, Xavier Debrun (Belgium) also joined the European Fiscal Board as a member. 9 The database encompasses the four main fiscal rules of the SGP:

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Fig. 5.8 “Numerical compliance with EU fiscal rules. The compliance database of the Secretariat of the European Fiscal Board”, May 2020 (Source Larch & Santacroce, 2020)

1. Deficit rule: a country is compliant if (i) the headline budget balance is at or above −3% of GDP or if (ii) an excess below −3% of GDP is small (i.e., 0.5% of GDP) and limited to one year. 2. Debt rule: a country is compliant if the debt-to-GDP ratio is below 60% of GDP or if the excess above 60% of GDP has been declining by 1/20 on average over the past three years.

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as obvious from the tracker there is very little compliance with the fiscal rules as of the mid-2020. In the wake of COVID-19, the EFB did issue a statement in March 2020 and commended the actions taken by the fiscal authorities and ECB to support the economy of the EU. It also urged on the “flexible interpretation of commonly agreed fiscal rules ”. Later in its “Assessment of the fiscal stance appropriate for the euro area” EFB reiterated its support for the fiscal and monetary measures while also cautioned on the premature withdrawal of stimulus. It rather advocated a strong focus on growth-enhancing government expenditure including investment, to provide stabilisation in the short-term while bolstering prospects of stronger future growth.

Learning from Good Practices Reverting the issue of Fiscal Union, so far it has been more like a framework of fiscal policies in the EU rather anything comparable with the Monetary Union. In order to be the real Fiscal Union, we will have to have a single fiscal policy in the Eurozone. This means a Finance Ministry or Treasury and a finance Minister for the whole Eurozone as has been proposed by some circles.10 The European Parliament is there, the bureaucracy in the form of Commission is there, the only missing piece of the jigsaw is the fiscal authority. While it is seemingly difficult, it is not impossible and delaying it any further may have some costs. A roadmap can be agreed upon in terms of revenue collections and distributions. Some transfers may occur but that is more like transfers in the UK from one part to the other. I must acknowledge here that Gerlinde Sinn and Hans-Werner Sinn (with whom I agree on several issues but not all) have raised some concerns while comparing the fiscal union with the German unification that resulted in transfers from the former West to 3. Structural balance rule: a country is compliant if the structural budget balance is at or above the medium-term objectives (MTOs) or, if it is below the MTOs, its structural fiscal effort (i.e., the change in the structural balance) is equal or higher than the benchmark requirement of 0.5% of GDP. 4. Expenditure rule: a country is complaint if the annual rate of growth of primary government expenditure, net of discretionary revenue measures and one-offs, is at or below the 10-year average of the nominal rate of potential output growth minus the convergence margin necessary to adjust towards the MTOs. 10 See Marzinotto et al. (2011).

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Former East Germany,11 especially, that it may also erode some competitiveness of regions to whom the transfers are made. Well, with all due respect I will revert to the example of the most successful Union, the UK. There are indeed huge differences between the competitiveness of different regions of the UK which have been prevailed and will always prevail, though they can certainly be narrowed as much as possible. For instance, London, the South East and the East of England all had net fiscal surpluses in the financial year ending (FYE) 2019, with all other countries and regions of the UK having net fiscal deficits. London had the highest net fiscal surplus per head at £4369 and Northern Ireland had the highest net fiscal deficit per head at £4978, in FYE 2019. But despite that, the Northern Ireland and Scotland incurred the highest expenditure per head in FYE 2019, at £14,821 and £14,497, respectively. But there is no political opposition to the transfers from the surplus to deficit regions. In specific to Eurozone, to deal with high levels of public debt and the risks it poses, there are proposals such as the one made by Banca d’Italia staff to create a European Debt Redemption Fund (ERF) that entails pooling a portion of sovereign debt.12 Though such proposals have certain merits but are not something that is a practice in the most successful monetary and fiscal unions such as the UK and the USA, such a framework will be explicit but partial mutualisation of debt stock. The insurance-like features that have been promoted in the ERF imply that those who will pay the premium may not need it and those who need it may have to pay a lot higher premium had they not mutualised it. Similarly, the budgetary instrument for convergence and competitiveness (BICC) to finance packages of structural reforms and public investments is also a pie in the sky and I have doubts in terms of effectiveness and size. I would say instead of these single and isolated funds and instruments what is needed is a single fiscal policy and single fiscal policy framework. When there are no restrictions on the movement of labour and capital there shall be no objection to a single fiscal policy. An EU citizen in a consolidating state has no incentive to pay higher taxes to bring the national levels of debt down, he would rather move to an area

11 See Sinn and Sinn (2015). 12 See Cioffi et al. (2019).

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of fiscal expansion and fiscal stability with better job prospects if possible. Although UK is no more an EU member, I think there is no harm to learn from the good practices of your ex-partner!

CHAPTER 6

Stagnation in Europe: A Lost Decade

Europe Will Above All Be Judged on Results In the previous passages of this treatise, I looked at the monetary and fiscal stance of the EU and the institutional infrastructures and the enormous changes that followed from the Global Financial Crisis and European Sovereign Debt Crisis. Now the question is that what has been the net result of these supposedly massive monetary and somewhat fiscal expansions and changes in the institutional architecture of the EU. Both the ECB and European Commission have tried to do “whatever it takes ” to preserve the Euro and the European Union. But the question is that how successful they have been; indeed, Euro has survived, and the predictions of its failure turned out to be wrong, despite the UK which has been a reluctant bride of Europe from day one, the remainder of the group members further integrated. The success of the EU should however not be based on how much the member states have been integrated but how much the lives of EU citizens have been improved. The benchmark for performance set by the Commission in the European Recovery plans was that “Europe will above all be judged on results ”. So, it is vital to review the results of all the fiscal, monetary and institutional measures taken in the wake of the Global Financial Crisis and the European Sovereign Debt Crisis. In terms of longevity of their impact, recessions are severe, sharp and long-lasting, leaving scars that take years and in some cases decades to © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6_6

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fade. The Global Financial Crisis was bound to have such a long-term adverse impact explicit in the sluggish growth and high unemployment in most of the developed countries. With some exceptions, for instance, Australia, crisis led to severe recessions in almost all the developed economies. Even though Europe was not the epicentre of the Global Financial Crisis, it had a devastating and prolonged impact, particularly in the periphery. Though the debt levels increased in all the nations due to economic slowdown, there were unprecedented and idiosyncratic repercussions in the Eurozone. Europe had the second movement and the European Sovereign Debt Crisis that followed the Global Financial Crisis, further exacerbated the economic outlook for eurozone, once again more severely in the periphery. What was once perceived to be a lost decade (a term initially used for Japan by Hayashi and Prescott) turned out to be a lot more than that, causing fears of a lost generation, new normal altogether1 and even at a point was posing an existential threat to EMU. Compared to the other major developed economies, for instance, the US, Japan and UK, the problems in Europe and particularly in the EMU have different contexts and implications. In response to the Global Finance Crisis and after the intervention to save the financial system, contrary to its counterparts, some of the EMU member countries had to be bailed out. Perhaps, according to some sceptics and as I discussed earlier, the response of the authorities in the EU had almost always been slow. Although, the “Verbal Easing ” of “Whatever it takes ” and the macroeconomic policy measure taken had some effects in terms of sovereign debt yield, particularly, for members like Italy and Spain, yet in terms of macroeconomic aggregates, the situation did not improve tremendously. This is evident in the fact that the real yield on the 10 years Spanish sovereign debt fell from its peak (7.1%) in August 2012 to approximately, 1.11% in August 2016. Similarly, in Italy, it fell from 6.3 to 1.2% in the same period. A prima facie manifestation of the argument that “while the economic rationale of monetary financing prohibitions is clear, they might under some circumstances contribute to the unfolding of a confidence crises”.2 This was very much the case, anyway I have discussed it at length earlier so will not reinvent the wheel. But despite the decrease in 1 In specific to UK, in 2016 Mark Carney the Governor of Bank of England argued, that “We meet today during the first lost decade since the 1860s. Over the past decade real earnings have grown at the slowest rate since the mid-nineteenth century”. 2 Bindseil and Winkler (2012, p. 44).

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the yield, the levels of the sovereign debt in the euro area remained high recently exceeding 100% of the GDP. The evidence on the yield specific to the euro area suggests that in addition to the financial and liquid risks, the fiscal and macroeconomic risks are perhaps the most important factors. Interventions in the form of Quantitative Easing (Q. Es) or Asset Purchase Program (APP) could have led to the decrease of the yield in the euro area, however, in its true essence, lowering yield merely leads to lowering the cost of borrowing for the sovereign. It has very little to do with the high levels of accumulated debt, constraining and limiting fiscal policies to manoeuvre. As I discussed earlier each country was on a different page in terms of fiscal outlook on the dawn of the Global Financial Crisis. Besides the robust recovery by Germany and other major None-EU economies like Canada the, UK and the US, on the whole, the Eurozone took a lot longer to hit its Pre-Global Financial Crisis peak (Fig. 6.1). Furthermore, despite the fact that on the whole the Eurozone might have recovered from the wounds of the Global Financial Crisis after six years, countries like Italy and Greece never recovered and were still way behind in catching up with their pre-crisis levels of output at the time of Pandemic outbreak. Portugal and Spain also took almost a decade to United States Canada

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regain their Pre-Crisis levels. Nonetheless, despite some modest growth in 2017–2019, Eurozone was still well below the long-term trend as the COVID-19 hit and obviously well behind the USA and UK which were supposed to have a greater adverse impact of financial crisis due to their gigantic financial sector. Sluggish recovery implied that it may take a few more years for Eurozone countries to catch up with their Pre-crises income level, for them, it is more than a lost decade. Compared with the USA and the UK, it took EMU about four and six years longer, respectively, to make up for the GDP losses due to GFC 2008. However, despite the follow-up on the recovery with other monetary unions like the USA and UK,3 there has been overall a snail recovery and in fact, EMU is not yet there on all the matrixes. This implies that if we go by the same pace, the recent outbreak of COVID-19 which has led to the 3rd shock and a whole new set of challenges to the EMU may have a longer adverse impact on Eurozone economies than any other region in the world. Nevertheless, it also seems that since 1975, in each recession the Eurozone take longer and longer to recover (Fig. 6.2). While the USA avoided the double-dip recession after the Global Financial Crisis 2008–2009, the Eurozone had its second dip from 2011 to 2013. It shows that every recession in the Eurozone seemed to put an even longer drag on the economy than its predecessor. Recovery has been slower in the recessions that occurred later and most significantly the Post-European Sovereign Debt Crisis. This implies that joining the Eurozone was limiting the members’ ability to recover a fact which is also explicitly in the countries which are not the member of Eurozone and recovered comparatively quickly. This also means that if not in the Eurozone, the member states, particularly those that have shown very sluggish recovery, might have recovered quickly after the Global Financial Crisis, perhaps, there would have been no European Sovereign Debt Crisis. A bird eye-view comparison of Eurozone recovery from the Global Financial Crisis and European Sovereign Debt Crisis and USA and UK from the Global Financial Crisis and even in the most recent case of COVID-19 recovery shows that the Eurozone has almost always recovered at a slower rate. Eurozone economy was already in bad shape before the arrival of the Pandemic. Since the 4th Quarter of 2017, the Eurozone economic activity had started to slow down. This economic sluggish

3 However, UK and USA are also fiscal unions or higher order.

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Fig. 6.2 GDP recovery path in euro area (Source CEPR)

continued until the arrival of COVID-19 and then the economies of the Eurozone took a nosedive (Fig. 6.3). The COVID-19 led to the free fall of the economies across the developed world, but this has been particularly the case in Europe. It’s not only the matter of going down but also how quickly you stand up on your feet. Since the Global Financial Crisis, it is the 3rd dip and perhaps the deepest one. The question would be, how long it will take to recover this time (Fig. 6.4). As the COVID-19 hit, the GDP of Greece was still well below 2010 levels, Italy was almost at the 2010 levels implying there was a textbook case of Lost Decade. Portugal had just started to show some modest growth. Germany had also started to slow down before the Pandemic hit and showed 0% growth in the 4th quarter of 2019 same as the Eurozone on the whole. Worst for Austria, France and Italy that contracted

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Fig. 6.3 Euro area and EU GDP growth rates % change over same quarter of the previous year, seasonally adjusted data (Source Eurostat)

US 120.

Germany UK France

110.

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EU-19 Spain Portugal

100.

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80. Greece

EU-19

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Fig. 6.4 GDP level from Global Financial Crisis to COVID-19 (Source OECD. Seasonally Adjustment: Chain linked volumes, index 2010 = 100 [2008Q1 to 2021Q1])

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by—0.2% in the same period which meant that before the COVID-19, Eurozone was already in trouble and that was after all the efforts I described at length in the previous passages, from all the fiscal, monetary and institutional changes. The following table makes it very clear (Table 6.1). Therefore, before we blame COVID-19 for all the damage to the European economies, there must be an acknowledgement of the fact that they were not doing great to start with. The same holds true for the labour market, particularly for Greece and Spain (Fig. 6.5). Labour market outlook of Greece, Italy and Spain remained very bleak during period between Global Financial Crisis and COVID-19. Though Italian and Portuguese labour markets started to show very slow recovery and unemployment came below double digits, at the end of 2019. Before the COVID-19 outbreak the unemployment rate in Eurozone was about 7.5% but with a country like Germany only 3.1% and Greece 16.8% suggesting large disparities. Since the COVID-19 the situation has started to deteriorate again. Single most discussed objective of the monetary authority of the Eurozone the ECB that has been the excuse for any monetary expansion either ample or not it took, the price stability or inflation target of below but close to 2% has been seldom achieved. Therefore, the so-called New Table 6.1 Growth rates of GDP in volume up to 2020Q2a Percentage change compared with the previous quarter

Euro area EU Belgium Czechia Germany Spain France Italy Latvia Lithuania Austria Portugal

2019Q3

2019Q4

2020Q1

2020Q2

0.3 0.3 0.4 0.5 0.3 0.4 0.2 0.6 0.0 0.8 −0.2 0.3

0.0 0.1 0.5 0.4 0.0 0.4 −0.2 −0.2 0.1 1.1 −0.2 0.7

−3.6 −3.2 −3.5 −3.4 −2.0 −5.2 −5.9 −5.4 −2.9 −0.3 −2.4 −3.8

−12.1 −11.9 −12.2 −8.4 −10.1 −18.5 −13.8 −12.4 −7.5 −5.1 −10.7 −14.1

Source Eurostat. Based on seasonally adjusteda data

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27

22

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%

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12 Italy Eu r o… France Portugal Ireland UK Germany

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Germany

Fig. 6.5 Eurozone unemployment rates from Global Financial Crisis to COVID-19 (Source Eurostat)

strategy of ECB the involves the adoption of a “symmetric” 2% inflation target over the medium term seems to be just all talk and less action, particularly in the light of the record on inflation targeting (Fig. 6.6). Most of the time the inflation has been undershooting its target of 2% in the Eurozone and this has been beside all the monetary easing which I have discussed at length earlier. The sluggishness of economic activity and the huge labour market slack that has been manifested in the high rate of unemployment in some of the eurozone members explains the dynamics of inflation. Most of the time the Eurozone had been struggling to avoid deflation. Now one thing we should expect from this deflation is the increase in the competitiveness of the Eurozone in general and deflating countries like Greece, Italy and Spain in particular. But has that really happened? Has the internal devaluation given Greece, Italy, Portugal and Spain anything? Their competitiveness and current account surplus should have been going through the roof, but did it? (Fig. 6.7) As obvious, despite the deflation and structural reforms and some of the most stringent measures to enhance the competitiveness of the Eurozone, the economies that were weak remained very weak. Greece continued to run a consistent trade deficit over a painful decade. It

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-3.

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must be taken into account that Greece had a smaller overall size of the economy than 2010 which means that deficit is in proportion to a lot smaller economy. Tightening the belt certainly not helped Greece. Italy showed modest progress in this regard but putting it together with its GDP, it seems that a whole decade of efforts could not enhance its economic growth. Perhaps, the gains on the external balance were losses in the domestic consumption. Portugal, France and Spain also showed a very little gain in terms of their trade balance and most importantly these trivial gains were lost before the COVID-19. Mid 2019 was the highest point for these economies and they start to run a deficit before the arrival of the crisis. This was beside the deflation and massive wage deflation as evident in the shrinkage in wages of a number of countries (Fig. 6.8). Greece and Portugal had large reductions in wages. There was an accumulated wage cut of about −23.8% from 2010 to 2016 for Greece whereas for Portugal the wages saw the biggest slump of about 6.5% in 2016 though on average, they contracted about −0.5% annually during 4

Germany

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Fig. 6.8 Labour cost index percentage change period on period (Source Eurostat)

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2010–2016. There was also wage stagnation and no substantial increase in the labour cost for Spain, Italy and France. Germany maintained a large trade surplus, fiscal balance and fairly robust economic growth but until the end of the decade, there was no substantial increase in German wage costs. This is a clear manifestation of the fact that an exportdriven economy cannot rely on the exports forever, particularly when the demand for its products diminishes due to the deterioration of counterparties economies. A huge level of unemployment that accompanied stagnating economic activity in some of the Eurozone economies also came with the lowering labour costs but with all this pain, there were very little gains. In fact, it was just a matter of time that the contagion of this contraction caught Germany. Collectively, the Eurozone statistics may show a little less bleak picture, but it is still not great when it comes to comparison with other developed economies. Overall performance of the euro area in terms of inflation, economic growth and particularly employment in the decade 2010–2019 are explicit in the Fig. 6.9. Despite the strong performance of countries like Germany, the weak members of the Union put a substantial drag on the economic activity on the whole. On average, Eurozone grew slower than Japan, UK and the US. In terms of labour market outlook, the unemployment levels remained high and consistently in double figures. In fact, if we compare 12.00 Unemployment 10.00 8.00 Unemployment

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Inflation GDP

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GDP GDP Inflation

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Fig. 6.9 Average annual inflation, growth and unemployment during the Lost Decade—2010–2019 (Source OECD)

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Eurozone with Japan, despite slow growth, both the inflation and unemployment have been very low in Japan implying a comparatively much lower social cost. Nonetheless, the recent years have shown stronger performance and historically very low rates of unemployment in the UK, the USA and Japan, while despite being very high on the Union level, the situation is even worst in some of the member countries of EMU, for instance, Greece and Italy remained around 1/5th of the labour force. High and persistent levels of high unemployment are a major issue for the long-term economic prospect of the EMU. Perhaps, in Keynes’s (1936, p. 372) words, “the outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes ”. It is a clear sign of more than a Lost Decade for some members of the EMU. On the Lost Decade in Japan Fumio Hayashi and Edward C. Prescott have argued, that “there is no evidence of profitable investment opportunities not being exploited due to lack of access to capital markets. The problem then and still today is a low productivity growth rate”. Unfortunately, in the case of Japan, it did not end in a decade, however, a notable point which requires emphasise here is that in the presence of very high unemployment, slow growth and huge sovereign debt, expecting productivity growth to shoot off is a flight of fancy. This has been the case in the Eurozone (Fig. 6.10). Clearly, there was no remarkable performance by Greece and Italy and their productivity in 2019 was at levels worse than in 2010. But I must say that the performance of Spain, France, Germany and Portugal is not greatly impressive either. It was a Lost Decade in terms of productivity for Europe. Evidence suggests that in the case of Japan the growth has been constrained due to the credit conditions particularly for the small firms, lack of investment, stagnation of household consumption, the decline in household wealth, uncertainty about the future and lack of coordinated monetary policy.4 Most of these factors found and declared responsible for slow growth and stagnation in Japan are unambiguously manifested in the case of EMU. Hence, very logically a parallel with the Japanese lost decade can be drawn, as a number of these causes, for instance, lack of investment is also explicit in the EMU case (Fig. 6.11). 4 see Motonishi and Yoshikawa (1999), Horioka (2006), Hamada and Okada (2009) for a detailed insight into the causes of prolonged stagnation and lost decade for Japanese economy.

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Fig. 6.11 Eurostat)

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AS the COVID-19 hit, productivity has also taken a nosedive. This could have long-term adverse implications for the EU and particularly for Greece and Italy as they have already lost a lot in the proceeding decade. A permanent shock means the last straw that will break the back of the overburdened and fatigued economies of the periphery. The COVID-19 is the third major challenge to the ECB since its inception where it has to do the Lender of Last Resort function. It is also a bigger challenge than the ones faced by the EU before! If we make a fair judgement, the period between the Global Financial Crisis and COVID-19 outbreak has been over a decade of failure on economic and political fronts where the second-largest economy of EU went for divorce. Now the question is how much will be learnt from mistakes and shall we expect another lost decade of sluggishness, we shall see! But just to remember that Europe will above all be judged on results which have not been great hitherto!

CHAPTER 7

TARGET2: Off the TARGET

Eurozone Monetary system---A Hub with Many Spokes Despite the similarities between Japan and the Eurozone in terms of slow growth and stagnation upon which I have drawn earlier, there are some major differences between EuroZone and its counterparts including the UK, Japan and the USA and one of the key differences is in their monetary system. The Eurozone being a currency union without fiscal union implies none of its members has a sovereign currency, neither their National Central Banks (NCBs) could act as the Lender of the Last Resort. Perhaps, this is the reason that led the European Central Bank (ECB) to make effort towards whatever it takes to bring stability to the euro area. Despite the efforts which included negative interest rates, Forward Guidance, collateral criteria changes, Long-Term Refinancing Operations (LTROs) and Large-Scale Asset Purchase Programme which entailed assets worth more than e3.017 trillion as it stands and monthly rounds of a grocery bill in excess of e80 billion, the outlook of the EMU economy has not and still isn’t all that promising. Perhaps, the reason given by the ECB at the time of expansion of the facility was that:

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6_7

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The expanded asset purchase programme (APP) includes all purchase programmes under which private sector securities and public sector securities are purchased to address the risks of a too-prolonged period of low inflation. (ECB, 2017a)

With hindsight, it is clear that the ECB has not been very successful in achieving even this single objective of inflation targeting. Nonetheless, the greater issues around growth and employment, particularly in the periphery remained a challenge throughout the period that followed the Global Financial Crisis and European Sovereign Debt Crisis. Perhaps, one can also argue that in the presence of high unemployment and sluggish growth, particularly in the periphery, the aspect of price stability is not very promising. A chain is as strong as its weakest link, the poor economic performance by some members of EMU weighs on the overall growth of the union. Undoubtedly, the low inflation adds to the difficulty of dealing with sovereign debts and deflation makes it worse. On the unemployment, British economist William Beveridge in 1931 famously described it as Unemployment is like a headache or a high temperature -- unpleasant and exhausting but not carrying in itself any explanation of its cause.

But, even if inflation had increased in such a scenario of low growth and high unemployment in the periphery, the social cost would have been even higher. Evidence on Large-Scale Assets Purchase Programmes Aka Quantitate Easing (QE) from Japan, UK and the USA suggest varying degrees of impact on growth and inflation. The Large-Scale Asset Purchase Programmes or Q. Es do come with a number of risks including risks in terms of financial stability, transmission failure and fatigue, redistribution and inequalities, coordination failure and government budget constraint. Concomitantly, it is logically plausible to look for some alternative, as strategies adopted by the ECB so far but did not bring hugely applaudable success in terms of growth and employment. Perhaps, the efforts on solving existential issues faced by the Eurozone have been more a matter of “muddling through” and focus had been on the regulatory side, completion of unions within the unions. Over a decade long stagnation had a drastic impact on European integration and the unfortunate part of it is that this stagnation was not completely a Black-Swan event:

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Based on current policy and its likely effects, we are looking at a lost European decade of economic stagnation low growth, high unemployment, zombie banks and vulnerability to exogenous shocks which will sap Europe’s strength, heighten political tensions about the future of the Eurozone and European Union, and cause Europe to play a diminished role in world affairs. (Wright, 2013, p. 7)

Indeed, the political constraints play a big role in defining the degree to which stabilisation policies can act effectively.1 Euro area stands apart from the earlier cited counterparts like USA, UK and Japan on various grounds, for instance, it is a monetary union without fiscal union and has institutional frameworks which differ and, in a nutshell, it is quite rightly perceived as an incomplete integration project, these deficiencies weigh on its economic performance.2 To reiterate, a unique feature of the euro area, like its intuitional architect which differs from the US, UK and Japan is its monetary system i.e. the Euro system. The structure of the Euro system is like “hub-and-spoke”, with the ECB being a hub working with a group of NCBs.3 All commercial banks in the Eurozone are legally required to maintain a reserve account with their NCBs which enables Euro system to handle large payments between banks by applying credits and debits to a reserve account to settle payments. Bank transfers from one Eurozone country to another results in the balance entries in which the central bank of the transferring country records a liability to the rest of the Euro system while the central bank of the receiving country records a credit. The NCBs are changed with printing currency, operating payment systems and undertaking monetary policy operations as directed by the ECB, furthermore, they keep the legal ownership of the assets acquired by these operations. Despite independence, the NCBs still hand over their surplus profit to fiscal authorities and are examined by national government auditors. This implies that the NCBs are more national than the European, this is an important aspect to keep in the context for understanding the function of Euro systems decades on. One of the key elements of this monetary system is the TransEuropean Automated Real-time Gross Settlement Express Transfer System (in short TARGET2). Since the GFC, there has been a huge 1 Gunzinger and Sturm (2016). 2 See Germain and Schwartz (2014), Jones et al. (2016), Copelovitch et al. (2016). 3 Whelan (2014b).

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build-up of the TARGET2 balances which then led to a bitter debate on their causes as well as consequences (detailed discussion in next section). Among the other deficiencies of the European integration project, there is no mechanism to date for the settlement of these imbalances, not even to keep them in check. In this treatise, I will propose a mechanism for the settlement of these balances in a fair and equitable way which as a consequence can have four-tier effects in terms of employment, growth, fiscal space and price and financial stability.

Trans-European Automated Real-time Gross Settlement Express Transfer System (TARGET2) Creation of the Economic and Monetary Union of the European Union (EMU) that was agreed in Maastricht was not a straightforward task. Some of these difficulties, including the movement of labour and capital within the EMU, were acknowledged in the All Saints’ Day Manifesto for European Monetary Union as early as 1975. However, it was assumed in the Manifesto that the EMU would not be a reason for high unemployment. A policy mix entailing transfers as well as productivity increases in the long term could solve the issue. With the benefit of hindsight, we can see that the situation is less promising. The Maastricht Treaty, which provided the legal basis for the EMU as well as the European System of Central Banks (ESCB) and European Central Bank (ECB), did not provide much operational details on the creation of the EMU, the functioning and operations of the ECB and National Central Banks (Euro system), or on any issue that may arise due to their functioning. Further work was left to the European Monetary Institute (EMI), which operated from January 1999 to June 1998 until its successor ECB took over. We must be aware of the fact that the treaties and laws of the land can be at odds with the laws of economics and economic realities, so have been the EU treaties and the economic fundamentals and realities on the ground! The EMI and its working groups, including the Working Group on EU Payment Systems, did work on establishing the Trans-European Automated Real-time Gross Settlement Express Transfer System (TARGET), which is the real-time gross settlement (RTGS) mechanism of the Euro system. This system worked reasonably well and, like any other system, is not 100 per cent perfect. Though the word “settlement ” is part of the TARGET (or TARGET2 as it’s called nowadays) system, there was no real settlement mechanism in a true sense. On the issue of settlement between the

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ECB and National Central Banks (NCBs), as EMI documents released under a public access regime suggest, it was decided that the participating NCBs and the ECB would not impose intra-day credit limits on each other, which could impede the execution of payments. So, by definition, the TARGET2 is a payment processing system that accounts for most of the cross-border money flows within the EMU. As it is a RealTime Gross Settlement (RTGS) system of the euro where the settlements take place in real-time, and each transfer is settled individually. The ECB keeps track of these cross-border flows in its accounting system. The net amounts of these flows are called TARGET2 balances. The TARGET2 is one of the largest wholesale payment systems, its significance can be judged by its magnitude as in less than four days, the size of payments it settles is equivalent to the annual GDP of the euro area. The daily average of processed payments could amount in access of a value as high as e1.9 trillion.4 In a nutshell, as acknowledged by the ECB: The TARGET2 has a key role and responsibility in ensuring the smooth transmission of monetary policy, the functioning of financial markets, financial stability and reduction of systemic risk in the Euro Area. (ECB, 2017b)

Seemingly complex the system works on a very basic double-entry accounting principle. Central bank transferring the money records a liability to the rest of the Euro system which the central bank of the receiving country records as a credit. If a country has a net TARGET2 liability, its banks in total have experienced net outflows of funds to the rest of the Eurozone. Conversely, if a country has net TARGET claims, its banks have received a net inflow of funds (Fig. 7.1). The TARGET2 claims have no collateral associated with them, it is due to the reason that they are claims on the ECB which can create euros and 4 The system is based on a single platform infrastructure and the entire application is based on an integrated central technical infrastructure i.e. “Single Shared Platform” (SSP). The SSP is operated by three central banks which are Banque de France, Deutsche Bundesbank and Banca d’Italia. The payments settled via TARGET2 are mostly related to the refining operations with the central banks, transactions between credit initiations and settlement in central bank money conducted by more than 80 other financial market infrastructures. There are over 1000 direct and over 700 indirect participates with over 5000 correspondents. There are over 57,000 banks (including branches and subsidiaries) which can be addressed via TARGET2. Please see ECB (2017b) for details insight into the history and functions of TARGET2.

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Fig. 7.1 TARGET2 payment system, a simple illustration

therefore no collateral is required.5 On this aspect, one can argue that the TARGET2 liabilities are collateralised by the government bonds that banks pledge to NCBs and that these liabilities present a kind of collateral which I discussed earlier have changed quality and criteria when and if required. In simple words, the collateral criteria have been relaxed and quality has been compromised when there have been issues. Hence there is a question that what’s the point of having a criterion that is turned and twisted when needed. Anyway, the pledged government bonds or collateral by the commercial banks to the NCBs are still owned by the former, nonetheless, they are counted as assets on the balance sheet of these banks and there is no mechanism to hand over these bonds to settle the claims. A point that has been sometimes made and shall be acknowledged here is that in the EMU, a claim in TARGET2 does not in itself reflect the relevant NCB’s exposure to financial risk. In fact, the risk exposure of the central banks forming the Euro system (i.e. the NCBs and the ECB) relates to the monetary policy operations themselves, not to the associated TARGET2 balances. As always, a central bank faces counterparty risk when implementing monetary policy operations. The risk associated with 5 Whelan (2014b).

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the provision of central bank liquidity as part of the implementation of monetary policy is mitigated by a risk management framework. Furthermore, that the Euro system’s collateral framework is based on a public list of securities fulfilling the relevant eligibility criteria, together with risk control measures. However, this line of reasoning has two flaws, first, as I discussed earlier at length, the eligibility of collateral and collateral framework is something not very consistent. Standards had been lowered when and if required. They are not really the standards! Second, there are debit and credit in the TARGET2 system and there are debtors and creditors. Perhaps, that is the reason that there is an interest to receive or pay depending on your net position.

OFF the TARGET In the last few years, particularly since the Global Financial Crisis, European Sovereign Debt Crisis and most recently under COVID-19, the functioning of the TARGET2 has resulted in large claims and liabilities on the Eurozone members NCBs’ balance sheets.6 In terms of size, these balance entries have piled up so much that some central banks e.g. Bundesbank has “Intra-Euro-system” credit well above a quarter of Germany’s annual national income or GDP. This scenario is explicitly depictured in the Fig. 7.2. Build-up of these entries (so-called TARGET2 balances) sparked debate on their existence as well as implications for the Eurozone economies. Most prominently, Professor Hans-Werner Sinn from Munich University declared them as a “The ECB’s secret bailout strategy” and a mechanism to finance the current-account deficit of the periphery, in particular, Greece, Ireland, Portugal and Spain (GIPS).7 Furthermore, that the lending by the National Central Banks of GIPS has come at the expense of Eurozone exporting countries which are forced to export public capital to deficit countries.8 Similar thoughts were expressed by 6 Sinn (2020). 7 Sinn (2011). In their remarkable study, Sinn and Wollmershäuser (2012, p. 469)

argued that the “Target credit financed substantial portions, if not most, of the current account deficits of Greece and Portugal during the first three years of the crisis, and a sizeable fraction of the Spanish current account deficit. In the case of Ireland, they financed a huge capital flight in addition to the country’s current account deficit ”. 8 Sinn and Wollmershäuser (2012).

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Germany

1100 1000 900 800 700 600

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Estonia Ireland Malta

Fig. 7.2 TARGET2 imbalances over two decades—Net claims on Euro system (Source Euro Crisis Monitor, Institute of Empirical Economic Research, Osnabrück University)

Michael Burda9 while looking through the lens of Scottish Philosopher David Hume (1752) wisdom on the adjustment of external imbalances.10 He to some extent intuitively argued that in the Eurozone there is no authority to regulate these imbalances and a passive monetisation of these

9 Burda (2012). 10 Hume (1752).

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imbalances by ECB has put the “Hume on Hold” making Germany a hostage to the monetary union.11 As private capital flows to these countries dried up and turned into the capital flight, the ECB has involuntarily financed the resulting balance-ofpayment deficits with monetary clearing credits, the so-called Target2 system. (Burda, 2012, p. 2)

There are some scholars12 who have suggested that the uneven reliance on liquidity and resulting TARGET2 imbalances are actually due to the flight of capital and not entirely down to the current account deficit, erroneously implying that Sinn and Wollmershäuser had argued otherwise. For instance, Raphael Auer has argued that it was only after 2007 when the relationship between current-account balances and TARGET2 imbalances became statistically significant and economically sizeable. He associated it with the reflection of “sudden stop” to private sector capital that funded Current-Account imbalances previously. In terms of the types of capital flight that has caused the swelling imbalances to post-Global Financial Crisis, he reported that there were mostly deposit flights by private customers, a substantial retrenchment of cross-border interbank lending, and also an increase of bank’s holdings of high-quality sovereign debt, he concluded that since the imbalances were caused by a sudden stop and they were unlikely to grow significantly, particularly when the current-account imbalances in the Eurozone had started to diminish. However, with hindsight, we can see that after some initial decline, 11 David Hume in 1752 wrote “Where one nation has gotten the start of another in trade, it is very difficult for the latter to regain the ground it has lost…. But these advantages are compensated, in some measure, by the low price of labour in every nation which has not an extensive commerce and does not much abound in gold and silver. Manufactures, therefore gradually shift their places, leaving those countries and provinces which they have already enriched, and flying to others, whither they are allured by the cheapness of provisions and labour; till they have enriched these also, and are again banished by the same causes. And, in general, we may observe, that the dearness of everything, from plenty of money, is a disadvantage, which attends an established commerce, and sets bounds to it in every country, by enabling the poorer states to undersell the richer in all foreign markets”. 12 for instance, Buiter et al. (2011a, 2011b, 2011c), Jobst et al. (2012), Merler and Pisani-Ferry (2012), Bornhorst and Mody (2012), Cecchetti et al. (2012) and Whelan (2014b).

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after the Global Financial Crisis and European Sovereign Debt Crisis, the imbalances started to increase again. Particularly the COVID-19 has brought them to exceptionally and unprecedently high levels. This means that the imbalances are there to stay and perhaps significantly increase in difficult times. On the current-account imbalances as the cause of TARGET2 imbalances, economic historian Clemens Jobst (2011) argued that the largest imbalances in TARGET2 could have arisen even without a currentaccount deficit. He has opposed the notion of putting a limit suggested by some scholars13 and argued that it can be harmful to the monetary union as well as Germany if a situation Pre-2007 prevails where the Bundesbank had large debts in the Euro system. I think that lines of reasoning intuitive and putting a limit on the capital flows inside the EMU are against the whole idea of a monetary union. Furthermore, in times of crisis when uncertainty and fear prevail, such a measure can also give a negative signal to the markets. Any prudential measure or safeguard shall be put ex-ante. Therefore, something else is needed to solve the problem, I will revert to it later. On the aspect of reasons of imbalances, Karl Whelan argued that the changes in the TARGET2 balances have been mainly due to the monetary policy operations while very little role has been played by the current-account deficit. The crucial role has been played by the capital flight from the periphery, for instance, in countries like Spain, due to the capital flight and unwillingness of investors to finance the Spanish banks due to default risk or exit from euro and in some cases, money moved from Spanish to other countries banks. Due to loss of funding and the necessity to honour the withdrawals, periphery banks had to seek replacement funds from their central banks.14 If they had gone for the fire sale of assets instead of replacement funding, it could have damaged their solvency. Hence, the TARGET2 balances are largely dictated by the private capital follows and operational rules set by the ECB’s Governing 13 Sinn and Wollmershäuser (2012). 14 Whelan (2014b) reported strong association between TARGET2 balances and central

bank lending, in Spain, Italy, Ireland and Portugal, whereas the regression analysis showed very trivial impact of TARGET2 balances on Current-account balance. But an important point here to account for is that the lending was to accommodate financing gap emerged due to the capital flight and the gap at first place was due to the current-account deficit. Surplus nations do not need to often worry about the capital flight as they have their own savings. See Comments made by Frank Westermann and Ethan Ilzetzki in Whelan (2014b).

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Council as loans are to be issued only against eligible collateral. Even where there are programmes like Emergency Liquidity Assistance (ELA) in which the NCBs make loans against non-standard collateral, it also needs to be approved by the ECB (as Article 14 suggests). Hence, there is no room for NCBs to deliberately increase their liabilities. Nonetheless, the ECB cannot create money outside procedures approved by the Governing Council. Whelan’s point of view was however strongly challenged by Frank Westermann as he argued that the close link between TARGET2 balances and central bank credit is an original finding of HansWerner Sinn and Timo Wollmershäuser. Furthermore, that the notion that capital flight leads to TARGET2 imbalances is not contrary to position by Sinn and Wollmershäuser and rather an integral part of their analysis. Ethan Ilzetzki in his remarks on the study by Whelan also argued that statistically we will not be able to find correlation between TARGET2 balances and current-account balance because of the very effective bailout provided by the TARGET2 system. In my personal view, the critique by Frank Westermann and Ethan Ilzetzki is fair, and I think trying to find a statistical relationship between the TARGET2 imbalances and currentaccount balances will be a red hearing or perhaps what we call in Germany Trick 17. On the point of eligible collateral, I would say that it is also a fact that the bar of eligible collateral and rules and procedures have been changing where and when required. On the capital flight being the root cause of imbalances, I think that argument makes sense, but the flight of capital should reverse at some time in future otherwise it is permanent, what the evidence suggests and clearly presented in the TARGET2 graph, the balances started to decrease from August 2012 to July 2014, but after that, they started to increase continuously reaching an all-time high as Pandemic hit. Hence, it is clear that the large imbalances are fairly long-term and have prevailed between crisis periods and there is no good reason to expect them to perish in foreseeable future. There is no set maturity or settlement deadline for the intra-Euro system claims; in fact, the TARGET2 liabilities are honoured by making interest payments. The payments are collected and redistributed by ECB to the central banks with positive TARGET2 balances. This is an important aspect as it means that a creditor country cannot force a debtor country to pay back and the creditor will have to live on an interest rate which could be zero and even negative in real terms. A negative nominal or real rate will imply a penalty for the creditor nations like Germany.

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Though there is an argument that due to the monetary income reallocation based on the capital-key weights, the increase in the net profit that NCBs of the surplus countries receive may become unrelated to the TARGET2 balances,15 furthermore, that in the case of Germany with its largest share in capital key and largest balances of TARGET2, it makes her the biggest recipient. But I think it is not the best argument on the grounds of fairness as the distribution of surplus based on the capital than mere capital key would be unfair to the creditor countries. Furthermore, as I said, there is not much interest either as the rates are ultral-ow around effective zero lower bound, so no net-profit income. On the exposure of the German banks, public and private sector to the risk of EMU breakup, Karl Whelan declared it modest due to two reasons that (a) Bundesbank’s liabilities to the rest of the Euro system in relation to the banknote issuances (b) falling claims of German commercial banks on the Eurozone periphery. I think so far, the banknote issuance-related liabilities of the Bundesbank have not been enough to completely offset the German credit balances, though, it might have done some good if used as a part of a wider policy which I will discuss in my proposal. As we witnessed there has been an increase in the German claims to unprecedented levels, so that argument does not hold either. Even if the EMU does not break up the cost to Germany will remain in the form of unsettled claims. There is a notion, that exit from the euro does not imply exit from TARGET2, as some members of the TARGET2 are not in the Eurozone, hence, given the fact that there is no maturity date of TARGET2 settlement, honouring the interest payments will be ample. Even in the case of a full breakup where leaving members of TARGET2 do not honour their liabilities, the Bundesbank would significantly gain from seigniorage-based economic gains. I think this argument is also not very convincing that the exit from TARGET2 Germany will gain from seigniorage-based economic gains. Does it imply that Germany can win its monetary freedom at the cost of TARGET2 claims? I don’t think anybody means that in the Eurozone. Furthermore, this may not be the case for other surplus countries like the Netherlands. Lastly, the argument on the loss of TARGET2 assets with an increase in German inflation is also speculative as well as the threat that due to the Breakup of EMU Germany would face appreciated currency, though the net asset position and issues

15 Karl Whelan (2014b).

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around financial stability are real. Therefore, the argument16 that in fact the German household, savers and financial intuitions have hugely benefited due to the presence of TARGET2 and its imbalances due to financial stability and the risk transfer from the private sector to central banks do not hold water. It’s not been the case that the TARGET2 imbalances have not been critiqued or everybody thought it’s Hunky-dory. Professor Hans-Werner Sinn has been one of the most prominent critics of TARGET2 imbalances in the Eurozone. He argued that there had been three phases of capital flows since the introduction of the euro. In the first phase, private capital flowed copiously from Germany to the periphery and helped the economies there to bloom. This led to the availability of cheap credit, build-up or property bubble, erosion of periphery competitiveness through wage and price inflation and increasing current-account deficit. To Professor Sinn, this was also painful for Germany who had to face low investment which compelled her to do strict reforms restraining wage growth under Mr Schroeder’s government to gain competitiveness. In the second phase, which started when the financial crisis hit, private capital dried up and the ECB helped out by running the money-printing press, which, as will be explained below, amounted to a forced capital export from the Bundesbank. According to Professor Sinn, overall, the ECB covered 88% of the current-account deficits periphery with the printing press in the three years following Global Financial Crisis. This also led to an increase in the TARGET2 imbalances and German credit claims. In the third phase, which begun in 2011, public capital flows by way of the rescue packages are being activated. By this Professor Sinn referred to the various bailout and support packages through European Financial Stability Mechanism (EFSM) and the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) which I have discussed earlier at length. I think there is some weight of evidence in the argument put forward by Professor Hans-Werner Sinn. As it is clear that the German savings have been flowing to the periphery in the pre-crisis period (Fig. 7.3). Without significant interest rate differentials between the core and periphery and equivalent rating of German and periphery debt, the capital is bound to flow where slightly higher rates were offered. The implicit guarantees in the form of mutualisation of liabilities or joint security of

16 Dullien and Schieritz (2012).

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Fig. 7.3 Destination of German savings a decade after Euro—2002 to 2010 (Source Sinn [2011a] *The TARGET claims of the Bundesbank amounted to e325.6 billion at the end of 2010; at the end of 2001 they were minus e30.9 billion. By end of September 2020, they have reached over e1.1 trillion)

Euro by all the members mean Bundesbank lends its creditworthiness. Though there is one thing we shall not condone that the TARGET2 related capital flows from and to Germany varied between pre- and postcrisis and average may hide the fact that in the pre-crisis Era there was a time when Germany was debtor and capital flew out. But as the Crisis hit the capital flows reversed.

Secret Bailout, Is It or Isn’t? Professor Hans-Werner Sinn has declared the TARGET2 credit as Europe’s Secret Bailout. He also cautioned that the Quantitative Easing in Eurozone is a high-risk operation, especially for Germany and the Netherlands. The build-up of TARGET2 imbalances has been seen as a big issue for the stability of the Eurozone by some other scholars.17 It led them to call for their settlements as well as causing a debate on their consequences. In their article “On making sense of TARGET2 imbalances ”, focusing on Ireland and Germany, William Buiter et al. argued that the imbalances in Ireland are actually multiple of Irish current-account deficit, concomitantly, there are also large net capital outflows from Ireland which led to 17 Buiter et al. (2011), also see, Sinn (2012a), Sinn and Wollmershäuser (2012), Dullien and Schieritz (2012), Tornell and Westermann (2011).

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these imbalances.18 Despite this, they declared TARGET2 imbalances as a symptom of issues in the Banking system of the periphery and therefore urged that the system should be put on sound footings. Chmielewski and Sławinski ´ 19 disagreed to the “Stealth Bailout ” notion arguing that: The ECB’s liquidity loans to commercial banks in the Eurozone debtor countries shielded the Eurozone from a much deeper financial crisis than it actually occurred. The emergence of the TARGET2 imbalances was actually only an accounting phenomenon resulting from the fact that these liquidity loans were technically extended by the debtor countries’ national central banks which are de facto (from the monetary policy perspective) ECB’s regional branches. Chmielewski and Sławinski ´ (2019, p. 28)

Well, I think the truth is somewhere in the middle, it is indeed a fact that the TARGET2 credit has contributed to the financial stability during the crisis and closing the tap would have not been a good idea in the middle of firefighting, but calling TARGET2 mere accounting phenomenon is an understatement and the NCBs are not really ECB’s regional branches, they have their own identities and had it not been so, they could have been just abolished which may not be a bad idea altogether! In another notable study, Raphael A. Auer argued20 that there are mainly two types of transactions that can lead to this uneven use of liquidity, the real transaction through current-account and the financial transaction outflow of funds through capital account, in either case, in the absence of drawing from the international market, the country with deficit requires drawing from the ECB facility. On this logic, the TARGET2 imbalances are indicative of the use of liquidity by the National Central Banks provided by the ECB. In the case of Germany, there has been little drawn from this facility, whereas, in the case of TARGET2 deficit countries, the facility has

18 They argued that the TARGET2 Imbalances: (a) Cannot be automatically linked to current-account deficits in those countries; (b) Do not automatically reduce central bank credit to commercial banks in other member states (and any reduction of central bank credit should not be interpreted negatively, as implying reduced funding for banks and their customers); and (c) Should not be interpreted as a measure of the risk exposures of the National Central Banks of TARGET2 creditor countries (Buiter et al., 2011, p. 5). 19 Chmielewski and Sławinski ´ (2019). 20 Auer (2014).

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been excessively used. Furthermore, the association between the currentaccount balance and TARGET2 balances has only become significant since the Global Financial Crisis. Thus, it was inferred that Pre-crises deficit was in fact financed by the capital inflows.21 Nonetheless, the flight of capital to the safety (high-quality sovereign) and cross-border interbank operations had significant implications for TARGET2 imbalances. Importantly, Auer argued that Since T2 (TARGET2) imbalances were caused by a sudden stop and are unlikely to grow without bounds as Eurozone CA imbalances are currently diminishing at a rapid pace, there is no evidence that the institutional set-up of the ECB is fundamentally flawed in the sense that it will lead to everincreasing imbalances akin to the ones in the Bretton Woods system. It thus does not require fundamental reform.

On the Risk transfer from the debtor to the creditor and private to public sector it was suggested that, T2 (TARGET2) balances should not be settled or limited, but that instead the focus should be on harmonising collateral policies across the Eurozone as soon as possible and on working on long-term policies that guarantee the quality of collateral.” Furthermore, “While the T2 system does not in itself create any risks (rather it makes the risks that are necessarily associated with a monetary union more transparent), it may well change the incidence of potential losses for T2 creditor nations in case of a partial or full euro break-up, as it makes it more likely that losses will arise for national central banks rather than for commercial banks. (Auer, 2014, pp. 146–147)

With the benefit of hindsight, it is prima facie evidence that the TARGET2 imbalances had decreased to some extent for countries like Ireland and Greece. But, for some countries like Italy and Spain, they have increased further and in fact the COVID-19 has brought them to unprecedentedly high levels. Contrarily, for Germany, Netherlands and Luxemburg the surpluses have increased. On this aspect, we shall acknowledge the argument22 that the TARGET2 imbalances are due to

21 As suggested by Lane (2012) and Lane and Milesi-Ferretti (2001). 22 Fahrholz and Freytag’s (2012).

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current-account deficits and have hysteresis effects and in fact, the imbalance will prevail.23 In fact, the argument is also right to some extent, with the benefit of hindsight, it is clear that although imbalances have persisted, there have been some significant changes in the positions of deficit countries. For instance, Ireland has shown considerable improvement, yet on the other hand, Italian and Spanish TARGET2 imbalances have worsened. Undoubtedly, Germany is an exception that has been consistently running a large surplus. At this juncture, a legitimate question can arise that shall these imbalances be settled, resolved or controlled and if there is an active policy response, what it shall be? Adjustment of TARGET2 imbalances is not important only for the periphery or deficits countries, but in fact even more important for Germany itself. The strategy of “kicking the can” is neither suitable for deficits nor appropriate for surplus countries. On this aspect, empirical evidence suggests that there are real costs of German claims on the Euro system through TARGET2. It has been reported by Bundesbank staff24 that: By the end of 2014 Germany had incurred accumulated losses of approximately EUR 17 billion in real terms due to TARGET2 imbalances. Additionally, calculating the real losses and gains for every euro area member country reveals that the TARGET2 system acts as an implicit redistribution mechanism, with a cumulated distribution volume of approximately EUR 40 billion. (Erler & Hohberger, 2016, p. 494)

It implies that even without the breakup of the Euro or a single country Exit, there is still some cost to hold the TARGET2 imbalance. An increase in inflation and persistence of ultra-low-interest rates would further increase the real cost for surplus countries. Clearly, it is not in the interest of Germany or any other surplus country to prolong the imbalances, particularly when the interest rates are too low. In the Post-COVID period as inflation may start to pick up, particularly with the New Strategy of ECB which may and may not work, real cost may substantially increase. But this is not good for the deficit countries either as they may have to pay higher interest in case of an increase in the MRO rates. Of course, 23 Furthermore, that the “TARGET2 is a disguised market-distorting subsidy of whole economies in the periphery of the Euro-system (p. 17)”. 24 Erler and Hohberger (2016).

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this does not seem to be a win–win situation. The question is how to get out of it. Can there be a settlement mechanism? On the aspect of settlements, Fahrholz and Freytag25 suggested an active role of government in repayments while Professor Sinn26 has suggested a cap on the balances. He also urged that the credit given by the Bundesbank (Target) to the GIPS is not to increase further. The Target balances are to be settled once-yearly with marketable assets bearing market interest rates, as is the case in the US. Transition rules for the existing balances could be agreed upon.27 Professor Sinn proposed settling the balances in a way similar to how the US system requires its District Feds to settle their Inter-district Settlement Account balances in each year April.28 It is done in a way that District Feds cover the net over the outflow of money by bilaterally transferring to the corresponding other District Feds marketable assets which they cannot issue themselves. Technically, this is done by reallocating ownership shares in, and annual interest distribution of, a joint clearing portfolio run by the Fed. In Professor Sinn’s proposal of transfer of assets by the TARGET2 debtor to creditor countries, it was argued “it would certainly be no solution to allow the deficit countries to settle their balances with normal government bonds that they issue themselves. That would be akin to jumping from the frying pan into the fire”. Therefore, the appropriate assets which can be transferred were the proposed marketable covered treasury bills or Euro Standard Bills, that would be standardised and collateralised by each corresponding government with state-owned real estate or senior rights to future tax revenue. As a minimum solution, Professor Sinn also showed agreement to former Bundesbank President Helmut Schlesinger’s idea of higher punitive interest rates on TARGET2 liabilities. I think the idea of asset transfer has some logic and might be applicable but with the higher interest rate, I doubt its practicality. The reason is that the debtor countries are and have been struggling and that is the reason they have been run huge TARGET2 liabilities. Increasing the interest will simply mean increasing the burden when their economies are struggling. These

25 Fahrholz and Freytag (2012). 26 Sinn (2011a). 27 Sinn (2011b). 28 Sinn (2012a).

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kinds of instruments are the things you do ex-ante. Buiter et al.29 also discussed and proposed some potential solutions. Assessing the potential options on the table in terms of response by Germany towards TARGET2 surpluses, they suggested that the German banks could either (a) take the increased deposit from the German economy and deposit it with the Bundesbank which will result in an increase in the monetary base of the Eurozone or (b) to reduce their loans from Bundesbank which will result in unchanged monetary base of Germany and the Eurozone but the Bundesbank credit to German banks would fall. They argued that it is entirely up to the German banks what they chose, although it seems more likely that the German Banks will cut their credit from the Bundesbank. But, cutting the credit from the Bundesbank and taking the deposit from the German economy to increase the Eurozone monetary base may not bring much good to the German economy either. The problem is rather more complex and requires a well-designed mechanism. Keeping that complexity in context, in this treatise, I am proposing a solution on the settlement of TARGET2 balances and critically compare it with alternatives as well as implementation approaches. Stagnation & Settlement of TARGET2 Though there has been some disagreement on the causes of TARGET2 imbalances as I discussed in the last passage, the fact on the ground remained that there have been significant imbalances in the Eurozone which obviously require something to be done about them. The remedy tried in the EMU seems to be what Brandon Sheehan described as a contractionist cure where the burden of adjustment is put on the shoulders of deficit countries.30 Adjustment is expected to be achieved by deflation, lower economic activity and high unemployment. The prima facie evidence in the case of EMU suggests that it has not worked; nonetheless, the surplus countries are not immune in this process either. In Marc Lavoie words:

29 Buiter et al. (2011). 30 Brandon Sheehan (2009).

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[W]ithin the Eurozone, the Maastricht spirit is ever more powerful, based on the assumption that external deficits are caused by public deficits or a lack of wage-cost competitiveness and hence that sinners must be punished through sanctions and austerity policies to be imposed on deficit countries. Meanwhile, no pressure is being exerted on creditor countries to expand their economic activity and imports so as to alleviate the problems of the deficit countries. Marc Lavoie (2015)

Lavoie further emphasised that the Eurozone crisis is not a crisis of the balance of payment but a flawed design and a self-imposed prohibition on purchasing a large amount of government securities. Though the ECB had carried out large-scale asset purchases and there have been some modest positive effects as I discussed earlier, however, overall, the picture is still very bleak, there was a clear case of a lost decade and even more for some economies and, the imbalances persist. On the settlement of TARGET2 imbalances, it seems that Germany has been and is likely to be continuously running large surpluses and particularly during the crisis when there is an increase in the economic uncertainty the TARGET2 imbalances swells. There is also hysteresis in the case of countries that have been running large current-account deficits which persistently run imbalances,31 there seems to be hysteresis in the behaviour of German current-account surpluses as well, though the COVID-19 has some severe implications. The data on the current-account balances of the lost decade presented provides us with an interesting insight into the argument on the nexus between the current-account and TARGET2 balances (Fig. 7.4). It suggests that the current-account balances have been consistently improving since the Global Financial Crisis; however, if we compare it with the TARGET2 imbalances, it implies there is not an improvement, particularly for Italy and Spain. The euro area has run a large surplus in excess of 3% of GDP which is quite significant. Concomitantly, it implies that the sluggish growth which we discussed at the beginning of this treatise cannot be solely attributed to the current-account deficits in GIIPS or euro area. Along with the flight of capital (discussed earlier), one possible reason for this bleak economic outlook and current-account imbalance is the imbalance in the savings and investment in the euro area as well as in Germany (Fig. 7.5).

31 Fahrholz and Freytag (2012).

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Current Account as % of GDP

9

Germany Euro-Zone Italy Spain France Portugal

4

-1

Greece

-6

-11

-16

France

Germany

Greece

Italy

Portugal

Spain

Euro-Zone

Fig. 7.4 Current account as % of GDP, Germany, France, GIPS & Eurozone (Source [OECD]) 15 Germany Ireland

10

Euro Area

% of GDP

5

France

0

Italy Portugal

Greece

-5 -10 -15

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Ireland

Spain

France

Germany

Euro Area

Portugal

Greece

Italy

Fig. 7.5 Saving rate Germany, France, GIIPS & Euro area (Source [OECD])

As it suggests that the euro area has been running large savings of over 5% of its annual GDP, for Germany, the savings have been consistently higher than the euro area average and any other country in the Eurozone. With Greece and to some extent Portugal’s exceptions, the rest of the

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countries have not been running a huge deficit in terms of savings.32 This then raises the question of where we stand in terms of investment and infrastructure needs in Europe and if there are imbalances there as well. On this aspect, Barry Eichengreen has pointed out (2017, p. 1) that The explanation for Germany’s external surplus is not that it manipulates its currency or discriminates against imports, but that it saves more than it invests.33

I think the assessment by Eichengreen is fair. Similar thoughts were expressed by Marcel Fratzscher34 emphasising the fact that Germany has one of the lowest public investment rates in the industrialised world. Furthermore, that there were unrealised investment projects of worth about e136 billion (4.5% of GDP) and Germany’s school buildings alone need another e35 billion for repairs (DIW, 2013). In fact, this was to have long-term negative consequences for the German economy. An annual shortfall of investment amounted to 3% of GDP (Approx. e75 billion). The net public assets in Germany also diminished since 1999 from 20% of the GDP to zero per cent in 2013. The figure below shows the German capital stock over the 22 years period. The investment has been below the EU average as well as below any other country in the EU except Latvia. This is clearly not a good sign for the largest economy of Europe or economy of Europe on the whole (Fig. 7.6). Lack of investment in the German economy despite its strong economic performance got to have long-term adverse consequences. Low public infrastructure investment and investment in public education and digital services obviously have negative long-term implications for private economic activity and can lead to a reduction in private corporate investment. Public investment of Germany which can be measured through the Public net fixed capital formation which includes public expenditures 32 Recent estimates for Portugal also showed improvement to −1.4 in 2016. 33 The large German surplus has become a political issue in the year 2016 it was

around e270 billion ($297 billion) or 8.6% of Deutschland’s annual GDP. Nevertheless, the bilateral trade surplus of $65 billion with the United States has just fuelled the fire of rhetoric and blame coming from Washington. The Germany including Japan, China, South Korea and Taiwan have been put on the watch list of potential currency manipulators under the Trade Facilitation and Enforcement Act (2015). There has been different proposal and comparison and critique of them is provided by Nasir (2017). 34 Fratzscher (2017).

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Fig. 7.6 Net Capital Stock (1995–2017), Germany compared to other EU countries (Source European Commission [2018], https://www.bruegel. org/2018/06/understanding-the-lack-of-german-public-investment/. Notes Measured in 2010 prices; 1995 values indexed to 100; Germany in red, all other EU28 countries in grey colours, European Union in black)

going into assets (tangible and intangible) remained lower than Spain, France, Italy, UK and many other EU economies. Taking into account the effects of the depreciation of capital for which the better view can be obtained by looking at the Public net fixed capital formation, Germany’s performance was even worst (Fig. 7.7). Between 1993 and 2017, the net public sector capital formation has been very modest and even negative in some years, this meant that the investment was not even enough to recoup the losses due to depreciation. This is the story of an economy that is the largest economy in Europe and with a strong trade balance. In the Post-Global Financial Crisis and European Sovereign Crisis, Germany was the strongest economy and shall

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Fig. 7.7 Public investment of Germany and selected EU countries—Public net fixed capital formation (Source European Commission [2018])

have used this strength to act as the locomotive of economic growth in Europe, but alas this was not the case. Both the public and private net capital investment declined since the early 1990s where the public net capital investment remained around zero. Specifically, in 1991 the private gross fixed capital formation was about 22% with a net of about 8.5%, with a gradual decline these have dropped to 18.1% and 2.8%, respectively, in the year 2017. This is evident in the following graph (Fig. 7.8): The story of public sector gross fixed capital formation is even worst, it was 3.2% in 1991 with a net of 0.8%, however, in 2017 it was 2.2% with a net of 0%. The duration between 1991 and 2017 included several negative periods of net public gross fixed capital formation. This obviously meant a decrease in the public assets and this negativity is bound to spill to the private sector. The local, state and central governments putting together account for the German general government net fixed capital formation that remained negative for considerable durations in the

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Fig. 7.8 Germany gross & net fixed capital formation, private & public sectors (as a % of GDP) (Source Destatis [2018a]. https://www.bruegel.org/2018/06/ understanding-the-lack-of-german-public-investment/)

last two decades. Though to some extent, it can be attributed to the limitation of local governments in raising revenues, the German fiscal position has been very strong in the recent year, besides that it had been one of the tightest fist economies in the world when it comes to public investment. Public investment venues and responsibilities may vary between the Central, state and local government but there is unanimity in terms of its dynamics at different levels. Putting it in simple English, public investment has been in decline in all forms whomever responsibility it was. For instance, the infrastructure projects which have been attributed to the central government to the education which has been the responsibility of states and local government, there had been a decline. Even where there has been a modest increase in the central government expenditure the larger decline in the local government expenditure has eliminated

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any nominal gains. The construction sector both residential and nonresidential has been particularly the adversary of lack of public investment. The aspect of unification may be an interesting one to bring to the discussion. The fact of the matter is that there was an initial increase in the gross capital formation i.e. both private and public post-unification, particularly in the East Germany. However, this trend consistently declines in West Germany and also in East Germany after the mid-1990s. This is despite the fact that all levels of government including local, state and central the fiscal outlook had been buoyant with even fiscal surpluses. From 2014 to 2019, Germany ran budget surpluses in billions of Euros exceeding e72 billion in 2018 i.e. approx. 1.8% of its GDP, and it took a global Pandemic for Germany to change course and break its addiction to the surplus. But the years of underinvestment and even dis-investment by allowing the depreciation to erode the stock of real investment Germany has not given herself any favour. Despite the very bleak outlook of capital formation, the environment for the public and private investment in Germany has been very fertile, with the strong position of public finances and low-interest rates. In terms of opportunities, studies published in 2013 suggested that there was a need to invest in energy transition (e31–38 billion), transport infrastructure (annual deficit of e10 billion) and more could have been spent on Education approximately about 1% of GDP.35 But since this lack of investment was not addressed which meant that you got to do even more than before, this environment of low investment also prevailed in the Eurozone, especially after the GFC as suggested in the figure (Fig. 7.9): The situation seemed dire, particularly for the stressed periphery countries; however, the situation is not very different from the Eurozone either.36 There has been a consistent decline in investment since the Global Financial Crisis and in the case of Germany, the crisis did not make much difference as the investment was weak to start with. In fact, there has been significant deleveraging and reduction in investment in the developed countries which has fuelled the fire.37 While, specific to Eurozone, the low investment to the decline in public investment, financial

35 See Fratzscher (2013) and DIW (2013) for detailed insight into the investment needs in Germany. 36 See Buti and Mohl (2014). 37 Ruscher and Wolff (2012) and Cuerpo et al. (2013).

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Fig. 7.9 Real gross fixed capital formation to GDP ratios (%) US & Eurozone (Source European Commission)

fragmentation and high levels of economic uncertainty has added to the economic difficulty,38 this implies an economic environment that can be best categorised as “Secular Stagnation”.39 In addition to the investment in the traditional infrastructure venues, the investments in the Research and development (R&D) expenditure and digital technologies have also been very low. This has led to an increasing gap in terms of productivity as well as firms struggling to find staff with upscaled skills that also posed an obstacle to investment. According to reports by European Investment Banks 2019–20, about 77% of firms in the survey have reported that a lack of staff with the right skills is an impediment to investment. A sustainable portion of current jobs is also at the risk of automation. Europe

38 Buti and Mohl (2014). 39 Hansen (1939) introduced the term “secular stagnation” expressing concern about

the low birth rates and the end of America’s farmland expansion would generate underinvestment, deficient aggregate demand, and slow growth. “This is the essence of secular stagnation-sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment” (p. 5). See Teulings and Baldwin (2014), for a detailed insight into the secular stagnation.

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Fig. 7.10 Infrastructure investment by region, (2008 = 100) (Source EIB Infrastructure Database [IJ Global, EPEC, Eurostat]. Note Data missing for Belgium, Croatia, Lithuania, Poland and Romania. The EU average excludes the United Kingdom)

lagged behind the USA for investment in information and communication technologies with a Gap of about 1% of GDP. The investment rates in the middle-income regions of the EU have declined by about 14% from 2002 to 2018.40 In recent years, the trend has started to reverse but the progress has been slow and for investment to have the fruits, you got to wait for long-term, particularly if you had a large hole in the investments in the past. According to the EIB, there has been an investment gap of about e155 billion per year. There is also been a significant disparity among the different regions of the Union (Fig. 7.10). Since 2008, there has been an infrastructure investment decline in the Southern and Central and Eastern regions. The nominal increase in the western and northern regions also started to diminish after European Sovereign Debt Crisis and remained very modest in size. The transition to a net zero-carbon economy and honouring the commitments of the Paris Agreement on climate change also requires Europe to do more in terms of green and sustainable investment. Yet, in 2018 it invested only 1.2% of GDP on climate change mitigation which was lower than the USA (1.3%) 40 EIB Investment Report 2019–20 available at https://www.eib.org/attachments/efs/ economic_investment_report_2019_en.pdf.

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and China (3.3%). So not only the investment in general but the climate change mitigation is also comparatively less funded by Europe. Before the COVID hit, the infrastructure investment in Europe was standing at a 15-year low of 1.6% of GDP, with the greatest declines seen in regions that are already lagging in infrastructure. Though Post-Global Financial Crisis the growth in the developed world had been modest, it has been rather worse in the Eurozone. What Europe witnessed between the Global Financial Crisis and COVID-19 was 12 years of poor economic performance. There have been also tremendous institutional changes and regulatory frameworks and directives, but this has not been resulted and reflected in the economic growth. The story of Secular Stagnation in Europe was not a black-swan event. There were fears that Europe may face greater risks than its counterparts, for instance, Crafts argued that: The risks of secular stagnation are much greater in depressed Eurozone economies than in the US, due to less favourable demographics, lower productivity growth, the burden of fiscal consolidation, and the ECB’s strict focus on low inflation. Crafts (2014, p. 91)

The figure gives a Bird’s-eye view of the potential GDP loss since 2008 (Fig. 7.11). Either Secular Stagnation or a Lost Decade, the situation in Eurozone had not been promising for years. In that depressed economic environment, there are suggestions for raising demand by increasing investment and reducing savings, particularly by the creditor countries.41 In a study by IMF staff, “Is It Time for an Infrastructure Push? The Macroeconomic Effects of Public Investment ”, it was strongly argued that “In countries with infrastructure needs, the time is right for an infrastructure push. Borrowing costs are low and demand is weak in advanced economies, and there are infrastructure bottlenecks in many emerging markets and developing economies ”.42 On this aspect, in order to stimulate growth in the Eurozone including the periphery, a growth that can accommodate the fiscal consolidation in the fiscally stressed countries, one suggestion could have been that the countries like Germany should take an expansionary 41 Summers (2014). 42 See Abiad et al. (2015) also, see Arslanalp et al. (2010) on rule of public capital in

growth.

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Fig. 7.11 Actual and potential GDP in the Eurozone (obtained from Summer, 2014) (Source IMF World Economic Outlook Databases, Bloomberg)

fiscal stance.43 There is indeed some logic to this notion, and it would be cogent to agree to this policy in principle, however, in the Eurozone where there is a monetary union without a fiscal union, it brings a new set of challenges. The fiscal rules leave very little space for the fiscal policy to manoeuvre.44 In terms of reducing the external (trade) imbalance by reducing the internal (budget ) imbalance through increasing the public spending also have a crucial constraint i.e. Schuldenbremse (“debt brake”) or the balanced budget act. According to this act, the German (Federal and state) governments do not have space to run a budget deficit. Hence, in reality, the German budget surplus can neither fulfil the unmet government spending needs nor can it substantially reduce the external

43 Moro (2016). 44 Whelan (2014a) and Verhelst (2012).

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surplus.45 Needless to say, that Germany has no currency of its own to appreciate it either. In the case of appreciation of the Euro, I am not sure how much competitiveness Germany will lose but it will hamper the southern economies which have already been struggling. In this scenario, we can go back to the internal devaluation as I discussed earlier, which besides being painful did not seem to be working in the Eurozone. Parallel with the restricted fiscal space and stagnation, as discussed earlier, an important issue in the EMU is the build-up of TARGET2 balances. This has caused debate, but it seems the issue has been rather put under the carpet by the EMU establishment. On the scholarly front, while discussing the accumulation of TARGET2 imbalances, Moro has argued that: The fact that for some banking systems, such as Germany’s, the refinancing obtained from the Euro-system, net of the funds placed with the reserve account and the deposit facility, is negative in no way limits the ability of the Euro-system to control the monetary base. What is important for the transmission of the monetary policy is the net liquidity provided to euro-area banks, not how it is distributed. More generally, the increase of TARGET2 imbalances does not interfere with the conduct of monetary policy or the objective of price stability within the area. In particular, the existence of a large positive TARGET2 balance in some euro-area countries does not entail a risk of inflation. (Moro, 2016, p. 4)

This is an interesting line of reasoning, contrary to the earlier discussed argument; it implies that the piling up of imbalances is not a major issue. Nonetheless, the distribution of liquidity does not matter. However, it is very simple logic that the constraint to liquidity or uneven distribution to some member states could have severe implications for their respective economies. If you have a bulk of money in your bank account which you cannot bring into use, what good it is? That is what it is for the large German surplus of about e1.1 trillion as it stands while this passage is written. At this juncture, one can either take the TARGET2 imbalances as a cause or symptom of underlying bigger issues. In terms of it being a

45 Germany had a budget surplus of e23.7 billion in 2016 which is less than 10% of its trade surplus (e270 billion). It has been consistently running surplus from 2014–2019.

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symptom, Buiter et al.46 suggested it to be an indication of problems in the banking system and urged on their settlement. Hans-Werner on the other hand did see the build-up of imbalances as a big problem and raised alarm earlier than anybody else, but the solutions he proposed were very difficult to implement. Putting restrictions or transferring the assets is something with a devil in detail. For a mechanism to have the transfer of assets to settle TARGET2 imbalances, it was something to be put in place beforehand. Now the collateral standards are lowered and almost anything is accepted as an asset, do you really want to settle your TARGET2 balance with a periphery bond? This aspect has been acknowledged by Professor Sinn and he is aware of this issue but his suggestion to settle with the high-quality assets is not possible in a crisis situation unless the debtor nations have ample high-quality assets to start with! So, given that the fiscal space is limited and a parallel problem or symptom (or both) in the form of TARGET2 imbalances stands, what can be the appropriate way to solve the issues around Secular Stagnation? Before we go to finding the answer to this question, perhaps there is one aspect of TARGET2 which requires attention. The Eurozone step-up and TARGET2 system have several features, which make them an interesting apparatus to compare with the International Currency Union (ICU) plan proposed by Keynes in the 1940s. A comparison was made by Lavoie47 which led him to conclude that there are several similarities and in fact, TARGET2 system is even more flexible than Keynes plan as it has no limits on the amounts of advances the NCBs can take from the ECB. However, unlike the Keynes plan, the surplus countries gain interest rates whereas in the former the surplus (credit) holder will either not gain any interest or rather pay the interest. Well, in real terms there might be a penalty as the nominal rate of interest is peanuts and even less than the inflation rate which implies the real rate being negative. But anyway, there is no penalty as such, though it might have infuriated Germany to retaliate and might have led to pressure to settle the balance. Similarly, BarredoZuriarrain et al.48 have argued that the TARGET2 imbalances shall be seen in the context of Keynes Plan’s around the “International Clearing Union” (ICU) where the burden of imbalances shall be shared by both

46 Buiter et al. (2011). 47 Lavoie (2015). 48 Barredo-Zuriarrain et al. (2017).

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debtors and creditors and they shall take shared responsibility to overcome the imbalances. I think I cannot agree more with the point that the TARGET2 imbalances are a European problem not a problem of a single member, it shall be seen in that context while keeping the principle of fairness in mind. No EU member state shall be infinitely expected to subsidise the other state and I think it would be against the dignity of people in the periphery! Anyway, most importantly, unlike Keynes Plan, there are no capital controls and devaluation in the Eurozone. This important feature or shortcoming implies that the TARGET2 imbalances may persist in the absence of a settlement mechanism. A Settlement Mechanism On the settlement and solutions of TARGET2 imbalances, there are a few suggestions which I have discussed earlier. These proposed solutions have various difficulties in terms of implementation. For instance, a cap could be very disruptive; furthermore, turning off TARGET2 would have still led to large imbalances as long as the free movement of capital has been allowed among states.49 In fact, it would have led to even larger TARGET2 imbalances and withdrawals due to anxiety among depositors, so any restrictions, particularly in the time of crisis are jumping out of the frying pan into the fire! Similarly, limiting the refinancing operation which is against the core principle of equality would not have been helpful either, rather as Karl Whelan’s argued, it would have led to fire-sales of assets. Although Sinn and Wollmershäuser have also proposed to settle the liabilities each year by transfer of assets which I think is more constructive, in the existing framework it may not have much effect on the practice of monetary policy in the Eurozone. On this aspect, Sinn50 argued that following such a procedure (in line with Fed) would restrict the creation of too much credit. But the practice in EMU and the proposal by the European Economic Advisory Group (EEAG) is different from Fed as it proposed settlement via national government bonds backed by stateowned real estate or senior rights to future tax revenue, which is not an arrangement that exists in the US. Such a proposal will also have unintended consequences and implications for the TARGET2 deficit countries

49 Capital controls are prohibited in EU according to Article 63 of European Treaty. 50 Sinn (2012b).

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and deteriorate the cooperation in the Eurozone. Despite some similarities between the Federal Reserve and the Euro system both being “hub-and-spoke” structures and centralised body (Board of Governors) working with a group of district banks, there are some significant differences between FED Reserve and Euro system. The Federal Reserve is more centralised in terms of control with seven members of the Board of Governors having the majority of the FOMC setting monetary policy, furthermore, it is only the New York FED that carries out open market operations.51 In terms of payment systems, between US banks, they are processed through the Federal Reserve’s District banks by using a Fedwire, a system comparable with TARGET2 in terms of size. Similar to the TARGET2 balances in the Euro system the payment process through Fed-wire generates Inter-District Settlement Accounts (IDS). The New York Fed carrying out open market operations on instructions by the FOMC influence the national supply of liquidity. In doing so, it does not distinguish between counterparty banks on the basis of which Fed district they are based and makes no attempt to control the monetary base and its district-wise allocation. There is one more major difference between Fed and Euro system in relation to the internal balances generated by the payments systems i.e. that the Inter-District Settlement Accounts are settled annually by reallocating the ownership of Fed’s securities in its System Open Market Account (SOMA) among district banks.52 The aspect of assets I have discussed earlier and to reiterate to re-emphasis, this is something which requires changes in the institutional design of TARGET2 and shall be step-up ex-ante. The demand made by HansWerner Sinn about the transfer of assets has explicitly and I would say fairly stated that the underlying assets should be good as gold i.e. goldbacked securities. But there are not enough assets of that kind possessed by the deficit countries in the difficult times which could satisfy over e1.1 trillion German claims. It would be appropriate to argue that the TARGET2 imbalances are symptoms of underlying problems as well as the cause; there is an inherent limitation of this mechanism that becomes explicit when the imbalances are not settled. Perhaps, in the existing framework, there are potential 51 See Cour-Thimann (2013) for comparison between the Federal Reserves and Euro system. 52 Whelan (2014b), also see Lubik and Rhodes (2012) and Koning (2012) for a detailed insight into the settlement of Inter-District Settlement Accounts (IDS).

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solutions that can not only bring growth and employment in the Eurozone but also create fiscal space for the surplus countries to meet their investment requirements while with the same stone settle the imbalances of TARGET2 in a fair and equitable manner. Most importantly, it could be done even without urging Germany and other surplus countries to run large deficits, an advice which they might be reluctant to follow. I will argue that the accumulation of the large surpluses (budgetary, trade and TARGET2) by Germany shall not be seen as a sin, however, it could be considered as a good job but half-done. In the presence of Germany’s current-account surplus, it is difficult to see how periphery countries can achieve export-led growth; the export-led growth requires external demand.53 Concomitantly, in this context, it is reasonable to argue making a case for an expansionary stance by Germany to create that demand, particularly if we consider its own infrastructure needs. But we must acknowledge that the availability of fiscal space being an EMU member with no sovereign currency and bounded by fiscal rules is an important aspect to account for. At this point, we must also not condone the fact that the Euro-system balances also emerged due to the banknoterelated claims.54 The assets and liabilities associated with these notes are allocated according to the banknote allocation key, according to which 8% are allocated to the ECB and the remaining 92% are allocated according to each country’s capital key. The entry appears on the balance sheet of each NCB and the adjustment is made to account for the banknotes that have been allocated to each NCB and the notes put into circulation. Hence, a country and associated NCB which has issued more banknotes than its allocation key has an intra-euro-system liability. The NCB with banknote-related liabilities pays interest at MRO rate with interest transferred to countries with banknote-related Intra-Euro-system assets. In 2012, the rest of the Eurozone had a claim of about e200 billion on Germany relating to banknote issuance55 which was about e349.7 billion in October 2020. These contextual factors make me outline a potential proposal for using the TARGET2 mechanism to not only settle the 53 See Smaghi (2013) and Wright (2013). 54 In addition to the banknotes, the Euro-system balance also emerged due to the

Foreign exchange reserves transferred from NCBs to ECB after inception of EMU and also contribution to the capital by the NCBs to ECB (Both items are a claim by the NCBs on the ECB). 55 Whelan (2014b).

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imbalances but to resolve the issue of stagnation in the euro area. In this approach, the countries with a surplus position are allowed to settle their balances by withdrawing more liquidity from the Euro system while the deficit nations settle their debts against the same allowance. It could be done in three possible ways out of which only 3rd approach (Option C) is robustness against the Free-rider and Moral-hazard problems: A. Each member country of the Eurozone is granted the right to settle their surplus balance by withdrawing liquidity from the Euro-system equivalent to the amount of their net claims on the Euro system, where the deficit countries’ liabilities are written off against the right to withdraw. However, doing so would lead to countries with large surpluses drawing huge amounts and the countries with large deficit balances would also get their debts written off, but the countries which have maintained the net balance would suffer. Therefore, it could also lead to issues around the Moral hazard. B. Each member country is granted a right to withdraw a certain amount e.g. e200 billion, and then their claims can be adjusted with their surplus/deficit balances. Doing so would lead to the withdrawal of liquidity by some of the surplus members in excess of their claims, but the settlement of balances of the deficit countries. However, this approach would have caused a free-rider problem with the small members gaining at the expense of larger economies with more contributions to the Union. Nevertheless, it may not be able to satisfy the large German claims which have exceeded e1.1 trillion. C. The third scenario could be that the countries are allowed to withdraw according to their paid-up capital which then can be adjusted against their net claims on the Euro system. In doing so the countries with the largest share like Germany which also has a large surplus will gain the most in terms of their share from settlement while the countries like Italy with a large key yet large deficit will be able to settle their claims against their deficits.56 In essence, this will be an adjustment to the monetary base; however, in the suggested approach it will be a fair and equitable mechanism, based on their capital-key weights. The reason and logic for doing so are

56 See Appendix for the Euro Are Capital share.

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also manifested in the fact that the NCBs including the Bundesbank is an ECB shareholder, participating in the profit and losses made by the entire Euro system. It would be similar to following the existing rules of profit-sharing by the NCBs which they concomitantly hand over to the corresponding sovereign states. In the USA the operations are executed through the centralised System Open Market Account (SOMA), but in the Eurozone, these are carried out through NCBs; therefore, these imbalances do not arise in the US. Yet, that does not imply that the NCBs in the euro area impede on the settlement of imbalances. One may rightly see this proposal as an adjustment to the monetary base (which is one aspect but not the whole of this picture) and raises concerns about the price level, however, the evidence and facts presented earlier on the Secular Stagnation and in the EU suggest otherwise. By a simple and logical comparison, if the APP of over £ e3 trillion has not created an inflationary pressure, the settlement of TARGET2 and a monetary adjustment of relatively smaller size shall not be seen as a major threat. Lastly, the evidence on this aspect also suggests that the relationship between monetary aggregate and inflation is weak, particularly for the low inflation countries.57 As the proposed approach is set out, it is prone to critique and rigorous examination. The very first question it could ask is what could be the consequences of doing so? Theoretically and logically, the proposed approach shall have four order or tier effects. As the primary effect, there would be an increase in the liquidity in the EMU due to the adjustment to the monetary base. The deficits would be eliminated, and surplus balances would imply having enough liquidity to supply to corresponding members states with surplus balances. In the second-order or secondary effects, there would be liquidity creation and expansion in the member countries. Concomitantly, in the tertiary effects, there would be the creation of “much needed” fiscal space as the NCBs including the Bundesbank will hand over their profits to corresponding sovereigns. Lastly, in the quaternary effects, there would be positive crossborder economic (monetary and fiscal) spillovers. I will reiterate that the

57 (See De Grauwe and Polan [2005] analysis on 160 countries for detailed insight).

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60 50 40 30

%

20 10 0 -10 -20 -30 2004M01 2004M06 2004M11 2005M04 2005M09 2006M02 2006M07 2006M12 2007M05 2007M10 2008M03 2008M08 2009M01 2009M06 2009M11 2010M04 2010M09 2011M02 2011M07 2011M12 2012M05 2012M10 2013M03 2013M08 2014M01 2014M06 2014M11 2015M04 2015M09 2016M02 2016M07 2016M12

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Germany

Greece

Ireland

ITALY

Portugal

Spain

EMU

Fig. 7.12 Money supply among Germany, GIIPS, & Eurozone standardised, seasonally adjusted, year on year % (Source Eurostat)

proposed approach is fair, equitable and is within the boundaries of the existing statute of the EMU. Under the proposed policy, it is obvious that there would be multiple and rippling effects that are obvious and intuitive. As for the second-order effects, given that there has been an adjustment in the monetary base at the EMU level, there would be an increase in the available liquidity for all EMU member states. In a monetary union, it is obvious and the following figure is just a glimpse of an obvious synchronization of money supply among Germany, GIIPS and EMU (Fig. 7.12). This can be further elaborated by looking at the correlation of the Money supply (M1) among the G-GIIPS and EMU which is almost perfectly positive.58 The strong correlation of this sort in a monetary union is intuitive. Furthermore, it also implies economic integration and co-movements of the subject economies for the analysis of which one can open further lines of inquiries, though, it is prima facie.

58 Correlation coefficient ranging between 0.85 and 0.95.

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In the third-order implications of the proposed approach, there would be the creation of additional fiscal space for the EMU members. This fiscal space is created due to the repatriation of gains to members/shareholders of the Euro system based on their capital key/shareholding. In the existing arrangements, the assets and liabilities associated with these notes are allocated according to the banknote allocation key. According to the key, 8% is allocated to the ECB and the remaining 92% is allocated according to each country’s capital key. The entry appears on the balance sheet of each NCB. Adjustment is made to the accounts for the banknotes which have been allocated to each NCB and the notes are put into circulation. Hence, a country and associated NCB which has issued more banknotes than its allocation key has an intra-Euro-system liability. An NCB with banknote-related liabilities pays interest at the MRO rate with interest transferred to countries with banknote-related Intra-Euro-system assets. In October 2020, the rest of the Eurozone had a claim of about e349.7 billion against Germany relating to banknote issuance. Yet, in the proposed policy, along with other earlier cited benefits for the real economy, there would be no banknotes related to interest payments by the countries like Germany. Creation of fiscal space would have a further stimulative impact on their respective economies by either funding the earlier discussed needs of the German infrastructure or to curb the unemployment in countries like Greece and Spain or to pay for the Pandemic-related expenses and recovery. An important point to note here is that although in order to stimulate growth in the Eurozone including the periphery, there are some studies like which have suggested that the countries like Germany should take an expansionary fiscal stance.59 However, on the whole, in the Eurozone where the monetary union without a fiscal union doing so is challenging. Nonetheless, the fiscal rules also leave little space for the fiscal policy to manoeuvre and just add to these challenges. Hence, in the proposed mechanism it would be possible to create some fiscal space without breaching the fiscal rules. Lastly, as fourth-order impact, there would be implications through the cross-border positive economic spillovers among the countries and regions. There is already ample empirical support for the notion of positive spillovers among the European economies. For instance, Bicu and Lieb in their analysis on the cross-country spillovers showed that there was

59 Moro (2016).

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a substantial impact of fiscal spillovers from Italy and Spain to Germany and France in terms of output, private consumption and investment.60 Concomitantly, I would conclude that the stagnation in Europe is a universal truth and there has been more than the Lost Decade for Europe and particularly for the GIIPS. Perhaps, there and substantial contextual differences between the scenario in Europe and the story of the Japanese Lost Decade. The comparison with the other monetary unions, for instance, the UK and the USA also suggest EMU lagging far behind its counterparts. In line with the sluggish economic growth, there has been a parallel issue of swelling TARGET2 balances. In their genre, the TARGET2 balances are not merely a cause but a symptom of underlying major issues in the EMU. In this context, the proposed approach to settle the TARGET2 balances by necessary adjustment to the monetary base, where the repatriation of gains is on the basis of capital-key weights would not only cater for the desperate needs of German infrastructural regeneration but would also stimulate growth in the GIIPS. The proposed policy will lead to considerable gains in terms of investment, consumption, wages, economic growth as well as intra-EU exports and imports between and among Core and Periphery countries. There would also be increases in the liquidity at the country level and the creation of much needed fiscal space for the EMU members. Given the EMU is a monetary union without a fiscal union and there are fiscal rules to follow, the proposed approach facilitates the creation of fiscal space. The resulting fiscal space will then be helpful to cater to the infrastructure needs of the EMU countries including Germany. The proposed approach will be in particular helpful for Germany to address its infrastructure needs, settlement of large external surplus without running a budget deficit or breaching the balanced budget act (Schuldenbremse). Furthermore, it would also help to curb the high and persistent level of unemployment in the periphery which has persisted despite the stimulative efforts so far. In the context of Post-Pandemic recovery in the Eurozone, it would be immensely helpful. Lastly, there would be fiscal and monetary spillovers from the EMU countries. Proposed strategy can be used as an unconventional tool of EMU’s monetary policy. As it stands, the proposed policy is fair, equitable and the cost is comparable with the stimulative efforts put in so far.

60 Bicu and Lieb (2015).

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Despite the operational simplicity of this proposal, one may look at the size of the imbalances and like to be more strategic and take a number of complementary measures that not only settle the current imbalances but also stop the emergence of future imbalances. In terms of getting rid of the prevailing persistent huge imbalances, it is advisable to settle them by (a) adjustment to monetary base and allocation of liquidity based on capital key as I proposed above, (b) redemption of some of the marketable securities (similar to Fed) and (c) conversion of some of the TARGET2 debt into equity (similar to the contingent convertible bonds [CoCo]). Once the TARGET2 claims by surplus countries like Germany, Luxembourg and the Netherlands are given equity status, they can redeem it for a greater share in the capital key (which in principle shall be meant more voting rights in the Governing Council of the European Central Bank) and redemption of assets. In terms of making the modifications and development of an institutional framework to deter the future emergence of such imbalances, there should be (a) periodic settlement of the imbalances arising from the monetary operation (b) better collateral requirements (c) a penalty for lack of discipline and (d) an inherited settlement mechanism by using “safe” covered bonds issued by NCBs and member states. These are operational arrangements that shall not require any changes in the Treaty. The EU can decide by a qualified majority. Such arrangements would be fair to the large debtor countries such as Italy and Spain, which in the current economic outlook are nowhere near settling these debts. On the path to integration, Europeans have made considerable progress which are prima facie evident in the peace and stability of the last few decades, in which, according to Winston Churchill’s wish “hundreds of millions of toilers are able to regain the simple joys and hopes that make life worth living ”. Yet, it is still a work in process and the TARGET2 imbalances are the manifestation that we need to do a lot more for sustainable and fair integration!

CHAPTER 8

Europe: The Way Forward

Seven Decades of Integration: A Work Still in Process Architects of the European integration project were well aware of the difficulties and challenges it entails and occasionally, they did openly and honestly express their concerns, though often with hope and pinch of optimism. Starting at beginning of the second half of the twentieth century, the economic and political integration of Europe is the largest and longest integration project in human history, but seven decades later, it is still a work in process. Integration at this scale undoubtedly comes with profound difficulties and it would be fair to be sympathetic with the architects and builders of this project. Difficulties and the challenges ahead were envisaged by the Founding Fathers of European integration, most prominently by Robert Schuman. In his famous speech (Aka the Schuman Declaration) on 9 May 1950, he acknowledged that the: Europe will not be made all at once, or according to a single plan. It will be built through concrete achievements that first create a de facto solidarity.

Schuman was right! It took another 42 years to achieve a major milestone, during which Europe went through a great amount of political, economic and social transformation. Maastricht was a major milestone in this journey of integration. The Maastricht Treaty (the Treaty on © The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6_8

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European Union) signed on 7 February 1992 led to the creation of the European Union, though one shall not be confused: the signing up for the creation of a union does not mean integration, particularly in economic and monetary terms. Economic realities are more stringent and are underpinned by the economic fundamentals, which did not change much by signing up to the Treaty. Unfortunately, they did not change either with all the regulations that have come out from the European Institutions in the last few decades, particularly after the Global Financial Crisis and European Sovereign Debt Crisis! The Maastricht Treaty, which provided the legal basis for the EMU as well as the European System of Central Banks (ESCB) and European Central Bank (ECB), did not provide many operational details on the creation of the EMU, the functioning and operations of the ECB and National Central Banks (Euro system), or on any issue that may arise due to their functioning. Creation of the Economic and Monetary Union (EMU) that was agreed upon in Maastricht was not a straightforward task. Some of these difficulties, including the movement of labour and capital within the EMU, were acknowledged in the All-Saints’ Day Manifesto for European Monetary Union as early as 1975. However, it was assumed in the Manifesto that the EMU would not be a reason for high unemployment per se. A policy mix entailing transfers as well as productivity increases in the long term could solve the issue. With the benefit of hindsight, we can see that the situation is less promising after the Global Financial Crisis, and even lesser promising after the European Sovereign Debt Crisis. The COVID-19 appears to be scarier if we base our expectations on the performance of the Eurozone through the previous two crises. Permanent and disproportionate transfers are not possible due to not only political reasons but also on ethical grounds if ethics and morality got to do anything here. For the legal, moral, political and economic feasibility and acceptability of the intra-EU transfers, in all contexts, the Union will have to be at par with the most successful unions in the world. The COVID-19 appears to be the new storm not only for the whole world but particularly for the Eurozone. As we witnessed that the Eurozone in general and the periphery in particular, took a lot longer to recover from the Global Financial Crisis and European Sovereign Debt Crisis and in fact some member economics never recovered, we have every reason to fear that with the COVID-19, the EU could repeat the bleak historical record on recovery.

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COVID-19 Mother of All Crisis for EU The COVID-19 has shaken the whole world and all aspects of human civilisation. Due to its global influence, it is probably the most significant event of its kind since WWII. By the end of July 2021, the cases of infections had already exceeded 195 million with over 4.18 million deaths and still counting. There had been some positive developments on the vaccine, which was first rolled out in the UK, the recently divorced partner of the EU. In the race to approval, the Medicines and Healthcare products Regulatory Agency (MHRA) which is the drug regulator of the UK was the winner as it approved the Pfizer/BioNTech vaccine on 2 December 2020. The reason that the UK was successful in rolling out the vaccine before EU was that it had brought some changes in the regulations beforehand. So, when it came to approval, the MHRA was able to give authorisation to the vaccine that met safety and efficacy standards but has yet to finish the licensing process. The UK was choosing for herself and therefore the rollout decision was prompter than group decisions. It was not the first time that the EU was slower in responding, there are various other examples including the various fiscal and monetary policies and instruments that I have discussed at length in the earlier chapters. In specific to the COVID-19 vaccine, the British government had formed a Vaccines Taskforce which has been engaging with the Pharma and had signed the agreements with the drug makers. The UK is a smaller buyer as compared to the EU, so it may have lesser bargaining power, but it was still a buyer of hundreds of millions of doses. There were concerns about the prices but in the Pandemic that can be overlooked without much political loss. A big issue might be the liability clauses where in the UK the liabilities rests with the government while in the EU is with the companies. Rollout approaches are also different in the EU countries, for instance, in France the procedure adopted entailed more bureaucracy and documentation. Anyway, by mid-January Commission had authorised contracts with six companies for vaccine doses of about e2.3 billion and a pledge of a e1.4 billion contribution to the Coronavirus Global Response, an initiative launched by the President of the European Commission Ursula von der Leyen. Slow response and high infection rate in the third wave led to huge criticism of the EU, the attempt to close Ireland’s border with Northern Ireland to prevent the export of vaccines to the UK also reignited tensions with the UK over

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the Northern Ireland Protocol of the UK’s Withdrawal Agreement. Statements by President Ursula von der Leyen about banning the export of vaccines were not received very cheerfully by other countries, particularly the UK. Such behaviour indicates a contrast, particularly when the Commission talks about providing leadership to the world about global issues like Climate Change, etc. Undoubtedly, there is no monetary value that can be attached to human life, in the British Chancellor of Exchequer Rishi Sunak’s words “there is no trade-off between public health and the economy”. But it cannot be ruled out that good public health needs a healthy economy. While the health crisis may come to an end in a couple of years, the scars it would leave can take ages to fade, particularly in the Eurozone. Considering the performance of the Eurozone in the previous crisis, I fear more about the aspect of its economic recovery post-pandemic than any other part of the world. Pandemic and the lockdowns in various European countries implied restrictions on socio-economic activities and that has resulted in severe contractions of EU economies.

ECB’s Response: Another Battle to Pick Response from the European Central Bank was in time as far as timing is the concern, keeping in mind the bad shape of Eurozone economies even before the crisis manifested in the second half of 2019 that had compelled ECB to restart the Asset Purchase Programme.1 Choice of instruments, their magnitude and effectiveness are the aspects I will revert later, but regarding the Pandemic, ECB did act fairly promptly, first on 12 March 2020 where the Governing Council took a number of measures.2 It was decided that the additional Longer-Term Refinancing Operations (LTROs) will be conducted on the basis of a fixed-rate full allotment tender procedure and that the interest rate would be equal to the average

1 For account of ECB on its response to the coronavirus pandemic, visit https://www. ecb.europa.eu/home/search/coronavirus/html/index.en.html, also see Mosser (2020) and Cantú et al. (2021) for various central banks including Fed, BoJ, Bank of England and ECB response to COVID-19. 2 For details on account of ECB about its Monetary Policy Decisions in March 2020, visit https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.mp200312~8d3aec3ff2. en.html.

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rate on the deposit facility. In order to support the economy and businesses, particularly credit extensions by banks to SMEs, it was also decided that in the TLTRO III, even more favourable terms would be applied from June 2020 to June 2021. Interest rates during this period were decided to be 25 basis points lower than the average Main Refinancing Operations (MRO) rate. The amount that the counterparties can borrow in the TLTRO III operations was also raised by 50%. The Euro-system committees were mandated to investigate the further easing of collateral standards. Yes! the collateral standards which I have discussed at length earlier and how these standards are lowered when the push comes to shove. It seems like the lending decisions are made first and then the issue of making collateral acceptable by any means is addressed. The Asset Purchase Programme (APP) was also decided to be extended with additional net asset purchases of e120 billion. Though it was declared temporary, we shall see! Since the start of Asset Purchase Programmes (APPs) or Quantitative Easing (Q. Es), particularly by the US Fed, Bank of England and ECB, there seems to be no rolling back, so far.3 The Governing Council did express its view that it is expecting to continue to run the net Asset Purchase Programme (APP) until necessary and it will only end it shortly before raising the policy rates. In 12 March 2020 decision, the interest rates on Main Refinancing Operations, marginal lending facility and the deposit facility were kept unchanged at 0.00, 0.25 and − 0.50%, respectively. It was also expressed that the policy rates would be intended to keep at a lower level until the inflation does not get closer but below 2% level which was the inflation target at that point. A target seldom achieved! Six days later, on 18 March 2020, as the Pandemic intensified and hit the heart of Europe, the ECB announced e750 billion Pandemic Emergency Purchase Programme (PEPP). This was a week from the announcement of the e120 billion Asset Purchase Programme which was deemed temporary. Purchases were intended to include all sorts of assets under the existing Asset Purchase Programme (APP) and continue throughout 2020. Benchmark for the allocation of purchases of public sector securities across jurisdiction was once again the Capital Key of the 3 In a notable study on this aspect, Echarte Fernández et al. (2021) argued that the monetary stimulus in the wake of COVID-19 is being channelled into financial markets, allowing governments to finance themselves at low-interest rates while also raised questions on long-terms consequences such policy as inflation picks up.

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NCBs but is specific to the purchases of public sector securities it was decided that there would be flexibility to allow the fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions. The Greek government-issued securities were also given a waiver from the eligibility criteria under the PEPP. The Corporate Sector Purchase Programme (CSPP) was extended to include commercial papers. As the impact of the Pandemic materialised into one of the worst recessions in European history, the size of the PEPP envelope was increased by e600 billion on 4 June 2020 and again by e500 billion on 10 December 2020, making the total e1850 billion.4 All the existing eligible securities were deemed eligible, and Greece got a waiver on eligibility requirements on their public debt. Eligibility of non-financial commercial paper was also revisited, and securities residual maturity requirement was reduced from six months to 28 days. Four additional pandemic emergency longer-term refinancing operations (PELTROs) were decided to be offered in 2021. It has been declared that the net asset purchases under PEPP will not be terminated until the Pandemic is going on and, in any case, will not be terminated before 31 March 2022. With the continuous monthly purchases since it rolled out, the holdings under PEPP stood over e1.2526 trillion by July 2021. It meant that under PEPP the purchases were about e3684 per capita and still counting. This is a lot of monetary injection in terms of size only by one instrument. Other measures including the collateral requirement changes and policy rates were on top of it. The ECB also revised its strategy and the new strategy announced in July 2021 to adopt a “symmetric” 2% inflation target over the medium term. How much is the difference between just below 2% (which was seldom achieved) and 2%? The word “symmetric” does not hold much weight either because when you intend to keep inflation just below 2% that means just below 2% neither too far below nor too far above. Anyway, that was the new strategy in a nutshell.

Fiscal Measures: Death of Debt Break In parallel to the monetary stimulus by the ECB, the governments also put in to shoulder their economies in the time of Pandemic. Fiscal rules and state aid rules had been suspended and the Commission adopted 4 For details on Pandemic emergency purchase programme (PEPP), visit https://www. ecb.europa.eu/mopo/implement/pepp/html/index.en.html.

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a temporary framework to enable countries to support their economies during the Pandemic. I will revert to the EU level of response but first, let’s consider the fiscal measures by the government. Almost every government in the world and including the EU member states took an expansionary stance by providing a fiscal stimulus. Government’s budgetary expansions came in various forms including the increased spending on health and medical resources, keeping people employed even when they are not working, subsidies to the business and Public investment, tax reductions, differences of taxes and social security contributions, liquidity provisions and credit guarantees.5 Size of stimulus varied from country to country with Germany making one of the most generous increases in the fiscal expenditure of about 8.3% of its GDP. The years of budget surplus and consistent fall in the debt levels had put Germany in the best position at least in terms of public finances. Expansionary measures were taken at federal, state and local levels in Germany, though much of it seems to come from the federal level. The Financial Times report that “Germany tears up fiscal rule book to counter coronavirus pandemic”.6 The policy of Schwarze Null or “Black Zero” and Schuldenbremse or “Debt Brake” did not survive the Pandemic. Going forward there can also be more government spending and an increase in the deficit. Interestingly, there seems to be an ambition to return to the fiscal discipline or restoring the debt break soon after the crisis, paying back the debt, of course by Austerity and effort to run the surplus. The most crucial thing would be the “Timing ” I do fear that the Germany and EU will jump the gun again and pull out the stimulus too soon. There are already calls made by influential figures like President of the Bundestag Mr. Wolfgang Schäuble to return to fiscal discipline. Fascination with balancing the book as quickly as possible was also manifested in the projected change in the euro area and euro area countries’ budget balances in 2021 relative to 2020. Where there was a deficit ranging from −6 to −10% of GDP with overall euro area average of − 8% in 2020, the projection for 2021 was surplus from 0 to 4% with an overall euro area average of 2% (Fig. 8.1).

5 For “The Fiscal Response to the Economic Fallout from the Coronavirus ”, see Anderson et al. (2020). 6 For “Germany Tears Up Fiscal Rule Book to Counter Coronavirus Pandemic”, visit https://www.ft.com/content/dacd2ac6-6b5f-11ea-89df-41bea055720b.

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Fig. 8.1 Projected change in the euro area and euro area countries’ budget balances relative to the preceding year (% of GDP) (Source European Commission’s Autumn 2020 Economic Forecast)

This was clearly over-optimism to expect a sudden jump in the revenues! Worsening economic outlook and further waves of Pandemic led countries to take further expansionary measures. France announced an additional e100 billion stimulus package in September 2020. The Italian government also approved a package worth about e260 billion, though most of the money was to come from the EU’s special fund which has its own complexities and how you divide it among the member states. Though in April 2021, French Finance Minister Bruno Le Maire expressed concerns about the EU’s e750 billion recovery plan, calling it “not on the right track” and that it may not be very helpful in supporting growth. Time will tell how it plays out, but I do share the concerns of Mr. Le Marie and considering the failure of past Recovery Plans that I have discussed earlier, I think there is a good reason for not being too excited. All the efforts to bring the debt and deficit levels down and somewhere closer to what is allowed under the fiscal rules failed and the usual suspects, Greece, Italy, Portugal and Spain, etc. did show sharp increases in their debt levels, well beyond 60% of their GDPs (Fig. 8.2). There is no doubt that the German fiscal position was one of the strongest in the world when the crisis hit, I am deliberately not declaring it as the strongest in the world as Germany has no currency of its own and

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Fig. 8.2 General governments debts 2019 and 2020 (Source Eurostat)

therefore cannot flex its monetary muscles like its non-Eurozone counterparts. But still, the debt levels were the lowest in the world and the overall fiscal outlook was robust. This gave Germany a good amount of fiscal room to manoeuvre but given that the Pandemic has suppressed the sovereign bonds yield and on top of that ECB is generously buying the Eurozone debt and other assets, there is no clear risk to the German fiscal position anyway. In this case, a good strategy would be to not too much worry about pulling out the fiscal stimulus soon. We shall see, but I must make it plain as possible that a rush to Austerity 2.0. and obsession with fiscal rules is a luxury EU can’t afford!!

EU and European Commission’s Response As the crisis hit, on 13 March 2020, the Commission set out the European coordinated response to counter the economic impact of the Coronavirus (Fig. 8.3). It was decided that the main fiscal response to the Coronavirus will come from Member States’ national budgets as discussed in the previous section. In so doing, the member state can directly support the consumers and businesses, for instance, in aviation and tourism. The Commission considered the Pandemic as “unusual events outside the control of government ”. This was quite an interesting situation where it was deemed event out of the control of government and governments were expected to provide the fiscal response under the umbrella of the EU which has

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Fig. 8.3 EU coronavirus response (Source European Commission)

limited resources. A generous e1 billion was decided to be made available from the EU budget to guarantee the European Investment Fund to incentivise banks to provide liquidity to SMEs and midcaps. It was expected that this may lead to credit creation of about e8 billion which if even it does was a drop in the ocean. Some other measures were also decided to be proposed in the coming weeks. But as the crisis intensified it did not take more than a week for Commission to wake up to reality to some extent and change its stance. On 19 March 2020, under the State Aid rules, the Commission adopted a Temporary Framework to provide support to the member states by enabling them to counter the negative impact of the Pandemic on their economies.7 On the legal grounds, the State aid Temporary Framework was based on Article 107(3)(b) of the Treaty on the Functioning of the European Union which deal with policies to remedy a serious disturbance in the economy of a Member State.8

7 For “Communication from the Commission” Temporary Framework for State aid measures to support the economy in the current COVID-19 outbreak, visit https://ec. europa.eu/competition/state_aid/what_is_new/sa_covid19_temporary-framework.pdf. 8 For the Consolidated version of the Treaty on the Functioning of the European Union, visit https://eur-lex.europa.eu/legal-content/EN/ALL/?uri=CELEX%3A1 2008E107.

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Temporary Framework provided aid in the five forms i.e. direct grants, selective tax advantages and advance payments to companies to overcome liquidity issues, state guarantees for loans taken by companies from banks, subsidised public loans to companies, safeguards for banks that channel state aid to the real economy and short-term export credit insurance. But the question that is always crucial, who will pay for it? Considering the limited size of the EU budget and resources, it was decided that the main response or in simple words money will come from Member States’ national budgets. But then there are fiscal rules which do put a constraint on the spending by the member states. So, on 20 March 2020, at the Union level, the Commission proposed the activation of the escape clause of the Stability and Growth Pact (SGP). Commission’s initial strategy to counter the economic impact of the COVID-19 as of 20 March 2020 was to “use the full flexibility of fiscal and state-aid frameworks, mobilise the EU budget to allow the EIB Group to provide short-term liquidity to SMEs and directing e37 billion to the fight against coronavirus under the Coronavirus Response Investment Initiative”. Measures like temporary state aid rules and escape clause were more of regulatory changes not much of the actual hard economic stimulus by the EU or at the Union level. So, the EU leaders have agreed to a recovery package of e1.8 trillion that combines the long-term EU budget for 2021–2027 and the programme called Next-Generation-EU. It was declared by President von der Leyen that the focus of the Recovery Plan for Europe will be to have a greener, more digital and more resilient Europe. The Budget was agreed on 17 December 2020 and in line with the declared focus, a big proportion of the amount in the budget is allocated to research and development, technological advancement and environment (Table 8.1). NextGenerationEU which is a e750 billion instrument has been brought into action to repair the socio-economic damage to the Union due to the pandemic. Out of this, a total of e672.5 billion was to be used under the Recovery and Resilience Facility through the loans and grants to support reforms and investments undertaken by EU countries. A further e47.5 billion was under the Recovery Assistance for Cohesion and the Territories of Europe (REACT-EU), which included the Coronavirus Response Investment Initiative and the Coronavirus Response Investment Initiative Plus. The funds would have been made available through the European Regional Development Fund (ERDF), the European Social Fund (ESF) and the European Fund for Aid to the Most

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Table 8.1 Multiannual Financial Framework (MFF) 2021–2027 total allocations Heads

MFF

1. Single market, innovation and digital 2. Cohesion, resilience and values 3. Natural resources and environment 4. Migration and border management 5. Security and defence 6. Neighbourhood and the world 7. European public administration Total MFF

e132.8 e377.8 e356.4 e22.7 e13.2 e98.4 e73.1 e1074.3

NextGenerationEU e10.6 e721.9 e17.5 – – – – e750

Total e143.4 e1099.7 e373.9 e22.7 e13.2 e98.4 e73.1 e1824.3

All amounts in e billion, in constant 2018 prices. Sources European Commission, https://ec.europa. eu/info/strategy/recovery-plan-europe_en *The amounts include the targeted reinforcement of ten programmes for a total of e15 billion, compared to the agreement from 21 July 2020. The programmes are Horizon Europe, Erasmus+, EU4Health, Integrated Border Management Fund, Rights and Values, Creative Europe, InvestEU, European Border and Coast Guard Agency, Humanitarian Aid

Table 8.2 NextGenerationEU breakdown

Recovery and Resilience Facility (RRF) of which, loans of which, grants ReactEU Horizon Europe InvestEU Rural development Just Transition Funds (JTF) RescEU Total

e672.5 e360 e312.5 e47.5 e5 e5.6 e7.5 e10 e1.9 e750 billion

Source https://ec.europa.eu/info/strategy/recovery-plan-europe_en

Deprived (FEAD). The total e750 billion of NextGenerationEU could be broken down as follows (Table 8.2). There is no doubt that there has been a considerable lack of investment in the EU, particularly since the Global Financial Crisis including in Germany which I have discussed at length. Under the tight fist policy that was followed in the decade proceeding COVID-19, the government investment ratio in the euro area dropped from 3.7% of GDP in 2009 to 2.7% in 2018. So, there is no doubt that the Eurozone economies are very thirsty for a significant amount of long-term investment.

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Now the question is who will pay for it? Money for the EU longterm budget is to come from the customs duties, the Member States based on value-added tax (VAT) and based on gross national income (GNI). A new source of contribution from January 2021 is to be based on the non-recycled plastic packaging waste. It was also decided that the EU will also borrow to finance the budgetary needs for recovery. This required the ratification of the Own Resources Decision by the member states according to their constitutional requirements. The Own Resources Decision entailed modernising the Traditional Own Resources for the EU by allocating more to the EU out of customs duties and a basket of new Own Resources. This basket shall include (a) the Common Consolidated Corporate Tax Base where the financing of the EU budget is directly linked to the companies operating in the single market (b) share of the auctioning revenue of the European Emissions Trading System (c) national contribution calculated on the amount of non-recycled plastic packaging waste. We are yet to see the implications of these measures, particularly the corporate taxation bit. That may certainly give the EU budget a big raise, but that would also deprive the member states of their revenues. A step that is perhaps difficult but potentially crucial to implement in furthering the integration. But mere transferring the spending power from the member states to the EU will not change the overall size of fiscal spending. On 22 December 2020, the European Commission confirmed its intention to issue e62.9 billion worth of bonds. It included the SURE (Support to mitigate Unemployment Risks in an Emergency) instrument to support short-term employment schemes in the EU Member States,9 European Financial Stabilisation Mechanism (EFSM) to refinance debt (extend the maturity) of Ireland and Portugal amounting to e9.75 billion, as well as the Macro-Financial Assistance (MFA) for assisting non-EU countries. According to the Commissioner for Budget and Administration Johannes Hahn: Between mid-October and mid-November, the Commission raised nearly e40 billion under SURE, while in parallel taking forward the rest of

9 For details on “The European Instrument for Temporary Support to Mitigate Unemployment Risks in an Emergency (SURE)”, visit https://ec.europa.eu/info/bus iness-economy-euro/economic-and-fiscal-policy-coordination/financial-assistance-eu/fun ding-mechanisms-and-facilities/sure_en.

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our operations. Our debut as a high-volume issuer capable of ensuring favourable conditions and passing them on to our Member States has been a vote of confidence to the EU as an issuer and a borrower. This has made us confident for the near future, when we will be rising to the challenge of successfully completing the implementation of SURE and launching NextGenerationEU .

It is an interesting case in the history of debt issuance where the liability is passed on or under-written but at what premium? The EU is 0% riskweighted as an issuer (Basel-III). Though the EU’s borrowings are direct and unconditional obligations of the EU but guaranteed by the EU Member States through the EU budget, each Member State’s contribution to the overall amount of the guarantee corresponds to its relative share in the total gross national income (GNI) of the European Union, based on the 2020 EU budget. This means that the biggest contributor is Germany. Under the “Support to mitigate Unemployment Risks in an Emergency” (SURE) programme by the end of 2020, about e40 billion had been raised while in 2021 it could be up to e100 billion.10 As the name suggests, the SURE is designed to help member States through a loan on favourable terms in meeting the expenditures to preserve employment. The bonds are considered as social bonds (Fig. 8.4). On 27 January 2021, the fourth issuance of e14 billion bonds was made by the Commission, consisting of bonds amounting to e10 billion with maturity in June 2028 and e4 billion with maturity up to November 2050.11 The issuance was well received by the market with a negative yield of −0.497% on the 7-year bond. The 30-year bond also had a yield of 0.134% which is exceptionally low and a clear manifestation of appetite for safe assets, particularly during the times of the Pandemic. Bonds were over-subscribed by 11–13 times which meant many folds greater demand than supply. With this high demand, the bonds were rated as AAA, AAA, Aaa, AA, AAA by DBRS, Fitch, Moody’s, S&P and SCOPE. No doubt the underwriting by the strong Eurozone members including the fiscally robust states meant good rating and low cost of borrowing. Wouldn’t

10 For details on European Commission to issuance of bonds, visit https://ec.europa. eu/commission/presscorner/detail/en/IP_20_2501. 11 Details on European Union EUR 14.0 billion dual tranche bond issue available at https://ec.europa.eu/info/sites/info/files/about_the_european_commission/eu_ budget/sure_4th_dual_tranche_press_release_final.pdf.

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Fig. 8.4 Council approval of SURE for 18 EU states (Source European Commission)

it be better that these countries would have used their credibility to tap on savings in good times and invested them in infrastructure projects, particularly Germany? Anyway, the biggest investors in these issuances by country of origin were Germany and UK. In the earlier three issues in October and November 2020 a total of 15 EU states had already received e40 billion under SURE. By July 2021, the Council had approved a total of e94.3 billion in financial support to 19 Member States under SURE. The short-term impact of SURE and other supportive instruments could be seen in sustaining employment, but that is less of an issue. Pains of the Global Financial Crisis and European Sovereign Debt Crisis were chronic and led to a Lost Decade. As and when the Pandemic is over and economic activity is resumed, one of the major questions would be recovery and paying the bills when the economy was in the Intensive Care Unit. That is where the things have gone wrong in the past and I do fear if the Eurozone repeats the same mistake, it will get the same outcome, i.e. Lost Decade 2.0.

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Fig. 8.5 The European Green Deal (Source European Commission)

Green New Deal, Digital Agenda and Ambitions for Global Leadership To tackle climate change, the EU has also announced a European Green Deal which tends to achieve the target of net zero emissions of greenhouse gases by 2050, decoupling economic growth from natural resources and in so doing not leaving any part of the Union behind.12 The Commission has set out a Plan and released communication in December 2019,13 just when reports of COVID-19 were emerging from China. The Green Deal is declared as an integral part of the Commission’s strategy to implement the United Nation’s 2030 Agenda and the sustainable development goals (Fig. 8.5). While setting out the Green Deal plan it is also stated that the EU can use its influence, expertise and financial resources to mobilise its neighbours 12 For details on the “A European Green Deal ”, visit https://ec.europa.eu/info/str ategy/priorities-2019-2024/european-green-deal_en. 13 For “Communication on the European Green Deal”, visit https://eur-lex.eur opa.eu/legal-content/EN/TXT/?qid=1596443911913&uri=CELEX:52019DC0640#doc ument2.

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and partners to join it on a sustainable path. Furthermore, the roadmap also clearly indicates EU global leadership intention on climate and President Ursula von der Leyen ambition to be the first carbon–neutral continent in the world. There is nothing wrong with being ambitious, but the realities do not change by ambition per see. I very much doubt that an Economic and Political Union which has been in a mess for over a decade is in a position to provide the rest of the world with any sort of leadership. There are also occasions when we have a tradeoff between economic, social and environmental objectives and there was an acknowledgement of these “potential trade-offs” in the Green Deal Plan. However, it was suggested that careful attention will be paid to them. There was no clear indication of what it means by careful attention. What followed was the intention that “the Green Deal will make consistent use of all policy levers: regulation and standardisation, investment and innovation, national reforms, dialogue with social partners and international cooperation”. Again, nice words! But actions speak louder, and they are yet to speak! It was mentioned in the Plan that Commission will propose the first European “Climate Law” by March 2020. It did that in March 2020. The proposal was however amended in September 2020 with the inclusion of an EU emissions reduction target of at least 55% as compared to 1990 by the year 2030. So, in simple words, by 2030 the emissions should be at least 55% lower than their 1990 levels. The issue as acknowledged in the Green Deal Plan is that between 1990 and 2018, the greenhouse gas emissions were only reduced by 23% and at the current rate and regulatory framework, it was expected at the time of the Green Deal Plan that they will be reduced by 60% by 2050. But with new ambitions to reduce by 55% by 2030 means having an extra 32% reduction which is a very difficult task. In the Green Deal Plan, the Commission has claimed and given the credit of a 23% reduction in the emission between 1990 and 2018 to the EU. The fact of the matter is that there is no evidence that this reduction is the sole success due to Commission or EU efforts. Anyway, we can let the EU claim the credit. Strategy to reduce the emission entails EU-Emissions Trading System and its extension, land use and forestry policy and Energy Taxation Directive. Measures may lead to carbon leakage where the EU products are replaced by imports which are more carbon-intensive. To tackle this issue carbon border adjustment mechanism can be proposed and implemented but their implementation at the global scale is an enormous challenge and in the current climate this might be interpreted as protectionism by the EU. Production and energy

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usage accounts for about 75% of the EU emission, this may require transition to renewable energy but that does not mean zero emission. The so-called renewable sources of energy such as solar and wind that needs panels and turbines require a lot of emissions in the manufacturing of the required tools. Furthermore, price and competitiveness are also vital issues that need to be addressed to make renewable energy more affordable. This then implies the Energy Union which was an idea of the Juncker Commission. Since the announcement of the energy union strategy in February 2015, regulations have been frequently issued with the goal of facilitating the achievement of environmental targets. Extraction of natural resources and materials globally has more than tripled since the 1970s which also contributes to greenhouse gases emissions, biodiversity loss and water stress. Recycling is still only a fraction of the total material used. Energy-intensive sectors such as construction, steel, chemicals and cement are indispensable for the EU economy and the usage of plastic and microplastics and replacement with biodegradable and bio-based plastics are big challenges. Applicability and practice of the right to repair for the circular economy are also necessary. Buildings also account for significant energy consumption, but the annual renovation rate of the building stock is too low, and a big number of houses are not energy efficient. This will require not only the legislation, which is often easily administrated by the EU, but the problem is who will pay for it. A shift to sustainable and smart mobility is also required and desirable to achieve the emission targets. To achieve all this and meet the emission targets, according to the Commission’s estimates an additional annual investment of e260 billion i.e. 1.5% of 2008 GDP is required. EU budget and “Own Resource” are raised through the instruments I discussed earlier, including the plastic-waste and auctioning of EU Emissions Trading System to the EU budget. But still, it is a huge sum and seemingly the contributions will have to come from the strongest partners. In January 2020, European Green Deal Investment Plan and the Just Transition Mechanism were presented by the Commission. It is expected that the InvestEU could bring e1 trillion in investments. The notion is that the InvestEU will mobilise public and private investment through the EU budget guarantee of e75 billion that will back the investment projects of implementing partners such as the European Investment Bank (EIB) Group and others and increase their risk-bearing capacity. The expectation that a e75 billion guarantee will lead to e1 trillion of investment is a bit

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farfetched and it is not the first time such expectations are formulated. Juncker Plan was just another good example of such an occurrence. The Just Transition Mechanism is expected to provide financial support e100 billion which is intended to entail a Just Transition Fund with e7.5 billion from the EU budget and the member states will match Euro for Euro. In conjunction with European Regional Development Fund and the European Social Fund Plus, it is expected to yield up to e30 and e50 billion of funding which again is a bit of optimism. The Just Transition Mechanism just transition scheme under InvestEU to mobilise up to e45 billion of investments from the private sector and public sector loan facility with the European Investment Bank backed by the EU budget to mobilise between e25 and e30 billion of investments. Numbers are vague, and it all seems like a pie in the sky. EU has intended to be the “global leader” in climate change efforts and commitments to the Paris Agreement that requires limiting the CO2 emissions in a way the global temperature can be kept below 2% of its preindustrial level. But the global leadership on climate will require a great amount of effort and leading from the front. The prospect that happens is not possible with a stagnating economy, Lost Decades and intra-union economic and political tensions. I don’t do betting for ethical reasons but if it had been so, I would have never put my money on EU’s Global leadership, whatever that meant!

A Europe Without UK If Europe and more specifically the EU is to provide leadership to the world as the EU leaders and particularly the Commission wishes to, if it ever happens in the future, though there is no good reason to expect that, it got to be without the UK. After a marriage of 47 years that started in January 1973 with the membership of European Communities, the reluctant bride of EU as on several occasions my European friends have called it, UK left the EU on 31 January 2020. There was a transition period till the end of 2020 which was mostly occupied and overshadowed by the outbreak of the Pandemic. The UK was not among the founding members of the EU as it was neither a member of the European Coal and Steel Community (1952) nor a signatory of the Treaty of Rome (1957) that led to the establishment of the European Economic Community (EEC). So, from day one, the UK’s relationship with the EU was not at par with its major European counterparts and there are several reasons

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for that including the UK’s unique historic, economic and political stature and role in WWI & WWII. In fact, the rejection of the UK’s membership application and veto by the French President Charles de Gaulle in 1963 and 1967 was a manifestation of this difference. The peace arguments and war threats used to justify the European project post-WWII are not equally applicable to the UK as its European counterparts. The UK relationship with the EU as a member lasted just a little less than half a century and, in that period, the world in general and the EU, in particular, has very significantly evolved. Through this period the integration went on and on which I have already discussed at length in the earlier parts of this treatise! Maastricht and Lisbon Treaties were major milestones. The UK did keep out from the Currency Union and Schengen Agreement, which implied it retaining some control on its money and borders. It must not be forgotten that the June 1975’s UK European Communities membership referendum was a referendum on the continuity of membership, not the membership per see as the UK had already joined the EEC about two and half years ago. At that point, the majority of British people voted in favour of continuity of membership but since then there was no further referendum despite the deeper and deeper integration of the EU, and it becoming an “ever-closer union”. Those who voted to remain in the European Communities and even still chose to stay in the EU in the 2016 Referendum cannot deny the fact that this was not the Union they signed up for in 1975. Public apatite makes politicians do things they might have not done otherwise, in the 2014 European Parliament elections, the Eurosceptic UK Independence Party (UKIP) secured more votes and more seats than any other party leaving the ruling Conservative Party at the 3 position as the 2nd position was taken by the main opposition Labour Party. This was a big political shock and a clear message to the British Prime Minister David Cameron who was going to face a general election very soon. Hence, after some negotiations and gaining some small concessions from the EU on social benefits to the new immigrants, etc. Mr. Cameron decided to play another gamble. He had already successfully campaigned in the 2014 Scottish Independence Referendum in which the majority of Scotts had chosen to remain in the UK. So eventually, this successful venture was followed by the second referendum on the continuity of the UK’s European Union membership, once again in the month of June, but 2016. This time the results were different as the majority of the British public voted to leave the EU. First casualty of the Referendum was British

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Prime Minister Mr. David Cameron as he had companied to remain in the EU. His successor Mrs. Theresa May who was also in favour of staying in the EU at the time of the Referendum but declared to lead the country out of EU Post-Referendum also lost her Premiership after her deal with the EU post-Brexit suffered multiple defeats in the House of Commons. It was feared that the UK may face the catastrophic impact of Brexit and the Brexit Referendum, but with hindsight, we can see that it was not the case. All the forecasts were wrong! The stock market lost some points but gained whatever is lost in the next few days and thereafter surged. As an immediate effect of the Brexit Referendum in June 2016, there was a sharp depreciation of the Pound Sterling (£) which actually helped to bring back the inflation to the Bank of England’s target and some improvement in the trade balance. The long-term impact, nobody knows and there is no measure to gauge or compare as counterfactual does not exist! In March 2017, UK trigged Article 50 of the Treaty on European Union which governs the withdrawal process of any member state leaving the EU. In December 2018, the European Court of Justice (ECJ) did rule that the UK can revive its marriage woes and revoke its notification for triggering Article 50 if it chose to do so. But this was something no UK government could have done as it would have been utterly nondemocratic. The UK had been asked to pay the Brexit financial settlement or divorce bill which were the UK’s obligations to the EU during its membership. Estimates varied due to the changes in the timings of withdrawal, but the estimates by the UK Office for Budget Responsibility (OBR) were about £32.9 billion. I will not go into the details and drama of the Brexit negotiations and various versions of Mrs. May’s deal as it is beyond scope of this treatise, but into the fourth year since the referendum, the British public had enough of the Brexit palava, so they gave a majority to the Conservative Party candidate Mr. Boris Johnson who companied to take UK out of EU without any further referendums. With the decisive victory, Mr. Johnson took the UK out of the EU on 31 January 2020 with a transition period that was to follow and ended in December 2020. A deal was agreed which was ratified by both the UK and EU (Fig. 8.6). Both the Brexit and the Brexit Deal that mainly included the Trade and Cooperation Agreement, along with an Agreement on Nuclear Cooperation and an Agreement on Security Procedures for Exchanging and Protecting Classified Information, were overshadowed by the Pandemic.

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Fig. 8.6 Brexit: what the European Union loses (Source Statista)

The impact of the Brexit and Brexit Deal would be impossible to gauge with full precision as there is no counterfactual world that exists. Nonetheless, the Post-Pandemic world seems to be very different from the projections in the Pre-Pandemic period. Once the health crisis is over the new challenges would be the restoration of economic activity and economic recovery. The performance of the EU in dealing with the Global Financial Crisis and European Sovereign Debt Crisis was not exceptionally great. Here the impact is even greater and the secondlargest economy of the EU which is also a global financial centre and is still a fairly significant player in global politics has left the club. Losing a member like the UK means a significant loss in terms of population, GDP and budgetary contributions. This is bound to have implications and their severity depends on the future economic as well as political relations between the UK and EU. The Trade and Cooperation Agreement (TCA) does not imply 100% frictionless trade in goods and services. Although there will be no duties and quotas on goods there would be still some non-tariff barriers and processes. Furthermore, rules of origin mean not all goods will qualify for tariff-free trade. Trade in the Services in which

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the UK had a surplus with the EU has minimal provisions in the TCA which means there will be greater barriers to it. Time will tell but the start of the new arrangements between the UK and EU was a bit patchy. We shall not forget that the starting point of the Trade and Cooperation Agreement (TCA) is the ending point of EU membership. Putting it differently the Trade and Cooperation Agreement (TCA) is a post-divorce settlement not a progression in the relationship. It is a downgrade in the EU-UK relationship and this downgrade was not confirmed until the eleventh hour and the possibility of a No Deal Brexit . This means an obvious lack of trust and political tensions in the run-up to the Trade and Cooperation Agreement where both parties wanted to ensure the availability of a safety mechanism in the deal. There had been diplomatic rows between the UK and EU over the status of the EU’s mission in London and the fishing dispute with France. But more than that the European Commission decided to trigger Article 16 of the Northern Ireland Protocol14 which allows both parties to take unilateral action if the protocol leads to the “serious economic, societal or environmental difficulties that are liable to persist, or to diversion of trade”. Realising the severity and political implications of divergence from the Northern Ireland Protocol the decision was reversed later. But this did expose the volatility of the relations between the EU and UK. It will therefore require a lot of trust-building and strong lines of communication between the UK and EU to have a better economic and political future. That will take the downgraded relationship further, may or may not be the full membership of the EU but something which can be seen as a close economic and political partnership. Such a relationship is of utmost importance, particularly when there are new hubs of global economic and political powers are emerging.

Rising Asia, New Trade and Cold Wars The twenty-first century is named to be the Asian century! Although a law-abiding proud British citizen, still I am ethnically an Asian, so one may argue that it might be my biased view or wishful thinking to say that. But it’s not mere my vague assertion, different projections suggest 14 For details on “Protocol on Ireland and Northern Ireland”, visit https://assets.pub lishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/840 230/Revised_Protocol_to_the_Withdrawal_Agreement.pdf.

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Fig. 8.7 Changing share of world GDP (PPP) from 2016 to 2050 (Source IMF estimates for 2016 and PWC projections for 2050)

that by 2050 China and India would be holding the first and second positions globally in terms of size of their economies i.e. GDP whereas the USA will have to settle for the 3rd position. The Pre-Covid PWC’s projections suggest that the share of the EU-27 (i.e. excluding the UK) GDP will shrink from 15% in 2016 to 9% of global GDP by the year 205015 (Fig. 8.7). The USA is also expected to have a smaller share of the pie while on the contrary, India is expected to have its share increased from 7 to 15% in global GDP and while with 2% further increase, China was projected to increase to 20%. I can’t recall who said this but sounds right to some extent that “In twenty-first century the level of nation’s dignity and respect

15 “The World in 2050 the Long View: How Will the Global Economic Order Change by 2050?”, visit https://www.pwc.com/world2050.

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is based on GDP ”. If that is so and the proportion of respect or significance a nation gains is proportionate to its share in the world GDP, then there is no doubt that the EU and USA share is bound to shrink. The Germany and UK may or may not be able to hold a position among the top 10 economies, and if they can, they may have to settle for the 9th and 10th positions, respectively, according to the same PWC’s forecast, though that has become even less promising after the Pandemic. But before we blame COVID-19 for doing any damage to the European economies, there must be an acknowledgement of the fact that they were not doing great to start with. While on the contrary, the growth in the emerging economies had been going through the roof (Fig. 8.8). The pandemic came as the worst shock to economies in centuries. Cease of the economic activities in the developed countries, particularly China

230

210

India 190

2008 = 100

170

Turkey

150

130

United States Canada United Kingdom France Euro area Japan Portugal Italy

110

90

Greece 70 2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

Fig. 8.8 Real GDP growth Eurozone and emerging world (constant 2010 US$, Year 2010 = 100) (Source Authors’ calculations using data from World Bank)

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in Europe is unprecedented and nowhere in developing countries, it is as strict. Damage done by the Pandemic both in the form of loss of human life and economy is far greater in the developed economies of the EU than anywhere else in the world. This is also depicted in the comparison of the economic outlook at the end of 2020 (Fig. 8.9). At the end of 2020, the Chinese economy had recovered all its losses and rather showed a net growth, however, all other economies showed a significant contraction. Significant contraction in the economies of Greece, Spain, UK, Italy and Portugal implied that these economies were hit very hard. History tells us that the recessions are sharp and deep, and the recoveries are relatively slow and erratic. It takes ages to recover the economic losses and regain the pre-crisis levels of GDP. In the Euro Zone, the situation has been worst after the Global Financial Crisis and Sovereign Debt Crisis, so, on the path to recovery the record of EMU is not great. The second and thirds waves and multiple rounds of restrictions have also constrained the socio-economic activities in 2021. Therefore, one shall not have too high expectations about the Eurozone coming out of recession at an escape velocity.

Fig. 8.9 2020 a year of uneven economic losses total, percentage change, same period previous year, Q4 2020 (Q3 for Greece) (Source OECD)

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Can Europe Be a Good Example? Closing Remarks An obvious question, with its rich history and being one of the oldest civilisations, can Europe be a good example for the rest of the world? The answer depends on whom you are asking and what do you mean by being an example. In terms of peace and reconciliation through regional integration, there have been no major wars in Europe since WWII. After the fall of the USSR and the Berlin Wall, indeed there has been political harmony and relative tranquillity in this region. On that aspect, there is no doubt that Europe has made significant progress and other regions of the world can look up to Europe and learn from the European mistakes and the idea of peaceful co-existence. But in socio-economic terms can Europe and specifically EMU also be an example? Is the loss of economic growth and dynamism the price Europe is paying for peace through European integration? I think we shall not be seeing it through that angle. Peace is economically beneficial and there are peace dividends. One may also argue that we may still have a Europe without European Union and there might be no wars even without the European economic and political integration as the other parts of the world, for instance, Canada, USA and Mexico did not have any wars in the recent years. But the counterfactual does not exist. How much inefficient the EU is and how much drag it puts on the economic growth through its structurally flawed and incomplete institutional structure is debatable, there are no two views on the fact that it does provides a forum for Europeans to talk to each other and reach a consensus on the matters of mutual importance. Therefore, the significance of this forum and its strength brings the countries together. Given that the world is changing fast, and the relative size of the EU-27 will shrink in the global economy, it’s only that coming together these countries can have more economic and political weight. But for that, the integration itself cannot be based on the Multi-speed Europe. Alliances within the Eurozone are the fault lines and forces that pull in opposite directions. Whether it is the NB6 (Nordic-Baltic 6), Hanseatic League, or its newish version Hanseatic League 2.0 that is also nicknamed “Gang of Eight ” or “Netherlands and the Seven Dwarves ”, these are signs of divisions. The longer the project goes on, there will be more integration fatigue which will cause political tensions, put a drag on the economic growth and hence on the project itself. Evidence and the studies clearly suggest that the areas of the union where the unemployment is high

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and economic performance has been poor show a high level of discontent and the Anti-Europeanism sentiment is quite high there.16 This has particularly been the case in the decade succeeding the Global Financial Crisis and European Sovereign Debt Crisis which led to a lost decade for Europe, not to forget that the rest of the world kept moving on. So, in a competitive world, if the EU wants to be externally strong it got to be strong internally first and play on its strengths. Hence, if the core is strong, let the core take the lead. With the freedom of movement of people, there shall be no issue if there are adjustments being made at the regional levels to increase the competitiveness. For these adjustments, if the creditor nations like Germany can be let having a bit more say in the European affairs, that would be just fair. In any enterprise, the voting rights are based on your stake or capital, so the voting rights in the Governing Council of the ECB should be based on the same principle of fairness. But to be at par and learn from the successful Economic and Monetary Unions like the UK and the USA, there is no good reason to not follow their monetary and economic institutional structures which obviously means thinking beyond nationalism and national boundaries. Just throwing some money on the problem has not and will not solve the deep-rooted structural problems but will simply fuel the fire by increasing the prices in the prices of everything creating bubbles and making governments and residence live beyond their means. Underlying reforms are needed but simply passing some directives and regulations is not ample. We seldom hear anything about the current-account deficit of US states against the rest of the world or among each other like California and Florida or Texas against Massachusetts. So why do we keep hearing about Greek, Spanish or Italian current-account deficit? That is a clear sign of us not being there despite over 70 years of integration. The EU response to the economic and financial crisis in the form of the European Semester that led to the legislative packages including the SixPack and Two-Pack did not do much on the ground. Facts and statistics on the economic performance of the Eurozone proceeding the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG) that came into force in Jan 2013 are prima facie evidence that it did not work out well. The focus has been on the imbalances and imbalances adjustment procedures and the debate has been focused more

16 Dijkstra et al. (2018).

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on the nation with deficits and less on nations with the surplus and even lesser on the net balance at the Union level. Furthermore, the debate has also been focused on the deficits of the Eurozone members viz-a-viz rest of the world which included the other Eurozone members. Though, it is vital that imbalances of Eurozone members against each other are a Eurozone’s internal affair, similar to the imbalances between the different parts of the USA and UK, the focus that remained on the competitiveness through fiscal stability provided little stability and next to nothing growth. Eurozone’s growth scorecard between the Global Financial Crisis and the outbreak of Pandemic is a bleak picture. European Semester 2021 is an exceptional one and it is called “an exception cycle” with emphasis on the coordination with the Recovery and Resilience Facility and the European Green Deal. There are no structural country-specific recommendations for 2021 but for how long. The question of who will pay for it remains and if the preferred answer is “we” instead of “they” then the EU will have to follow the examples of the Asian families where the person with the more responsibility holds more authority. The share of the EU budget as a proportion to its national income is not comparable to the other Economic and Political Unions like the USA and UK. I must say that the countries which are larger than the EU in size like China and India have many regional differences at cultural, religious, political and economic levels. But besides that, we do not hear much about the intra-country or intra-state economic tensions of this sort, though they do persist. Proposals such as Eurobond that shall include the mix of traditional national bonds (red bonds) and jointly issued Eurobonds (blue bonds) will not be the permanent, long-term and solution either. Different forms of Eurobonds, e.g. Full Eurobonds with joint liability which can replace the national issuance, and the Partial Eurobonds with joint liability that can have partial issuance by the Eurozone nations and the Partial Eurobonds without joint guarantees are not straightforward solutions. While the Pandemic could not scare the fiscally conservative nations into buying the idea of Eurobonds the Multiannual Financial Framework (MFF) at least provided some sort of framework with the long-term EU budgetary aspect in context. But that is again limited in its scope and size and not a long-term solution. While he was the President of the European Commission, delivering the Jean Monnet Lecture in Florence, Mr. Roy Jenkins argued that going further and having more integration and achieving the Economic and

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Monetary Union, it will take about 5–7% of GNP to perform the functions required to be performed at the Union level.17,18 The date was 1977 and the level of integration was nowhere closer to where we are now. But what is the size of the EU budget? And how much of the activities are at the Union level? Though the bureaucratic structure in the form of EU institutions and regulatory frameworks have been imposed on the member states that bring them together in some form is this bureaucratic structure a chain with which all the countries are tied together? I leave this question for my readers. But I do think looking at the matrix of results and facts on the grounds the criteria set out by the European Commission that the “Europe will above all be judged on results ”, I am afraid they are not very impressive so far. The COVID-19 has brought more challenges to the EU than any other region in the world. To tackle these challenges European leaders will have to be brave and do things differently this time. But besides all my optimism, unimpressive track record on recovery, vulnerabilities and limitations of policy space including central banks running out of ammunition, the inherent weakness of Eurozone economies at the time of the pandemic’s outbreak and obsession with fiscal rules, there are real fears of Europe’s Lost Decade 2.0. Concomitantly, my expectations are unfortunately not very high. But we shall see!

17 For the Address given by Roy Jenkins on the creation of a European monetary union (Florence, 27 October 1977), visit https://www.cvce.eu/obj/address_given_by_roy_jen kins_on_the_creation_of_a_european_monetary_union_florence_27_october_1977-en-98b ef841-9d8a-4f84-b3a8-719abb63fd62.html. 18 Campbell, J. (2014).

Appendix “A”

Euro Area NCBs’ Contributions to the ECB’s Capital National Central Banks

Capital key %

Adjusted Capital Key %

Paid-up capital (e)

Nationale Bank van België/Banque Nationale de Belgique (Belgium) Deutsche Bundesbank (Germany) Eesti Pank (Estonia) Central Bank of Ireland (Ireland) Bank of Greece (Greece) Banco de España (Spain) Banque de France (France) Banca d’Italia (Italy) Central Bank of Cyprus (Cyprus) Latvijas Banka (Latvia) Lietuvos bankas (Lithuania)

2.48

3.52

268,222,025.17

18.00

25.57

1,948,208,997.34

0.19 1.16

0.27 1.65

20,870,613.63 125,645,857.06

2.03

2.89

220,094,043.74

8.84

12.56

957,028,050.02

14.18

20.14

1,534,899,402.41

12.31 0.15

17.49 0.21

1,332,644,970.33 16,378,235.70

0.28 0.41

0.40 0.59

30,537,344.94 44,728,929.21 (continued)

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6

297

298

APPENDIX “A”

(continued) National Central Banks

Capital key %

Adjusted Capital Key %

Paid-up capital (e)

Banque centrale du Luxembourg (Luxembourg) Central Bank of Malta (Malta) De Nederlandsche Bank (The Netherlands) Oesterreichische Nationalbank (Austria) Banco de Portugal (Portugal) Banka Slovenije (Slovenia) Národná banka Slovenska (Slovakia) Suomen Pankki—Finlands Bank (Finland) Total

0.20

0.29

21,974,764.35

0.06

0.09

7,014,604.58

4.00

5.69

433,379,158.03

1.96

2.79

212,505,713.78

1.74

2.48

188,723,173.25

0.35

0.49

37,400,399.43

0.77

1.10

83,623,179.61

1.26

1.78

136,005,388.82

70.39

100.00

7,619,884,851.40

1) Owing to rounding, the total may not correspond to the sum of all figures shown. Source (ECB)

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Index

A AAA, 70, 72, 102–104, 150, 151, 280 Additional Credit Claims (ACC), 72, 78 All Saints’ Day manifesto for European Monetary Union, 14 Article 50 of the Treaty on European Union, 287 Asset-Backed Securities Purchase Programme (ABSPP), 96, 100 Asset Purchase Programme (APP), 96, 213, 271 Austerity, 91, 124, 143, 145, 159, 275 B Bank for International Settlements (BIS), 8, 10, 14, 19 Banking Union, 169, 172–174, 178–181, 191, 192 Banque de France, 73, 78, 112, 229, 297 BASEL-III, 168, 186

BBB, 70–72, 103, 104, 112–114 Berlin Declaration, 53 Berlin Wall, 5, 19, 21, 293 Brexit, 35, 84, 144, 145, 165, 182, 287–289 Buiter, Willem H., 71 Bundesbank, 16, 80, 98, 100, 112, 163, 229, 231, 234, 236–238, 241, 242, 261, 297 Bundestag Federal Republic of Germany (FRG), 21 C Cameron, David, 286 Capital Key, 39, 271, 297, 298 The Capital Market Union (CMU), 182 Capital requirements directive (CRD IV), 166 China, 21, 38, 130, 246, 253, 282, 290, 295 Christian Democratic Union (CDU), 132 Churchill, Winston, 4, 22, 265

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2022 M. A. Nasir, Off the Target, https://doi.org/10.1007/978-3-030-88185-6

311

312

INDEX

Collateral framework, 69 Collateral Requirements, 68 Common Agriculture Policy (CAP), 13 Common Assembly, 10 Common Consolidated Corporate Tax Base (CCCTB), 184 Competitiveness, 35, 43, 57–59, 62, 125, 128, 132, 142, 151, 155, 182, 191, 204, 208, 218, 237, 244, 255, 284, 294, 295 Convergence criteria, 32, 34, 35, 38, 40, 58, 60 Corporate Sector Purchase Programme (CSPP), 96, 112, 272 counterparties, 80, 81, 88, 167 Covered bond purchase programme (CBPP3), 96 COVID-19, 23, 67, 96, 144, 185, 195, 203, 207, 214–218, 220, 223, 224, 231, 234, 240, 244, 253, 268, 269, 276–278, 282, 291, 296

D Debt Break, 199, 272 Delors Committee, 19, 204 d’Estaing, Valéry Giscard, 54 Deutsche Mark, 16, 86 Draghi, Mario, 83, 119, 188, 190

E Economic and Financial Affairs Council (ECOFIN), 23, 57 Economic and Monetary Union (EMU), 19, 20, 25, 29, 268 Economic and Monetary Union of the European Union (EMU), 1, 57, 228

Emergency Liquidity Assistance (ELA), 78, 235 EONIA, 120 EURIBOR, 120 Eurogroup, 57, 152, 160, 188, 190, 193, 194, 196, 197 Europa, 4, 15, 38, 39, 48 European Atomic Energy Community, 12, 13 European Bank for Reconstruction and Development (EBRD), 22, 127 European Banking Authority (EBA), 165, 169, 172, 174 European Central Bank (ECB), 24, 30, 78, 82, 225, 228, 268 European Citizenship, 28, 33 European Coal and Steel Community (ECSC), 10, 13, 51 European Commission, 10, 17, 18, 26, 27, 32–34, 53, 57, 85, 123, 127, 134, 138, 147, 149, 151, 152, 154, 156, 166, 168, 170, 173, 178, 182, 185, 190, 194, 195, 201, 202, 205, 211, 247, 248, 251, 269, 274–276, 278–282, 289, 295 European Council, 18, 23, 25, 27, 32, 34, 50, 51, 53, 55, 56, 123, 165, 171, 183, 188, 190, 195, 196, 198 European Court of Justice, 10, 154, 164, 287 European Currency Unit (ECU), 16, 39, 177 European Deposit Insurance Scheme (EDIS), 176, 177, 191 European Economic Community (EEC), 12, 14, 17, 23, 285 European Economic Recovery Plan, 123, 124, 130

INDEX

European Financial Stabilisation Mechanism (EFSM), 147, 279 European Financial Stability Facility, 101, 147, 149, 199, 237 European Fiscal Board, 192, 194, 204–206 European Fiscal Compact, 154, 202 European Insurance and Occupational Pensions Authority (EIOPA), 165, 167, 169 European Investment Bank (EIB), 33, 80, 124, 127, 129, 194, 284 European Monetary Agreement (EMA), 10 European Monetary Cooperation Fund (EMCF), 14, 16, 31 European Monetary Institute (EMI), 20, 30, 31, 228 European Monetary System (EMS), 16, 26 European Parliament, 2, 10, 13, 26, 27, 33, 47–53, 55, 130, 149, 154, 171, 172, 177, 184, 190, 192–194, 196, 207, 286 European Payment Union (EPU), 7 European Recovery Plan, 126, 130, 133, 148 European Recovery Program, 6 European Securities and Markets Authority (ESMA), 165, 167, 169, 187 European Social Fund (ESF), 125, 128, 277 European Sovereign Debt Crisis, 23, 42, 65, 73, 145, 164, 184, 191, 199, 211, 214, 226, 234, 252, 268, 281, 288, 294 European Stability Mechanism (ESM), 101, 153, 164, 188, 191, 193, 201, 237 European Systemic Risk Board (ESRB), 165, 167, 168, 180

313

European System of Central Banks (ESCB), 24, 30, 32, 228, 268 European System of Financial Supervision (ESFS), 164, 165, 168, 180 Excessive Deficit Procedure (EDP), 203 Exchange Rate Mechanism (ERM), 37, 42 F Federalists approach, 5 Federal Republic of Germany, 6, 10, 21, 22, 27 Fiscal rules, 196, 272 Fiscal Stability Treaty, 200, 203 Fiscal Union, 191–194, 198, 202, 204, 207 Five Presidents Plan, 190, 191 Forward Guidance, 119, 120, 225 G German Democratic Republic (GDR), 21 German–Polish Border Treaty, 22 German Unification, 20, 21 GIIPS, 40, 244, 245, 262, 264 Global Financial Crisis, 23, 31, 42, 47, 59, 65, 67, 86, 88, 90, 109, 117, 118, 123, 126, 134, 139, 142, 144, 145, 148, 151, 155, 164, 170, 173, 174, 176, 177, 180, 184, 191, 197, 199, 211–218, 224, 226, 231, 237, 240, 244, 247, 250, 253, 268, 278, 281, 288, 292, 294, 295 Gorbachev, 19 Governing Council, 50, 68, 78, 79, 82, 88, 90, 91, 93–95, 97, 98, 100, 102, 105, 106, 112, 119, 164, 171, 235, 265, 270, 294

314

INDEX

Great Moderation, 47, 63 Green New Deal, 282

H Hanseatic League, 293 High Authority, 10, 11, 13 Hugo, Victor, 2

I India, 2, 130, 290, 295 Intergovernmental Conference (IGC), 23, 24, 47 International Clearing Union (ICU), 256

J Jean-Claude Trichet, 86 Jenkins, Roy, 295, 296 Junker, Jean-Claude, 24 Junker Plan, 194

K Kant, Immanuel, 2 Keynes, John Maynard, 70 Kohl, Helmut, 25, 27

L Large-Scale Asset Purchase (LSAP), 87 League of Christian Nations, 1 League of Nations, 4 Lehman Brothers, 66, 109 Lender of Last Resort, 68, 76, 224 Lisbon Strategy, 126–128 Long-Term Refinancing Operations (LTRO), 67, 82 Lost Decade, 211, 221, 222, 253, 264, 281, 296

Luxembourg Compromise, 12

M Maastricht Treaty, 23, 26, 29, 31, 33–35, 41, 47, 52, 54, 89, 91, 182, 228, 267, 268 Main Refinancing Operations (MRO), 67, 82, 93, 271 Markets in Financial Instruments Directive (MiFID), 187 Marshall Plan, 6, 9 Mill, John Stuart, 3 Morgenthau, Henry Jr., 5 Multiannual Financial Framework (MFF), 196, 278

N National Central Banks (NCBs), 24, 78, 88 NATO, 22 Negative Interest Rates, 117 New Strategy of ECB, 241 NextGenerationEU, 277, 278, 280 Nordic-Baltic 6, 293

O Office for Budget Responsibility (OBR), 287 Organisation for Economic Co-operation and Development (OECD), 7 Organisation for European Economic Co-operation (OEEC), 7 Outright Monetary Transactions (OMT), 163 Own Resource, 284

P Paris Agreement, 252, 285

INDEX

Penelope Project, 52 Penn, William, 2, 38 Potsdam Agreement, 6, 21 Primary market purchases, 155, 156 Public Sector Purchase Programme (PSPP), 96, 98 Purchasing power parities (PPPs), 42

315

Solidaritätszuschlag, 20 Sovereign Bond-Backed Securities (SBBS), 180 Stabil Wie Die Mark, 85, 86 Support to mitigate Unemployment Risks in an Emergency (SURE), 196, 279

Q Quantitative Easing (Q.E.), 87

R Refinancing Operations, 67, 80–82, 91, 96, 102, 119, 225 Riksbank, 116, 117 Ruhr region, 6

S Schäuble, Wolfgang, 273 Schuldenbremse (Debt Brake), 254, 264, 273 Schuman Declaration, 10, 267 Schwarze Null , 273 Secondary market purchases, 155, 156 Secular Stagnation, 251, 253, 256, 261 Securities Markets Programme (SMF), 100 Settlement Mechanism, 257 Single European Act (SEA), 18 Single Resolution Fund (SRF), 175, 191, 192 Single Resolution Mechanism (SRM), 173 Single Supervisory Mechanism (SSM), 160, 169, 188 Sinn, Gerlinde, 207, 208 Sinn, Hans-Werner, 43, 65, 208, 231, 234, 237, 238, 242, 257 Six-Pack, 188, 189, 199

T Targeted Longer-Term Refinancing Operations (TLTROs), 67, 102 Thygesen, Niels, 14, 19, 204 Trade and Cooperation Agreement (TCA), 288, 289 Trans-European Automated Real-time Gross Settlement Express Transfer System (TARGET2), 228 Treaty Establishing a Constitution for Europe, 51, 53 Treaty of Lisbon, 28, 53–55, 57 Treaty of Nice, 47–50, 54 Treaty of Paris, 10 Treaty of Rome, 12, 23, 47, 52–54, 182, 285 Treaty of the Functioning of the European Union (TFEU), 78 Treaty of Versailles, 4 Treaty on European Union (TEU), 29 Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG), 200, 203, 294 Treaty on the Final Settlement with Respect to Germany, 21 Trichet, Jean-Claude, 65, 85, 86, 90, 198 Two-Pack, 188, 189, 200

316

INDEX

U United States of Europe, 2, 4, 5, 38, 150 V Victor Hugo, 3 W Werner Plan, 15

Werner Report, 13, 14 Whatever it Takes, 80, 83 World Bank, 162, 213 WWI, 3, 286 WWII, 3–5, 7, 21, 22, 133, 176, 269, 286, 293

Z Zero Lower Bound, 117